“The Fed is under no mandate to continue quantitative tightening, or raising interest rates. If the stock market goes to pieces, if the economy…”
by Brian Maher via Daily Reckoning
The emerging mainstream narrative runs to sweet music…
At 4.1%, unemployment scarcely exists.
Wages are rising… and wage-driven inflation is on the jump.
Retail sales are roaring. So is consumer confidence.
Corporate profits are ringing the registers.
And because of tax cuts, more money will soon jingle in consumer pockets.
Rising global growth provides the beautiful cadenza, the final flourish.
In this rosy-dawn view interest rates are rising because economic conditions justify them.
Too much growth could overheat the economic engine… and the Fed is under bonds to run the equipment at safe speeds.
While this pleasing melody soothes investors, Bank of America analysts run their nails over a chalkboard:
We, on the other hand, are a lot more worried that global growth might be peaking… and that a highly indebted world is too fragile to be challenged by central bank balance sheet contraction in 2019… We are getting more concerned about a global policy error, of too much expected monetary tightening in the U.S….
The Federal Reserve raised interest rates three times last year.
It has also embarked upon quantitative tightening.
At current rates the Fed is expected to lighten its balance sheet $420 billion this year.
That figure swells to $600 billion next year… and another $600 billion the following year.
That is, some $1.6 trillion of market-supporting liquidity is scheduled to come off duty.
Our old friend Richard Duncan has fashioned a market-tracking device he calls the Liquidity Gauge.
Its logic is simple…
When liquidity is positive, stocks tend to rise.
When liquidity is negative, stocks tend to fall.
Recall, the Fed has been withdrawing liquidity.
Overall, Richard says liquidity ran to negative $56 billion last year.
But now comes the objection:
Didn’t stocks set records last year?
If liquidity was negative, explain the records.
Ah, but the Federal Reserve is not the only source of liquidity.
The European Central Bank (ECB), for example, was hosing 60–80 billion euros a month into the markets last year.
Also to consider are the contributions of such grandees as the Bank of Japan (BOJ).
As the folks at Yardeni Research note:
During January, the sum of the assets held by the Fed, ECB and BOJ rose to a new record high of $14.6 trillion, led by the ECB.
Note the parallel track of the S&P:
But what about the rest of this year?
If 2017 witnessed a slight drying… Richard says 2018 promises a parching drought.
From a slightly negative $56 billion last year…
The so-called Liquidity Gauge is set to swing to a Sahara-like negative $904 billion — the largest liquidity drain on record.
Are markets aware?
But a question follows:
If the Fed plans to trim its balance sheet only $420 billion this year… and raise rates only at the margins…
Why the negative $904 billion?
The answer, says Richard, arrives from Washington…
The combination of tax cuts and ballooning government spending over the next few years leads straight to $1 trillion-plus deficits.
The government must sell massive amounts of bonds to finance these deficits… which siphons money from the financial machine.
Add these sky-shooting deficits to quantitative tightening and a negative $904 billion picture emerges.
But the projected drought worsens…
This Liquidity Gauge is projected to score negative $1,165 billion in 2019… and negative $1,237 billion in 2020:
That amounts to a cumulative liquidity drain of $3.3 trillion over the next three years, far worse than anything the United States financial markets have ever endured before.
But what about the ECB? Might they offset the flow?
It is unlikely.
Last year’s 60–80 billion euros of asset purchases a month is down to 30 billion euros a month.
It may strike zero this September — if they make good on current plans.
The Bank of Japan may keep the business going yet. But not enough to offset the outflows (see below for more on Japan).
But can the economy — can the markets — withstand a massively receding liquidity tide?
To ask the question… seems almost to answer it.
Of course, the Fed is under no mandate to continue quantitative tightening, or raising interest rates.
If the stock market goes to pieces, if the economy drops into recession, we are confident the Fed will re-open the sluice gates.
It will keep them open as wide and as long as necessary.
And we will likely hear no more talk of returning its gargantuan $4.4 trillion balance sheet to “normal.”
Markets will simply not allow it.
So rather than a great liquidity drain, we may face another reality, equally disconcerting in its way:
Undoing the once-unthinkable… has itself become unthinkable…