These Numbers Could Push the Fed to Do Something Stupid

The Daily Treasury Statement data for the end of month August showed some improvement in total tax collections, including a slight uptick in withholding taxes and an even bigger increase in excise taxes.

The numbers suggest that an early summer slowdown has ended. After the expected downward revisions in June and July jobs data, the August uptick in jobs was not a fluke. And the excise tax data suggests strong retail sales.

So, not an altogether bad summer – if you happen to be a politician or government taxman. But what about for investors?

Well surprise, surprise, surprise! Good news is bad news, which is what we’ve been talking about here all along.

Good economic news, as presaged by the uptick in tax receipts, will encourage the Fed to keep tightening.

And tighten they shall, in two ways: Most importantly, most destructively, they will drain more money from the banking system. Secondarily, they’ll continue to rubber-stamp tightening money markets by raising the Fed funds rate.

And that, as I have been shaking my fist at the sky about for months, is really bearish.

The stuff has not hit the fan yet, but it is coming…

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All the good-bad news about jobs and soaring GDP, was the impetus for some outright bad-bad news.

On Monday, Boston Fed-head, and former staunch policy dove, Eric “The Red” Rosengren, suggested that the central may need to do even more slashing, burning, and pillaging of the money in the banking system.

OK, so he didn’t use exactly those words. ┬áBut here’s what he did say in interviews with Reuters, and, later, on CNBC, where he would be sure that professional investors would see or at least hear about it loud and clear:

“If things work out well for the economy, and that’s what I expect and hope, then we’ll be in a situation where we need to have somewhat restrictive policy over time.”

Now I don’t know about you, but I don’t exactly consider rising economic numbers sparked by massive, unprecedented deficit spending, courtesy of tax cuts and surging military outlays, to be “working out well for the economy.”

But what is important here is that the Fed sees it that way, except for one little problem: Rising inflation.

Rosengren told Reuters, “This is not hair on fire. There is upward pressure on inflation, and given that we are already at 2%, labor markets are already tight … that is going to be a situation where we start persistently having inflation above what our target is. There is an argument to normalize policy and probably be mildly restrictive.”

Just as we already knew, the Fed is not only behind the curve, it is pushing the curve, because raising rates sends a signal to business people and consumers to expect higher rates, and therefore higher prices.

That causes them to accelerate spending and investment, which stimulates that which they’re trying to reign in – higher inflation.

This also causes the economy to grow faster, into a final blowoff, as consumers, business people, and – lest we forget – investors rush to go all-in.

The problem with such behavior only becomes apparent after everyone is all-in. That leaves a demand vacuum going forward, and ultimately financial and economic collapse. In the meantime, the economy accelerates, albeit toward a cliff edge.

So the Fed is just waking up to the fact that it is behind the curve.

Normally, I’m all for enlightenment, but this is the central bank we’re talking about here. I’ve long maintained that, should the Fed actually realize it’s behind the curve, it could become even more aggressive in tightening.

Now we have confirmation of that.

Fed-heads are floating trial balloons. The history of the past dozen years tells us that when Fed-heads start talking about something, it’s all but a done deal. It should take two, maybe three more Federal Open Market Committee (FOMC) meetings before they make it official with a policy announcement.

It could take the form of more aggressive balance sheet reductions, but more likely they’ll start to raise rates in half-point rather than quarter-point increments.

In fact, the money markets will force them to. Treasury bill rates are soaring relentlessly. The Fed has no choice but to tag along raising the Fed Funds rate. Otherwise it will appear to have lost control.

Soaring T-bill rates are a sign of the market running short of cash in the face of a constant onslaught of massive bill supply, while the Fed steadily removes money from the system. Remember, it is now extinguishing $40 billion per month. Next month that goes to $50 billion.

The drains are scheduled to remain at that level until bank reserves on the Fed’s balance sheet reach a “normalized” position.

Without going into the particulars, I have estimated that at $50 billion per month, the Fed’s balance sheet finally be good n’ normalized in May 2020.

Rosengren thinks the Fed should make hay while the sun shines. He doesn’t think the Fed has enough room from here to loosen enough to be really stimulative when the next recession comes along.

In other words, the beatings will continue until we’ve crushed the economy, and then we’ll be able to drop rates and loosen policy enough to restart it. Rosengren wrote in a Boston Fed release that “‘More attention should be given to establishing appropriate policy buffers to mitigate future shocks.'”

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This calls for a little judicious shorting of the S&P 500, via the SPDR S&P 500 Trust ETF (NYSEArca: SPY).

I think it’s time to start buying SPY puts.

I like to go out about a month and buy the contract that’s just in the money. For instance, with SPY at $289, I’d buy the SPY October 12, 2018 $290 put (SPY181012P00290000).

If you followed my recommendation of the past year, you have gradually gotten heavy in cash in your portfolios. You have virtually eliminated risk by being mostly in cash, and you have capital to apply to moves like this.

If you’re risk averse, I’d limit the amount of the put purchase to no more than the monthly income you would receive from holding short term T-bills.

That way, you could profit from a decline in the stock market and your only risk would be the income from your cash.

Of course, if you’re feeling more daring, you can increase the size of the purchases. But beware of the fact that if the market rallies over that month, those puts could go to zero. No doubt we will make a lot of money if the market crashes. But timing is the issue, and if our timing is off, the loss can be substantial or even total.

Manage your risk according to your financial situation and risk appetite. Remember: the Fed is irresponsible and clueless, not us.

Sincerely,


Lee Adler

3 Responses to “These Numbers Could Push the Fed to Do Something Stupid”

  1. I am a professional who watches market internals avidly. I am dumbfounded how this market is still hovering here when the internals are so rotten. It is not just the narrowness but the money is all in wrong places – when the interest rates are rising, the so called dividend stocks are paying half of US 2 year! Not to mention the European negative yielding situation and Japanese bankrupt and so is China, not to mention our own good old US of A

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