The Federal Reserve: A Not So Noble History
The Fed just fascinates me. From its current market rigging to its mercurial (i.e. illegal) origins on Jekyll Island in 1910 where a handful of insiders effectively created an illegal banking cartel made legal only by the signature of President Wilson in 1913.
Wilson later admitted signing the Federal Reserve into law was the darkest day of not only his Presidency, but of US history… He was right.
But I digress…
Yet long before Wilson’s moment of supreme weakness in the early 20th century, Thomas Jefferson saw the writing on an 18th century wall. He said the idea of a private central bank (for indeed the Federal Reserve is neither “Federal” nor a “Reserve”) controlling the supply and price of a fiat (i.e. non-gold-backed) US currency scared him more than the prospect of a foreign army on our shores…
Tack on a few decades and President Jackson described the bank’s prior incarnation as the “prostitution of our government for the advancement of the few at the expense of the many.” Yet despite the wisdom of Jefferson, the straight-talk of Jackson or the weakness of Wilson, we –and our markets—find ourselves firmly under the trance of this admitted aberration, this, well monster…
Monster? How can that be?
After all, the Fed is our savior, a superhero like cabal (The Fed’s Powers) of brilliant economists, private bankers and highly educated Chairmen/women who bailed America out of the 2008 crisis and now, nine bullish years later, have skillfully positioned (marketed) themselves as able to dial inflation, markets and employment figures up and down as if part of an elaborate thermostat.
In short, the markets, the media and a majority of investors believe the Fed has their back and that a new, post-08 era of stability and rising markets is here to stay.
I, of course, disagree.
I’ll write elsewhere about the mathematical myths (i.e. lies) behind the so called “employment miracle” and inflation stability for which the Fed has falsely taken credit since 2008. Real math confirms we are far from “peak employment” and that the CPI—our official scale for measuring inflation—is as fake as Canal Street handbag. (Our CPI scale reminds me of a fat-camp where the more pizza and beer you drink, the lower the weightings are…) But again, I digress…
What the Fed Actually Does
For now, let’s just look bluntly at what the Fed really does, and how and why the big banks and the US Treasury Department are part of the most transparent and “forward guided” market fix in our nation’s fiscal history.
To keep it simple, imagine the lemonade stand I wrote of recently (Federal Reserve Fantasy), where a spoiled kid opens for business in the tundra, sells crappy lemonade to non-existent clients and yet still manages to make a fortune?
How? Because he has a rich uncle who buys all his inventory…
Since the market crash of 2008, that rich uncle was the Federal Reserve and that spoiled kid was an amalgam of our banking system, our S&P and our bond market—all made fat by a Fed-supported subsidy rather than the once respected center-piece of economics 101—namely: supply and demand.
Most investors, like most financial salesmen on Wall Street, have no idea what any of this means, for most have never taken a moment to trace what the Fed and its brood of “Primary Dealers” actually do.
Since 2008, what the Fed did (and still does indirectly) comes down to this: it prints lots of money to buy securities (i.e. MBS, or “Mortgage Backed Securities” and US Treasuries) that no one else would buy, thereby giving the illusion of real markets and real market strength. Yellen & Co call this “accommodation.” I call it “faking it.”
From 2009 to late 2014, the Fed clicked a mouse and added zeros to the US money supply. It then took this artificially created money and pumped it straight into another fancy-termed (i.e. misleading) collection of what the market calls “Primary Dealers,” which is just a slick way of saying the big banks like Goldman Sachs and Citibank.
(You remember them—the very banks who we bailed out for not having any buyers for the crap-load of crappy MBS securities they bought before the 08 sub-prime bubble popped…)
So the Fed prints trillions of dollars out of thin air and then injects this money into the trading accounts of the TBTF banks. What happened next? Well, a number of disturbing things…
The Fed Distorts Bank Reserves and the Relevance of Short-Term Interest Rates
First, nearly $2.7T of that magically created $4T+ of printed money went into the reserve accounts of the Big Banks. Stated simply, these banks are flush with HUGE reserves, just HUGE cash reserves! Which raises an ironic point that most market and Fed watchers don’t understand and thus constantly overlook: The Fed’s interest rate hikes are in many ways a non-issue…
Why the Obsession with Rate Hikes Is a Bit of Joke…
But how can this be so? Don’t the pundits and headlines hang on every word the Fed mutters? Don’t rate hikes, or even the whisper of rate hikes, send the capitalist hearts and bankers’ pulses all a flutter?
