As discussed in the latest Digger, despite all the tightening and rate hike talk by the Fed during the past year, it seems that reality has now finally caught up with it. With the markets being dangerously addicted to its accommodative policies, the Fed (as well as the ECB and the BOJ) has backed itself into a corner with no moves left.
On the one hand, the need to normalize its policies is urgent, lest it has no tools left to fight the next recession, which is arguably already on the horizon. On the other hand, the slightest hint of higher interest rates or the removal of the artificial crutches that keep the markets standing is sure to trigger a tantrum that could easily escalate into a meltdown.
Financial markets are addicted to “cheap money”. The Fed understands this well. It knows that if it went back to a normalized monetary policy, it would crash the stock market. However, the Fed also knows that the current policy direction is not sustainable either. So, according to the latest report, the US central bankers appear to have switched to “tightening by stealth”.
So, what is the Fed doing? About US$12 billion/week have been drained from the market, to put the Fed on course for its prior US$50 billion/month decrease in reserves. Thus, liquidity is tightening despite Fed-speak that might lead you to think otherwise.
Federal Reserve Total Assets vs. S&P 500
Source: Thomson Reuters Datastream
The balance sheet fell below US$4 trillion a week ago. Most market participants and all the popular talking heads thought that this would never happen. However, as of April 10th, the balance sheet shrank to US$3.985 trillion.
It will be difficult to do this “secretly”. Certainly, President Trump has been on the Fed’s case and is not happy with Fed Chair Powell’s job performance during his tenure. In our estimate, the Fed will continue trying to tighten without crashing the stock market – a tight-rope act indeed.
The fact that stocks have been lackluster has a lot to do with this. There’s not enough stimulus for higher prices. But, so far, there has been no crash either. However, chances are that, without the Fed’s support and that daily dose of easy money, stock markets could correct sharply at any time. The Trillion-Dollar question remains: how long can the Fed keep the party going?