Over the weekend, we discussed the little-known secret that in today’s post-QE world, the Fed actually doesn’t control rates… it just rubber-stamps what the market is already doing.
And the market is tightening all on its own – whether we like it or not.
You can see what’s happening in the market from the chart of the 13 week T-bill, which has risen relentlessly, both before and since the Fed raised the Fed Funds target in March. Rates are rising because as the Fed removes cash from the system, the demand for short term paper can’t keep pace with the supply.
As the Fed drains cash and the Treasury pounds the market with supply, the situation spirals increasingly out of control.
We may be looking at a rather large market “accident” as soon as July.
Here’s what’s going on – and what it means for you.
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“Rotational Liquidation” Can Only Keep Us Afloat Through July
I have been making the point for months that liquidity is insufficient to support bull moves in both stocks and bonds. If one rallies, the other must be the source of funds for that rally. So we see asset class rotation from day to day and week to week. Sometimes both markets do rally concurrently for a day or so. Invariably that leads to both selling off together for a few days, often to lower lows.
I expect more of this rotational liquidation in the months ahead. But as the Treasury continues to bury the market with supply month in and month out, and the Fed pulls more and more money out of the system, the time will probably come when both stocks and bonds sink together.
I had warned throughout the fourth quarter of 2017 and in January 2018 that as the Fed pulls money out of the financial system, there would no longer be enough liquidity to support bull moves in both markets simultaneously. I also cautioned that the rotational theme would last for only a little while longer. In mid-January I wrote that I expected that stocks would succumb to a growing shortage of cash as the Fed pulls money out of the system and the Treasury pounds the market with immense amounts of new supply.
Furthermore, I warned back in January that, “This first quarter of 2018 should be the turning point. We are facing be the worst liquidity conditions that we have seen since the 2008 collapse and those conditions will only tighten more through the year as the Fed increases its drains from the system and the Treasury pounds the market with gargantuan slugs of new supply.”
That has happened, and it will only get worse from here, despite these spirited 2-3 day rallies that keep popping up.
Spurring those rallies is the fact that every April the Treasury takes in a few hundred billion in tax collections. This year, individual non-withheld and corporate income tax collections totaled $350 billion in April.
The Treasury uses a portion of that annual windfall to temporarily pay off some of its outstanding debt. When the Treasury pays down debt, it puts money back into the accounts of the dealers and institutions which held the maturing paper.
That money burns a proverbial hole in the pockets of those dealers and institutions. They spend it to buy more Treasuries, and also equities. The paydowns of Treasury debt thereby boost the stock and bond markets virtually every year in April and May. So there’s never any mystery why the market usually rallies during this time. We’re always on the lookout for it, as we were this year.
The Treasury then resumes borrowing in May. Treasury supply always increases after the April windfall, particularly in the third quarter. Increasing supply would cause prices to fall across all financial asset classes, if all other things were equal. During the years of QE, that was no problem. The Fed printed money and pumped it into Primary Dealer accounts via QE every month. They did enough of that to finance all of the new Treasury issuance, with some left over to boost other asset prices.
But today the Fed is doing just the opposite, pulling money out of the system under a program that it euphemistically calls “normalization.” It’s anything but. It’s actually more like “bloodletting.”
So with the Fed running its bloodletting treatment, it makes the annual seasonal increase in Treasury supply headed our way, a big problem. And this year it’s an even bigger problem because thanks to the BBA (Budget Busting Act) and tax cuts, the government’s deficit is mushrooming and Treasury supply is exploding. An estimated average of $100 billion per month in new supply is set to pound the markets month after month.
Now, this year’s April paydown was only slightly greater than last year’s. But in the middle of the month, from April 5 through April 26, paydowns totaled a gargantuan $133 billion.
The Treasury robbed its piggy bank to pay down debt and inject enough cash into the markets give stocks and bonds a boost. It did that just when stocks threatened to break down early in the month. It worked, but only a little. The bond and stock markets have not been able to sustain rallies, and they remain in danger of price breakdowns. In the case of Treasury yields, that means that an upside breakout above 3% on the 10 year is all but inevitable.
