The Fed started shrinking its balance sheet in October 2017. It euphemistically named the program, balance sheet “normalization”. I call it “bloodletting”, in honor of the medieval medical treatment for the disease.

The Fed’s QE had caused asset markets, including stocks, bonds, housing, and commercial real estate, to become bloated and diseased as prices inflated relentlessly. They floated higher on a sea of the Fed’s newly conjured money.

The Fed pumped that money directly into the accounts of the big shots who make the markets, known as Primary Dealers. The Fed appoints the Primary Dealers to be its exclusive correspondents in the execution of monetary policy. They’re also responsible for absorbing a significant portion of the Treasury’s issuance of new bonds, notes, and bills. They mark that paper up and sell it to investors.

The Fed expanded the money supply by buying securities – US Treasuries, Agencies, and Mortgage Backed Securities (MBS) – directly from those Primary Dealers.

The dealers used the money to buy Treasury securities from the US Government. Since they are trading firms, they also used the cash to buy other bonds, as well as stocks, and occasionally exotic derivatives. Those cash injections helped ignite and promote animal spirits among hedge funds and other massive leveraged speculators, along with more conservative investment institutions. We saw the effect in the long-running big bull that became a bubble market. The policy of QE ultimately carried stock prices to extremes of valuation only seen at modern major market tops.

The Fed stopped QE in late 2014, but the stock market continued bubble upward. That was partly because the Fed was still pumping a little money into dealer accounts through its MBS replacement purchase program.

The Fed Ended Its QE in 2014, But Here’s Why The Bull Rolled On

More importantly, in late 2014 the European Central Bank (ECB) started buying all manner of European government and corporate bonds hand over fist in a QE program that essentially took the handoff from the Fed when the Fed left the field. The same big banks that are Fed Primary Dealers also operate in cahoots with the ECB. That’s how money printed in Europe by the ECB can instantly show up on Wall Street and in US markets. That helped to keep stock prices inflated and rising.

But the Fed went into reverse in October 2017, and the ECB also tapered its buying and will go to zero purchases in December. Its balance sheet will also begin to shrink. More money will leave the worldwide pool of market liquidity, which is just a fancy way of saying money available for investment. There will be less of it.

Here’s what that means for the market today, and what you can do to profit while others follow Wall Street to portfolio destruction.

Central Banks Are Starving The Markets

The US stock market is being starved of cash. At the same time, dealers and investors must absorb nearly $800 billion in new Treasury bills, notes, and bonds over the 6 months ending in March 2019. It won’t get easier after that either. Treasury supply will pound the market at an average of $100 billion plus per month after month for years. And the Fed isn’t there to buy or finance the purchase of that paper like it was from 2009 to 2014. The ECB and European banks won’t be there either. And the Fed is making it even harder for the market to absorb all the new paper because it is pulling money out of the system.

Still, the stock and bond markets can and do rally from time to time, and those rallies can be ferocious, as we witnessed over the past week. Wall Street lives on the theory of “hope springs eternal.” Bullishness is a way of life. An old friend of mine called it “hopium.” The media and the market find ways to see hope in a few choice words of a Fed chairman or a President. But words change nothing. Money talks. Words walk.

The name of the Wall Street game is “sell or starve”. The purpose of the Street’s sales job is to keep those trillions of everybody else’s money, including your money, under the Street’s management and control. It must do that so that it can extract massive fees, and yes, trading profits, from your capital.

It snags those trading profits by taking the other side of your trades. It encourages you and manipulates you to do its bidding with an endless stream of PR through house organs like CNBC and the Wall Street Journal. When mouthpieces of the Wall Street mob are recommending something for you to buy, you can bet that their trading desks are on the other side of that trade, selling it to you.

But here’s the problem. The Fed is Wall Street’s bank, its financier. The Fed stopped providing its support for Wall Street’s game, in October of last year. Since then the Fed has slashed $373 billion in assets off its balance sheet. It has promised to continue to do so at the rate of $50 billion per month until the balance sheet has reached a “normal” position.

Historically, “normal” means keeping bank reserves at the minimum necessary for the banks to have the no more than the required reserves as a percentage their deposits. I’ve done a back of the napkin calculation that would take until roughly May 2020 for that to happen. A few Primary Dealer spokesmen have made similar estimates. No doubt, big selloffs make them cry for the Fed to stop the spanking sooner, but the Fed now has a strict daddy who seems inclined not to listen.

When the Fed sheds assets, it also gets rid of the reserve deposit liability that was created when the Fed originally bought the asset. The flip side of that reserve is money in the financial system.  Now that the Fed is redeeming those assets, those reserve deposits are also being extinguished. So there’s less and less money in the system. The Fed has pulled $373 billion out of the system so far. Between now and May of 2020, the Fed will pull another $900 billion out of the banks.

That’s a lot, and its especially gargantuan when you consider that the Fed had been adding over a trillion dollars a year to the banking system at times from 2009 and 2014, outside of a couple pauses, and the taper in 2014. This is a huge negative swing.

Now, the Fed’s two main cohorts, the ECB and Bank of Japan are also all but out of the money printing business, while the Fed is slashing away.

Here’s Why Markets Rally Despite Tight Money

Sure the markets rally sometimes. There are huge speculators and hedge funds who have massive short positions, which they buy back quickly when they have big profits to protect. They are notoriously hair-triggered. And as I pointed out the other day, the more often a trading range is crossed, the thinner it becomes. So when the short covering starts, the upside fireworks can be pretty impressive.

But it works both ways. The market is thin in both directions. And there’s just not enough cash around anymore to sustain bull moves for long.

Frankly, I was even a little surprised that this rally ran out of gas so dramatically when it reached the doorstep of resistance at 2800. In a matter of 4 hours today (Tuesday, December 4) the S&P 500 dropped 80 points and ended the day losing 90 while the Dow dropped nearly 800. And of course, it was only a few days ago that the Dow jumped 600 points in a day. The wild volatility in both directions is symptomatic of an increasingly illiquid market.

This can’t end well because, for the foreseeable future, liquidity will be a one-way street. Down. There will be less money, and that means there will be less demand for securities. The market will at the same time need more money to be able to absorb the massive flow of new Treasury supply coming its way, without forcing prices down. The fundamentals of supply and demand tell us that when there’s more supply and less demand prices must fall.

Fed Policy Means There’s Only One Strategy

There can only be one strategy in this environment. If we want to make money, we need to sell rallies short, because they can’t be sustained for long. Eventually, prices will make new lows. I continue to like the tactic of buying near in the money SPY puts with about a month to expiration whenever the market pokes its head up to chart resistance. Keep a mental stop just above resistance. Take some off the table when the market tests support. And let the rest ride as a bet that support will break down.