Looks Like the Fed’s Been Duped – but It Hasn’t “Lost Control”

Rumors of the U.S. Federal Reserve's demise - in part because it was "duped" by the biggest bank in the United States - have been greatly exaggerated, though headlines would have us believe otherwise.

MarketWatch declared in April, "The Federal Reserve Has Lost Control of the Financial Markets."

The Wall Street Journal asked in June, "Has the Fed Lost Its Mojo?"

Not only has there been no letup, but fearmongering headlines are being ratcheted up.

Just last week, on Dec. 18, The Economist, with a graphic of a fire extinguisher in the shape of a dollar sign poised over rising flames, cautioned, "Despite the Fed's Efforts, the Repo Market Risks More Turbulence."

Repos (repurchase agreements) are short-term borrowing facilities traded in the fed funds market, where banks and other systemically important financial players borrow from each other. It is frightening that they blew up in September - right under the Fed's nose.

It's even more frightening that the turn of the year could put exponentially more pressure on repo rates, and spiking rates could force selling - with continued selling as margin calls force asset prices lower and lower.

Once again, it looks like we're looking over the edge of an abyss at potentially huge market losses.

But the truth is the Fed hasn't lost anything. At least not yet.

Maybe the Fed was duped by the biggest bank in the United States into restarting quantitative easing (QE). Or maybe it saw what was happening and let it happen to scare the hell out of banks and overleveraged hedge funds.

No one knows the truth there. The Fed's never going to tell.

But, the "Fed's lost control" narrative is fake news. Sure, one hand came off the tiller, but it still has control of the ship. At least for now.

Let's take a closer look...[mmpazkzone name="in-story" network="9794" site="307044" id="137008" type="4"]

Here's What Really Happened

The potent narrative that the Fed's "lost control" spiked in September. That's when the fed funds market - the market where the Fed targets interest rates that banks charge each other for overnight loans - blew up.

News broke quickly that some banks had to pay as much as 9% on repos even after the Fed had lowered the fed funds rate (the rate banks pay on repos) to between 1.75% and 2%.

Why would banks have to pay so much in a market the Fed's supposed to control with an iron fist? Had they lost control over the fed funds market and over the fed funds rate? Had the Federal Reserve lost control over how it sets interest rates across the economy?

What happened on Monday, Sept. 16, 2019, was that banks were simply short of cash, resulting from an unusually large auction of Treasuries the Friday before that had to be paid for on Monday. This was then combined with corporations drawing down bank balances to pay quarterly tax bills, leaving banks short of the cash they needed by the end of the day to meet mandated reserve requirements.

As banks scrambled to borrow from each other, they discovered there wasn't the usual amount of cash available to borrow, and they had to pay dearly for what was there.

Maybe the Fed Has a Partner in Crime - or Maybe It Was Played

So, how could banks not be prepared and have enough cash to meet withdrawals and reserves? How could the Fed not have known the fed funds market was prone to a cash crunch?

It turns out that the biggest bank in the country, JPMorgan Chase & Co. (NYSE: JPM), was doing something very few people knew about. But the Fed sure knew what it was up to.

Since the beginning of the year, JPM had been cutting its loan portfolio and repositioning its balance sheet, buying longer-maturity Treasury bonds, to the tune of $350 billion.

According to Reuters, which used public data while conducting its analysis of what really happened in the fed funds market, JPM, which had been the lender-of-second-to-last resort in the fed funds market by using the cash it had on deposit at the Federal Reserve (some of its "excess reserves") to buy Treasuries, dramatically shrank the cash it had been lending in the repo market.

The sobering truth is it only took one bank's drawdown of liquidity in the fed funds arena to cause the spike in repo borrowing costs.

To ameliorate the devastating liquidity crunch, the Fed had to pump tens of billions of dollars into the market by restarting quantitative easing - only this QE would not be the old QE they announced.

And indeed, it's not.

The new QE has the Fed buying less than one-year maturity T-bills from banks to supply them with cash, not coupon Treasuries. That's a big difference. T-bills are not T-bonds.