Well, not really…
Technically, the Fed’s rate hikes are all about the Fed-Funds Rate, which is the interest rate big banks charge each other for short term borrowing needs to insure against 1929-like bank runs. In the old days, this interest rate and this pool of banks were of great relevance and esteemed importance, and thus the rate charged for that borrowing was critical to our banking system.
But after 2008 and the Fed’s $2.7T cash infusion to these banks (aka “Primary Dealers”), they are so flush with their own reserves that inter-bank borrowing (as well as the rate/cost of that borrowing) is as obsolete and irrelevant to banking as a walkie-talkie is to telecommunications.
In short, no one at Goldman or JP Morgan is worried about borrowing from each other at any interest rate the Fed sets. In simple English: they’re too rich to worry about that Fed anymore…
So What are the Banks Really Doing Today?
Flush with free money, these banks have not only been bailed out, but are continuing to enjoy the benefits of a Federal handout. That is, they are actually enjoying a coupon return for the free money they hold in their reserve accounts.
The TBTF banks are enjoying “Interest on Excess Reserves” (IOER), another fancy term which just means they are being paid to keep money in the banks rather than in the real economy.
Unspoken Inflation Fears
Why? Because the wise folks over at the Fed know that if those bank reserves ever flow into the system (i.e. real economy) rather than remain safely on the bank’s balance sheets, a market force known as the “velocity of money” will flow into the economy, and that flow would more resemble a flood than a stream.
More to the point, that flood of money is like a flood of water added to lemonade: it dilutes the flavor. In economic terms, it dilutes the currency—which economists call “INFLATION”—and I’m talking real big inflation…
Honor Among Thieves
So the Fed in 2017, like its cartel origins in 1913, is effectively (and once again) engaged in a relationship with the banks akin to “honor among thieves.” That is, the Fed bails the banks out, soaks them with printed money, and, in turn, the big banks tacitly agree to keep their fingers in the dike of their near bursting reserve accounts (aka “handouts”) to prevent an inflationary (and market) catastrophe/flood.
But the problem with honor among thieves, is that it includes the thief part… Big banks, like George Washington’s realpolitik depiction of nations, have “neither permanent friends nor permanent enemies, just permanent interests.”
And the banks have one permanent interest: greed and money.
Greed Among Thieves
We all know this. Heck, I worked with em, and I know it too…At some point that interest return (the IOER) the banks are getting from the Fed to keep their bail-out money on ice won’t be as seductive as the return they can get from lending that money back into the system. In other words, at some point the banks might betray their mother-bank, the Fed.
Wall Street institutions will eat their young for a profit. Loyalty lasts only so long. Back in 08, for example, when banks were lending billions to hedge fund margin accounts so they could lever returns, those same hedge funds had no ethical trouble shorting the very banks that fed them for a profit—essentially eating (rather than biting) the hand that fed them.
Fast forward to today and we now must ask how and when will those big banks stick it to the Fed the same way hedge funds stuck it to the banks in 08? Simple. As soon as bonds tank and yields (and thus interest rates) spike, the banks will turn their back on the FED and its IOER and look instead to desperate borrowers willing to pay rates much higher than the IOER. In short, they’ll lend rather than hold their fat reserves. Why?
Simple: because the returns will be better.
But this assumes there will be borrowers able to pay the higher rates demanded by those charming banks. When rates rise due to bond market sell-offs (remember: yields [aka rates] = coupon/price) rather than Fed rate hikes (again: the bond market, not the Fed, really controls rates), it’s possible that this bond/credit crash will leave a swath of dying enterprises in its wake, which means there will be less and less solvent borrowers out there to pay the banks higher rates.
In such a scenario, everyone eats each other. The Fed, the banks and the borrowers all panic together.
This is the kind of craziness that results from honor among bankers, and the biggest bank (the Fed) has its finger prints all over this mess…
The Fed Creates Historically Unprecedented Security Bubbles
In addition to totally distorting traditional banking practices and setting the stage for an historical Mexican stand-off among banks, the Fed, the bond market and corporate borrowers, the huge, post-08 cash infusion the Fed gave to the Primary Dealers has created a massive stock and bond bubble, of which I’ve been tracking and whining about for years… (The Bloated Bond Market).
When the Fed gave those banks all those trillions of dollars, the banks then set to work buying things, including securities of all shapes and sizes, thereby stimulating the biggest stock and bond market highs (i.e. bubble) in our history.
