The Fed Is Backed Into A Corner With No Way Out

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The primary driver of stocks is the carry trade.

The positive metrics of the carry trade are shifting.

The Fed's decision to end QE is primarily to defend the dollar against the yen and protect the positive metrics of the carry trade.

Even if the Fed can defend the dollar the undesired consequence of the current shift in policy will have negative effects on the economy.

I frequently get asked the question - how is it that the market continues to shrug off all negative news? Most seem inclined to attribute it to irrational euphoria that typifies bubble markets - a kind of momentum driven, irrational risk taking that pushes stocks much higher than what would seem reasonable.

Other explanations suggest manipulation of markets - a thesis that seems well supported by many investigations into the matter. I have written on some of these manipulation techniques and the truth is this is not a matter of conspiracy theory. Rather, it is a real time phenomenon that regulators continue to allow even as they exact significant fines from the perpetrators.

For the sake of those who demand evidence of the massive levels of corruption in the markets today, the following excerpt from a WSJ article offers a run down on the costs assesed against the biggest violator of the law in regards to fraud and manipulation:

Here's a tally of the biggest J.P. Morgan settlements in the past few years. Even for MoneyBeat's readers who have been following the drama at the bank, the size and the breadth of what the bank has settled is mind-boggling:

Dec. 4, 2013 - $110 million (€80 million) - As part of a settlement between the EU and six banks, J.P. Morgan agreed to settle for its alleged role in the manipulation of the Japanese yen version of Libor in 2007.

Nov. 19, 2013 - $13 billion - J.P. Morgan settled civil claims with federal and state agencies over its underwriting practices and its sale of mortgages before the financial crisis, as well as what was sold by Bear Stearns and Washington Mutual. $4 billion of the settlement was set aside for distressed homeowners. The bank admitted to deceiving investors about the quality of its mortgage underwriting.

Nov. 15, 2013 - $4.5 billion - The bank paid $4.5 billion to a group of 21 institutional investors including BlackRock and Allianz SE to settle losses from mortgage-backed securities that J.P. Morgan sold them before the crisis.

October 16, 2013 - $100 million - The bank paid the Commodity Futures Trading Commission to settle charges related to its so-called London Whale trades.

Sept. 19, 2013 - $920 million - In settlements with the OCC, the SEC, the Fed and the U.K. Financial Conduct Authority, J.P. Morgan agreed to pay a total of $920 million to settle all claims about its management and oversight of traders involved in the London Whale debacle. The bank also admitted wrongdoing in the matter, a trade that cost the bank more than $6 billion.

Sept. 19, 2013 - $389 million - The bank paid $80 million in fines and refunded $309 million to credit-card customers to settle regulators' charges that it harmed consumers by allegedly making errors in hundreds of thousands of debt-collection lawsuits and leading more than two million credit-card customers to buy services they didn't want.

July 2013 - $410 million - FERC alleged J.P. Morgan Ventures Energy Corp. traders gamed rules that help set the cost of electricity in California and the Midwest with 12 manipulative trading schemes starting in 2010. The DOJ is now investigating the claims. The $410 million included a $285 million fine and the bank agreed to give back $125 million in profits.

January 2013 - $1.8 billion - In two separate agreements, the bank contributed $1.8 billion to the nationwide bank settlement on allegations the banks improperly carried out foreclosures during the housing crisis, including employing so-called robo-signers. The bank also agreed to contribute $3.7 billion in aid to troubled homeowners and nearly $540 million in refinancing. The first part was reached in a nationwide settlement in February 2012.

November 2012 - $269.9 million - The bank settled with the SEC over the creation and underwriting of mortgage-backed securities.

August 2012 - $1.2 billion - The bank disclosed in a filing its share of a broad settlement over interchange allegations against the banks and Visa and Mastercard.

Even though manipulation is going on, an objective person can't attribute everything that seems irrational in market pricing to manipulation - at least in the sense that it is explained in the WSJ article above. That said, market manipulation in a broader context does seem to explain why markets refuse to price in negative news.

