The Fed: Masters of Illusion, Part 2
In last week’s update, The Fed: Masters of Illusion, we learned the Fed has used policy tools to create the illusion of economic prosperity. They did this in an attempt to rescue the economy from the Great Financial Crisis of 2008-09 which was arguably caused by the Fed’s easy-money policies, following the bursting of the dot-com bubble, in the first place.
To orchestrate their grand plan, the Fed needed to create the illusion of prosperity and asset inflation without printing money, which they were able to successfully accomplish after several rounds of Quantitative Easing and by lowering interest rates.
In magician-speak, the second phase of an illusion is the “turn” where the magician takes the ordinary and makes it extraordinary. The Fed’s “turn” was when they pushed asset prices and long-term interest rates higher through their Quantitative Easing programs. Rising asset prices and long-term interest rates occur during periods of high inflation, but we didn’t experience inflation, which is how the Fed turned the ordinary into extraordinary.
The third phase of an illusion is referred to as the “prestige” which is when the audience believes the trick really happened. The “prestige” for the Fed is making all of their debt disappear without actually paying it off. Of course, the Fed isn’t going to actually make all of their debt disappear, but they do want to make it seem rather insignificant.
Making debt disappear without paying it off is as simple as creating wage-growth. A person with $500,000 in debt and $50,000 of income per year simply needs to increase their income! If their income rose to $150,000 per year, then the $500,000 in debt wouldn’t be as much of a problem. The problem for the Fed is they lack the tools to create wage-growth, and they don’t seem to understand what causes wage-growth.
The Fed needs the American consumer to buy into their “magic trick” because the Fed can’t create wage-growth. The Fed believes wages can rise as long as consumers are willing to borrow and spend more money. As more money is borrowed and spent, the economy grows. As the economy grows, wages rise. When examining the Fed’s policy tools, it becomes clear the Fed is limited to how far they can take their illusion.
The Fed can raise and lower the Federal Funds rate, which affects short-term interest rates. As interest rates rise, lending falls, and as interest rates fall, lending should rise. As lending increases, more money is injected into the economy which increases the money supply. As the money supply expands, employers are forced to raise wages. In theory, lower interest rates should lead to higher wages, but they didn’t.
The other policy tool the Fed has is to increase excess reserves within the banking system. Asset prices are largely determined by the amount of money in the banking system and by raising excess reserves, the Fed increased asset prices. The Fed really believed rising asset prices would lead to higher wages, but it didn’t. Higher asset prices do not cause wages to rise.
Many households employ the services of others to assist with maintaining their homes. For example, landscapers charge a price based on the size of the property and the work they are doing to maintain the property. The price paid for landscaping services is not based on the value of the property. If the property doubles in value, the homeowner does not double the price paid to their landscaper.
The same relationship holds true for business owners. Many small business owners have benefited from the Fed increasing asset prices. Not only is their business worth more money, but the actual property where the business is located has also increased in value. For business owners who also own the property underneath their business, this is a huge benefit. However, business owners don’t base their employee’s wages on the value of their business assets.
The Fed lacks the policy tools and ability to affect wage-growth which is why the American consumer is a key component in turning the Fed’s illusion into reality. The Fed can attempt to manipulate businesses into raising wages, but they can’t force them to do so. During press conferences, Chairman Powell has stated the Fed is perplexed as to why wages aren’t growing. It should be obvious that the Fed doesn’t understand what drives wage-growth. Once you understand what drives wage-growth, you will realize why the third phase, or “prestige”, of the Fed’s grand illusion always fails.
Wage-growth is a function of production. Let’s say for example I am a tree trimmer. With nothing more than a saw, I can trim one tree per day. My income is limited to the revenue generated from trimming one tree per day. Let’s say I invest in a chainsaw, which allows me to trim five trees per day. With a chainsaw, I can increase my revenue by increasing my production. Let’s say I invest in a bucket truck which allows me to get to the top of trees faster than climbing them. Now I can trim ten trees in a day, which increases my production and revenue. My ability to increase my income is directly correlated to my ability to increase my production or output.
An increase in production has nothing to do with a decrease in interest rates or an increase in asset prices.
Even the Bureau of Labor Statistics (BLS), who publishes the monthly payrolls, is in on the illusion. In an effort to convince consumers the economy is doing well, the BLS continues to publish fabricated jobs numbers. The monthly payroll report is a combination of actual jobs created and an estimate of the number of self-employed jobs created. The number of self-employed jobs is referred to as the “Birth-Death Model” and is entirely fictitious.
Over the past six-months, the BLS reported the economy created 1.278 million jobs. From those 1.278 million jobs, 571,000 were created under the Birth-Death model. Only 716,000 verified jobs were created or an average of 119,000 jobs per month, which is much lower than the BLS reported average of 215,000 jobs per month. Clearly, the BLS is in on the act.
