Blame the Fed: Asset Prices are Falling
The Federal Reserve has been tightening monetary policy for nearly two years now and it is having a direct impact on global asset prices. Stock-, oil-, and real estate-prices, and even cryptocurrencies, are on a rapid decline, yet few people seem to understand why. Since the Great Financial Crisis, the Fed manipulated the amount of money in the financial system which caused asset prices to rise. For the past two years, they have been slowly removing that same amount of money in the system, which is having the unintended consequence of lower asset prices.
After nearly ten years of asset prices effortlessly rising, year-after-year, the magic seems to be wearing off. While most people believe their stocks and homes will continue to appreciate, the Fed’s policies are undermining those beliefs. To understand why asset prices are falling, it is important to understand how the Fed orchestrated asset prices to go higher, without creating rampant inflation, in the first place.
In 2006 Congress passed a law to grant the Federal Reserve permission to pay banks interest on their excess reserves. Excess reserves are the amount of money banks hold above the amount required by the Fed. Prior to this law, the Fed did not pay interest on excess reserves, so there wasn’t much incentive for banks to hold much in excess reserves.
Most large banks have excess reserves, which they either lend to other banks who are short on their nightly reserve requirement or they lend it out to borrowers. When Congress passed a law allowing the Fed to pay interest on excess reserves, it was done to help stabilize the housing market in the mid-to-late 2000s, which eventually triggered a housing-led recession.
Following the Great Financial Crisis, the Fed engaged in a series of emergency monetary measures called Quantitative Easing 1-3. The purpose of QE 1-3 was to replace the bad loans on the balance sheets of the largest banks with new U.S. Treasury bonds and then to replace the Treasury bonds with clean U.S. dollars. This money went onto the balance sheet of the largest banks as excess reserves.
With the Federal Funds rate at zero, the normal move for banks would be to loan out the nearly $4 trillion in excess reserves. Since banks can lend nine-times against deposits, these excess reserves could have turned into $36 trillion of new money in the economy. Adding $36 trillion to our economy would be inflationary, which is something the Fed didn’t want to happen. Therefore, and to keep the money sitting on bank balance sheets, the Fed authorized the payment of interest on excess reserves. Taxpayers would pay tens of billions of dollars in interest each year to the very same bankers whom taxpayers bailed out from the mortgage crisis.
For the bankers, this was a fantastic arrangement. Rather than taking the risk associated with lending money, they sat back and collected interest from American taxpayers without taking any risk. By paying interest on those reserves, the Fed could ensure money-printing inflation wouldn’t take off, as is normally associated with such schemes. However, there are intended and unintended consequences from boosting excess reserves.
Asset prices are highly correlated to the amount of money in the financial system. Stock-, housing-, and oil-prices, the value of the U.S. dollar, and interest rates all rose in response to the newly printed excess reserves. In a sense, the Fed was using this monetary injection to cover up their mistakes from the dot-com and mortgage bubbles that they themselves created. Once everyone agrees the higher asset prices are normal and begins making transactions against those higher asset prices, the underlying issues from the prior two recessions hopefully disappear.
To illustrate the effect of increasing the amount of money, let’s take an example of two castaways stuck on an island. After some time, both castaways decide they need a form of currency to use as a medium of exchange for goods and services between each other. The rarest item on the island are sand dollars, ten of which have been found during their short time on the island. It is important to understand that no good, service, or item on the island can cost more than ten sand dollars. Should something be deemed to be worth more than ten sand dollars, it can’t be purchased by either castaway.
After a particularly bad storm, the two castaways decided to comb the beaches to see what gifts the storm washed up on their shores. The castaways find ten more sand dollars, but the new sand dollars are in a location currently unreachable by either. Think of these ten new sand dollars as excess reserves – they exist, but nobody can really touch them.
With the addition of ten new sand dollars to the monetary system of the island, prices on goods and services immediately double. The new sand dollars aren’t in circulation, but their effects on the monetary system are the same. The reason they affect the monetary system of the island is due to the possibility they can eventually be recovered from their unreachable location.
The Fed boosted bank excess reserves by nearly $4 trillion, but to prevent those reserves from being leaked out into the economy, the Fed paid, courtesy of American taxpayers, interest on excess reserves. Why did the Fed do this? There is only one logical conclusion – the Fed intended to boost asset prices to clean up the financial problems from the prior two recessions. After all, most central bankers believe the solution to every financial problem is more money. But by law, the Fed can’t print more money, so they did the next best thing – boost excess reserves.