The broader context I am referring to is the central bank planned method of manipulation - the "wealth effect" - that uses the stock market as a proxy for the real economy. Whether the Fed really believes in the idea that high stock prices will eventually influence sentiment in a way that produces the desired effect or, in the alternative, they have perpetrated a giant fraud on the American people that has worked to make the rich wealthier and the middle class poorer is a matter for another time. What is certain though is that the Fed's agenda has, in fact, made the rich wealthier and the middle class poorer but it hasn't worked to ignite "animal spirits" and propel the economy forward.

But back to the point - how is it that stocks have managed to shrug off all negatives and continue to levitate? In a recent article I made the following comments in my summation. The comments articulate the reason - in my opinion - for why stocks have seemed so resistant to moving lower on negative news:

The truth is the dynamics of the markets have undergone major change since the turn of the century. Many of us have continued to cling to that paradigm that existed before the repeal of Glass Steagall - a decision that rendered traditional analytical tools ineffective. The truth is the sentiment of investors no longer moves markets. In fact, what does move markets is market movement itself and unaffected by human emotion.

The retail investor is so insignificant in terms of market volume today that one must understand the new paradigm in order to effectively forecast markets. What has driven stocks higher since the end of the recession has been a very unemotional process of momentum following, high leverage, machine driven bids in the market. The machine doesn't react to disappointing data in the same way that humans do and in fact just keeps buying as long as the metrics of the carry trade support that decision.

In a paper entitled Yen Carry Trade and the Subprime Crisis, Masazumi Hattori and Hyun Song Shin explain the dynamics and resultant consequences of the carry trade:

Aggregate liquidity can be understood as the rate of growth of aggregate balance sheets. When financial intermediaries' balance sheets are generally strong, their leverage is too low. The financial intermediaries hold surplus capital, and they will attempt to find ways in which they can employ their surplus capital. In a loose analogy with manufacturing firms, we may see the financial system as having ''surplus capacity.'' For such surplus capacity to be utilized, the intermediaries must expand their balance sheets. On the liabilities side, they take on more short-term debt. On the asset side, they search for potential borrowers that they can lend to. It is in this context that the broad yen carry trade comes into sharper focus. By allowing intermediaries to expand their balance sheets at lower cost, the broad carry trade fuels the financial boom. Aggregate liquidity is intimately tied to how hard the financial intermediaries search for borrowers. In the subprime mortgage market in the United States we have seen that when balance sheets are expanding fast enough, even borrowers that do not have the means to repay are granted credit-so intense is the urge to employ surplus capital.

The seeds of the subsequent downturn in the credit cycle are thus sown. Jimenez and Saurina (2006) show from their study of Spanish banks that the loans granted during booms have higher default rates than those granted during leaner times.

The excerpt above explains in concise terms what fuels market movement in the new, post Glass Steagall paradigm era. What happened in 2008-09 with the Fed was a concerted effort to inflate stocks by making all other investment alternatives unattractive. The combined effect of QE and ZIRP was that the funding was provided along with the low borrow cost.

What made the whole configuration even more appealing is that the Fed facilitated massive levels of deficit spending that pumped money into the economy and supported GDP even as we struggled with job creation. Those funds the US Treasury pumped into the economy were spent resulting in a consistent flow of funds into the coffers of corporations as they were simultaneously cutting costs by engaging in lay offs.

The point is that those arguing the increase in stock price was earnings driven are, in fact, correct - at least up to a point. The following chart - courtesy of - reflects the S&P 500 earnings growth rate:

Although earnings growth stayed positive until late 2011 at which point it stalled out at the zero growth line, stocks have continued to surge ever higher. In June of 2013 the growth rate again began to turn higher. Some will argue that the Fed's policy is finally producing positive results. I would suggest the more likely explanation is that corporations have engaged in creative accounting and stock buy backs but that is a matter for another time.

The chart below of the S&P 500 (NYSEARCA:SPY) reflects the various iterations of quantitative easing:

What's different about this chart from many others is that it reflects both Fed actions and BOJ actions to expand asset purchases. BOJ's actions since 2007 are explained below:

In early October 2010, the Bank of Japan announced that it would examine the purchase of ¥5 trillion (US$60 billion) in assets. This was an attempt to push down the value of the yen against the US dollar in order to stimulate the domestic economy by making Japanese exports cheaper; it did not work.

