Let Me Tell You A Story
This is a story about the Federal Reserve being torn asunder by a global tug of war of epic proportions.
This is a story about the Federal Reserve being torn asunder by a global tug of war of epic proportions.
What the Federal Reserve ultimately decides to do, whether by choice or by force, will determine the fate of the market in the near-future (near as in 1-2 years).
Let’s start.
📝 Very Quick Primer: The Federal Reserve
The US’s central bank, the Federal Reserve, was created as an independent counterweight to the elected US federal government.
The Federal Reserve’s job is to manage the total US Dollar money supply to meet two goals:
Price stability (2% annual inflation rate)
Full employment
📉 Two Decades Of Low Inflation
The two decades before 2020 was marked by persistently low inflation.
It felt like no matter how much money the Federal Reserve printed, inflation just would not rise.
As a result, during these two decades, the Federal Reserve massively expanded its balance sheet from around $700 billion to $4.5 trillion.
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In the past few issues, I’ve written about:
How multi-strat hedge funds are so wildly and consistently profitable
Why the US stock market won’t stop rising despite interest rates being at multi-decade highs
How the US Treasury rebelled against the Federal Reserve to stimulate the financial system
How the Bank of Japan is able to print an infinite amount of money without crashing the Yen
🔥 The Inflation Dragon Wakes Up
Then, in 2018, Trump started a trade war with China.
This was followed by a global pandemic which crippled the global supply chain.
At the same time, to save the US economy from a lockdown-induced collapse, the Federal Reserve and the US Treasury embarked on the largest money-printing operation the country had ever seen.
The Federal Reserve dropped interest rates to 0% and expanded its balance sheet from $4 trillion to $9 trillion while the US Treasury sent US citizens trillions of dollars of free money.
This resulted in a massive expansion in both the Federal Reseve’s balance sheet ($4 trillion to $9 trillion) and the US federal government’s annual budget ($4.5 trillion to $7 trillion).
At the same time, the second largest oil producer in the world, Russia, launched the first major land war in Europe since World War II.
Through this sudden perfect storm of global events, the low inflation of the past two decades was gone and US inflation spiked to almost 10% in 2022.
🛡️ The Federal Reserve Mounts A Defense
Starting in 2022, the Federal Reserve significantly tightened monetary policy by raising interest rates from 0% to 5% in about a year while at the same time, shrinking its balance sheet by $95 billion a month.
Tight monetary policy, a recovering global supply chain, and the US government turning a blind eye to Russian oil illicitly flooding global markets, helped cool inflation down to about 3% today.
🪢 The Tug Of War
TLDR:
The US government needs to raise a lot of new debt this year ($1.9 trillion in new debt vs $1 trillion last year). A lot of this goes to funding two major proxy wars.
This is a Presidential Election year.
To keep the government’s interest expenses under control amidst all this new debt issuance, the Federal Reserve needs to lower interest rates.
The Federal Reserve can’t lower interest rates if inflation remains high.
The proxy wars that the US is funding right now are next to major global oil-producing regions.
When oil prices rise, inflation rises, and the Federal Reserve can’t lower interest rates.
The wars must be funded, but the oil must also keep flowing.
Inflation falling from 10% to 3% in the past year and a half sounds good right?
Well, not really.
The Fed is now stuck in a disastrous policy quagmire.
Inflation has been stubbornly hot and won’t fall below 3%.
An increasingly desperate Ukraine is striking Russian oil refineries, forcing Russia to ban all oil exports for 6 months starting in March.
These Ukrainian attacks on Russian oil refineries surprisingly, yet also unsurprisingly, drew ire from the US!
Financial Times headline: “US urged Ukraine to halt strikes on Russian oil refineries”.
It’s like the US has one hand pushing Ukraine to fight Russia while with the other, it’s buying oil from Russia behind Ukraine’s back. Then it’s using this money to pay Ukraine to keep fighting!
When one takes this headline at face value, it’s expectedly nonsensical. Its rationality only becomes clear when looking at the second order effects of the relevant events.
Just look at how oil prices have risen since Russia’s gasoline ban that started in March.
Rising oil prices means high inflation. High inflation means the Federal Reserve can’t cut interest rates.
When the Federal Reserve can’t cut interest rates, it’s a lot harder for the US federal government to raise debt to fund its wars.
China and Japan, two of the biggest foreign buyers of US government debt, have largely cut back on their appetite for US government debt.
At the same time, the US government needs to raise more debt than ever.
This year, they need to raise $1.9 trillion in new debt. This is almost double last year’s demands and 9 times that of 2016!
So who is going to buy all this new debt?
Without buyers, long-term interest rates will rise and that greatly hurts the economy (and the stock market).
To add more spice to the boiling stew, there’s a presidential election this year and if the Biden administration wants to remain in power, it needs to keep long-term interest rates down.
📈 So What Does The Federal Reserve Do?
CHOICE 1: Keep monetary policy tight to fight inflation.
Tight monetary policy makes it very difficult for the US government to continue funding its proxy wars. It’ll also hurt the Biden administration’s chances at re-election.
CHOICE 2: Loosen monetary policy to help fund the US government.
This is a very precarious option.
If inflation reignites after the loosening of monetary policy, the Federal Reserve will lose a lot of credibility, the markets will fall from inflation fears, and high inflation may force the Federal Reserve to tighten monetary policy anyways.
RESULT: What does the Federal Reserve choose to do? It chose to loosen monetary policy.
On Wednesday, the Federal Reserve announced that even though it wasn’t going to lower the Fed Funds Rate, it was going to significantly slow down how fast it was shrinking its balance sheet.
Starting in June, the Federal Reserve will start shrinking the amount of US treasuries on its balance sheet by just $25 billion from $60 billion per month.
That’s a $35 billion reduction!
This, in effect, adds $35 billion more in buying demand for US treasuries to the market per month.
Why are they doing this?
Fed Chair Jerome Powell says he wants to get ahead of financial instability, but there are zero signs of financial instability.
Even if we do take the justification that this is a preemptive adjustment for financial stability, this is an extraordinarily large preemptive adjustment.
To get a feeling for how big this reduction in quantitative tightening is, just look at how hard the Japanese Yen bounced against the dollar after the FOMC press conference.
(At a very high level, the value of the Yen tracks how loose US monetary policy is. The looser US monetary policy gets, the more the Yen appreciates.)
The best explanation I have for why the Federal Reserve would choose to suddenly cut quantitative tightening by this much at this time is that they are playing politics. Nothing else makes sense.
💡 The Hidden Third Choice
The Federal Reserve is playing a very precarious game.