Leave It To The Fed

Summary

• Investors are well aware of the current situation.
• Possible near-term scenarios.
• What investors can do.

The Fed is the prime mover of the financial system and as such should be closely watched. Of course, the Fed has to operate in the context of the current financial situation, so it behooves investors to be aware of certain developments. The first part of this article will provide a list of points to bear in mind. Since they have been thoroughly examined by various commentators and constitute a brief recap, it will suffice here simply to list them with an occasional short comment.

The Situation

The Fed base rate is currently 1.5-1.75%. This is extremely low but higher than the ECB that is at present at -0.5%. The federal debt is up to $23.2 trillion and increasing at a rapid pace. The national debt may well surpass $ 30 trillion even before 2030. The government is spending more than it takes in via taxes. The Fed is providing liquidity to the Treasury currently at about $60 billion a month by purchasing T-bills. The Fed is also financing the repo market and making huge amounts of liquidity available to the big banks. The stock markets are at all-time highs with exceptionally high P/E ratios. Investors should not expect that there is still a lot of room for stock prices to go much higher. Stocks are already very expensive. Stock buybacks have buoyed up the markets as corporations have increased debt to record levels. Stock prices are highly inflated. Inflation figures produced by government agencies have little connection with reality and hide real inflation. Consumers are at peak debt with mortgages, student loans, car loans and credit card debt. The economy is not really doing so well even if GDP growth is reckoned at 1.5-2%. Unemployment figures are extremely low but do not correspond to reality as the percentage of working-age Americans that are employed is about the same as the workforce in 2000. The most recent development that could concern the Fed is the outbreak of the coronavirus, which could bring on a global recession. A lot has already been written on possible effects the coronavirus could have on the global economy. This is a brief summary of the financial situation that the Fed has to deal with. All of this should be clear and known to investors.

Possible Scenarios

There are various outcomes that may result from the present situation as there are various measures that the Fed could implement. One is to turn to outright purchase of stocks and ETFs in case of a market downturn. The SNB and BoJ have shown the way with stock and ETF purchases. The SNB (Swiss National Bank) creates money and buys euros and American stocks among other things. The Fed could follow the example of the SNB and intervene directly in the markets. At the present time, the SNB has about $90 billion of American stocks in its reserves. See the chart below to get an idea of what the Swiss have been doing.

The BoJ has gone to extreme lengths to stabilise markets as can be seen from the charts below. The BoJ has practically eliminated price discovery from the Japanese bond markets and also prices for ETFs are determined by what the central bank purchases. The BoJ has increased its balance to a great extent without the Japanese economy imploding.

BoJ

So far, the Fed has been buying T-bills to keep the Treasury in funds and supplying liquidity to the repo market. In the event that the Fed starts buying stocks and ETFs, that could cause market distortions. As the Treasury needs money to cover deficit government spending, the Fed will probably continue its monetization of the federal debt, currently at the pace of $60 billion of T-bills monthly as mentioned above.

Given the precedents of the SNB and the BoJ, without even mentioning the QE efforts of the ECB, it seems that the Fed could also monetize a good portion of the national debt without causing undue stress. One real danger is deflation with excessively low interest rates. The EU and Japan have not succeeded in bringing up their inflation rates 2%, and their economies remain sluggish.

At the same time the Fed is financing the repo market with great amounts of money, hundreds of billions of dollars in liquidity is being supplied to the banks. There is really no exit strategy in place even if the Fed declares that the “exceptional” repo financing will end in 2020. That remains to be seen.

Since the Fed is injecting huge amounts of liquidity into the economy, one might reasonably expect that there would be more inflation as opposed to deflation. Of course, BLS statistics are “doctored,” and the real inflation rate for consumers is more like 5-6%. Workers are becoming poorer and poorer as wages have stagnated for years.

In the event of a downturn, it is also the case that the Administration has a Plunge Protection Team (PPT) ready to intervene in the markets should there be any serious developments. Many analysts assume that with the markets so overbought, there could be a correction of 5% in 2020, but that apparently is really nothing to worry about. Just buy the dip. There are very few analysts that see catastrophic market falls of 50%.

