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Fed FOMC Statement May Be Dovish, But Here’s Why It’s Not Bullish

About that “dovish” Fed FOMC statement yesterday, everything is relative. Dovish is not the same as bullish.

The whole world has concluded that this is an epic about-face by the Fed. Indeed the Fed has left behind a program that was outright hostile to the markets. So that’s dovish. But it’s what the Fed did not say that’s more important, and bearish.

Raising rates from zero to 2.5% was a red herring.  Its program of balance sheet “normalization” that I called bloodletting, was draconian. It has lately been removing funds from the banking system at the prodigious rate of $600 billion per year.

Meanwhile, the US Treasury has been demanding roughly a trillion a year in new money from the markets at the same time. That’s forecast to grow more than a trillion a year over the rest of this year and for the foreseeable future. That means that the market must absorb an average of $100 billion per month of new Treasury supply every month.

The Fed did not utter a peep about helping the market to absorb that, whether now, or in the future.


Before Normalization Started, The Fed Had Stopped QE

Prior to starting “normalization,” the Fed had stopped outright QE in late 2014. That made it tougher for the Primary Dealers and other investors to absorb new Treasury supply. But the Fed continued to purchase MBS from the dealers, and that cash helped with that absorption.

At the same time, new Treasury supply was declining persistently. The Fed could reduce and end QE because it no longer needed to finance the Federal budget to the degree that it had between 2009 and 2014. Over that span, the Fed pumped enough money into Primary Dealer accounts each month to absorb 100% of the net new Treasury supply.

Between 2012 and 2014 the government’s deficit financing needs had dropped from over $100 billion per month to under $50 billion. The 12 month average bottomed near $40 billion in early 2016. So it was easy for the Fed to get out of the market propping game of QE.

Federal Budget Deficit

Not coincidentally, Treasury bond prices topped out and Treasury yields bottomed out in 2016. Remember those 10 year yields at 1.4%? I didn’t think so. But with the bond bull raging, it was easy  for the Fed to think about pulling the punchbowl.

It was even easier because the Fed had two buddies who had taken the QE handoff, the Bank of Japan (BoJ) and the European Central Bank (ECB). The ECB in particular was a huge friend to the market, introducing negative interest rates and a massive new QE program in September 2015.

There’s Just One World Liquidity Pool, and The Pipes Flow Through Wall Street

That matters because the big 3 central banks all pump into the same worldwide liquidity pool. And the same massive banks are counterparties in the money pumping games of the 3 Musketeers, the Fed, the ECB, and the BoJ. Money pumped anywhere can, and usually does, find its way to Wall Street PDQ.

The central banks print and pump the money into those banks by buying securities from them. Sooner or later, some of that money that the ECB and BoJ prints and pumps into their counterparty banks, ends up in the US Treasury market.

So when the any of the 3 Musketeers prints, money flows to Wall Street and the US Treasury via the Treasury auctions or the secondary market. Dealers and institutions use that money to bid up the prices of financial assets. The results of these rotating rounds of QE are long running asset bubbles.

As those asset bubbles were inflating here in the US, in 2014, there was less issuance from the Treasury sucking up available liquidity (aka money). The stock market bubble was running hogwild. So the Fed decided it could stop the printing. It stopped buying Treasuries, but continued feeding cash to the Primary Dealers by continuing to buy MBS.

Everything Was So Great in 2017, The Fed Decided It Could Pull The Punchbowl

By 2017, the ECB and BoJ were printing heavily with big QE programs that they had started in 2015. The Treasury bull market had peaked and yields were rising, but the stock market was bubbling away in in 2017.

So the Fed decided that it could start shrinking its balance sheet. It coined the euphemism “normalization.” I like “bloodletting” better. But the effect is what matters. It meant that the Fed would drain money from the banking system.

