The Stage is Set Again

Every economic contraction and expansion always begins with the Federal Reserve, including the current one. Investors believe the Fed will drop interest rates to zero and implement Quantitative Easing 4 the next time the stock market drops. Unfortunately, the notion the Fed will tighten or ease monetary policy based on changes in stock prices is the furthest from the truth.

The Fed is beholden to currency-inflation, not to the fluctuation of asset prices, even though the Fed appears to be able to inflate asset prices on a whim. If the Fed had the power to create perpetual economic growth and wealth, they would have figured it out by now. After all, kings, queens, and central bankers have been trying to create perpetual expansions since mankind first invented currency.

The Fed’s guide for currency-printing inflation is not the expansion of the currency supply, even though an expansion of the currency supply is, inflation. Instead, the Fed chooses to follow an increase in consumer prices, or more specifically, Personal Consumption Expenditures (PCE). The difference being consumer prices are based on household surveys while the PCE is based on business surveys.

The real issue is the Fed needs to continue tightening monetary policy to give them the tools to combat the next recession. The reason the Fed has been talking about zero interest rates, negative interest rates, and further rounds of Quantitative Easing’s, is this is their plan for the next recession. Until there is a recession, the Fed does not have the leeway to ease without the risk of currency-printing inflation taking off.

During recessions, the Fed typically lowers the Federal Funds rate by -5%. With the Federal Funds rate at 2.25-2.50%, the Fed cannot lower interest rates by -5% without utilizing non-traditional monetary policy tools. The Fed can resume buying U.S. Treasury bonds and Mortgage-Backed Securities, but there is a point where further asset purchases become ineffective. During the next recession, the Fed and other central bankers will learn that zero interest rates are no longer enough to resurrect the economy.

When a central bank drops interest rates to zero and they don’t work, just as the Fed did during the Great Depression, it leads to a prolonged economic depression and deflation. It’s not just the negative effects of a zero-interest rate policy that leads to an economic depression, it’s the monetary lags. The initial euphoria of the Fed easing eventually wears off when the real economy fails to recover.

The performance of the stock market has become a proxy for the economy, which is a problem since corporations have been using cheap money and the tax cuts to buy back their shares. The reason corporations repurchase their stocks is to allow their stock-rich executives a means to sell their shares of company stock. For the next month, starting this week, corporations will enter their quarterly share buyback blackout period where they are prohibited from buying their shares back.

Unlike the first quarter, when I expected stock prices to fall, the set up for a plunge in stock prices during this blackout period is even more compelling. It’s not just that stock prices have risen back to an extremely high level or that volatility has been crushed to an extremely low level – it’s the U.S. Treasury bond market.

In early January, the U.S. Treasury bond market nearly broke through its major support level at 2.620%. This level is significant since the popular trade has been to use the cash proceeds from shorting U.S. Treasury bonds to buy equities. Shorting Treasuries was so popular, that last year the largest number of short positions was taken out against the U.S. Treasury bond market in history! While there is still a substantial amount of Treasury short positions on the books, it is no longer at a record level.

While investors are clamoring for higher stock prices and further monetary easing, they fail to realize the colossal reversal of fortune the will occur should U.S. Treasury yields continue to fall. Due to the extreme amount of short positioning, a continued drop in yields will force investors who are short, to buy U.S. Treasury bonds in order to exit or to reduce the losses from their short position.

With cash levels in brokerage accounts near record low levels, investors will need to sell other assets to cover their Treasury short positions. The only option available will be to sell equities. Selling equities will trigger a second feedback loop in volatility.

The same investors who have been using the proceeds from shorting Treasuries to buy stocks have also been shorting volatility or the index that tracks the fluctuations in the S&P 500. When equity prices fall due to Treasury yields falling, investors will need to sell even more equities to cover their volatility short positions or to buy volatility to minimize their losses from their short positions.

This feedback loop, which I have written about in the past, is nothing new to the stock market. Based on the design of our monetary system and the ability to take on highly leveraged positions, this feedback loop occurred during the prior two recessions. The only difference between current market positionings and prior market positionings is there is more money allocated to equities, short bonds and short volatility than ever.

If this week’s update seems to be a repeat of an update I wrote about three months ago, it is. The same setup is going to repeat itself every quarter until corporations run short on the amount of money needed to keep stock prices propped up. Going into the past two recessions, corporations were the largest and last marginal buyer of stocks. While they continued to repurchase shares during the prior two recessions, the amount of money available was insufficient to keep stock prices from crashing.

Corporations do not have an infinite amount of money at their disposal. If not for the twenty-percent corporate income tax rate cut, corporations would not be repurchasing as many shares as they have since the Tax Cuts and Jobs Act of 2017 was passed. Even with the tax cut in 2017, stock prices could not stay elevated due to the monetary tightening by the Federal Reserve. In 2018 there will not be any fiscal stimulus, leaving corporations as the last marginal buyer of stocks.

Corporations are facing massive headwinds themselves. The money supply has been decelerating since 2016, which means the economy is not creating enough money to maintain asset prices like it did in years past. World Dollar Liquidity is contracting, which has led to a global recession every time except in 2016 when China bailed out the world’s economy. Corporate earnings are expected to fall in the first quarter after projections showed an increase in corporate earnings just three months ago.

In order to continue funding corporate tax cuts, corporations need to continue generating profits. The Chinese tariffs, which are a tax on American consumers, will prevent corporations from lowering their prices enough to offset the deceleration in the money supply. The solution will be increased layoffs, just as we have seen in the past. With first-quarter earnings reports fast approaching, investors are hoping for big profits may be disappointed.

Since corporate executives are cashing out their stock at a record pace and leaving their jobs at a rate not seen since the last recession, corporate executives know they can’t keep propping up their stock price indefinitely. Corporate share repurchases in the first quarter have been at a rate double what they were this time last year, without doubling the amount of money committed to buying back their shares.

Based on share repurchase commitments, this year should see the same dollar amount allocated to buying shares back as last year. Last year, corporations ran low on monies for repurchases at the beginning of October. At their current pace, corporations will run low on money by mid-year. Once corporations run out of money, the last marginal buyer of stocks will disappear.

Looking out at the markets, the next leg down in stock prices will prove or disprove if the stock market is still in a Bull market or if it has entered a Bear market. Should stock prices fall and hold their December 2018 lows, it will be a compelling argument that the Bull market is still on. Should stock prices fall below their December 2018 lows, as I suspect they will, it will be a strong argument that the Bear market is on.

The coming corporate share buyback blackout period and first-quarter earnings reports should set the stage for an interesting change in stock prices. A large move lower in stock prices will create an opportunity for those with cash should stock prices break below their December 2018 levels. Either way, the stage is once again set for something interesting to happen.

Corporate Buyback Blackout Roadmap (03/18/19 – 15 min)


The Fed Turns Dovish (03/20/19 – 15 min)


Weekly Economic Update (03/22/19 – 30 min)