Below is an excerpt of our January 2020 Forecast Report. If you would like the full report, please subscribe at the bottom of this page.
The Federal Reserve.
During the last year, we spent quite a few pages of this newsletter discussing the Federal Reserve and Central Bankers in general. I believe it’s a very important consideration as an investor. Their liquidity in the last quarter of 2019 generated the momentum for US Stock Indices to reach new all time highs and provide outsized market returns. The US Government isn’t the only government in the world taking on more debt. This has become a global debt binge. The fact is that the Fed and other Central Banks are printing money to finance the purchase of debt, not to stimulate the economy. The Fed is forced to do so by the market. Let me explain.
Currently, the Fed is discussing a standing repo facility and a permanent intervention. As Barron’s describes, “A standing repo facility would be a permanent outlet for banks or bond dealers to borrow cash through repurchase agreements or repo transactions with the Fed. Using such a facility, banks would sell their Treasury securities to the Fed and agree to buy those bonds back on a future date; basically pledging their Treasuries as collateral for cash loans from the Fed.” It’s not just banks using the Fed’s standing repo facility, it’s also hedge funds. You may ask yourself why a hedge fund would need cash from the Fed. I asked the same question. Back in September, it was postulated that hedge funds needed the cash for short-term financing or paying taxes. Well, that wasn’t really why the hedge funds dabbled in this market. Hedge funds used this facility to borrow from the Fed at 1.5% and use that cash to go out and buy Treasuries that yield 1.55%, effectively arbitraging and pocketing the difference. This may not seem like much money, but I assure you when these dudes are leveraging this trade over and over again, it can add up fast. Think about this circle of transactions. Remember when I said the Fed is printing money to finance the purchase of debt. The hedge funds are getting loans from the Fed, purchasing Treasuries with that cash and pocketing the difference. So, effectively, the Fed is printing money to finance the purchase of Treasury debt. The ability of hedge funds or banks to purchase unlimited amounts of Treasuries is Modern Monetary Theory. Ta da! We are all underestimating the Fed's sneakiness...
Here's the scary part, in the words of the Fed, “A prolonged period of low interest rates encourage a large buildup of debt. That debt grows to the point where it can only be serviced by a debasement of the currency. The debasement leads to a run on the currency which leads to hyperinflation. At some point, the central bank is forced to dramatically raise interest rates to restore faith in the currency and prevent economic ruin.” Unfortunately, the never ending rise in stock prices reinforces the idea that these policies are supportive rather than detrimental to equity and fixed income investments. This is what history tells us about these policies, but if you’re someone who believes that we are ushering in a new era of unprecedented prosperity and a never ending march higher in equity prices read The Great Crash, 1929. Learn from history, don’t repeat it.
As we look back upon 2019, the one thing that we can take away is that the FED’s liquidity spout was successful in driving the market to all new highs over and over again. Once that spigot was turned on in September 2019, the race was on for the FOMO crowd (Fear of missing out). And, if you are confused as to what I’m talking about, please refer back to our October 2019 newsletter about “Not-QE4”, where the Fed poured record amounts of liquidity through the Repo market. The most recent liquidity binge is as large, if not larger, than QE3. This is backdoor QE4.