Tagged: Federal Reserve

The Middle

Keep it between the lines, advises an old country song from my youth.

“Quast,” you say. “If it’s from your youth, drop the modifier ‘old.’ That’s a given.”

You’d be right. Yesterday was ghoulish, as my Halloween trick was turning 50. Dead in the middle between zero and a hundred. And so now that I’m an elder I can pontificate with more gravity. Or such is the hope.

The Federal Reserve wraps a quiet meeting today where no doubt much pontification by elders ensued, and the trick for the Fed is to keep it between the lines. I expect the Trump administration, if the next Fed head is current Fed governor Jerome Powell, hopes to hew to the middle. No rocked boats or roiled waters, is the thinking.

The stock market is the same. It migrates to the mean. So successful is the average in 2017 that we’ve not had a single short-term market bottom (I’ll explain shortly).

The Wall Street Journal’s list of international indices shows none in the red the last 52 weeks. Root through Bloomberg and you’ll find a few deep in the ranks. Qatar is down 20%. Pakistan, Montenegro, Botswana and Bosnia in the red. But losers are few.

In the deep green are the Merval in Argentina, up 62%, the S&P 500 in the US, 21%, and the Dow Jones Industrial Average comprised of plodding blue chips, up 29%.  Even economically beleaguered Venezuela (native son Jose Altuve guilds baseball’s Astros) should’ve told citizens to buy local stocks as they’ve rocketed 4,700% in a year.

I tallied data on DJIA components.  The average blue chip is trading at 27 times earnings, with shares up 90% the past five years, 18% per annum on average. Yet a survey of financials the past four years across the thirty shows average revenue DOWN 2%, earnings down 7%.

There are some strong blue chips. But money and market structure have distorted the valuation picture (where markets and the Fed dovetail). While we’re not wary, we know it’s true and there will be blood. We’re just in the middle where everybody forgets about cause and effect.

We use the ModernIR Behavioral Index to predictively meter short-term movement of money on a 10-point scale. Over 5.0, more money is coming than going.  Under it, the opposite.  Historically, over 7.0 was a market top predicting profit-taking the next 30 days, and under 4.0 was a near-term market bottom, a value signal.

The market in 2017 is in the middle. That’s a buy and hold market, yes. But it lacks value signals too. People are overpaying. Stocks in 2012 dipped below 4.0 on 41 trading days out of roughly 260 total.  In 2013, there were 31 market bottoms; in 2014, 22; 2015, 39, and 2016, 31.

In 2017, none. Zero. The ModernIR Behavioral Index was 3.5/10.0 on Nov 8, 2016, the last bottom (those who bought then correctly read sentiment!).

I’m glad the US economy is posting numbers many thought impossible – 3% GDP growth for consecutive quarters. It can deliver even better data.  But right now too much money is chasing too few goods.

There’s one source of blame: The Federal Reserve.  Other central banks influence money supply but there’s still just one reserve currency (all efforts thus far to change it notwithstanding).

Result: Picture a Cape Canaveral launch. The space shuttles now retired would blaze 37 million horsepower fighting off gravity. The Falcon Heavy from SpaceX lifts goods to the space station with power like 18 Boeing 747s strapped on and throttled up.

There is no floating economy in space where gravity doesn’t exist. A great gout of central-bank money cannot as with space travel blast the planetary fisc past the gravitational pull of debt and spending. It can only create a long comet trail of stock prices and real estate prices and bond prices.

We think we’re in the middle. And we are. But not how we suppose. We’re between.

The Shiller PE as we wrote last week is the second steepest outlier in its history. Fundamentals don’t match stock prices. Gravitational pull is coming. We’re nearer the edge than the middle, viewed that way.

Many have decried central banks for opening floodgates, claiming it would produce a monetary Katrina. I supposed it would be two years from when the Fed’s balance sheet stopped expanding in latter 2014. But the Trump Rocket took us to zero market bottoms.

What’s tripped up doomsayers is a misunderstanding of the middle. The space between actions and consequences can be long. What is the Fed getting wrong?  It’s keeping us in the middle. It’s eliminating winners and losers.

We’ve got to get out of the middle before the bottom of it drops out.  Jerome Powell, can you help?

Easy Riders

It’s been so easy making money on stocks around the planet that the actual easy money has been forgotten.

The European Central Bank Thursday is expected to signal intent to curtail long-running mass purchases of corporate debt. Of course the Federal Reserve, the American central bank, sees higher interest rates yet last raised in March, so who do you believe?

And why should you care?

