17 years ago I developed an indicator to track the amount of cash that the Fed was pumping into Primary Dealer Trading accounts. The indicator proved its mettle over time. It was one of the best predictors of stock market behavior because Primary Dealers literally “make” the markets. Market price levels reflect how much cash the dealers have on hand to ignite the cycle of securities inventory markups and markdowns that drive market price trends.
The indicator is composed of the cumulative value of operations which the Fed conducted directly with Primary Dealers in Open Market Operations (OMO). It measures the flow of cash into Primary Dealer accounts that came from the Fed’s purchases of securities from them. It’s similar to some of the charts you see of how the market tracks the Fed’s balance sheet. But there are some important distinctions that made it work better for us.
There’s just one problem.
Those distinctions no longer matter.
The Fed isn’t buying securities from Primary Dealers any more. It’s no longer pumping cash into the markets. It stopped doing that in October 2017, when it started the systemic bloodletting program known as “normalization” that has caused so much consternation in the market.
And it isn’t selling securities to the dealers under that program either. That would be one way to shrink its balance sheet and pull money out of the banking system. The Fed has opted for another way. That is to simply redeem its holdings of US Treasury notes and bonds as they mature. The Fed also allows its mortgage backed securities (MBS) to be paid off by normal prepayments over time.
It’s a passive approach, but insidious and dangerous.
Here’s how it worked, why it doesn’t work anymore, and what we can to do about it to stay on top of the liquidity game.
QE Was Just an Expansion of the Fed’s Open Market Operations – The Old Fashioned Way
The growth of dealer cash under the Fed’s last program of QE was the fastest in history. It was a singularly bullish influence on stock prices. Flush with cash from the Fed, the dealers marked up their inventories of equities and sold them to their customers, particularly hedge funds and institutions. Those customers were also flush with buying power thanks to their own rising cash levels and zero financing costs. The Fed made sure that cash and leverage was were the name of the game. The Fed rigged the market to go up.
Then the Fed stopped QE and simply treaded water for a few years while their fellow central banks, the ECB and BoJ, did the heavy lifting. All central banks pump into one worldwide pool of liquidity managed by the same big multinational banks. Eventually some, if not most, of that money flows to and through Wall Street, and US securities prices are boosted.
That all worked fantastically well until the Fed started draining money from the system in October 2017. With the Fed neither pumping cash into dealer accounts, nor pulling cash out directly, the line on our favorite chart turned absolutely flat. And it will stay that way until the Fed returns to the old way of doing things – Open Market Operations.
Click to Enlarge But The Fed Is Always Morphing The Game
We don’t know when that will be, if ever. The Fed seems to find new monetary games and new financial toys to play with every generation or so. I’ve studied the history of the Fed, and this long term morphing of policy goals and methods and tools is not new. It’s a feature. Fed policy has been 106 years of essentially clueless trial and error. When the latest policy fails, try something else.
In the process we get massive mission creep, from the original purpose of lender of last resort, to the current purpose of the greatest central planning, market rigging institution the world has ever seen.
So this indicator is no longer the pre-eminent fail safe indicator that it was. Once upon a time, this was the only liquidity indicator we needed. That’s no longer true.
Today, the Fed’s normalization game is not conducted the way monetary policy was traditionally executed.
In the good old days, say since the 1970s, virtually all monetary policy actions were transmitted to the market via the conduit of Fed trades with Primary Dealers. Those trades were called Open Market Operations (OMO).
Draining Money From the System Is New, But So Is the Method
Now, the Fed is draining money from the system, which itself is new. But it’s not using OMO. Instead of selling its paper directly to the Primary Dealers, which would force them to pay their cash to the Fed, the Fed is doing a complex 3-way dance between the Fed, the US Treasury and the banking system.
Its effect on the stock and bond markets is indirect but powerful
The Fed is first, simply letting its Treasury holdings mature. The Fed had lent the Treasury, oh, just a couple trillion or so, by buying the Treasuries notes, bonds and bills. Then it constantly rolled over those loans. The US Treasury was never asked to repay. Nobody thought that would happen.
Except it did. The Fed decided to ask for its money back. In the process of “normalization” of its balance sheet, the Fed politely asks the Treasury, “Pay me back, now! Or I’ll break your … OK, never mind.
When the Treasury pays off the Fed’s maturing paper, it must find the cash to pay back the Fed. It does so by selling new debt directly to investors, dealers, and other central banks, via its weekly Treasury auctions.
Primary Dealers are part of that market, so they’re in the mix, but it’s not the same as their being forced to buy a fixed amount of paper from the Fed every week under an OMO program.
Dealer participation in the auctions varies. The weaker that public demand is, the more they are forced to absorb. And they have absorbed a lot lately. They are loaded to the gills. Likewise, they hedge to the gills by shorting bond futures to offset their long inventory of Treasuries.
And this leads to a whole slew of problems that I’ll get into in our next report. Let’s just say it can lead, and has led, to a whole lotta shakin’ goin’ on.
In the meantime, the upward pressure on interest rates will continue, regardless of what the Fed says, so I’m comfortable recommending that you stay with the program of rolling over your T-bills, while waiting for the next big market selloff.
Meanwhile, there are ways of extracting amazing profits from the market regardless of whether its going up or down. Our trading research gurus can show you how to do it. Like this one:
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