Asset prices are a function of the monetary base, or the total amount of money in the financial system. The monetary base consists of all the money in circulation, plus bank reserves, including excess reserves. The reason stock prices, housing prices, interest rates, the dollar, and even cryptocurrencies rose in value, was due to the expansion of the monetary base. Increasing excess reserves has the same effect on asset prices as the introduction of new sand dollars increased prices for our castaways.
The Fed’s plan is not without merit. A Big Mac that once cost $2.50 now costs $5.00; a car that once cost $25,000 now costs $50,000; and a house that once cost $250,000 now costs $500,000. Since our monetary system is debt-based, as it relies on an ever-increasing amount of borrowing to function, raising asset prices and lowering interest rates is a good way to entice people to borrow money. If everyone accepts and believes these higher asset prices are real, it can work. While there are appearances the Fed’s plan worked, it didn’t.
The evidence the Fed’s plan didn’t work is visible on a chart of bank excess reserves, which is freely available on the St. Louis Federal Reserve FRED database. In between each round of Quantitative Easing, and after QE 3, excess reserves and the monetary base fell. Why did they fall and where did the money go?
Excess reserves normally fall as lending increases. Prior to the Fed paying interest on excess reserves, there was no incentive to hold large amounts of excess reserves. Yet, there was no increase in lending following each round of QE, as evidenced by the decrease in the year-over-year rate-of-change in commercial lending and the monetary base falling.
To make matters worse, the money supply abruptly decelerated at the end of each round of QE. This is an indication of a structural problem. Had lending increased after each round of QE to validate these higher asset prices, then the growth rate of the money supply should have accelerated or at least remained constant.
The deceleration in the money supply is an indication of what the structural problem is and where the money disappeared. Due to the huge amount of low-interest debt our economy has taken on since the Great Financial Crisis, money is being destroyed at a rapid pace, since only interest paid on a loan actually remains in the financial system. The economy needed to create a large amount of new money on its own to maintain asset prices following each round of QE, but it didn’t. Without the Fed pumping up excess reserves to maintain the monetary base, the money supply decelerated, and the economy slowed.
Due to concerns about cost-push inflation, or rising consumer prices, the Fed began destroying money each month starting in October 2017. Today the Fed is destroying $50 billion per month which is causing both excess reserves and the monetary base to fall and the money supply to further decelerate. When the monetary base falls, so do asset prices.
Periodically our two castaways check on the unobtainable ten sand dollars in hopes they can reach them. One day the castaways observe two large birds each flying away with a sand dollar in their beaks, reducing the unobtainable pile to eight sand dollars. The removal of two sand dollars from the island’s monetary base causes an immediate reduction in the cost of goods and services, along with asset prices, by 20%. Prior to the removal of two sand dollars, there were ten circulating sand dollars and ten unobtainable sand dollars; a total of 20. Now there are eighteen, which causes asset prices to adjust to the island’s new monetary base.
To absorb all the excess reserves from QE 1-3, stock-, asset-, and housing-prices, interest rates, the value of the dollar, and cryptocurrencies, in general, all rose. Most believe stock prices rise on earnings and profit growth, but they mostly rise due to the expansion of the monetary base. With the Fed planning to destroy $50 billion per month and continuing to raise the Federal Funds rate, which destroys approximately $50 billion with each rate hike, the monetary base will continue to decline and the money supply will continue to decelerate until it contracts.
Stock- and housing-prices, interest rates, the value of the dollar, cryptocurrencies and other assets, will decline in value as a consequence of the Fed’s actions. Due to the inherent lags in monetary policy, even if the Fed were to stop tightening, asset prices could continue to fall for a year or more. The Fed is going to tighten monetary policy until we have a recession, just like they always have. Knowing what the effects will be of the Fed’s monetary easing on asset prices, we can use that information as a guide for investing in the best asset classes, as the Fed’s monetary tightening creates new opportunities.
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Daily Market Briefs
- Thoughts from the Weekend
- What happened to the stock market on Monday?
Cyber Monday came early to the stock market, as the major indices quickly reversed all losses going back to Tuesday of last week. Investors are hopeful the Fed will become dovish, the trade skirmish with China will end at the G-20 meeting and that OPEC will cut production. Stock prices shot higher on above-average trading volume in early trading, but there is no sign of the big money buying in.
General Motors announced this morning they will close 7 plants and layoff 14,700 of its North American workers, or 15% of its workforce. Eighty-percent of homeowners who refinanced in Q3 selected the cash-out option, a number last seen at the cycle peak in 2007. Despite claims of a robust economy, this information confirms that many American households are struggling to get by.
