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Joseph Stuber
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Joseph has been an analyst, investor, and student of economic theory; money and banking; and statistical methods for evaluating and implementing risk/reward trading algorithms since 1972. Joseph is also an occasional contributor to financial publications and his essays are frequently cited by... More
  • Understanding The Schizophrenic Fed's Risk-On / Risk-Off Messages  19 comments
    Jun 27, 2013 9:52 PM

    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 JP Morgan (NYSE: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 JP Morgan. The book entry to the Fed is a debit to the Fed's bond account and a credit to excess reserves in favor of JP Morgan. On JP Morgan's books the entry is a debit entry to the cash or reserves account and a credit to the bond account.

    If JP Morgan then chooses to replace that bond by making a purchase in the secondary market that purchase tends to support bond prices. In addition JP Morgan could then generate additional cash through the hypothecation of the bond to a third party. The bond remains an asset on JP Morgan'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 banks own account. The chart below tends to offer empirical support for my thesis:

    (click to enlarge)

    The chart above compares the Fed's balance sheet growth to the DJIA (NYSEARCA: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 over due 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 (NYSEARCA:GLD) market. Here is what it looks like:

    (click to enlarge)

    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:

    (click to enlarge)

    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 (NYSEARCA:BND) have reacted to the Fed's efforts to dampen the irrational stock price expectations of investors as reflected by the S&P (NYSEARCA: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:

    (click to enlarge)

    Stocks shot back up in short order by about 3% in 3 days. Bonds (NYSEARCA: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:

    (click to enlarge)

    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:

    (click to enlarge)

    Concluding thoughts

    A free market works to achieve accurate price discovery and that is a good thing. A manipulated market almost always ends badly and manipulate 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.

    Disclosure: I am long VXX, FAZ, TZA, TECS.

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Comments (19)
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  • Joseph Stuber
    , contributor
    Comments (1716) | Send Message
     
    Author’s reply » I haven't posted an instablog in a while as I have no way of knowing whether it is being read as opposed to a regular article where I do get a tally on readers. It would be useful to me if you would click the like button on this comment even if you don't care for the post so that I will know the number of readers on this article. If the number is high enough I will continue to post instablogs in the future.

     

    Thanks.

     

    JS
    27 Jun 2013, 09:57 PM Reply Like
  • Rolytee
    , contributor
    Comments (31) | Send Message
     
    JS - excellent article. As a member of the choir, its clear the Fed has been engaging in a futile, even insane, policy for far too long. I don't believe there is an easy way out - every option looks ghastly from here. Any attempt by the Fed to defer pain will only make it more painful later... so my hope is that the beatings begin immediately and that we take our lumps now, as quickly as possible, in the hope that we can revert to rebuilding a strong and stable economy sooner rather than later... or am I asking too much?
    28 Jun 2013, 07:23 AM Reply Like
  • Joseph Stuber
    , contributor
    Comments (1716) | Send Message
     
    Author’s reply » Roly

     

    It could be accomplished in fairly short order in my opinion but not without pain of course. I agree - the sooner the better. We should have allowed for the needed deleveraging after QE1 and the bail outs - at least that is what I think now. At the time I thought the Fed's aggressive moves would work but it has been obvious for some time now that it wasn't going to work.

     

    JS
    28 Jun 2013, 08:13 AM Reply Like
  • Rolytee
    , contributor
    Comments (31) | Send Message
     
    I was watching Marc Faber on Bloomberg a few days ago and he mentioned going with the Fed to QE99, and to believe Bernanke would do otherwise was akin to believing in Father Christmas... as much as I'd like to, his position is difficult to dismiss entirely. I only hope the Fed has the intestinal fortitude to do the right thing...
    28 Jun 2013, 08:23 AM Reply Like
  • pdtor
    , contributor
    Comments (1486) | Send Message
     
    JS one of your best macro analysis. Could you speak to how this process works on the manipulation in commodities through the COMEX. You forgot the oil bubble 140-40. I personally feel that there is gross manipulation by financial means , no longer the laws of supply and demand. Could you also speak to the inflation/deflation debate. I feel we are in stagflation, where a good portion of the prices are going up, just not the same of the 70's, where it was wages, housing, and gold.

