Did the Fed Bow to President Trump?
For the past two years, investors have been demanding higher interest rates and, with the major stock indices effectively flat for the past twelve months, investors are now begging the Fed to stop. Even President Trump, who appointed Jerome Powell to the Chairman of the Federal Open Market Committee (FOMC) board, has gotten in on the action by accusing the Fed of raising rates too quickly. Both the President and investors have a good reason for their outcries, as the Fed’s monetary tightening is slowing down economic growth.
Two weeks ago, Fed Chair Powell spoke at the Economic Club of New York, and the mainstream media interpreted his speech to mean the Fed was about to stop raising the Federal Funds rate. Investors around the world breathed a sigh of relief and resumed pouring money into U.S. equities. Unfortunately, I think their optimism may be premature. While interpretations of Powell’s speech do vary some, there was no indication of the Fed bowing to President Trump’s demands.
The Federal Reserve is a private bank and while members of the FOMC board are appointed by the President, the President nor Congress have any influence over monetary policy. The purpose of a central bank, such as the Fed, is to gradually create inflation by expanding the money supply to support an ever-expanding government. By increasing the supply of money, a government has more resources to expand its military, social programs, and various government-subsidized entities.
Following the FOMC’s October 3rd meeting, Powell stated the Fed was, “a long way from neutral.” The neutral rate for the Federal Funds rate, or overnight bank lending rate, is the interest rate where monetary policy is not too loose nor too tight. Unfortunately, there is no easy way for the Fed to determine what the neutral rate is, so they adjust monetary policy on a periodic basis and watch the economic data to see the effects. In October the Fed believed they were a long way away and during Powell’s speech to the Economic Club of New York, he indicated we may be closer to the neutral rate than previously thought.
The current Federal Funds rate is between 2.00-2.25% and the Fed is expected to raise the Federal Funds rate to 2.25-2.50% at the conclusion of their December 18-19th meeting. Previously the FOMC board suggested the neutral rate was somewhere between 2.50%-3.50% and that three rate hikes in 2019 may be necessary. For the Fed to reach the neutral rate of 3.00%, they will need to raise the Federal Funds rate three more times. What upset President Trump was Powell’s comment back in October when he said that the Fed “may have to go above the neutral rate,” which would suggest four more rate hikes.
Increasing the Federal Funds rate over the perceived neutral rate is four more rate hikes, with one in 2018 and three more in 2019. This view is consistent with the FOMC board’s projections for where the Federal Funds rate should be, so it is “neither speeding up or slowing down growth.” While President Trump and investors want the Fed to pause, as they both believe a dovish Fed will resume the stock market rally, the damage from higher interest rates and the Fed’s balance sheet unwind have been done.
Based on my model of the number of commercial banks versus the Federal Funds rate, the Fed passed the neutral rate in January 2018 when the Federal Funds rate crossed over the number of commercial banks. In the past, when the Federal Funds rate overshot the number of commercial banks, our economy was one-to-two years away from a recession.
Other experts suggest the neutral rate should be one percent less than the Gross Domestic Product (GDP) growth rate. With government estimates for GDP growth to be 3.5-4.0% in the quarters to come, the Federal Funds rate should be somewhere between 2.5-3.0%, which is in line with the FOMC’s projections.
Due to the inherent lags in monetary policy, the effects of the Fed’s rate hikes will not be felt by the economy for one or more years in the future. Should the Fed pause after December, it won’t be until December 2019, or later, when the economy feels the effects of the rate hike. The monetary lags suggest the effects we are feeling today are from when the Fed raised the Federal Funds rate in December 2017 to 1.25%-1.50%, which was shortly after they began their balance sheet unwinding program in October 2017. The economy should start experiencing the effects of tighter monetary policy in the months that follow.
