The Macro Market Wrap Up With The Mad Genius, Vol. 25

So getting into a review of my January 2018 forecast for the year, the first thing I forecasted was the removal of liquidity by the Fed and other central banks. And remember, my analogy in this regard is that raising interest rates and selling Fed assets is to the economy just like motor oil is to your car engine.

The Fed itself said that it would do 3 rate hikes this year and by October it was supposed to be selling its own assets at $50B per month. The Fed did that, and they added a 4th rate hike as well. In addition to the Fed, several other central banks around the world were supposed to follow suit. For example, the Bank of England has raised interest rates, the European Central Bank has completely stopped buying bonds, Turkey raised rates, and at last count 14 of 20 of the biggest central banks around the world are either raising rates, selling assets, or both.

I actually didn’t anticipate the Fed going this hard on the rate hikes. I anticipated 2–3, but I was not expecting 4. However, I said that rate hikes and assets sales would be very deflationary, and I expected the real fireworks to begin just two months ago in October. As I’ve been saying over the last 4 weeks, if the central banks and our own Fed sell assets, that means whoever buys those assets has to pay the Fed with cash, and that cash would straight into the Fed’s vault.

So cash is being pulled out of the banking system. And we know this to be true, because take a look at this chart of excess reserves of all commercial banks. This is data from the St. Louis Fed. Excess reserves is the extra cash that banks have on hand, above what is required by law. It peaked in August 2014 at $2.7T, rate hikes began in December 2015, and excess reserves are now $1.65T. Aside from the total quantity reducing over the last 4 years, the rate of reduction is also accelerating, which is now at a -24.8% annualized, as of November.

The question is where did all that cash, $1.05T, go? Well, remember that the Fed is selling treasuries and MBS, and someone has to buy it all up. Other central banks around the world are also paring their holdings. As far as foreign entities selling treasuries, I have not been able to find any regulatory requirements for domestic financial institutions to buy what foreign banks and sovereign wealth funds sell. However, when our own government auctions treasuries, banks are required to participate. Insurance companies too.

Suffice it to say, as the both the Treasury and Fed sell, all banks are using their excess reserves to buy. And by the way, if you’re wondering why bank stock shares are falling, this is but one of the reasons…the profits on treasuries that they are required to buy are not nearly what the profits are on loans. Now, they’re buying those treasuries with their excess reserves by government fiat, but they’re also doing it, rather than lending, because they think it’s the safer bet. After all, this is treasuries backed by the full faith and credit of the US government, for what its worth, and lending is just too risky now because the yield curve is nearly inverted. So banks are buying treasuries instead. Excess reserves may also be used to charge off bad debts, and we’re already starting to see defaults rise, but relative to excess reserves this is not significant yet.

As banks and other financial institutions buy these bonds, the cash they are using is coming out of the banking system and into the Federal Reserve’s vault in NYC. This takes the cash completely out of the banking system, meaning that one of the three major components of what causes inflation or deflation is now in deflation mode. The one we are talking about is money supply, and the other two components are the velocity of money and the perception of prices.

So as banks and other financial institutions buy up all these treasuries from the Fed, that money comes out of the banking system, never to be seen again. It is tremendously deflationary in nature, and that is why we have seen such downside volatility in the stock market and in home prices. In January I predicted this to begin in full force as of October, because like I said then and like I just mentioned, that is when the central banks of the world would be operating at peak tight-money policy.

And boy oh boy, have we seen down side volatility. The Russel 2000 is off over 27% since August 31, the Dow is off 18.8% since October 3, NYSE off 18.6%, Dow Transports over 25% off, S&P 19.8%, NASDAQ 23.6%, and bank and financial indices are off by 19–32%. Do we really need to have the Dow and S&P cross 20% to call this a bear market? Well over 50% of all equity issues are down by over 20% already!

That’s it for today. Happy holidays to all celebrating tonight and tomorrow. Let me know what you think in the comments. Thanks for reading Volume 25 of The Macro Market Wrap Up With The Mad Genius. Until next time remember that there is always a bull market somewhere in the world, and on the opposite side of every crisis, lies opportunity.

#economics #Fed #liquiditycrunch #forecast2018 #bearmarket