Because there are two giant macro inputs to stocks, investors and public companies:  currencies and interest rates.  Central banks pull the biggest levers affecting both.  Stocks are denominated in currencies that when fluctuating can spawn violent ripples (2008 was a huge spike in the dollar).

With central banks coordinating currency policies to smooth fluctuations, price volatility has appeared to vanish. It’s not gone, however. It’s just stabilized – like the amazing stabilization technology in my Google Pixel phone. Whizzing down the road on a bike I can hold my camera behind me and film followers and the video is dead stock still. Nary a jitter. The central bank of phones.

If I wipe out on the bike, no amount of stabilization will compensate. That’s not an intended analogy but maybe it’s apropos.  We’ve all been easy riders.  Stocks don’t fall, they just rise.  Prices hardly vary save to pop periodically.

Back to the ECB, a Wall Street Journal article yesterday offers perspective. Last year the ECB bought $115 billion of corporate bonds, more than the entire eligible supply of $103 billion.

One result is high-risk companies are getting investment grade financing with a taxpayer guarantee. The thinking is that buying risky corporate borrowings drives more economic output. But the public was outraged about backstops for giant banks in the financial crisis.  One wonders how taxpayers will respond if those bonds fall apart.

The WSJ article notes that a mere 0.2% tick up for bond yields would wipe out a year’s worth of returns (because the value of the bonds would decline, and bond buyers are now chasing rising prices more than yield).

The ECB isn’t buying bank bonds, but it’s bought so much other issuance that a quarter of continental investment grade corporate debt has negative yields. Investors are paying for the privilege of owning them because prices keep rising (it’s a bit like equities where rich multiples mean investors are paying for the privilege of one-way stocks).

Low interest rates remove a clarion call about the value of money and the presence of risk. Investors priced out of high-yield bonds by central banks instead look to other even riskier things for returns. Those traditionally buying investment grade instruments are forced to move to higher risk too, for a desired return.

Everywhere risk increases yet paradoxically it appears to vanish, because interest rates say there is none and all prices rise.

For investor-relations professionals today, it’s a reminder of how important your job is.  So many things besides story now populate your whiteboard, ranging from passive investment, to a shrinking sellside, to macro factors. Keep execs informed.

And investors, never forget that your assets are as good as the stability of the money denominating them, and creating value is hard work. We’ve been easy riders a long time. We may get a hint Thursday from the ECB of hills ahead.

Dalhart vs Artifice

Texas is booming. We road-tripped it June 28-July 6, giving y’all a break from market structure.

We rolled the I35 corridor from frenzied Frisco north of Dallas, to Austin, now home to 950,000 people, to San Antonio, the fastest-growing Texas city last year, pushing 1.5 million.

From there on July 5 following fireworks the night before in three directions from Hotel Emma, our favorite in the country, we were up in Amarillo by evening (an oblique musical reference back past George Strait to Chris LeDoux, God rest him), and in Denver the next day.

You’d suppose Texas would be taking it in the nose on low oil prices. Yet bergs like Dalhart on the reaches of the Llano Estacado (yaw-no esta-kahdo), the vast plain staked over north Texas, bustle on Main Street and prosper on the boulevards.  If the world blows up, hunker between Texline and Masterson on Highway 87.

What’s Texas tell us about investor-relations, the stock market, investing, the Federal Reserve, the economy?  The farther you get into the heartland the less the things the people in charge think matter, matter.  Life goes on.

Of course, all of us gathered right here at this moment are rooted deep in the market, the Fed, the economy – even those of you in the heartland. We don’t have the – what’s the way to put it?  Convenience.  Of slipping off into the quiet purple of the fruited plain.

Looking from Dalhart, this strikes me:

The stock market.  Passive Investment depending on average prices is carrying the market beyond fundamentals, producing superior outcomes. Can average breed superior, sustainably? Malcolm Gladwell and reality both say no. So prepare for mean-reversion between fundamentals and prices.

When? Nobody knows.  It’ll come with no VIX signal, maybe as the Fed sells assets and spikes the dollar (The Fed trades bonds for dollars, so fewer dollars means higher dollar-value). It’s not that I’m pessimistic. I’m opposed to artifice in the economy, the market. I don’t think Dalhart would accept it. We don’t like it in people, politicians. Right?

Speaking of artifice, our estimable central bankers at the Federal Reserve have determined that after eight years of mediocre output we are ready to rock – though curiously weak inflation, they call it, vexes.

Say Sammy Hagar contended there were several ways to rock. We’d laugh. If I hear one more time that inflation is good, I’m heading to Dalhart.

Inflation is rising prices, which trims both buying power and productivity, the pillars of prosperity. The Fed might be underwhelmed by the increase but we’re paying more. For the same stuff. And calling it growth.

