The Crayon Has Limits

I am of two minds here. One, ZB and TLT aren't dusted yet. This is an area from which a rally can begin and that comports with a very bearish outlook for equities and my forecast of deflation hitting.

The second thought is that normalizing monetary policy requires permanently higher interest rates. In one sense, the Federal Reserve's QE policy is life support for the bond bull market over the intermediate-term, arguably long-term if we're talking about financial market cycles. In the immediate present, running QE in reverse (QT) at around 80 percent of peak asset buying should be highly deflationary and push rates lower. Evaporating buying from the Fed will initially be overwhelmed by "safe-haven" buying by traders, seculators and investors.

My Nasdaq WAG is complete. I don't expect a crash lower, but I do think the best time to short was August 15 and 16. My last major trades ahead of vacation were on August 15, adding more AAPL 140 puts and SPY 380 puts for October.

Crude oil has been quite volatile. I still expect there will be a $60 handle sooner rather than later.

Will QT Ever Arrive?

Here are the different phases of the Fed's balance sheet. It stops growing at the start of 2014 and stocks gain about 5 percent annualized into the November 2016 Presidential Election. Then the "Trump boom" kicks in with tax cuts boosting corporate earnings. Then QT kicks in starting October 2017 and continues until the Fed pivots in early 2019. Stocks experience a 20 percent correction until the Fed stops rate hikes. Then QT continues for awhile until the summer 2019 repo crisis hints at major trouble coming. The coronavirus ends up being in the right place at the right time for a panic. Then the market surges on insane amounts of QE and federal stimulus. The Fed announces plan for taper in November 2021. The Nasdaq tops almost immediately, the S&P 500 Index in January. Up next, assuming the Fed stops lying about its plans this year (it delayed the taper and has delayed the first stage of QT), is stepping on the accelerator next month with $95 billion in bonds maturing off the balance sheet.

Before QE and QT, the Fed's balance sheet didn't matter. I believe their best course of action is doing nothing because the Fed's balance sheet doesn't seem to do much except prop up equities. By engaging in QT, they will achieve the reverse of QE: a decline in stock prices and nothing else. The central bank is a failed institution that should blend itself back into the background of the economy and financial markets, if abolishing it entirely isn't an option.

Fed Taper Still Going Slow

The gap between what the Fed should have tapered and what it has tapered, continues to widen.

Fed Balance Sheet Shrinks $21B Last Week

QT kicks in.

Tired: US Gold is Gone; Wired: Chinese Everything is Gone

Yahoo: Traders in China Rush to Check Metal Stocks on Pledging Concerns

Traders are rushing to check that the metal they hold in Chinese warehouses really exists, as allegations of irregular financing trigger a widespread loss of confidence in the world’s largest aluminum market.

...Last week’s allegations, which are focused on a facility in the city of Foshan in southern Guangdong province, have spooked China’s metals markets, which rely on warehouse receipts to prove ownership. Several traders have alleged they lent a total of more than 500 million yuan ($75 million) against stockpiles of the metal stored in the Guangdong warehouse, but then found the inventories were worth significantly less than that.

Some Chinese traders have started moving inventories to warehouses they believe are less risky, according to the people.

Back in 2014 it was copper. Please note the date of these copper posts from June and July 2014, right when the U.S. dollar began its bull market in the midst of the Federal Reserve's taper of QE3. Economic and financial market patterns are repeating!

Credit Guarantee Nightmare; How The Qingdao Port Scandal Goes Viral

China Copper Scandal May Have Spread to Penglai; Bad Debt Could Reach Billions of Dollars

Steel Trade Lawsuits Explode; Banks' Unceasing Nightmare; Defendants Flee

ZB Inverted

The H&S bottom hasn't been invalidated yet...as QT kicks off.

QT2: Judgement Day

Some prior posts on QT, mostly from 2018. 

This is a chart from November 2018 that helps show the relatively high correlation between the S&P 500 and the Fed's balance sheet within one week.

Feb 2018: Will Fed Balance Sheet Reduction Be QE in Reverse? only has this chart:

Feb 2018: A Look Back at 2015- gives some economic context.

March 2018: Federal Reserve Bought Treasuries in March a reminder that QT, like the taper, will be voluntary and lumpy even if they don't backtrack

May 2018: Another Narrative Failure: Foreign Treasury Sales a reminder that selling treasuries could be forced by dollar illiquidity. Still many traders are looking for a weaker dollar, but these tightening episodes have been dollar bullish in the past.

