The Fed: Between A Boulder And Hard Place And How To Benefit

by: Adem Tumerkan


The market only listens to the Fed today. Fundamentals and growth have taken the backseat. A few words from Yellen can do far more than any fundamentals justify.

Many credit the Fed for saving the economy since 2008. But beware confusing correlation with causation. The markets most likely would have recovered without its multi-year interventions.

The Fed has postponed any more rate hikes for now because of weakening inflation and softening data. Yet, it plans on unwinding its balance sheet - this makes no sense.

If the Fed begins unwinding, it will create a liquidity crisis and dolalr shortage. Such events spark a deflationary cycle and spikes in short term interest rates to attract capital.

I believe the Fed is simply preparing for the next recession it expects is approaching sooner than later. Be prepared and position yourself for that event by thinking two moves ahead.

The market since 2008 has been in a weird period where a few words from Central Bankers move the price of almost everything. No longer does the market care about fundamentals or growth.

GDP down? Stocks rise because they expect the Fed to come out and protect our backs.

Stock prices fall? No worries, the Fed will pause hiking rates and possibly reverse course.

Due diligence be damned! And, cheap words prevail.

But - words are easy to mince. And, even easier to go back on. So, for the speculator to really keep their head above water, they need to think two moves ahead and remember that being skeptical is wise.

Modest doubt is called the beacon of the wise - William Shakespeare

Last week, I wrote an article about how the Fed is leading us into the next recession. And today, we remain on course.

Hiking rates is one thing, which the Fed has postponed until further notice because of softening inflation and slowing growth. But talks of unwinding its bloated $4.5 trillion dollar balance sheet is another thing.

Wednesday's decision not to raise rates was expected. Markets anticipate that the central bank might raise interest rates again by the end of the year, which would mean three rate increases this year. - the Washington Examiner.

The Fed has imprinted in our minds that the economy is recovering. The crisis times are over. And that it is time to get rates back into "normal" territory.

The problem I have with this is that it has been almost 10 years since 2008. Even if the Fed did not intervene, wouldn't markets have corrected over time on their own? The Fed takes credit for home prices increasing and a lowering unemployment rate. But just like every crash before 2008, don't things get better on their own? Humankind moves forward, no matter the small bumps.

This is where I fear many have believed that correlation (a relationship connecting variables in a pattern) is causation (cause and effect). Instead of, "don't confuse correlation for causation."

Correlation: a mutual relationship or connection between two or more things.
Causation: the action of causing something. the relationship between cause and effect; causality - from the Dictionary.

For example of this, by looking at the chart below, one could make a well done graph and statistical diagram explaining how fresh lemon imports have reduced highway fatality rates.

Or, my personal favorite, who could have ever guessed that the number of people who drowned falling into a swimming-pool correlated with the number of films Nicolas Cage appeared in?

Illusory correlation is the phenomenon of perceiving a relationship between variables (typically people, events, or behaviors) even when no such relationship exists.

Of course, this is absurd. These are simply coincidences. But you would be surprised how many people get duped by nice correlated graphs and then decide on its causation.

Especially in economics and finance...

It is easy for us to disregard silly coincidences when we read headlines stating, "Economy Recovering Thanks to the Fed's Low Rates." Couldn't the markets have recovered on their own?

Everything since 2008, the market has correlated it all from the Fed's doing. As if the central banks were our saviors.

But I don't believe that - I know better than to think the Fed did anything besides juice up asset prices. That's all it can really do: cut rates and print money and hope to cause a 'wealth effect'.

The wealth effect is the premise that when the value of stock portfolios rises due to escalating stock prices, investors feel more comfortable and secure about their wealth, causing them to spend more.

There will undoubtedly be unintended consequences from the years of zero-interest rate policies and money printing. For the Fed to focus on two mandates only - unemployment rate below 5% and inflation at 2% - this has created many other distortions, like student debt bubble, auto loan bubble, stock market bubble, junk bond bubble, and more.

What even is the "normal" rate of interest the Fed wants? I wrote weeks ago that the Fed will target 3% only so that it can cut rates back to 0%. Why? for it to give some stimulus to the economy during the next (and nearing) recession.