That’s artifice. A treadmill offering the illusion of forward progress, like confusing volume and liquidity (we’ll return to market structure next week so stay tuned).

The Fed should never have institutionalized economic mediocrity with eight years of training wheels. The Tour de France is underway coincidentally, drama on wheels turned by superlatives. You don’t reach the Tour on training wheels. You don’t become an economic tour de force by moseying.

Yet we can’t have an economic adult riding on training wheels. It just looks bad. So we’ll soon have the financial equivalent of a biker barreling into the shrubbery head over handlebars. Dalhart. Life goes on. We’d be better off without Fed artifice. Period.

Same with the stock market. The pursuit of average has become superior there, thanks to big training wheels (a good name for a rock band) from central bankers. Yet we value companies the same, engage in the same IR work. Why do we accept artifice?

Now pedaling toward the economic sludge, the training wheels are coming off the market. Central bankers believe they need only make a pronouncement that all is well and we’ll skim the muck.

The mistake we make is legitimizing it. But there’s reason for good cheer!  The quicker these things mash in a big dustup (and they will), the sooner we get back to Dalhart, and a prosperous global boulevard free of artifice where what’s real matters.

We’ll have to cross the Llano first. Put’er on cruise control, and keep driving.

The Clash

On Friday Feb 10, behavioral-change in the stock market rocked the Richter.    

Stocks themselves seem rather to be rocking the Casbah, Clash-style (obligatory Grammy Awards Week musical reference, and showing my age I reached back to 1982).  Plus it’s that time again: Options expire today through Friday.

Naturally, Janet Yellen picked this week to tell the market – I say “tell” loosely since her utterances are so inscrutable that we’re left to construe and guess – a rate-hike is coming.

I find it troubling that the regulator of the world’s most important banking system appears to be ignorant of how markets work. Why hint at momentous monetary matters two days before volatility bets lapse?  Then again, maybe it’s purposeful.    

And far easier than ruminating on Chair Yellen’s comments for signals is checking the Fed’s balance sheet. Want to know if the Fed will raise rates?  Look for big moves in either Reverse Repurchases or Excess Bank Reserves.

Let me interrupt here:  Investor-relations folks and investors, I return to the Fed theme because it remains the linchpin of the market. We’ll make it an intriguing visit!

On the Fed’s balance sheet, sure enough – big changes.  Excess Reserves have risen from about $1.8 trillion in January to $2.2 trillion last week (huge numbers, yes. For the 20 years before the financial crisis, excess reserves averaged about $10 billion). 

That’s a $400 billion push, almost as big as the $500 billion the Fed heaved at the market last January and February when it was collapsing under the weight of the mighty buck following the Fed’s first rate-hike in ten years.

You can hardly remember, right?  Back then, the top price-setter (followed by Fast Trading) was Asset Allocation – selling by indexes and ETFs jammed up at the exits.

It stopped because the buck didn’t. The dollar fell. When the dollar weakens, stocks generally rise because they are denominated, like oil, in dollars. Smaller dollar, bigger price.

And vice versa. The dollar strengthened ahead of the 1987 stock market crash.  Ditto the Internet Bubble. In May 2010, the dollar rose right ahead of the famed Flash Crash. Last January’s swoon? The dollar surged in November and December with the rate-hike.

From Mar 2009 until Aug 2014 the dollar was weak as the Fed trampled it, and stocks, commodities, bonds, housing and so on all rose.  Then abruptly in latter 2014 the Fed stopped beefing up dollar-supplies. Stocks statistically flatlined till Nov 9 last year.  The Dow was 18,000 in Dec 2014 and 17,888 Nov 4, 2016.

Since the Fed is no longer creating new dollars rapidly by buying debt, it instead moves money into or out of the counted supply.  Excess reserves increase the counted supply of money, which decreases dollar-value.  And yup, from early January to last week, the dollar dropped 4% (using the DXY, the dollar-futures contract from The ICE).

Why does that signal a rate-hike? Because increasing interest rates is akin to reducing the supply of money.  The Fed hopes the yin of bigger reserves will mesh with the yang of higher rates and stop the buck in the middle.

But the buck is back up 2% already. We come to the Richter move I mentioned to start.  We track the four big reasons people buy and sell stocks. From Nov 9 to Feb 9 as stocks soared, the leading price-setter was Active Investment. Rational people are bullish on American economic prospects.

But the Number Two price-setter is Risk Management – portfolio leverage with derivatives. And it’s nearly as big as Active Investment.  Investors are buying the present and betting on the future, which means both present and future back current stock-prices.

