Why January's "Best Stock Performance in 30 Years" Is A Mirage

The WSJ font page article Friday ('Stocks Post Best January In 30 Years'.)  babbled shamelessly:

"Banks and smaller companies propelled stocks to their best January in 30 years, a sign investors are favoring sectors tied to the U.S. economy....The Fed's statement Wednesday that interest rate increases are on hold helped ease investors' worries that higher rates would lead to higher borrowing costs and curtail corporate profits."

Well, of course the Federal Reserve's statement would do that, given - god forbid - it doesn't want to halt the cheap money bandwagon. Or, for that matter, toss cold water on the manic leverage that now dominates stock purchases as well as corporate expansions.  It seems every  manjack now wants to go into debt to achieve a gain - and of course at the hoi polloi's expense.  Because they are the ones that will have to do the bailing out. (Think of the AIG bailout in 2008, and Long Term Capital Management before that.)

Off the financial media's radar is the other part of the cheap money equation: quantitative easing ("QE") which has undergone several iterations since the credit crisis.  Most ordinary people are not even aware of the amount, the magnitude - of the crutches the Fed has provided to prop up the markets. Most  investors, ignorant though they may be,  have been beneficiaries of the Fed's infusion of "crack" in the form of  QE  cheap money "crack".  Notice especially how the DOW stopped dropping once the buzz began about QE3  (following QE1 and QE2)   - back in 2012- which have together infused $4.3 TRILLION in bond purchases.

But at some point, the cheap money flow has to stop and we know even if it's done slowly Maul Street will respond hysterically. This  is what has prompted discussion of how large a future correction will be   But let's get back to the Journal's blabber - woky of the greatest January in 30 tears. We agree the Fed deciding not to raise interest rates is part of it - but the other part ("that which must not be mentioned") is the quantitative easing - and rolling it back to get the Street off its addiction.

Flash now to an article on the same day (p. B12,  Heard on the Street, 'The Fed's Balance Sheet Needs Taming')  whereupon we learned:

"The famously plain-spoken Mr. Powell  left the market with little doubt that the probability of tightening has shifted, noting on Wednesday that the 'case for raising rates has weakened'.  But policy rates are only part of the story.

Since the financial crisis the Fed has used its balance sheet as a powerful tool, buying bonds to affect the yield curve. Since late 2016, it had begun to slowly unwind those purchases, most recently at a pace of $50 billion a month.  The Fed's balance sheet has shrunk by only 10 percent."

Okay, let's do the math: if the original balance was $4.3 trillion and the QE balance sheet has shrunk by only ten percent - according to the WSJ - then than means only about $430b  has been removed.  That leaves $3.87 trillion still to be unwound.  Now, at the rate of $50 b a month how long will it take to remove all that excess crack?

Again, we can do the math:   

Y   =   $387 trillion/  ($50 b x 12) = 6.45 years

And that only holds up if we don't get yet another recession.

And this may well be lowballed because "the actual amounts have been closer to $40 billion in recent months" (WSJ, January 29, ibid.).

How is this unwinding happening?  Well, by allowing the purchased Treasury and mortgage securities to mature without replacing them.  But even this tortoise -paced process has some prominent investors rattled, such as Stanley Druckenmiller who claims it's "a big factor behind the return of market volatility".  ('Fed: Stock Swings Not Tied To Bond Moves', p. A2, WSJ, January 29).

Now, let's back up and process what the yield curve means and how the Fed's QE policy is affecting it and how it could lead to a new recession. As noted in my post of December 5th: the U.S. Treasury yield curve is the spread between the 2- and 10-year Treasury bond yields.  It is taken to be a predictor for recession especially if it becomes "inverted".  (See e.g. 'Fear Of Inverted Yield Curve Stalks Markets', Jan. 10, p. A2)

Prior to that inversion, it becomes "flattened" in other words, the difference between the 2 and 10 year bond yields is minimized.  Specifically, recessions tend to occur once the "flat" yield curve becomes "inverted" - with short term (e.g. 2 -year)  bond rates now higher than long term (e.g. 10 year) rates. As a recent (December, 2018) T. Rowe Price Investor Bulletin noted (p. 4)

"The yield curve is not flat yet ...but it could be by next March if the Fed maintains its 0.25 percent per quarter pace of rate hikes and the 10-year Treasury continues to meet resistance above the 3.0 percent level.  Starting the historical average 16-month clock from the spring of 2019 would raise the specter of a major downturn by 2020."

But ok, you say, the Fed is no longer going to increase interest  rates, so we dodged a bullet. Not so fast.  There's still that huge balance sheet. To make this clearer let's understand that the QE balances are really an alternative to printing more money. (Which we understood used to be done in the old days, or more recently by the last government of Barbados to try to pay all its obligations.) 

According to one technical financial paper

Monetary easing is the Fed’s way of putting in more money into circulation in the economy....and it does not involve the printing of new banknotes

True, but still it effects the yield curve. How?   According to the same Market Research paper:

The Fed’s QE initiatives have successfully shifted the yield curve downward, that is, lowered the Treasury yields across maturities.

In other words, shifted down as in flattened the yield curve.  More worrisome - from the earlier cited WSJ article on the Fed's balance sheet needing taming:

"Moreover, he (Powell) raised the possibility that the balance sheet  could be an 'active tool' if warranted. In other words more bond purchases if markets or the economy cry out for more help."

In other words, merely postponing the 'big one' while other recessionary signs build - and the "insurance" of QE itself becomes a ticking time bomb.

What are those other recessionary pressures?  From a separate WSJ article ('Chances of Recession are Rising') they include:

-  Another shutdown following the one for over 4 weeks which sapped GDP at the rate of 0.1 % per week.    That initial "partial" shutdown already hurt "sentiment measures:  - but these ought to rebound provided there are no further shutdowns.  But given the bombastic fool holding office, who can say? We know he will likely try to make another specious case for his ignorant 'wall' tomorrow night. Another reason not to waste one's gray matter or time tuning in to Dotard's lies, bragging and  babble.

- "The tight labor market is another reason the recession chances have risen" i.e. in models including from JP Morgan.    Most economists in addition believe the current rate is unsustainable.

A further cautionary take has been offered by James Mackintosh (WSJ, Jan. 30, p. B1) who notes there is clear evidence the Phillips curve (the statistical link between inflation and unemployment has "broken down".  Mackintosh adds:

"If the relationship is finished economists will need to build new models of how the economy works.  Investors should applaud such a change if it shows that higher wages tempt people back into the workforce.  That would demonstrate more spare capacity than thought, so the economy could grow without sparking inflation"  -  and presumably inciting a Fed reaction like more QE!

Where the biggest risk lies is perhaps in a confluence of factors. That is, the Fed is reducing its bond portfolio at the same time the Treasury is issuing more bonds to fund large federal budget deficits - crowding out capital for other types of investment. This is the same type of risk I forecast after the Trump - GOP tax cuts were implemented.  Basically, a systemic instability triggered by unnecessary deficits from a stimulus not needed when the economy was already humming - thanks to Obama's wise moves in holding deficit spending down. (As finance specialist Steve Rattner  aptly pointed out this a.m. on 'Morning Joe')

Watch for what transpires in the next two weeks and whether Dotard calls for another shutdown. If he does, and renews his temper tantrum, the probability  of a recession increase to more than 90 percent. Especially as over 4 million federal  contractors are still trying to financially recover from the last debacle!