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What Will the Fed Do Now? Part One

Central banks are cause of inverted yield curve recessions

It’s urgent time to pull together all the background layed about central banks and their plans for the future from the Patron Posts of the last year and put that together with the situation the Fed is in now based on articles written most recently from central bankers about what the Fed should do.

The Repo Crisis as it now exists

Let’s start with something really simple to understand the fix the Fed is in. Remember how the Fed told us that its overnight and term repos were not quantitative easing because they would start rolling off the books in January? And remember how I kept saying throughout the fall, “No, that will never happen? They will just morph into QE as the Fed rolls them over into bond purchases.”

Well, here’s a simple current picture that proves my point:

You can see how the Fed ramped money supply in reserves halfway back to where it was before they began their ill-fated monetary tightening, and you can see in the last couple of months, how, even as they started to back away from rolling over repos, reserves continued to rise slightly. If the Fed was not maintaining reserves as permanent QE, they should have started to decline. There’s one simple explanation for that. As the Fed eased out of repo, it kept replacing a little more than what it was losing from reserves by the repo fade with continued purchases of government bonds.

I also said, the Fed would not really be able to roll out of repos all that easily because repo demand was going to go back up as we got nearer to tax day. Well, look at what just happened to demand for Fed repos (both overnight and term):

Zero Hedge

Surprise, surprise, demand is now greater than for any other repo issuance in both overnight repos and term, even going back to the peak of the Repocalypse. As, I said back then in an allusion to Alien, “She’s baaaack!”

Zero Hedge notes,

We warned that “this continuing liquidity crunch is bizarre, as it means that not only did the rate cut not unlock additional funding, it actually made the problem worse, and now banks and dealers are telegraphing that they need not only more repo buffer but likely an expansion of QE… which will come soon enough, once the Fed hits 0% rates in 2 months and restart bond buying.”

Zero Hedge

And we’re still not that close to tax day. Of course, this could just as well be due to the ruckus in stocks. Remember those collapsing hedge-fund clearing houses that I revealed in an earlier Patron Post as the core problem festering in the Repo Crisis? Perhaps they are back in trouble because of all these manic moves causing some major transactions that need overnight funding.

And it is certainly possible that problems from the COVID-19 crisis are already playing through the financial market, though it is not likely to be the case quite yet, unless through the action in stocks. But soon it will come directly via problems that are building in the background for banks.

A tsunami building in the background of the Repocalypse that may sweep over the world

Zoltan Pozsar of Credit Suisse, who helped the Fed avoid a Christmas Crisis in repo, now says the coronavirus outbreak is making the reserve repo-funding crisis much more dangerous:

Today’s liquidity conditions are like the waters receding before a giant wave…. According to ancient Andaman folklore, when you see the waters disappear, move inland and get to the highest point you can find, away from the shoreline. As banks hoard the highest form of liquidity – reserves – the periphery will come knocking for liquidity…. A sharp IP [industrial production] shock is therefore a potential risk for widespread financial distress and missed payments globally.

Credit Suisse

Pozsar describes this tsunami-sized resurgence of the Repo Crisis as building in the background this way:

Dollar funding is always the orphaned child of crises as the regions where the pressures flare up have no control over it, and the Fed, uncomfortable with the reality of it being the de facto central bank of the world, always takes its time to step in to ease the pressures until it’s absolutely necessary….

It’s hard to say how fast firms are going from running positive to negative dollar deposits at banks as missed payments accumulate [due to financial losses from the Coronacrisis]…. Some corporations are becoming deficit agents – that is, entities that are losing dollar deposits and will soon borrow dollars…. Over time, missed payments due to a prolonged halt in manufacturing and services will start to dominate and the funding impact of the outbreak will flip from positive to negative….

We are probably nearing the end of the initial grace period for global dollar funding. Funding pressures will likely increase from here as missed payments accumulate and fixed costs drain dollar balances, forcing more firms to become deficit agents over time…. Prolonged periods without dollar inflows will make servicing even the interest portion of debts problematic….

We know that these impacts are already happening and are impacting more and more firms in both manufacturing and services – the barrage of negative earning guidance we read about every day suggest that more and more firms are going from running positive dollar balances to depleting dollar balances on their way to become deficit agents….

As corporations deplete their dollar balances, the banks they bank with are also being pushed into becoming deficit agents and … pressures will accumulate in interbank markets where the deficit banks go to get funded…. These dynamics can quickly push banks to go to funding markets…. If so, the deficit banks will borrow from surplus banks in interbank markets at high prices.

