If you’ve been reading my work for a long time, you may have noticed something by now…
I’ve been telling you the same thing again and again… the market is going to decline, and it has to do with the Fed and liquidity.
That’s because the Fed and liquidity are the most important pillars of the demand side of the supply/demand balance that drives market prices.
Most Wall Street analysts distract you with fodder about insignificant events and short term market movements. I take the opposite approach. I adopt a big picture view-the forest, not the trees-and I deal with actual data, not narratives, or stories about the data that often aren’t correct.
Recently, someone told me that my writing is repetitive.
And he was right – I do talk about the same things again and again. Because those things are what’s important, and they change slowly, almost imperceptibly over time. It’s like watching the hour hand of a clock and reporting on it every 5 minutes. We can’t see it moving, but we know that it is.
Right now, the Fed is deflating the financial system. It has been deflating the system for the past 10 months – but at a rate that until now has been imperceptible to the stock market, and has been showing up in the bond market and the money markets. The Fed has been increasing the rate at which it deflates the system slowly, but now that rate is approaching critical mass. It will sooner or later will cause a tremendous decline. That time is coming.
So when it comes to criticism, you could say I’m kind of like Noam Chomsky. Chomsky has been broadly criticized for giving unconventional lectures. When challenged about the unconventional manner of his presentations, he simply says something to the effect of, “I like it that way … it sticks to the facts.”
So you could say that my own writing is such for that very reason – it sticks to the slowly, imperceptibly changing facts and data. Ultimately the impacts will be felt grossly and quickly. They will be all too obvious. There will be a cataclysmic break. And it will too late for you to do anything about it.
But it’s part of a slow moving process that you need to be hyper aware of…
That’s why today I will continue to share with you exactly what I see when reviewing the Fed’s balance sheet and weekly banking system data this weekend, even though it may seem repetitive…
The Latest Fed Balance Sheet Reveals That Asset Withdrawals Will Suffocate the Market
Just to recap, the Fed has shed $192 billion in assets since mid-October 2017, just before the first cuts under the Fed’s balance sheet “normalization” program.
It started at the rate of $10 billion a month in October of last year, and has increased by $10 billion per month every quarter. It’s now $40 billion per month and will increase to $50 billion this October, where it is scheduled to remain for the duration of the program.
This is the Fed’s balance sheet as of last week.
According to this data, assets shrank by $27.8 billion over the past 4 weeks. There’s a built in settlement lag due to technical factors, but the total drop since the program began suggests that the Fed is sticking more or less to its published schedule.
By the end of the year the Fed will have withdrawn $450 billion from the banking system if it continues to follow the schedule.
The annual withdrawals 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 goal is to get back to a “normal” reserve position, which means few or no excess reserves. It would take to mid-2020 to reach that level under the current schedule.
In recent weeks we have seen the media reporting that the Fed will, should, or needs to slow the pace of drains and rate increases. But as long as the economic data and consumer inflation numbers remain on track, the Fed will stay the course of tightening.
So what, you may ask, accounts for the resilience of the stock market?
I believe I have the answer.
A Surprising $23 Billion Treasury Expenditure Gave the Recent Rally a Push
Part of the reason for these rallies may be that over the last 4 weeks the Treasury pulled $23 billion from its account at the Fed and spent it.
That put money into the economy and reduced the amount of Treasury supply that would have hit the market over that period, helping to reduce supply pressure on the markets.
Over the longer run, the Treasury has been building its cash account on deposit at the Fed. As of July 25, 2018, the US Treasury’s deposits at the Fed totaled almost $339 billion, which was up $143 billion from mid-October 2017 when the balance sheet reduction program began.
You can see that on the liability side of the Fed balance sheet at the third line below the Deposits heading.
The Fed’s balance sheet bloodletting and the buildup of Treasury cash are unrelated, but when the Treasury increases its deposits at the Fed, it pulls money out of the banking system. It’s a de facto tightening. However, at other times, the Treasury draws down this account and puts cash back into the system, as it did over the past 4 weeks.
