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February 13, 2019

Fed Says Not To Worry, So Why The Market Took a Dive in December?

A border deal has been reached… in principle. Will President Trump sign it? Who knows.

U.S. trade negotiators are set to meet with the Chinese while China’s economy is taking a turn for the worse.

And the Brexit debacle will eventually conclude, one way or another, despite Theresa May’s attempts to delay, delay, delay.

With all these potential landmines, investors seem to be trading on hope. The markets bounce every time there’s a glimmer of hope of a trade deal with the Chinese… or some dovish comment out of a central bank… or even positive insight from an in-the-know politician.

We’ll see how all of this plays out in the weeks and months to come… but it seems Harry’s Dark Window scenario may be upon us.

In the meantime, the Census Bureau and the Bureau of Economic Analysis are still playing catch-up after the shutdown. That means there haven’t been any market-moving economic releases.

A few Fed officials had scheduled speeches last week, with more to come this week. But none of them said anything of great importance, so far.

As for the stock market?

It was down over the last week but bounced on Tuesday. For the most part, investors have ignored bad news, bad earnings, and the worsening economy to keep the bubble inflated.

The Federal Reserve is allowing its balance sheet to shed Treasury and mortgage-backed securities by $50 billion per month. It’s been doing so for more than a year now. And it still sits at over $4 trillion.

So why the big worry back in December?

Analysts blamed the market crash on the balance sheet reduction. Fed Chair Jerome Powell commented that the reduction was on “auto-pilot” until it was normalized to a point where it’s much smaller than the current size, but larger than before quantitative easing (QE) after the 2008 financial crisis.

He and his cronies didn’t notice any reaction when those securities matured and weren’t replaced, starting over a year ago. So, what changed?

According to former Federal Reserve Bank of New York President, Bill Dudley, he was “amazed and baffled” at the attention the wind-down is getting. He wrote in a Bloomberg Opinion column this week:

“The Fed’s balance sheet isn’t the threat market participants sometimes make it out to be…”

Dudley continued by saying,

“Market participants would be better off focusing on the economic outlook. This is what will drive monetary policy and the Fed’s decisions… if the outlook changes, so will the Fed’s thinking.”

Dudley contends,

“…economic growth and corporate profits looked set to falter in 2019, as the effects of corporate tax cuts waned and the labor market tightened. Demand for scarce labor should increase its share of income, crimping profits.”

So, that’s why the market took a dive in December…

Thanks for the insight, Mr. Dudley!

Fed Chair Powell walked back his comment about the balance sheet reduction on “auto-pilot” shortly after the drop. Then again during his policy statement last month. In short, he said the Fed will use the balance sheet if the economy falters, and that the Fed needs ammunition beyond lowering the federal funds rate. In other words, if we see another crash like we did in 2008… expect QE again.

There’s a reason the Fed needs a much larger balance sheet than before the crisis in 2008. Member banks are required to keep larger reserves. And the Fed, by law, is required to pay interest on those reserves.

Well, I guess that explains everything…

Except for why the Fed cronies were patting themselves on the back when they expanded the balance sheet through QE, creating wealth by inflating asset prices… Which raises the question: Why does the Fed think that by reversing this policy experiment it won’t have the opposite effect?


Oh, well. It’s probably nothing. As Dudley suggests, don’t worry about the balance sheet. Rather, pay attention to the Dark Window and the opportunities it has in store for you this year.

Courtesy of Lance Gaitan, Economy & Markets (article archive here)  

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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