In the past few weeks there have been a couple of wounded Wall Street donkeys out there braying that the Fed is either about to, or should, slow the pace of interest rate rise, or slow or halt the shrinkage of the Fed’s balance sheet sooner than expected.
You can see an article from Reuters here, and an article from Bloomberg here – both indicating that the Fed may soften its gruesome bloodletting operations.
One question is whether these are semi-official trial balloons emanating from the bowels of the Fed, or just the bleating of wounded animals whose bond portfolios are tilted way too far to the long side, both in terms of positions and duration.
I’d vote for the latter, but I would all stress that it just doesn’t matter.
Why? Because it’s all just a bunch of talk. You know what they say. Money talks and bull___ walks. That’s why I’m debunking this nonsense yet again, right here…
It’s Too Late to Reverse $50 Billion of Monthly Unwinding Before October
First, even if these emanations were the first trial balloons of policy change, normally it takes about 6 months from the first trial balloons until the Fed would pre-announce an actual policy change. Then it’s usually another month or so before the change takes effect. But the market trend only reverses in response to actual changes in liquidity levels, not rumored ones.
So let’s consider that even if the Fed were to announce that it would slow the pace of its balance sheet bloodletting, it’s already at $40 billion per month this month. And it goes to $50 billion per month in October. The Fed minutes released this afternoon showed no hint that the FOMC was considering slowing this pace. So if there’s to be any backing off from the planned reduction rate, it probably won’t come before October, when the rate goes to $50 billion per month.
Furthermore, while Federal tax revenues were weaker in June, excise taxes and individual income taxes not-withheld continued to increase. That suggests that top line economic data will remain strong for the time being (written before this morning’s jobs data confirmed). The Fed will see no reason to slow the pace of balance sheet reductions, or rubber-stamping interest rate increases, as the money markets tighten on their own.
This bloodletting is part of the Fed’s balance sheet “normalization” program, whereby the Fed gets rid of some of its assets each month in an effort to get back to a balance sheet size that is “normal” in relation to bank reserves.
A historically “normal” position is when the level of bank reserves on deposit at the Fed are tight in relation to banking system assets. There are little or no excess reserves. The Fed controls market interest rates under those conditions by adding or draining a few billion in reserves daily. That’s “normal.”
To get back to “normal” would require the Fed to whittle its assets back to around $1.5 trillion from the current $4.3 trillion, which is down from $4.5 trillion at peak last October. At the currently published scheduled bloodletting rate, I have estimated that that will take until May 2020.
I have also forecast that the Fed will never get there because it would cause a market cataclysm well before the balance sheet ever arrives at that level. One way or the other, the Fed is likely to reverse course before May 2020. The market will force it to. What the pundits say doesn’t matter, because we already know that the Fed will reverse course before the forecast date.
Some pundits are saying that the Fed will stop tightening in mid-2019. But by then the damage will be done. The markets are slowly being starved of liquidity right now. It has shown up in the relentless rise of Treasury bill rates, and the upward pressure on bond yields, particularly in the junk bond arena, but also in Treasuries, as the 10 year hangs around near 3%.
Meanwhile, despite the bullish pronouncements of stock market pundits, the so called “bull market” hasn’t made a new high in 5 months.
Sure, there may be some front running when it becomes clear that the Fed is seriously considering a course adjustment toward ease, but talk alone is never enough to turn the tide. Money talks. When there isn’t be sufficient money to sustain a rally, prices fall back. “Hope” alone will never sustain a rally for long. The tide of market prices follows the tide of liquidity. Contrary to conventional wisdom, the market doesn’t discount the future. It simply responds to changes in liquidity levels.
Furthermore, there’s a new sheriff in town, and it doesn’t matter what a few Fed doves, or bankster mob mouthpieces say. It matters what the guy with the gavel says, and the big mahoff in this case is none other than Chairman Jerome Jerry Jay Powell.
While a few banksters who have found themselves badly positioned in this market bleat for relief, the boss of bosses says it’s not coming. On June 20th, in a speech in Portugal he said, “With unemployment low and expected to decline further, inflation close to our objective, and the risks to the outlook roughly balanced, the case for continued gradual increases in the federal funds rate is strong,” He also said that asset valuations were high compared to historical standards. Duh!
But valuations don’t matter, nor does what the Fed Chair says matter. When there’s lots of liquidity around, such as under the Fed’s QE regimen, so called “valuations” stay high as long as QE continues. What matters is what the Fed does, and for the foreseeable future the Fed will continue to remove cash from the banking system, at the rate of $40 billion per month now, and $50 billion per month starting in October.
As the Treasury simultaneously issues an average of $100 billion per month in new supply, that will pull cash from the financial liquidity pool. So make no mistake. There will be pain for both stocks and bonds.
Corporate CEOs Are Getting Out – You Should Too
Furthermore, it does not matter whether the Fed slows the pace of systemic withdrawals of cash from the markets. Once the downtrend in prices takes hold, it will become self-feeding. Waves of selling will lead to waves of margin calls. Then the bears will come to the bulls brief rescue. Short covering will lead to brief, violent rallies, restoring hope to the multitude. But hope is the ally of bear markets. As hope surges, erstwhile sellers start holding their positions again. Some even start buying.
But hope can only take a rally so far. It takes money to sustain rallies and the quantity of money will continue to diminish until the Fed literally reverses course and starts printing again. And that is well beyond the horizon.
Even if the Fed slows or stops QT- Quantitative Tightening, it won’t matter, because the Treasury will continue to pound the market with supply. Dealers and investors will need to liquidate something at the margin to pay for that new supply. That will put downward pressure on prices. To constantly absorb that much supply without downward pressure on prices would require a return to a concerted campaign of money printing-QE- by at least one of the other Big 3 central banks while the other 2 are on hold.
The little bit of printing by the ECB and BoJ now doesn’t offset the Fed pulling $40-$50 billion per month out of the financial system and extinguishing it. The BoJ and ECB are reducing their QE and the ECB has indicated it will stop buying altogether in December. The BoJ has been reducing its purchases without saying much about it other than to proclaim, “QE now! QE forever!” But their balance sheet growth has been materially slowing down in recent months. The BoJ is tapping the brakes, just like the ECB.
So there’s no longer enough central bank printing to absorb $100 billion per month in US Treasury issuance, not to mention billions more in other sovereign and corporate debt issuance. Stock buybacks that reduce the supply of equities help the stock market, but they don’t cover cost of Treasury issuance to overall investment markets. S&P FactSet just reported record buybacks of $166 billion for the February-April quarter. Even with that, stocks haven’t been able to get out of their own way.
And the bad news is that corporate CEOs buying back their own stock option grants have an inverse relationship to market performance. Buybacks are heaviest when stocks are most expensive, at the top of the market. Buybacks are lowest when stocks are cheapest, at the bottom of the market. That’s because buyback games require lots and lots of liquidity. As liquidity is withdrawn from the markets stock prices plunge and buybacks dry up. If corporate insiders were really concerned about adding long term value to their companies, they’d buy low and issue new shares high.
But no. They buy back at the highest possible prices! Why? Because they are using the corporate Treasury as personal piggy banks to pay themselves! The company is buying back the stock options that the suits in the C-suites just issued to themselves. They are selling their own stock high, lining their own pockets, leaving shareholders to hold the bag when the price bubble that they inflated with their buybacks ultimately implode. They’re getting out while the getting is good.
The question you should be asking is why you aren’t doing exactly the same thing.