The Fed Sends Market Big, Fat Gift

The clouds part, and a crack of sunshine scatters the gloom…

Markets learned today the Federal Reserve may soon declare victory… and mothball its ambitious balance sheet reduction plans.

From today’s Wall Street Journal:

Federal Reserve officials are close to deciding they will maintain a larger portfolio of Treasury securities than they’d expected when they began shrinking those holdings two years ago, putting an end to the central bank’s portfolio wind-down closer into sight.

Does the Journal speculate to simply draw itself a crowd?

No — the news bears the invincible authority of the Federal Reserve itself:

“A lot of the heavy lifting has been done,” says Kansas City Fed President Esther George.

Unsurprisingly, stocks were up and away today…

The Dow Jones rose 184 points today

The S&P was up 22; and the Nasdaq, a thumping 91 points.

Still we wonder:

If a lot of the heavy lifting has been done, as Ms. George suggests… how strong are the arms doing the lifting?

The Federal Reserve worked its balance sheet from a pre-crisis $800 billion to roughly $4.5 trillion.

Quantitative tightening began in October 2017.

How much has it run off to date?

Some $400 billion — about 10% of the post-crisis onslaught.

But as recently as November, Jerome Powell claimed the business would continue on “autopilot.”

The autopilot was set to some $50 billion of monthly drawdowns this year — $600 billion by year’s end.

“In about three or four years,” said Mr. Powell, confidently, “we’ll be down to a new normal.”

But his comments tripped the warning bells, and the red lights began flashing.

Markets spiraled on his words… like an airliner that’s lost a wing.

And stocks came within a whisker of a bear market by Christmas.

Of course, the Federal Reserve said QT would have no market impact.

Like “watching paint dry,” was the specific analogue.

But was it coincidence the stock market suffered its worst year since 2008, shortly after QT’s onset?

It would seem not.

And it appears Mr. Powell has come around…

By early this month he was whistling a different, much sweeter melody.

At a Jan. 4 meeting of the American Economic Association Powell claimed the Fed would be “listening carefully” to markets.

He further pledged to announce a halt to QT “if needed,” adding, “We wouldn’t hesitate to change it.”

And as if by the magician’s wand… the Dow Jones climbed 400 points in the hours following the remarks.

Stocks have remained under the white magic three weeks running.

And today’s abracadabra only deepened the spell…

Coming out in favor of today’s dovish news is Krishna Guha, head of the global policy and central bank strategy team at Evercore ISI:

In our view this is the natural play for the Fed, which had to abandon the position that the balance sheet is on autopilot after the adverse market reaction in December… 

The Federal Reserve has long desired to return the balance sheet to “normal” — an aspiration reinforced by Powell’s November comments.

But what is “normal”? And how would they know?

Is it the pre-crisis $800 billion? Perhaps $1 trillion?

By its own telling, the Federal Reserve ranges it anywhere between $1.5 trillion and $3 trillion — still pretty handsome.

Well then, friends and countrymen, the balance sheet may remain abnormal for the duration, down to the last chapter.

This Guha fellow expects the Fed to halt at roughly $3.5 trillion — $500 billion above the highest official estimates.

We don’t know of course. Yet we arrive at one conclusion:

The Federal Reserve will never truly “normalize” its balance sheet — despite all gabble to the contrary.

Wall Street will simply not allow it.

But will it be enough to keep the show going?

Let us look backward for clues, so that we may look forward…

In June 1936, the Federal Reserve decided to start its own version of QT after years of accommodation.

It was time to return to “normal”… as it is today.

Christina Romer, former chair of the Council of Economic Advisers:

In 1936 the Federal Reserve began to worry about its “exit strategy.” After several years of relatively loose monetary policy, American banks were holding large quantities of reserves in excess of their legislated requirements. Monetary policymakers feared these excess reserves would make it difficult to tighten if inflation developed or if “speculative excess” began again on Wall Street.

Could not these words describe these past few years?

The Dow Jones peaked in February 1937 — 10 months after the business began.

It proceeded to drop some 10% over the next four months.

It then found its legs for one month.

The next two months it spent upon a seesaw — up and down, down and up.

Then down — and how.

The Dow Jones plunged nearly 50% the following eight months.

It spent the next 8.5 years shoveling out.

Now roll the calendar forward…

The Federal Reserve began QT in October 2017.

The Dow Jones peaked last Oct. 3 — not quite one year later.

Not 1937’s 10 months — but within hailing distance.

The market proceeded to sink nearly 20% early October–December.

The fall was steeper than 1937, but perhaps one month less in duration.

Let us go ahead and declare a draw.

But as in 1937, the Dow Jones has recovered this past month after its extended swoon.

So… what next?

Will the markets oscillate for the next two month… and then proceed to plummet nearly 50% for the following eight months?

The folks at Macro Capital reminded us of the chronology. More from whom:

So far the Dow is repeating the path of 1937, and this recent rally may be only a bear market trap for investors. It is a reminder to be cautious as 1937 shows just how quickly things can deteriorate as the Dow Jones industrial average dropped by almost 50% in eight months because of the Fed policy being caught. 

We have no idea if history will repeat — or even rhyme.

The Federal Reserve only reopened its medical bag of easy money in 1938 — after the damage.

Perhaps the dovish new QT comments will knock markets off 1937’s course.

But only the gods know. And they are silent.


Brian Maher
Managing editor, The Daily Reckoning

The Daily Reckoning