Another factor that investors should consider is that about 17% of stock market capital is concentrated in very few stocks, like Alphabet (Google) (GOOG) (GOOGL), Amazon (AMZN), Apple (AAPL), Facebook (FB) and Microsoft (MSFT). If the Administration undertakes anything that could break up the near monopolies that these companies have, that would have repercussions on the markets. This is something that the Fed is certainly aware of but about which not much can be done at the present time. The Fed cannot undertake legislative action to impose anti-trust laws on the internet giants.

Further lowering interest rates in order to align with the other major central banks like the ECB and BoJ is a possibility. The reasoning behind such a move is at the moment somewhat hard to discern as nominal inflation is still below the Fed’s 2% target. The Fed could still lower interest rates from the present 1.5%, and this would further support the equities market. So investors should watch out for any Fed decision to lower rates. Higher interest rates in the US, however, would tend to reinforce the US dollar in forex markets, thus making it more difficult for American manufacturers to compete in international markets. Higher interest rates on the part of the Fed would favour bonds over stocks. The Fed has stimulated the economy by lowering rates and reversing its policy of QT (Quantitative Tightening), namely decreasing its balance. At the same time increasing the basic rate from 1.5-1.75% could cause a liquidity crisis similar to what happened in December 2018. In fact, the Fed reversed its policy so as to save the stock markets from further falls.

If the Fed discontinues its support of the repo market, then the repo interest rate might again soar to 8% as it did in September 2019. It is therefore unlikely that the Fed will make good on its promise to suspend the repo program. The big banks will continue to be short of the reserves required by current regulations. This will make them more vulnerable in the event of a financial crisis. Consequently, the probability of a large scale bailout of the big banks as in 2008 is significantly higher. The Fed will not want a repeat performance of the failure of the Lehman Brothers bank. One may therefore expect an increase in the Fed balance for 2020, something already discounted by various market observers. See the chart below for the increase in the Fed balance.

The Bottom Line

What all this portends for investors is more market uncertainty. With volatility at low levels, investors become complacent and take on additional risk without hesitation. See the chart below for the volatility index. Synchrony Financial

Corporations continue to go into debt to finance share buyback programs with the result that corporate debt is at extremely high levels. See the chart below.

The message for investors is that they should get out of BBB corporate bonds as soon as possible, and that means now before any liquidity event brings on a corporate debt crisis. The current spread with better investment grade debt is so narrow that better positioning will more than compensate for marginal differences.

Regarding equities, one can assume that the Administration would prod the Fed to intervene in the event of a severe downturn in the stock markets. There is also the consideration that millions of Americans with their 401k accounts have invested heavily in the stock markets and that their pensions would suffer should the stock market tank. The PPT would almost certainly be activated to save the retirement savings of a large segment of the population.

Even though the present recovery is the longest on record and the stock markets have reached record highs without much regard for fundamentals, stock prices are likely to edge even higher as corporations continue to buy back their own shares. So it would seem that being long equities is a reasonable proposition. The real question is to what extent corporations can go into debt to finance share buybacks and whether there will be a liquidity crisis that could endanger the huge stack of debt that has been piled up. If the Fed should raise interest rates to fight inflation, which could trigger a market crash, the Fed would obviously be blamed for raising rates at the wrong time. The Fed could also be expected to intervene in markets should there be a real crisis. Leave it to the Fed to save the situation.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Data from third-party sources may have been used in the preparation of this material and WWS Swiss Financial Consulting SA (WWW SFC SA) has not independently verified, validated or audited such data. WWS SFC SA accepts no liability whatsoever for any loss arising from use of this information, and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user. Please consult your own professional adviser before taking investment decisions. The comments, opinions and analyses expressed herein are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy. All investments involve risk, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments.

