The Game We Know Is Over - A New Game About To Begin?

Includes: DIA, QQQ, SPY
by: TrimTabs

By Chris Hamilton

Since 2009, a lot of analysts have learned the hard way not to play Chicken Little and scream the sky is falling. However, after last week's FOMC meeting as a capper to so many other economic and geopolitical issues brewing, seems things are getting serious. Take a looksee at yet another chart here.

First chart shows the year over year (in Billions of $) change in Gross Domestic Product, Federal Deficit, and Federal Reserve Balance sheet. Should be pretty clear Deficit and Federal Reserve Balance sheet since '08 are growing much faster than GDP.

The quick commentary on this 2nd chart incorporating further elements along with first chart:

In the previous four recessions of '81, '90, '01, and '07, there was a simple pattern…

Oil prices spike -> recession follows -> Federal Reserve lowers interest rates plus the Federal government provides deficit spending to accelerate GDP -> Fed then raises rates (but to a lower rate than previous) and deficit spending is reduced-> oil prices spike -> wash, rinse, repeat.

How to read chart…

  • Left side = Oil priced in dollars per barrel, Fed funds rate indexed from 100-1 from peak in '81
  • Right side = Compares year-over-year change in Billions of $'s for Gross Domestic Product, Gross National Debt, and Adjusted Monetary Base (proxy for Federal Reserve balance sheet), and price of gold in $'s).
  • Grey shaded vertical columns = Recessions

Low and behold, in '08 the Federal Reserve lowered rates to zero, the Federal government ran a gargantuan budget deficit, but this was not adequate and the Fed's new "tool" of Quantitative Easing was initiated (bond buying to monetize "demand" for the great supply of bonds @ below "market" yields) to allow accelerated economic activity.

Now in 2014, oil prices are maintaining recession inducing levels, rates are still zero, deficits and QE are large but less than half their peak, and not surprisingly GDP is slipping… another negative quarter and the U.S. is officially in recession. Typically, this is where the Federal Reserve would begin looking to the next cycle of lower rates and increased Federal deficit spending to accelerate GDP and economic activity to shorten the next recession.

However, the Federal Reserve can only increase QE (absent paying lenders to take money in a Negative Interest Rate Policy) in conjunction with a Federal deficit providing new stimulus… but the Federal Reserve's balance sheet and Federal Debt are in need of economic growth to allow them to be serviced. Janet Yellen meet slippery slope! But Mrs. Yellen implied exactly the opposite policies last week!?!

Mrs. Yellen and the Federal Reserve are suggesting GDP "growth" can continue without Budget deficits and QE? But even more correctly, the Federal Reserve is suggesting the economy can not only thrive in the absence of an "accommodative" Federal Reserve but in the midst of anti-stimulus while rates are raised and Fed's balance sheet shrunk?

According to "sources" in the Federal Reserve, the Fed's goal is an Effective Funds Rate of 3.75% and a Federal Reserve balance sheet of $1.5 Trillion. This means, beginning in 2015, continual rising rates for likely 2 to 5 years and 5 to 10 years of Fed Balance sheet sales or roll-off of $350 to $700 Billion per year in Treasury's / Mortgage Backed Securities.

This anti-stimulus would likely have the following impacts…

30yr fixed mortgage rates (based on the 10yr Treasury) rising easily to 6%… For example, a $200 k house financed today at 4% for 30 years, assuming financing of $200 k has a Principal & Interest payment of $955/mo. With 30yr mortgage rates at 6%, the same payment of $955/mo finances a $160 k home, a reduction of nearly $40 k in the amount financed. Unless salaries rise by 20%, the value of a house… or housing in general is going to fall by that same 20%. This would put some 20% or more of homeowners back under water and in danger of restarting another round of strategic defaults and bank collapses. This would mean the $11 Trillion of mortgage debt banks and GSE's and the Federal Reserve hold would be going very sour… again.

Also would mean interest payments on Federal government debt (assuming a blended 5% interest rate) would rise to $900 Billion… up $675 Billion from '13… consuming 30% of 2015 projected tax revenue just to pay the interest… up from just 6% in 2013. This leaves two choices based on this increased interest cost…

  • Increase budget deficit from $500 Billion to $1.2 Trillion just to service the interest but with no "stimulative" economic impact.
  • Cut the same amount from the budget (in essence, cut everything but Medicare/Medicaid, SS, defense, and interest payments…no welfare, no education, pretty much nothing else).
    • Or some combination of deficit and/or budget cuts.

Oh, and by the way, the U.S. has had 11 recessions in 69 years since 1945, occurring on average every 6.5 years… this would mean the cyclical business cycle is well under way and counting down to the next recession… while the Fed hasn't even begun a "normalization" of its balance sheet or raised rates.

If all this leaves you feeling like this is crazy talk on top of silly notions, you understood it all correctly. Last week's move in Gold / Silver may be saying the Federal Reserve and Federal Government have run out of time and the issues / resolution path are far too transparent. The economy is not growing anywhere near enough to pay for the debt. The debt is far too large to be financed at higher yields. So, we now are very likely near a non-linear point which few of us have seen in our lifetimes. A monetary solution to a non-monetary problem. Bond buying, money printing, and the much hyped hyper-monetization or potentially hyperinflation.

So, the die is cast and time is short. Strange days are likely to get far stranger before some sanity hopefully returns. Always glad to hear opposing views or corrections or any omissions.