The December market meltdown spooked the Fed enough so that it changed its tune about the balance sheet bloodletting being on autopilot. “Autopilot…autopilot…autopilot…” had been the zombielike mantra whenever any financial infotainment reporters asked the Fed about it. Which was almost never to begin with. There was a kind of conspiracy of silence. No one wanted to awaken the sheep.
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But in October, the pressure of that $50 billion per month in Fed balance sheet reductions started to cause pain. Since then, the mouthpieces of the Primary Dealer mob and a few buy side behemoths have regularly been trotted out to bleat about it to their breathless captured media crowd.
Before that, while I had been warning you about what would be coming for a year, the Wall Street media remained dead silent. Apparently they had been read their rights. As in, “Anything you say, can and will be used against you.”
The dealers and a few sharp professional investors knew, but they didn’t want others to know, particularly clueless whale institutional investors who think that the economy and the trend of business drive stock prices.
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The dealers obviously knew that the Fed balance sheet reductions would eventually bite. But they had to keep their customers on the buy side so that they could distribute their own stock inventory to the unsuspecting crowd.
As the market rolled over in Q4, the complaints of the sheep herders, including the White House Sheepherder in Chief and his Wall Street plant over at Treasury, grew so loud that it woke up the somnambulant Fed Chairman. Suddenly he was no longer Chairman Pow! He changed his tune and began to sing a sweet lullaby to the market.
We’ll pause raising rates, he crooned, and he and the choir sang a new tune. It was no longer Normalization Sky Pilot, but rather, I Don’t Have A Hammer.
Effectively, Powell and his cohorts said that, if needed, they would slow the rate at which the Fed reduces the size of its balance sheet. In other words, if the market has another round of episodic pooping, they won’t cremate $50 billion, they’ll do something less. It even leaves open the possibility that they could pause.
What Powell and his minions did not say was, “We might reverse policy and go back to QE.” That is assuredly not on their radar.
The first step will probably be to ratchet down the size of the drains. Unless there’s a crash. Then they might stop. But the likelihood is that they will not return to outright QE until all else fails.
Prior to the new attention to balance sheet reduction, the Fed had repeatedly said that it would only soften policy when a market decline led to a decline in economic consumption. The message was that they were focused on the economy and were telling Wall Street that if we get a little asset deflation, “Well good!”
That was unrealistic. The powerful have too much at stake, and not just in the fact that they’d become less rich. Consumers and businesses take their cues from the direction of stock prices. If stocks tank, it won’t be long until the economy does too. Some policy makers and Wall Streeters are well aware of that, not the least of which are the Messers Trump and Minuschin.
As a result, now the Fed is saying, Mr. President, we hear you, and we’re ready to play ball. If the market tanks, we’ll react.
We know that when the Fed starts talking about a policy change, the lead time is usually 6-9 months before they implement it. In an emergency, like the next stock market crash, coming soon, they’ll move faster. But there’s the problem. No matter how quickly they act, they’ll be reactive not proactive.
In other words, the market will crash first. Then, they’ll do something. Not before!
Which will be too late for anybody who is still heavily long stocks, which is virtually every investment fund manager on earth. They hate to hold cash, witness the rally of the past two weeks. The cash went up, the cash when down, the cash played pinochle on their crown. They simply could not sit still with it.
The problem is that the Fed ain’t printin’ more of it. The Fed’s balance sheet is shrinking and banking system deposit growth is slowing to a crawl. If the Fed continues this $50 billion per month in bloodletting, with the ECB now no longer printing either, I expect US and European deposit growth to go to zero or even negative. That is really bad news because the US government needs to soak up $100 billion per month from those deposits.
Yes, the Treasury will spend that money right back into the banking system. But here’s the problem. Banking system deposits are comprised of two types of money. There’s the money that circulates in the economy, and theirs all that excess money that nobody needs that exists in the financial circulatory system.
That money circulates not via economic activity but via stock and bond transactions. It’s investment money. Some of it is held by small fry like you and me, but most of it is held by the behemoths of wealth and Wall Street. So when the Treasury sucks up $100+ billion per month of investment money to spend into the US economy – good for the economy, but not good for the financial markets.
In fact, it’s really bad for the markets because it’s a transfer of cash from a pool of investment funds, AKA liquidity, that is no longer growing and may even be shrinking. Furthermore, the Primary Dealers, who own and make all the financial markets are required to bid and take down some of that Treasury debt paper all the time. That’s why they’ve been complaining so loudly.
I have been reporting for more than a year that the Primary Dealer positions data showed they were getting squeezed by massive inventory they were forced to carry, while the bond market was persistently going against them. The results of that squeeze started to show up eaerly in 2018 when the financial sector plunged unmistakably into a bear market.
They have led the way. Financials always lead because they are most sensitive to the real market effects of monetary policy. So when the Fed decides to tighten policy, it effectively decides to cause a bear market, and it always starts with the financials.
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The fact that the Fed now says that it will respond to a selloff in the market represents barely a bandaid on a hemorrhage. Slowing the rate at which it pulls money out of the system will not help one iota. It will merely prolong the pain.
The only thing that will potentially reverse a bear market is the same thing that always reverses a bear market. That is that the Fed must dramatically reverse monetary policy from tightness to extreme ease. It must pump enough newly conjured Fed cash into Primary Dealer accounts that they can absorb, if not all, at least most of that $100+ billion of net new Treasury issuance. That way there will be enough cash left over for them and their customers to stop selling stocks and bonds and start buying them again.
Until that day comes when the Fed announces that policy, we need to stay away from chasing rallies, and just keep rolling those 13 week T-bills in a Treasury Direct account.
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In the meantime, while you keep the vast bulk of your money safe in these interest earning T-bills, you can also potentially profit from the market’s gyrations by using a limited amount of capital trading puts and calls.
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