We are seeing significant volatility and huge swings in the market. No doubt that panic is starting to rear its ugly head. While I am critical of this market and do expect a correction, I don’t believe the Fed will sit by in this next FOMC meeting and risk a significant market sell-off heading into the mid-terms. Of course there is the chance that Yellen fumbles the ball on the 1 yard line with vague Fed’s words and little action, only to fall on deaf ears. However, we saw the knee jerk huge rally after the uber-dovish Fed minutes. Regardless how dovish the Fed speak is, they will have to act or at the very least offer a very clear dovish statement to cool the fears. Yet, the question remains – how much more Fed “easy money” can kept the market and leverage aloft, at some point and usually when we least expect it, it just fails. For now the Zero Interest Rate Policy (ZIRP) is here to stay.
If you are at zero, where can you go? That is a concerning question that economist have in relation to the Fed’s ability to jump start the economy, if we move into another recession in the near-term. I would argue we have been in recessionary environment since 2009 (if we remove the appreciation of the stock market). Looking at real unemployment data and also job creation – it has been a weak recovery at best, if you want to call it that. Even the Fed has used terms like “structural unemployment” problems and “slack labor market”, they see the raw data and it doesn’t reflect anything remotely like the U3 5.9% unemployment rate would have us believe, hence the Fed lowering the U3 target rate and now dispensing with it all together. The Fed has technically admitted – the U3 is not accurate in reflecting the unemployment problem in this nation.
That gets us back to the problem of the major tool in their tool box, interest rates. If they are running them at zero there is nowhere to go. They are floored and if you run zero interest rates and can’t jump start the real economy by pouring in free money, then you have a serious problem.
What’s far worse than not being able to jump-start the economy with a Zero Interest Rate Policy (ZIRP), is the massive hidden tidal wave of monetary inflation. The Fed has poured trillions into the market, but it is not moving, it’s dammed up behind an invisible wall. At this point the velocity of money (the circulation – how fast money passes from one holder to the next) compared to the ratio of the increase of money is inverted. Money is being printed, but is dammed up somewhere.
The Keynesians at the Fed believe that if they print lots of money and lower rates to zero, the massive amount of extra money will trickle down through the system. People will borrow and spend it, it will create jobs, and the flow (velocity) will pick up. Well that is what their theory states and that is what 6 years of ZIRP is trying to accomplish, yet it’s not working. The Fed monitors both the M1 and M2 velocity vs. the nominal GDP, nad while I don’t think this gives us the resolution and magnitude of the problem, it does clearly show the velocity is in a massive decline. The results are the exact opposite of what the Fed is intending to do. The Keynesians and more Dovish Fed members, including Yellen believe we have not printed enough – we need to print more. Perhaps printing more will get the money moving. Really? It is that absurd.
So what creates Velocity?
Natural velocity in a free capital markets is balanced by free market interest rates. Money flows into savings and then back into capital investments. Money will also seek returns, either monetary returns or intrinsic value returns. Money will also flow into necessity assets – like food and energy. As risk increases, interest rates increase, and velocity slows and seeks out safe returns (bonds). As risk decreases, interest rates decrease, and velocity picks up as it seeks out growth.
When you interrupt this natural velocity, you create a dam. In the economic crisis money was trying to flow to safety (bonds) and out of risk assets (stock). However, when the Fed artificially fixed interest rates to zero, it slowed velocity – in fact it stalled and collapsed. Money no longer naturally seeked safety in bonds, because bonds paid nothing – it didn’t offset risk or inflation. In fact the velocity into treasuries almost completely disappeared altogether, the Fed had to print even MORE money to start buying U.S. treasury bonds to make up for this contraction of money flow into treasuries. Who wants to buy a treasury that pays nothing and returns NEGATIVE real returns? The ZIRP policy created a dam and halted the velocity of money.
Hoover Dam – courtesy of wikipedia
In my very humble opinion the Fed has it all wrong, completely wrong in fact. While I agree with Keynesians and most likely all economists, about the math of velocity of money and its significance, where I, along with Austrian economist part ways with our Keynesian cohorts, is the CAUSE of the velocity. Keynesians believe that they just need to flood the system with money and zero rates and it should start moving. That theory reminds me of someone trying to start a car and believes it needs MORE gas and just floods the engine or someone that is trying to unclog a toilet just continues to flush it thinking that MORE water will unclog it.
Keynesians, much like politicians of similar ideology, tend to ignore the CAUSE and rather just address the symptoms. Their answer usually always falls back on, “We didn’t spend enough!”, “We didn’t stimulate enough!”, and “We didn’t print enough!” – They never ask the questions about the WHY or WHAT? Which until you are able to ascertain that, you can’t come up with the HOW? You hear this same argument over-and-over with many problems, like education – “Schools need MORE money!” I am not sure at what point they realize that MONEY is not the magic answer that solves ALL problems.
The other problem is the basic structure of leverage. While leverage does allow for higher returns on capital, it also increases the risk factor and additionally it puts at risk additional capital. This additional capital, used to provide the margin doesn’t actually exist. It is credit provided by the Fed and is not expected to be called upon.
