Happy Monday and welcome back to this week’s What’s Happening Now.
Last week was quite a week, no?
It seems we’re not the only ones seeing red with our “Fed Red Days.” Last Monday, the Fed saw red, too, and jumped to the rescue of an out-of-control repo market to assure liquidity for bank and other short-term financing needs.
This Relationship is Rigged to Fail
In the interim, here are some current highlights.
By Tuesday last, all hell broke loose when the Fed funds effective rate (the white line below) spiked to some 10% intraday, settling (after significant Fed intervention) at 2.30% (still above the Fed target rate).
The system ran short of liquidity – i.e. it ran out of dollars. The Fed jumped in, providing $278 billion in cash injections over four days.
But that was last week; what’s happening this week is far more disturbing.
Namely, there are more Fed injections on the way, 3.8x as much in fact. On Friday, the Fed announced $1.05 trillion (yes, trillion) of additional purchases this week through October 10.
That takes total injections to $1.328 trillion over 18 business days – all to keep the effective funds rate within last week’s lowered target range of 1.75%-2.00%.
That’s more fake money in the span of days than the entire U.S. national deficit for the entire year of 2018.
Read that last line again. True, it’s a rollover facility… but a rollover facility with some sense of permanency that can easily grow over time.
So, how long can the Fed create money and extend debt – as well as bailouts – to the banking system? How long can they pretend we are not in full-on desperation mode as markets flirt with new highs?
Houston, we have a liquidity problem. More importantly, we have a debt problem – the largest in our history – and guess what eventually turns that problem into a full-on economic collapse?
Rising interest rates.
When rates in the repo market spiked last week due to lack of funds, banks began charging each other much higher borrowing costs than what the Fed was artificially setting (“controlling”?) from D.C.
In other words, Mr. Market suddenly stepped in and nearly ended the Fed’s 11+-year party by raising borrowing costs to the moon for other banks. This meant the banks would have to spread those rising costs to corporations (and Wall Street hedge funds) – who survive off low borrowing costs (the carry trade) and debt roll-overs to stay in business – i.e. buy back their own stocks and fill their own pockets.
The Fed’s guiding role is to benefit the markets, not the real economy – i.e. you and me.
Thus, when the market started to cough last week, the Fed came in and dumped an absurd amount of money into the repo markets to keep Wall Street rising while Main Street continues to decline.
Don’t want to believe me? I don’t blame you. But in future articles, I’ll show you the facts, the numbers, and the backdrop to make this painfully clear.
If this angers you, it should. Despite the Fed trying to keep this most recent bailout on the down-low, the relationship between the Fed and the markets is now transparently rigged, and – as more of us catch on while the Fed runs out of manageable excuses and funds – this relationship is equally rigged to fail.
For now, market survival hinges exclusively on the Fed’s ability to keep rates artificially low. Central banks, moreover, are powerful and can accomplish this for years, as we’ve seen since 2008.
But forcing rates to the floor and avoiding an eventual “uh oh” moment (like last Monday) is no more possible than forcing hurricanes from landfall with a really big electric fan.
In short, low rates gave us the biggest market bubble in history (stocks at 26 PE multiples and a corporate bond market that is essentially at junk status).
Rising rates, in turn, will give us the biggest market collapse in history.
So, let’s do a reality check on interest rates, for it gives us some clues on what’s going on here.
Below is a look at global Central Bank interest rates since the Great Recession. Back in 2007, interest rates were much higher, which is why lowering them helped to get us out of a black hole.
Rates now, however, are MUCH lower.
And that’s a BIG problem as we head toward the end of a 121-month business cycle, the largest ever recorded – thanks entirely to market steroids.
Rates are still slightly positive here in the U.S.; the U.K., too, is positive (barely); but the ECB, Bank of Japan, and Swiss National Bank are all negative, as shown below.
Which raises these questions: Are we slowly running out of bullets? And how low can we go before more ice starts to break?
The U.S. looks like the only credible global player that can go lower when it comes to interest rates. But can we? And at what expense? It used to be that the Fed controlled the short end of the yield curve while the markets controlled the mid and back ends.
But all of a sudden (as in overnight), all that seems to have changed. Last Tuesday, Mr. Market sent the repo rates to our shores with a massive punch to the short-end, with interest rates on the day spiking to 8.75%!