The impact of the Fed’s draining operations showed up mostly in the form of soaring Treasury Bill rates in April. That’s been one of our keys to this market. Rates skyrocketed in April despite the fact that the Fed did not move to raise rates. The market is tightening on its own, and that will only get worse as the Treasury resumes pounding the market with supply in May and June, and throughout the third quarter.
That’s likely to lead to a market accident after the Fed increases its withdrawals of cash from the banking system from $30 billion per month to $40 billion in July. So, if you’re not already out of the market and in cash, now is the time to be getting there, especially on these 2 day wonder rallies.
The relentlessly rising 13-week T-Bill chart is a real time meter that shows us a perfect snapshot of what’s happening.
Treasury Supply Is Headed to The Moon – and You Should Head for The Hills
So in April, the Treasury robbed its piggy bank to give stocks and bonds a boost when stocks threatened to break down early in the month.
But the yields on longer term Treasury notes and bonds forged higher in spite of all that cash pouring into the market. At one point late in the month the 10 year yield was above 3%. That’s only one small step in the ongoing giant leap of bond yields to higher ground. In other words, I think bond yields are headed to the moon. As the Treasury floods the market with massive amounts of supply and the Fed pulls increasing amounts of money out of the market under its bloodletting program in the months ahead, the upward pressure on yields will be relentless.
This pressure was most apparent in bill rates last month. Bill rates rose 39 basis points on average. This happened despite the massive bill paydowns and before
the FOMC announcement of no rate increase. That wasn’t a surprise. The consensus was that there would be none.
There was a bit of downward push in rates concurrent with the biggest bill paydowns, but other than that, the pressure was all to the upside.
Last week the 4 week bill went off at 1.65%, which was down a little from the week before as the Treasury again paid down some outstanding bills. But it was 10 bp higher than the month ago auction. The 13 week bill rose by 41 basis points last week vs. the previous week, hitting 1.84%. The 6 month bills rose to 1.99% from 1.25% the previous week.
That’s right. You can now get 2% on 6 month paper! When was the last time we could say that?
These are enormous jumps. Clearly some of the money that would normally have gone into the bills moved out to longer term securities, including 10 year Treasury notes, which have gotten the benefit of a bid for a few days. Stocks have also seen a bid. Meanwhile the sustained rapid upward movement of rates shows just how tight the financial markets are becoming as the Fed drains money from the system.
The market is tightening on its own. When the Fed does raise the Fed Funds target, it is merely ratifying what has already occurred. It skipped that pretense at last week’s FOMC meeting. It did not raise the Fed Funds target, but T-bill rates kept rising, making it absolutely clear that rates are rising on their own.
So you see that the Fed doesn’t lead the market in raising interest rates. It simply ratifies what has already happened.
This will continue as the Fed drains more money from the system. Those draining operations will increase from the current $20 billion per month to $30 billion in April, $40 billion in July, and $50 billion in October.
That will push rates higher. The Fed will ratify those moves by increasing interest on excess reserves (IOER), which is really just an outrageous subsidy that the Fed pays the banks at taxpayer expense. It reduces the Fed’s surplus that it returns to the US Treasury every month, so in the end, it costs US, to add to bank profits.
Ironically, raising IOER has a loosening effect because it pumps cash into the banks. This despicable policy rewards the banks for all the fraud that led to the last financial crisis and is leading to the next one. But the IOER subsidy is nowhere near enough to fully offset the size of the Fed’s draining operations. They will increasingly pressure the markets as they are increased in July and October.
The spectacular rise in the 13 week bill rate is a sign of just how tight money is becoming. It’s a warning sign that, with the policies in place, this trend will continue. It means that there won’t be enough money around to keep stock and bond prices stable, let alone rally.
We should be all but out of the markets by now. Now is not the time to get back in, or even trade intermediate swings from the long side. Interest rates are rising fast. Cash is king, and finally at long last the day is at hand where they’ll pay you a bit of interest income for holding on to it. That’s a lot better than seeing your stock and bond portfolio lose value in the months ahead.
As always, if you’re interested in the short side, in addition to our ideas here, you can check out Shah Gilani’s put play recommendations in Zenith Trading Circle.