Ten-year Treasury yields moved slightly higher in early trading, however, they held a recent support level on low volume. Low volume is an indication the short-sellers are exhausted. The Fed is scheduled to destroy over $17 billion on Friday as part of their balance sheet unwinding program, which many interpret as bullish for yields. The late famed-economist Milton Friedman showed periods of monetary tightening lead to lower long-term bond yields, not higher.
Today’s 2-year Treasury auction saw direct, or domestic bidders come back in a big way. This is an early indication that money managers are shifting their allocations into bonds. Ten-year Treasuries held their recent support level.
Stocks rallied into the market close, which is something they haven’t done in with much consistency over the past few months. During Bull markets, stocks will rally into the market close. In Bear markets, stocks sell into market close.
Today’s move ought to set up a retest of the recent overhead resistance levels, however, I still believe the major support level from the past twelve months will be tested at some point. Despite today’s large move in stock prices, trading volumes were 30% below average.
- What happened to the stock market on Tuesday?
U.S. equities got off to a strong start on news that President Trump may enact tariffs on imported vehicles as early as next week and that he is likely to proceed with increasing the tariff on Chinese imports from 10% to 25% in January. How exactly such news is bullish is beyond me.
Fed Vice Chair Richard Clarida maintained support for gradual rate hikes in his recent speech titled “Data Dependence and U.S. Monetary Policy.” Other members of the Fed will be speaking over the next two weeks, including Chair Powell, as investors look for any clues on future rate hike guidance.
This week the U.S. Treasury is scheduled to auction off $200 billion in debt, a 100% increase over this time last year. Despite claims the bond market is dead and interest rates are going to the moon, today’s 5-year Treasury auction saw both strong domestic and foreign demand. Yields on 5-, 10-, and 30-year Treasuries fell after the auction.
Yesterday’s trading volume was 30% below average, and today, it was even lower. Despite today’s low trading volume, the major large-cap equity indexes all closed higher. Treasury yields were down slightly.
After failing to break a resistance level last week, the gold mining stocks sold off and are likely to retest a support level that has been holding for the past three months. Physical gold also fell, breaking below its 50- and 100-day moving averages.
Agricultural commodities are holding support as trading volume increases, a sign buyers are stepping in to counteract the sellers.
Crude inventories came in well above analyst expectations with a +3.45M barrel build, according to the API report. Even Cushing saw a build of +1.302M, while gasoline inventories fell -2.62M and distillates rose +1.185M. Oil prices rallied after this report. The official government numbers will be released tomorrow morning.
- What happened to the stock market on Wednesday?
Stocks leaped higher as global stocks moved higher on hope the U.S.-Chinese trade war will soon be resolved and that the Fed will turn dovish. After the API reported higher crude inventories, investors were hoping the government data would show a much smaller build. They were wrong.
According to the Department of Energy, crude inventories rose +3.58M barrels, Cushing +1.177M, gasoline -764k and distillates +2.61M. Oil prices fell following the report.
New home sales were down -8.9% MoM, the biggest drop since 2011. Supply is now at 7.4 months. Clearly, the housing market is not able to absorb higher interest rates.
Third quarter GDP revision showed that out of the 3.5% growth number, 2.7% can be attributed to government spending and inventory building, leaving consumers with a mere 0.8% of the final number.
The computer algorithms loved Jerome Powell’s speech, as they shot stocks higher, Treasury yields lower and the dollar lower on comments by the Fed Chair that we are much closer to the neutral rate than previously thought. This means the Fed may stop raising rates soon, but there was no indication the Fed would halt its balance sheet unwind.
Wall Street took the most optimistic view of Fed Chairman Powell’s speech today and drove all of the major equity indices higher. Trading volume on the major equity indices did not indicate a move in by large investors, as volumes were slightly higher than their recent average. Treasury yields held flat.
Powell said the Fed was close to the “neutral” rate or, the rate at which they will stop hiking. The Fed Funds rate is at 2-2.25% and the neutral rate, based on prior Fed minutes, is between 2.5-3.5%. The market decided today that the Fed will hike one more time and stop. The damage from the rate hikes is done, and stopping after the next hike, won’t change much.
Today’s 7-year Treasury auction saw strong demand from both domestic and foreign bidders, which is a sign that the ‘Smart Money’ is continuing to rotate into bonds.
- What happened to the stock market on Thursday?
After a big 3-day rally in equities, Treasury yields finally reacted by falling in overnight trading. Equity investors are hopeful the Fed will pause, and a trade deal will be struck this weekend.
