The U.S. Fed this year has confounded investors. Something does not add up. After the markets crashed in the fourth quarter of 2018, the carpet was pulled out from underneath them as reminiscences of 2008 seemed to flash before their eyes. They have u-turned too quickly and too aggressively this year, going from tightening to easing without allowing the market to react to "normalized" conditions. Other than Trump spending the larger part of 2018 taunting the Fed to cut rates and that "they were insane," the answer to this mystery is that the Fed knows the system is broken and has been for some time.
But rather than try to put the fire out, they try to contain it with few sprays here and there. One day the fire will be too big to be contained, but hey, that will be the next guy's problem! This has been the case of U.S. monetary policy since 2009, but the cracks only started to appear from 2014 and were exacerbated in 2018. Every central banker knows this and is too vain to admit it or be the one that pops the bubble to bring the whole system down, a reset of sorts which would actually end up being better in the long run.
Since 2018, the Fed has been trying to rid the economy of the excess reserves it had pumped into the system since the Global Financial Crisis in 2008. In 2018, the Fed only managed to reduce their bloated balance sheet by $1 trillion before the markets and the economy got wobbly. At that time, the data was very good, so the Fed decided to keep on going. They are a backward-looking indicator so when they see record-low unemployment and 3% GDP growth, they cannot justify not using this opportune time to wean the victim (market) off of its opioid fix (free money).
In January 2019, Fed Powell first hinted that he would be "flexible with the U.S. balance sheet" (meaning after year of embarking on Quantitative Tightening, they could be open to halting that altogether and even increase it if need be to "sustain the expansion"). This produced a 3.5% rally in just one day. After that, in May 2019 when the markets collapsed yet again, we got a series of Fed speakers jawboning the market with Powell saying he "was ready to act." In July, we had the first rate cut for 25 basis points (bps) and then another in September. Now the market is pricing in a greater than 80% probability of another 25 bps rate cut in October.
By September 2019, it was certain that perhaps the Fed had tightened the system too much as they had withdrawn reserves beyond what was needed by the system. Cracks appeared in the repo market in September when overnight rates shot to above 10%, compared to a Fed Funds target range of 2.25%-2.5%; certainly not normal. But the U.S. Fed lied to us -- this was not a plumbing problem or a one-off quarter-end financing issue as tax receipts were due. If it were so, then why was there still a shortage of dollar liquidity after the quarter end into Q4? Repo rates did not settle down and demand for overnight auctions was way ahead of the Fed's $75 billion daily injection limit. Overnight auctions have been 3x-5x oversubscribed every day.
On the September 17, it was just meant to be for a few days. On September 19, they extended it to October 10, for an amount of $75 billion overnight operations and $30 billion term operations. Then in October, they extended this operation through November 4, only to extend it until January 2020 just a few days later.
To top it all off, they also announced a $60 billion per month Treasury-bill buying operation with no end date.
The icing on the cake was Wednesday night. The U.S. Fed, out of nowhere, just came out and said "we are expanding our overnight repo operations to $120 billion and term operations to $45 billion." That is a 65% increase in Fed injecting daily liquidity into the system overnight. It smells way too fishy and is certainly not representing a system that the Fed claims to be a "temporary fix" or "not the start of quantitative easing."
Call it Uncle Sam's ice cream money or whatever you want. Any way you look at it, this is ultra-accommodative monetary policy just renamed to avoid the taboo of the U.S. Fed initiating yet another round of Quantitative Easing. This has been evident throughout history, especially in Japan and the eurozone. Decades of stimulus and low rates, negative even in some cases, have failed to boost GDP and stoke inflation. Now we are beyond negative interest rates and they still want to do more. Alas, central banks do not pay heed to mistakes of the past but use it as a guide to continue using the same principles.
Something seems to be brewing in China as well. Last week they injected about 250 billion yuan in reverse overnight operations (aka adding liquidity -- forget the fancy name, as there are people paid a lot of money to come up with newer, more-elusive names to mask the same thing). This week they added 510 billion yuan more, with 250 billion on Monday, 250 billion Yuan on Tuesday, and another 60 billion Yuan Wednesday night.
China has a real problem and they and the world are well aware of it. Their GDP growth is at risk of falling short of the holy-grail 6% number or worse, but they can never admit it. The Trade Wars have cost them a lot, as their entire system is built on credit, leverage and cheap interest rate policy. When that is challenged, there is a risk of the entire house burning down. So, what does China do? Throw even more money at the problem, stimulating the economy to boost growth, investing in infrastructure projects to show a quick positive trend in Industrial Production and GDP.
The system is one big financial hoax. There is a reason why sayings such as "don't fight the Fed" and "better to be liquid than smart" are cornerstone mottos each trader is taught when they first join this world. There is a time to be smart and a time to be cerebral. But one needs to respect the power of liquidity. No matter how diabolically unjust it may seem, it is the system we live in, corrupt or not. If one needs to operate, one needs to accept it.
Fundamentals do supersede in the long run, but if central banks are flushing the world with cash, fundamentals will not matter in the short term. And that is where we are right now. Earnings are disastrous, with company guidance being lowered even further, showing more than 4% year-over-year decline. But stocks will not fall further if the Fed is doing its "Not-QE" Quantitative Easing. In the last few days, the market has rallied -- and it boils down to central banks inflating the system further, doing whatever it takes hoping to jump start the economy. It works for a short while, but then system crashes. The only question is, how long can this go on before the quick fixes don't work anymore?