Every Bear market in stocks has a catalyst, with the most recent one being the Coronavirus. Many people believe the Coronavirus has caused stock prices to crash, but the virus merely tipped an already wobbling global economy into what will likely be a global recession or depression, unless the Federal Reserve acts quickly enough. While many investors are hoping the Fed will come to the rescue with a massive monetary stimulus package, investors should be forewarned that it will have the opposite effect.
Every economic expansion and contraction can be traced back to the handiwork of the Fed. Expansions begin after the Fed eases monetary policy and contractions begin after the Fed tightens monetary policy. When the Fed eases, dollars are created within the global economy and when the Fed tightens, dollars are destroyed within the global economy. Since the dollar is the world’s reserve currency, the Fed’s monetary manipulations directly affect World Dollar Liquidity.
World Dollar Liquidity is the cycle in which dollars flow through the global economy. The cycle begins when American consumers demand foreign-produced goods and services, which are paid for in dollars. Foreign corporations then trade those dollars with their local bank, who in turn trades their excess dollars to their foreign central bank for local currency.
As dollars pile up in the accounts of the foreign central bank, they become inflationary, so to reduce the effects of inflation, those dollars are used to purchase U.S. government debt at the U.S. Treasury’s debt auctions. The Federal government then spends those dollars back into the domestic economy where the number of dollars expands, and the cycle continues. As the number of dollars in the global economy expands, asset prices rise.
When consumer prices rise faster than the Fed wants, they begin to contract World Dollar Liquidity by tightening monetary policy. Unfortunately, the Fed does not realize destroying dollars in a debt-based economy always leads to an economic contraction or recession. The amount of monetary tightening directly correlates to how severe the next recession will be.
When the Fed started raising the Federal Funds Rate in December 2015 to over 2.25% three years later and subsequently selling off $755 billion of its balance sheet, it set the stage for what will likely be the worst recession in modern times. Since the Fed tightened monetary policy, World Dollar Liquidity has contracted by the largest amount, by far, in history. While the Fed’s monetary tightening will be the cause for the next recession, it was not the sole contributor to the contraction in World Dollar Liquidity.
One of the underlying purposes of the Tax Cuts and Jobs Act of 2017 was to repatriate dollars in offshore bank accounts. When those dollars came home, it further reduced the number of dollars in the global economy needed to conduct global trade. The trade war with China led to a contraction in global trade and a reduction in dollars in the global economy.
High oil prices were a boon for U.S. shale producers, which allowed the U.S. to become the largest exporter of oil. From a World Dollar Liquidity perspective, foreign buyers must pay for oil in dollars, so high oil prices have contributed to a contraction in World Dollar Liquidity.
The Coronavirus, while bad for many other reasons, is also reducing the flow of dollars into foreign economies as global travel is grinding to a halt. All of those factors combined were more than the U.S. stock market could handle, which caused stock prices to finally crash.
The eventual decline of stock prices was predicted back in October 2018 when Treasury yields began falling while stock prices continued to rise. Normally stock prices begin to follow Treasury yields lower, on average, three months after Treasury yields start their decline. Due to the corporate tax cut, corporations continued to buy their stock back which kept the Bull market in stocks running longer than it should have.
When the economy and the ascent of stock prices started to slow, the Fed began lowering the Federal Funds Rate. While lower rates helped boost stock prices for several months, stock prices eventually fell. When stock prices fall, consumer spending falls, so the Fed came to the rescue by buying $60 billion per month of short-term Treasury Bills. The Fed’s monetary magic did not work since stock prices continued to fall. Fortunately for the Fed, the Coronavirus arrived at just the right time.
The Coronavirus, while only playing a small part in the contraction in World Dollar Liquidity, has given the Fed the green light to further cut the Federal Funds Rate, which they did in March by taking it to 0% and to increase their monthly purchase of Treasury securities to $80 billion. When the Fed eases, it causes both short- and long-term Treasury yields to fall, even though most investors believe otherwise.
Most investors do not understand World Dollar Liquidity, which is the sum of foreign-owned Treasury securities and the Monetary Base. The Monetary Base is the total amount of currency in circulation or the amount of commercial bank deposits held in the central bank’s reserves. While the Fed cannot control the amount of money in circulation or the amount of foreign-owned Treasury securities, it can control commercial bank deposits.
The Fed can raise commercial bank deposits by a process referred to as Quantitative Easing (QE). Quantitative Easing is when the Fed purchases Treasury securities from commercial banks for dollars, which in turn must be deposited in the Fed’s reserve account. To restore World Dollar Liquidity, the Fed will need to restart Quantitative Easing at a scale that dwarfs its current $80 billion per month purchase program.
The notion of a return to Quantitative Easing has investors salivating since they believe QE leads to higher stock prices and Treasury yields. While investors are grabbing stocks as they fall in price and have resumed shorting Treasuries, investors are about to find out the cold hard truth about Quantitative Easing.
Quantitative Easing leads to a huge spike in volatility, which will happen the Fed realizes it will have to purchase a far more than $80 billion per month of Treasury securities to stop the global economy and the stock market from crashing. When volatility spikes, stock prices, and Treasury yields crash. Volatility today is near its peak set back during the Great Financial Crisis, which suggests that the resumption of large-scale asset purchases will lead to an unprecedented rise in volatility and a massive crash in stock prices.
Treasury yields fall during or shortly after the Fed makes large-scale asset purchases, which causes bond prices to rise. Bond prices rapidly rise since the Fed buys huge quantities of Treasury securities at marked-up prices from the commercial banks, who buy Treasuries in anticipation of selling them to the Fed at a future date for a profit.
When the Fed first started Quantitative Easing 1, yields plummeted until they fell far enough to spur lending growth. In every subsequent round of QE, yields either fell or fell shortly thereafter, so those betting against Treasuries are going to find out the hard way that yields fall when the Fed buys.
When the Fed is forced to increase the size of its large-scale asset purchases, even above the $700-800 billion per month increase announced on Sunday, ten-year Treasury yields are likely going to go negative, while thirty-year Treasury yields are going to get near zero percent. At the same time, volatility will spike to unimaginable levels, which will lead to a complete collapse in stock prices. Those who had the foresight to own long-term Treasury Bonds will reap a huge profit when bond prices soar and have the opportunity to buy stocks at ridiculously low prices.
Had it not been for the Fed engaging in the longest and largest contraction in World Dollar Liquidity and corporations continuing to push stock prices to unrealistic levels, the impending global recession would likely never have occurred. While the Coronavirus plays a role in the contraction of World Dollar Liquidity, it is merely the catalyst that is about to send the global economy spiraling down. When the Fed takes action to prevent the collapse they engineered starting back in December 2015, it will make a few wise investors wealthy while simultaneously annihilating the wealth of the masses.
QE is Not Inflationary! (3/16/20 - 28 min) https://www.facebook.com/svmfin/videos/192544082176856/
Lots of Bond Volatility (3/18/20 - 32 min) https://www.facebook.com/svmfin/videos/318051269154655/
Stocks Continue to Drop! (3/20/20 - 34 min) https://www.facebook.com/svmfin/videos/298589244436149/