Today, the moment I have been warning about finally arrived. The Fed announced that it would begin “normalizing” its balance sheet, probably later this year. Back on April 18, I wrote:
By late this year the Fed may have begun to implement its proposed policy of “normalizing” the balance sheet. That’s a nice way of saying “shrinking” the balance sheet. To do that the Fed is proposing to allow its Treasury holdings to mature and not be rolled over. It’s also proposing not replacing its MBS holdings as they are paid down.
By doing it slowly over several years, the Fed may be able to avoid crashing the market. I use the word “may” with reason. Any shrinkage of the Fed’s assets will increase the odds of an accident. Slow and steady tightening will act like the drip, drip, of a Chinese water torture. It will promulgate a bear market in stocks. Accidents do tend to happen in bear markets. The drip, drip, drip eventually drives the market into a panic.
I have written over the past few years since the Fed started talking about raising the Fed Funds rate that we’ll know the Fed is serious about tightening monetary conditions when it starts shrinking the balance sheet. Raising interest rates won’t stop a bubble, but removing money from the system will. Right now the Fed is in the signaling stage. They’re talking about it. When the Fed talks about an idea, it eventually gets around to doing it. The Street is already telling you it will be no big deal. Don’t believe it. I would be selling the rallies.
The fact that the Fed voted to raise the Fed funds rate to 0.75-1%, and to follow with more increases in the months ahead, is “irrelevant and immaterial.” Rising rates never stopped a bull market. I will show you the historical evidence on that point in a later report. But tightening the money supply did stop past bull markets and bubbles and will do so again. Central banks trigger both bull and bear markets based on how much money they decide to add or drain from the system. If you deprive a bubble of its fuel–excess cash– it implodes.
In the past, consumer price and wage inflation caused the Fed to tighten by either slowing or stopping the growth of its balance sheet or actually shrinking it. In both the 2000 market top and the 2007 top, it wasn’t consumer price inflation, but asset inflation that caused them to pull the punchbowl.
Today is no different. The Fed has made clear that, frankly my dear, it doesn’t give a damn about the below 2% PCE. At the same time it has had plenty to say about asset prices. It may not admit to targeting asset prices for a bubble piercing, but the public comments of Janet Yellen, other Fed governors, and District Fed presidents for the past year or so should leave no doubt that this is the focus of their concern.
So the Fed has decided to pull the plug on this bull market. This is the real deal. Stock prices should make little additional headway from here, but it will take time for the top to play out.
Typically, tops take 9-18 months to develop before the bottom drops out. We can’t yet pinpoint the timing of whether this top building process has already begun or if the clock starts now. If the market goes on to make new highs in the short run, then the clock would start from the beginning of the next rally. However, if it fails to make a new high over the next couple of months we’ll need to evaluate the chart pattern over the past several months to pick the most likely point where top building began. In that case the lead time to the breakdown would be shorter than if the market does reach a new high in the short run.
The Fed did say that it was making no changes to its balance sheet at this time. It will continue rolling over its maturing Treasury holdings and MBS that are paid down each month for the time being. But that may not be for very long. Here’s what Yellen said at her media circus today (source: Reuters):
“What I can tell you is that we anticipate reducing reserve balances and our overall balance sheet to levels appreciably below those seen in recent years but larger than before the financial crisis,” Fed Chair Janet Yellen said in a press conference following the release of the Fed’s policy statement.
She added that the balance sheet normalization could be put into effect “relatively soon.”
A survey of Primary Dealers revealed that a majority of them expected that the balance sheet reductions would be announced at the September 19-20 FOMC meeting. The Primary Dealers are communicating with the Fed all day every day, so this is likely to be correct.
Here is the Fed’s statement on “Policy Normalization”:
Addendum to the Policy Normalization Principles and Plans
All participants agreed to augment the Committee’s Policy Normalization Principles and Plans by providing the following additional details regarding the approach the FOMC intends to use to reduce the Federal Reserve’s holdings of Treasury and agency securities once normalization of the level of the federal funds rate is well under way.1
The Committee intends to gradually reduce the Federal Reserve’s securities holdings by decreasing its reinvestment of the principal payments it receives from securities held in the System Open Market Account. Specifically, such payments will be reinvested only to the extent that they exceed gradually rising caps.
- For payments of principal that the Federal Reserve receives from maturing Treasury securities, the Committee anticipates that the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month.
- For payments of principal that the Federal Reserve receives from its holdings of agency debt and mortgage-backed securities, the Committee anticipates that the cap will be $4 billion per month initially and will increase in steps of $4 billion at three-month intervals over 12 months until it reaches $20 billion per month.
- The Committee also anticipates that the caps will remain in place once they reach their respective maximums so that the Federal Reserve’s securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.
Gradually reducing the Federal Reserve’s securities holdings will result in a declining supply of reserve balances. The Committee currently anticipates reducing the quantity of reserve balances, over time, to a level appreciably below that seen in recent years but larger than before the financial crisis; the level will reflect the banking system’s demand for reserve balances and the Committee’s decisions about how to implement monetary policy most efficiently and effectively in the future. The Committee expects to learn more about the underlying demand for reserves during the process of balance sheet normalization.
The Committee affirms that changing the target range for the federal funds rate is its primary means of adjusting the stance of monetary policy. However, the Committee would be prepared to resume reinvestment of principal payments received on securities held by the Federal Reserve if a material deterioration in the economic outlook were to warrant a sizable reduction in the Committee’s target for the federal funds rate. Moreover, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.
This is the Boa Constrictor method of monetary policy. It will gradually squeeze the bull market to death. The program will increase the cuts to its balance sheet holdings from a total of $10 billion a month to $50 billion a month in quarterly increments over the course of a year.
Don’t believe the pundits who say that this won’t hurt the stock market. $10 billion a month in the first quarter of the program may not do much, but $50 billion a month should be the spine crusher for this bull.
First it means that the Treasury will need to go into the market to issue additional $30 billion per month in new Treasury supply.
In addition, dealers and investors and dealers will need to absorb $20 billion per month more in regular MBS issuance than they would have when the Fed was buying in the market.
This is a critical factor. The Fed has been buying its replacement purchases of MBS directly from the Primary Dealers. That has cashed out the dealers every month on a guaranteed basis at rates of up to $45 billion a month as recently as early this year to about $25 billion a month over the past couple of months. The removal of that guaranteed cash flow from the dealers will cause them to be less active on the bid side of other markets. They just want have as much cash to play with.
Make no mistake. The Fed has decided to end this asset bubble. However, it believes as always that it can manage a soft landing. History shows that most of the time when it tightens with that belief, it gets an ugly surprise.
There’s time for one final blowoff before the Fed begins the tightening process. There may be a rally or two after that before the big breakdown, but in any case, sell the rips.
This report is derived from Lee Adler’s Wall Street Examiner Pro Trader Macro Liquidity Report.
Lee first reported in 2002 that Fed actions were driving US stock prices. He has tracked and reported on that relationship for his subscribers ever since. Try Lee’s groundbreaking reports on the Fed and the Monetary forces that drive market trends for 3 months risk free, with a full money back guarantee. Be in the know. Subscribe now, risk free!