The Fed, of course, got the shock of a lifetime, and tried to add more sandbags against naturally rising swells/rates – desperately shoveling (and committing to shovel) a $1.328 trillion U.S. dollar rollover facility to quell the tide through Thursday, October 10.
So, are we out of bullets? Sandbags? Steroids? Pick your metaphor.
No, we’ve still got our printing press, greased and oiled. But how low can we go on rates? Can we print another $4 trillion of QE? $8 trillion? Can we take rates to zero and below, as others before us? Is the Fed all-powerful and graced with magical powers?
If so, this means recessions and national debts are extinct and that we might as well just stop paying taxes, working or even keeping a budget, for it seems the central banks have outlawed reality. For every problem – just print more money and magically keep borrowing costs at zero or below with no repercussions.
If this sounds too good to be true, that’s because it is. Common sense matters here more than fancy diplomas, Wall Street savvy, or the Fed speak on our national media, which few of us of any political persuasion actually trust – and for good reason.
The question is whether either of these extraordinary tools (money printing and rate suppression) will have any impact, for these are paper bullets, only as good as the paper issued, and going to zero and below will assuredly tip us back into the abyss.
Voltaire once quipped that all fiat currencies eventually revert to the intrinsic value of the paper their printed on.
So, the question here is who’s really in charge? Paper or magic?
For now, the Fed is still stacking up its sandbags and Wall Street is still taking the steroids – rising and rising on borrowed time and borrowed money. But time, and low rates, for all the reasons addressed here, are running out.
When fiat currencies around the world lose both the faith of investors and the monetary punch of the past, natural forces – i.e. Mr. Market – will get the last, macabre laugh as old-school assets like gold replace Fed speak.
Even cryptocurrencies (a topic I’ve avoided) like Bitcoin will surge, which means I have no choice but to be writing about these volatile yet timely assets very soon as well.
Here’s What’s Working
Amidst all this news, a few sectors are working for now – mostly defensive sectors as you might imagine – like real estate and utilities.
As we move forth in a riskier investment environment, consider the Real Estate Select Sector SPDR ETF (XLRE) with a market cap of $3.9 billion. XLRE is already up 28.80% YTD 2019. Not so shabby, but then again, susceptible to nearing a peak.
The same is true of the Utilities Select Sector SPDR (XLU) with a market cap of $11 billion, up 23.50% YTD.
For those looking to ride this trend, do so carefully and intelligently – with an eye on acceptable volatility and stop-loss disciplines – i.e. exit doors.
Here’s a little tip… when looking at rate-of-return for a particular security, look equally at the security’s volatility, as that helps you measure and thus manage risk. Then calculate the return vs. (divided by) the risk. You can eyeball the return/risk in the chart above. The S&P 500 Index earns less, at higher volatility (up and down) than either of the ETFs mentioned above.
That makes the S&P 500 Index inferior. The risk embedded in Index ETFs longer-term, when the downturn comes, will shock you. You need to be aware.
But as for the above ETFs, here’s the current math. An equal-weight allocation to XLRE and XLU for 2019 YTD had a risk/return ratio of 3.15 vs. 2.17 for the S&P 500 Index. That’s 45% better for the ETFs and that’s huge, especially over longer periods.
Plus… the correlation of the equal-weight portfolio to the S&P 500 Index was just 35%. No wonder!
Here are a few questions for you that will help us help you. In this investment climate, for that part of your portfolio that is NOT invested in cash:
- What is your objective for an annualized rate-of-return (on a scale of 1:100 percent)?
- How much volatility/risk are you willing to absorb (on a scale of 1:100 percent)?
- What level of loss are you prepared to absorb before adjusting your portfolio (on a scale of 0-100% percent as well)?
Your thoughts would be appreciated in the comment box below, so we can address setting expectations in next Monday’s What’s Happening Now.
In the meantime, and despite topping markets, we hope you are following our cash recommendations and waiting patiently for these nosebleed markets to tank so that we can buy at bottoms, not tops – where the real fortunes and fun begins.
As I wrap up this issue, I would just say that it’s getting whacky out there. The better word is absurd.
Trends are extended. Financial conditions are weak and getting weaker on a daily basis and the Fed has all but taken over what were once “free markets.” Global equities are not rallying enough on lower rates or on the Fed monetary injections, which means the old tricks are running out of “magic.”
Bonds have weakened as interest rates have recently begun to spring up, as we’ve warned. Commodities have strengthened, which sounds good, but for the wrong reasons – namely winds of war in the Middle East, hence the oil spike.