The problem arises if the future isn’t what it used to be, to paraphrase Yogi Berra.  And one axiom of Market Structure is that behavioral volatility precedes price volatility.  Much like clouds gather before a storm.

On Feb 10 clouds formed. Risk Management marketwide jumped almost 18%. It’s unusual to see a double-digit move in any behavior, and this is among the biggest one-day moves we’ve ever seen for Risk Management. Is money questioning the future?

It came right ahead of the Grammys. And more importantly, before Options Week and Janet Yellen.  Were we monitoring the Ring of Fire for seismic events, we’d be predicting a temblor.

Of course, in the same way that seismic activity doesn’t mean The Big One is coming, it might be nothing.  But stocks are near a statistical top in our 10-point Behavioral Sentiment Index again and the buck is rising toward a March rate-increase. Sooner or later, the present and the future will clash. 

Life will go on.  And we’ll be measuring the data. 

Fed Up

We’re in New York hoping to run into Janet Yellen because today the Federal Reserve probably raises rates.

In December last year the Fed hiked, and markets jumped – and then imploded. Worst January start ever for the stock market.

If you’re not right now feeling a deadening of your senses, you’re an outlier. Assemble a focus group and you’ll find folks have roughly the same reaction to the words “monetary policy” that they do to “dental appointment.”  It’s all floss, scraping and blood.

With stocks at all-time highs due more to the growth of the Fed’s balance sheet than verve in the economy, one wonders if it’s held together with dental floss. The world’s leading currency manipulator by my estimation isn’t China but us. The USA.  We micromanage the supply of dollars, and all currencies turn on the value of the dollar.

So we have to talk monetary policy. If the supply of money expands faster than the economy, inflation will show up somewhere. Inflation simply means your money doesn’t go as far as it used to.  See everything from real estate to education to stocks now.

The Fed from 2009-15 increased the supply of dollars by 62% while the economy grew 24% (about 2% per year). The adult population expanded 7%. Those employed increased 10% (but only 4% if you back up to peak mid-2008 pre-crisis jobs).

The only way an economy grows faster than population is if productivity – doing more with less – increases. Our most productive year by far in recent times was…wait for it…2009.  Yes, when the economy imploded and the value of the dollar exploded, suddenly our money went farther, and the bloat came out, and productivity spiked 5.5%.

But the Fed immediately shoved the entire economy full of bucks. Productivity nose-dived because our money didn’t go as far as it used to, as prices for everything from houses to stocks climbed sharply.  Productivity since has averaged less than 1% growth per year and totals but 5% from 2010 through the third quarter this year.

So if the supply of money is the only thing growing rapidly, we have an economy built on what the sellside analysts call multiple-expansion, which is just another name for your money doesn’t go as far as it used to.  You’re paying more for the same thing.

This, while we’re at it, is how income inequality increases.  When governments expand the supply of money, people with more (the rich) spend it on houses and cars and art and stocks, increasing the prices of those things, and the rich get richer.

But for the poor who do not have assets, the money they have doesn’t go as far because stuff like toilet paper and cereal and toothpaste costs more.  So they have less (we thus have a curious confluence in which the Fed rails against income inequality while promoting it with policies).

The ideal structure is for money to have timeless value so that technology for making things boosts productivity, and prices come down some over time (prices declined by 50% from 1800-1900 and we had our most explosively productive stretch ever) and everybody’s money goes a little farther.

The Trump administration brings a message of opportunity. That unstoppable force of hope is slamming into the immovable object of economic fact. Stocks are up some 10% without underlying change. It says how much we long for the good times to roll again.

There are two questions here as we conclude. First, do we want to build the future atop a giant pile of wobbly Fed pillows stuffed full of cash, or would it be better to ground it firmly on economic output?  Hope is a powerful elixir but it’s not empirical. Empirically, there should be a massive sale – everything must go – in America before we begin again.

And question number two is will that happen?  The US dollar strengthened sharply before the Internet bubble burst in 2001, putting everything on sale. We have valuations now matched only by those then.  The dollar is at the strongest level since then.

The strong dollar will mean weaker Q4 revenue and profits for multinationals and if it continues into Q1 next year, the economy will first slow before Trump policies may put wind in the sails. When record stock markets mash into falling corporate profits and slowing economic outcomes, expect trouble.

I’m excited about the future in America. Before it comes, we should first get Fed up.  Dump these asset prices created by a vast accumulation of cash.  Start fresh. Will it happen?  That’s the unknowable part.

Long December

Are you a Counting Crows fan?

Karen and I saw the band years ago at Red Rocks, our fabled foothills venue. Front man Adam Duritz lived, he said, in Denver as a child.  One great song goes, “It’s a long December and there’s reason to believe that this year might be better than the last.”

