That’s right, on November 20, I headlined my Liquidity Trader subscriber report with:
Inflation is Dead, Fed Policy Will Stay Bearish Until It’s Too Late
So, yesterday’s CPI “surprise” came as no surprise to us.
Here’s an extended excerpt from that November 20 report:
That’s right. Inflation is dead. But it doesn’t matter, because the Fed won’t pull the stake out of its heart until it’s too late. I’ll get to that below but first, let’s talk about the interest rate bogeyman. It’s a fake issue, a diversionary tactic.
Interest rates don’t matter in terms of policy effects on the markets. They are merely a meter of monetary tightness. That tightness is Fed policy, and market interest rates, T-bills in particular, continue to post warning signs about that day in and day out.
The Street and its captured handmaiden media mouthpieces keep talking about the Fed raising interest rates. But the Fed has never actually raised rates. It has simply rubber stamped the increases that have already happened in the money markets to the meaningless Fed Funds target rate. And it hasn’t done a very good job of keeping up with market increases.
The evidence shows, ladies and gentlemen of the jury, that the market keeps outrunning the Fed’s rubber stamp. Regardless of all the bullish speculation on when the Fed will pause, or slow down its rate increases, or whatever it is that the Street wants investors to believe, the fact is that monetary conditions are still tightening, and will continue to tighten. And that will keep a lid on the markets. Rallies should continue to make lower highs, to be followed by lower lows.
The best meter of those conditions are short term Treasury bill rates, and those are still rising. This simple measure of the market shows clearly that the demand for short term funding continues to be greater than the supply of ready cash. Last week, both the 13 week bill rate and the 4 week bill rate hit new highs, as the Treasury repeatedly came to market with massive new T-bill offerings.
This won’t change any time soon. We already have a good idea of how much Treasury borrowing will pound the market in December, likely to be in the neighborhood of $110-120 billion. In addition, we have a guesstimate from the TBAC on the first quarter of next year. It’s not pretty.
The TBAC is looking for $578 billion in new supply in Q1, mostly in February and March.
That’s a huge number that would crush the market, in view of the fact that the Fed won’t be absorbing any of that.
Remember that in the bad old days of endless QE, the Fed constantly either directly absorbed or indirectly funded 85-90% of new Treasury issuance. It needed to so that to keep fixed income prices at a permanently high plateau, thereby artificially suppressing bond yields.
Without the Fed’s buying, dealers, investors and foreign central banks are called on to absorb all of the new supply. They can’t do that without selling something else that they already own.
That means that they sell older bonds, or stocks, or whatever liquid assets that they can. It puts all asset classes under pressure.
In fact, the Fed contributes to that supply with $60 billion per month in redemptions of its existing holdings of Treasuries. At the same time, it cripples demand by pulling $95 billion per month out of the bank deposits of investors and money market funds. That’s how much they must pony up to buy the Treasuries and MBS that the Treasury and GSEs must now sell to the public that the Fed had been buying and holding, and is now redeeming.
Miraculously, the markets haven’t succumbed to that pressure in November. Is justice delayed, justice denied, or is the market judge yet to hand down a harsh judgement?
Barring a Fed policy reversal, I think that Judgment Day is coming. I can’t say when. Optimism seems to ring eternal in the fourth quarter of each year. We know from the Composite Liquidity analysis, that stocks look oversold in terms of the parameters of the past. Maybe those parameters still matter, although I doubt it. I’m in the Wile E. Coyote moment camp. Traders just haven’t realized yet that they are spinning their wheels in midair above the abyss.
Inflation and the Coming Fed Policy Pause
I’m always on the lookout for things that could upset the bearish outlook. Wall Street is constantly proposing excuses to be bullish. I do examine those trial balloons, because some of them may hold water, and I don’t want to get hit by a giant water balloon. I’m confident that the market won’t successfully front run a Fed policy reversal, but at the same time, I want to have my antenna up for any conditions that might prompt such a reversal.
One such condition would be an unexpected and persistent drop in the inflation rates represented in the popular measures of consumer prices. As you know, those measures are deeply flawed. They have badly understated general inflation, mostly because they ignore home prices.
Making matters worse, the BLS and BEA, who make up the popular inflation measures, even count rents in an absurd way that results in both suppression and lag in government reported housing inflation. They use existing, backward looking, contract rents as opposed to current market rents.
Those 15-20% annual inflation rates in home prices and rents never made it into the CPI or PCE. But now, home prices are dropping like a stone, and market rents have also recently rolled over at a record pace. Over the past few months we’ve seen unprecedented rates of DEFLATION in housing.
