Signaling Tighter Fed Liquidity

Bank of America CIO Michael Hartnett wrote in his Flow Show report that tighter Fed liquidity would spark recession or default fears and create a “Minsky Moment-” a time when valuations quickly collapse.

Via Zerohedge,

“Putting it all together, what does Hartnett - who like Morgan Stanley's Michael Wilson - has been reluctantly bullish into this meltup, think happens next, and when will he finally sell? His answer below:

We stay ‘irrationally bullish’ in Q1: positioning not yet ‘euphoric’ & Fed caught in ‘liquidity trap’; we expect rising probability of a ‘Minsky moment’ to coincide with peak positioning & peak liquidity in Q2 triggering ‘big top’ in risk assets; sell S&P500 when PE >20X, go short credit & stocks when new lows in bond yields & US$ appreciation becomes disorderly bearish signaling tighter Fed liquidity & sparking recession/default fears.”[1]

Tighter Fed liquidity (selling assets) means higher interest rates.[2] The stock and bond market remain high because of low interest rates from the Fed buying bonds from banks who buy stocks. The Chairman of the Fed also agrees that higher interest rates will spark recession fears. He said,

“I think we are actually at a point of encouraging risk-taking, and that should give us pause. Investors really do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but that they have every incentive to take more risk, and they are doing so. Meanwhile, we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy.” -Jerome Powell, Chairman of the Federal Reserve, then member of the Board of Governors, Oct 2012 Federal Open Market Committee

The Fed is already stuck in a liquidity trap as they had been gradually raising interest rates since December 2015 because the economy had been improving.[3] However, on July 31st and September 18th, 2019 the Fed began lowering rates (buying assets)[4] in preparation for a downturn and then in response to the September 15th and 16th repo crisis.

[6]

[7]

Hence, some investors are staying irrationally bullish in Q1 because they understand that the Fed will be there to prevent serious losses in a Minsky Moment. Investors have every incentive to take more risk until the Fed signals higher interest rates and investors become “disorderly bearish.”

Will there be a Minsky Moment or will the Fed respond to every downturn by keeping interest rates low and printing money to keep the banks and government solvent forever?[7]

“The United States can pay any debt it has because we can always print money to do that. So there is zero probability of default.“ -Former Federal Reserve Chairman Alan Greenspan, Meet the Press, August 7, 2011.

Whatever happens, central bankers around the world have been hedging with gold.

“But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against ‘real’ goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.” -Ludwig von Mises, Human Action (1949), page 428.

[1] https://www.zerohedge.com/markets/bofa-we-are-witnessing-biggest-asset-bubble-ever-created-central-bank

[2] https://fred.stlouisfed.org/series/fedfunds “The Federal Open Market Committee (FOMC) meets eight times a year to determine the federal funds target rate. As previously stated, this rate influences the effective federal funds rate through open market operations or by buying and selling of government bonds (government debt).(2) More specifically, the Federal Reserve decreases liquidity by selling government bonds, thereby raising the federal funds rate because banks have less liquidity to trade with other banks.”

[3]https://www.federalreserve.gov/monetarypolicy/files/monetary20151216a1.pdf “The Committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective. Given the economic outlook, and recognizing the time it takes for policy actions to affect future economic outcomes, the Committee decided to raise the target range for the federal funds rate to 1/4 to 1/2 percent.”

[4]https://www.hamiltonmobley.com/blog/risky-debt “The Repo Rate is the interest rates which banks pay on overnight lending backed by bonds as collateral. It hit all-time highs on Sunday night [Sept 15] (7%) and Monday night [Sept 16] (10%). Interest rates are rising in the repo market because either there is not enough money to be used for loans or people do not want to loan risky banks money at low interest rates.

The Federal Reserve decided that there was not enough money so Tuesday night [Sept 17] they printed money and bought $75 billion worth of repo bonds to keep interest rates low.”

[5]https://fred.stlouisfed.org/series/FEDFUNDS

[6] https://fred.stlouisfed.org/series/WALCL

[7]https://www.hamiltonmobley.com/blog/anen4naaz8leom7ygbfzjacxz8hff2