Weekly Economic Update 07-27-2018

President Trump is Right; the Fed is Going to Blow Up the Economy

And I predict it’s going to happen sometime in the next six months!

On July 19, 2018, during an interview at the Whitehouse, President Trump told CNBC’s Joe Kernen, “Because we go up and every time you go up they want to raise rates again. I don’t really — I am not happy about it. But at the same time, I’m letting them do what they feel is best.”

President Trump is correct – since their inception in 1913, the Federal Reserve has created every economic expansion and contraction. He’s afraid the Fed is about to create another contraction by continuing to raise the Federal Funds rate.

Most analysts are predicting a recession sometime in 2020. Under normal conditions, I would agree with their assessment, but given the current conditions, I believe we are much closer to one than most realize. The basis for a recession in 2020 has to do with the Federal Funds rate. The consensus is the Federal Funds rate needs to be over 3.5% before the economy begins to struggle under the weight of higher interest rates.

Typically, the Federal Reserve raises the Federal Funds rate four times a year during a hiking cycle. The Fed prefers to hike rates by 0.25% each time and they wait approximately three months to allow the economy to adjust. With the Federal Funds rate at 2%, it would take the Fed until 2020 before we are at 3.5% — assuming there will be two more rate hikes in 2018 and four in 2019.

I set out to determine when I think we will likely see a recession and how high interest rates need to go before they stall out the economy.

I began with a historical chart of the Federal Funds rate going back to 1955 and marked with every recession. Since the 1980’s, every recession has been triggered by the Fed raising the Federal Funds rate. The chart also shows that the Federal Funds rate never rises to the level that triggered the previous recession.

The Federal Funds rate alone isn’t enough to help me determine how high interest rates can go before the economy stalls out. All this chart tells me is that the last recession occurred when the Federal Funds rate reached 5.25%. Therefore, the next recession will likely occur before the Federal Funds rate reaches 5.25%.

I have been studying and trying to grasp a deeper understanding of the Money Multiplier. In the near future I will share it with you. The Money Multiplier is one of the most critical functions in our banking system and I believe it has not been functioning properly. The Money Multiplier is what leads to inflation and why the Fed is unable to create inflation, but that is a story for a future update.

The reason I mention the Money Multiplier, I believe the reason it isn’t functioning properly is due to the number of Commercial banks in our country. The more Commercial banks in the system, the more potential money has to multiply. When money has the opportunity to multiply, it can create true inflation and allow interest rates to rise beyond the rate of the prior cycle.

I pulled the chart showing the number of Commercial banks in the United States going back to the mid-1980s. Since the mid-1980’s, the number of Commercial banks has steadily fallen from over 12,000 to less than 5,000 today. I have no idea why the number of Commercial banks has been falling; all I can tell you is they have been falling.

I devised a simple ratio which takes the Federal Funds rate at the point just prior to a recession and I divided it by the number of Commercial banks. I further divided the number by 1,000 to make the ratio easier to read. Here’s what I found:

Year of Recession: FF Rate ÷ (# of Commercial banks ÷ 1,000) = Ratio

1990-91 Recession: 8.25 ÷ 12.2 = 0.67

2000-02 Recession: 6.5 ÷ 8 = 0.80

2008-09 Recession: 5.25 ÷ 7.1 = 0.74

To solve how high the Federal Funds rate can rise under the current cycle before triggering a recession, I averaged the ratio to come up with 0.73. The current number of Commercial banks is 4,800. With those two data points, I can easily solve for the rate:

Next Recession: 0.73 x (4,800 ÷ 1,000) = 3.53

Assuming this ratio is correct, the economy should stall out once the Federal Funds rate reaches approximately 3.5%. Based on the current Federal Funds rate of 2% and the Fed’s projected path of rate hikes, this shouldn’t be a problem until 2020.

Knowing there won’t be a recession until 2020, we should dive head first into the stock market because stocks should have another year or so to rally. Under normal conditions, there would be a great deal of historical accuracy to that statement. However, there is one aspect every analyst is overlooking – the Fed’s balance sheet unwind.

During the Great Financial Crisis of 2008-09, the Fed purchased nearly $4 trillion of U.S. Government bonds and Mortgage-Backed Securities to raise excess reserves in the banking system and to suppress short-term interest rates. Beginning in October 2017, the Fed gradually started selling off their holdings.

Every time the Fed raises the Federal Funds rate by 0.25%, it has the effect of removing approximately $60 billion from the money supply. Every $60 billion the Fed sells of its balance sheet should have the economic equivalent of a 0.25% rate hike.

Since October 2017, through the end of July 2018, the Fed will have sold off $220 billion of its $4 trillion balance sheet, which is effectively the same as raising the Federal Funds rate by 3.5 times or raising the Federal Funds rate by 0.92%. The current target range for the Federal Funds rate is 1.75-2.00% or approximately 1.88%.

