In its not infinite generosity of spirit, every week the Fed gives us reams of data. Some of that data is quite revealing, and quite useful for our purposes. The data helps us to understand the current monetary/liquidity environment, which helps us to understand the context of the current market milieu. That in turn helps us to divine where the market might be headed.
But there are times when the Fed thinks its information might be too helpful to us. So what does it do? It eliminates that item from its data. Poof! Something that had been helpful to us for years no longer exists.
It has happened before, and it just happened again, with an item that had been extremely revealing.
Apparently this information had become too useful to us. So, naturally, the Fed made it disappear. Now only the Fed knows about it. Oh, that data is still being collected, but they buried it with several other items into a useless catchall line item.
But fortunately they’ve give us a new line item that may be just as useful.
Viewed in conjunction with the data that disappeared, this new data shows us what’s really going on – a wildly speculative financial asset bubble in its death throes.
Here’s The Chart The Fed Doesn’t Want Us to See (And Why They Killed It)
At the end of 2017 I reported that I saw an unusual increase in speculative leverage as the likely driver of the blowoff in stock prices. This chart showed the type of short term loans that dealers and speculators use to finance securities purchases.
This chart shows the level of speculative financial borrowing by dealers, hedge funds, and institutions. I have overlaid a graph of the 10 year Treasury yield, inverted. Inverting the yield scale shows us the direction of bond prices.
So, as you can see, increases in this type of borrowing correlated closely with bond market moves. Obviously there was a feedback loop here, with cause and effect running in both directions. Traders borrowed more and bond prices rose. As bond prices rose, traders would borrow even more.
Then there were also periods where the opposite occurred. Less borrowing went hand in hand with falling bond prices.
But not in the second half of 2017, right up until the end of the year when the Fed killed the data. Speculative short term borrowing secured by financial assets soared. But bond prices didn’t move.
However, stocks sure did! It was pretty clear from this data that these big speculators had shifted their activities away from Treasuries and toward stocks. It became much easier for them to accumulate stocks, mark them up and distribute them at a profit, than it was to trade bonds successfully. The increase in speculative leverage drove the rally in the stock market!
Indeed, margin debt data just released for December confirms this massive surge in speculative borrowing to buy stocks. It’s nice data, but it has a 6 week lag. The Fed’s data was weekly, with just a 9 day lag. Too bad! They killed it.
After seeing the yawning divergence grow on this chart toward the end of last year, I had opined , “That leverage will likely be unwound beginning in the first quarter of 2018 as the Fed’s draining operations begin to take a toll.”
Sure enough, we got a swan dive in both stocks and bonds from the end of January into the second week of February. But since then, the lemmings have returned.
Now here’s the problem for everyone piling back into the long side of the market (even me- as my short term trades list has gone back overwhelmingly to the long side for now). This rally will not be long for this world. Get ready to say Kaddish for the markets.
Here’s why. The Fed’s balance sheet “normalization” operations will require the Treasury to increase debt offerings to raise the cash to pay the Fed for the holdings that it is redeeming. Dealers and investors will buy that paper partly with cash that they’ll withdraw from their checking accounts. It will go to the Treasury, and the Treasury will in turn pay off the paper held by the Fed.
In that way, deposits will come out of the system and money will be extinguished as the Fed’s balance sheet shrinks. Less money translates into less demand for securities. This is an ongoing process that will increase in severity as the Fed drains more and more from the system.
Remember, the Fed is building toward $50 billion a month in withdrawals from the banking system in quarterly increments until October. Then it will maintain that pace until the balance sheet reaches a “normal” reserve position. Without going into the nitty gritty of the calculations, that process could last into 2020. We’re talking about $600 billion a year in extinguished money! That’s going to hurt.
Given that context, we come back to the Fed’s weekly data on loans backed by securities. It was extremely useful to us, because it gave us a clear picture of what was driving the stock rally.
Too useful, apparently. It made clear that the rally in the second half of 2017 was based not on increasing central bank cash. No, it was based purely on a massive increase in speculative leverage. The obvious conclusion was that we were in the midst of a historic speculative bubble blowoff in the markets. The Fed did not want us to see that.
Too late! We saw it.
But lo and behold, they’ve give us a new line item that may, in the long run, be just as useful.
If You Know Where to Look, This New Chart Shows A Giant Bubble
The new chart is called “Loans to Nonsuppository Financial Institutions.” The Fed describes it thusly:
Includes loans to real estate investment trusts, insurance companies, holding companies of other depository institutions, finance companies, mortgage finance companies, factors, federally-sponsored lending agencies, investment banks, banks’ own trust departments, and other nondepository financial intermediaries.
In other words, this is pure financial leverage lending, both the fountainhead and a product of the massive asset bubble that has lifted prices for 9 years.
The data goes back only to 2015, but it bears some correlation with stock and bond prices. At times, the amount of these loans outstanding follows changes in Treasury prices. When the bond market fell (prices down, yields up) in late 2016, financial lending slipped in December 2015 and January 2016. Then as bond prices began falling again in December 2017, these loans also fell, and the stock market subsequently broke.
Today, with the Fed draining funds from the system, the speculative bloom is off the rose. This type of action should become the rule and not the exception in 2018.
This data could be as useful to us over time as the Fed’s earlier series that it just killed. I’ll continue to track this for you to see if it can tip us off to anything untoward that might be heading our way.
Meanwhile, despite the current stock market rally there’s nothing here that suggests that the context of the market has changed. This still appears to be part of a major topping process.
I’m comfortable with a current investment position of 60-70% cash. For those who have not reached that level, I’d use this rally as an opportunity to lighten up, with the goal of reaching that cash level (more or less depending on your personal circumstances) by the middle of the second quarter.
Originally I had said by the end of March. But I’m extending that because there are positive seasonal effects coming up in April-May. That should be the last good opportunity to reach that 60-70% cash position before the Fed’s liquidity draining operations really begin to bite in the second half of the year. With that cash, we should be able to take advantage of buying opportunities at lower prices both late in the second half of this year and probably in 2019 as well.