Leverage in the housing and equity markets started accelerating. When leverage increased and assets increased in value, it created UNREALIZED wealth. This newly created UNREALIZED wealth was then borrowed and further leveraged. It also accelerated the velocity of money, because when you borrow money (leverage) and then pour it back into the system, it accelerates the velocity money and this can become exponential. Velocity doesn’t know or necessarily care how the money was created – just that it is flowing. This fact is also ignored by the Keynesian economists.
Leverage, just like a credit card, is not a bad thing – it is just another tool. However, when the rules allow for an expansion of leverage, if it goes unchecked, and the government condones such action by creating regulations and policies that further encourage MORE leverage (like Freddie and Fannie – remember “Home ownership is a RIGHT!” type attitude), the math and risk is ignored. As the assets (homes) increase in price, year-after-year, the concern about the math and risk used to create such leverage is ignored. People are blind and believe that prices will only go up. The accelerates velocity and eventually it becomes parabolic and debt mounts.
Keynesians don’t look at the risk and further don’t really care about debt, if in the short-term it accelerates asset prices. They never SEE the bubble they are creating and then cry FOUL when it bursts. The Keynesian and social ideology that encourages this behavior, provides the monetary policies, legislation, and the regulation that permits this behavior, is one of the core blames for creating these bubbles. Having the likes of Barney Frank (a trusted elected Congressman that Chaired the House Financial Services Committee), making statements like “Home ownership is a RIGHT for every American!” and blindly supporting the GSEs (Freddie and Fannie), which he oversaw 100:1 leverage ratios, and defended the GSEs when accounting scandals came forth – only further inflate the bubble and encourages leverage debt acceleration. It is Frankly irresponsible, pun intended.
Courtesy of wikipedia
The Fed’s policy of zero interest rates, coupled with buying up trillions of unwanted Treasuries and Mortgage Back Securities (MBSs), never addressed the leverage issue. In fact, they never really saw the leverage issue as a problem. Part of the reason is that it is far too difficult to accept failure. Remember, these Fed members have been raised as Keynesians Economists – that is (for the most part) the only economic theory taught in school. It has been here since the 1930s and they blindly look back fondly at FDR and the New Deal their savior from the Great Depression. Never admitting even the faint possibility their interventionism and theories could be at fault, even the slightest. They ignored the fact their supposed greatest monetary achievement, Bretton Woods, failed. They blame the gold standard, which they had once embraced, as being the failure. It was certainly NOT their inability to “Maintain” their accountability and responsibility. Because they fail to look at the cause and certainly skirt any responsibility, they blindly maintain their belief that the only thing that is needed is MORE money.
Keynesian Resurgence in 2008-2009 – leader of the Keynesian movement, Paul Krugman – courtesy of wikipedia
The Fed was so concerned about JUMP STARTING the economy, rather than reducing debt by holding companies and individuals responsible, they have allowed MORE leverage and debt to accumulate. The first wave of 100s of billions was just filling up leverage debt holes – paying off margin debt. Then as the leverage and bailouts removed risk from the private sector (shifting it to the public sector), the Fed – through their monetary policy – continued with zero interest rates and more money printing and asset purchases, ramping up leverage again, now bigger than before. The problem is never solved, just kicked down the road. The Fed is buying time and hoping that the economy jump starts – but how can it when the economy is now addicted and reliant upon zero interest rates and more government money. The circle continues.
Function of Interest Rates
I have covered this before; interest rates are a function of risk. With the Fed artificially lowering interest rates to zero, it is impossible for lenders to provide capital to those that need it the most (higher risk borrowers). Why, because the entire function of interest rates is to off-set the risk of the borrower? If the banks are forced into low interest rates, they will be unlikely to lend money at the low rates to high risk borrowers – because the risk of default is just too high. So the only borrowers become those that don’t need the money, the rich (those with money and assets).
Zero interest rates also freezes velocity as money does NOT flow into bonds and what is left is eventually forced into to risk assets (stocks) as it seeks returns. This exacerbates the leverage (margin debt), because interest rates are ZERO.
The ZIRP policy acts as a DAM for the velocity of money, while expanding leverage debt. It does the EXACT opposite of what the Fed is trying to do. It certainly provides CHEAP money for those that don’t need it (low risk borrowers – the rich). To some extent the argument the “Rich getting richer” is true and ironically it is the cause and effect from a Fed ZIRP policy, who’s best of intentions is trying to help create jobs and boost the middle class. Ironically it is only hurting the middle class. If more wealthy people realized the benefits of ZIRP, they probably would all vote Democrat.
Courtesy of wikipedia
I am frequently asked when is this HYPERINFLATION risk that I am so concerned about going to happen. The honest answer is I don’t know. I guess the best analogy I can give is that I am watching the flood of money behind this massive ZRIP dam rise (money is not moving, there is NO velocity). Watching this ZIRP dam, one can’t help but wonder how much MORE money can it hold and how structurally sound is it. Everything has a level of structural integrity and the question is how strong is the might of Fed ZIRP dam? Can it last another week, month, year, or decade? It lasted two decades in Japan – maybe it will hold that long here, but I very much doubt it. Japan had the benefit of being the ONLY ZIRP Dam, now we have the European and Fed ZIRP dams – which are only expanding the problem and trillions more if flooding behind it’s walls.