On 4 August 2011 the BOJ announced a unilateral move to increase the commercial bank current account balance from ¥40 trillion (US$504 billion) to a total of ¥50 trillion (US$630 billion).[65][66] In October 2011, the Bank expanded its asset purchase program by ¥5 trillion ($66bn) to a total of ¥55 trillion.

On 4 April 2013, the Bank of Japan announced that it would expand its asset purchase program by US$1.4 trillion in two years. The Bank hopes to bring Japan from deflation to inflation, aiming for 2% inflation. The amount of purchases is so large that it is expected to double the money supply. This policy has been named Abenomics, as a portmanteau of economic policies and Shinzō Abe, the current Prime Minister of Japan.

I want to reiterate that the fuel for the impressive stock market climb from the 2009 lows has not been retail investor sentiment nor has it been a function of an optimistic economic outlook. That, of course, is a part of the pundit explanation but there is substantial circumstantial evidence to support the thesis that I am setting forth here.

The thing that seems to stand out the most in the chart above is the lack of volatility in 2013. Stocks simply kept climbing and absent of any real correction. My explanation for that anomaly is that the combined effort of the Fed to diffuse the impact of the "fiscal cliff" issue in December of 2012 with QE4 combined with the BOJ's massive move to push the yen down had the effect of fueling the rally as sophisticated investors increased their leveraged bets in the yen carry trade and those funds found their way into US and Japanese equities.

The chart below reflects the USD/YEN, the S&P 500 and the Nikkei.

As one can see, both the Nikkei and the S&P 500 benefited greatly from the yen weakness but it would seem reasonable to assume the dollars strength against the yen would have produced the opposite effect in US equities. Perhaps that would be true except for the fact that the US dollar has not been strong even though the chart above would suggest otherwise. Additionally, the only thing that really seems to matter is the yen weakness and BOJ's willingness to continue to flood the system with liquidity.

To put things in perspective and add additional circumstantial evidence to the thesis set forth herein one needs to look at the yen and the dollar relative to a basket of currencies. The yen futures chart and the dollar index futures chart are reflected below:

The charts above show that both currencies were generally weak with the yen starting its descent in late 2012 in anticipation of Abenomics and the dollar only coming under pressure when China began to move away from the US dollar with the sale of US Treasuries and the decision to bypass the dollar as a reserve currency by entering into bilateral trade agreements with a number of nations.

Of some interest is the fact that the dollar did get a boost in late 2013 in anticipation of the Fed's ending of QE but even that has failed to lend continuing support to the dollar. The dollar peaked in July of 2013 after the Fed hinted at tapering on QE only to resume its slide thereafter.

More relevant to the point, we are now fully engaged in QE taper with the prospects for ending all asset purchases in the next few months. Furthermore, the Fed's forward guidance on interest rate increases suggests that we may well see an increase in rates before the end of 2014. That should be bullish the dollar yet we haven't seen much dollar strength this time around unlike what we saw with just a hint that taper was on the way in early 2013. That suggestion pushed the dollar up from roughly 80.50 to about 85.50. Now that we are fully engaged in QE taper the most the Fed could do was push the dollar from 79.50 to 81.50 before falling back to 79.50 again.

Of course the reason for the weak dollar in spite of its relative strength against the yen is the euro. Here is the futures chart for the euro:

What really matters going forward is whether or not these relationships can be maintained in a way that supports the carry trade and that necessarily means the yen weakness must continue. This is how the yen carry trade was explained in a 2006 Bloomberg article:

"All liquidity starts in Japan, the world's largest creditor country,'' said Jesper Koll, chief economist for Japan at Merrill Lynch & Co. "When rates go up here, rates go up everywhere."

What makes the carry trade so worrisome is that nobody really knows how big it is. For example, the BOJ has no credible intelligence on how many hedge funds, investors and companies have borrowed cheaply in ultra-low-interest-rate yen and re-invested the funds in higher-yielding assets elsewhere.

That was 2006 and we know what followed. The facts are the carry trade has become the new paradigm and any analyst that fails to consider this in their forecasting methodologies is overlooking the only thing that really matters. Bringing the matter into the current time frame, here is an excerpt from a June, 2013 Barrons article - JPY Is the New VIX:

The reality is that cheap yen has been used to fund asset investment and speculation around the globe. Investors could borrow yen at virtually zero interest to invest in anything from U.S. stocks or junk bonds or emerging markets or even Japanese stocks. In effect, it was better than money for nothing; a speculator got paid to borrow in ever-depreciating yen.

