Yesterday I said that I am going to begin reviewing my 2018 forecast as well as letting you know what I think we are in for in 2019. To start that off, I said that I’ll be talking about what happens when the Fed loses credibility. Fed policy impacts every last transaction in the economy, and therefore it’s probably the most important topic to address.

Let’s take a moment to remember that the Fed is the central bank of America, created in 1913. Prior to the creation of the Fed, there were several failed attempts at central banking in America, leaving a bad taste in the mouths of Americans. So when Fed was created, the government had to disguise the fact that it is the central bank, and therefore called it the Federal Reserve instead. In other words, the government already knew that central banking had credibility issues to begin with.

So what happens when the Fed loses credibility? First is that means that already, no one trusts the Fed to do what it is supposed to do. One of the things that translates into is that no one will believe the Fed has set interest rates at the correct level. 

Let’s imagine for a moment that you own a Treasury bond in your retirement account, which most of you probably do regardless if you realize it. If you own a treasury either directly or indirectly in a mutual fund, let’s say the interest rate on it is 3%. What if you think that’s wrong? What if you think it should really be much higher, say 6%, 7%, or 8%. 

The normal thing to do would be to sell that bond and get as much money back as you can, while someone else is still willing to buy it. By the time you go to sell your treasury bonds, you probably won’t be the only one. And that will cause the interest rate on treasury bonds to rise.

Now, you might be asking how I know you’ll be selling treasuries and you won’t be the only one? That’s a good question, and I am certainly not a prophet or soothsayer, no kabalistic incantations, no crystal ball, and no tarot cards. So how do I know? Well there’s two big reasons. 

First is that America’s biggest trade partners are already paring back their treasury positions. The first one is Russia. Politics aside, back in March, Mother Russia dumped nearly its entire treasury position of close to $100 billion worth. That alone caused interest rates to spike by nearly half a percent. The Saudi’s are also trimming back on treasury holdings. Japan is reducing their holding already too. And the biggest trade partner who will be most problematic for us, is China. Lots of others are also paring their holdings, but these guys are the biggest.

The second reason I know you’ll be selling treasuries is because Wall Street has a herd mentality, and when Wall Street begins selling Treasuries, whoever is managing your mutual funds will be selling too. Remember your economics 101 class in college? I don’t remember the class you took either, but the professor probably taught that supply and demand is the mother of all economic problems. 

That applies to Wall Street as well, because if everyone in creation is selling treasuries, that means the market will be flooded with supply, but there won’t be a demand to soak it all up. Kind of like if we know that there is a need for 5,000,000 iPhones, but Apple would try to sell 1 billion of them. The only way they could do it is if the price falls. So the price of treasuries will fall dramatically, and when the price of a bond falls, the interest rate must rise. Just like a see-saw; if price falls, the interest rate must rise, and vice versa.

Now, if the Fed loses credibility and the price of treasuries falls while interest rates rise, the very next thing the Fed will do it try to contain interest rates by lowering the Fed Target Rate…the very same rate they just hiked (it won’t work). When the Fed announces it is lowering interest rates, we’d like to think the announcement might be quarter or a half percent, but that is not the most likely scenario. 

You see, by the time the Fed is forced to publicly admit what is going on, their next rate reduction will be too little too late, and it’s more likely they’ll go straight to zero. Nobody in their right mind will lend money to the government for zero return! They’ll get their money back, sure, but because of inflation their money won’t be worth as much as when they lent it. It’s what we call return-free risk.

Anyone who didn’t realize it by this time will finally realize what I’ve been saying all along, that the economy is in a shambles. Once this happens, the entire world will scramble to get rid of their dollars. And that will bring the next Fed move. You see if the world wants to get rid of their dollars, that means the value of the dollar will fall precipitously, causing you and I to spend more for the same old stuff, like groceries. 

The Fed’s reaction will be to buy up all the bonds that everyone wants to sell, and they’ll pay the lowest bid first. Regardless, the system will be flooded with dollars, meaning more supply of dollars, and if the supply of dollars is increasing, the value of those dollars is decreasing. Any kids who ever collected baseball cards understands this very clearly. It’s the very reason that the 2018 Noah Syndergaard is worth about 8 cents, but the 1909 Honus Wagner is worth millions…scarcity. The rarer something is, the more it’s worth, and that also holds true with the cash in your wallet.

What I’m getting at here is that when the Fed loses credibility, there will be a currency crisis in the US Dollar. The value of the dollar will sink, the world will lose confidence in the dollar, and stuff in America will get more expensive because no one else will want those dollars. And that is why this is the single most important thing to consider going into 2019.

Not to worry though, because the dollar has been reformed four times in just the last 105 years…1913 with the creation of the Fed, 1933 FDR banned gold ownership, 1944 the Bretton Woods Agreement, and 1971 Nixon took us off the Gold Standard. Life as we know it will go on, but there will be changes to our monetary system.

Also, not to worry, because remember that there’s always a bull market somewhere in the world, and on the opposite of this dollar crisis, like any other crisis, there will be opportunity.

That’s it for today. Let me know what you think in the comments. Thanks for reading Volume 24 of The Macro Market Wrap Up With The Mad Genius.

#economics #Fed #credibility #Outlook2019 #dollarcrisis