On this last day of November I’m thinking back.  On November 30, 2015, marketwide short volume – daily trading on borrowed shares – was about 43%, a low number versus trailing standards. By January 2016 it had risen to 52%. At Nov 28 this year its 43%, the same as last year.

The dollar then as measured by the DXY Index was the strongest in a decade, at 100.5.  It’s at 101.0 now, a fourteen-year high.

Let’s pause. What’s a strong dollar mean? Using an analogy, a football field is one hundred yards long. Suppose your team is way behind, down 30-0. So the referees shorten the field to 60 yards to give you a chance to catch up.

A strong dollar is a long field. A weak dollar is a short field. Weak dollars shorten play by making prices rise, earnings from abroad converted back to dollars appear stronger, and borrowing cheaper.

From 2009-14, the USA played on a short field, thanks to the Federal Reserve. We were down 30-0. By latter 2014 we trailed about 30-14.  I use that score because by historical measures – housing starts, GDP growth, discretionary income, retail sales (excluding autos), industrial output, productivity and more – we are half what we were.

But we’re catching up, so the Fed is getting set to stretch the field again (Aside: We should never shorten the field. If you’re used to running 60 yards in practice but the games play at 100, your training is all wrong. A steady dollar is what we need.).

DXY

Courtesy Dow Jones Marketwatch

 

Getting back to our December comparisons, in 2015 the Fed inched the cost of overnight borrowing called the Fed Funds Rate up to 0.25%-0.50% (it settles sort of in the middle), the first hike in ten years.  This December it’s widely expected the Fed will mosey the rate up another 25-50 basis points.  Simpatico again.

In December 2015, the bond market was weak, with interest rates on the 10-year US Treasury at 2.33%, up from 1.7% in January, a 39% increase (prices and rates move inversely, so when people sell bonds, rates rise and when they buy them, rates fall). As November 2016 ends, the 10-year Treasury is 2.32%, from 1.4% in July (68% rise).

And the S&P 500 is about 5% higher now. (Speaking of stocks, don’t miss our NIRI webinar tomorrow called Hide and Seek: The Incredible But True Story of How Big Institutions Buy and Sell Your Shares.)

There is one major difference between then and now. Using our long-field/short-field analogy in a different way, when the Fed’s balance sheet has big bank reserves, that’s a short field. Low bank reserves, long field. Between early December 2015 and early January 2016, the Fed took $500 billion out of bank reserves, pushing the playing field to the full hundred yards as it tightened rates.

The whole globe rocked.

Stocks imploded and money screamed into bonds, driving rates down. For awhile at the end of January it seemed downside for the market was bottomless.

By pushing the entire $500 billion back into reserves and chopping the playing field to 60 yards, the Fed got stocks to reverse and soar all the way to the Brexit (they overdid it).

This time they’re starting December where they began January, with a long field and low reserves. They believe they can hike rates December 14 and hack the playing field down to 60 yards by boosting bank reserves, and thus next year will be better than the last.

They might be right.

I’ll tell you the risk should they get it wrong and what would set it off:  If the economy lurches sharply down – despite headlines this week there’s a real chance of a recession next year looking at trends – then the Trump Rally will be a big belly well out over the Fed’s skis as winter hits. If that happens this current year will be better than the next.

I’m hoping for a short December.

Do The Math

Anybody ever said to you, “Do the math?”

Yesterday on CNBC’s Squawk Box legendary hedge-fund manager and founder of Omega Advisors Leon Cooperman said the world is crazy.  That’s anthropomorphizing the planet but I agree. He was referring to the math behind negative interest rates, which means paying people to borrow money.  That’s crazy all right, but happening.

He also said, paraphrasing, that if the population of the country grows by 0.5% and productivity increases by 1.5%, that’s 2% economic growth.  Add in 2% inflation and you have 4% “nominal” growth, meaning the numbers add up to that figure.

He said if the S&P 500 trades at 17 times forward earnings, that puts the S&P 500 at roughly 2150, about where it is now, so the market is fully valued but not stretched.

Why should you care in the IR chair? Macro factors are dominating markets, making a grasp on economics a necessary part of the investor-relations job now.

Whether Mr. Cooperman would elaborate similarly or not, I’m going to do some math for you.  Inflation means your money doesn’t go as far as it did – things cost more.  If a widget costs $1 and the next year $1.02, why? Prices rise because the cost of making widgets is increasing.

Making stuff has two basic inputs:  Money and people. Capital and labor.  If you must spend more money to make the same stuff, then unless you can raise prices or reduce the cost of labor, your margins – which is productivity or what economists call the Solow residual – will shrink.

