Twenty years after the end of the War to End All Wars on the European continent, the British government was terrified at the thought of going to war with Germany again. Hitler had become increasingly aggressive. He had already annexed Austria when he declared his intention to invade Czechoslovakia and annex the German speaking Sudetenland, on October 1, 1938.
Unprepared to counter Nazi aggression militarily, and aware of the anxiety of the British people at the mere thought of another war, British Prime Minister Neville Chamberlain decided on a policy of appeasement to keep Hitler at bay.
On September 30, 1938, Chamberlain returned from a meeting with Hitler in Munich in which he simply capitulated to German threats. He agreed to allow Germany to annex the Sudetenland. He declared to a wildly cheering crowd of his Conservative Party supporters gathered in front of 10 Downing Street:
My good friends, for the second time in our history, a British Prime Minister has returned from Germany bringing peace with honour. I believe it is peace for our time. We thank you from the bottom of our hearts. Go home and get a nice quiet sleep.
Meanwhile, a throng of 15,000 protested the capitulation in Trafalgar Square. The leader of the Labor Party suggested that the piece of paper that Chamberlain waved to his adoring crowds was “torn from the pages of Mein Kampf,” Hitler’s manifesto.
Hitler marched into the Sudetenland unopposed. A year later he invaded Poland, and Britain and France declared war against Germany. The critics were right. Chamberlain’s capitulation was useless. It barely delayed the inevitable. But it did buy time for the United Kingdom, a crucial year to prepare for war, a war for which the nation was woefully unprepared in October 1938.
What the heck does that have to do with the new FOMC statement? Click here to find out just that, and why it’s so important to you as an investor.
Facing Threats of Destruction, Powell Capitulated
Yesterday, Fed Chairman Jerome Powell became the 21st century Western central banking version of Neville Chamberlain. He declared a policy of appeasement of Wall Street and the Trump Regime, both of whom had repeatedly threatened him with destruction. These were threats for which the Fed was woefully unprepared. Wall Street threatened market and financial institution collapse, and Trump threatened Powell’s job and the independence of the Fed.
Powell decided on a course of appeasement. Appeasement of the market and appeasement of a truculent government leader who seemed to hold the power to destroy his institution, the Fed.
Yesterday, Powell announced a complete reversal of the Fed’s previously avowed policies of gradual interest rate increases, and more importantly, of a steady reduction in the size of the Fed’s balance sheet.
I find it extraordinary that the systematic shrinkage of the Fed’s balance sheet only became an issue to the Street, the media, and the Fed in response to a big market selloff in the fourth quarter of last year.
I made you aware of the likelihood of that decline since the Fed first started officially discussing the idea of balance sheet normalization in Q3, 2017. I had been raising the issue for months before that in my Wall Street Examiner reports. I continued to warn you about the likely impacts of what became popularly known as QT, or Quantitative Tightening, throughout last year.
I’ve reported that the Fed reiterated several times over the past year that the policy would remain on autopilot. I have reported that Fed said that the first policy easing would only be in response to a significant and sustained market downturn that caused a material economic slowing. The Fed also said that the first response would be to lower interest rates, not reduce the pace of balance sheet reductions.
Stupidly, I believed what turns out to have been a bald-faced lie. Perhaps it was well intentioned, but it was a lie, nevertheless. Having analyzed the Fed’s behavior for many years, I should have known better.
When the market sold off barely 20% from October to December, Wall Street began to complain that the balance sheet “normalization” process, might, just might, be the cause of that decline. To the once resolute Mr. Powell, that selloff apparently represented a threat of unimaginable financial destruction. As the selloff worsened, Powell began to quickly backtrack from his past statements. He put himself out there, and sent his minions out, to begin the old soft shoe routine of the carny barkers that they are.
Powell was in full retreat.
At the same time, the President was also complaining loudly about Powell’s performance. Threats to fire Powell were widely reported. The opinion pages of the Wall Street media were filled with the falsely pious calls that the independence of the Fed must be protected. That was another sideshow sham. But Trump’s manipulation clearly had the intended effect. The message was received at the Fed.
