Before last week’s FOMC meeting, a few well connected banker talking heads started floating the rumor that the Fed would reverse course on tightening sooner than anyone currently expects.
Naturally, CNBC, the mouthpiece of the mob, ran with the story, breathlessly.
The Fed has a surprise in store that could mean an early end to interest rate hikes
— blared the headline on CNBC.com. The first three paragraphs of the story were epic breathlessness.
The Federal Reserve could have a surprise in store for investors this week, even if everyone already knows the central bank is raising interest rates.
Along with the quarter-point increase in the Fed’s benchmark short-term target, the policymaking Federal Open Market Committee is likely to announce another change that would signal an early exit from its history-making program to reduce the level of bonds being held on its balance sheet.
The mechanics are a little complicated. Yet it suggests that what once appeared to be an operation to shrink the amount of bonds the Fed owns that would have run well into the next decade could be wrapped up next year, or early 2020 at the latest.
Now, I’ve been tracking and reporting on the Fed ever since 2002, around the time the Fed began publishing reams of data about its operations on the internet every day. Analyzing liquidity, particularly central bank liquidity and its effects on markets, is the nexus of my research and analysis, along with technical analysis.
So I know something about this.
The Fed’s “Big Surprise” Is Mainly Smoke and Mirrors…
So let’s look at this story. We’ll start with this first three paragraphs.
“The Federal Reserve could have a surprise in store.” Could is the kind of word that allows wiggle room. It’s about the same as saying, “may or may not.”
So what’s the big surprise that may or may not happen?
“…another change that would signal an early exit from its history-making program to reduce the level of bonds being held on its balance sheet.”
If you’ve been following me, you know that I think that this is important. The quantity of money is what matters. Interest rates, or the price of money, are merely a reflection of the supply of money relative to the demand for money – i.e. credit demand.
Interest rates are rising not because the Fed is raising rates. They are rising because the supply of money is growing at a slower and slower rate, soon to turn negative, by the way, while the demand for credit, particularly from Uncle Sam, is soaring. The money markets are tightening on their own as evidenced by soaring T-bill rates, even without a Fed target rate increase at the March meeting, and even before the Fed’s increase at Wednesday’s FOMC circus performance.
This is a chart of the 4 week Treasury bill rate, before the Wednesday FOMC announcement. This isn’t Heinz ketchup. It’s not “anticipation.” It’s a picture of a tightening market under an onslaught of short term Treasury borrowing and speculative bank borrowing to beat expected rate increases. In case the Fed hasn’t noticed, rising rates stimulate loan demand. They don’t suppress it. It’s a case of borrow and spend now before rates go up again. This isn’t new. It has always worked that way!
So the Fed just rubber stamps what the market has already done.
I’ve made the point that the program of reducing the size of the Fed’s balance sheet is the most draconian tightening in history. The chart above is a picture of the effect of that tightening in the face of massive Treasury and private borrowing.
The rumor had it that the Fed would send a signal that it would end this tightening program earlier than expected. Expected by whom? They say:
“…The mechanics are a little complicated. Yet it suggests that what once appeared to be an operation to shrink the amount of bonds the Fed owns that would have run well into the next decade could be wrapped up next year, or early 2020 at the latest.”
OK, first of all, “would have run well into the next decade.” Who said that? It’s utter nonsense. I’ve done the math and at the rate of the Fed’s published scheduled reductions, which it has followed, the Fed’s balance sheet would return to a normal tight reserve position in May of 2020. That’s “well into the next decade?” The next decade starts in 2021!
This program never would have run “well into the next decade.”
My position has been that the negative effects on the stock market should begin to be seen once the Fed gets to a rate of $40 billion in monthly draining operations in July. And when they go to $50 billion per month in October I thought that the effects would be devastating, especially if the ECB stopped printing money by then, as widely rumored.
We got confirmation on Thursday at the ECB’s dog and pony show that the ECB would reduce its press runs to just €15 billion in September and end the printing altogether in December. That’s bad enough. But right now it’s about the Fed.
World’s largest hedge fund predicts market will plummet in 2019 (or sooner)
Bridgewater Associates – the largest hedge fund on the planet – just made a prediction that sounded alarms across the globe. In a note released to their clients which just went public, they warned, “2019 is setting up to be a dangerous period for the economy… for investors the danger is already here.” Whether you’re ready or not, this disaster is ready to strike – and remaining inactive could have devastating consequences. You may only have a small window of time to learn how to protect yourself before this wave of wreckage hits.