The NAR, which is the most timely and comprehensive measure of US home prices because it uses current MLS data on the most recent month’s sales contracts, shows home prices down 9.5% between June and October. Yes, prices normally drop a tad during this period, but never in recorded history have they dropped this much in such a short time, at any time of the year. This is an epic reversal of the artificial inflation of housing that the Fed caused with its subsidy of home buyers through QE mortgage rate suppression.
And that isn’t anywhere close to an equilibrium price. Without going into the minutia of the data, let me just state that the drop in home sales over the past 3 months is among the worst in history. The market has frozen. The lower prices we are just starting to see are only the beginning of the adjustment process.
I spent much of my life in real estate sales and finance, and this is how it works. First buyers disappear. There are suddenly fewer sales. But sellers are stubborn for a few months. Then seemingly all at once, they wake up and start dropping their listing prices. Next come the foreclosure notices and the jingle mail. It takes a few years for prices to find a new equilibrium. We’re just at the beginning of that process. It’s deflation, and it’s here, now.
Let me give you another datapoint that I found that I think is instructive. The Mortgage Bankers Ass. publishes real time data on mortgage applications weekly. One of its data points is average mortgage size. Loan to value ratios are relatively constant on average, so that the size of the mortgage is closely related to the price of the collateral. Since March, the average mortgage size has dropped by 15%.
15%! In 8 months!
This is real time market data based on mortgage applications, which take place within a week or two of the sale contract. This is data through November 11. This is real folks. It’s happening right now.
And just look at the top pattern! That’s just epic. I can’t wait to see what the next few weeks look like. The Fed began QT in March, and that’s exactly when average mortgage size peaked.
By the way, having been through these cycles before, and having sold a home at the top of the last cycle, I could feel this coming in my bones. This time, I sold my house in Florida at the top of the blowoff in March.
Admittedly, I reinvested most of my winnings in my new home here in Nice, France, but who cares. It’s all funny money, and I’m where I want to be, living mortgage free, in a beautiful place where taxes, insurance, utilities and maintenance fees are 75% LOWER than they are to carry a property in Florida for properties in similar price ranges. Part of the problem is that Florida is a rolling natural disaster, where, if you can get property insurance at all, it will cost you about 2% of the value of the property every year.
If you own a home in the US today, and you have a mortgage, you’re going to be faced with shrinking equity. If you bought recently there’s the possibility of being upside down on your mortgage in the next year. It’s an unhappy prospect, but something to be thinking about in terms of how to reduce your exposure. The answer may be to do nothing. It’s your home, and only you can measure the value of you and your family’s emotional attachment to it.
But if that value is inconsequential, then the question is whether to take a smaller loss now rather than later, or whether to grin and bear it and wait ten years to see if the market bails you out again.
All of this is tangential to our purpose here, but it’s such an important topic to all of us, that I wanted to digress. The real point for our purposes is that housing is deflating. The housing component comprises about 40% of Core CPI. The Fed’s favorite measure, Core PCE is closely related to that. So if housing were measured accurately, these measures would be coming down markedly already.
The fact is that they are not. And because of the way housing is measured in the CPI and PCE, they will come down less, and with a lag, than reality would otherwise dictate. At the current pace of Fed rate increases, if inflation were measured accurately, the Fed Funds rate would cross above an accurate inflation measure as soon as next month.
Inflation follows the size of the Fed balance sheet with a lag of 6-12 months. The Fed’s balance sheet topped out in March. We’d expect the inflation measures to start reflecting that now, and they are.
Last month, I illustrated how January was projected to be the point at which the Fed decides to pause its rate increases. January was when the trend of the Fed raising the Fake Funds rate would intersect with a somewhat likely trend of the Fed’s favorite inflation measure, the Core PCE.
That still appears true, despite the updated projections I have made as a result of the latest data from the PPI Core Consumer Final Demand measure, which tends to lead CPI and PCE by a month or two.
We now have two consecutive monthly declines in that measure. It is now falling at an annualize rate in excess of -11%. In fact, the last few months of Core CPI and Core PCE are also negative.
Inflation is dead. But the market doesn’t know it yet. Policy makers don’t know it yet. The media doesn’t know it yet.
We know it. But it doesn’t matter. Because the Fed will almost certainly continue QT, removing cash from the system, even if they “pause” in pretending to raise interest rates. The Fed is reactive, not proactive. It will wait until something big breaks, before it takes action to aggressively reverse policy and start pumping enough money into the markets to re-ignite long bull runs that carry stocks and bonds to new recovery highs.
Any rallies that happen before such a policy change will be temporary, and will lead to the markets again readjusting downward in response to a shortage of cash.
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