The Fed Distorts the US Treasury Market
These cash-rich banks also directed lots of this money to the US Treasury Department, purchasing US debt directly from the US Treasury in a marry-go-round of rigging and perma-bidding that started at the Fed, continued to the big banks and ended at the US Treasury Department. By the way, the technical term for this artificial market demand is “deficit financing.”
Ok, so we know that money created out of thin air went directly to the banking system and the US Treasury—and indirectly to the stock, bond and housing bubbles over which the Primary Dealers became effective market-makers (i.e. cash distributers).
But what about Main Street? What about the actual US economy? You know, the one Thomas Jefferson and Andrew Jackson worried about? Was the Fed any friend to the little guys in the real world?
The Fed Failed to Stimulate Main Street
With annualized GDP essentially in a flat-line mode since 2008, it’s fairly clear to me, and even to the geniuses at the Fed, that their “stimulus plan” was great for banks and market bubbles but absolutely worthless for economic growth.
What’s funny today is that Yellen and the others over at the Eccles Building are finally starting to realize this and are increasingly looking a bit pale…a bit worried, and in some ways, even a bit more hawkish (See Hawkish Fed).
Indeed, the Fed is even starting to talk about unwinding some of that stimulus by slowly, carefully and with a Goldi-locks “just right” turn of policy, reigning in these market bubbles by carefully dialing up interest rates and even more carefully tightening (i.e. rebalancing) of the Fed’s bloated balance sheet.
(As I’ll turn to elsewhere, there is massive risk in the backdrop of this market bubble in trying to raise rates “just right” as well as in re-balancing the Fed’s balance sheet in an organized and non-disruptive manner. For the Fed to pull this off, a convergence of unlikely miracles and historically unmatched blind luck would be required. In short, don’t count on it. But again, I digress…).
If all we have to show for trillions in Fed money creation are fat banks, even fatter market bubbles and a thin economy, things will end badly not only for the soon-to-pop bubbles, but for the already thin economy and the dying (well-deserved) reputation and credibility of the Federal Reserve.
In short: Thomas Jefferson and Andrew Jackson will whisper from above: “I told you so.”
How Will Artificial Market Bubbles Grow Without the Fed?
The big issue now is who will support the current “everything bubble” of stocks, bonds and real estate when the Fed is no longer there to grease the wheels of the above-described “deficit financing”?
For now, we can still count on the equally inept (and temporarily popular) Bank of Japan and the ECB to print magical money and keep market bulls under the spell of central bank steroids. After all, the current $150 billion per month of printed money is a lot of dough, and a lot of that money will undoubtedly continue to reach Wall Street from overseas. That’s why even a cynic like me can imagine more and more rising markets to come.
In this backdrop, some straight-faced bulls are even claiming the markets could melt-up to a DOW at 31000 as the US market and dollar increasingly gain perception as the best horse in the global glue factory. Their arguments are lucid, emphatic and essentially come down to this: US markets are the default go-to safe-haven and central banks are already directly purchasing stocks. In short: more artificial hope and equally artificial rallies.
But me, I’m not so bullish…
Time Will Tell
As for my own prognosis, the greatest enemy of a bull market—especially an artificially created bull market—is time, and we are already eight+ years into a raging bull. Is now the time for a correction?
My best guess: not yet.
Our signals are constantly surveying bond spreads, yield curves, 10-year Treasury yields, volatility channels, and myriad other recession indicators for the coming correction (aka “collapse”), and for now, there is no flashing red light, other than the obvious over-valuations we see across so many securities and sectors.
But as I’ve written elsewhere—keep your eye on the 10-Year Treasury’s YIELD. Once it passes 2.6% and holds, you’ll know the bond bubble is beginning to leak. (Again: yields rise when bond prices fall.)
Eventually all central banks will have to tighten; eventually more bond traders will need to sell (as they finally see there’s not enough yield for the risk); and eventually faith will decline across market sectors in general and central banks in particular.
In other words, time will tell, for time (and faithlessness) are the true bull killers.
Until then, the intoxication and distortion continues…
Is it hard for you to stay faithful in these conditions? If so, you’re not alone.
But if you listen very carefully, that market bear is starting to chuckle.
One response to “A Case Study in Rigged Markets, Bullish Euphoria, and a Bearish Last Laugh”
July 20 2017