Monetary Easing is Going to Crash the Stock Market

The Federal Reserve is going to crash stock prices by easing monetary policy. I realize that statement sounds strange and even counterintuitive, but it is true. The reason most investors and professional money managers are mispositioned going into Bear markets is that they do not understand how the Fed can crash stock prices by easing monetary policy. Yet, the Fed is in the process of crashing stock prices again, when most investors are heavily invested in stocks.

After studying our monetary system for the past decade, I have learned the markets do not work the way most investors and professionals believe. The belief most investors hold is that low-interest rates are inflationary and will lead to higher stock prices. This view was likely born in the decades following the peak in interest rates back in the early 1980s, but this was following the early 1970s reset of our monetary system.

Based on the design of our monetary system, Treasury yields, or interest rates should follow stock prices higher during Bull markets. It does not mean they both need to rise in unison every day, week or month, but Treasury yields need to follow stock prices higher to validate a Bull market in stocks. Bear markets work just the opposite, where stock prices follow yields lower.

In a debt-based monetary system, rising Treasury yields are an indication of loosening financial conditions and falling Treasury yields are a sign of tightening financial conditions. In a Bull market, Treasury yields rise to validate economic growth as demand for lending leads to higher yields. In a Bear market, Treasury yields fall to create demand for lending to reignite economic growth.

In Bull markets, consumer prices tend to rise, and since consumer prices are the Fed’s preferred gauge of inflation, the Fed raises interest rates to moderate the rate of inflation. Unbeknownst to the Fed, higher interest rates validate the Bull market in stocks since both short- and long-term Treasury yields follow the Federal Funds Rate higher.

After raising the Federal Funds Rate for several years or more, higher interest rates cause economic growth to slow. As economic growth slows, Treasury yields will start to fall to spur lending demand, even when the Fed is not yet easing.  This leads to a very important dislocation between stock prices and Treasury yields, which is a signal of an impending Bear market in stocks.

When Treasury yields begin to fall while stock prices are rising, it is a sign of tightening financial conditions. Falling interest rates are not inflationary unless there is a corresponding increase in lending growth. When lending growth slows despite falling interest rates, it means interest rates will continue to fall until rates are low enough to spur a large increase in lending demand.

As Treasury yields fall, consumer price inflation starts to slow and will eventually follow Treasury yields lower. To spur inflation, the Fed then starts easing monetary policy by lowering interest rates. Without a corresponding increase in lending growth, the Fed inadvertently tightens financial conditions by lowering interest rates. Since both short- and long-term Treasury yields follow the Federal Funds Rate lower, as the Fed continues to ease, it further tightens financial conditions.

The Fed has two policy tools: it can raise and lower the Federal Funds Rate and expand or contract the size of its balance sheet. Both tools involve buying or selling short-term Treasury Bills and both have the same result. When the Fed lowers the Federal Funds Rate, it buys Treasury Bills. When the Fed increases its balance sheet, it buys Treasury Bills, until there are no more left, and then it buys Treasury Notes and Bonds. When the Fed announced it was going to start buying $60 billion per month of Treasury Bills in October 2019, investors should have expected yields to continue falling.

In its attempt to ease financial conditions by buying Treasury securities, the Fed inadvertently tightened financial conditions by reducing the supply of Treasury securities available in the market. Even though investors thought interest rates would rise when the Fed started buying $60 billion per month of Treasury Bills, yields continued to fall. Rather than alleviate the tight financial conditions, the Fed caused them to further tighten by expanding its balance sheet.

At the peak of every modern-day Bull market, Treasury yields begin to fall, on average, three months before stock prices fall. Treasury yields peaked back in October 2018 and stock prices peaked in February 2020, making this the longest dislocation between stock prices and Treasury yields in history. The reason this dislocation is the longest likely had to do with the corporate tax cut which led to corporations buying large quantities of their shares back and kept the rally in stock prices going long after it should have stopped.

Since stock prices and Treasury yields need to follow each other, either stock prices need to fall to catch down to Treasury yields or Treasury yields need to rise to catch up to stock prices. Corporations have been holding stock prices higher by buying their shares back, but they do not have an unlimited source of funds. The Fed has been pushing yields down by buying Treasury securities, and they do have an unlimited source of funds.

As much as this does not make sense, the Fed drains liquidity by lowering interest rates. Lower interest rates do not ease financial conditions until they are low enough to spur a huge increase in lending growth. Hence, monetary easing does not ease financial conditions until it does. Until it spurs lending growth, monetary easing causes financial conditions to tighten.

Out of fears, the Coronavirus will send an already slowing global economy into a recession, the Fed has started lowering interest rates. The proof the Fed’s easing is causing financial continues to further tighten is validated by Treasury yields, which continue to fall the more the Fed eases. This is the key reason why most investors are mispositioned at the peak of Bull markets since they do not know that monetary easing leads to tighter financial conditions until it eases.

As the Fed drives Treasury yields lower, it sets up a huge move lower in stock prices, since the Fed is tightening financial conditions. The problem exasperated due to the largest and longest dislocation between stock prices and Treasury yields in history. It suggests stock prices could fall much further than most think is possible when the Fed finally tightens conditions enough to break the stock market.

Looking back at prior Bear markets, it is clear that the faster the Fed cuts rates to ease financial conditions, the faster the stock market implodes. In the past, investors claim the Fed cutting rates sends them into a panic, but it is tightening of financial conditions from the rate cuts that will break the financial markets. Anything that causes the Fed to panic and to slash interest rates, such as the Coronavirus, threatens to send stock prices into a violent Bear market.

In March the Fed has already cut the Federal Funds rate by -0.50% on top of its plan to purchase $60 billion of Treasury Bills this month. In response, Treasury yields crashed, which indicates the Fed’s rate cut tightened financial conditions rather than easing them. Treasury yields are putting pressure on the Fed to slash the Federal Funds Rate to zero at its next meeting, which if done, will likely cause financial markets to seize. Now you know how monetary easing is going to crash the stock market and cause Treasury bond prices to soar.

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