There’s no growth if you’re selling the same number of widgets, even if revenues increase 2%. And if prices rise, there is on the fringe of your widget market some consumer who is now priced out. That’s especially true if to retain margins you cut some labor costs by letting the receptionist go.  One more person now can’t buy widgets.

And so sales slow.

The Federal Reserve is tasked with keeping unemployment low and prices stable (a bad idea but that’s another story). Its strategy is to increase the supply of money, the theory being more money prompts hiring and rising prices are better than falling prices (errant but again for another time).

One simple way to see if that’s occurring is to look at currency in circulation on the Fed’s balance sheet.  There is now $1.5 trillion of currency in circulation, up $82 billion from a year ago.  Our economy is growing at maybe 1.5%.

In 2000, US GDP growth (right ahead of the bursting Internet bubble) was 4.1%.  In 2000, currency in circulation was $589 billion, down $30 billion from 1999 when currency in circulation grew by $100 billion over the previous year. It increased $35 billion in 1998, $31 billion in 1997.

For 2013, 2014 and 2015, currency in circulation grew $74 billion, $80 billion and $97 billion, and since July 31, 2008, before the financial crisis, currency in circulation is up $645 billion, more than total currency circulating in 2000.

Back to economic basics, what happens to the cost of stuff if money doesn’t go as far as it used to?  Prices rise.  Okay, the Fed is achieving that aim. Its plan for remedying the recession was to get prices rising.

But rising prices push some people out of the market for things.  And if to make things you’ve got to put more money to work, then something has to give or productivity declines.

It’s declining.

And if stuff costs more, people who aren’t making more money can’t buy as much stuff.  What you get is weak wages, weak growth, weak productivity. Check, check, check.

Haven’t jobs numbers been solid? We have 320 million people in this country of which 152 million have jobs. If 1% leaves every year for retirement, having kids, going to school and so on, 200,000 jobs each month is 1.5% economic growth at best.

And that’s what we’ve got.

If you want a realistic view of the economy, do the math.  At some point the rising cost of things including stocks and bonds will push some consumers out of the market.  The only head-scratching thing is what math the Fed is doing, because its math is undermining, jobs, economic growth and productivity.  It seems crazy to me.

Balancing Act

If you want to know what a business is capable of doing, look at its balance sheet.

If you want to know what the Federal Reserve is capable of doing too, look at its balance sheet. Having scrutinized it, Karen and I are leaving today to ride bikes in the Pyrenees and will return if the Fed survives.

Just kidding.  Except for the Pyrenees. We’ll report back on Catalonia in a couple weeks.

Meanwhile, there is again a glaring focus on the Fed as markets shudder. Clients know our Sentiment Index had a “four handle” at 4.9/10.0 Sept 8, the first negative read since early July. Volatility bloomed. As with weather, the market reflects preceding patterns.

It’s the same with the Fed’s balance sheet. Monday with Rick Santelli on CNBC’s Squawk on the Street I attempted to describe in a handful of seconds that the Fed can breathe in and breath out and impact rates and market stability.

Simplifying, the Fed has two levers for pushing rates up and down. When the Fed buys assets like mortgages or Treasuries from the big banks supporting our payments system (called the primary dealers), the supply of money expands, which makes credit cheaper and pushes down rates.  These are bank reserves.

On the opposite side, the Fed can borrow money from banks, tightening supply and prompting an increase in borrowing costs.  These are called Reverse Repurchase Agreements (RRPs).

We described last week how both changed little over the two decades preceding 2008. Tweaking one or the other was simple and economical. Need to tighten 2-3%? Boost RRPs by $10 billion.

But now bank reserves are $2.3 trillion, 26,000% more than historical levels. RRPs are 1000% higher than history at $300 billion. The three-to-one ratio the Fed long maintained is now one-to-26.

These facts produce a paradox that traps the Fed. Twenty-five basis points, the increase expected when or if the Fed moves, is no biggie against $10 billion of reserves.  But the Fed pays interest on reserves (and RRPs). Now 50 basis points, the rate would jump 50%.

The interest expense alone boggles the mind. Plus, the government will lose money. A rider on the December transportation-funding bill passed by Congress requires the Fed to send earnings on its massive portfolio over $10 billion to the US Treasury general fund.

Do you see? The data driving the Fed aren’t economic but financial. It’s about the Fed’s balance sheet. And government coffers, dented if the Fed starts paying more interest.

They may still hike but it’s a hindrance. And there’s more. The same giant banks providing margin accounts to traders and derivatives to institutional investors are partners called primary dealers helping implement Fed policy. When the Fed moved $100 billion to RRPs out of excess reserves Sept 1 at the same time that its balance sheet shrank slightly, the impact rippled through all the banks financing hedges and margin-trading.

