I was Drinking coffee at 3 a.m. because I couldn't sleep. So I thought, screw it, I am just going to pull an all-nighter and begin writing my first of three parts about the Fed and what I expect going forward.
One thing I can't stop writing about is how these 'experts' expect the Fed to simply clean their balance sheet up without deflation or recession. It literally bugs me how I hear 99% of the time that the Fed has control of everything.
Do you honestly think they know what is coming next [the Fed]?
Putting it simply, the Fed spent over $4 trillion dollars transferring toxic mortgages on to their own balance sheet from Wall St. and buying Treasury bonds to finance the U.S. government and suppress yields. In doing so kept liquidity plentiful for all.
The process went something like this...
The banks were stuck with worthless, or at least nearly worthless, MBS (mortgage backed securities) and other related securities during 2008. These things were bad. Not only was their re-sale value collapsing, but who knew if their intrinsic value (money they needed from homeowners paying their interest payments) was going to keep flowing in.
In an act of desperation, the Fed printed up money with a few clicks. And through "Open Market Operations" they gave the banks money through paying top dollar for those toxic 'assets'. They transferred fresh money back to Wall St. and inherited those 'assets' onto their own balance sheet - at the expense of taxpayers.
This was called "quantitative easing", QE for short.
Ever notice how the 'experts' use names that seem to fly over our heads? It is almost as if they do it on purpose so we don't ask questions because it seems so complicated...
The Fed justified this all by telling the public that with healthier banks and their new riches, they would lend to eager borrowers. The more money borrowers have, the more they can consume. And with our GDP roughly 70% consumption, this would fuel the economy, increase employment because of the increased demand, and everything would be as good as before.
Being a natural born skeptic, I still doubt their proposed intentions.
In reality, the Fed needed to kick the can down the road...
"How does this even make sense," I asked myself, "if too much debt and over-consuming was the problem leading up to 2008, why would they add even more debt to force greater consumption?"
Let's go over a couple things the Fed truly intended...
He basically makes the argument that deflation leads to prolonged slump in growth, increased debt burden on borrowers, and joblessness. And that the world's Central Banks must prevent this (deflation) by all means possible so that we don't suffer another Great Depression scenario.
The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand--a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers.1. . Sustained deflation can be highly destructive to a modern economy and should be strongly resisted... For this reason, as I have emphasized, prevention of deflation is preferable to cure... But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation. - quotes from Bernanke's speech.
Why is this important for today? Within this boring text there was one line that is strikingly relevant with today's Fed situation...
...some observers have concluded that when the central bank's policy rate falls to zero--its practical minimum--monetary policy loses its ability to further stimulate aggregate demand and the economy.
Bernanke goes on to saying that the Fed can do other acts, extreme measures, such as printing money and injecting it into the economy, as a solution if a recession strikes during a time with 0% rates (which they did post 2008 with 3.5 rounds of QE).
This is why the Fed, led by Yellen today, is hiking and tightening when the economy and inflation are anemic. They need to raise rates so that when a recession does come, they will be able to cut them for "stimulating aggregate demand in economy". I detailed this in an article a couple weeks ago, here is the link.
Here is the irony: by raising rates, the economy contracts. This is pretty much common sense. During the boom years credit expands cheaply. People borrow more and buy more being able to service these debts cheaply. The added consumption from debt boosts employment and the multiplier effect kicks in [every dollar you give to Ford (F) when you buy a car, they pay employees salaries/commission, who goes out and buys clothes from Macy's (M), and so on].
But raising rates reverses this entirely. The cheap servicing of debt becomes more expensive. Marginal borrowers default or sell their houses and cars, which pushes prices downwards - deflationary effect. Companies cut marginal employees and overleveraged firms bankrupt or simply shut down.
Basically the inverted causal sequence of the boom years occurs during the tightening years, i.e. the bust.
This is the paradox for the Fed today. They need to hike rates so that they will be able to cut rates during the next recession. But, by doing this tightening, they are causing that very recession.
Since we witnessed Japan and Europe needing extra help, since 0% and bond buying (QE) wasn't doing enough, they cut rates negative.
As an investor thinking for the longer term, we can expect the Fed to do the same next time as well. But it won't stop there.
The Fed will need to expand their bond buying drastically in attempt to re-liquidate and re-stimulate the economy. How can they get home-owners, who have already been refinancing during the last few years with roughly 3.5 - 4% mortgage rates, to do so again? How can they get millennials, whom are over-indebted with student loans, be able to afford greater consumption? How can they get corporations with huge amounts of debt to make enough sales to cover their costs of loans and employee people? The list goes on.
The next step will be much more than what they did after 2008 because the costs are much higher today. The Fed went to extreme lengths simply to keep things barely going since then.