Since it became apparent last November that Shinzo Abe would be elected Japan's prime minister on a platform of aggressive monetary and fiscal stimulus, global risk assets from emerging markets to U.S. stocks were in ascent. The Bank of Japan's money printing not only sent the Tokyo market soaring but also put the spurs to other risk-asset markets.

To emphasize, the BOJ's money printing had done more to boost asset prices by providing a source of cheap money than to stimulate the domestic economy. And the cheap yen was exploited around the globe.

You see, the issue isn't the economy. Unemployment, GDP growth, inflation rate and even earnings growth are simply not relevant as long as money can be borrowed on the cheap and invested in an asset that continues to rise and the reason for why it is rising is simply of no importance. The only thing that matters is that it keeps on rising and cheap money continues to be available.

Why the Fed is ending QE and the implications of this move

Make no mistake - the Fed has a vested interest in maintaining the status quo regarding the positive metrics of the yen carry trade and that necessarily requires a vigorous defense of the dollar. Certainly it can't be said that the Fed has met their target goals that we were told repeatedly would be that point where they would consider unwinding QE.

The Fed's stated inflation goal is 2%. The chart below demonstrates that we have moved in the wrong direction since the first of the year as it relates to that goal:

One could argue that the unemployment situation is a little better in terms of meeting the Fed's target goal if one were willing to overlook the fact that the Labor Participation Rate is the reason this metric reflects a positive trend:

A look at GDP also suggests the Fed - if their QE/ZIRP policy was good policy in the first place - is exiting the policy strategy a little early:

Quite honestly, anyone who isn't questioning this sudden and dramatic shift in policy despite no evidence at all that it is time to do so based on domestic economy metrics has been completely desensitized to risk. There is a reason though and that reason is the need to keep a lid on the yen and to protect the yen carry trade and that necessarily requires an aggressive effort to keep a floor under the dollar.

Also relevant to the point was Janet Yellen's comments on when the Fed would think about raising rates. Consider this excerpt from a Reuters article on the matter:

After a two-day policy meeting on Wednesday, the Fed said it expected to keep benchmark interest rates near zero for a "considerable time" after it wrapped up a bond-buying stimulus program, which it is widely expected to do toward the end of the year.

Pressed on the statement at a news conference afterward, Fed Chair Janet Yellen said the phrase "probably means something on the order of around six months or that type of thing." Stocks and bonds immediately tumbled as traders took the statement to suggest rate hikes could come sooner than they had anticipated.

As an additional point of interest on the matter of the Fed's dramatic shift in policy in spite of the fact that they have failed to meet their stated objectives is the largely unreported levels of reverse repos the Fed has engaged in over the last several months - a strategy that is consistent with the need to protect the dollar at all costs.

In a recent article I did expose this strategy by explaining that the Fed's reverse repos totaled over $4 trillion since the first of the year. There is literally no precedent for the size of the reverse repo actions since the first of the year. Just to put the matter in perspective - one of my readers did the leg work on this matter by tallying the total dollar volume of reverse repos for each year going back to 2001. His comments and the data he provided are found in the comments section of a recent article I wrote on the matter and found here:

The volume of reverse repos exploded in 2014 (why?). In the first 2.5 months of 2014 the volume of reverse repos exceeded the total volume for the previous 13 years combined (!).

Here is the reverse repo volumes since 2001:

2014 $4084.793B

2013 $1042.141B

2012 $11.92B

2011 $13.32B

2010 $5.86B

2009 $0.99B

2008 $1275.00B (reverse repo volume spiked here!)

2007 $19.00B

2006 $0.00

2005 $0.00

2004 $4.75B

2003 $22.75B

2002 $0.00

2001 $0.00

Why the sudden spike in 2013? The answer seems glaringly obvious to me - China elected to begin the process of bypassing the US dollar in bilateral trade agreements with 23 different nations and they began the process of reducing their holdings in US Treasuries. These actions are a very direct attack on the US dollar and they began in 2013. The Fed's decision to ramp up their reverse repo actions began in August of 2013 and the volume has steadily increased ever since.

