A little over a month ago, I wrote that we were in the midst of a paradigm shift regarding Fed policy. It was and still is my opinion that the Fed was trying desperately to talk investors into backing off a little. My thought was that the market was getting a little frothy and the last thing they wanted was to see a parabolic spike in stock price that clearly wasn't supported by economic metrics.
It has been my opinion for some time now that the Fed was directly involved in manipulating the market. Before anybody gets too carried away and accuses me of being a conspiracy theorist or overly paranoid, keep in mind that the Fed conducts open market operations through the New York Fed as part of their agenda to achieve policy objectives. As the Fed states here:
Open market operations are one of three basic tools used by the Federal Reserve to reach its monetary policy objectives
Traditionally the Fed has limited their open market actions to treasuries. In more recent times, they have included mortgage backed securities in the mix. Whether you like the term "manipulate" or not it is what the Fed does and they have no problem admitting as much although they don't come right out and call it manipulation.
What's different in the last few years is the Fed's indirect participation in the stock market. I have asserted that the Fed - through their surrogates - has been directly involved in manipulating stock prices. According to my thesis, the Fed's surrogates are primary dealer banks. It is my opinion that JPMorgan (JPM) has been a major player in this process.
Here is how the manipulation occurs. The Fed makes an asset purchase - a treasury bond for example - through a primary dealer - let's say JPMorgan. The book entry to the Fed is a debit to the Fed's bond account and a credit to excess reserves in favor of JPMorgan. On JPMorgan's books, the entry is a debit entry to the cash or reserves account and a credit to the bond account.
If JPMorgan then chooses to replace that bond by making a purchase in the secondary market, that purchase tends to support bond prices. In addition JPMorgan could then generate additional cash through the hypothecation of the bond to a third party. The bond remains an asset on JPMorgan's books so the cash is then available to acquire other assets in off balance sheet transactions.
My thesis is that these off balance sheet asset purchases have been stock purchases for the bank's own account. The chart below tends to offer empirical support for my thesis:
The chart above compares the Fed's balance sheet growth to the DJIA (DIA). The chart dates back to the time QE4 started. The correlation from early December through May 15 of this year was .96 - an extremely high correlation that suggests that the Fed's money was moving directly and immediately into stocks.
However, from May 15 on the correlation is a negative .86 - again a very high correlation but inversely correlated to the Fed's balance sheet. This inverse correlation suggests that the Fed is no longer in the game as far as propping up stocks. It is highly relevant in my opinion that this shift in the dynamics of the market was announced by none other than Jamie Dimon himself the first week of June:
"It's a different world when central banks are managing interest rates," Dimon said, referring to the Federal Reserve's orchestrated effort to keep long-term rates low. He reminded the audience that 10-year bond rates haven't been set by the Fed since World War II, and rates didn't normalize until around 1950. "Until it gets back to normal [this time], it's going to be scary and volatile."
One wonders if Jamie Dimon's prescient warning was based on his experience and objective assessment of things economic or if he was privy to information the rest of us didn't have. In other words, they were going to "be scary and volatile" because he was going to make them that way. He was no longer going to prop the bond market by re-employing the Fed's new cash and he was no longer going to be buying stocks with the Fed's money either. Actually the odds are the primary dealers are continuing to replace bonds with the Fed's QE money but it would appear based on the chart above that they are no longer hypothecating those replacement bonds to generate cash to support stocks.
Keep in mind the Fed's balance sheet has continued to expand, but since late May the market hasn't cared all that much. One could argue that the sell-off was long overdue and that the market is merely in the process of a healthy and normal correction. I would argue that you are correct. Still, we have been overdue a correction for several months and we didn't correct.
In fact I would argue that there was no reason for the market to have spiked higher starting in late December as Congress grappled with the "fiscal cliff". Certainly in light of the fact that most everything anticipated in the context of the "fiscal cliff" matter occurred. In other words, we pretty much did go over the "cliff" as the sequestration cuts happened and a good portion of the tax hikes happened as well.
