Keep buying bonds and gold, writes Landon Whaley, who breaks down central bank cycles in a conversation about the Fed.
There has been a ton of ink spilled (digital and literal) to speculation about changes to the Federal Reserve’s policy and the timing of those changes. But despite all this coverage, no one seems to be discussing the balance sheet.
No matter what the Fed does (or doesn’t do) with rates, as long as it is shrinking the balance sheet, financial conditions will continue to tighten. If history has taught us anything, it’s that a central bank that continues to tighten after growth begins slowing is jump-starting a recession.
Remember, every $200 billion in bonds the Fed allows to “roll off” its balance sheet has the same tightening consequences as if it actively raised rates by 0.25%.
By last week, $34.2 billion worth of Treasuries had been allowed to roll off this year, and the Fed had allowed another $23.3 billion to mature without re-investment. That gives us a balance sheet that’s already shrunk by $57.5 billion from Treasuries alone this year, which equates to another Fed hike of 8 basis points.
This balance sheet reality means that the most important statement from last week’s Fed minutes was this one: “… participants agreed that it was important to be flexible in managing the process of balance sheet normalization, and that it would be appropriate to adjust the details of balance sheet normalization plans in light of economic and financial developments if necessary [emphasis mine] to achieve the Committee’s macroeconomic objectives.”
This balance sheet commentary is a long way from being full-on dovish and tells us that while the Fed may stop raising rates, its balance sheet policy is going to stay the course, for now.
You’re So Predictable
Saturday I discussed the predictable sequence of central bank events and the resulting investor psychology: Central bankers turn dovish, investors rush to buy stocks and other risk assets because the juice is loose, stock markets and risk assets rise in price, investors realize that central bankers turned dovish because economic conditions were guano, stock markets and risk assets sell off quick, fast and in a hurry.
In a similar fashion, there is a very predictable central banker progression:
- “The economy is overheating, so we’d better hike now before it gets away from us!”
- “The markets don’t like our raising rates, but we are staying the course because we are data-dependent.”
- “The markets are really getting squirrelly; we’re staying the course, but now we’ve got one eye on what they’re doing.”
- “Markets are volatile and economic data isn’t as strong as it was three to six months ago, so let’s pause here and reassess.” (though the Fed technically does not react to market activity as their mandate is to foster conditions for stable prices and maximum employment)
- Fast forward six months to a year: “Let’s make just one rate cut …”
- Ten rate cuts later, the Fed Funds rate is as low as it goes (+0.25%), effectively zero, and it remains there for seven years.
- Repeat steps 1-6.
The Bottom Line
If the Fed “pauses” in March, then it means that despite +3.0% annual GDP growth, the lowest unemployment rate since the 1970s and benign inflation, the U.S. can’t handle a Fed Funds rate of even just 2.5%! The long-term implications of this economic reality are mind-numbing. The upside is that you’ll get to live in Japan without ever having to move there.
A quick word about the Fed pausing. Technically the Fed never pauses, because this implies that it stops raising rates for a period and then begins to raise them again, but this has never happened before.
In each of the previous tightening cycles, once the Fed stops raising rates, its next interest rate policy move is to cut rates, always. We’re going to proceed as if this time is no different and in March the Fed will officially announce that we are at step four of the central banker progression. Despite the massive amount of speculation that will ensue once that meeting passes, there are far too many factors (inflation being a critical one, which we’ll discuss at another time) to know exactly what they’ll do or when they’ll do it.
Luckily for us, we don’t need to be a descendent of Nostradamus or Miss Cleo’s love child to profitably trade the next three to six months. Based on the current Fundamental Gravity, and the most likely progression of Fed policy, being long Treasuries, gold and gold miners is the only way to trade on the long side, for the time being.
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