The Fed, the Federal government, and supporting agencies have all gone out of their way to make the illusion appear to be real. Even the stock market is in on the illusion which has prompted investors to pour their life savings into risk assets. I will give them all credit where credit is deserved; there has never been a greater attempt to fool the American public than this. However, the Fed nor any central bank in history has ever successfully completed the “prestige”, or final phase, of their illusion. This time will be no different.
At this point in the business cycle, which runs about every eight years, governments, municipalities, corporations, and consumers are all heavily in debt. As the Fed raises short-term interest rates, the cost to service this massive amount of debt rises. As debt-service costs rise, consumption falls.
In addition to rising debt costs, after eight-to-ten years of consuming, pent-up demand falls. Consumers find themselves in a position where they don’t need a larger house, newer cars or more electronic gizmos. When consumers begin to accept that wage-growth is not coming, they start to pay down their debt, which reduces consumption.
Rather than implementing policies to increase production, productivity and output, which will lead to higher wages, the Fed used the only policies at their disposal. The Fed does not have the tools nor abilities to create wage-growth. Now you know why the Fed always fails at the “prestige”.
The Fed has attempted to create a grand illusion to push consumption and to make all of the debt that was accumulated over the past couple of decades “disappear”.
No matter how hard the Fed tries, they can’t force the economy into a perpetual state of mass consumption. When this illusion fails, as it always does, Americans will be forced to face the consequences of the Fed’s debt-fueled lies.
Q&A with Steve – Your Questions Answered
- What happened to the stock market on Monday?
Over the weekend I read quite a few articles about how the market was once again, about to take off for a 30%+ run or more. With the Fed draining liquidity, I keep asking the same question – where is this money going to come from? After six months of corporate share buybacks, only the Nasdaq-100 and Russell 2000 have set new all-time highs. If the S&P 500 and DJIA can’t set new highs under a wave of corporate share buybacks, what is going to push them through the roof?
Retail sales met expectations with a +0.5% year-over-year increase. The biggest increase was gasoline sales, which shouldn’t come as a surprise. Netflix was down about 10% after missing expected subscriber growth, which is impressive, considering the move happened in one minute. I’ve been saying for a long time that when liquidity dries up in this market, stocks can and will drop faster than anyone wants to believe.
Treasury yields started the day higher but quickly reversed course. It is becoming increasingly obvious that the Treasury short-sellers are about to find themselves on the wrong side of the trade.
Physical gold fell back to the bottom of my target trading range but looked very weak. I expect physical gold, the gold miners, and silver miners to make one last move down. The large gold miners found support at a short-term resistance level going back to late last month, but again, I don’t see any indication prices should hold there.
Agricultural commodities are once again trying to form a bottom. An even bigger heatwave is moving east, which shouldn’t be good for crop conditions.
- What happened to the stock market on Tuesday?
Industrial Production numbers were up +0.5% after last months’ -0.5% drop. Wage growth is a tied to Industrial Production, so rising production should be good news for workers pushing for a pay raise.
2,800 appears to be the line in the sand for the S&P 500, which was broken this morning. For day traders and short-term speculators, shorting the S&P 500 at 2,800 seems logical since this is the fourth time the S&P 500 has run into resistance at 2,800. Be forewarned – the market is chasing down anyone who is selling short. Today’s move is mostly the market flushing out short sellers.
The S&P 500 finally broke 2,800 and should be off to the races. I suspect this will be the door to a retest of its all-time highs. Traders are pointing out that the S&P 500 is becoming very correlated to the Fed’s balance sheet unwind.
Treasury yields ticked up slightly but held their ground. There may be a correlation with yields and the Fed’s balance sheet unwind as well. As we know, the Fed’s unwinding should cause long-term bond yields to fall.
Agricultural commodities appear to be attempting to set a bottom. What I like is that trading volume has dropped, which could be an indicator that short sellers have exhausted their positions. If that is the case, a rally could be coming soon.
Physical gold broke below support at $1,238/oz. The next move is a soft support zone between 1,220-1,225/oz. Today physical gold touched $1,225/oz and bounced slightly. The next move is likely down to the stronger support range of $1,196-1,206/oz.
The gold miners didn’t react too much to today’s drop in physical gold, but the silver miners did. Due to the correlation between the metal and the miners, I still expect the gold miners to fall further.
The U.S. dollar index (DXY), which I am interested in, keeps running into a wall every time it tries to pass $95.
- What happened to the stock market on Wednesday?
Housing permits and starts were both down today, even though expectations were for them to rise. Higher interest rates and a decelerating money supply do not lead to an increase in housing demand. While there is demand for housing, it has become unaffordable for many.
