The Fed Is Behind Schedule, But Not by Much. Here’s How We Know…

The Fed has shed $293 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 2017, and has increased that by $10 billion per month every quarter.

As of October 2018, the rate of money expungement is now scheduled at $50 billion per month, where it is scheduled to remain for the duration of the program.

They’re close to their targets, and they’re going to continue to at least attempt to hit them.

And that’s bad news for the stock and bond markets.

Here’s why, and what you should do about it.

A Few Technical Issues May Have Temporarily Hamstrung the Fed, But It Doesn’t Matter

Technical issues will sometimes cause the bloodletting to get a little behind schedule, but the Fed is whacking away, and the pace doesn’t really matter.  If it takes longer than scheduled to get back to a normal tight reserve position, it would just prolong the pain.

Important: These shockwaves will be felt for years to come

Here’s a look at the most recent Fed balance sheet:

If the Fed ends the program sooner than expected, it would only be because something really bad has happened in the market and the economy.  We don’t want to be holding long through that.  In addition, we want to take advantage of the great opportunity to make money on the market’s downside.

The timing of that can only be handled with technical analysis, which I address in the Wall Street Examiner Pro Trader Weekly Market Updates.  But when the timing looks good, I’ll give you an occasional heads-up here at Sure Money, as I did back on September 25. Had you bought that SPY put when the S&P 500 crossed under 2900, you would have a nice profit.

The scheduled banking system bloodletting will now plateau at or near $600 billion per year until the balance sheet reaches a tight reserve position.  That should happen around May 2020, based on my rudimentary back of the envelope calculations.

Janet Yellen pronounced a “material adverse event” criteria for a renewed Fed intervention. I suspect that it will intervene before the balance sheet returns to “normal.” The event would probably need to be a full blown stock market crash, or Jerry Jay Powell’s criteria of a “significant and lasting correction in the financial markets.”

That sounds suspiciously like a bear market to me. Simple intermediate market corrections of 10% or so typically do not lead to material changes in consumer spending, which Powell subsequently alluded to as his chief worry. Bear markets do, but not initially! By the time the Fed reacts to a downturn in consumer spending, it will be too late for stockholders!

Urgent: Predicted market drop (sooner than you thought)

For example, the last time retail sales fell enough for the Fed to notice in the last “significant and lasting correction,” was around October or November 2008. By then the stock market was already down 35%.

The Fed was already cutting rates.  In the early stages of rate cutting, stock prices continue to decline. The Fed started QE Lite in November 2008 but the stock market continued its decline until March 2009. It’s not until the Fed aggressively eased via massive direct purchases of Treasuries from Primary Dealers did the market reverse in March and April 2009.

If You’re Not Worried About the Market, This Powell Statement May Change Your Mind

Powell said something at his September press conference that should give you a chill.

“I wouldn’t want to speculate about what the consequences of a market correction should be. …We would look very carefully at the nature of it… What hurts is if consumers are borrowing heavily and doing so against, for example, an asset that can fall in value. So that’s a really serious matter when you have a housing bubble and highly levered consumers and housing values fall. And we know that that’s a really bad situation. A simple drop in equity prices… all by itself, doesn’t really have those features. … It could certainly affect consumption and have a negative effect on the economy, though.

So the Fed really isn’t worried about a bear market in stocks. It’s worried about another housing crash that leads to a drop in consumption.

House prices started to turn negative in 2007. At that point Bernanke was telling the world, “Remain calm, nothing to see here.” Prices did not start to crack badly until 2008.

Right now house prices are still rising. The question of when the Fed would react to a drop in house prices is still over the horizon. The Fed will continue to tighten at least until prices drop materially.

Furthermore, the Fed has stated that its first move won’t be to stop draining reserves. It will first attempt to lower interest rates. History shows us that the first rate cuts do not stem the tide of falling stock prices. It will take far more aggressive action, probably aggressive outright QE again to get stocks turned upward.

We’re a long way from that, and a long way from getting long stocks again.

As for when to close that SPY put trade, I would have a mental stop at 2772 on the S&P 500 early this week. If we’re on our way to close above that, I’d take the profit and look for reentry subsequently. Below that level, I would hold the position.

For other ideas on how to play this market, check out Chris Johnson’s Night Trader service here.

Sincerely,

Lee Adler

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