Adding the two together (1.88% + 0.92%) gives us an effective Federal Funds rate of 2.79%. When factoring in the Fed’s balance sheet unwind, it is easy to see the effective Federal Funds rate is much closer to the 3.5% target than most realize!

The Fed is planning to unwind $40 billion per month of its balance sheet in August and September. Starting in October, until otherwise canceled, the Fed plans to unwind $50 billion per month. Assuming no further rate hikes, due to their balance sheet unwind, the Federal Funds rate will feel like its 3.54% at the end of November.

Should the Fed hike rates by 0.25% in the next couple months, which is widely expected, the Federal Funds rate will feel like its 3.58% by the end of October.

To make matters worse, the Fed is scheduled to unwind $600 billion of its balance sheet in 2019. Dividing by $60 billion means there will be the equivalent of 10 rate hikes, or an equivalent increase in the Federal Funds rate of 2.5%, from the Fed’s balance sheet unwind alone!

There are several things we can take away from my research:

The Fed will never be able to normalize interest rates without directly inflating the money supply.

When the next recession hits, the Fed will be forced into taking the Federal Funds rate into negative territory, but it won’t work.

The Fed will be forced into a massive amount of Quantitative Easing in order to reflate the financial system. But like Japan who has been doing some form of QE for thirty years, it won’t work.

The global banking system will likely collapse under the weight of all the debt issued since 2008-09 and need another bailout. I expect some central banks will become insolvent, which will require the central bank of central banks, or the Bank of International Settlements, to bail them out.

Congress, the Fed, and the Federal government will attempt to flood the economy with money. This will massively devalue the US dollar.

The money supply will collapse as borrowers default on their loans. When the money supply collapses, so will asset prices, including stocks.

The Money Multiplier will collapse, just as it did during the past two recessions.

I’m not sure if President Trump or someone in his administration fully understands how the Federal Reserve will crash the economy by raising the Federal Funds rate and tightening monetary policy, but regardless if you like President Trump or not, he’s going to be right about this.

Q&A with Steve – Your Questions Answered

  1. What happened to the stock market on Monday?

Treasury yields shot up today on what is mostly a technical move. Some are citing President Trump’s comments about the Fed hiking rates as a sign the Fed will reverse course, and thus lead to higher Treasury yields. The Fed is an “independent” agency and does not answer to the President.

Traders over the weekend were talking about adding to their record short positions. Keep in mind, stocks must indefinitely rise, and bond yields must indefinitely rise to keep this market structure intact. Speculators are being forced to defend their positions against the Fed, who is unwinding their balance sheet. As I have proven and validated last week, as the Fed tightens, bond yields fall.

Thirty-five percent of all S&P 500 companies are due to release their second-quarter earnings this week, so it should be interesting!

The S&P 500 pushed back over the 2,800 mark on very low volume but didn’t manage to get much further. As I already mentioned, Treasury yields jumped and bond prices fell in what appears to be a purely technical move.

This week the U.S. Treasury is auctioning off a monster amount of debt and the Fed has a little over a week to unload an additional $35 billion of its balance sheet. Both will pull liquidity out of the stock market.

Physical gold fell today along with the miners. The gold miners dipped into my targeted “Buy Zone,” but didn’t appear to run into any buyers. The silver miners have a bit further to go.

The dollar tagged its 50-day moving average for the second time since bottoming in April, which is a good sign. Technical traders, I follow are pointing to the dollar falling back down to $93, which I tend to agree with.

Agricultural commodities quietly found some buyers and it appears for the moment, a bottom is in place.

  1. What happened to the stock market on Tuesday?

I mentioned in the last week or so that Russia was selling off their U.S. Treasury holdings, which appears they are selling all of them off. Care to guess what they are buying with the proceeds? Physical gold. While speculators and money managers are shorting gold, central banks are buying as fast as they can. At some point in the future, it will be obvious why central banks bought gold. They know all the money printing they have done isn’t working and the financial system is going to come crashing down soon.

Along with a deluge of corporate earnings, the U.S. Treasury is auctioning off over $100 billion of new debt which will pull liquidity out of the system. Today’s two-year Treasury auction saw yields as high as they were in July 2008. Shortly after the auction, equities started to sell off and longer-term Treasury yields fell.

If there was a day to spark a big market rally, today would be the day. After Google surprised the market with its earnings which sent the futures market higher. Stocks “gapped” up which should have set the stage to bring the Bulls in. But they didn’t really show up.

What you see in today’s market action is a lack of liquidity. Between the Fed tightening and the U.S. Treasury auctioning a ton of new debt, there’s not much left to go into stocks outside corporate share buybacks. And after several days of Treasury yields rising, they fell. Another indication of liquidity drying up.