Pending home sales fell -2.6% MoM in October after analysts were expecting a +0.5% MoM gain. This brings the year-over-year rate of change for pending home sales to -4.6%, which is not a good indication of a booming economy.
Income and spending were up big in October after slowing the prior two months. The Fed’s preferred gauge of inflation, or Core PCE, slowed from their target of +2.0% YoY to +1.8% YoY. Long-time clients and readers know that inflation expectations follow the money supply, which has been decelerating for over two years. Look for lower consumer prices in the future.
Wages for private workers increased +4.7% YoY and wages for government workers rose +2.9% YoY, yet the savings rate fell to +6.2%, the lowest level since December 2017. Rising consumer prices, higher interest rates, and large debt levels continue to weigh on the average American.
Jobless claims rose to an 8-month high, which on the surface isn’t a big deal. When jobless claims start rising from an extremely low level, as they are now, recessions tend to come quickly.
Technical resistance levels to watch are 2,735 on the S&P 500, 6,900 on the Nasdaq-100, and 25,335 on the DJIA. The trend-following CTA computer models went back into the market on Tuesday and are close to going ‘Max Long,’ meaning they are fully invested. The CTAs have been ‘Max Long’ several times since the peak, an indication that they are losing money in this choppy market and that they cannot push the market to new all-time highs. Should the recent 3-day rally fail to hold, the sell signals for the CTAs aren’t far below.
The Federal Reserve released the minutes from their most recent meeting, which showed expectations for one more rate hike in 2018, followed by three more in 2019. It appears the computer algorithms and stock market got excited yesterday on the belief the Fed will pause, but the meeting minutes suggest the Fed will continue to gradually raise rates. There were no changes to the Fed’s balance sheet unwinding program.
After breaking the previously identified support levels, equities looked like they were going to continue to rally, but an hour before close, stock prices fell. The S&P 500 closed two points over resistance, the Nasdaq-100 below resistance, and the DJIA four points over. I mentioned in the Wednesday video that the S&P 500 may attempt to rally over its 200-day moving average and 50-week moving average, which are very close to the same price level, and the S&P 500 came close to both but didn’t close over either.
Treasury yields were lower on the day, physical gold was flat, the gold and silver miners were down, and agricultural commodities closed higher off a key support level. Ten-year Treasuries did hit 3% and as expected, short-sellers came in, but without the strength, they have exhibited in the past.
- What happened to the stock market on Friday?
Much to the market’s surprise, Treasury yields are slowly falling despite a huge supply of Treasury bonds hitting the market from the massive fiscal deficits our country is running. The average investor sees this supply and interprets it to mean interest rates must go higher. Investors should look at lending demand, or businesses and consumers who want to borrow, and see demand is falling. Interest rates are a function of supply and demand. When lending demand falls, so do interest rates.
For the past year, I’ve suggested the rise in Treasury yields is a massive topping pattern, which it is starting to appear as such. With the money supply decelerating and lending demand falling, as a result, this chart pattern further suggests we are likely to see new all-time lows in Treasury yields during the next recession. When interest rates fall, bond prices rise, which is why the “Smart Money” has been buying bonds. The profit on bonds when yields get near zero is quite large.
The stock market is putting a great deal of hope on President Trump and President Xi’s Saturday dinner meeting. The Chinese don’t negotiate over dinner but behind multiple closed-door sessions. Look for comments from both sides following the meeting and likely more on Sunday. Keep in mind, any deals struck must be approved by Congress.
Investors rushed to buy stocks ahead of the G20 meeting, but trading volumes were slightly below yesterday, indicating the “Smart Money” is still on the sidelines. The S&P 500 closed just over its 50-week moving average and just below its 200-day moving average, which sets up either a move up to 2,800 or back down to 2,600.
Ten-year Treasury yields quietly closed below 3%. I expected the short-sellers who have been bullish on yields to come out in full force, but they didn’t. While a one-day close doesn’t mean the bond market is going to rapidly move, this does indicate yields should continue to fall to 2.8% where the big battle line between the bulls and bears will be drawn. Perhaps on Monday, the short-sellers will be back, but maybe they are too exhausted to continue the fight at 3%. We’ll find out soon enough.
Physical gold fell again and remains in a 5-month consolidation pattern. The gold miners dropped below their 50-day moving average again and the silver miners are back testing their 6-month lows. Agricultural commodities were flat on the day but are staging another reversal pattern after heavy selling from earlier in the month.
There is a great deal at stake for both bulls and bears on the outcome of tomorrow’s dinner meeting between President’s Trump and Xi.