Hardly a week goes by where the President is not tweeting about the stock market or how high it is going to continue to rise under his tenure. Yet investors have long since forgotten that President Trump routinely commented during his candidacy that the stock market was overvalued. Even though half of all Americans hardly own any stocks, if any at all, the reason President Trump is desperate to drive the stock market higher may shock you.
Many of the reasons may sound obvious, as a strong stock market means President Trump has a strong chance at reelection, should he choose to run, plus it increases the probability for other Republican candidates to win their elections. While President Trump may or may not seek a second term, as he is rightfully concerned about a recession during his tenure, leaving the Presidency without the economy recessing gives him the latitude to proclaim he was one of the best Presidents this country has ever had.
Opinions and egos aside, the economy does benefit from rising stock prices. Estimates show that for each ten percent increase in the broad equity market, Gross Domestic Product growth increases by one percent. Since our current economic expansion has been the worst in our country’s history, rising stock prices are a welcome boost to economic growth.
The reason rising stock prices boost economic growth is due to the symbiotic relationship between stock prices and consumer confidence. Consumers respond they are more confident about the economy when their brokerage accounts are rising. When Americans feel confident, they are willing to borrow their futures away to spend today.
But those aren’t the reasons why.
During the Great Financial Crisis, the Federal Reserve made a cataclysmic mistake that had unintended consequences. When the Fed started their experimental program to rescue the economy, better known as Quantitative Easing, they had no idea what the long-term economic effects would be. All the Fed knew was they needed to reflate the economy and zero percent interest rates were not working, so they stuffed the banks with reserves to boost asset prices. Fortunately for the Fed, their plan worked, and the Great Financial Crisis was averted.
Little did the Fed know at the time that Quantitative Easing and zero-percent interest rates would sow the seeds for the next financial crisis. After all, it appears the Fed’s plan worked as the economy did recover and the stock market rose in value. Since most American’s look to the stock market as the barometer for the health of the economy, everything looks rosy. Underneath the shiny veneer is a very weak economy due to the Fed’s easy monetary policies.
What the Fed inadvertently did was convince the world that they could control stock prices and make the stock market perpetually rise.
When the Fed started their Quantitative Easing program, they initially purchased billions of dollars worth of U.S. Treasury bonds on a monthly basis. The program would later be expanded to include Mortgage-Backed Securities, which made the Fed the largest holder of mortgages in the country. The purpose of the program was to inject currency into the economy to spur bank lending.
While many experts thought this program would be inflationary, it turned out not to be. The Fed was buying Treasury bonds from the largest U.S. banks who were buying them from anyone who had them. The Fed required the banks to deposit the currency they received into accounts held at Federal Reserve member banks, where the largest U.S. banks would be paid interest on the currency they received. As a result, most of the currency created from Quantitative Easing just sat in the Federal Reserve bank accounts collecting interest, which is inflationary but does not lead to rampant inflation.
Since the banks could not deploy this currency into the economy, it became a form of excess reserves, which is currency banks hold above their normal reserve requirement. In a debt-based economy, such as ours, asset prices rise in response to new currency entering the financial system. Asset prices, including stock prices, rose as the Fed engaged in more QE. By the end of the program, the Fed had purchased $3.6 trillion of U.S. Treasury bonds and Mortgage-Backed Securities.
What the Fed did not expect was how investors would react to this. Most investors prefer to own both stock and bonds as the financial services industry has touted the benefits of diversification for decades. With the Fed buying every U.S. Treasury bond and Mortgage-Backed Security in sight, investors were forced into risk assets. As the years passed and the Fed continued with QE, more and more investors were forced into buying stocks.
The problem President Trump and Federal Reserve face is they convinced over 75 million Baby Boomers, who are in retirement or headed into retirement, to put all their investible assets into stocks.
As the Fed started tightening monetary policy by raising the Federal Funds rate and reversing Quantitative Easing, investors continued to buy stocks over bonds. Since Quantitative Easing was determined to not be inflationary by investors, the opposite must be, so investors remain confident that they are on the correct side of the market. Except they are not.
The purpose of Quantitative Easing was to inflate asset prices, and along with it, long-term interest rates rose. The opposite effect should cause asset prices to fall, which has started, and long-term interest rates to fall, which they are.