That ripple is the current tsunami hitting the stock market. The Fed has already unwound these RRPs, returning $100 billion to excess reserves. But the damage was done. The Fed tried similar tactics in December last year when it hiked for the first time since 2006, and markets caved in January and the Fed had to pump up excess reserves by $500 billion – much more than it had moved out of the money supply – before markets stopped falling.

And the Fed oversteered.  Markets shot like a rocket into May, flummoxing all. Our Sentiment pegged the positive needle for weeks.

The same happened around the Brexit vote. The Fed was in the process of tightening by lowering excess reserves and lifting RRPs.  The markets imploded. In two weeks, the Fed reversed. The market shot up, once more prompting global head-scratching.

The Fed cannot seem to calibrate its levers without overshooting or undershooting and in any case creating chaos in stocks and bonds. There is no better evidence of the folly in the size of its balance sheet.

Is there a way out? Sure. The Fed could write off 80% of its balance sheet and put us back to pre-crisis leverage.  But interest rates would explode and the entire globe would fall into depression because that would be a restructuring, a technical default.

Is there another way out?  Yes. Normalize rates and take our chances. But that demands a fortitude that’s missing in the sort of jittery lever-yanking one can observe on the Fed’s balance sheet.

The Blue Whale

Last week US jobs were weak and the market welcomed the news.   

We tend to laugh or snort when stocks do the opposite of what they should. But if the market is powered by an economy that’s weaker than expected, why should it rise?

And if you’re an investor-relations professional or in the investment business, you need to understand these outcomes even if you’d prefer to go to the dentist for molar removal.

“It’s the Fed,” you say, rubbing your jaw. 

All right, it’s the Federal Reserve.  What does that mean?

“I’m not sure,” you say.

“What do you think it means?”

“That when The Fed raises rates the economy is better and borrowing will cost more.”

Stop. What?

Study the data pouring forth from the government and the private sector and you’ll see that when you’re doing better, borrowing costs…wait for it…LESS.  

Yes, a strong credit score – a good personal economy – means you pay less to borrow than those with weak personal economies.  Miss a payment and the rate slams UP.

“Yeah, but what the Fed was trying to do was get people to spend,” you explain. “They keep rates low to juice the economy with consumption, and when it starts to overheat and there’s too much borrowing, then they slow it down by raising rates.” 

Okay. I follow that.  But why is it a good idea to get people to spend if borrowing too much money is what created the financial crisis?  And where’s the growth by the way?

“Look,” you say.  “I’ve got a dental appointment I need to get to.” 

The Fed has got everyone thinking it’s the Millennium Falcon in Star Wars and the economic data are TIE Fighters to line up in the sights and then…boom!  We hike rates. 

That’s as absurd as fueling economic recovery with a seven-year teaser rate prompting people to borrow and spend.

Forget that. Here’s the real dilemma for the Fed. Last Thursday before the jobs data the Fed’s balance sheet shrank to the smallest level since I believe Oct 9, 2014 when it was $4.496 trillion.  It was $4.503 trillion, down about $20 billion week over week.  And Reverse Repurchases exploded to $442 billion, $100 billion more than a week earlier.

That’s tightening.  With an “RRP,” the Fed borrows from banks to take money out of the counted supply.  When bank reserves rise because the Fed buys debts, the money supply increases.  It’s like fishing line. Let some out, reel some in.

So maybe the Fed wants to raise rates and then if the dollar spikes and assets like stocks and bonds fall, it can reverse these and flood markets with money. After all, when the Fed hiked by 25 basis points last December, stocks and bonds nearly imploded. Remember January 2016?

But here’s the problem.  Prior to 2008, bank reserves ran about $10 billion (and didn’t change in a decade).  RRPs ran about $35 billion, twice the size of reserves, and changed maybe $3 billion over a whole year.  Moving rates 100 basis points was no biggie, like hauling in a minnow on your steelhead fishing line.

Now the Fed has $442 billion of RRPs and it’s paying about 25 basis point of interest on them.  Bank reserves that pre-crisis were $10 billion are today $2.3 trillion, 26,000% higher.  Now the Fed has a fly rod with test line and it’s trying to land a blue whale.

It’s potentially catastrophic. If the Fed raises to 50 basis points, unless there’s a better place for bank reserves to go, money could stampede to RRPs, causing the dollar to skyrocket and stocks and bonds (and oil) to implode – as they nearly did in January. 