Comments

[Aricool]

Here is the worst-case black Swan that I see as high probability. That is, China being the trigger of a US banking crisis, as follows: China BKs and NPL soar to breaking point as most all SEOs (and mid-sized rust-belt/industrials) become zombie companies where they (soon) begin taking debt just to pay interest on debt and rolling over debt becomes prohibitive as spreads widen. Cascade of BKs hit like a wave, hastened by a blackhole of fake collateral and cross-party indemnification guarantees and surging USD, which quickly hits Tier 1 banks forcing them to tighten credit causing widescale layoffs and drop in PMI. This forces PBOC to either do a full bank bailout to the tune of at least $2T but up to $3-4T. They either use all their FX reserves or print money out of control. Either way the Yuan collapse, hastened by a mass exodus of Foreign USD money (already starting) as manufacturing relocates, FDI is called back, and derivatives/carry trades are closed. As the Yuan has a massive devaluation there will be massive capital flight to Tier 1 foreign cities real-estate (despite current draconian capital controls). The EUR likes takes a dive too. In the US, a lot of bad bets go wrong and ‘risk on’ bets are closed all at once and collateral calls start happening at all levels. As the collateral calls spread to Tier 1 banks they (in survival mode) turn to ‘risk off’ credit, which causes a recession b/c autos, industrials, and housing are too weak to support any growth. The US collateral calls start exposing the widespread use of rehypothecated USTs (and other supposed Tier 1 collateral) causing inter-bank short term lending spreads (esp. in repo) to blow out slowing down or freezing money to the markets and economy. The Fed tries to back stop this, but finds that repo and QE operations are just a drop in the bucket of the $60T “risk on” derivatives that the banks have written and are getting closed out or have to be paid out.

I suspect the markets would crash before the Fed figures out any suitable damage control. I suspect they would have to follow Japan’s footsteps and start directly (or via repo) buying most of the stock market and toxic UST & MBS assets, likely doubling its balance sheet and effectively monetizing most of the stock and housing market. This then corners the youth to hate there stupid/greedy parents that created and dumped this shit onto them. They push the US into pure socialism and wealth of upper class is redistributed to the rest.

I think there is some evidence to support that black swan scenario. That is, the Fed cannot set or control its own IOER or target rates and just chases them up/down after the PDs (et. al.) drive the EFF spread. Also, evidenced by the PDs avoiding funding the more lucrative repo markets. Also, evidenced by the Fed being blind-sided by the repo market collapse at all and the scale of it, still lasting today and counting. Hence, they are obviously clueless. Also, evidenced by the Fed doing a 180 from 'normalizing rates in strong economy' to 'recession & stocks collapse coming, preemptive slashing rates'.
JS details the IOER/EFF evidence very well here:
www.realclearmarkets.com/...

I suppose the demise of the American experiment is at great risk, esp. as the populous loses trust in all branches of government and institutions because they have been trained to hate each other for the political power gains of and wealth transfers to the upper class… I do not expect this ends well for the markets, or the people… I’m shifting much of my assets to real-estate in Tier 1 capital flight cities as my best hedge.

[WWS Swiss Financial Consulting SA]

Thank you for the lengthy comment.There are of course many situations that could help to spark a crisis, like overvalued equities and excessive corporate debt besides the enormous amounts of derivetives in the markets. It is, however, to be expected that the Administration would try to avoid having a downturn become ruinous. The PPT would take measures to stabilize markets. The Fed could possibly intervene in the market by acquiring futures indexes. It is to be expected that the Fed will monetize a lot more of the federal debt. With the low interest rate environment currently in vogue, inflation could still develop into hypeinflation, but that remains to be seen.

[David de los Ángeles Buendía]

Hello @WWS Swiss Financial Consulting SA ,

1) You wrote: "The Fed is providing liquidity to the Treasury currently at about $60 billion a month by purchasing T-bills."

The Federal Reserve Bank (FRB) does not purchase United States Treasury (UST) securities from the UST. When the FRB conducts Open Market Operations (OMO), all they do is conduct an auction (or more precisely a reverse auction). They announce what UST that they would like to buy, and then the owners of UST securities make an offer to sell those securities to the FRB at a given discount. The bids / offers that meet the needs of the FRB, are purchased. OMO has no impact on UST liquidity.