I have been explaining to readers for months now that the Fed has indirectly been manipulating the stock market. This afternoon an associate of mine called to tell me about the following excerpt from David Stockman's recent book. The excerpt is from Chapter 23 of the book and found here. I think it adds a lot of credence to the arguments I have been making for the last several months. In fact it is not at all unreasonable to think that Stockman's book influenced the Fed (and their primary dealers) to discontinue their market manipulations. Here is the excerpt from Stockman's book:
But what was actually going on in the interior of the stock market was nightmarish. All of the checks and balances which ordinarily discipline the free market in money instruments and capital securities were being eviscerated by the Fed's actions; that is, the Greenspan Put, the severe repression of interest rates, and the recurrent dousing of the primary dealers with large dollops of fresh cash owing to its huge government bond purchases. This kind of central bank action has pernicious consequences, however. By pegging money market rates, it fosters carry trades that are a significant contributor to unbalanced markets. Carry trades create an artificially enlarged bid for risk assets. So prices trend asymmetrically upward
The Greenspan Put also compounded the one-way bias. For hedge fund speculators, it amounted to ultra-cheap insurance against downside risk in the broad market. This, too, attracted money flows and an inordinate rise in speculative long positions.
The Fed's constant telegraphing of intentions regarding its administered money market rates also exacerbated the stock market imbalance. By pegging the federal funds rate, it eliminated the risk of surprise on the front end of the yield curve. Consequently, massive amounts of new credit were created in the wholesale money markets as traders hypothecated and rehypothecated existing securities; that is, pledged the same collateral for multiple loans.
The Fed's peg on short-term rates thus fostered robust expansion of the shadow banking system, which as indicated previously, had exploded from $2 trillion to $21 trillion during Greenspan's years at the helm. This vast multiplication of non-bank credit further fueled the "bid" for stocks and other risk assets.
What's different today than any other period in the past
I understand irrational market behavior as I have witnessed it in the past. What I've never witnessed is a micro managed market where the Fed is so actively involved in price fixing in stocks. Here's the point - we've witnessed the end of two bubbles in the last 15 years - the dotcom bubble and the housing bubble. Both of those bubbles were based on high expectations that didn't materialize. When it became evident that stock prices were not supported by rational expectations, the markets rapidly re-calibrated - in other words we crashed.
We've had another bubble that resulted in a crash in the last 5 years that is typical of what happens in a normal market and that crash is the gold (GLD) market. Here is what it looks like:
Gold is much like the dotcom crash and the housing market crash. In both instances, the market got ahead of itself based on expectations that in the end didn't materialize. The recognition that the market rally was based on unrealized future expectations produced a rapid recalibration in price. In the case of gold this chart was probably what precipitated the really sharp $200 sell off a few weeks back. The PCE number was the lowest ever recorded suggesting deflation - not inflation:
This chart sets forth 2 different measures of inflation and shows that we just don't have an inflation problem in spite of QE. The "gold bug" frenzy was the result of very high inflation expectations based on the Fed's massive money printing campaign but as we know - at least those who pay attention know - the Fed's QE has not been inflationary as the new money has not moved into the broader economy. Rather it has remained trapped in excess reserves.
The gold market acted like any irrational market bubble - once it was obvious the asset was inflated based on erroneous expectations, the market re-calibrated. That hasn't been the case with stocks though as the Fed has attempted to micro manage stocks. I understand that as it pertains to bonds - that is what the Fed does. I don't understand that as it relates to stocks as the Fed has never been actively involved in a price fixing scheme in stocks before.
Here's the point - the Fed in my opinion has finally reconciled to the fact that their "virtuous circle" plan that stimulates economic growth by driving asset prices higher - the so called "wealth effect" - hasn't worked. I think there is ample support for that conclusion based on the chart above comparing the Fed's balance sheet to the Dow.
