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The FED Can’t Keep its Spoiled Child in Check

Today, March 20, 2019, a FOMC rate hike decision was made. It is official-the FED can’t keep its spoiled child in check.

First, you will find below the FED’s dot plots from December and today. The dot plot is a tool that the FED uses to convey to the market what the Federal Funds Rate will be in the future.

Using the upper range of the current Federal Fund’s Rate of 2.5%, we can analyze the swing in the projection. On December 19, 2018, 15 of the 17 dots were above the 2.5% line for 2019 projection. Today, only 6 of the 17 dots are above the line for 2019 projection.

So, why did this happen?

https://www.cnbc.com/2018/12/19/fed-dot-plot-december-2018.html

https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20190320.pdf

Below, you will find a graph of the FED Funds Futures. The first one is for what the market was predicting the FED Funds Rate would be on March 20, 2019 over time. After the December stock market meltdown, the market began projecting that the FED would be close to capitulating, employing the “Powell Put,” or saving the market…whatever you want to refer to it as.

Think of the market as a spoiled child and the FED as its parent. In December, the market sold off violently. Essentially, the market threw a tantrum and the FED came in and said it would be less hawkish going forward like a parent getting its child to shut up by buying it a present. The child liked this and as you can see by the chart below, the probability of the FED Funds Rate being 2.75% by the March meeting plunged from around 40% to 0% and the probability of it remaining at 2.5% skyrocketed from around 50% to 100%. This led to the market appreciating by roughly 20% since the December lows!

https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

So what’s the issue? Below, you will find that the FED Funds Futures chart for January 20, 2020. The market expects the FED Funds rate to be 2.5% with a probability of over 60%. In short time, I expect this number to reach near 100%.

Each time the market throws a tantrum, the FED has less presents to give. The next present that will be given is most likely a rate cut. Once that game begins, the FED only has presents for the market from 2.5% to 0%.

I leave you with two questions.

Do you think that the buffer zone to cut from 2.5% to 0% is enough to levitate markets indefinitely?

What happens if inflation shows up in the CPI and the FED is forced to raise rates without the market’s blessing?

Lords of Finance by Liaquat Ahamed (pg. 87)

However, when the Reichsbank was being formed in 1871, his [Count Otto von Bismarck] own private banker and confidant, Gershon Bleichröder, warned him that there would be occasions when political considerations would have to override purely economic judgements and at such times too independent a central bank would be a nuisance.

Lords of Finance by Liaquat Ahamed (pg. 86)

Determined never again to be held hostage by moneymen, Napoleon changed the Bankque’s statutes so that henceforth the governor and the two deputy governors would be appointed directly by the government, which at that time meant Napoléon himself. He declared at the time, “The Banque does not only belong to its shareholders, but also to the state…. I want the Banque to be sufficiently in government hands without being too much so.”

“The Market ALWAYS Comes Back” and “You CAN’T Time the Market” Debunked

When a bear and a bull meet at a crossroads, a debate ensues. In the amateur world, the debate will end with the bull saying something along the lines of “the market always comes back.”

The first issue with this statement is that the time it takes for the market to come back is not specified.

Let me clarify that I am assuming that the bull would claim anytime is a good time to buy stocks, since the bull says, “The market always goes up over time.” This clarification allows me to illustrate some times the bull should have kept his or her mouth shut without the hindsight dismissal of “You cherrypicked the worst times.”

The best current example is the Nikkei 225. This is one of the headline indexes out of Japan. Immediately, those with the home bias of the US will say, “This is irrelevant. That is Japan.” Anyways, this illustrates that in the modern era a country’s major stock market index can exhibit an inability to “always come back.” If you invested in the Nikkei 225 in 1989, you are still underwater. It is now 30 years later.

Below, is a historical Log scale chart of the S&P 500. If you had invested in 1929, it would have taken you 25 years to get back to even. If you had invested in 2000, and did not sell for a minuscule gain in 2007, then you would have been underwater for approximately 12.5 years. Also, I have attached the standard scale chart of the S&P 500 just to demonstrate the parabolic nature of the recent move and its similarity to Japan years ago.

Next, I would like to stress an important point that is misunderstood by many. This point is the proper use of opportunity costs. Those who say you cannot take your money out of “the market” due to giving up on gains are confused. Opportunity cost is not a function of…

[Returns you could have had in the market-ZERO]

This function would be correct if the money that comes out of the market does not re-allocate towards anything at all. Cash is an allocation. If cash returns 2% (1.8% in 2018), and if the S&P 500 returns 10%, your opportunity cost is not 10% for being “out of the market.” Your opportunity cost is actually 8%. Also, I will not get into it, but cash is not the only alternative when getting out of “the market” as many seem to think.

