Fed Day With Extremely Loose Financial Conditions

Today is the day,  folks.

The consensus is the Fed announces the start of quantitative tightening (QT).   History in the making.

Draining Liquidity

Though monetary tightening officially began in December 2015,  this will be the first time the Fed drains liquidity from the financial system in any meaningful amount.

That is because of the Orwellian monetary policy we have discussed in previous posts.   That is paying interest on reserves – i.e., injecting liquidity into the system through paying interest on reserves  – rather than a traditional monetary policy where open market operations remove liquidity by draining reserves to peg the Fed Funds rate.

As a result, the Fed has lost control of the financial markets, in our opinion.

Consider this.  Since the monetary tightening began:  1) the S&P500 is up almost 23 percent; 2) the 10-year T-Note is down 4.8 bps; 3) the 2-10s yield curve has flattened 46 bps; 4) Corporate credit spreads have come way in  with AAA – 12 bps, BB -97 bps, BB – 241 bps, and B -346 bps;  5) the dollar index has fallen 6.7 percent; 6) the VIX is down over 50 percent; 7) the JP Morgan sovereign bond ETF (EMB) is up almost 20 percent; 8) the emerging markets equity ETF is up over 46 percent, and 9) commodities, measured by the CRB is up only 4.79 percent.

Emerging market equities up almost 50 percent in a Fed tightening cycle?  WTF?  Aren’t they supposed to flop during a U.S. monetary contraction?

Granted the nature of capital flows to emerging markets are much different today.   We will have much more to say on the structural changes taking place in EM sometime soon.

Is a move from zero to 1 1/4 percent in policy rates with liquidity injections really a monetary tightening?   The markets seem not to think so.  What ever happened to “don’t fight the Fed”?

 

Given the extremely loose financial conditions,  coupled with the monumental and unprecedented task of shrinking such a large balance sheet, it is difficult to anticipate what tone the Fed will strike in their FOMC announcement later today.  We think most members realize they have blown a massive asset bubble.

Given the small window for a soft landing in the asset markets and the adverse economic consequences of a hard landing,  the Fed will be inclined to reassure the markets.  The markets are likely to focus on the dots and where they perceive the terminal rates are heading.  We suspect around 3 percent the markets get very nervous, but not there yet until inflation picks up.

The start of a $10 billion reduction in reserves may cause volatility to pick up a bit, but not crash the markets.  Moving to, say, a 10 percent reduction in the balance sheet will begin to bite hard.  Will the markets allow that?

The Fed’s Big Problem

The Fed is in an impossible situation. They need to shrink the balance sheet,  so as not to overshoot policy rates,  and remove a lot of reserves from the system, but financial markets may not allow it.   If credit and growth begins to expand rapidly and inflation picks up, they may  not have a choice, however.

They may have already crossed the Rubicon, and we never see a “normalized” Fed balance sheet.  Asset markets now rule the day and the economy, for that matter.

In addition, bull markets are fun.  Hardly anybody cares to stress test market drivers and their views because everyone is making a ton of money.   For now.

The Fed will start by trimming no more than $10 billion per month from its balance sheet, with that cap rising each quarter for a year until it hits $50 billion per month.

That should shed nearly $300 billion in bonds over the first 12 months, and nearly $500 billion over the second, according to analysts’ projections.

The main unanswered question is whether the central bank will spread its remaining monthly repurchases evenly across the spectrum of maturities, or whether it will focus on shorter-dated assets and accelerate the process.

That will affect how far long-term yields may rise as the Fed allows bonds to run off. Another wild card may be the pace at which the Fed’s mortgage-bond holdings shrinks, which depends in part on homeowners’ refinancing decisions. – Reuters

To quote Churchill,

Now, this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning. – Winston Churchill, November 10, 1942

Ironically, the inverse of the beginning of the end will most likely begin on the European continent, the genesis and original home of Churchill’s war.  That is where the big bond bubble is and the ECB is waaaaaaaaay behind the curve and in a big pickle.

Growth and inflation are picking up and interest rates are much too low.

The Euro

Why is the euro rallying?  Because it can.

The euro/dollar move is a classic case of Le Chatelier’s principle, or “The Equilibrium Law”, first introduced into economics by the great Paul Samuelson.

When any system at equilibrium is subjected to change in concentration, temperature, volume, or pressure, then the system readjusts itself to counteract (partially) the effect of the applied change and a new equilibrium is established.

In other words, whenever a system in equilibrium is disturbed the system will adjust itself in such a way that the effect of the change will be nullified.

.. It is common to take Le Chatelier’s principle to be a more general observation, roughly stated:

Any change in status quo prompts an opposing reaction in the responding system
– Wikipedia

Bonds cannot or are slow to adjust to the much improved economic and inflationary conditions in Europe due to repression caused by the ECB’s asset purchases (QE).  The pressure has to be released elsewhere to maintain a general equilibrium, and the currency market has little or no government intervention and trades relatively free.  It may also be causing the euro to overshoot its equilibrium value.

European Temper Tantrum On its Way And New Divergence

We expect a European bond market temper tantrum sometime soon, most likely in October, where market interest rates – those that can – will increase sharply as they worry about the ECB’s dilemma.  It should spill over into the U.S. markets, given the high comovement with the Bund and U.S. bonds,  and cause the short, sharp sell-off in risk assets we are expecting.  The sell off can be bought as interest rates will still be relatively low unless inflation really gets out of hand.

Never take Bagehot’s dictum lightly:   John Bull can stand many things, but he can not stand [negative, zero, and] two percent.   Yield and return chasers will bury the shorts in this type of financial environment.

The start of a bear market ex/ some Black Swan event?   Probably not, unless the trading ‘bots short circuit and magnify the downdraft, which is a real possibility.  We would not be trying to catch the falling knife, but given the increase in technology and the new market structure you must be quick to buy the turn.   Most sell offs have now morphed into flash crashes.

A seven to plus ten percent correction and a decent blowout in credit spreads precipitated by the  European bond market temper tantrum with the level of current valuations?   In a heartbeat.

Cash has a very high option value today, but also a high opportunity cost in this raging bull market.

Therein lies your investment dilemma. We could be wrong in our analysis and view.

However, remember these words,

“After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: It never was my thinking that made big money for me. It was always my sitting.” – Jesse Livermore

Time to be a tourist and take up alien residency.

Mr. October on deck.