Whacky trends mean there is a lot of knee-jerking going on, which means that risk is elevated as money races with abandon from one sector to another.
Upside return has been limited. Risk far outweighs reward, so depending on one’s tolerance for risk, you should invest accordingly and consider the chart below if you need further confirmation.
In this chart, market return has clearly not been worth the associated volatility for the last two years. See for yourselves:
In short, the so-called “surges” in this hated “bull market” have barely compensated for huge losses along the way. Imagine, moreover, how much worse this imbalance will get once markets shift from bull to bear, for even this bull offers so little.
Thus, for those deeper in cash or still considering cash, and thus fearing you have or will be “missing out,” it’s fairly clear that “you ain’t missed nothing.”
Also, just a few notes on the remainder of the week.
No less than eleven Fed officials will be speaking this week, no doubt with calming adjectives about the need for these huge repo injections, as more folks are starting to pay attention, despite efforts by the Fed to downplay the fly in the yogurt.
NY Fed President John Williams and St. Louis Fed President James Bullard will speak on Monday; Chicago Fed President Charles Evans and Bank of Dallas President Robert Kaplan on Wednesday; and Bank of Dallas President Robert Kaplan on Thursday, with seven others interspersed. Bullard and others will be pushing for further and faster rate reduction – i.e. more market methadone. No shocker there…
Plus, the United Nations convenes at the UN General Assembly in New York this week, that includes a Climate Action Summit, providing world leaders with sidebar conversations about what’s happening now in the Middle East and amongst Central Banks.
As for questions, numerous readers have been asking about our timeline as to when the next recession and sell-off will begin. There’s no easy answer for market timing, but last week we gave you our best answer here. Take a look.
In response to the repo disaster, Edouard D. asked about how on earth the banks could ever be short of lending repo reserves, given how much they already have in their own reserves. Great question.
The answer is a bit complex, but the broad answer boils down as follows.
Yes, in the post-’08 bailout and QE periods, the big banks enjoyed massive inflows into their reserves, effectively by purchasing bonds the Treasury and Fed needed buyers for; in return, the Treasury/Fed cabal pays these banks a nice fat easy fortune for holding these bonds/reserves – it’s called “Interest On Excess Reserves” (IOER) and the banks are collecting this interest for doing nothing more than sitting on these reserves.
Who pays this interest to the banks that fleeced you in 2008? YOU do…
The banks thus sit on these reserves and earn interest, quietly agreeing not to release these funds into the market – for if so, the velocity of money effect would flood markets and lead to inflationary risks.
Thus, the banks and the Fed are in a complicit win-win (nod and wink) agreement to play (rig) this game and keep such funds behind a dam.
The repo market, however, is different, and the same banks taking the IOER handout have no trouble sticking it the hand that feeds them – i.e. the Fed – when it comes to pricing rates in the repo market.
That is, when money is scarce in the repo market, the wolves of banks X, Y, or Z will price those rates naturally (i.e. painfully), rather than with complicity – hence the recent disaster when natural pricing actually stepped on the scene for a brief cameo moment.
The bottom line today is that Fed intervention and un-natural price discovery have so distorted normal market action – and hence laid so many potential land mines – that it’s getting harder and harder to know just where or when the next explosion will come.
Things are just so fully screwed up today due to massive debt levels and liquidity risks born from un-natural monetary policies that we can only expect the worst and prepare accordingly, as post-’08 markets are so distorted today that the old predictive tools, as I’ve said elsewhere, just aren’t as reliable or predictive.
These landmines can be tripped off anytime and anywhere – i.e. even in the repo markets of all places…
Edouard, I hope that helps. I’ll tackle this and other questions and issues in the coming days/articles, as we aim to address our readers concerns, break down the complex and make it simple.
In the meantime, stay informed, stay patient and stay on top.
Most importantly, stay careful with: (1) stocks trading at 26 PE multiples; (2) corporate debt at the highest levels in history; (3) the “Buffet indicator” at record risk-levels (stocks higher than GDP by 150%); (4) the Shiller/CAPE indicator at 33; (5) margin debt outpacing stock growth by 300% while (6) stock markets rise almost exclusively on over $5 trillion in stock buybacks (a trick once banned after the Great Depression of 1929). Think Home Depot, IBM, GE, CISCO, LOWES, and Apple… Look out below.
12 responses to “Fed Sees Red – The Real Numbers Behind the Most Recent Bailout”
September 23 2019