This
week’s landmark Federal Open Market Committee decision to launch
quantitative tightening is one of the most-important and
most-consequential actions in the Federal Reserve’s entire 104-year
history. QT changes everything for world financial markets
levitated by years of quantitative easing. The advent of the QT era
has enormous implications for stock markets and gold that all
investors need to understand.
This
week’s FOMC decision to birth QT in early October certainly
wasn’t a surprise. To the Fed’s credit, this unprecedented paradigm
shift had been well-telegraphed. Back at its mid-June meeting, the
FOMC warned “The Committee currently expects to begin implementing a
balance sheet normalization program this year”. Its usual FOMC
statement was accompanied by an addendum explaining how QT would
likely unfold.
That
mid-June trial balloon didn’t tank stock markets, so this week the
FOMC decided to implement it with no changes. The FOMC’s new
statement from Wednesday declared, “In October, the Committee will
initiate the balance sheet normalization program described in the
June 2017 Addendum to the Committee’s Policy Normalization
Principles and Plans.” And thus the long-feared QT era is now
upon us.
The
Fed is well aware of how extraordinarily risky quantitative
tightening is for QE-inflated stock markets, so it is starting
slow. QT is necessary to unwind the vast quantities of bonds
purchased since late 2008 via QE. Back in October 2008, the US
stock markets experienced their first panic in 101 years.
Ironically it was that earlier 1907 panic that led to the Federal
Reserve’s creation in 1913 to help prevent future panics.
Technically a stock panic is a 20%+ stock-market plunge within
two weeks. The flagship S&P 500 stock index plummeted 25.9% in
just 10 trading days leading into early October 2008, which was
certainly a panic-grade plunge! The extreme fear generated by that
rare anomaly led the Fed itself to panic, fearing a new depression
driven by the wealth effect. When stocks plummet, people get scared
and slash their spending.
That’s a big problem for the US economy over 2/3rds driven by
consumer spending, and could become self-reinforcing and snowball.
The more stocks plunge, the more fearful people become for their own
financial futures. They extrapolate the stock carnage continuing
indefinitely and pull in their horns. The less they spend, the more
corporate profits fall. So corporations lay off people exacerbating
the slowdown.
The
Fed slashed its benchmark federal-funds interest rate like mad,
hammering it to zero in December 2008. That totally exhausted the
conventional monetary policy used to boost the economy, rate cuts.
So the Fed moved into dangerous new territory of debt
monetization. It conjured new money out of thin air to buy
bonds, injecting that new cash into the real economy. That was
euphemistically called quantitative easing.
The
Fed vehemently insisted it wasn’t monetizing bonds because QE would
only be a temporary crisis measure. That proved one of the biggest
central-bank lies ever, which is saying a lot. When the Fed buys
bonds, they accumulate on its balance sheet. Over the next 6.7
years, that rocketed a staggering 427% higher from $849b
before the stock panic to a $4474b peak in February 2015! That was
$3625b of QE.
While the new QE bond buying formally ended in October 2014 when the
Fed fully tapered QE3, that $3.6t of monetized bonds remained on the
Fed’s balance sheet. As of the latest-available data from last
week, the Fed’s BS was still $4417b. That means 98.4% of all
the Fed’s entire colossal QE binge from late 2008 to late 2014
remains intact! That vast deluge of new money created remains out
in the economy.
Don’t let the complacent stock-market reaction this week fool you,
quantitative tightening is a huge deal. It’s the biggest market
game-changer by far since QE’s dawn! Starting to reverse QE via QT
radically alters market dynamics going forward. Like a
freight train just starting to move, it doesn’t look scary to
traders yet. But once that QT train gets barreling at full speed,
it’s going to be a havoc-wreaking juggernaut.