May 2018: Fed to Investors: Not Our Fault You Overpaid for Assets my paraphrasing after Powell discussed capital flows out of EMs and into the US.

May 2018: Contrarian View: Higher Interest Rates and Deflation who knows what happens now, but the underappreciated risk for markets is the Fed normalizes policy. This could happen if say the CPI gets to around 6 percent, the Fed is at 4 percent, the economy is clearly in recession and the Fed announces it will halt rate hikes as long as the CPI stays flat or declines. This is the "there is no pivot, QE is over" horror show for equity bulls.

May 2018: Does Fed Balance Sheet Matter

April 2022: RIP Bull Market, QT is Here

I went back and tagged a bunch of posts with the QT label. Many of them are weekly updates on the Fed's balance sheet.

I do not expect major balance sheet changes until later in June, but given the history, I think we can also guess what the next weekly update will show by the behavior of the market. It's not perfect, but in 2018 it was good enough. If stocks tumble, there will likely be an associated drop in the Fed balance sheet.

QT2 and Stocks

The Fed slowed the balance sheet to a crawl in April and stocks went straight down. Coincidence?

Fed Starts QT at $47.5 Billion in June, Maxes to $95 Billion After Three Months

The Fed announced their QT schedule. Starts at $47.5 billion in June, almost the same as maximum QT from October to December 2018. They will ramp it to $95 billion after three months. They also hiked rates by 50 bps.

The Last Time the Fed Hiked With QT

Gold bottomed first, thenlong-term treasuries, then stocks and oil when the Fed ended rates hikes in January 2019. Stocks and oil went up during QT last time, but the amount of QE didn't hit $50 billion per month until October 2018. Based on public statements by FOMC members, the Fed will hit its $95 billion per month target by July or August, and will probably cross $50 billion by June or July at the latest. Depending on whether they start QT in May or move the start to June.

Fed Rainbow

Could teh Fed engineer a symmetrical drop in rates? Yes, if the start QT from $50 billion or more.

The Fed Should Not Do QE or QT

The best policy for the Fed here is to freeze the balance sheet and normalize interest rates. Instead of doing QT, announce there will never be QE again like was done the past 13 years. Throw it out of the toolkit except as a one-off bailout mechanism (nobody would believe they'd freeze the balance sheet forever). Instead, QT will inevitably lead to more QE and the economy will remain trapped on the Fed's wheel of suffering.

Update: Fed Will Shrink Balance Sheet by 1pc Per Month

The stock market tracks the Fed's balance sheet since 2009. The only lengthy period of time it stopped being correlated was from November 2016 to January 2018. When Trump tax cuts boosted the market and the Fed kept the balance sheet stable. Every single end of QE and the one instance of QT produced major market corrections.

The Fed plans on reducing the balance sheet by 1 percent per month within 3 months. I get the argument that they'll quit soon after starting, but how soon?

Update: Here is the percent reductions by month during QT1. Not that the data is weekly and the balance sheet changes are lumpy.

Fed Balance Sheet and the VIX

RIP Bull Market, QT is Here

Back in 2018, I expected a big bear move. I fortuitously posted this piece the weekend before the Volmageddon (though did not expect it). End of Rally or End of Bull: Is It 1987, 1994, 1997, 1998, 2000, 2007 or 2014?.

I expected a bear move in 2022 too, before knowing what type of QT, if any, was coming. See: The Bear Pill Adding QT to this backdrop only intensifies the bearish outlook for stocks.

QT was a major drive of Volmageddon and the autumn swoon in stocks. My thesis back then (I was far from alone in seeing this) was that the market tracked the Fed's balance sheet. The percentage change in both was very similar from 2008 to 2014. When QEs ended, there were sell-offs or sideways moves in stocks. A hypothesis was proposed. 

WALCL up (the FRED code for the balance sheet), SPY up. 

WALCL flat, SPY flat (with down moves and recoveries). 

WALCL down, SPY down.

QE also suppresses volatility as Federal Reserve Chairman Powell, then Vice Chairman, explained at the October 2012 meeting:

MR. POWELL. I have concerns about more purchases. As others have pointed out, the dealer community is now assuming close to a $4 trillion balance sheet and purchases through the first quarter of 2014. I admit that is a much stronger reaction than I anticipated, and I am uncomfortable with it for a couple of reasons.

