There Will Be no Retreat into Grandma’s House

Dear Reader,

The perpetual holiday is over. We packed our bags and headed to the airport. The kids cried. They didn’t want to leave. As in really didn’t want to leave. My eldest escaped out of the car and ran back into ‘Grandma’s’ house.

It was a traumatic departure. We told them that well-worn life lesson. ‘All good things must come to an end’. We explained that holidays are so special because they are rare. If you work hard at school and your chosen sport all year, a holiday and a rest is the reward for that hard work.

But holidays are not real life. They are the exception, not the norm.

Let’s hope they don’t grow up and work on Wall Street. They will wonder what type of absurd lessons we tried to impart…

Every day is a holiday there.

Doing it a little tough?

You just had to witness the S&P 500 dip 0.5%?

Don’t worry, the Fed will revive the holiday spirit.

Fed adds billions in short-term liquidity

Overnight, the Fed added US$60.7 billion in short-term liquidity to the market. It’s been adding liquidity nearly every day for months. Its ‘repurchase agreements’ facility has gone from zero in September to US$240 billion as at 9 January.

Christmas came early. And it continues. With no end in sight.

Let me briefly try and explain the reason for the extended holiday cheer.

The ‘repo’ market, as it is known, is where financial market participants with excess cash lend to other participants in need of cash. The borrowing is usually overnight, and is collateralised with US Treasury bonds.

The interest rate on this borrowing is the ‘repo rate’. It is the same as the ‘Fed Funds rate’, the official US interest rate set by the Federal Reserve.

In September, for reasons no one knows, this market ceased to function properly. Or, at least it ceased to function in the way our central planners wanted it to. The repo rate spiked to nearly 10%, well above the official interest rate.

So the Fed had to step in and intervene. Since the start of September, its balance sheet has increased by just over US$406 billion. As well as supplying repo funds to the market, the Fed has purchased around US$170 billion in short-term Treasury bills.

All this liquidity must go somewhere. And it’s not hard to see that it’s ending up in equity markets. Have a look at the chart of the S&P 500 below. It’s in melt-up phase.


Money Morning

Source: Optuma

[Click to open in a new window]

The thing to understand about this US$400 billion Fed gift is that it’s not a one-off boost. When cash goes into the financial system, it doesn’t sit idle. The cash in your bank account isn’t waiting patiently for you to use it.

In fact, it’s not even there.

Cash is constantly moving around the system. The financial system is playing hot potato with it. Each time it moves through someone’s hands, it represents a transaction. In a hot financial market, a little bit of excess cash can bid up prices tremendously as it moves through many hands.

So US$400 billion in cash is quite a holiday treat. The fact it’s from the Fed encourages an even greater level of speculation.

No one seems to worry that this all happened because the market — left to its own devices — broke down in September. Excess cash holders, for unknown reasons, decided they needed a much greater reward for the risk of lending that cash short term.

Put another way, the supply of cash diminished to such an extent that its cost shot much higher than the government set rate (the official interest rate).

As I said, no one really knows what caused it.

But by early September 2019, the Fed had already shrunk its balance sheet by nearly US$450 billion year on year. Did the market suddenly realise liquidity had evaporated?

I thought the Fed sorted that problem out early on in the year? That’s what delivered the market a stunning 2019.

Whatever caused the repo rate to spike higher in September last year, it will remain a mystery…for the time being, anyway.

The RBA is now considering negative interest rates.’ Click here to watch this interview with US economist and gold expert Jim Rickards.

The market cannot handle the Fed ‘normalising’ its balance sheet

The bottom line is that the market cannot handle the Fed ‘normalising’ its balance sheet. It needs plenty of cash swirling through the system and feeding its speculative appetite.

Which is all well and good if you’re only concerned about the very short term. As I’ll show you in tomorrow’s essay, the global economy heads into 2020 in reasonably good shape. Most of the world’s equity markets are at or near all-time highs. Everything is bullish.

But it’s times like these when you have to be on your guard.

The market is nearly always counter-intuitive. When things look rosy, risk is actually quite high. When the market is in panic mode, longer-term risks diminish.

Sounds weird, I know. But that’s just how it works. With that in mind, it’s time to be concerned. With the global economy doing OK, the Fed pumping in liquidity daily, and equity markets at all-time highs…what could possibly go wrong?

Well, lots. I just don’t know where and when. But eventually, the time will come. And then, as my daughter painfully experienced recently, there will be no retreating into Grandma’s house.

Regards,


Signature
Greg Canavan,
Editor, The Rum Rebellion

PS: Interest rate cuts will trigger the next global financial crisis. Here is what you should do now to protect your wealth.


Greg Canavan approaches the investment world with an ‘ignorance is bliss’ philosophy. In a world where all the information is just a click away at all times, Greg believes we ingest too much of it. As a result, we forget how to think for ourselves, and let other people’s thoughts cloud our own. Or worse, we only seek out the voices who are confirming our biases and narrowminded views of the truth. Either situation is not ideal. With regards to investing, this makes us follow the masses rather than our own gut instincts. At The Rum Rebellion, fake news and unethical political persuasion are not in the least bit tolerated. It denounces the heavy amount of government influence which the public accommodates. Greg will help The Rum Rebellion readers block out all the nonsense and encourage personal responsibility…both in the financial and political world.


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