Today, I want to take a few moments and show you both sides of the Fed’s balance sheet – its assets and its liabilities – and exactly what that means for you.
The Fed has shed $154 billion in assets since mid-October 2017, just before the first cuts under the Fed’s bloodletting or balance sheet “normalization” program. It’s now draining $30 billion per month from the banking system, going to $40 billion in July and $50 billion in October, where it is scheduled to remain for the duration of the program. The total drop since the program began suggests that the Fed is sticking to its published schedule.
Now let’s look at the other side of that balance sheet.
The mirror of the Fed’s asset side of the balance sheet is of course its liabilities. Bank reserves are on the liability side. They are the deposits of banks at the Fed. They are the biggest part of what the economists call the “monetary base.” As the Fed sheds assets, it simultaneously pulls deposits out of the banking system, resulting in a drop in the reserve deposits of the banks. The “monetary base” thus shrinks. That’s all just a fancy way of saying that there’s less money in the system.
And when there’s less money in the system, there’s less money to fuel demand for investment securities, which include both bonds and stocks. At the same time, the supply of securities is always growing, thanks to Treasury issuance.
As they must under the rules of accounting, total Fed liabilities, which, in essence, are everybody else’s cash assets, fell $21.7 billion in step with the Fed’s assets over the prior month. Since October when the Fed started its draining operations, total liabilities have fallen by $152 billion.
The Fed pulling money out of the banking system creates a problem like the one that caused the stock market to crash in 2008. The dealers were unable to maintain orderly markets back then because the Fed had denied them the cash they needed to do so. By pulling money out of the system, and by not funding dealers directly as they did under QE, the Fed is denying the dealers of the funds they need to maintain orderly markets.
Therefore, we should not be surprised by periods of pronounced weakness in the stock market, at least until the Fed reverses course on “Quantitative Tightening” (QT) the Fed’s monetary bloodletting program to “normalize” its balance sheet. As systemic liquidity levels fall, those periods will become more frequent and more severe, leading to a persistent downtrend in stock prices.
What You Should Do With Your Remaining Money As The Drains Increase
We have already seen the effects particularly acutely in the rates on Treasury bills and bond yields and are beginning to see the effects on the stock market. These effects will get worse in the months ahead. If you haven’t already prepared for that, you need to do so now.
By the end of the year the Fed will have withdrawn $450 billion from the banking system if it sticks to its published schedule. The annual bloodletting will then plateau at $600 billion per year until the balance sheet reaches a tight reserve position. That should happen at some point in mid 2020.
The effects will increase as the drains increase in size and persist at the $50 billion per month rate. At some point the markets will force the Fed to relent, but not until Janet Yellen’s “material adverse event,” whatever that is. Jerome “Jerry Jay” Powell and the gang seem determined to tough it out for the long haul.
Meanwhile weekly measures of the US commercial banking system are skyrocketing as animal spirits kick in thanks to rising interest rates. This happens in every rate cycle. Speculators, business people, and consumers all increase borrowing and spending when interest rates are rising. The motivation is to beat the next increase.
The Fed seems not to understand this dynamic. Therefore it is not only behind the curve, by tightening monetary policy it pushes the curve further ahead. That continues until rates become punitive, that is, significantly greater than the asset inflation rate, and the consumer inflation rate. Both rates tend to rise as interest rates rise.
The crossover to positive real rates occurs very late in the cycle, when the Fed jams on the monetary brakes. In this cycle they have already done that by pulling money out of the system from the start. Rates have risen as the quantity of money has diminished.
Meanwhile the credit bubble continues to expand. The economy will continue to run hot, thanks to massive deficit spending and business investment, but the stock, bond, and money markets will be increasingly starved of cash. We may well see a terrific bear market while the economy continues to print larger topline numbers. That will keep the stock bulls snorting, exhorting you to stay in the market. But the time to be out is now, and for the foreseeable future.
Don’t expect the Fed to end this monetary tightening any time soon either. Janet Yellen pronounced at one of her press conferences before the end of her term that the Fed would continue to tighten until the goal of balance sheet normalization was met or in the case, in her words, of a “material adverse event.” That apparently is a “matter of such great importance that nobody knows what it is.” She didn’t define it.
Furthermore, the Fed even went so far to put in writing that this policy of draining reserves would be so automatic, so set in stone, that they would no longer even so much as mention it in their regular FOMC statements. It’s like the cop at a big crime or accident scene telling the crowd, “Nothing to see here, move along!”
Yellen did say that the Fed’s first tool in the case of such an accident would be to lower interest rates. If you know anything about the history of bear markets, the first couple of cuts in rates are often accompanied by sharply declining stock prices. More recently the market of 2007-09 didn’t reverse until the Fed started direct QE through the purchase of bonds from Primary Dealers. Lowering rates alone had no effect.
And Powell seems to be a tough guy willing to allow the stock market to suffer a far bigger decline than Greenspan or Bernanke were. There will be no “Powell Put.” Thus an investment strategy of “holdin and hopin,” waiting first for a “material adverse event,” then for cuts in interest rates, before finally the Fed starts QE again, would see your portfolio get decimated before it began to recover.
Think about it. Despite the bullish braying of Wall Street talking heads about stocks always going up, it would take years for prices to recover fully, assuming they even do. If you, like me, are of a certain age, before we elect that “holdin and hopin” strategy, we should look in the mirror and ask ourselves how much time we have. Are we willing to sacrifice our lifestyles if we suffer big losses in our portfolios, then be forced to wait years for them to come back to today’s levels?
Meanwhile, we must also consider that as interest rates continue to rise, we will be compensated more and more fairly for not taking risk. This will be a long-needed return to the old-time religion of earning a fair income on your savings.
No sir! I would rather be out.
If you’d like to profit from the declines ahead you can buy puts on the SPY or baskets of puts on a sampling of stocks. Here I am referring to a series of short term bets designed to capture the meat of market declines. The current time window looks opportune to catch the July decline that I expect. I am recommending going out no more than 5-6 weeks and buying slightly in the money puts to reduce time decay. I’d also bet no more than I’d be willing to lose in case I am too early and the market rallies in the short run. In that case these options may go to zero by expiration.
On the other hand, if we’re right, they can increase by multiples of the original bet. This is a good means of participating in market moves while the bulk of your money earns interest in Treasury bills, US Treasury money market funds, or in interest bearing bank accounts up to the FDIC limit.
You can also look at our ideas here, or check out Shah Gilani’s put play research and recommendations in Zenith Trading Circle.