Fed’s Monetary Tightening Could Become a Havoc-Wreaking Juggernaut

The price of gold has fallen four straight weeks, primarily driven down by anticipation of Federal Reserve monetary tightening. The kickoff of the Fed’s balance sheet normalization program and the expectation of rising interest rates have helped spark a dollar rally. But few people seem to be paying any attention to the pitfalls of quantitative tightening. In fact, the Fed’s policy to push interest rates higher could turn out to be a havoc-wrecking juggernaut.

We’ve already discussed the impact rising interest rates will have with the government more than $20 trillion in debt. Any substantial interest rate increase would crush the US budget under interest payments. Analysts have calculated that if the interest rate on Treasury debt stood at 6.2% – its level in 2000 – the annual interest payment on the current debt would nearly triple to $1.3 trillion annually.

But the Fed has an even more basic problem. It has inflated a stock market bubble. This attempt to shrink the balance sheet may well pop it. Peter Schiff pointed this out during his podcast earlier this month.

I don’t know why the markets are excited about the prospect of a plan to shrink the Fed’s balance sheet, because if the Fed actually shrunk the balance sheet, the markets wouldn’t like it because it would put dramatic upward pressure on interest rates which are not good for stocks.”

In the wake of the 2008 financial crisis, the Fed quickly pushed interest rates down to zero. With that gun empty, it began quantitative easing. In simplest terms, the central bank created money out of thin air and used it to buy bonds. Over a span of nearly seven years, the Fed’s balance sheet increased 427%. According to a MarketSlant article the central bank did $3,625 billion of QE.

So, where did a lot of that new money go?

The stock market.

Analysis reported by Yahoo Finance last year showed that 93% of the entire stock market move since 2008 was caused by Federal Reserve policy. It doesn’t take a Wall Street tycoon to figure out quantitative tightening may well suck the air out of that bubble.

At some level, the Fed seems to realize this. The plan is to start its quantitative tightening program slow. Instead of reinvesting Treasuries and mortgage-backed securities, it will simply allow them to mature off its balance sheet. It will start with a $10 billion rolloff in October and increase it each quarter until it reaches $50 billion next year.

MarketSlant compared the Fed’s quantitative tightening program to a train slowly leaving the station.

Starting to reverse QE via QT radically alters market dynamics going forward. Like a freight train just starting to move, it doesn’t look scary to traders yet. But once that QT train gets barreling at full speed, it’s going to be a havoc-wreaking juggernaut.”

The Fed announced its plan back in June. It was more aggressive than anticipated, but the markets didn’t react to the trial balloon. That gave Yellen and company the green light to set things in motion. The folks at MarketSlant say the markets have missed the boat.

These complacent stock markets’ belief that such massive monetary destruction won’t affect them materially is ludicrously foolish. QT will naturally unwind and reverse the market impact of QE.”

In the big scheme of things, the Fed has backed itself into a corner. It knows it needs to get interest rate up so it has something to cut during the next inevitable downturn. If the economy tanks tomorrow, the Fed has virtually no monetary policy firepower. It needs to stock up ammunition. That means getting interest rates up and clearing some space on its bloated balance sheet. But as MarketSlant points out, this level of QT has never been attempted and it’s extremely risky for these QE-levitated stock markets. The Fed is attempting to thread the needle between preparing for the next market crisis and triggering it.

The bottom line is this could end up being a disaster for stock markets, but nobody seems to really believe it – yet. It’s like a storm that’s still a week out. It’s fun to plan your hurricane party. It’s not so fun living through a hurricane.

With stock markets at all-time record highs this week, QT’s advent seems like no big deal to euphoric stock traders. They are dreadfully wrong. CNBC’s inimitable Rick Santelli had a great analogy of this. Just hearing a hurricane is coming is radically different than actually living through one. QT isn’t feared because it isn’t here and hasn’t affected markets yet. But once it arrives and does, psychology will really change. Make no mistake, quantitative tightening is extremely bearish for these QE-inflated stock markets.”

Peter has said  he doesn’t believe the Fed will ultimately shrink its balance sheet very much. He said before they get even a tiny fraction of the way, they’re going to have to reverse course, because they’re not going to allow interest rates to spike.

The Fed keeps pretending to be more and more hawkish. They keep testing the market by, ‘Oh, you know we’re going to raise rates … we’re going to raise them more. We’re going to shrink the balance sheet. You know, we’re data dependent.’ And they just kind of ignore a lot of the bad things that are happening, and they keep kind of pushing the envelope. And the question is when are they going to push it too far?”

It’s like a game of “monetary chicken.” The question is how far can it go? Peter compared it to proverbial straws on the camel’s back.

The problem is at some point the straw is going to be one to many. You just don’t know that until you put it up there and watch the camels knees buckle.”

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Photo by Geof Sheppard