Get Ready for These Bearish Liquidity Trades Today

LAMPP Outlook: Headed Towards Red

For now, the long term LAMPP is still a green light. But the intermediate LAMPP is yellow. Given the Fed’s recent statements that it is about to shrink its balance sheet, it won’t be long before both LAMPPs turn red.

That means we’ll be looking at a number of bearish opportunities soon…

First, let me tell you why we’re seeing these green and yellow signals now – where the red is coming from – and then how to profit.

The Fed Is Still Adding Cash to The Bubble – But Not for Long

The Fed holds the settlements of its regular monthly purchases of MBS in the third week of each month. The purpose of those purchases is to replace its holdings of Mortgage Backed Securities that were paid down over the past month. That keeps the size of the Fed’s balance sheet flat. More importantly, because the Fed purchases the replacement paper from Primary Dealers, the purchases cash out the dealers. This is still a positive influence on the Intermediate and Long Term LAMPs (Liquidity and Monetary Profits indicators).

The cash flow from the Fed is essential to the dealers in carrying out their market making function. Their business consists of accumulating securities inventory for distribution to the public at a profit. That requires cash flow. The Fed necessarily supplies some of that to facilitate the Primary Dealers in their role of making markets in US Treasury securities.

In July the Fed added $26 billion in cash to Primary Dealer trading accounts held at the Fed. This is slightly more than the June addition of $24.9 billion. Those settlements took place over the period July 13-20.

The exact total to be settled in August is not yet known but it should again be in the $25-26 billion range. These settlements will occur over the August 14-21 period. The markets frequently get a little boost during settlement week as the cash flows into dealer accounts. But Treasury supply will be heavy this month. That could sop up any excess cash that would otherwise be available to boost stock prices.

The Treasury has scheduled $74.6 billion in new Treasury supply over the period of July 17 to August 10. There could be more coming supply coming every week until the end of September, when the Treasury has warned it must have a debt ceiling increase.

Treasury issuance is a counterweight to the Fed cash. The Treasury paper must be absorbed by dealers and other institutions. That is a normal feature of the market which would put downward pressure on securities prices in a vacuum where there were no new funds available to absorb the paper.

The current ratio of Fed cash to dealers relative to new Treasury issuance is around .35. That’s enough to keep the LAMPP on yellow, but it is on the razor’s edge. I expect the ratio to turn red in October when the Treasury must sharply increase its issuance, assuming that the debt ceiling is lifted.

While the Fed has been much less active in cashing out dealers since the end of 2014, its cohort central banks, the ECB and BoJ, have taken up the slack. Some of the money that they print for their markets has ended up flowing to the US markets. That has helped to sustain the US market bubbles.

However, the Fed will always be the prime mover of the US market. Foreign central banks are more than bit players, but the Fed is the 700 pound gorilla here.  The gorilla has been beating its chest, warning with increasing ferocity that it is about to attack the market. It is no accident that our intermediate term LAMP indicator is on a yellow light. We need to be both cautious, and ready to slam on the brakes, when the Fed turns from chest beating to outright hostile attack on the markets.

“Chinese Water Torture” for The Markets Starts In 3, 2, 1…

From 2009 to 2014, the Fed had resolved to force trillions in excess cash into the banking system. When it ended QE in 2014, it then resolved to make sure that the amount of the cash in the system did not shrink. It did that each month via its program of MBS replacement purchases.  That resupplied the dealers with cash, and replaced the Fed’s holdings of MBS that had been paid off the month before. The Fed also was happy to allow capital inflows from Europe and elsewhere feed the bubble.

Lately, their attitude has changed.

All parties must end. Market bubble parties end when the central bank says enough is enough, and pulls the punchbowl. The Fed covers its true intention by talking about wanting to stave off inflation. In reality the Fed worries about bubbles, and has moved to stop them in the past. It tightened policy in both 2000 and 2007 in response to massive bubbles. It is about to do so again today.

I warned a couple of years ago that we would know that the Fed was getting serious about tightening, not when they talked about raising interest rates, but when they talked about shrinking the balance sheet. The Fed’s word for that is “normalizing” the balance.

Doing that would mean shedding assets. The effect of that would be to drain funds from the market and the banking system. In essence, the Fed will demand from the US Treasury that it repay the loans the Fed made to the government when it bought all those notes and bonds under QE. As those notes and bonds mature, the Treasury must raise the funds in the market to redeem the Fed’s paper.

So there will be more supply for the market to absorb. The other side of the coin is that the Fed won’t be there to cash out the dealers so that they can buy the paper. Therefore, in addition to adding supply pressure to the market, the Fed will also reduce effective demand by withholding the cash that would have absorbed that paper.

I cannot stress enough just how bearish that is. The Fed did something similar in 2008, starving the dealers of cash when the Treasury was selling massive amounts of debt. The Treasury won’t be selling so much new paper in this go round, but there will be an increase in supply. And there will be less cash available to absorb it. This will be a policy that could last for years. Rather than a crash, it could be like Chinese water torture for the market. It will be a long and painful process.

This Month’s Profit Opportunities: Bearish

I suspect that the Fed will be patient with a retreating market for months, if not years, as long as the economic data refrains from going over a cliff. So long as there’s a Federal deficit supplementing government spending, I don’t expect that to happen. The US economy should continue to limp along. Government measures of consumer prices and wages will continue to tick up modestly as interest rates rise.

Markets top out when the economic news is good because that’s when the Fed pulls the punchbowl. The Fed will stay tight until the markets and the economy really crater, very late in the cycle. It’s a process that history tells us will take from several years to a generation to complete.  Japanese markets suffered for that long after its great bubble ended in 1989.  The US could suffer a similar experience.

Under the circumstances, the likelihood is that we’ll see more red and yellow on the Intermediate LAMP indicator. Green will be exceedingly rare. The long term LAMPP will turn red in the initial stages of the Fed’s program of “normalization.” And it will stay red until the Fed starts printing money again.

Consequently, now is an appropriate time to begin a regular program of paring down your long positions, if you haven’t already done so. And it’s a good time to be scoping out, and even establishing pilot positions on the short side in industries that are already in decline, or are technically overextended, such as the ETFs for Consumer Discretionary Select Sector SPDR ETF (NYSEArca:XLY), or iShares US Broker-Dealer ETF (NYSEArca:IAI) (which is thinly traded and should never be bought or sold in size). Another group that should come under pressure when the Fed starts shrinking its balance sheet would be the Financial Select Sector SPDR ETF (NYSEArca:XLF).

Purchases of puts as a speculation on the short side would be way for you to play it when the LAMPP turns red, if you can tolerate the additional risk. It’s too early for that today, but we’ll be on the lookout for those conditions in the months ahead.

We’ll be on the lookout for top patterns developing in the charts of both the market indexes and in component industries and individual stocks. There will be money to be made on the short side. We will participate!

Till next time,

Lee Adler

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