QT
will start small in the imminent Q4’17, with the Fed allowing $10b
per month of maturing bonds to roll off its books. The reason the
Fed’s QE-bloated balance sheet has remained so large is the Fed is
reinvesting proceeds from maturing bonds into new bonds to keep that
QE-conjured cash deployed in the real economy. QT will slowly taper
that reinvestment, effectively destroying some of the
QE-injected money.
These monthly bond rolloffs will start at $6b in Treasuries and $4b
in mortgage-backed securities. Then the Fed will raise those
monthly caps by these same amounts once a quarter for a year. Thus
over the next year, QT’s pace will gradually mount to its full-steam
speed of $30b and $20b of monthly rolloffs in Treasuries and MBS
bonds. The FOMC just unleashed a QT juggernaut that’s going to run
at $50b per month!
When
this idea was initially floated back in mid-June, it was far more
aggressive than anyone thought the Yellen Fed would ever risk. $50b
per month yields a jaw-dropping quantitative-tightening pace of
$600b per year! These complacent stock markets’ belief that
such massive monetary destruction won’t affect them materially is
ludicrously foolish. QT will naturally unwind and reverse the
market impact of QE.
This
hyper-easy Fed is only hiking interest rates and undertaking QT for
one critical reason. It knows the next financial-market crisis is
inevitable at some point in the future, so it wants to reload
rate-cutting and bond-buying ammunition to be ready for it. The
higher the Fed can raise its federal-funds rate, and the lower it
can shrink its bloated balance sheet, the more easing firepower it
will have available in the future.
But
QT has never before been attempted and is extremely risky for these
QE-levitated stock markets. So the Fed is attempting to thread the
needle between preparing for the next market crisis and
triggering it. Yellen and top Fed officials have been
crystal-clear that they have no intention of fully unwinding all the
QE since late 2008. Wall Street expectations are running for a half
unwind of the $3.6t, or $1.8t of total QT.
At
the full-speed $600b-per-year QT pace coming in late 2018, that
would take 3 years to execute. The coming-year ramp-up will make it
take longer. So these markets are likely in for fierce QT headwinds
for several years or so. At this week’s post-FOMC-decision
press conference, Janet Yellen took great pains to explain the FOMC
has no intentions of altering this QT-pacing plan unless there is
some market calamity.
Yellen was also more certain than I’ve ever heard her on any policy
decisions that this terminal $50b-per-month QT won’t need to be
adjusted. With QT now officially started, the FOMC is fully
committed. If it decides to slow QT at some future meeting in
response to a stock selloff, it risks sending a big signal of no
confidence in the economy and exacerbating that very selloff! Like
a freight train, QT is hard to stop.
With
stock markets at all-time record highs this week, QT’s advent seems
like no big deal to euphoric stock traders. They are dreadfully
wrong. CNBC’s inimitable Rick Santelli had a great analogy of
this. Just hearing a hurricane is coming is radically different
than actually living through one. QT isn’t feared because it isn’t
here and hasn’t affected markets yet. But once it arrives and does,
psychology will really change.
Make
no mistake, quantitative tightening is extremely bearish for these
QE-inflated stock markets. Back in late July I
argued this
bearish case in depth. QT is every bit as bearish for
stocks as QE was bullish! This first chart updated from that
earlier essay shows why. This is the scariest and most-damning
chart in all the stock markets. It simply superimposes that S&P 500
benchmark stock index over the Fed’s balance sheet.
Between March 2009 and this week’s Fed Day, the S&P 500 has powered
an epic 270.8% higher in 8.5 years! That makes it the third-largest
and second-longest stock bull in US history. Why did that happen?
The underlying US economy sure hasn’t been great, plodding along at
2%ish growth ever since the stock panic. That sluggish economic
growth has constrained corporate-earnings growth too, it’s been
modest at best.
Stocks are exceedingly expensive too, with their
highest
valuations ever witnessed outside of the extreme bull-market
toppings in 1929 and 2000. The elite S&P 500 component companies
exited August with an average trailing-twelve-month
price-to-earnings ratio of 28.1x! That’s literally in formal
bubble territory at 28x, which is double the 14x
century-and-a-quarter fair value. Cheap stocks didn’t drive most of
this bull.