The Fed’s monetary tightening has been very effective at slowing the growth of asset prices. President Trump has staked the success of his presidency to the stock market and investors have crowded into U.S. equities, both of which are foolish moves. For the past twelve months, the stock market has been mostly flat, despite more than $1.2 trillion in corporate share buybacks and dividends, and the fiscal stimulus from the Tax Cuts and Jobs Act of 2017. With the fiscal stimulus from the tax cuts fading and corporate share buybacks expected to slow significantly into next year, the lag from the Fed’s tightening should continue to weigh on asset prices.
The real thing that should concern investors is the unwinding of the Fed’s $4+ trillion balance sheet of U.S. Treasury bonds and Mortgage-Backed Securities. The Fed pumped the monetary base, or the total amount of currency in circulation and in bank reserves, to increase asset prices without the inflationary effects associated with money-printing inflation.
Based on the reduction of bank excess reserves since the Fed began tightening, I estimate that each rate hike is equivalent to a $50 billion reduction in excess reserves, which is the same amount the Fed is unwinding from their balance sheet on a monthly basis. The Fed has not indicated they plan to slow down or stop their balance sheet reduction, which should continue to cause asset prices to fall.
The Fed clearly raised the monetary base to bail out the banks who were upside down on their loans during the Great Financial Crisis as asset prices fell to prevent the banking system from becoming insolvent. This begs the question of why the Fed is undoing the mechanism which is keeping asset prices elevated? The answer has to do with the fear of true money-printing inflation invading our economy.
The Fed is paying the banks interest on their excess reserves to prevent the banks from lending against those excess reserves but paying interest on excess reserves doesn’t prohibit banks from lending against it. The reason the Fed is unwinding its balance sheet is to remove the excess reserves from the financial system. As the unemployment rate falls, the Fed believes more businesses and consumers will demand loans.
When lending demand increases enough to where the banks can lend at a profitable rate above the rate the Fed is paying, new money will rapidly enter the financial system. To prevent a flood of money from being created, the Fed must either pay enough interest on excess reserves to limit lending or remove them from the financial system.
Even if the Fed were to stop raising the Federal Funds rate after December, the monthly $50 billion balance sheet unwind has the same effect as a +0.25% increase in the Federal Funds rate. The Fed will face a bigger problem during the next recession, as most experts believe they will be forced into lowering the Federal Funds rate back to zero and implementing another round of Quantitative Easing, but they may not be successful.
President Trump has been outspoken about wanting a weaker dollar, and during the next recession, he will get it. The strength of the dollar is a function of commercial lending, which is expected to fall during the next recession. Commercial lending demand has been tepid with most of the money being funneled back into corporate share buybacks. Once the recession hits, corporations will stop borrowing money to buy their shares back, which will cause corporate lending demand and the dollar to fall.
Should the dollar fall relative to other currencies, dollars will flood back into our country. As the world’s reserve currency, more than half of all dollars are held outside the United States. If the dollar is stable or appreciating, those holding them are happy to do so. Should the dollar weaken, those holding dollars will be eager to trade them for anything else. Commonly dollars return to our country in exchange for U.S. Treasury bonds, agricultural commodities, and oil.
While President Trump may be happy for a short while with a weaker dollar, it will lead to money-printing inflation that we’ve been exporting for decades. Under this scenario, the Fed will be forced to raise the Federal Funds rate and continue unwinding their balance sheet, even as our economy is in the depths of a recession. This is truly a monetary nightmare scenario, but if the global economy falls into a recession, the Fed and other central bankers will fire up the printing presses once again.
Without any global currencies tied to gold or any other precious metal, the central bankers will attempt to print their way out of their financial obligations. Experts estimate the United States needs $200 trillion to cover the unfunded liabilities to the Baby Boomers for their Social Security and Medicare benefits, plus their Federal, state and local pensions.
To put $200 trillion into perspective, our government currently owes about $21.5 trillion and the total amount of base money in our financial system is less than $3.5 trillion. Adding $200 trillion of paper to the economy will lead to money-printing inflation and a massive devaluing of the dollar. Politicians will be able to say they met their obligations, but the value of the dollar will be nearly worthless by the time the printing presses stop.