So the CNBC report said in reference to the “signal” that the FOMC would send, that “The mechanics are a little complicated.” I’ll say! “Complicated” is just another word for econogibberish, that no one reading the report would understand because the reporter doesn’t understand it either. And economists and central bankers certainly don’t understand it. They’re making this stuff up as they go along.
So the truth is that the Fed’s balance sheet bloodletting would never have run “well into the next decade.” At most it would have run until May 2020. This report gets all excited that the Fed “may or may not” flash an unintelligible “signal.”
Smart Money’s Coded “Cry for Help” Is Buried Deep in The Report
So, well below the fold and long after everyone has stopped reading and gone to sleep, the reporter gets to the issue of the “a little complicated” mechanics that would be the “signal” that the Fed is going to end the program in late 2019 or early 2020, instead of May 2020 as I had estimated based on straight line math.
“A solution suggested at the meeting was that the Fed raise the rate paid on reserves by 0.2 percent while it hikes the funds rate 0.25 percent. Doing so would be expected to hold back the funds rate from getting too close to the target ceiling, judging by the funds rate’s tendency to trail behind the IOER rate.”
As it turned out, the Fed did just that, but wait! What? IOER (Interest Rate on Excess Reserves) is a direct subsidy to the banks. It is free cash flow to them. It in no way restricts their lending. In fact, IOER lowers their cost of funds (COF). It enables banks to have “wink wink” unpublished rates that are below where they would otherwise be in the absence of this subsidy.
How in the world does increasing IOER by any amount raise interest rates when it lowers banks’ COF? Of course Fed Funds is lower than the IOER. IOER isn’t a lending rate. It’s a deposit rate. What’s pushing rates up, and the CNBC reporter got this right by accident, is the massive short term Federal borrowing via T-bill issuance.
The article pointed this out correctly, but we have known this ever since Congress passed the tax cuts and the BBA (Budget Busting Agreement) early this year. I immediately told you then that massive increases in Treasury supply would cause the money markets to tighten. It’s not rocket science. We knew that there would be a massive increase in the Federal government’s need for funding, and that Treasury supply would increase massively. Treasury supply is loan demand. So rates rose in the Fed tightening the availability of money.
For now, until Fedheads themselves start talking about slowing the balance sheet bloodletting program, the Fed will stick to the program. Based on the usual historical pattern of the Fed signaling past policy changes, first a few Fedheads will make speeches or comments in interviews to the effect that they might change something. Then about 6 months later, they’ll make an announcement of intent, and the actual change will follow some months after that.
My guess is that this report was nothing more than a cry for help. Somebody out there, almost certainly one of the big Primary Dealers, is seeing big losses, because they positioned themselves wrong in the market. You don’t think the “smart money” does that? Ahem, remember 2008? That was caused by all the big money players being positioned wrong. They were the only ones who didn’t see the crisis coming. Most normal market observers, like you and me, saw it coming for years. When it comes to greed, the smart money ain’t so smart.
So I think the Fed will continue this bloodletting. I don’t think that they’ll even think about reversing course until what I call the Yellen Criteria, “a material adverse event (MAE),” as she put it, is reached. It is a matter of such great importance that nobody knows what it is. With the stock market still bobbing around within 5% of the highs, we’re a long way from “a material adverse event.”
Finally, whether the Fed stays the course until May 2020, or stops a year from now, makes little difference. When it goes to $40 billion per month in bloodletting in July, and $50 billion a month in October, it will matter. I have never felt that the Fed would make it all the way to May 2020 anyway. Because $50 billion a month in draining operations in the face of $100 billion a month in Treasury supply hitting the market month after month, will, in fact, cause a “material adverse event” that will force the Fed to reverse course.
The Fed has told us that their first tool in the event of the MAE would be to lower interest rates. We know from history that the initial steps in lowering rates are always accompanied by falling stock prices. It isn’t until they dramatically ease monetary tightness, which in this day and age means, until they return to printing money, QE, that the market will begin to recover from that MAE.
Do you want to wait around, fully invested, until whatever MAE happens? I know I wouldn’t. It will pummel our portfolios. So I continue to recommend staying out of the market until, and beyond that event.
If (for some reason) you’re still in the market, and interested in learning how to make profits on the downside, you can look at our ideas here, or check out Shah Gilani’s put play research and recommendations in Zenith Trading Circle.