The Fed has begun to accelerate its balance sheet shrinkage according to the schedule it set forth last September. Not surprisingly, the effects are beginning to be felt in the markets, just as I had warned. Only the timing was in question, but my technical work took care of that, and it got us heavily short by the time the slide began on Jan. 29, reaching 90% short on Feb. 3.
This balance sheet shrinkage program, which the Fed calls "normalization," actually removes money from the banking system and financial markets. It is the opposite of quantitative easing (QE), so we may as well call it quantitative tightening (QT).
The rate of withdrawal doubled in January and will go up by $10 billion per month every quarter until it hits $50 billion per month in October. If $20 billion a month in QT can cause the kind of damage we saw over the past two weeks, what would $50 billion do? Think about it.
When it comes to the interaction of monetary policy and the financial markets, it is the quantity of money, not the cost of money (interest rates) that matters. Considering that, this "normalization" program isn't "normal" at all. It is the most drastic tightening of money in history.
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The effects of this policy have begun to be felt in the financial markets. Bond yields have been soaring for months, and stock prices have crashed over the past two weeks.
Yields bottomed in September, when the Fed announced the policy, even though it didn't start until October. Then yields started going parabolic in December, a rise which has continued into February. Stocks finally succumbed on Jan. 29. There simply was no longer sufficient liquidity (money) in the system to support the manic blowoff in stock prices.
Wall Street pundits are calling the stock market plunge a "pullback" or a "correction." I say let's call a spade a spade. A 10% drop in prices over two weeks is not a "pullback." It is a crash. And remember, the Fed told us that this program of "normalization" is on autopilot. The Fed has told us that the policy is so set in stone that it refuses to even discuss it or mention it in future FOMC statements. So with Fed policy set to only get even tighter in the months ahead, the type of market action that we've seen in the past two weeks will happen again and again. This pattern won't end any time soon.
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We understood the significance and implications of this momentous Fed policy change even before it was announced in September. I warned last summer that it was coming because the trial balloons had been floated in the media. Even a couple years before that I had warned that when you see the trial balloons about shrinking the balance sheet, it would be time to take the idea of real tightening seriously.
Finally, I wrote right here in the last report on the Fed's balance sheet and banking indicators back in early January: "It hasn't happened yet, but at some point during this period of ratcheting up of the pressure, the stock market should start to roll over."
"At some point" started on Jan. 29. And it won't end any time soon. It calls for a trading strategy of shorting the rallies and an investment policy of, if not being largely short the market, at least being mostly in cash.
A Closer Look at the Fed's "Money Drain" - and How to Profit
Here's an overview of the asset side of the Fed's balance sheet this week, along with my interpretation of some of the implications.
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Over the four weeks ended Feb. 7, the Fed's assets fell by $25.3 billion. That represents the increase in the Fed's monthly draining operations from $10 billion to $20 billion in January.
Some variance is normal as the Fed adds assets in some weeks when no Treasuries are maturing, then sheds more when paper matures. The purchases are being reduced according to the schedule that the Fed published in September 2017. The reductions will increase in size every three months, but there will be weeks where even those reduced purchases slightly boost the balance sheet size for a week or two.
About two months after the initial publication of the schedule of balance sheet cuts, the Fed strangely announced that it would no longer publish the schedule of balance sheet reductions, nor discuss it in the FOMC statement. It was to become permanent and immutable until reserves reached a normal level relative to deposits in the banking system.
That translates to a tight reserve position where there are no excess reserves. The Fed is committed to draining cash from the banking system until it reaches that level of tightness. This is the most draconian policy action in Fed history, and the Fed refuses to discuss it! As if "nothing to see here, move along!" They have told us that this is a done deal, come hell or high water. Given this policy, I'd have to say that both are coming.
Since mid October, just before the first cuts, the Fed has shed just under $49 billion in assets. It started at the rate of $10 billion a month in October, and increased that to $20 billion per month in January.
The schedule calls for the Fed to take $30 billion per month out of the banking system in April, then $40 billion in July, and finally $50 billion per month in October. By the end of the year, the Fed will have withdrawn $450 billion from the banking system.
That's reverse QE, folks. Let's call it QT, or quantitative tightening. QT has the opposite effect of QE. QE added money to the markets. QT pulls it out. QE drove demand because it put cash into the accounts of primary dealers. QT doesn't pull cash directly from primary dealers, but it has the same effect because it denies dealers the funding they need to purchase Treasuries.
This is the same problem that caused the stock market to crash in 2008. The dealers were unable to maintain orderly markets because the Fed had denied them the cash they needed to do so. Consequently, we should not be surprised by the stock market action of the past two weeks. Nor should we be surprised if we see similar periods several times this year, or at least until the Fed reverses course on QT.
My recommendation beginning in September had been to raise cash in your portfolio by gradually and systematically selling a little stock each month. The goal was to reach a cash level of 60% to 70% (or more or less, depending on your personal circumstances) by the end of January. As time went on, I added that for those who had not begun to do so, the selling program should be started with the goal of getting to that cash level by the end of March. I also recommended a short "set it and forget it" trade, which you can get here.
At the end of January, I posted a report showing the similarity between the shape of the massive market blowoff since November 2016 and a collection of modern era bubbles and crashes. I suggested that it might be a good idea to accelerate our selling.
Now, with the damage that has occurred already and a reaction rally due, I'd alter that to say sell aggressively as the coming rally shows signs of rolling over. I believe that this is only the first warning shot of a new bear market. It isn't done with us yet, and it won't be until the Fed reverses its draconian policy. That's a long way off, given the Fed's stance that "normalization" is immutable.
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The post This Isn't a "Pullback," This Is a Crash. Here's How to Play It. appeared first on Lee Adler's Sure Money.
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.