The Fed isn’t bowing to President Trump or anyone else. Jerome Powell took on the impossible task of attempting to clean up the monetary mess his two predecessors left while trying to keep the weakest economic expansion in our country’s history running. Unfortunately for Powell and the Fed, the odds are stacked against them. History books suggest the greatest currency-printing experiment in history will fail, which will cause many of these paper currencies to revert to their intrinsic value – zero.
As the Fed continues to tighten and reduce the monetary base, asset prices will continue to fall. Treasury yields and equities appear to be the last two, but when they succumb to the monetary drain, they too will rapidly fall.
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Daily Market Briefs
- Thoughts from the Weekend
From the G-20 meeting, Russia signaled there will be no further oil output cuts, although this could change at the upcoming OPEC meeting.
President Trump said he will begin the process for withdrawing from NAFTA, leaving Congress with the choice to approve the new USMCA or have no North American trade agreement.
The dinner between President’s Trump and Xi appears to have gone well, but it looks like China was the clear winner. President Trump decided to postpone increasing tariffs on January 1st from 10% to 25% on $200 billion of Chinese goods until March 1st.
This postponement is on the expectation that China will purchase a “substantial amount of agricultural, energy, industrial and other product(s)” from the United States. According to representatives from China, China will purchase more goods from the U.S. based on the needs of the Chinese people. No amount or timeline was given by the Chinese.
Both sides agreed to keep communications open with the goal to completely remove all tariffs. Only the Trump Administration is placing a 60-day timeline on progress.
In my opinion, China is the clear winner of this meeting. They managed to get President Trump to grant them a 60-day extension from additional tariffs without committing to any changes. Based on my understanding of how the Chinese negotiate, they will either make token purchases to see if it will appease the Trump Administration, or they will do nothing until the 60 days has passed, at which time they will then attempt to renegotiate.
While it’s hard to say how the stock market will react since nothing has structurally changed outside of a 60-day moratorium, the next resistance level for the S&P 500 is at 2,800, will support is at 2,600. Any rallies are likely to be short-lived.
The real headwind for the equity markets is the Fed, who is continuing to tighten monetary policy. Anyone who understands the effects of tighter monetary policy knows that it’s only a matter of time before the U.S. stock market falls. Since President Trump has tied the success of his presidency to the stock market, any further drop in equity prices is likely to cause him to back off his spat with China.
China knows this, which is why they need to continue buying time until the inevitable tightening cycle causes U.S. stock prices to catch down with the rest of the world. This is why China can walk away from this dinner as the victor without making any purchases of U.S. goods.
- What happened to the stock market on Monday?
Global markets rallied on a 60-day extension of the next round of tariffs by President Trump. Without any material commitment from China, this is just a stalling tactic by President Xi. Investors seem eager to buy stocks and this news gave them every excuse to do it.
Trading action on the U.S. indices suggested not all are buying into the story, as all the major indices closed below their daily highs. Strong rallies usually close at or near their daily high. Look for equity markets to move higher tomorrow as Nomura’s CTA quant computer programs will buy into a 100% long position tomorrow on the S&P 500. Major resistance on the S&P 500 is 2,815, a price level the bulls want to break, and the bears want to hold.
The big story of the day was in the bond market, as Treasury yields tumbled following the ISM manufacturing report showed prices paid fell. Falling prices are disinflationary, and bond yields reacted accordingly. Three-year Treasury yields are now higher than 5-year Treasury yields, which happens when the yield curve inverts. When short-term yields are higher than long-term yields, it is a signal that something is wrong with the economy. Banks borrow against short-term yields and lend against long-term yields, so an inverted yield curve should slow lending growth.
Ten-year Treasury yields closed at 2.98%, their lowest level since September. Thirty-year yields also closed lower on the day, both of which are putting pressure on the Treasury short-sellers who drove yields higher. As the shorts unwind, look for yields to fall.
