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Financial Markets To Federal Reserve: Is That All You’ve Got??

So the Fed, as expected, cuts interest rates again. And – also again – Fed Chair Powell implies that he’s done cutting for a while. The financial markets – also once again – react like junkies contemplating their final hit.

Stocks are falling…

S&P 500 monetary delusion

…and Treasury yields are plunging, which is to say Treasury bond prices are rising as everyone goes “risk off”:

10 year Treasury monetary delusion

Which brings us back to the perennial question of how bad the withdrawal has to get before the Fed caves. This is monotonous, but also a nice, tradable pattern, one that seems obvious to everyone but the main players.

Consider the delusions now driving monetary policy:

• Fed governors appear to think they can stop cutting interest rates if they want, when in fact they can’t, ever. Rates must continue falling to make the debts taken on at past higher rates manageable. Put another way, in a financial system this overleveraged, there can be no “neutral” interest rate. Every rate is catastrophically high in the face of a mountain of bad debt and has therefore to be replaced by ever-lower rates to delay the eventual/inevitable deflationary Depression.

• Wall Street traders seem to think that easy money is a good thing for asset prices no matter how bubbly the assets’ valuation. This explains the near-universal bullishness among money managers, as evidenced by their willingness to be long at current prices. Their delusion is not so much wrong as one-sided. At cyclical extremes (like now), what easy money produces is volatility. So yes, asset prices can rise during the manic phase of the process, but they plunge commensurately when the market’s mood shifts and hot money stampedes for the exits. That day is coming.

• Trump appears to believe that bullying the Fed into negative interest rates “like the rest of the world” will produce an outcome different from the stagnation/chaos of those other countries. But it won’t because interest rates are price signaling mechanisms that, via the “cost of capital,” tell entrepreneurs and businesses how and where to invest. Move rates below zero and borrowing itself becomes a cash flow positive endeavor, making productive investment beside the point. This explains the ongoing leveraged buyout of US public companies via share repurchases, as executives choose to make their money the easy way.

Viewed from a slightly different angle, by the time rates turn negative, all the available projects with positive returns on capital will have been financed (since money was available all the way down; if a project wasn’t financed when credit cost 2% or 1%, then by definition that project wasn’t worth much). So by the advent of negative rates, all that’s left to finance are bad projects that are only viable if the financing itself is profitable. That’s why Japan and Europe are stagnant despite all the free money.

• The Democrats, last but definitely not least since they might be in charge shortly, think massive new entitlement programs are feasible in an already hyper-leveraged economy. This is a big subject with a lot of moral angles, but here it’s enough to say that we’re broke, so big new entitlements will be swept away in the coming national bankruptcy in any event, making their implementation wasted effort.

Target-rich environment
The nice thing about mass financial delusion is that it offers a target rich environment for the non-delusional. So let’s make some lemonade by sketching out a trading strategy for the next round of official mistakes.

Month 1: While the Fed tries to ignore the junky markets writhing on the floor, short US stocks, with an emphasis on wildly-overvalued Big Tech. Put whatever funds are left into “risk-off” staples like bonds, cash and gold.

Month 2: As the realization begins to dawn that an equities bear market might break the global financial system, consensus shifts to not whether the Fed will cut again, but when. Ease out of your stock shorts and long bonds. Keep your gold. Because you should always keep your gold.

Month 3: When everyone has concluded that the next Fed meeting will see another, possibly big, cut along with at resumption of QE, shift back to “risk-on”. Dump your remaining bonds and stock shorts, and go long the stocks that made you all those short profits.

Month 4: Leave the party. Convert the past few months’ trading profits into real assets like farmland, energy stocks, a rental house, and gold – always more gold. Then sit back and watch the delusions crumble.

 

Emigrate While You Still Can – To Finca Bayano

6 thoughts on "Financial Markets To Federal Reserve: Is That All You’ve Got??"

  1. JR has laid things out pretty well so I’m going to focus on a pet fantasy of mine. I think Trump is exposing the Fed and setting it up for dissolution. I’d like to think he’s doing it with conscious intent but I’m not so sure about that (probably not.) Nevertheless, that’s what he seems to be doing.

    Consider:

    1. By berating the Fed and belittling its chairman he’s calling attention to both and paving the way for others to also criticize – and ultimately question – the whole framework. Why does the Fed control interest rates to begin with? And why should it be decided by unaccountable bureaucrats?, Et cetera.

    2. By demanding that the Fed lower interest rates more he is interfering with the Fed’s desire to appear politically independent. Trump knows(?) it will “have to” do so anyway but he’s making the Fed appear subservient. (Another reason to not have a central bank?)

    3. Because the Fed is not lowering interest rates as quickly and as low as Trump wants any problems with the economy, especially relative to the “global economy,” will be blamed on the Fed for acting too timidly, especially if the “solution” to economic decline after the fact is to lower rates even more. (Another reason why the financial markets should determine rates, not the Fed?)

    4. The continued lowering of interest rates will ultimately back fire and the blame will be on the fact that the Fed failed to remove the “punch bowl” soon enough. There may be debate as to whether the Fed kowtowed to the stock market as early as 2011, or to Trump and the financial markets “back in 2018” but all possibilities lead to the same conclusion: the Fed failed because of human error or corruption.

    5. Ex Fed chairs Yellen and Powell will be judged harshly for not having the guts to stop the madness like Chairman Volcker did when he cranked rates up over 10% to arrest price inflation. So, should we-the-people have a say in who runs the Federal Reserve? Or is it easier to just let the financial markets determine rates similar to “price discovery” – the price discovery of money. And why does the Fed get to “print” money anyway?

      1. Most people haven’t read that, and even if they had the problem now is how to kill the beast. The Fed and central banks continue to get away with their shenanigans because most people don’t understand what they do and the effects it has. Just like the deep state swamp is being exposed by bringing attention to it, central banking needs to get direct exposure and criticism NOW so when the poop hits the propeller people will have been forewarned which could make the dissolution of central banking more political feasible.

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