As far as the markets go, they've had an incredible run since 2009.
That's because the U.S. Federal Reserve bought more than $4 trillion worth of bonds and securities in the open market to flatten interest rates and buoy said markets.
But going forward, starting in September, the Fed's stopping its monthly purchases of billions of dollars' worth of bonds… and that could send the markets into a tailspin.
Today, I'm covering what Fed Chair Janet Yellen said in her recent Humphrey-Hawkins testimony to Congress. More importantly, I'm covering what she didn't say, and what could happen starting in September.
If you own stocks, you're going to want to take this seriously…
How the Fed Is Currently Propping Up Our Markets
The bottom line is that the Fed doesn't have any capital to speak of. It buys bonds on made-up credit.
When it purchases bonds in the open market, from the big bank "primary dealers" it deals directly with, it pays them by issuing electronic credits. Banks and dealers use those credits to make loans or buy more bonds and securities themselves, which the Fed comes back to them to buy, again and again.
That's how that game was played.
The direct winners in that game were, of course, the big banks who were crushed by the financial meltdown in 2008 and needed rescuing.
The secondary winners were the markets. With so much credit available to borrowers who wanted to buy stocks and to companies who wanted to buy back their own shares, the markets not only recovered, they went on a tear.
Not only did the Fed buy bonds banks couldn't sell to other banks (because none of the big banks were technically solvent and were afraid if they sold bonds or securities to other banks, they would never get paid), and not only did the Fed buy bonds and securities that were at the time almost worthless. The Fed lent banks money so they could buy more government bonds from the Treasury and in the open market, which the Fed would then buy from the banks.
All that bond buying by banks – which helped lift bond prices and lower interest rates, which they then sold to the Fed for a nice profit, left the Fed with a balance sheet laden with $4.5 trillion worth of bonds and securities.
While all eyes have been on the Fed's interest rate moves (especially the three interest rate hikes it's made over the past three quarters), the Fed's balance sheet's been off everyone's radar.
The process of "normalization," meaning letting interest rates rise from the artificially manipulated levels they were knocked down to, starts with the Fed hiking the fed funds rate.
The fed funds rate is the interest rate banks charge each other when they lend each other money overnight. After the three hikes the Fed induced, the fed funds rate is now between 1% and 1.25%. That's an annualized rate.
It's the only rate the Fed directly influences, but it influences all other rates along the yield curve for government bonds, corporate and junk bonds, and, of course, loans. Hiking that is the outward path to normalization.
But the 800-pound gorilla in the room, the Fed's enormous balance sheet, has to be reduced to some normal level if we are ever to have free markets again.
The Shadows in the Fed's Solution
About the Author
Shah Gilani is Chief Financial Strategist for Money Map Press and boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker. He helped develop what has become known as the Volatility Index (VIX) - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk and established that company's "listed" and OTC trading desks. Shah founded a second hedge fund in 1999, which he ran until 2003. Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see. On top of the free newsletter, as editor of The 10X Trader, Money Map Report and Straight Line Profits, Shah presents his legion of subscribers with the chance to earn ten times their money on trade after trade using a little-known strategy. Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on FOX Business' "Varney & Co."