     

    Looking forward to your comments, always a good read

     

    Keep up the good work
    28 Jun 2013, 08:17 AM Reply Like
  • Joseph Stuber
    , contributor
    Comments (1716) | Send Message
     
    Author’s reply » pdtor

     

    As to the inflation/deflation issue I see no way we avoid a deflationary condition. We have been in a disinflationary situation for months now and moving very, very close to deflation. I think the same applies to GDP - we are very, very close to turning negative.

     

    As the pundits continue to talk as if things are normal I would suggest there is nothing normal about our situation today.

     

    JS
    28 Jun 2013, 12:51 PM Reply Like
  • Bill J
    , contributor
    Comments (24) | Send Message
     
    An excellent review of what's going on, thanks. Your comment about GDP caught my attention. Starting in July, the "official" GDP calculations will include an "intangible" factor designed to boost the "official" number by as much as 3% as some have suggested. Since HFT/computer algos have the impact they have how do you figure that these new phoney GDP numbers will impact the markets?
    Bill
    30 Jun 2013, 10:04 AM Reply Like
  • flash9
    , contributor
    Comments (3677) | Send Message
     
    The Fed is predicting through its models that the economy will get better and interest rates will rise, and therefore if correct they will taper. Never forget, Bernanke was right in the middle of the financial crash and did not see it. He even said subprime was contained and housing would not go down. So the prediction of an improving economy is what we should be worried about.
    28 Jun 2013, 10:31 AM Reply Like
  • mdesilvio
    , contributor
    Comments (78) | Send Message
     
    you have a bad link in the Stockman reference. Here is the correct link: http://bit.ly/1alKF3n
    28 Jun 2013, 10:44 AM Reply Like
  • Joseph Stuber
    , contributor
    Comments (1716) | Send Message
     
    Author’s reply » md

     

    Thanks.

     

    JS
    28 Jun 2013, 12:43 PM Reply Like
  • glaserdx
    , contributor
    Comments (202) | Send Message
     
    JS-another outstanding analysis-
    I have read articles from Dave Rosenberg also corroborating 90% Fed balance sheet-stock market correlation - but not the more recent negative correlation, which to me is convincingly authentic and quite definitively shows the schizophrenic nature of the Fed you describe.

     

    Question for you. Yesterday or day before you thought a short position in the stock market could play out by today--does the Fed's schizophrenia render that mute?
    28 Jun 2013, 12:05 PM Reply Like
  • Joseph Stuber
    , contributor
    Comments (1716) | Send Message
     
    Author’s reply » glas

     

    I think I said that fading the rally would show a profit by todays close. Of course I didn't see yesterday's ramp but still think my call could pan out. I think the price in the opening minutes was in the 1603 area on the S&P. We need to close under that and I think that has a decent chance of occuring. We will see.

     

    JS
    28 Jun 2013, 12:47 PM Reply Like
  • Flash Crash Gordon
    , contributor
    Comments (311) | Send Message
     
    I was surprised to see the bond selloff post the Bernanke "slip-of-the-taper-ton... I think some of the bond selling was actually in response to the liquidity issues in China, and banks there may have unloaded some of their UST for cash.

     

    Treasuries are likely to perform okay given an equity risk off move, as they still carry a safe haven status. Japan shows yields can continue to move much lower, especially in a deflationary environment, which we are clearly in, and the Fed is desperately fighting.
    28 Jun 2013, 11:37 PM Reply Like
  • Joseph Stuber
    , contributor
    Comments (1716) | Send Message
     
    Author’s reply » Flash

     

    You are probably right that treasuires will be OK at some point. At the present rate of QE the Fed will acquire about 75% of total new issue based on current deficit projections so it isn't a lack of demand as the Fed has that covered.