So as the Fed signaled investors to back off a little and the Fed withdrew stock market support the market did sell off and that is I suppose OK with the Fed at this point. Here's the problem though - the rhetoric that drove stocks down had a similar effect on bonds:
The chart above shows the rate of change from May 15, 2013. The problem from the Fed's perspective is that bonds (BND) have reacted to the Fed's efforts to dampen the irrational stock price expectations of investors as reflected by the S&P (SPY). That presents a bit of a conundrum for the Fed.
My assumption is the Fed has reluctantly given up on the idea that the "wealth effect" will produce real growth in the economy and they are more than willing to let stock prices move unfettered by further Fed manipulation from this point forward. The problem is that the Fed doesn't want the bond market to crash along with stocks. If stock prices crash at this point, it could be argued that no "real economy" impact will be felt. High stock prices based solely on multiple expansion don't do much for hiring or GDP growth.
On the other hand, high interest rates can and will have a dampening effect on an already sick economy. What will it impact - virtually all purchases that are financed and that includes almost all purchases over a few hundred dollars. Televisions are financed, cars are financed, houses are financed - you get the idea - we are a society that relies heavily on credit and higher rates are bound to dampen already dismal GDP levels.
Keep in mind the GDP for the 4th quarter of last year was essentially flat and the revised number for the 1st quarter was only 1.8%. The 2 quarter average was about .9% and the 2nd quarter is not likely to be much better as the sequestration cuts weren't reflected in the 1st quarter data.
The schizophrenic Fed messengers
This is what I think has happened - the Fed got concerned about investors pushing stocks well beyond what reasonable valuations justified. In my mind that is a little naïve as it was the Fed through indirect intervention in the stock market with rhetoric and back door open market action that caused the irrational behavior of investors in the first place.
Notwithstanding that fact the Fed seemed more than a little concerned back in May and did what they could with rhetoric to get investors to back away from the edge of the cliff. When investors in the bond and stock market both took the Fed's message to heart, the Fed had a new dilemma - spiking yields on bonds.
So out come new messengers pleading with investors not to overreact - in other words we didn't really mean what we said. Or the official version goes like this - you misunderstood us so please don't panic. Here is how the market reacted to the new message:
Stocks shot back up in short order by about 3% in 3 days. Bonds (TLT) less enthusiastically moved up about ½ that amount. So here is what the Fed has accomplished with their meddling in the free markets - an over extended stock market reflected here:
And here is what the Fed has accomplished with their meddling in the free markets as it relates to bonds - an oversold bond market that is threatening to dampen GDP even further:
A free market works to achieve accurate price discovery and that is a good thing. A manipulated market almost always ends badly and manipulation is exactly what the Fed has done and with great deliberation. As a stock analyst and an avid student of economic theory, it is blatantly clear to me the Fed has created significant distortions in price and severe imbalances in terms of risk exposure. These are the two characteristics of a "bubble" and that is what the Fed has managed to achieve - they've created a "bubble" in risk assets and additionally they've facilitated the creation of massive amounts of government debt which will only exacerbate an already serious problem.
The idea that the Fed can continue this charade forever is utter nonsense. I think the Fed has finally come to the point where they realize the mess they've created and they are now doing what they can to mitigate the damage they've caused. The problem - if they dampen the enthusiasm of overly zealous stock investors, they are likely to crash the bond market in the process and create very real damage to an economy already in dire straits.
If they don't dampen the enthusiasm of stock investors, we will rapidly move into a parabolic spike in stocks that will likely end with a crash the likes of which none of us has ever seen before. I think the Fed knows this and I think they will try their best to manipulate markets in a way that moves stocks back to price levels that comport with realistic valuations based on equally realistic profit expectations going forward.
Maybe they will succeed in talking stock investors into a more objective mindset that gets them to quit bidding up stocks as economic metrics continue to deteriorate and maybe they will be able to hold the line with interest rates but I seriously doubt it. One thing that seems clear to me though is that the Fed will only back stop stock prices if necessary to keep bonds from falling going forward.