2) You wrote: "There are various outcomes that may result from the present situation as there are various measures that the Fed could implement. One is to turn to outright purchase of stocks and ETFs in case of a market downturn."

The FRB does not have legal authority to purchase stocks or Exchange Traded Funds (ETF). Section 14 of the Federal Reserve Act (FRA) limits what the FRB)can purchase through OMO [1]. In particular 2(b) limits the FRB to only very low risk government issued bonds, notes, bills, &c. The FRA prohibits the FRB from purchasing stocks.

More to the point, what would be the point of the FRB purchasing EFTs? The Bank of Japan purchases EFTs because it has run out of other assets to purchase. This is not the situation in the United States. The FRB owns a small percentage of all available UST securities. There is thus no reason for the FRB to want to purchase EFTs.

[1] www.federalreserve.gov/...

[2] www.brookings.edu/...

[kkvakk]

Hi @David de los Ángeles Buendía 
You like this stuff, I do too, so I want to run this idea by you:
-The Fed creates Central Bank Reserves, also called Federal Reserve Coin, or simply 'Reserves'.
-Suppose banks consider these Reserves the ultimate liquidity as it can settle payments outside of market hours, and that after 2008, banking is based on this and not unsecured interbank credit (which is dead).
-The Fed thought banks would prefer to hold Treasuries, but the big 5 hold 90% of the Fed-created Central Bank Reserves, and in September the Fed found out that these banks stubbornly held on to Reserves and did not want to lend them out against collateral even overnight.

Then:
-Production is what matters, hence companies are THE economy.
-They are valued/measured in money, which is leveraged Reserves.
-SP500 = Reserves x 16.66.
-A 6% leverage ratio makes for 16.66 times leverage."...a subset of eight of the largest and most complex U.S. banks ... must meet an requirement of 5% at the holding company level and 6% at the depository level." (from fas.org/... 

SP500 = Reserves x 16.66.
What do you think?
If you are interested I can show you how it fit in April, July and December last year. And how it gave the bottom last Friday.
And where it will be in April unless something happens to break this relationship.

-With QT, the Fed reduced outstanding Reserves.

-At end April 2019, total Reserves (fred.stlouisfed.org/...) were 1.560T. Leveraged it becomes 26.0T. Total market cap of SP500 also reached a high of 25.8T on 30th of April, before falling 10% into the summer.

-At end July Reserves were 1.513T, leveraged= 25.2T 
SP500 (market float) also topped out at 25.2T on July 27th.
Market float is all the stocks that are free to trade (not held by the issuing company).
-At end December Reserves were 1.630T, leveraged= 27.15T
SP500 (market float) was also on 1st of Jan =27.16T

To calculate the level of SP500 as indicated by Reserves, simply multiply by Reserves in billions (instead of trillions) per 2. Because SP500 market float is 'points divided by 120'. 
Example: 1.1.2020 SP500 was 3260, divided by 120 makes 27.16T like above.

So Reserves (in trillions) x 16.66 X 120 = Reserves (in trillions) x 2OOO = Reserves (in billions) x 2 =SP500(market float)

I can explain it to you better if you find the math tedious, but it is very simple.
Now, since September, the Fed creates new Reserves www.newyorkfed.org/...
+30B in Oct, +60B in Nov, +60B in Dec, +67.5B in Jan

On September 18th, at the very height of the Repo crisis (lack of Reserves) bank's Reserves were 1386B fred.stlouisfed.org/...
This was a 'crisis' Reserve level, meaning the economy did not have room to grow further.
1386+30+60+60+67.5 in new Reserves makes 1603.5B = SP500 at 3207 
The low last friday, 31. Jan, SP500 was 3213.
So SP500 did not break below 'crisis level + new Reserves'.

Also, at end Wednesday last week, Reserves were 1612 = SP500 at 1624. The week closed at 3228.
fred.stlouisfed.org/...