Powell’s previous guidance had been that the Fed would ignore mere market corrections, and would only ease policy in response to significant and lasting market declines that led to material declines in consumption.
On Wednesday, he said exactly the opposite.
There’s been no significant and lasting market decline. There’s been no decline in consumption. But faced with terroristic threats, Powell capitulated.
The FOMC statement said that the Fed would no longer raise interest rates as previously expected, and would adjust the Fed Funds rate in response to incoming data. That put lowering rates on the table. In addition to that statement, the Fed released an additional statement on balance sheet normalization. The statement said that the shrinkage of the balance sheet will no longer be on “autopilot,” as they had previously insisted it was. Instead, it now says:
“The Committee is prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments. Moreover, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.”
Here’s How Much Difference The New Statement Really Makes
The first part of that statement means that the Fed will slow the rate of the runoff, now at $50 billion per month, if the market blows chunks again. The second part says that if not just the market but the economy also goes in the tank, then the Fed could go so far as to start printing again. QE infinity, here we come.
Ironically, the second part of the statement did not add a single thing to what we already knew. The Fed will print again when the economy starts to stink again. Duh.
The first part is more interesting and nuanced. The Fed did not say that it was planning on reducing the bloodletting rate, now at $50 billion per month. It said that it would do that only if the stock market tanked, or some other calamity befell the financial markets. Yes, Powell did say at his press conference that the stock market was one of the considerations.
But here’s the thing that the market has ignored from the moment of the announcement until I was writing this at 12:30 PM on Thursday. For now, the $50 billion per month in reductions will go on.
The Fed did not pinpoint a target for the size of the Fed’s portfolio. They’re still trying to figure that out. But he did not dispute a widely discussed notion that it might be $3.5 trillion. The current size of the balance sheet is $3.98 trillion. That implies 10 more months of bloodletting at the current rate.
Treasury Supply Rears Its Ugly Head While The Fed Continues Draining
During that 10 months, the markets will need to absorb an average of $100 billion per month or more of new Treasury supply. February will be an even bigger problem because the government must make payments owed that weren’t paid during the government shutdown. That’s on top of the usual oversized borrowing needed to fund the biggest month of tax refunds.
Until the Fed really does cut the bloodletting rate, and not just talk about it, it will continue to withdraw $50 billion per month from the banking system. With less cash available, for buyers of Treasury paper to be ready, willing, and able to bid for the new paper, they will need to sell assets and require higher discount rates and yields on the new paper.
The Fed’s statements on Wednesday did not change any of those facts. The Fed will only be forced to finally reduce the bloodletting rate of its still bloated asset base in response to a weaker market. The damage comes first. Then the response.
Moreover, a reduction in the pace of balance sheet shrinkage will not materially ease market conditions. It might give the market an initial psychological boost. But the law of supply and demand is still the law. So long as the Fed removes even $1per month from the system while the US government is borrowing $100 billion per month, the supply of financial assets coming to market will continue to be greater than the market’s ability to absorb that supply at a stable price. Financial asset prices ultimately must decline.
Furthermore, even at the point where the Fed declares that it has reached its balance sheet target size, the US Government, not the Fed, will still be the real problem! Because the market cannot absorb that much new supply every month without help from the central bank. Until the Fed restarts QE, financial asset prices should follow each intermittent rally with a decline to lower prices.
Given this background, I still think that cash is king-cash in the form of holding and rolling shorter term US Treasury bills. That will hold true until the Fed stops simply talking and starts actively printing again. Or maybe a miracle will happen that permits the US Government to pay its bills without having to borrow a trillion dollars or more every year. Do you believe in miracles like that? Sorry, that time is not on the horizon.
Meanwhile, our trading gurus here at Money Map Press, like Tom Gentile, will help you find opportunities to profit handsomely from any market swing, regardless of its direction.
You better see this now (Tom is telling all)