Momentum on agricultural commodities is turning up, and since momentum leads price, prices should follow. Agricultural commodities closed right on their 50-day moving average, on hopes China will follow through with President Trump’s claim they will buy a “substantial” amount of U.S. agricultural products in the next 90-days.
Oil rebounded on news China may start buying U.S. oil again, however, the media failed to realize they still are buying U.S. oil. With inventory data due out on Tuesday and Wednesday, we’ll see if today’s jump holds or folds.
- What happened to the stock market on Tuesday?
In what was expected to be the early stages of a bull market surge for stocks, stock prices took a hard reversal today. Reports from China are showing a different interpretation of the G-20 dinner between President’s Trump and Xi, while at the same time the Trump Administration appears to be backtracking on their interpretation of the outcome of the meeting.
I mentioned yesterday that Nomura’s CTA quants were going to move to a 100% equity exposure for their S&P 500 models, which they did. Those models then reversed as the market fell and in the same day, sold down to a +65% long S&P 500 position.
Treasury yields fell as short-sellers are forced to buy as their short positions are getting squeezed. Ten-year Treasury yields briefly fell below 2.9% and closed at 2.914%. The two- and 3-year Treasury yields are now higher than 5-year Treasury yields, which have caused the 2s5s and 3s5s to invert. Two-year Treasury yields are coming close to being higher than 10-year Treasury yields. Inverted yield curves are a major warning sign of an impending recession.
In a report out of Europe yesterday, the European Central Bank is expected to end their version of Quantitative Easing this month. The M3 money stock, which is an expanded version of the M2 money stock, was growing at a 5% rate when the ECB was buying 80 billion Euro’s worth of bonds each month. In the third quarter, the M3 growth rate fell to 2.1% and experts believe it will fall to zero in the first quarter of 2019, followed by an outright contraction in the money supply.
The major indices were all down more than 3% today as systematic trading programs sold, which wiped out all the gains from the past three days. When liquidity is low, markets can fall quickly. This was not a major liquidation, as trading volumes were average. Don’t be surprised if there’s more selling Thursday, as the equity and bond markets are closed tomorrow to honor the passing of George H.W. Bush, our 41st President.
The API inventories came out showing an unexpectedly large inventory build – Crude: +5.36M, Cushing: + 1.4M, Gasoline: + 3.6M, Distillates: +4.3M.
- What happened to the stock market on Wednesday?
The stock market is closed to celebrate the life of George H.W. Bush, our 41st President, who passed away on Friday, November 30, 2018.
- What happened to the stock market on Thursday?
Stocks were pummeled out of the gate as a huge sell order came in yesterday when the futures market opened, which caused the major indices to open lower. In the past, large sell orders would be buffered by the securities dealers, but they aren’t doing that anymore. Welcome to a computer-traded market. Instead, the futures exchange was forced to pause the market every 10 seconds to deal with this large sale.
Stock market Bulls were once again forced to ‘buy the dip,’ as the major indices were trading near a major technical level, which if breached, could see a flood of selling. Most investors do not understand how much debt and leverage is sitting under this market that will lead to mass liquidations if stock prices continue to fall. At some point, the equity bulls will run out of money to prop the market up.
The Bulls were aided by a timely Wall Street Journal article which suggested the Fed may pause after the December rate hike. Due to the lags of monetary policy, any pause won’t matter. There is at least a one-year delay from when the Fed raises the Federal Funds rate and unwinds its balance sheet before the economy feels it. The stock market and economy are experiencing the tightening going back to the fourth quarter of 2017. All of the tightenings of 2018 has yet to hit the economy and when it does, stock market bulls will be powerless to stop it.
The Treasury-bond Bears were also forced to play defense today as 10-year Treasury yields hit a low of 2.826%, just above the major support line at 2.8%, which if breached, will see yields plummet. For the first time in more than a year, 30-year Treasury yields closed below their 200-day moving average.