Physical gold continues to look for buyers, but sellers are still dominating. I am expecting physical gold to drop closer to $1,200/oz before the sellers give up. Both the gold and silver miners found buyers today, but no signs of any major strength. I expect both the miners to fall a bit more before I get serious about buying in.

  1. What happened to the stock market on Wednesday?

Equity markets started the day in an excited tone in anticipation of Facebook’s after-hours earnings announcement. The minute after Facebook released their earnings, their stock dropped 10%. This should be a reminder to all of those chasing the equity market that computer algorithms are responsible for market liquidity and 70% of all trades. When they decide to stop providing liquidity or decide to sell, stocks can and will drop rapidly.

Post update, update… Facebook is now down over 20% in after-hours trading. Going into tonight’s earnings announcement, over 91% of all analysts had a buy rating and it’s the #1 stock owned by hedge funds. Ouch!

The S&P 500 is about 5.5 points away from filling a “gap” that formed between the close on January 29th and the open on January 30th. While most “gaps” are filled, not all of them are. I’m going to go out on a limb to say this one is likely to be filled, which will put the S&P 500 within striking distance of its all-time highs.

The DJIA is back into its “Sell Zone” where sellers have shown up over the past six months. It will be interesting to see if the market can rally from here or if the sellers have been patiently waiting for buyers to drive prices back up. The Russell 2000 has formed a triple-top, which from a technical perspective is bad news.

Treasury yields were down a little and rose on news of a trade deal with Europe. Don’t read too much into to the trade news for the day – nothing official has been signed. It is positive that the US and EU agreed to work together to resolve matters.

The five-year Treasury auction saw very strong interest, which is a sign that inflation fears may be overdone. Based on my research, they are way overdone.

Agricultural commodities rallied on news the EU will buy more soybeans from the US. No doubt this is a potentially welcome relief for America’s farmers.

The dollar slid on news of the US and EU working together on trade, which is the correct move for the dollar to make on such news. While I remain hopeful something positive can come out of today’s meeting, it doesn’t change my view that the dollar is staged to rally. I remain very interested in its next pullback towards $93 on /DXY.

Even though physical gold isn’t trading any higher than it was last week, both the gold and silver miners rallied into the closing bell. While this may be the beginning of a reversal, sellers have been strongly selling both the physical metal and the miners. It’s possible this is a bottom, but I’m not holding my breath. I still expect another several percentage points drop in the miners before a strong buy signal forms.

  1. What happened to the stock market on Thursday?

One might think that Facebook’s 20% drop in after-hours trading might spook the market. It didn’t. Investors continued to buy without much regard. Facebook traded over 165 million shares today, which means half of those people were sellers.

Durable Goods orders came in below expectations which for some strange reason sent bond yields higher. Economic decelerations usually lead to lower bond yields, but speculators remain dead set that inflation will drive yields higher. Today’s 7-year Treasury auction was met with strong demand, which continues to support a rotation into bonds.

Physical gold failed to rally and closed at $1,2222/oz. I still believe it will see $1,200/oz sooner than later. As gold fell so did the gold and silver mining stocks. The large gold miners are sitting on the top end of their “Buy Zone” and the large silver miners are in between two zones. More downside to come. Earnings reports from the miners are looking good. Once the selling is done, seasonality ought to kick in.

Agricultural commodities faded the news that the EU will buy more soybeans, but the story on agricultural commodities is more about the weather than anything. The southwest United States is experiencing Dust-Bowl-like weather that could easily find its way into the midwestern growing region. There are drought conditions all over the globe which are likely to intensify.

  1. What happened to the stock market on Friday?

It’s a classic buy the rumor sell the news day. With a bulk of corporate earnings out this week, the market is starting to look forward to the rest of the year and quickly coming to the realization that growth is likely to slow as the tax cuts fade, and wages remain flat. All major indices were down today, including small-caps, which were believed to be immune from tariffs and trade wars.

Bond yields fought to move higher, but not for the reasons most think. The market is dead set that long-term yields must rise because short-term yields are. Unfortunately, many financial professionals came into the industry after 2008-09 and don’t realize long-term yields are not correlated to short-term yields.

Physical gold slid a little along with the gold and silver miners. I am still expecting them to fall a bit more. Hedge-fund managers are massively short gold which has led to a short squeeze in the past. I am looking forward to buying the miners once prices stop falling.

Despite all the bad press, agricultural commodities are slowly stair-stepping their way higher. This will be one of the hottest summers on record and there are already signs in other parts of the world where crops and livestock are being damaged. The southwest is seeing similar conditions to the “Dust Bowl” and if those conditions hit the Midwestern growing region, crop prices can go straight up.