     

    The big problem with bonds at the moment - at least in my opinion - is the unwind of the carry trade. Borrowing at .75% or less to buy bonds at 3.5% or more is a pretty good deal until the 3.5% bond gives up 10% in market value in a matter of a few months.

     

    JS
    28 Jun 2013, 11:59 PM Reply Like
  • Flash Crash Gordon
    , contributor
    Comments (311) | Send Message
     
    I suppose it depends which carry trade you are referring to, what tenors are held, and how many are willing to let them mature, locking in whatever credit spread they received at the time. I guess the biggest issue would be margin calls relating to paper losses on such positions forcing liquidation...but I'm no expert in that realm.

     

    However, I do see a general paradigm shift in the average consumer towards return of capital over return on capital. If equities ever begin to show true capitulation, I think there will be strong demand for UST as simply a means of protecting from losses. Where else are you going to put your money in such an environment?
    29 Jun 2013, 12:19 AM Reply Like
  • Rolytee
    , contributor
    Comments (31) | Send Message
     
    I think if you're most worried about return of capital, the safest place will be cash in the short term... OK, interest rates are negative, but at least you're not running the risk of losses in the 10-30% range if in bonds or equities. Staying in cash for 6-12 months in order to wait until the dust settles is probably the most prudent approach right now
    29 Jun 2013, 01:21 AM Reply Like
  • JDiab
    , contributor
    Comments (6) | Send Message
     
    Joseph,

     

    Thanks for another excellent article. Can you clarify how primary dealers can be holding both excess reserves and be using Fed QE money to drive up equity prices? You mention that the Fed conducts QE through "a credit to excess reserves" of primary dealers, and later explain that "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"

     

    I'm not clear on how the Fed's money could be ending up both in reserves and in the market. I am not suggesting the premise is incorrect, just that I don't understand the mechanism by which Fed money ends up directly in the equity market while reserves are at these elevated levels.

     

    Thanks.
    29 Jun 2013, 06:04 AM Reply Like
  • Joseph Stuber
    , contributor
    Comments (1716) | Send Message
     
    Author’s reply » JD

     

    "I'm not clear on how the Fed's money could be ending up both in reserves and in the market"

     

    I thought I explained the process but I will try again. The Fed buys a bond and that results in an accounting entry at the Fed of a credit to reserves and a debit to the Fed's bond account. Reserves just went up.

     

    Now to the bank or primary dealer. The accounting transaction is a debit to cash or reserves and a credit to bonds. The bank now has cash from the transaction earning the excess reserve rate. They decide to buy a replacement bond with the cash and the result is excess reserves move back to the level they were before the Feds QE purchase.

     

    Now the bank has a bond that they hypothecate - in other words pledge the bond to a 3rd party for a short term loan. They now have off balance sheet cash - as the bond remains on the banks balance sheet - that they can use to buy more long term bonds or stocks.

     

    Did that make sense?

     

    JS
    30 Jun 2013, 01:57 PM Reply Like
  • AlgoTrader
    , contributor
    Comments (3) | Send Message
     
    Joseph,

     

    Excellent analysis! I first stumbled upon your articles here a few weeks back, have read pretty much all of them from the last few months and it is such a great feeling that I am not alone in thinking that all this recent Fed rhetoric is obviously intended to just impact sentiment of stock investors in light of the parabolic rise in prices vs. to imply and communicate any real possibility (let along timeline) of QE tapering.

     

    This said, the correlation between the size of Fed balance sheet and stock prices, while very close to 1.0, does not automatically imply direct or indirect manipulation by the Fed. It is sufficient that the sentiment exists that while Fed is doing QE the stocks are bound to go up because <insert your favorable reason here>. And then one ends up having a perfect correlation between 2 straight lines. So the Fed does not _have_ to mess with direct manipulation. This is just an observation. It does not really contradict the rest of your analysis.

     

    I am too skeptical that they will be able to talk the stock market precisely where they want it to be. At some point the market will either get really scared or it will decide it is all just talk.
    29 Jun 2013, 06:10 AM Reply Like
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