The other camp that understands the market can take very large amounts of time to come back, may say “you can’t time the market.” This statement is said with so little backing. To those who make such a statement, have you ever even calculated the amount of time you have to time the market? I am simply going to use the past 2 cycles as precedent in the US for market timing abilities. I think this is fair, since if the bulls can extrapolate into the forever future, shouldn’t a bear be able to?

If you determined that the tech bubble of 2000 was a bubble, then you had a nearly a 6 year window to time it right. For example, if you exited “the market” in May 1997, then you could have bought in at February 2003 with no opportunity loss via “market” investments. Theoretically, you could have never invested in the housing bubble cycle, since the subsequent trough in the housing bubble cycle was lower than that of the trough of the tech bubble cycle. You could have even exited “the market” in December of 1996 and entered in February 2009 with no opportunity loss via “market” investments. That is a little over 12 years. If past is prologue, and the S&P 500 falls the average of the past two bubble cycles, then the S&P 500 will fall 48.6% (44.6% in 2000 and 52.6% in 2008). If the S&P 500 fell 48.6% from an assumed peak in September 2018, then it would land at about 1506. With that in mind, you could have theoretically sold in February 2013, with no opportunity loss via “market” investments.

I would like to leave those in the camp of the market always comes back with one last thought. Have you considered the risk that nominal “market” values come back, but real “market” values do not?

Lords of Finance by Liaquat Ahamed (pg. 80)

Though the directors of the Bank were charged with governing the supply of credit in Britain, and by extension around the globe, they did not pretend to know very much about economics, central banking, or monetary policy. An economist of the 1920s once described them as resembling ship captains who not only refused to learn the principles of navigation but believed that these were unnecessary.

Lords of Finance by Liaquat Ahamed (pg. 76)

Once they had exhausted every potential source of loans, they relied on a technique almost as old as war itself: inflation. Unlike medieval kings, however, who accomplished this either by shaving pieces of gold and silver off the outer edge of their coins–a practice known as clipping–or of issuing coinage made of cheaper alloys–currency debasement–governments in the Great War turned to their central banks, often relying on complex accounting ruses to disguise the process. Central banks in turn, abandoning their longstanding principle of only issuing currency backed by gold, simply printed the money.

Is a VOLATILITY event in the making?

The situation the market currently resides in is one where market participants cannot decide which force is stronger…

“Powell/Mnuchin/Trump Put” + China Trade Deal Prospects

vs.

Fundamental overvaluation of equities + “U.S. Earnings Recession” + “Synchronized Global Economic Slowdown”

Let’s first look at the technicals on the U.S. equity market (S&P 500) in tandem with the VIX. We know that the S&P 500 has 3 prior failed breakout attempts above the 200-day moving average on 10/17/18, 11/17/18, and 12/3/18. We also know that we currently reside just above this powerful line in the sand once again.

Now, let’s take a look at the VIX. I have circled the prior instances that the S&P 500 was above the 200-day moving average on the VIX chart. These circles all occurred pre-VIX spikes.

From 10/17/18-10/24/18, the VIX jumped from 17.40 to 25.23 in a 45% move. From 11/17/18-11/20/18, the VIX jumped from 18.14 to 22.48 in a 24% move. From 12/3/18-12/24/18, the VIX jumped from 16.44 to 36.07 in a 119% move.

Today, 2/22/19, the VIX is flirting with the 14 mark, which is below the 10-day moving average as other pre-VIX spikes had been prior to their moves.

Some technicals are certainly in play, but now we must ask if we have any catalysts coming to fruition. The answer is yes. On 2/28/19, the long awaited Q4 2019 GDP results will be released. The market already ignored the downward revision of the Atlanta Fed’s potentially lofty estimate. We shall wait and see if confirmation of a downward revision, or a further downside surprise, will have an effect on the market.

Lords of Finance by Liaquat Ahamed (pg. 69)

Also gold coins began mysteriously to vanish from circulation. Having been burned by disastrous experiments with paper money twice before–once in the early eighteenth century during the ill-fated Mississippi Bubble, and then again by the assignats issued during the Revolution–the French had developed a healthy mistrust of banks and all but the hardest metallic currency.

Lords of Finance by Liaquat Ahamed (pg. 54)

The 1907 panic exposed how fragile and vulnerable was the country’s banking system. Though the panic had finally been contained by decisive action on Morgan’s part, it became clear that the United States could not afford to keep relying on one man to guarantee its stability, especially since that man was now seventy years old, semiretired, and focused primarily on amassing an unsurpassed art collection and yachting to more congenial climes with his bevy of middle-aged mistresses.

Lords of Finance by Liaquat Ahamed (pg. 43)

In the middle of the crisis, Germany was hit by a financial panic. The stock market plunged by 30 percent in a single day, there was a run on banks across the country as the public lost its nerve and started cashing in currency notes for gold, and the Reichsbank lost a fifth of its gold reserves in the space of a month. Some of this was rumored to have been caused by a withdrawal of funds by French and Russian banks, supposedly orchestrated by the French finance minister.