To quote myself from that article, "Economic research tells that in a recession, the Fed needs to cut rates at least 3% to get stimulus... But interest rates after today sit at 1-1.25%. How is it going to be able to cut 300 basis points if it is only at 1%? Well, it can't. And, at its current pace of hiking, it will take at least another 1.5 years (written June 15th 2017)."

If the Fed hikes too much, the economy will weaken much more. And, if it hikes too little, it will prolong these debt fueled bubbles - making things worse - and it won't get enough stimulus from the rate cuts during the next recession.

This is why the Fed is stuck between a boulder and a hard place...

Adding even more weight on the Fed's shoulders, it needs to clean up its balance sheet to prepare for when it needs to print more money via QE during the next recession. Just as what it is doing with preparing rates today.

Think of it as this way: it needs fresh ammo to deploy during the next crisis to reinvigorate market confidence, keep liquidity plentiful, and above all else prevent deflation i.e. falling asset prices.

But can it do so?

Thorsten Polleit at the Mises Institute wrote,

"The Fed ramped up banks' cash holdings from US$ 24,9bn to US$ 2,398 (red line).1bn from September 2008 to July 2017. It did so by buying Treasuries and mortgage-backed securities (MBS) amounting to US$ 1,908.9bn and US$1,770.3bn, respectively. In the meantime, however, banks have repaid most of the loans provided by the Fed... This, in turn, has reduced banks' cash holdings to US$ 2,398.2bn. As a result, it has become impossible for the Fed to sell all the bonds it has purchased. "

His conclusion? The Fed can't sell back the bonds it purchased because there is not enough money in the banks to buy them back - all $3.7 trillion.

It is simple math. There is $2.4 trillion in bank deposits that would need to absorb $3.7 trillion of the bonds the Fed is selling.

If the Fed were to simply sell slightly less than 70% of its holdings, it would evaporate all liquidity from the US banking system. There would be an unreal dollar shortage.

And, what happens when banks need dollars and liquidity (a problem they haven't had since 2009 onwards)? They liquidate their assets to raise cash, further exacerbating the deflation, and short-term interest rates will skyrocket to attract the capital they need.

Imagine what this would cause throughout the global banking system today...

That is why I believe the Fed's "talks" of Quantitative Tightening (QT) is all it ever will be. Empty words.

The bond market seems to agree with me as it has hardly priced this QT in, even though the Fed's balance sheet unwinding should clearly cause higher rates.

The Fed does not want a flattening, or inverting, yield curve. I have written about this often because the inversion problem signals a recession is approaching.

But recently Barron's ran a piece discussing the same idea that I had. That the Fed is only talking about unwinding its balance sheet to push long-term rates higher i.e. steepen the yield curve.

This is why the Fed may be interested in trying to start up its balance-sheet reduction plan sooner rather than later. By letting longer-dated Treasury securities shift out of its portfolio as they mature, the Fed could spur the longer end of the yield curve to start rising. Given that the Fed will no longer be a big buyer of Treasuries and mortgage-backed securities, Fed purchases won’t weigh down those yields any longer - Brian Jacobsen, a senior investment strategist at Wells Fargo Asset Management

My thesis is that the Fed is too late in all this. The economy is already anemic at best. The bond market is skeptical of the Fed's optimism, hence the flattening yield curve.

I expect the Fed will cease hiking and begin slashing rates, possibly into negative territory, because I doubt it can get them up to 3% before a slowdown happens. The economy and financial markets are fragile. It will then have to quit its jawboning about QT and bring back some form of quantitative easing (QE).

I am long gold (GLD) and own long dated, 1 and 2 years, out-of-the-money Call options on select gold miners that will benefit from a rising gold price. Such long options are for Yamana Gold (AUY), IAMGOLD (IAG), and the VanEck Junior Gold Mining ETF (GDXJ). By purchasing long dated OOTM calls, the price should be very cheap and give you plenty of time for the market to realize the Fed's dilemma.

As always, try to think two moves ahead.

Disclosure: I am/we are long GLD, GDXJ, AUY.

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.

Additional disclosure: I found more asymmetry (low risk/high reward) from buying 1 & 2 year CALL OPTIONS that are "out of the money". By buying the call options the investor's downside is limited in case my thesis is wrong. And if it proves correct, upside is unlimited within the options time frame. I have strike prices that are between 50-150% higher than current share prices.