Despite the facts, the financial media and financial analysts have convinced investors that the next big Bull market in stocks has begun. Unfortunately for these so-called experts and those who follow their advice, they are completely wrong. After all, those same experts failed to warn investors prior to the last two recessions, yet investors are eager to believe.
The real reason President Trump is pushing the Fed to lower interest rates and resume Quantitative Easing is partially due to the weakening of the global economy, but mostly because the financial security of 75 million people, or voters, is dependent on the stock market never going down again. At least not during President Trump’s tenure.
Once the stock market goes, and it will, the Fed will be powerless to stop it. Most investors believe the Fed has the magical ability to perpetually raise stock prices, but they do not. The Fed can raise the Monetary Base which does support higher asset prices, including stocks, but the economy does not instantaneously respond to the Fed. Therein lies the problem.
Whenever the Fed makes a change to monetary policy, there are short-, mid-, and long-term effects. The short-term effects are well known, the mid-term effects are assumed, and depending on what the Fed is doing, the long-term effects are unknown.
The problem with the long-term effects is there is a lag, which currently is somewhere between eighteen to twenty-four months. These long-term monetary lags can be a huge boost to the economy when the Fed is easing, and they can be a huge detriment to the economy when the Fed is tightening.
For example, the Fed started easing monetary policy by lowering the Federal Funds rate in August 2007. The Fed did not stop lowering interest rates until January 2009, eighteen months later. The stock market started having problems in October 2007 but did not bottom until March 2009, which is eighteen months later. While the monetary lag is unknown, and I wrongly determined it was fourteen months, it is at least eighteen months, if not longer.
Looking back, the Fed did not begin its aggressive tightening cycle until October 2017, which was nineteen months ago. Prior to October 2017, the Fed hiked rates four times. If the monetary lag is still eighteen months, and it may be longer, the economy is now feeling the effects from October 2017. If the monetary lag is longer than eighteen months, and the lag is a function of how much debt an economy has, then we may have already or are about to feel the effects from the June 2017 rate hike, which happened twenty-three months ago.
The scary part for investors should be the monetary lag, which normally leads to a recession after the Fed tightens. However, no central bank in history has ever engaged in Quantitative Tightening where they unwound or sold off some of their bonds. The Federal Reserve is the first central bank to unwind their balance sheet, and potentially the last, depending on how the monetary lags of the balance sheet unwind effect the economy.
It should be obvious to investors that a synchronized global expansion is now turning into a synchronized global downturn. Yet investors have become convinced that the Federal Reserve and President Trump can somehow keep the stock market elevated and the economy growing despite the forthcoming negative effects from the Fed’s balance sheet unwind.
While nobody knows for sure what is going to happen, it is reasonable to assume that if asset prices rose as the Fed expanded their balance sheet, then asset prices should presumably fall at some point in response to a reduction of their balance sheet.
When charting the Monetary Base, which is the total amount of currency in the financial system plus the amount of currency held in excess reserves, against the broad equity market, investors can see what the future may hold.
The S&P 500 should be trading at about 1,600 points, which is about -44% from where it is today. The Dow Jones Industrial Average should be at 16,000 points, which is about -40% from where it is today. And those numbers are not assuming we have a recession, which could make them much worse.
Once the monetary lags kick in, the Fed will not be able to rescue the economy or the stock market. The Fed tried in the past two recessions and failed, precisely due to the monetary lags. Unlike the past two cycles, where the Fed rapidly tightened, relatively to today, the Fed has been tightening for over three years, which means the next recession is going to be longer and potentially deeper than the last two.
Now you know why President Trump is eager to keep the stock market up and why he, and his administration, has been pumping up the stock market and calling for the Fed to ease monetary policy. Once the monetary lags kick in and asset prices fall, the retirements of 75 million people will suddenly be destroyed – that is unless they learned from the past two recessions. For those investors who have taken the conservative path, the next market bottom will make the financially very happy for the rest of their lives.
Trade Wars and “Dumb” Money Positioning (05/06/19 – 15 min)
The Trade War is About to Escalate! (05/08/19 – 15 min)
Weekly Economic Update (05/10/19 – 30 min)