The Fed began draining in October 2017. It pulled the punchbowl at an announced schedule that would ratchet up the pain every 3 months. It would do so by redeeming its Treasury holdings and allowing its MBS holdings to be paid down in the natural course of mortgage payoffs.

In case you are wondering how that drains money from the banking system, here’s a quick answer. As the Fed systematically redeemed some of its Treasury holdings, the Treasury needed to raise money in the market to pay off the Fed. Dealers and investors withdraw money from their bank accounts to buy the new Treasury issuance. The Treasury pays off the bonds held by the Fed, and poof, the Fed’s asset disappears, and so did the corresponding deposit in the banks.

But While It All Looked Good, There Was A Big Problem

Meanwhile, the Federal budget deficit, which had been shrinking from 2012 to 2014, leveled off in in  2015. It then started growing again in 2016. The tax cut and increased spending in the 2018 fiscal budget exacerbated that. The government is now borrowing an average of roughly $100 billion per month to cover the increasing deficit. It must sell that much new debt to dealers and investors every month to fund that deficit.

I had warned repeatedly since the Fed’s trial balloons about “normalization” started in mid 2017, that it woud be a problem for the market. That problem started to come to fruition in the fourth quarter. Stocks were liquidated at a breakneck pace, partly because the Treasury market was crowding out everything else, sucking up all available liquidity.

The Fourth Quarter 2018 Meltdown Spooked The Fed

The Fed finally got spooked. The Trump Regime was acting out, threatening to fire Fed Chairman Pow. Treasury Secretary Minuskaching put on a kabuki theater performance with the banks, and also called in the PPT (Plunge Protection Team, aka the President’s Working Group on Financial Markets).

They made sure that it was all well publicized. They didn’t need much help. The Wall Street captured media laps this stuff up. You know that “Markets In Turmoil” thing.

And so the Fed started the old softshoe that led to Wednesday’s dramatic and apparently dovish FOMC announcement.

That Led to the Dovish Announcement, But Dovish Is Not the Same as Bullish

But was it so dovish? Well, sure, relative to pulling money out of the system. The Fed now says that it will end the bloodletting in September. Prior to that it will only slow the rate of the drip.

So, yeah, that’s dovish compared with the most hawkish central bank policy since Paul Volcker sent interest rates to 18% in 1981. But I would argue that anything less than a return to outright QE is NOT BULLISH. Dovish? Yes, Bullish? No.

And this is a distinction that market participants universally seem to be missing.

The Fed has only announced that it will first slow down the draining operations, and then it will stop draining. That’s not the same as pumping money into the system. And the system will need that money because, remember, Treasury supply is mushrooming again. Month after month, the US Government will pound the markets with an average of $100 billion per month. It must do so to fund those trillion dollar plus budget deficits that stretch out as far as the eye can see.

The Fed said nary a word about a possible return to QE to help fund those deficits. And if that’s not troubling enough, God forbid if the forecasts of a weaker economy are correct. Because those deficits will blow out even  more.

The Funding Source For the Rally Is the Problem

And what about the ECB and the BoJ? Are they any help? NO! The ECB has stopped its gargantuan QE program, and the BoJ has cut its QE way back. There’s no help coming for the US from the Two Other Musketeers.  And the Third Musketeer, the Fed, did not utter a peep about a return to QE in yesterday’s FOMC statment.

What has funded the post Christmas Eve rally? Debt. Piles and piles of new debt have built up as dealers and institutions use margin and repo financing to leverage up in support of their bullish wet dreams. I chart that data a couple of times a month in my Liquidity Trader reports. It’s ugly.

A rally built purely on leverage and a false narrative probably won’t end well. Regarding that narrative, in the immortal words of the late great attorney Johnnie Cochrane, “If it don’t fit, you must acquit.”

I would amend that to say, “If the Fed don’t pump, you must dump.”


  1. KenM

    Are there numbers to support how much the primary dealers are buying each month and how much leverage they are using….is the NY Fed helping to fund this?

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