With such an enormous, and unnecessary, pile of cash, the Treasury certainly can, and probably does, use that money to manipulate markets from time to time. There are chart watchers at the Treasury who know the importance of the 3% level on the 10 year note. Once that level is cleared, there will be no stopping bond yields from moving higher.
I suspect that the Treasury likes to use some of that cash to buy bonds to prevent that from happening. That can only go on for so long however. Ultimately the long term forces of supply and demand will force yields through the 3% “barrier” for good. That will be another signal that the fact that there’s less and less money in the system to absorb more and more Treasury supply is biting. For many institutional investors, stocks and bonds are interchangeable. They rotate from asset class to the other. And the fact of less money and more Treasury supply means that stocks will ultimately succumb to the law of supply and demand, just as bonds and T-bills already have.
The Fed’s deposit liabilities are the banking system’s money. The most important and largest of these is reserve deposits, known as “Other deposits held by depository institutions” on the Fed’s balance sheet. They rose $6.4 billion to $1.95 trillion over the 4 weeks ended July 25.
But reserves are supposed to be shrinking! What happened?
The upward blip resulted from short term funds being pulled out of the Reverse Repo (RRP) line item, which was down by $10.4 billion. Those funds were simply transferred back into reserve deposits. A holder or two were simply moving the spaghetti around on the plate.
RRPs are really an alternative form of deposit. Banks and mutual funds can “lend” cash to the Fed collateralized by Treasury paper (as if the Fed needs to post collateral). It’s overnight money, so it’s as good as cash to the banks. Moving funds from RRPs to reserve deposits has no effect whatsoever on systemic liquidity. It just shows up in a different Fed liability line item.
Reserve deposits have dropped by $308 billion since the Fed’s balance sheet bloodletting began in October. RRPs are down by $98 billion. $143 billion of that was merely shifted into the Treasury’s account. An increase of $72 billion in Federal Reserve Notes (paper money) accounted for much of the rest of the decline in reserves. Total deposits fell by $19.4 billion over the last 4 weeks and are down $173 billion since the Fed began “normalization.”
As they must under the rules of accounting, total Fed liabilities, which are everybody else’s cash assets, fell $27.8 billion in step with assets over the prior month. Since October when the Fed started its draining operations, total liabilities have fallen by $190 billion.
That’s real money being erased from the banking system. But it’s only a drop in the bucket compared to the $2.5 trillion in excess reserves that were bloating and distorting the system last October before the Fed began draining. And it pales in comparison to what lies ahead with the Fed now extinguishing $40 billion per month, and going to $50 billion in October. At these rates, equivalent to annual rates of $480 billion now and $600 billion per year beginning in October, as the old joke goes, “Pretty soon you’re talking real money.”
Overwhelming Evidence Tells Us to Be Patient and Stay Out of the Market
With the data and logic telling us that the stock market should turn bearish, it’s frustrating that it has been holding up near its highs. But the forces of diminished liquidity are having an impact.
The fact is that only a few big stocks are seeing the bulk of the buying, and this is skewing the market averages.
Lest we forget, prices were rising relentlessly in the final stage of the bubble in 2017 through January of this year. Since then stocks have gone nowhere.
The Fed’s modest draining operations have stopped the previously relentless bull market in its tracks, have pushed T-bill rates relentlessly higher, and have kept bond yields bobbing along near their highs, after doubling from their 2016 lows. People are pointing to the fact that the 10 year has had trouble staying above 3% as somehow bullish. But my goodness! Yields have DOUBLED since 2016. It’s normal for markets to take a breather after that kind of move.
So the effects are there. Stock investors are always the last to get the news. Stocks are always the last asset class to feel the pain. That pain is coming.
The weight of the evidence tells us to be patient and stay out of the stock market.
The good news is that finally, after years of savers getting stiffed by ZIRP, they’re finally paying you to be patient and prudent by holding T-bills or federally insured bank CDs, rather than leaving your money at risk in stocks or long term bond funds.
Meanwhile, if you need more evidence of the market’s impending decline, check out my special collapse to profit/ collapse to protection report , or check out Keith Fitzgerald’s The Great Reckoning.