Grant's Almost Daily:

The Fed is Going to Drive the Stock Market Down

The spigots are off. On Wednesday, the Federal Reserve will conduct its final policy meeting of 2018, with a 25 basis point hike to the overnight funds rate the likely outcome; interest rate futures currently price 74% odds of policy tightening, down slightly from 78% two weeks ago. One interested observer is happy to provide chairman Jerome Powell with some free advice. This morning, Donald Trump shared his thoughts on Twitter: 

It is incredible that with a very strong dollar and virtually no inflation, the outside world blowing up around us, Paris is burning and China way down, the Fed is even considering yet another interest rate hike. Take the Victory!

It’s not just leveraged real estate-speculators turned commander-in-chief who are advocating a cessation of policy tightening, which is taking place not only through rate hikes (eight and counting since December 2015) but also the ongoing “QT” asset sales.  In today’s edition of The Wall Street Journal, former Fed governor Kevin Warsh and Duquesne Family Office LLC chairman Stanley Druckenmiller argue that the Fed needs to pump the brakes, particularly on QT:

The Fed’s balance sheet is where the money is. Yet it has provided little additional clarity on its balance-sheet plans since Chair Janet Yellen’s tenure. At a time of global quantitative tightening and uncertain economic prospects, the Fed’s silence on its asset holdings is contributing to the tumult. We were assured by policy makers that QE provided large benefits to the real economy. If so, won’t its reversal in the form of QT come with a cost? It can’t all be rainbows and unicorns.

Protestations by the executive branch, former colleagues and Wall Street luminaries aside, the Fed forges ahead.  Although securities held outright held steady last week at $3.896 trillion, $20 billion below the trailing four-week average, total balance sheet assets are down by 8.2% since the Fed began to run off its balance sheet in October 2017.  

The pace has been quickening. Thus, while Federal Reserve bank credit has declined by 7.9% over the past 12 months using the trailing four-week average, the contraction has accelerated to a 11.1% annualized rate over the past three months. Broad M2 money supply has grown by 3.9% over the past 12 months, but just 3.1% annualized since September.

Consequences of the liquidity drain are increasingly apparent, as the Druckenmiller/Warsh pair cites sharp recent drops in the banks (BKX Index is down 21% since late September and 14% in the last two weeks) and commodities (the CRB Index is down 11.6% since early October). In credit, the most speculative issues have been hammered, with the option-adjusted spread on the Bloomberg Barclays CCC and Below Index jumping to 934 basis points today from 619 basis points in early October. Today, the Financial Times reports that “not a single company has borrowed money through the $1.2 trillion U.S. high-yield corporate bond market this month.”  It would be the first time since November 2008 without any new high-yield supply.

The un-bullish turn has likewise put a dent in the leveraged loan category, with the FT reporting that two deals were scratched last week after major banks including Barclays and Wells Fargo were unable to locate buyers. Those failures were no outliers.  Bloomberg reports today that issuance of collateralized loan obligations (collections of loans that have been packaged and securitized) fell 25% year-over-year in the first half of December, accelerating from a 10% decline last month (for more on CLO’s, see the Sept. 7 edition of Grant’s).  
  
The broad reversal of financial conditions can indeed be laid at the feet of the Fed, according to David Rosenberg of Gluskin Sheff + Associates, Inc. At the spring 2018 Grant’s conference, Rosenberg told the audience that as the post-2008 bull run can be largely chalked up to the ultra-dovish policies of past Fed chairs Ben Bernanke and Janet Yellen, and investors should gird themselves for the opposite dynamic as monetary stimulus is withdrawn. 

We’ve never had a cycle where the stock market has done what it did in the context of such weak economic growth. If I took the ratios of what the stock market does benchmarked against what the economy does in nominal and real terms, this bull market and the S&P 500 would have stopped out at 1800, not 2800. The excess is central bank liquidity. The central banks added 1000 points. Not fundamentals. Central bank liquidity.

Now people say to me: No cycle ever dies of old age. I get that. But, they die at the hands of the central bank. The Fed. Each cycle has died at the hands of the Fed. Every bear market ended by the Fed. Every recession ended by the Fed. By the same token every bull market / expansion, the Fed has its thumb prints over every expansion. There is nothing more important, not fiscal policy, not trade policy. Nothing is more important for what we do than Fed liquidity. 

Slowly but surely, the pool is draining.