In a typical day, the largest S&P 500 Exchange-Traded Fund should see over 100 million shares change hands. Lately, it has been trading around 50-60 million shares per day. Today it traded less than 40 million shares, which was less than it did on July 3rd when the market closed early.
When volume drops off when the markets are high, it is a sign that buyers are exhausted, and the market should change directions. So far nobody seems to want to sell, but the Fed continues to drain liquidity.
Treasury yields were up as banks have been posting strong profits, but don’t expect yields to keep rising. Fed Chairman Powell testified in front of the Senate and House over the past two days where he affirmed the Fed will continue a gradual increase in the Federal Funds rate along with the continuation of its balance sheet unwind.
Agricultural commodities are showing signs of holding a bottom as prices have been flat for six days in a row. Perhaps the short-sellers are gone?
Physical gold touched the bottom of its short-term resistance channel at $1,220/oz and rebounded to $1,227/oz. No major sign of strength here. Unless buyers step in, I expect gold to head down to $1,200/oz very quickly.
- What happened to the stock market on Thursday?
U.S. equities opened the day down as weakness from Asian and European markets are finding their ways into domestic stocks. After trying to rally, all three large-cap indices closed red for the day.
Treasury yields have been rising for the past few days but made a strong move down today. Longer-term Treasuries are coming close to a technical breakout to the upside.
Physical gold moved down strongly last night as those who are long gold begin to sell. After President Trump commented he didn’t like a stronger dollar, gold’s brief rally eventually faded. Both the gold and silver miners are headed back down into a “Buy Zone” which has existed for the past two years – a positive sign.
The dollar keeps getting hammered back every time it tries to make a move over $95 (DXY). The dollar should continue rising as the Fed tightens, but many traders are short the dollar and do not want to see it rise any further.
Agricultural commodities rose a bit today and appear to be putting in a floor.
- What happened to the stock market on Friday?
Finally, some volume! Even though the major indices didn’t move much, sellers were selling against the buyers which kept stock prices from rising. The S&P 500 did close the week over 2,800, it didn’t do it with any signs of strength. Next week’s price action will be critical in determining if this is just a brief pause on a rally or a signal of an impending move down.
Treasury yields shot higher today with no major news. Treasury short-sellers are in a desperate position to push yields higher to support their record short positions. It is entirely possible these same investors are selling their gold holdings in an attempt to prop up their long stock positions and short Treasury positions. The same thing happened in 2008…
Physical gold rebounded a bit on President Trump’s comments, but I don’t believe it will hold. The next major support level for physical gold is $1,200-09/oz. Failure to hold there will cause a liquidation of those holding long positions, which means physical gold could fall much further. The gold and silver miners are slowly moving down which is a positive sign!
Agricultural commodities continue to form a bottom which is possibly aided by the U.S. dollar getting rejected again at $95 (symbol DXY). I do like a long dollar position, but there’s no confirmation on the trend. A move back and a hold at $93 should confirm as a potential entry point.
Next week should be more interesting, especially if the Fed sells off part of the $35 billion it needs to by the end of the month. It’s pretty interesting the stock market was largely stuck in neutral the past two weeks with the Fed on the sidelines.
Video Topic of the Week –
Update on Fed Chairman Powell’s Congressional testimony and thoughts on the stock market.
Chart of the Week – S&P 500 & U.S. Treasury Yields Under Quantitative Easing
I’ve stated repeatedly that the S&P 500 and U.S. Treasury yields rose under Quantitative Easing and therefore both should fall under Quantitative Tightening. These two charts will prove I’m right or wrong!
Bonus (24 min):
- M2 Money Stock YoY% vs Recessions
- Commercial & Industrial Loans
- Consumer Loans
- Federal Reserve Balance Sheet
- Total Savings Deposits at all Depository Institutions
- Treasury and Agency Securities at Commercial Banks
- Retail Sales
- Industrial Production
- Housing Permits and Starts
- Philly Fed
- Initial Jobless Claims
- Facebook Global Usage
- US Treasury Futures Net Speculative Positioning
- S&P 500 (SPY) Chart
- 10-Year Treasury Yield (TNX) Technical Analysis
- 30-Year Treasury Yield (TYX) Technical Analysis
- Gold Futures (/GC) Technical Analysis
- Vaneck Vectors Gold Miners (GDX) Technical & Momentum Analysis
- Global X Silver Miners (SIL) Technical & Momentum Analysis
- iShares 7-10 Year Treasury Bond (IEF) Technical & Momentum Analysis
- iShares 20+ Treasury Bond (TLT) Technical Analysis
- PowerShares DB Agriculture (DBA) Technical Analysis
- U.S. Dollar (/DXY) Technical & Momentum Analysis