This Is What Happens When The Fed Tightens!

by: Comstock Partners

When They Raise Rates, It Ends Ugly!

We know we just changed our comments to the first Thursday of every month rather than each Thursday. However, we thought it might make sense to write this comment since we have been discussing what would happen when the Fed's monetary ease comes to a halt.

The financial press and media were at first concerned about the Portugal, Argentina, and Ukraine problems as well as the Russian sanctions, but the overriding problem was the potential for reversing the monetary easing. We had a taste of the Fed possibly raising rates a little earlier than expected. This erased all the gains for the year by dropping over 300 points. We have consistently warned our readers about the ramifications of the unwinding of the Fed's loose monetary policies of the past few years.

In fact, we just wrote on June 19th, "What Happens When the Fed Unwinds Their Balance Sheet?" In it we stated, "The Fed has tried to stop QE strategies before but were unsuccessful. During the first two QE programs, they set a date when the programs would end. Once those dates were announced, the markets began to unravel which resulted in the Fed starting another QE. They essentially had to start a new QE in order to keep the "wealth effect" alive. Apparently, they noticed that stopping their programs at a specific date was not working, so they came up with the idea of getting out gradually (tapering) as if no one will notice and everything will go back to normal." We also stated, "However, we believe the market will correct significantly before the Fed ends the tapering of the bond purchases." We also stated that if and when the market corrects, the Fed may change course and start another QE.

For all the people that believe the Fed is omnipotent, you have to keep in mind that the Fed did not see the bubble that they were causing in housing all through 2003, 2004, 2005, 2006, and 2007 when they lowered Fed Funds to 1% in June of 2003 and kept it there for a year. They also watched as banks and mortgage companies enticed every American with a heartbeat to buy homes they couldn't afford. The Fed had to use loose monetary policy after the housing bubble burst, but they still never believed that they caused the bubble in the first place. Remember Greenspan proclaiming that it is impossible to recognize a bubble until it bursts - remember Greenspan had the control of the Fed throughout 2003, 2004, and 2005.

The problem with what the Fed is doing now, is that they have taken the policies that were needed in 2009 with QE-1, 2010 with QE-2, and started the latest QE-3 that was driven by bond purchases, and no ending time limit (this is why it was called "QE to Infinity"). The problem with what the Fed has done is that they have taken the policies needed with "QE to infinity" is that it got out of control by expanding the Fed's balance sheet from $800 billion to $4.4 trillion while keeping the Fed Funds rate at close to zero. The problem with this is the negative stock market's reactions to the unwinding of their balance sheet, or even just any indication of rising interest rates. Now, every time there is any indication of the Fed raising interest rates or the unwinding of their balance sheet, we believe the ending of this excessive monetary policy will be ugly!