Credit Suisse

And that’s just “stage one” according to Pozsar. Don’t let the current financial calm fool you, Pozsar says. Accounts are turning negative and that represents a “growing risk … for the current calm in global dollar funding markets.” It is, in other words, just the calm before the storm, and you can feel the first breezes of the coming storm in the resurgent repo events shown above.

Those rapidly building operating account deficit pressures are due to this:

Coming soon to a business near you. Spreading over time to more industries.

(For a refreshed on the cause of the Repocalypse, Pozsar laid out, exactly why the Repo Crisis happened. His analysis is completely in keeping with my last Patron Post and others I’ve written about the Repo Crisis, as well as all the articles I wrote before the crisis warning it would arrive last summer, saying it would be huge enough to bring on a recession, and why it would come. It’s mind boggling that the Fed could not see that it never had the capacity to shrink the reserves it had created without destroying its own recovery when I’ve been saying this would happen for years. I even said all along that the Fed would not see this coming, and it didn’t. Genius? No. Common sense, which the Fed doesn’t have. You cannot “create a wealth effect” by pumping up reserves and not deflate that balloon when you let the hot air back out. Pozsar believes September was just “micro-tremor” of what is to come: https://link.bloomberg.fm/BLM9630636913 )

Whatever the proximate cause for the rebirth of the Repo Crisis, the deeper cause is the one I pointed out all along the way: the Fed created markets that are dependent on all the new money it zapped into the economy during the decade-long recovery period, and it cannot take that money back out without deflating the bubbles it created. So, here we are.

On the one hand, we see the Fed is replacing repos with treasury purchases, and we know those “short-term” treasury purchases are also really QE because the Fed is no more going to be able to roll those successfully off the books than it is doing with repo. On the other hand, we see that repo demand is rising because the Fed is now doing fewer repos. So, the market is not letting it get away with what it wants to do.

At the same time coronavirus is creating stresses that have not even begun to move through yet, as Poszar’s report points out, but they will soon. Imagine what will happen if the growing coronavirus stresses pop at the same time that massive tax transactions put stress on repo in April!

So …

What is poor Father Fed to do?

Let’s try interest-rate cuts. That has always worked well for us in the past when the stock market is falling apart. In fact, let’s double down and do twice as large of a cut as any we have done since our Great Recovery Rewind started to undue our recovery and crash stocks.

Oops. That didn’t work. Stocks crashed harder. (And we can see based on the graph what kind of times are typically related to Fed cuts of this size.) The market, which had predictably rushed upward with every past cut, went down.

That should recall a theme I have been warning about throughout the years of the Fed’s recovery effort. So, let me pull up just a small number of quotes going back through the years on this theme. I have been warning this day would come when the Fed would revert to its old cuts and money creation when its unwind failed. I want to point out that I have also been warning this would be one of the most critical times in the whole post-“recovery” re-recovery effort. So, you will want to pay attention when you see I also pointed all along the way why it would fail as soon as it began:

As recently as last October, I reminded readers of this repeated theme:

The Fed would find itself behind the wave because its response would not only be too late but it would be too small because the Law of Diminishing Returns has already shown us that greater and greater amounts of QE are needed to have a similar effect.

“Quick Recap of the Fed’s Foundering Follies and Our Descent into Economic Madness,” October 19, 2019

When the Fed returns to QE, it will find QE4ever is far less effective than QE was during the first series of QE1-3 because of the law of diminishing returns and because of diminishing credibility. If the Fed loses credibility because it has been wrong in almost all it has said — especially if we now are entering another recession the Fed fails to see — the Fed will find it has fewer willing players. That will make QE4ever less tenable.

“QE4ever Arrives in One Quantifiable Quantum Leap!” October, 14, 2019

Going back in time, step by step, here are some of the similar comments about the diminishing returns the Fed would be facing for both interest-rate cuts and quantitative easing when it eventually tried to restart the recovery that it would be responsible for killing:

Moreover, the Fed’s illusion requires increasing doses of Fed Med because the Law of Diminishing returns is still as active as it has ever been, in spite of the fact that economists largely stopped believing in that economic law years ago. Economists, after all, have been blind guides leading the blind because the majority of them now ascribe to philosophies (not truths) that plug up the brains of otherwise intelligent people just like Alzheimers does. That is why they never saw the Great Recession coming, and it is why they were almost all foolish enough to believe Fed Med would actually work, and it is why they didn’t see the present crash coming either, and it will be why they will counsel us to go back onto Fed Med immediately!