When the dam breaks, we will see the velocity of money accelerate and depending on that acceleration we could see high inflation. Buffet expects double digit inflation of the 1970s, others expect far worse. Back in the late 1970s and early 1980s, the Fed Chair, Paul Volcker took the unpopular action of raising interest rates far above inflation to stop the flooding and slow the velocity. It hurt the economy, but saved the dollar. I am not sure if Yellen, who is such a radical Keynesian and Dove will ever come to the realization that her (the Fed’s) policies are the root cause of the problem. She is meek and I don’t believe has the cojones to play the radically unpopular Volcker card. For if she did, she would have to admit that her core belief has been wrong, her teaching, her speeches, her papers, and her policy – all wrong – she doesn’t seem like someone that can emotional come to terms with that type of realization, after reading her papers. She BELIEVES unquestioningly in her theory.
The End Game
The Fed “hopes”, even after almost 7 years of velocity contraction that it will pick up. If we can see a slow and steady increase in the velocity, then perhaps it can happen and we will eventually get out of this. However, that rise needs to be SLOW and steady, as to avoid high or worst hyper-inflation. I don’t know – as I have said – if the Fed and Yellen are capable to get in front of a radical rise in the velocity.
What is more likely to happen is a catalyst situation that cracks the ZIRP dam.
1. China or BRICs re-pricing commodities into another currency. Dollar loses reserve status.
2. European country/s have economic collapse – most likely one of the PIGS or even France.
3. The Fed goes too far and takes rates NEGATIVE and that triggers an exodus from the dollar.
4. Large trade or major corporations require additional non-dollar denominated collateral.
I am not sure if we will see a war or geopolitical unstable event be the cause to crack the dam. In fact, and I really hate to say it, a war could just be the thing that helps the velocity of money to rise in a steady fashion to bring us out of this malaise. It makes me sick to even think or suggest such a thing, but after studying money, debt, and velocity during the 1930s- 1940s you see how impactful WWII was to getting the flow going again. Sad when war is the solver of economic woes, because our own leaders fail in their accountability and responsibility to maintain the soundness of our currency.
The recent Market Previews are talking about the BIG PICTURE, huge economic swells and not stocks or earnings of late. This is because we are married to the Fed policy; it is driving the bond market, the stock market, and the value of the dollar. The Fed is IN the market – it IS the biggest player – we MUST take heed and understand the impact.
I expect a volatile end game, but I am not sure if we are seeing the cracks in the ZIRP dam today. I think the Fed still has enough strength to shore up the dam for a little longer and the mid-terms play a pivotal character in this Keynesian play. The Fed, through recent statements and their minutes have indicated that the dam will hold (no rate hikes and perhaps MORE money printing).
Until the FOMC meeting in a couple of weeks – we should expect big-intra-day volatility. As we test the structural integrity of this ZIRP Dam. It will break at some point – but I think it can hold for now – at least until Nov 4th.
Support & Resistance
I think we will close positive today – perhaps a little reprieve from the volatility. The 16,400 level is the low area that we rallied from in August. We could visit that level, perhaps not today – but certainly before the FOMC meeting.
The NDX is always the most volatile when you least expect it. It takes only one heavy weight to grab this index by the nap of the neck and shake it like a rabid dog with a bone. I think we could get some strength into the close.
SPX 1900 – 1940
We could see some closing strength, perhaps pushing this index back up into the 1930-1940 range. The VIX is now up to the 18+ level and I suspect we are getting into fair-value options pricing after being so undervalued.
The larger concern for me is that the broader based index was unable to hold the 1100 and if we can’t see some rebound in this index and a drive back above 1100, we could be in for a larger drop. Perhaps the FOMC will ride to the rescue.
It is in the Fed’s court at this point. The dollar is rallying against the basket, while Europe and Japan continue to fire all guns – pounding us with massive amounts of Euro and Yen from their QE guns. Meanwhile Yellen has not fire back a single broadside this year – the QE guns have begun to quiet and are expected to stop firing entirely by this next FOMC meeting.
The Fed, in their minutes, are very concern about the economic growth and have directly pointed to the dollar rise (the ECB and BOJ QE blasts) as the culprit. I believe that Yellen is mustering the troops, loading the QE guns for bear and ready to announce her own broadside that will send the dollar down. Her ZIRP Flag will continue to fly high – zero rates are here to stay.
For if she remains weak, she fumbles at the next FOMC, any hints of hawks tone (intended or not) – will send this market into a nose dive and the dollar rocketing higher. It will also be the nail in the Democrat coffin come this election – as a falling market (the only thing that Fed policy has helped) will now bring forth a wave of pessimism.
I don’t think she will let that happen – she must be ready to face criticism for more accommodation from the Hawks, but the two most vocal Hawks are leaving and have announced their retirement – she is surrounded in a love blanket of Keynesians that will only hail her name, if she brings the QE warship back into action.
Then – after the mid-terms – we are back in a full blown Devaluation Currency War and time will tell if our ZIRP dam can hold and for how long.