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The Fed started shrinking its balance sheet in October 2017. It euphemistically named the program "balance sheet normalization." I call it "bloodletting," in honor of the medieval medical treatment for disease.
The Fed's Quantitative Easing (QE) program had caused asset markets, including stocks, bonds, housing, and commercial real estate, to become bloated and diseased as prices inflated relentlessly. They floated higher on a sea of the Fed's newly conjured money.
The Fed pumped that money directly into the accounts of the big shots who make the markets, known as "Primary Dealers." The Primary Dealers are appointed by the Fed to be its exclusive correspondents in the execution of monetary policy. They're also responsible for absorbing a significant portion of the Treasury's issuance of new bonds, notes, and bills. They mark that paper up and sell it to investors.
The Fed expanded the money supply by buying securities – U.S. Treasuries, Agencies, and Mortgage-Backed Securities (MBS) – directly from those Primary Dealers.
The dealers used the money to buy Treasury securities from the U.S. government. Since they are trading firms, they also used the cash to buy other bonds, as well as stocks, and occasionally exotic derivatives. Those cash injections helped to ignite and promote animal spirits among hedge funds and other massive leverage speculators, along with more conservative investment institutions. We saw the effect in the long-running big bull market. The policy of QE ultimately carried stock prices to extremes of valuation only seen at modern major market tops.
The Fed stopped QE in late 2014, but the stock market continued its bull run. That was partly because the Fed was still pumping a little money into dealer accounts through its MBS replacement purchase program.
Here's Why the Bull Rolled On
More importantly, in late 2014, the European Central Bank (ECB) started buying all manner of European government and corporate bonds hand over fist in a QE program that essentially took the hand off from the Fed when the Fed left the field. The same big banks that are Fed Primary Dealers also operate in cahoots with the ECB. That's how money printed in Europe by the ECB can instantly show up on Wall Street and in U.S. markets. That helped to keep stock prices inflated and rising.
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But the Fed went into reverse in October 2017, and the ECB also tapered its buying and will go to zero purchases this month. Its balance sheet will also begin to shrink. More money will leave the worldwide pool of market liquidity, which is just a fancy way of saying money available for investment.
Here's what that means for the market today, and what you can do to profit from the Fed while others follow Wall Street to portfolio destruction.
Central Banks Are Starving the Markets
The U.S. stock market is being starved of cash. At the same time, dealers and investors must absorb nearly $800 billion in new Treasury bills, notes, and bonds over the six months ending in March 2019. It won't get easier after that either. Treasury supply will pound the market at an average of $100 billion plus, month after month for years. And the Fed isn't there to buy, or finance the purchase of that paper, like it was from 2009 to 2014. The ECB and European banks won't be there either. And the Fed is making it even harder for the market to absorb all the new paper because it is pulling money out of the system.
Still, the stock and bond markets can and do rally from time to time, and those rallies can be ferocious, as we witnessed over the past week. Wall Street lives on the theory of "hope springs eternal." Bullishness is a way of life. An old friend of mine called it "hopium." The media and the market find ways to see hope in a few choice words from a Fed chair or a president. But words change nothing. Money talks. Words walk.
The name of the Wall Street game is "sell or starve." The purpose of the Street's sales job is to keep those trillions of everybody else's money, including your money, under the Street's management and control. It must do that so that it can extract massive fees, and yes, trading profits, from your capital.
It snags those trading profits by taking the other side of your trades. It encourages you and manipulates you to do its bidding with an endless stream of PR through house organs like CNBC and The Wall Street Journal. When mouthpieces of the Wall Street mob are recommending something for you to buy, you can bet that their trading desks are on the other side of that trade, selling it to you.
But here's the problem. The Fed is Wall Street's bank, its financier. The Fed stopped providing support, both overt and tacit, for Wall Street's game in October of last year. Since then, through Nov. 28, the Fed has shed $373 billion in assets. It has promised to continue to do so at the rate of $50 billion per month until the its balance sheet has reached a "normal" position.
About the Author
Financial Analyst, 50-year charting expert, finance + real estate pro, and market analyst; published and edited the Wall Street Examiner since 2000.