At the risk of sounding like a broken record, the main drag on markets is not the rolling narrative of politics, it is the money flow of central banks and in particular the Federal Reserve.
The stock market has been going up since the credit crunch of 2007/2008 because liquidity has been pumped into the system and made the value of assets go up as the cheap credit has driven participants to seek out assets that will appreciate faster than the interest they have to pay. This is how QE (quantitative easing) saved the global economy and a lot of people’s homes and jobs.
Now that rescue cycle is deemed over, the Federal Reserve has decided to (and has been encouraged to) reverse the QE, to get its assets and liabilities downsized. From a QE high of $4.5 trillion they have shrunk the balance sheet down to $4.1 trillion.
It is no coincidence that this process started in earnest this January and coincides with the U.S. stock markets going into cardiac arrest or at least changing its never-ending upward trend into a serious of vicious slumps and rallies. The rest of the world who have bathed in cheap dollar finance are especially suffering from this credit ‘cold turkey’ and markets and economies all over the world are suffering the beginnings of an economic winter.
Reverse-QE, as I call it, is draining liquidity. When QE pumped in, liquidity equities rose and now the reverse is happening so is the opposite.
The trouble is if the Fed is to get its balance sheet back down to 2008 levels of approximately $1 trillion at the advertised rate of $50 billion a month it will take 3-4 years of reverse-QE and ever-increasing tightening to get there.
Now the danger is reverse-QE will crash the markets and crush the global economy and the Federal Reserve is not stupid. You can see the $80 billion stated number as about equivalent to the level of economic growth in the U.S. economy. It’s a number that could strike a balance between liquidity withdrawn and liquidity generated. As such, reverse-QE might not break the system.
The trouble is, it is breaking the system. Why is not so important, my belief is that liquidity from growth is entering different parts of the economy from the direct injection of money from the Federal Reserve, so the effect is not equivalent.
However once again, the Fed is not stupid so they appear to be trying to keep things on track.
Evidence?
The Federal Reserve stated reverse-QE would be gently ramped to $50 billion, but the fact is reverse-QE or QT (quantitative tightening) is going at an irregular pace.
This is both good and bad news. The good news is that the Fed is actively open to the short-term needs of the economy and markets and is not doggedly welded to a policy and the demands that it shrink its balance sheet at a set rate. The bad news is that if they are to shrink their balance sheet back to $1 trillion it’s going to take more than five years where asset values will be either under pressure or at very least highly volatile.
It could be that after an extended period of economic weakness or a sudden market crash or even the obvious possibilities for one, that suddenly a big Federal Reserve will become seen as a good thing and QT will be ended, but for now the tide of money is going out for as far as the eye can see. So without a U-turn, whether it’s death by a thousand cuts or by a single dislocation, the outlook is at best poor and potentially awful.
You can see on the Federal Reserve’s site that they have actually at times reversed policy and for a week or so gone into what looks like QE mode. You can find the path of QE/reverse-QE on their site here.
You can see in August and November the moments when the Fed balance sheet grew.
So the call is, can the Federal Reserve walk this incredibly long tightrope, with all the outrageous global political and economic developments, without falling off?
My opinion is that it will take a miracle and even if they pull it off the process will be gruelling.
The days of the market ‘melting up’ are gone, the days of minor bad news sending the stock market skidding are back.
I think the rout has begun, but I am reassured the regulators are at least trying to keep things on the rails.
If you are a bull you see the market will sideways trade; if you are a bear, like me, you see the crash has already begun.
If you are a bear you will point to the German DAX as a crash already underway and a path the U.S. markets are about to follow.
Here is that chart with the German DAX now down 20% from its high:
(Sidebar: It doesn’t look too bad but that’s a 20% drop in the DAX.)
Even at 20% down you need to be a brave optimist to say this is the low and if it isn’t it’s hard to pick one that isn’t very bearish indeed.
With ‘reverse-QE forever’ on the cards the only call you have to make is the one and only ever important one.
Which way is the market going? For me that is a rhetorical question.
----
Clem Chambers is the CEO of private investors Web site ADVFN.com and author of Be Rich, The Game in Wall Street and Trading Cryptocurrencies: A Beginner’s Guide.