Therefore I believe the Fed will be forced to engage in "Helicopter Money", and sooner than many think. Author and economist, Jim Rickards, has an excellent thesis for this outcome that actually makes sense.
The idea is that the Fed will need more help than monetary stimulus alone can do. It will take both the Treasury (fiscal policy) and the Fed (monetary policy) to do so. For instance, the Treasury can give huge tax cuts and larger tax rebates back to citizens, leaving them with more money in their pocket, and large public spending projects (like rebuilding infrastructures). But how can they afford this with the national debt already over $19 trillion? Simple, the Fed will print money and finance the Treasury, covering the difference. They will also put rates negative, starting slow with a -0.25%, and ramp up their QE program for the banks.
In theory at least, helicopter money could prove a valuable tool. In particular, it has the attractive feature that it should work even when more conventional monetary policies are ineffective and the initial level of government debt is high… The fact that no responsible government would ever literally drop money from the sky should not prevent us from exploring the logic of Friedman’s thought experiment, which was designed to show — in admittedly extreme terms — why governments should never have to give in to deflation… In more prosaic and realistic terms, a “helicopter drop” of money is an expansionary fiscal policy — an increase in public spending or a tax cut — financed by a permanent increase in the money stock - Ben Bernanke in 2016.
Again, instead of calling it "helicopter money", they will give it a complicated name - as Bernanke puts it, "Money-Financed Fiscal Program” (MFPP)...
Of course this is under the assumption that the market will allow all this printing and debt. Maybe the dollar will crash from their attempts to do this "helicopter money" plan? Just because Japan and Europe did it doesn't mean it will always work. But, for argument sake, let us say it will happen without the market rejecting it.
That is why today Yellen is tightening whenever the market allows her to, and now, talking of unwinding up the balance sheet.
But - nearly every time the Fed unwinds their balance sheet, it ends in a recession...
Virtually every time the central bank has tried it in the past, recessions have followed - from CNBC.
Five-out-of-Six (5/6) times in the last 100 years that the Fed tried reducing their balance sheet has ended in recession. If you think raising rates is deflationary, that is nothing compared to the Fed selling bonds i.e. sucking the money supply out of the economy. This is their way of reversing the money printing they did through bond buying i.e. QE. By selling bonds, the banks are using the money they made to return it to the Fed and get the bonds back on their books. This is Quantitative Tightening i.e. QT.
You can already see the problem here. If the largest buyer of bonds, the Fed, is now going to start selling their holdings, who would hang onto bonds? It's like expecting a wave of selling from the biggest owner of something to start soon and you don't rush to unload your position first.
Current market expectations are that the Fed will keep rolling off proceeds until the balance sheet hits around $2 trillion to $2.5 trillion, a process that could take four or five years. Fed Chair Janet Yellen likes to say the process will be akin to "watching paint dry" and won't be disruptive to markets.
However, skeptics question whether it will be so painless.
Of course, Yellen can't come out and say what history tells us about the recession correlation with reducing the Fed's balance sheet. She has to make it appear like it won't be disruptive to markets.
But we should know better...
That is why I believe the bond market hasn't really reacted to her news of the QT. There is no stampede to get out of bonds. There hasn't been stock market sell offs either. And the USD Index has actually fallen over -10% this year.
If the Fed can't tolerate deflation, then the softening inflation since 2017 started is a warning sign for them to stop tightening.
(From the BLS June 2017)
Thus, the market is calling Yellen's bluff. With the CPI weakening and the economy still anemic, they will plunge us straight into deflation by unwinding their balance sheet. This contradicts the Fed's war against falling prices. So they won't do it. It is only empty words.
Various economists, including a group calling itself Fed Up, are urging policymakers to increase their current inflation target from 2 percent and hold off on further rate hikes [because the economy can't handle it].
But, if they do unwind - just like the rate hikes, it is to prepare for the next recession. They will need their balance sheet cleaner to initiate the "helicopter money" financing so that the market won't reject it.
Therefore, I believe this is the true underlying intentions of the Fed. They are doing what they can and quickly to get rates up slightly and their balance sheet slightly cleaner (or at least the impression they tried) so they can have "ammo" to use during the next recession and deflation cycle.
Ben Bernanke's war on deflation is widely shared by the current Fed governors. That is why I am long gold (GLD) and their subsequent miners (GDXJ) and have been. There is no clean or way out of the mess we're in, and because I expect the Fed to reverse course suddenly, and relatively soon.
This is part one of three that I am doing on the Fed and why you should expect the opposite of tightening going forward and prepare.
Disclosure: I am/we are long GLD, GDXJ.
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.