The Fed doesn’t HAVE to take the money it borrows via RRPs, but it says about $2 trillion of Treasuries (collateral) are eligible. The Fed can tighten confidently only if there’s enough demand from the economy to keep the blue whale away. 

Look around. The Bear Stearns Moment of the Week is the bankruptcy of Hanjin Shipping.  It’s among the ten biggest shipping companies in the world, moving the goods of global commerce. When Bear Stearns and Lehman failed we discovered the world had a financial crisis. When Hanjin folds, you have a budding economic crisis. 

So that’s the truth. What matters isn’t if there are 150,000 jobs (which isn’t enough to offset the traditional attrition rule-of-thumb of 1% of the workforce so don’t be fooled) but what the blue whale will do.  Disturb it and things start coming apart.

The Fed doesn’t want to do that, but it can’t figure out how to get the blue whale off the hook either.  And this you see is a much bigger deal than if you make your numbers. The market wants to know the Fed will keep feeding it line. Or a line. 

 

Up and Down

If money leaves, how is it stocks rise?

After all, most suppose the market is premised on buying leading to higher prices and selling producing lower ones. And humanity has also held through the ages that a thing seeming too good to be true probably is.

In that vein, Lipper US Fund Flows, a Thomson Reuters unit, tracked billions in outflows from US mutual and exchange-traded funds in equities throughout June including about $7 billion from US equities the week of June 29.

As the Brits fled the European Union so did money from stocks, which offered a stomach-curdling free-fall reminiscent of the Summit Plummet at Disney’s Blizzard Beach. Doom loomed.

Instantly, US equities boomeranged back, a weird financial-markets mulligan. Pundits cheered. Most of us prefer to be richer rather than poorer so heralding rising stocks is natural. But shouldn’t we want to understand why they’re up? Particularly if we’re getting contradictory data such as higher prices from less money?

Could it be short-covering? ModernIR tracks daily short volume, and it was 45.7% of all trading for  the week ended June 13, 45.8% at June 27, and by last Friday had risen to 46.7%. Higher, not lower (yes, nearly half the volume is short).

How about fundamentals? A rosier future economic view can cheer current money. Ah, but from the Federal Reserve, to the Organization for Economic Cooperation and Development, to the International Monetary Fund, hoary heads of the dismal science see deepening malaise worsened by the Brexit, creaky European banks, possible copycat flight from the Eurozone – even a slowdown for the USA.

If things that should drive stocks up are down and yet stocks are up anyway, what might we predict ahead?  There’s a saying that it’s better to keep one’s mouth closed and look like a fool than to open it and remove all doubt.  Forecasting the future is a fool’s errand.

But drawing sound conclusions never goes out of style. Economist Herb Stein, father of Ben, coined Stein’s Law:  If something cannot last forever, it will stop.

Stocks by nature reflect things that can’t last. They go up and down.  And the market is not really up. On Dec 29, 2014, the S&P 500 closed at 2090 and on July 5, 2016 finished at 2088. Stocks are now characterized by short-term ebbs and flows.

The pursuit of short-term price-changes is arbitrage, which isn’t additive investment behavior. Can a market characterized by declining money flows, weakening fundamentals and arbitrage, with no material gain in over eighteen months, gather steam?  Anything is possible. But it’s not a sound conclusion.

Plus, stocks are a mirror for something larger. We call it the Great Risk Asset Revaluation.  Starting in 2009, the Federal Reserve bought trillions’ worth of government and mortgage debt with dollars it created. Much of that money found its way via banks into risk assets – things with variable valuation – such as stocks, bonds, real estate and commodities like oil. Prices for these soared.

And then it all stopped.  See Stein’s Law. At Sep 3, 1998, the Fed’s balance sheet was about $500 billion.  At Sep 4, 2008, it was $900 billion.  At Aug 21, 2014, it was $4.5 trillion. And at June 30, 2016, it was $4.5 trillion.  The Fed’s balance sheet stopped expanding in latter 2014.  Since then, the US stock market has not risen and the global economy has been thrown into turmoil.

It’s all about the money.  Not how much is in the stock market but what the value of the US dollar is relative to other currencies. When the Fed ceases expanding its balance sheet, the dollar appreciates. It’s math. The bad news is that prices of risk assets will reset correspondingly lower.  The good news is that it’s the way back to reality.

When?  In the housing crisis, it was two years after home prices stopped rising that the bottom fell out of the mortgage-backed securities market.  In August it’ll be two years since the Fed’s balance sheet stalled.  Oil alone has repriced so far.

Whenever the Stock Reset comes (and much will be done to stop it), we’ll all survive it – and real opportunity will again abound. Besides, who wants a market that seems too good to be true?