And
if this bull’s gargantuan gains weren’t the product of normal
bull-market fundamentals, that leaves quantitative easing. A large
fraction of that $3.6t of money conjured out of thin air by the Fed
to inject into the economy found its way into the US stock
markets. Note above how closely this entire stock bull mirrored
the growth in the Fed’s total balance sheet. The blue and orange
lines above are closely intertwined.
Those vast QE money injections levitated stock markets through two
simple mechanisms. The massive and wildly-unprecedented Fed bond
buying forced interest rates to extreme artificial lows. That
bullied traditional bond investors seeking income from yields into
far-riskier dividend-paying stocks. Super-low interest rates also
served as a rationalization for historically-expensive P/E ratios
rampant across the stock markets.
While QE directly lifted stocks by sucking investment capital out of
bonds newly saddled with record-low yields, a secondary indirect QE
impact proved more important. US corporations took advantage of the
Fed-manipulated extreme interest-rate lows to borrow aggressively.
But instead of investing all this easy cheap capital into growing
their businesses and creating jobs, they squandered most of it on
stock buybacks.
QE’s
super-low borrowing costs fueled a stock-buyback binge vastly
greater than anything seen before in world history. Literally
trillions of dollars were borrowed by elite S&P 500 US corporations
to repurchase their own shares! This was naked financial
manipulation, boosting stock prices through higher demand while
reducing shares outstanding. That made corporate earnings look much
more favorable on a per-share basis.
Incredibly QE-fueled corporate stock buybacks have proven the
only net source of stock-market capital inflows in this entire
bull market since March 2009! Elite Wall Street banks have
published many studies on this. Without that debt-funded
stock-buyback frenzy only possible through QE’s record-low borrowing
rates, this massive near-record bull wouldn’t even exist.
Corporations were the only buyers of their stocks.
QE’s
dominating influence on stock prices is unassailable. The S&P 500
surged in its early bull years until QE1 ended in mid-2010, when it
suffered its first major correction. The Fed panicked again,
fearing another plunge. So it birthed and soon expanded QE2 in late
2010. Again the stock markets surged on a trajectory perfectly
paralleling the Fed’s balance-sheet growth. But stocks plunged
when QE2 ended in mid-2011.
The
S&P 500 fell 19.4% over the next 5.2 months, a major correction that
neared bear-market territory. The Fed again feared a cascading
negative wealth effect, so it launched Operation Twist in late 2011
to turn stock markets around. That converted short-term Treasuries
to long-term Treasuries, forcing long rates even lower. As the
stock markets started topping again in late 2012, the Fed went all
out with QE3.
QE3 was radically
different from QE1 and QE2 in that it was totally open-ended.
Unlike its predecessors, QE3 had no predetermined size or duration!
So stock traders couldn’t anticipate when QE3 would end or how big
it would get. Stock markets surged on QE3’s announcement and
subsequent expansion a few months later. Fed officials started to
deftly use QE3’s inherent ambiguity to herd stock traders’
psychology.
Whenever the stock
markets started to sell off, Fed officials would rush to their
soapboxes to reassure traders that QE3 could be expanded anytime if
necessary. Those implicit promises of central-bank intervention
quickly truncated all nascent selloffs before they could reach
correction territory. Traders realized that the Fed was
effectively backstopping the stock markets! So greed flourished
unchecked by corrections.
This stock bull
went from normal between 2009 to 2012 to literally central-bank
conjured from 2013 on. The Fed’s QE3-expansion promises so
enthralled traders that the S&P 500 went an astounding 3.6 years
without a correction between late 2011 to mid-2015, one of the
longest-such spans ever! With the Fed jawboning negating healthy
sentiment-rebalancing corrections, psychology grew ever more greedy
and complacent.