First, the question, why stop at $4 trillion? The market in most cases will cheer us for doing more. It will never be enough for the market. Our models will always tell us that we are helping the economy, and I will probably always feel that those benefits are overestimated. And we will be able to tell ourselves that market function is not impaired and that inflation expectations are under control. What is to stop us, other than much faster economic growth, which it is probably not in our power to produce?

Second, I think we are actually at a point of encouraging risk-taking, and that should give us pause. Investors really do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but that they have every incentive to take more risk, and they are doing so. Meanwhile, we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy.

My third concern—and others have touched on it as well—is the problems of exiting from a near $4 trillion balance sheet. We’ve got a set of principles from June 2011 and have done some work since then, but it just seems to me that we seem to be way too confident that exit can be managed smoothly. Markets can be much more dynamic than we appear to think.

Take selling—we are talking about selling all of these mortgage-backed securities. Right now, we are buying the market, effectively, and private capital will begin to leave that activity and find something else to do. So when it is time for us to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response. So there are a couple of ways to look at it. It is about $1.2 trillion in sales; you take 60 months, you get about $20 billion a month. That is a very doable thing, it sounds like, in a market where the norm by the middle of next year is $80 billion a month. Another way to look at it, though, is that it’s not so much the sale, the duration; it’s also unloading our short volatility position. When you turn and say to the market, “I’ve got $1.2 trillion of these things,” it’s not just $20 billion a month— it’s the sight of the whole thing coming. And I think there is a pretty good chance that you could have quite a dynamic response in the market. And I would just say I want to understand that a lot better in the intermeeting period and leave it at that. Thank you very much, Mr. Chairman.

Now let's go to the charts.

First is WALCL and SPY.

Here is WALCL and SPY from December 2008 on, as a performance chart. The increase in SPY vs the increase in WALCL. Did you know the Fed reduced the balance sheet briefly at the start of 2009? That was yet another confirmation point of the QT thesis.

If I back up the chart a few months to October, you can see how tight the fit was until Trump was elected. That is my explanation for the 2016 to 2018 run. Trump's corporate tax cuts had a meaningfully positive impact on stocks. Additionally, before QE there was no correlation between stocks and the Fed's balance sheet because the Fed's balance sheet was rising so slowly it might as well have been a flat line. We should see stocks and the Fed's balance sheet uncorrelated in a normalization scenario.

Here is WALCL with VIX. It isn't a 100-percent correlation, but anyone in the markets since 2009 will remember the 2010 flash crash, 2011 correction, and 2015-2016 correction that really got underway with the yuan depreciation in August 2015. All of which came when there was no QE. And the QT period we covered above. The repo crisis of September 2019 that was swept under the rug by stealth QE4. Here we are again with QE5 ended and QT2 about to begin next month.

QT2

Back in 2018, the Fed's QT program peaked at $50 billion per month ($30 billion treasuries and $20 billion in MBS) in October. Two months later, the Fed panicked and ended balance sheet reduction.

This time, they want to phase in over about three months to a peak of $95 billion per month, composed of $60 billion in treasuries and $35 billion in MBS.

What do you propose will happen? 

On top of all this evidence, former Fed bank president Dudley called for the Fed to knock stock prices lower as part of a tightening effort. He all but confirmed what many have speculated, that rising stock prices is the real goal of QE. By extension, if the Fed wants to reverse QE via QT, should it not want to see equities decline at least at the start? Rising stocks signal the market "doesn't get it" or that the market thinks the tightening isn't enough. Bulls cannot win because if stocks go higher, the Fed will come back with a tighter policy until the equity market finally cracks under the pressure.

Trading QT2

The Fed started QT1 in October 2017 and it wasn't until it accelerated in January 2018 that the market finally cracked. It would take until October 2018 for the broader market to finally enter a sustained sell mode. There were many trading opportunities before then. Emerging markets fell steadily throughout the year as one example. I've been posting charts of stocks and sectors I see as weak now. 

As for when the major indexes start tumbling, I posit that it could start very soon. Earnings season is coming up and I already expect there will be more warnings and negative guidance in the mode of the Restoration Hardware call. QT2 will hit in May as well and will quickly hit the maximum of $95 billion per month. Phasing in by thirds, month two (June) of balance sheet reduction will exceed the peak of QT1. If the Fed starts big and phases in two smaller bumps, May's asset sales could be on par with the peak of QT1.

