The Fed increased its scheduled bloodletting of the banking system to (up to) $50 billion per month in October.  We’ve seen the effects.

The Fed calls this program “normalization” but I call it “bloodletting”, in honor of the medieval medical treatment for a disease. That barbaric treatment used leeches to suck the blood from sick patients.  The Fed is bloodletting bloated financial asset bubbles by shrinking its balance sheet. It is letting assets mature and is redeeming them, which gradually reduces the size of its balance sheet to normal levels.

Most importantly, as it redeems its holdings, that sucks money out of the banking system.

The Fed’s Two-Pronged Attack Is Sucking The Market’s Blood

To achieve its ends, the Fed is doing two things.

First, it has now essentially ended its purchases of MBS (mortgage-backed securities) from Primary Dealers. It had been buying MBS to replace the MBS that were prepaid (paid down) each month. That goes on in the normal course of business as borrowers pay off existing loans. Without the replacement purchases, the Fed’s MBS holdings will shrink. The amounts will vary according to the total mortgages paid off by borrowers each month, whether through new purchase mortgages, refinancing, or other payments.

Again, here’s what’s important. As borrowers pay off the mortgages held within the MBS, that extinguishes a like amount of deposits in the banking system.

Secondly, as of October, the Fed is allowing up to $30 billion per month of its holdings of Treasury notes and bonds to mature. Prior to the start of the bloodletting in October 2017, the Fed had always rolled over all of its Treasury holdings. It thus extended the loans it had made to the US Treasury. No more! The Fed is now telling the US Treasury, “Pay us back $30 billion per month!”

Money Disappears from the System When The Fed Shrinks Its Balance Sheet!

To get the cash to pay off the Fed, the Treasury must borrow that money in the market. It must sell debt to investors and dealers. As they purchase the new debt from the Treasury, they withdraw the cash from their bank accounts and pay the US Treasury in exchange for the new debt paper, whether Treasury bonds, notes or bills.

The Treasury simultaneously pays off the Fed for the notes and bonds the Fed is redeeming. The assets on the Fed’s balance sheet shrink and, more importantly, the money leaves the banking system for good when it is used to pay off the Fed.

That’s how the Fed’s balance sheet “normalization” causes the amount of money in the system to fall and financial market conditions to tighten. It has been most evident in soaring T-bill rates over the past year. But lately, it has been showing up in stock prices too.

As the Fed drains money from the system, there is less and less of it available to absorb the constant flood of future Treasury supply. Dealers and investors are forced to liquidate other assets to absorb the crush of the new supply. Those liquidations cause the prices of all financial assets to fall. Bonds have been in a bear market since 2016. The bear market in stocks is only beginning.

The actual amounts paid down depend on Treasury maturity schedules and mortgage market conditions. As mortgage rates rise, mortgage payoffs slow down, which slows the Fed’s balance sheet reductions.

How The Fed’s Shrinking Balance Sheet Pressures the Markets

But that doesn’t matter. Whether the amounts redeemed are $30 billion or $50 billion per month, the effect of the drains in the market are cumulative. Any amount of Fed drains is now just another turning of the screw squeezing the markets.

As JP Morgan famously said, “The Fed’s balance sheet will fluctuate!”.

Actually, he said, “The market will fluctuate”. But hey, let’s not quibble. From 2009 to 2017, the Fed was the market. It pumped $3.7 trillion in new, zero cost, money that it conjured up out of the ether, into the accounts of Primary Dealers. It rightly expected the dealers to use that cash to buy stocks and bonds, bidding up their prices and setting off a speculative frenzy that lasted nearly a decade.

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Since 2017 however, the Fed has not only stepped back from inflating the market, its draining operations are indirectly causing the market to deflate.

In early October I wrote in the Wall Street Examiner,

A growing shortage of money will eventually result in a bear market in stocks that won’t end until the Fed reverses policy. 

The exact pace of these drains does not matter. This is not a case of the Fed pulling cash directly from dealer accounts. QE was added directly to the market via trades with Primary dealers with cash flowing into their accounts. That was a measurable, predictable, direct impact. Under the Fed’s balance sheet bloodletting, the effect on the stock market is indirect, diffuse, and delayed.  

Very delayed. Investors have decided that they will use whatever remaining cash they have to buy stocks. And they’ve decided to use leverage on top of that… When this burns out, the turn will be violent and merciless because the cash to support the markets will simply no longer be there.

There Are Still Ways to Profit!

Some time ago I suggested that if you had been in the market over the past 9 years you have probably made some money and that it was time to take your money home and let it hug you. Hopefully, you are enjoying that hug!

But you can still participate in and potentially profit from the violent swings that are so typical of a bear market. You could use a small percentage of your total capital as your risk capital to buy either short-term put or call options depending on the market’s short-term direction. Several of the gurus here at Money Map Press specialize in just that kind of trading advice.