QE3 was finally
wound down in late 2014, leading to this Fed-conjured stock bull
stalling out. Without central-bank money printing behind it, the
stock-market levitation between 2013 to 2015 never would have
happened! Without more QE to keep inflating stocks, the S&P 500
ground sideways and started topping. Corrections resumed in
mid-2015 and early 2016 without the promise of more Fed QE to avert
them.
In mid-2016 the
stock markets were able to break out to new highs, but only because
the UK’s surprise pro-Brexit vote fueled hopes of more global
central-bank easing. The subsequent extreme Trumphoria rally since
the election was an incredible anomaly driven by euphoric hopes for
big tax cuts soon from the newly-Republican-controlled
government. But Republican infighting is making that look
increasingly unlikely.
The critical
takeaway of the entire QE era since late 2008 is that stock-market
action closely mirrored whatever the Fed was doing. Ex-Trumphoria,
all this bull’s massive stock-market gains happened when the Fed was
actively injecting trillions of dollars of QE. When the Fed paused
its balance-sheet growth, the stock markets either corrected hard or
stalled out. These stock markets are extraordinarily
QE-dependent.
The Fed’s balance
sheet has never materially shrunk since QE was born out of that 2008
stock panic. Now quantitative tightening will start ramping up in
just a couple weeks for the first time ever. If QE is responsible
for much of this stock bull, and certainly all of the extreme
levitation from 2013 to 2015 due to the open-ended QE3, can QT
possibly be benign? No freaking way friends! Unwinding QE is this
bull’s death knell.
QE was like
monetary steroids for stocks, artificially ballooning this bull
market to monstrous proportions. Letting bonds run off the Fed’s
balance sheet instead of reinvesting effectively destroys that
QE-spawned money. QE made this bull the grotesque beast it is, so
QT is going to hammer a stake right through its heart. This
unprecedented QT is even more dangerous given today’s bubble
valuations and rampant euphoria.
Investors and
speculators alike should be terrified of $600b per year of
quantitative tightening! The way to play it is to pare down
overweight stock positions and build cash to prepare for the
long-overdue Fed-delayed
bear market.
Speculators can also buy puts in the leading SPY SPDR S&P 500 ETF.
Investors can go long gold via its own flagship GLD SPDR Gold Shares
ETF, which tends to move counter to stock markets.
Gold was hit
fairly hard after this week’s FOMC decision announcing QT, which
makes it look like QT is bearish for gold. Nothing could be farther
from the truth. Gold’s post-Fed selloff had nothing at all
to do with QT! At every other FOMC meeting, the Fed also releases a
summary of top Fed officials’ outlooks for future federal-funds-rate
levels. This so-called dot plot was widely expected to be more
dovish than June’s.
Yellen herself had
given speeches in the quarter since that implied this Fed-rate-hike
cycle was closer to its end than beginning. She had said the
neutral federal-funds rate was lower than in the past, so
gold-futures speculators expected this week’s dot plot to be
revised lower. It wasn’t, coming in unchanged from June’s with
3/4ths of FOMC members still expecting another rate hike at the
FOMC’s mid-December meeting.
This dot-plot
hawkish surprise totally unrelated to QT led to big US-dollar
buying. Futures-implied rate-hike odds in December surged from 58%
the day before to 73% in the wake of the FOMC’s decision. So
gold-futures speculators aggressively dumped contracts, forcing gold
lower. That reaction is irrational, as
gold has surged
dramatically on average in past Fed-rate-hike cycles! QT didn’t
play into this week’s gold selloff.
This last chart
superimposes gold over that same Fed balance sheet of the QE era.
Gold skyrocketed during QE1 and QE2, which makes sense since debt
monetizations are pure inflation. But once the open-ended
QE3 started miraculously levitating stock markets in early 2013,
investors abandoned gold to chase those Fed-conjured stock-market
gains. That blasted gold into a massive record-setting bear market.
