In the Fed’s July report to Congress, Jerome Powell unleashed what was likely the most important statement to the Trump administration. Powell said that interest rate hikes, which had been forecast to include two more hikes this year, would be executed at a gradual pace ‘for now.’
Those two coded words are very important.
The biggest banks on Wall Street will likely view those two words alone to mean that the Fed is still cautious about the economy and the financial markets. What they know is that the Fed is signaling that it reserves the right to return to its full toolkit of monetary policy options.
The Fed could apply one of three options: to further its gradual quantitative tightening (QT) program, to remain neutral, or to launch another round of quantitative easing.
The Fed bloated its balance sheet from $800 billion to a high of $4.5 trillion since the financial crisis first appeared on its radar screen. That money was allegedly used to bolster financial markets and keep the economy afloat in the economic aftermath of the 2008 crash.
The Fed added $700 billion to its balance sheet from September 2008 to November 2014. Incidentally, that figure was more than the U.S. nominal GDP expanded over the same period.
It’s hard to believe, but this November will mark the 10th anniversary of quantitative easing (QE).
And what do we have to show for it?
As Stephen Roach, former chairman of Morgan Stanley Asia notes:
The verdict on QE is mixed: the first tranche (QE1) was very successful in arresting a wrenching financial crisis in 2009, but the subsequent rounds (QE2 and QE3) were far less effective. The Fed mistakenly believed that what worked during the crisis would work equally well afterwards.
Wall Street made out like bandits, while Main Street mostly got crumbs. The majority of Americans saw very few benefits from QE.
Now that process has swung into reverse — somewhat.
At the end of last year, the Federal Reserve announced it would aim to reduce the size of its massive book of assets by $50 billion per month as part of its efforts to ‘taper’ its quantitative easing program.
But the devil is in the details. As one CNBC article notes, “the Federal Reserve’s efforts to unwind its mammoth portfolio of bonds isn’t as easy as advertised.”
It turns out that the money the Fed gets from the payments coming from the mortgage-backed-securities (MBS) it holds, is “running below the capped level of payments it has targeted for runoff later this year.”
What this means is that that the Fed isn’t hitting the proper levels to meet its own book reduction goals.
Either it couldn’t compute its own book proceeds properly — or it was lying to test the markets for a downside reaction while tapering.
Yes, quantitative tightening is happening — the Fed has actually reduced its books by $100 billion so far this year on top of $67 billion last year — it’s just unfolding slower than promised. At less than $170 billion, that’s still barely a drop in the bucket when you look at its total balance sheet.
This means that more central bank credit, or what I call dark money, will still be available for the markets than the Fed (or the media) had indicated.
Quantitative easing never created strength, it only camouflaged weakness by increasing debt and stock buybacks.
But there’s little to signal that central banks will totally ended their QE programs, even though they have switched to a QT narrative for now. If things get bad too quickly, there could be a flurry of more QE coming in from the Fed and its central bank partners in Europe and Japan.
The real story is that the Fed still fears the next recession.
The Fed is aware of all of the underlying risk factors in today’s economy. And I bet a possible economic crisis is keeping Jerome Powell up at night.
As geopolitical tensions rise, trade wars mount, currency wars spawn and volatility continues to build, it’s clear the economy faces increasing pressure that could spiral into recession or worse.
When the Fed raises rates, which it’s been doing, it allows itself room to cut them in a financial crisis.
But the Fed faces a dilemma. If it raises rates too quickly and accelerates QT, it would spark the very recession it’s trying to avoid.
Higher rates also strengthen the dollar and make trade wars harder to win. That’s because if other currencies weaken relative to the dollar, it makes buying goods from those countries more attractive.
On the other hand, the Fed could do nothing and risk pushing the asset bubbles down the road for an even bigger problem in the future.
The Federal Fund Rate is approaching 2% in the U.S. this year. And while there’s a very remote possibility of getting its balance sheet down to $4 trillion, interest rates are still well below where they should be now that we’re 10 years into an economic expansion.
Ultimately, the Fed has one play left. It would have no choice but to either launch another round of QE (QE4). Or at the very least, the Fed would end its QT policy.
In the meantime, there’s just so much uncertainty out there.
And in a world of uncertainty, cash is king. With the $34 billion worth of tariffs on goods from the U.S. and China, and the possibility of Trump slapping another $200 billion of tariffs on Chinese goods, companies are running scared.
That kind of incentive is a strong catalyst for banks to deploy a chunk of their tax cut savings into buying their own stocks. By doing so, they can push their stock prices higher.
Because corporations look to build up their full-year earnings per share, the more buyback firepower they use now, the greater chances their stocks remain high in the short-term.
That’s why amidst escalating trade wars and all the other concerns facing today’s markets, executing buybacks have short-term appeal to the companies that have the cash to engage in them.
You can see this clearly in the market as Wall Street is both getting and deploying extra cash into their own stocks.
Second-quarter buybacks reached a record high. And analysts at my old firm Goldman Sachs project that stock repurchases will total an astounding $1 trillion this year, up nearly 50% from 2017.
This means that companies are more likely to buy their own shares than to invest in longer-term projects, factories and workers, even though that was a promised from the “signature $1.5-trillion tax cut.”
As a Reuters article notes, “the escalating trade war between the United States and China may prompt U.S. companies to shift money they had earmarked for capital expenditures into stock buybacks instead, pushing record levels of corporate share repurchases even higher.”
What this means is that the companies with money for buybacks go double down. And these record buybacks could prop up the market through volatile periods ahead and drive the current bull market even further.
It’s not sustainable, but in the short run the buyback wave will keep the game going a while longer.