In conclusion, a significant decline in equities could begin immediately if the market front runs QT. By June or July at the latest, stocks may have hit a tradable low substantially below current prices and also well below the February lows. Complicating factors include inflation, interest rates and geopolitical risk. Stocks could relentlessly fall if rates and inflation stay high, or they could experience a compressed panic drop followed by a big recovery if crude oil and the 10-year Treasury yield plummet with equities.

If History Repeats, Oil Has Topped

QE is Finished

Normally I'd buy the glitch argument, but when bonds are aiming for a breakdown, it tells me teh Fed may be accelerating the taper.

ZH: Fed Cancels Bond-Buying Plan Today, Blames 'Technical Difficulties'

Crude Oil and Resource Currencies

The Speculative Investor looks at the Canadian dollar versus oil. The divergence with the Australian dollar is even more pronounced and looks similar to the prior Fed tightening periods.

Bearish as Ever

The market is approaching the conjuntion of a line formed by the 1929 and 2000 tops and a line formed between the post-QE1 top and QE2 top. The latter line served as resistance for the tapering of QE3 and for the current QE 4 taper, as this line has held since the Fed announced the taper (despite increasing QE!)

Could I be wrong? Of course! But right here, I'm as certain as I can ever be in the markets that the Federal Reserve will, however temporarily, follow through with a taper and rate hikes for a time. If not, then I'd rather own crude oil futures than the S&P 500.

Assuming I'm more right and the Fed somehow loses control in the next downturn, or is unable/refuses to intervene because some combination of the U.S. dollar, crude oil and interest rates prevents them, then I expect a low somewhere below the 2000 level. Similar to the 2s10s ratio chart I've posted before, I see the market waves since 2018 as created by the failure of the Federal Reserve. It painted itself into a corner by doing QE for far too long. There was a meltup in 2018 that caused the bank to think it was safe to reduce its balance sheet. Then it chickened out after a 20 percent correction. Then in panicked in September 2019 and started up repos again. Then came the early 2020 when the pandemic probably interrupted another topping process. It then created the largest move yet.

Going back to the start of QE in December 2008, the stock market has moved in lockstep with the Fed's balance sheet except between November 2016 and January 2018 when the Fed's balance sheet was stable and the Trump tax cuts boosted corporate profits. After that, the stock market and Fed balance sheet "reattached" and have been linked ever since.

Take an extremely simplistic view of the market and assume all S&P 500 gains that tracked the Fed's balance sheet are unsustainable and will be lost, that leaves about 100 percent return for the S&P 500 Index from its December 2008 level, which projects to arond 1800. I suspect a test of the 2000 and 2007 highs, closer to 1500, could mark the low for a real bear market. I therefore expect a bear market low would be around 1500 to 2000 on the S&P 500, or a 58 to 67 percent decline in the nominal S&P 500 Index.

The Slope of Hope

Bull markets climb a wall of worry. Bear markets ride the slope of hope.

Hellenic Shipping News: Iron ore rally built on China hope, not fundamentals

The spot price of iron ore for delivery to north China has surged almost 25% in the past three weeks, bouncing off a 19-month low as the market takes an optimistic view on Chinese steel demand next year.

H/T: The Sounding Line

I keep things simple. Optimism about China and inflation-memes push commodity prices up for a couple years. Then it all collapses when reality hits. I can boil the whole inflation-deflation debate down to this pattern. The cycle is assumed intact until it is proven dead. Trading is more nuanced, for example oil made a higher high this time. Is the cycle broken? My hunch is commodities will not make a new low in the next downturn (seems impossible outside of deflationary depression) and then there will be a higher high and higher low in place. My hunch is the market has learned, or will learn, to buy commodities instead of stocks in the next round of stimulus/interventions. I can see the exit now because the pandemic, Green policy and Baizuo arrogance has finally reached the point where economic devastation comes to everything the ruling class touches. Inflation will be unleashed by political incompetence or intentionall by the ruling class, with the Federal Reserve as a hapless bystander and likely scapegoat. Until then, I assume Lucy will pull the football away again. Investors all-in on inflation trades will look up at the sky wondering how prices are collapsing with so much "money printing" going on.

What if I'm wrong? If I'm wrong I will make more money. Based on how I expect the macro to play out, I believe rising inflation is more bearish for the financial markets. I am not heavily shorting commodities. On the contrary, I accumulate resource producers and will be buying heavily if there is another panic like 2020 that causes spike drops in junior mining share prices.