In a
normal world, quantitative easing would always be bullish for gold
as more money is injected into the economy. Gold’s monetary value
largely derives from the fact its supply grows slowly, under 1% a
year. That’s far slower than money supplies grow normally, let
alone during QE inflation. Gold’s price rallies as relatively more
money is available to compete for relatively less physical gold.
QE3 broke that historical relationship.
With
the Fed hellbent on ensuring the US stock markets did nothing but
rally indefinitely, investors felt no need for prudently
diversifying their portfolios with alternative investments. Gold is
the anti-stock trade, it tends to move counter to stock
markets. So why bother with gold when QE3 was magically levitating
the stock markets from 2013 to 2015? That
QE3-stock-levitation-driven gold bear finally bottomed in late 2015.
Today’s gold bull was born the very next day after the Fed’s first
rate hike in 9.5 years in mid-December 2015. If Fed rate hikes are
as bearish for gold as futures speculators assume, why has gold’s
23.7% bull as of this week exceeded the S&P 500’s 22.8% gain over
that same span? Not even the Trumphoria rally has enabled stock
markets to catch up with gold’s young bull! Fed rate hikes are
actually bullish
for gold.
The
reason is hiking cycles weigh on stock markets, which gets investors
interested in owning counter-moving gold to re-diversity their
portfolios. That’s also why this new QT era is actually
super-bullish for gold despite the coming monetary destruction. As
QT gradually crushes these fake QE-inflated stock markets in coming
years, gold investment demand is going to soar again. We’ll
see a reversal of 2013’s action.
That
year alone gold plunged a colossal 27.9% on the extreme 29.6% S&P
500 rally driven by $1107b of fresh quantitative easing from the
massive new QE3 campaign! That 2013 gold catastrophe courtesy of
the Fed bred the bearish psychology that’s plagued this leading
alternative asset ever since. At QT’s $600b planned annual pace, it
will take almost a couple years to unwind that epic $1.1t QE seen in
2013 alone.
Interestingly the Wall-Street-expected $1.8t of total QT coming
would take the Fed’s balance sheet back down to $2.6t. That’s back
to mid-2011 levels, below the $2.8t in late 2012 when QE3 was
announced. Gold averaged $1573 per ounce in 2011, and it ought to
head much higher if QT indeed spawns the next stock bear. That’s
the core bullish-gold thesis of QT, that falling stock prices far
outweigh monetary destruction.
Stock bears are normal and necessary to bleed off excessive
valuations, but they are devastating to the unprepared. The last
two ending in October 2002 and March 2009 ultimately hammered the
S&P 500 49.1% and 56.8% lower over 2.6 and 1.4 years! If these
lofty QE-levitated stock markets suffer another typical 50% bear
during QT, huge gold investment demand will almost certainly
catapult it to new record highs.
These QE-inflated stock markets are doomed under QT, there’s
no doubt. The Fed giveth and the Fed taketh away. Stock bears
gradually unfold over a couple years or so, slowly boiling the
bullish frogs. So without a panic-type plunge, the tightening Fed
is going to be hard-pressed to throttle back QT without igniting a
crisis of confidence. As QT slowly strangles this monstrous stock
bull, gold will really return to vogue.
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The
bottom line is the coming quantitative tightening is incredibly
bearish for these stock markets that have been artificially
levitated by quantitative easing. QT has never before been
attempted, let alone in artificial QE-inflated stock markets trading
at bubble valuations and drenched in euphoria. All the
stock-bullish tailwinds from years of QE will reverse into fierce
headwinds under QT. It truly changes everything.
The
main beneficiary of stock-market weakness is gold, as the leading
alternative investment that tends to move counter to stock markets.
The coming QT-driven overdue stock bear will fuel a big renaissance
in gold investment to diversify stock-heavy portfolios. And the Fed
can’t risk slowing or stopping QT now that it’s officially
triggered. The resulting crisis of confidence would likely
exacerbate a major stock-market selloff. |