“Fed Med is Dead: How We Went from Fake Recovery to Freefall” Dec 26, 2018

And, so, go back to it in 2019 we did, just as I said we would. But, going back further in our time machine:

We are now exiting the longest period of central bank stimulus in the history of mankind. As that time dragged on, central banksters began to see nothing but diminishing returns for all their extravagant money printing, known as quantitative easing coupled to the lowest interest in the history of the modern world.

“Irrational Exuberance During Trump Rally Exceeded All Records!” May 29, 2017

This should make it clear that for the past decade the Fed has had just two big tools in its box — interest cuts and QE — and that those are worn out.

Now, let’s go back to an article that was about central banks taking a deeper step into stocks. Some say that is the next step now that diminishing returns on their interest cuts and QE mean they have to shift to direct stock purchases as their next big tool in order to directly directly pump up a stock market that is no longer responsive to their cut-rate epinephrin:

The Fed began talking early last year about the possibility of buying stocks directly. However, they implied that would only happen, if at all, in some distant future should the economy crash again. I stated that this thing they would like to be able to do overtly and with everyone’s blessing was something they were already doing covertly….

Recently Bank of America, the Wall Street Journal and others have begun to state that central banks are buying stocks in huge quantities. The only question remaining is whether they are doing so at the Fed’s bidding and whether they are doing it primarily to prop up an otherwise failing stock market….

Among the reports on portfolio holdings yesterday, we heard from the Swiss National Bank…. Switzerland’s central bank has more freshly printed money to put to work every quarter, and has been increasing their allocation to equities dramatically–$80 billion of which is now (as of the end of the first quarter) in U.S. stocks!…

Another sliver of proof comes from the Bank of Finland, which states that it started buying stocks in 2014….

The precarious part of this equation is what it shows of the Law of Diminishing returns that I keep harping about as an economic fundamental that cannot be averted even by central banks. The further we have gone into the “recovery,” the greater the amount of global stimulus that has been needed to keep the recovery afloat and the more direct and broad the intervention has had to become….

The stock intervention has become greater, not smaller, because of the Law of Diminishing returns….

To see where this all goes, we have only to look at Japan where, again, the Law of Diminishing Returns erodes endlessly at their goals. Japan entered the game of rigging its stock market back in the 1990s, and it is still as desperately stuck in this liquidity trap as ever….

There is no end game. A recent poll of currency reserve managers at reserve banks showed that 80% of the 18 central banks polled plan to increase their investment in stocks….

These people are flying by the seats of their pants to go where no man (or one Yellen) has ever gone before. They are trying to figure their way out as they go, just like Japan, which finds itself endlessly pitched back into new and greater rounds of QE every time it tries to taper. As a result, the Bank of Japan has now become one of the top-five owners in eighty-one companies on the Japan Nikkei 225 index and is close to being the number-one owner in fifty of those companies. (Effectively nationalizing those stocks.)

…Interestingly, Japan’s Nikkei 225 Stock Average is actually down more than 8% year-to-date [diminishing returns, anyone?]

“Central Banks Buying Stocks Have Rigged US Stock Market Beyond Recovery,” Jun 16, 2017

So, I already covered that. It’s been happening covertly for a long time, and it isn’t working so well anymore either. It wasn’t even working well then. And further back in time:

You cannot beat the Law of Diminishing Returns, but modern economists at the Federal Reserve and in government and on television stopped believing in economic laws long ago…. There has, I believe, in the history of the world never been such a large group of intelligent people who look so consistently dumb in the area of their own expertise and who get so consistently rewarded for looking dumb … as modern economists….

The rate at which the benefits of stimulus have diminished over the past decades even while the size of stimulus has exponentially increased shows clearly that the next round (helicopter money that is being talked about all the time now along with negative interest rates) will be the most massive application of life support the world has ever seen and, yet, will result in the patient barely recovering to a comatose state at the edge of the red line. The next dose of stimulus may stir a brief heart flutter, but will actually kill the patient. It will drive the zombie economy to a level of death where even artificial life support can no longer make it appear to be alive.

“This graph says it all — US 2016 Recession Already Here!” August 4, 2016

That was said clear back in 2016. We haven’t even gotten to helicopter money yet because banks cannot stand the idea. If they do try it, it will be some perverse form that benefits themselves first and foremost, so it won’t work either.

Before the Fed resorts to helicopter money, it will probably claim that what it really needs to do is gain the capacity from congress to buy stocks directly. It will believe the stock buying didn’t work because it was covert, but if they had the power to do it openly, they could buy as much as they needed to whenever they need to, pumping everything in to the black caldron of dimishing returns to see if they can fill it and make it overflow with restored health; but it is a witches’ brew.

