The Market’s Being Set Up For A Hard Fall

The market’s melt-up since the Feb. 11 interim low has been positively surreal. It has gone up 19% since that February low of 1,829 on the S&P 500.

But there’s nothing sustainable about it.

This latest rebound was the work of eyes-wide-shut day traders and robo-machines surfing on a thinner and thinner cushion of momentum. What comes next, in fact, is exactly what happens when you stop pedaling your bicycle. Momentum gets exhausted, gravity takes over and the illusion of stability is painfully shattered.

The simple truth is, the Fed’s long-running interest rate repression policies have caused systematic, persistent and massive falsification of prices all along the yield curve and throughout all sectors of the financial market.

The Fed is just systematically juicing the gamblers, and thereby fueling ever greater mispricing of financial assets and ever more dangerous and explosive financial bubbles. What we’re seeing now is the illusion of stability.

During this year’s final pulse of the great stock market bubble of 2009–2016, the illusion of stability was reflected in the complete collapse of the VIX Index or, as it is often called, the fear gauge.

Take a look at a chart from the last cycle, culminating in the crash of 2008. The Greenspan housing, credit and stock market bubbles were inflating. At the same time, volatility was steadily drained out of the market by increasingly more bullish and complacent traders.

Accordingly, between the stock market’s bottom in September 2002 and the first hints of the subprime crisis in February 2007, the VIX Index dropped relentlessly. In fact, it was then down by 75% to a bottom index value of 10.2 on the eve of the mortgage crisis.

When the financial bubbles began to implode, however, the VIX exploded. By Oct. 28, 2008 it had risen by 550%. Traders who saw it coming and got long volatility, or “vol,” made a fortune.

It just so happens that during the last few weeks, the VIX came close to its early 2007 low, touching 10.8 on an intraday basis. That meant that it had declined by 62% from its Feb. 11 level — and it had declined by 58% from its dramatic late-June spike at the time of the Brexit surprise.

In a word, by mid-August, the casino had become so complacent and fearless that you needed a motion detector to identify signs of life. At approximately noon on Aug. 16, in fact, the VIX Index literally did not move for upward of an hour.

Things are almost laughably quiet right now.

Fed funds futures are now showing a 32% chance of a September rate hike, despite the latest “good” jobs report and other supposedly good economic news. That’s up substantially from where it was just a few weeks ago, but it’s still just one in three.

But the larger question is why a tiny bump in interest rates should even matter at all.

After seven years of zero or next to zero interest rates, it must be truly wondered how supposedly rational adults can obsess over whether the another tiny smidgeon of a rate increase should be permitted this year or next, or whether the economy can tolerate a rise in the funds rate from 38 bps to 63 bps when it finally does move.

The difference is just irrelevant noise to the main street economy. It can’t possibly impact the economic calculus of a single household or business!

But then, again, the Fed doesn’t serve the main street economy. It lives to pleasure Wall Street.

Having pinned the money market rate at the zero bound for so long and with such an unending stream of ever-changing and silly excuses, the occupants of the Eccles Building are truly lost.

They do not even fathom that they are engaging in a word-splitting exercise no more meaningful to the main street economy than counting angels on the head of a pin.

Indeed, if they weren’t mesmerized by their own ritual incantation they would not presume for a moment that fractional changes of the money market rate away from ZIRP would have any impact on main street borrowing, spending, investing and growth.

So why does the Fed persist in this farcical minuet around ZIRP?

The principal reasons are not at all hard to discern. In the first instance, the Fed is caught in a time warp and fails to comprehend that the game of bicycling interest rates to heat and cool the macro-economy is over and done.

The credit channel of monetary transmission has fallen victim to “Peak Debt.” This means that the main street economy no longer gets a temporary pick-me-up from cheap interest rates because with tapped out balance sheets they have no further ability to borrow.

The only actual increases in household debt since the financial crisis has been for student loans, which are guaranteed by Uncle Sam’s balance sheet, and auto loans which are collateralized by over-valued vehicles.

Stated differently, home equity was tapped out last time and wage and salary incomes have been fully leveraged for years. So households have nothing else left to hock.

Accordingly, they now only spend what they earn, meaning that the Fed’s interest rate manipulations — which had potency 40 years ago — have no impact at all today. Keynesian monetary policy through the crude tool of money market rate pegging was always a one-time parlor trick.

Then why on earth do our monetary central planners cling so desperately to ZIRP?

The answer is they appear to believe that cheap money might still do a smidgeon of good. Besides, it hasn’t caused any consumer price inflation, or at least that’s what they contend — so where is the harm?

Well, yes. Doing a rain dance neither causes harm nor rain. Yet there is a huge difference. Zero interest rates are not even remotely harmless. They amount to a colossal economic battering ram because they transform capital markets into gambling casinos.

And the complacent casino is being set up for a fall when the battering ram hits.

The Fed is out of dry powder and out of time. And it could easily spook the market at its upcoming meeting on Sept. 20–21.

After what will be 93 months crouched on the zero bound, it will have no excuse not to raise rates by 25 basis points. Especially if it continues to be deluded by the false and lagging indicators of the BLS jobs report.

But the market has most definitely not “priced in” a rate hike. It will sell off violently if the Fed goes ahead and raises rates. This has been recently suggested by its key rate strategist and Goldman man on the case, Bill Dudley, president of the New York Fed.

On the other hand, if it punts until another time, that decision will come with new concerns. Concerns that continuing head winds from China, Europe and the rest of the world have the potential to seriously harm the struggling domestic recovery.

Even the day traders and robo-machines must know that the Fed is out of dry powder. It cannot go to subzero interest rates without triggering a Donald Trump-led domestic political conflagration. Nor can it abruptly shift to a huge new round of QE without confessing that $3.5 trillion of the same has been for naught.

In short, if it fails to raise rates and even hints at the risk of domestic recession, there will be pandemonium in the casino. The gamblers recognize that there will be no monetary fire brigade waiting at the exits.

Either way, Sept. 21 will be a day of reckoning. This time, I believe that the Fed’s desperate last resort to verbal intervention will fail, causing a market now living off the fumes of momentum to hit the skids.

Another September event could trigger volatility as well. On Sept. 26, Trump and Hillary will have their first presidential debate. The results of this debate could also blindside the market because at the moment Hillary Clinton is considered to be a shoo-in.

I beg to differ and have some personal experience with respect to what might be an October surprise.

Back in 1980 I was actually Ronald Reagan’s sparring partner in his Jimmy Carter debate rehearsals. I saw what can happen when a candidate finally gets the pulse of the country and scores big in the Presidential debates.

Reagan did that and came from way behind to win. There is no telling what Donald Trump will do, but at this stage of the game there is absolutely no reason to think that the market has it right and that Hillary has it in the bag.

Regards,

David Stockman
for The Daily Reckoning

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