The Department of Energy (DOE) reported crude inventories:
- Crude -7.323mm (-2mm exp) – biggest crude draw since July
- Cushing +1.729mm
- Gasoline +1.699mm (+1.75mm exp)
- Distillates +3.811mm
With refinery maintenance season mostly over, crude inventories are expected to fall. OPEC is expected to cut production, but the details are still unknown. Oil closed lower on the day.
Factory orders fell -2.1% MoM as the ISM Manufacturing survey rose. October’s Durable Goods orders fell -4.3% MoM. Clearly, the manufacturing survey is not reflecting lower demand.
Initial jobless claims hit a 5-month high as investors are hoping for a blowout Nonfarm payroll report tomorrow. Should this rising trend in jobless claims continue, it’s another indicator the economy has peaked. ADP reported +179k private-sector jobs were created in November, below expectations of 195k jobs created. ADP noted that “job growth has likely peaked.”
Adding insult to the trade war, our trade deficit with China hit a record high as it increased to $43.1 billion in October.
- What happened to the stock market on Friday?
November’s Nonfarm Payroll report came in at +155k jobs, below expectations of a +198k print. The Bureau of Labor Statistics (BLS) birth-death model showed a modest drop of -9k jobs, bringing the adjusted total to +164k jobs. The 12-, 6-, and 3-month average of jobs created are 123k, 108k, and 114k. When the job creation engine falls below 150k jobs per month, it’s a signal the economy is in the late stages of growth.
October’s payroll data was revised down, while September was revised higher, showing the number of jobs created was 12,000 less than previously reported. Average hourly earnings rose +0.2% MoM, below expectations of a +0.3% increase. The year-over-year rate of change in hourly earnings increased to +3.1%, which will keep the Fed in play for a December rate hike.
The workweek fell to 34.4 hours worked from 34.5 hours worked, which doesn’t seem like much. However, a 0.1-hour decline in hours worked translates to 370k workers being laid off, even though they just worked less. David Rosenberg, chief economist for Gluskin-Sheff, summed up the jobs report by saying, “Any time you get a payroll report that contains declines in the workweek, average weekly earnings and the index of aggregate hours worked, you know it’s a dud.”
The hotly watched OPEC meeting concluded today with a widely expected production cut. Oil price jumped on the new but struggled to hold increase.
The University of Michigan reported its preliminary survey data for December, which showed home-buying conditions fell to their 10-year lows.
One trillion of wealth was wiped out from U.S. stocks this week as Treasury yields fell. As I have previously mentioned, when Treasury yields fall, the Treasury short-sellers will be forced to sell stocks to buy Treasury bonds to cover their short positions. It appears this is playing out as I thought it might.
All major equity indices closed lower for the week, with the S&P 500 showing a ‘death cross,’ which occurs when its 50-day moving average slices down through its 200-day moving average. The last time the S&P 500 signaled a death cross was back in January 2016 when the S&P 500 fell 13%. The Russell 2000 performed the best today, as it was down slightly less than 2%, but it closed below a key support level that could see more selling going into next week.
Ten-year Treasury yields closed the week at 2.856% as the drop in bond yields this week led the drop in stock prices. The key technical level for 10-year Treasuries is 2.80%, which if broken, could see yields drop significantly. After closing below their 200-day moving average yesterday, 30-year yields closed just over it. Treasury yields were down across the board.
After doing nothing for months, physical gold closed at $1,249/oz and is starting to show signs of a breakout. The gold miners matched this move, which is starting to signal a move in. I still think there’s one last move down to confirm the moving averages, as a rally from this point might be premature. Either way, this a positive sign for gold moving into its next Bull market. Positions, when taken in the mining stocks, will start small and build.
Agricultural commodities closed the week higher as well and above their 50-day moving average. Earlier this week, the short-sellers were aggressive, but so were the buyers. This sector continues to remain poised for an upside breakout.
Portfolio Shield™ Update –
Portfolio Shield™ will begin its hedging program on December 3rd by adding long-term Treasury bonds to the allocation.