What's worrisome is the Fed buying at least $60 billion to $75 billion of T-bills a month to flood the fed funds market with cash to ease the pain caused by JPMorgan's huge liquidity withdrawal.

Sure, the truth is the Fed knew what JPMorgan was doing, it could see JPM was withdrawing excess reserves, it could see the fed funds market tightening as liquidity was being siphoned off. It knew it was going to have to restart QE, and for all intents and purposes, make it a semi-permanent policy tool by which it conducts and justifies its monetary control practices.

As Zero Hedge said at the beginning of October, "It also explains why Jamie Dimon said, just days after the Sept. 16 repo shock, that the Federal Reserve did the 'right thing' in injecting funds to support overnight funding needs for banks."

The Fed wasn't duped. It was aided and abetted by JPMorgan to justify the expansion of its own balance sheet.

But there's a catch. Buying T-bills ain't gonna cut it.

Banks, especially JPM, have been buying coupon Treasuries, and they want the Fed to buy those assets from them, like they did in the old QE days. Why? Because buying Treasuries is a trade - a moneymaking trade.

If JPM gets the Fed to restart the real QE, the Fed's going to be buying JPM's coupon bonds at higher and higher prices, handing the big bank gigantic profits on its clever trade.

Clever? It sure is.

The Fed was going to have to restart QE anyway (I'll tell you the dirty truth about that soon). The Fed knew it, and JPM knew it. It's just that JPM had the balance sheet and moxie to front-run the Fed and force it to intervene in the fed funds market.

JPM didn't expect the Fed to screw up its trading strategy and buy T-bills; it wants the Fed to buy the coupon bonds it's been amassing all year. And that is the short-term problem markets face at the "turn" coming up.

Year-End Jitters

Coming into year-end - or the "turn," as it's called - banks are going to find themselves short of the cash they need to meet reserve requirements, and they're going to have to borrow in the fed funds market. So are hedge funds, which must mark their positions at the turn and must constantly rollover the loans they get in the fed funds market.

Because the Fed didn't want to look like it had lost control and didn't want to look like it was restarting the old QE, it flushed up the fed funds market with T-bill repos.

Even though it's going to add in about $500 billion into the fed funds market over the next few weeks, that may not be enough to make the turn smooth.

A lot can go wrong at the turn, and the Fed knows it. That's why it's adding so much liquidity. And because it's going to have to restart the old coupon-buying QE in short order, whatever happens in the short run around the turn, markets are going to keep going up.

It'll be like déjà vu all over again. The fed will expand its balance sheet, and stocks will go up.

But maybe not at the turn.

We are coming into a very dangerous turn for markets, bonds, and stocks. A lot can go wrong very quickly, which is why I've got two cheap, smart trades - call them insurance plays - to make going into year-end a lot smoother.

Here's What You Need to Do

If there's a serious blowup in the fed funds market and repo rates soar, banks and hedge funds are going to have to get their hands on cash fast. And the most liquid, easiest to sell assets are Treasuries.

Hard selling of Treasuries will knock their prices down. Even if it's just for a few days, the right insurance plays could turn into a few big winners.

That's why I'm recommending buying ProShares UltraShort 20+ year Treasury ETF (NYSEArca: TBT). This inverse ETF goes up in price if Treasury prices fall.

The smart play is buying TBT Jan. 17, 2020 $29 calls and paying around $0.10 for them.

If the Treasury market sells off, you can make 50%, 100%, or more, depending on how hard prices drop.

Another insurance play to make money on if markets turn sour would be to buy calls on the VIX.

The VIX is trading around 12, so any panic selling in the equity markets would cause the VIX to soar. Buying some $20 strike price calls there isn't a bad play either.

But don't get greedy if the turn yields panicky selling. Take your profits on your insurance plays, and get ready to ride the markets higher when the Fed comes to the rescue and proves the fake headlines about its demise are greatly exaggerated.

At least for another few quarters or years...

Stay tuned for more as I continue revealing the false market narratives out there and showing you what's really going on and how to stay ahead of it all to profit.

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