We are actually now far down the end slope of the bell curve where more stimulus equals doesn’t just give less in the way of results but actually turns negative, yielding the opposite of what the Fed once got!

Going further back to be clear that ALL of this was easily foreseeable and was foreseen because it is basic economics:

Even if the Fed didn’t raise rates, it was clear that the law of diminishing returns was now the prevalent force because the market was rounding more and more downward, even with zero-interest fully engaged. Zero interest stopped lifting the market in the summer; after which, it was barely able to slow the market’s rate of descent.

“The Epocalypse Spreads its Gaping Jaws and Smiles,” Jan 16, 2016

And skipping waaay back to the beginning of this blog in the days before QE3 began:

We are about to enter the no-fly zone where the economy stalls just as its leaving the runway … again. That means you’ll be hearing more and more talk of QE3, just like this time last year. Only now it will be a third and final round of quantitative easing because no one is going to believe in that trick after one more round fails worse than the previous rounds. (Law of diminishing returns for those who still believe in real economics.)

“Economic News Articles in the Great Recession — Archive for the week of 04/01/2012“

By “final round,” I meant the final round that would actually accomplish or appear to accomplish what the Fed wanted — the final round that would work out for the Fed. That’s right! Clear back in 2012 I predicted QE3 would fail; and, therefore, no one would believe in QE4 when the Fed was ready to begin that one because a move to start QE4 would prove QE had failed.

What do you think happened when the market nose-dived immediately after the Fed gave a double-dose of its old medicine? That was the market saying, “Oh no! Not more of this!”

Because it finally realized this past fall the truth I had said clear back in 2012, the Fed in full recognition of that reality did everything it could in how it spoke to assure everyone that what it was doing was “not QE4.” God forbid, anyone should think of it as more failing QE! (They also knew that permanent QE is monetizing the debt, which is illegal under their charter.) They did everything they could to avoid calling this QE4.

So you see, QE3, as far as the Fed was concerned, was where it stopped! Everything else will have to be called something different if at all possible, but people are seeing through that deceit, which will make anything else hard to believe in and, therefore, less effective. The Fed knows it is losing credibility and that credibility is all it has to sell, as its money has no intrinsic value. It’s value is locked entirely in faith in the Fed.

So, now here we are with even the Fed actually admitting this past week that what just happened in the market with its last rate cut indicates its credibility is eroding:

But the real shock was from Federal Reserve Bank of St. Louis President James Bullard, who admitted central banks are losing their credibility rapidly:…

“Credibility of central banks, instead of improving over time based on the achievement of stated goals, seems to be eroding instead.”

That’s quite an admission but 100% correct and this week’s carnage after an emergency 50bps rate-cut did nothing to calm fears.

And despite a huge resurgence in the Fed’s balance sheet, stocks were not playing along at all…

Zero Hedge

So, the Fed is at that critical juncture I said it would eventually run into where QE and rate cuts just don’t work and doing more actually makes things worse — makes the stock market drop. Both QE and rate cuts hit the wall of demishing returns at the same time:

Zero Hedge

And investors panicked and dove into the safe haven of US bonds. Wow! did they dive:

To make matters worse for the Fed, interest rate cuts, if it keeps trying them because it is clearly a slower learner, may even exacerbate the Fed’s problems. If cuts drive money out of stocks by eliciting fear that results in flight to safety, long-end yields will drop more, inverting the yield curve all the more. Rates are already near zero with the ten-year bond well under 1% now, so much more movement will finally put the US in that dizzying wonderland of negative interest rates that has done so poorly for Japan and Europe.

We also saw in a recent Patron Post how the Fed approved a move up the spectrum from purchases of short-term treasuries (notes maturing in a year or less) to gradually increased purchases of longer-term treasuries (as necessary to try maintain a balanced yield curve, they said). But that, too, will flatten everything toward negative rates.

You can see now that ALL of this was foreseeable from the very beginning of the Fed’s recovery program. With QE’s back finally up to the wall of diminishing returns and interest rates about to dive under the floor into the negative twilight zone, what is the Fed to do?

Part One here lays the basis for understanding the true nature of crisis that the Fed is just starting to realize it will have to solve and the limits to its response. Part Two will lay out the Fed’s indications in past and recent writings of its next kind of response and whether that can resolve this crisis. It is being assembled now and will be published in the next day or two.

I wanted to break down the reading burden in terms of article size and get something to you as quickly as I could, given how the flood of economic breakdown news is now keeping me constantly occupied in research and writing. Thank you for your support to keep me at it. If you think this is of value, please let other readers on The Great Recession Blog know.

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March 8, 2020 @ 5:00 pm
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