Coronavirus Is NOT Biggest Market Story

KW: Dow tumbles 600 points as fear of coronavirus takes toll on markets…But that is not the most important factor here. We should all be concerned about coronavirus but in my opinion not become alarmed unless you hear over the next couple of weeks that millions are now infected with an uncontrolled explosion of cases, other wise its serious but not really bad for the health of the worlds population. The real stuff is about the constant and building market support by the FED printing BILLIONS $  of new money every day to keep markets from jamming up.

From the Daily Reckoning

Everyone’s focused on the coronavirus right now. The Dow was down over 650 points at one point this afternoon over the latest fears, or at least that’s the official explanation.

But while it’s a potentially significant development, the biggest market story right now isn’t the coronavirus — it’s the Federal Reserve. It held interest rates in place during this week’s FOMC meeting. But interest rates aren’t the central story. The Fed’s balance sheet is.

The Fed’s current balance sheet expansion policy, which began in October, is by far the most powerful factor pushing stocks higher. No other factor has come close to the Fed’s money printing in driving the market. Before the recent hiccup from the coronavirus, stocks rallied almost nonstop since this policy was announced on Oct. 11, in reaction to trouble in the short-term money markets.

Forget about the coronavirus for a minute. All other factors affecting markets have faded into the background, including U.S.-China trade talks, unimpressive corporate earnings and the lackluster global economy. All three will certainly return as important market drivers in the future. But for now, the main story is the balance sheet.

To Inflate or not inflate….. Since early September, the Fed’s balance sheet has ballooned from $3.7 trillion to about $4.11 trillion. The balance sheet didn’t even expand at that rate during the financial crisis.

Meanwhile, the New York Fed just added $82.58 billion in new liquidity yesterday. Will the Fed continue printing? Or will it pause on worries that the market has misinterpreted its goals?

That second question is especially important. That’s because for many investors, buying stocks has become a knee-jerk response to a rapid increase in the Fed’s balance sheet. That really wasn’t the Fed’s intention when it initiated the policy, which was designed to plug a leak in the financial plumbing system.

Fed officials say that this particular balance sheet expansion is not the same as quantitative easing, or QE. “These actions are purely technical measures to support the effective implementation of the FOMC’s monetary policy,” said the Oct. 11 Fed statement, “and do not represent a change in the stance of monetary policy.” So the Fed is technically correct when it says it’s not engaging in QE.

But investors have already concluded that the Fed won’t have the guts to unwind its balance sheet, even if it started causing problems with the U.S. dollar’s exchange value or with inflation expectations. Does the Fed want to leave investors with the impression that it’s become a tool of the Treasury department or the guarantor of stock prices?

To explore potential answers, let’s look back to the reason for the initial spike in repo rates in September.

The FED declared war on honest prices. Trouble began because there was an imbalance between supply and demand in the Treasury auction market. In the real world, price changes correct imbalances between supply and demand. A supply shortage or demand surge sends price higher; a supply glut or demand crash sends prices lower. But the market for newly issued Treasury securities is not a real-world market. It’s managed by three highly conflicted parties looking to maintain order and control: the Fed, the U.S. Treasury and large primary dealer banks on Wall Street.

Treasury supply, driven by a big federal deficit and the end of the latest debt ceiling showdown, temporarily overwhelmed demand for short-term Treasuries. The debt ceiling limited total U.S. Treasury debt to around $22 trillion for much of 2019. In August, it started growing rapidly again at a pace that took primary dealers off guard. The result was a rate spike. Treasury debt surged to $23.2 trillion by year-end 2019, with much of the new debt issuance funded directly or indirectly by the Fed. And here we get to the heart of the issue in today’s central bank-driven markets:

The Fed will not permit honest price discovery in the market for Treasury debt.

Banana Republic?

If the Fed wants to avoid the growing impression that it’s monetizing Treasury debt like a banana republic central bank, then Fed officials need to start communicating that there will soon be an end to its recent balance sheet expansion. At this week’s FOMC meeting, Fed Chair Jay Powell did… sort of. He said the current policy will extend at least through April:

Over the first half of this year we intend to adjust the size and pricing of repo operations as we transition away from their active use in supplying reserves. This process will take place gradually… We expect to continue offering repos at least through April.

The magic words here are “at least.” We’ll have to see what that really means. But in December he mentioned January as the possible cutoff, so take from that what you will.

Meanwhile, most stocks have run far ahead of their earning potential. So those who now hold massively overvalued stocks simply because the Fed has boosted its balance sheet had better hope the program continues for a while.

Otherwise, they could be in for a massive headache if the music stops.

Share Button