The Fed will add 60B Reserves each month out April and then taper.
Unless SP500 breaks the lower channel (from Sept 18th +++ as described above), the trend is up and SP500 could hit 3600-3700 in end April.

What do you think?

[David de los Ángeles Buendía]

Hello @kkvakk ,

1) You wrote: "-The Fed creates Central Bank Reserves, also called Federal Reserve Coin, or simply 'Reserves'."

I would disagree with this description. Bank in the United States have to have reserves and have had them for more than 200 years. The question is where are those reserves stored? Banks that are members of the Federal Reserve Bank (FRB) store some of their reserves in the vaults of the FRB but others they store in their own vaults. The reserves held in the banks own vaults may be "Vault Cash" or they may be in the form of United States Treasury (UST) securities. Reserves in the form of UST securities are less liquid than vault cash or FRB held reserves. When the FRB conducts Open Market Operations (OMO), they conduct an auction and purchase UST securities from banks and give the bank FRB reserves in exchange. The net effect is to both move more bank reserves into the FRB vaults and out of the banks own vaults which also increases in liquidity of the bank reserves overall. The FRB does not *create* the reserves, it merely facilitates the *transfer* or reserves from banks to the FRB.

2) You wrote: "Suppose banks consider these Reserves the ultimate liquidity as it can settle payments outside of market hours, and that after 2008, banking is based on this and not unsecured interbank credit (which is dead)."

It is true that loans directly between banks has declined significantly since 2008 but this largely because so many banks have moved their reserves from their own vaults to the FRBs vaults. They can now lend each other reserves held by the FRB instead of direct bank to bank loans.

3) You wrote: "The Fed thought banks would prefer to hold Treasuries, but the big 5 hold 90% of the Fed-created Central Bank Reserves, and in September the Fed found out that these banks stubbornly held on to Reserves and did not want to lend them out against collateral even overnight."

It is certainly true that the repurchase market has been very tight. There is considerable debate about why this is the case. The immediate issue is that there are not enough reserves that are liquid enough and so banks have been reluctant to loan their reserves out lest they be caught short as occurred in the fall of 2008. This is, in my opinion, the result of an impending recession. The 10 year - 3 month UST securities spread (aka the UST Yield Curve) has inverted twice in the last twelvemonth signaling a recession is approaching. It is very common for interest rates all sorts of short term credit instruments to rise before a recession.

[kkvakk]

"When the FRB conducts Open Market Operations (OMO), they ... give the banks FRB reserves in exchange"

We are saying the same thing. The Fed gets an asset (treasury paper) which it pays for with a liability (Central Bank Money).

"The 10 year - 3 month UST securities spread (aka the UST Yield Curve) has inverted twice in the last twelvemonth signaling a recession is approaching".

Yep, I agree.
The 10 year - 2 year is the one banks are watching according to this brilliant article:
seekingalpha.com/...

[katmandu100]

What is your opinion that the SNB and BOJ buy ETFs?
Looks like a high risk.
Excellent data and commentary Swiss.

[David de los Ángeles Buendía]

Hello @katmandu100 ,

They are indeed higher risk purchases compared to government guaranteed securities. However the Japanese economy is in a situation where the Bank of Japan believes that it needs to take greater risks. The Federal Reserve Bank (FRB) owns about 13% of all United States Treasury securities while the BOJ owns about 43% of the Japanese government issued securities. The BOJ has a balance sheet beyond 100% of gross domestic product which is much more than the 18% of GDP that the FRB owns. The BOJ faces much greater deflationary pressures than the FRB so they believe that they need much more aggressive, and thus riskier, monetary position.

[WWS Swiss Financial Consulting SA]

ETFs are obviously riskier than US Treasuries. The SNB and BoJ have different policies but intervene on the markets. The SNB sells Swiss francs on the market and buys euros with the purpose of weakening the Swiss franc in Forex markets so that Swiss companies can compete in international markets. This is clearly currency manipulation. The BoJ wants a stable market and a stable economy and tries to stimulate the Japanese economy.