Here is the Fed's statement on the matter found on the NY Fed's website:

Statement to Revise Terms of Overnight Fixed-Rate Reverse Repurchase Agreement Operational Exercise

March 4, 2014

As noted in the September 20, 2013, Statement Regarding Overnight Fixed-Rate Reverse Repurchase Agreement Operational Exercise, the Open Market Trading Desk at the Federal Reserve Bank of New York has been conducting daily, overnight fixed-rate reverse repo operations as part of an operational readiness exercise.

Beginning with the operation to be conducted tomorrow, Wednesday, March 5, the per counterparty bid limit for each operation will increase from $5 billion to $7 billion. All other terms of the exercise will remain the same.

As an operational readiness exercise, this work is a matter of prudent advance planning by the Federal Reserve. These operations do not represent a change in the stance of monetary policy, and no inference should be drawn about the timing of any change in the stance of monetary policy in the future.

Prudent advance planning - in my opinion - means we stand at the ready to increase short term rates at a moments notice through reverse repo actions if necessary to defend a further decline in the dollar. Notwithstanding that view, the truth remains that this action is not just a matter of advance planning as the Fed's reverse repo actions are withdrawing liquidity at the same time they are rapidly winding down QE and signaling an increase in rates is coming much sooner than many expected and much sooner than the Fed had signaled in previous statements.

So - to the big question - will the Fed manage to defend the dollar and what will the impact to markets be if they are successful?

To fully appreciate the pressure the dollar is under relative to the yen one only need look at the chart below:

As one can clearly see the dollar peaked in early January and has been falling ever since. What seems counterintuitive is that the dollar has fallen in spite of the Fed's decision to end QE. That decision should lend significant support to the dollar yet we see the exact opposite.

Of some interest here is the fact that the yen is also firming against the euro as reflected in the chart below:

As I have noted in previous articles and comments, the Fed is between a rock and a hard place here in that their efforts to support the dollar against the yen, and in so doing, protect the yen carry trade means that they see that as more important than the economy. Keep in mind that raising rates at this juncture could have devastating effects on the real economy and yet they are telling us in a number of ways that is the choice they have made. The following remarks - found here - reflect my view on the risks of losing control of the positive metrics supporting the yen carry trade:

The problem with a carry trade driven bull market is that those who have bid the market ever higher based on favorable carry trade metrics are all dependent on one thing - cheap and abundant credit - and when that cheap credit is no longer cheap or abundant the only thing one can do is sell the asset. It becomes an involuntary decision as it is a highly leveraged trade.

What matters here is that the volume in the market today is substantially from that one source. That means that those who have driven stocks substantially higher based on the carry trade metrics must now exit and exit involuntarily and the problem is there is no one to sell to as everyone has gathered on the same side of the trade. That is what produces crash scenarios and why stocks fall much faster than they climb.

Today we have a situation that is very serious in that the dynamics of the carry trade are changing and that is reflected in the price action of various risk assets. It is also reflected in the fact that the Fed has been forced to engage in massive efforts to withdraw liquidity from the system while attempting to put on the face of optimism.

Summing it up

As is always the case, market forecasting involves a lot of supposition. In other words, suppose this happens or that happens and in this case the supposition is simple - suppose the Fed can't successfully defend the dollar against the yen.

There is a second consideration as well - what if they do manage to defend the dollar but mess up the very fragile economic recovery in the process? One thing seems certain - the Fed is not reversing policy because the economy is on fire. That leaves only one other explanation - the dollar is under attack and the prospects of destabilizing economies across the globe and losing control of the positive metrics of the yen carry trade are so significant that nothing else matters to the Fed at this point.

We do indeed live in a new paradigm as far as what drives markets is concerned and that has been the case since the repeal of Glass Steagall that has allowed international banks to align with the Fed and other central banks in their efforts to manipulate outcome through market intervention. If you have the money at your disposal - and the banks do - then it is hard to know just how long they can keep the markets aloft. One thing seems certain - the Fed will stop at nothing to keep stocks from falling even if it means raising interest rates and plunging us into another recession in order to achieve that end.

It is that carry trade driven boom/bust cycle that has produced this:

Out of this:

Disclosure: I am long GLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.