This is a brief update because I’m actively watching the markets and trading this week. I chose the title ‘Danger Ahead’ because I’ve watched and made fun of Carl Icahn’s Danger Ahead video several times over the years.
Macro doomers are a dime a dozen, and I know all the jokes about economists calling 7 of the last 2 recessions, etc.
Still, there are times to be cautious, and this is one such time.
The one chart that scares me:
The Fed’s balance sheet is back at August 2020 levels. Yes, you read that right. While bitcoin is partying like its “money printer go brr” time, the Fed’s balance sheet shows the exact opposite.
It actually gets worse.
When the Fed sells treasuries and mortgage backed securities at a loss, it doesn’t take a hit to its capital. Instead, it creates a liability called “Earnings remittances due to the US Treasury”, similar to dividends accrued but not paid.
If you account for it the right way, the Fed’s balance sheet has actually shrunk to $6.786 trillion, which takes it all the way back to May 2020 levels.
Now that’s a real tightening.
Why has this not had an impact on liquidity?
Because commercial banks have picked up the slack. Bank credit is at all-time highs.
Banks unrealized losses on held to maturity securities ($513 billion) is 21.7% of their equity base, and Fed rate cuts should help repair their balance sheet before the next Silicon Valley Bank collapses.
The SVB bailout was the moment the Fed passed the baton to the commercial banks. Knowing Yellen and Powell have their backs, banks got back into the lending game.
Draining the RRPs to prop up the Treasury market got everyone’s attention, but it was just one aspect of the overall growth in credit.
The Treasury has also been stimulating in two ways: one, by ramping up deficit spending and directly injecting money into the economy; two, by making the wealthy even wealthier through higher interest payments on the debt.
As a direct consequence of this, money market funds have enjoyed a major boom.
But this is where the credit expansion stalls out.
At lower interest rates, banks lose the incentive to lend. At lower interest rates, the Treasury pumps less money into the economy as interest.
According to economics textbooks, we’re at the part of the cycle where the economy should be experiencing disinflation. Remember, Keynesian theory says the central bank should hike rates to temper the boom and cut rates in a recession to stimulate aggregate demand. In reality, the Fed is tightening but inflation is running hot, and the stock market is hitting fresh records.
The Fed can’t do QE because that would mean a market melt-up after a historic 40% one year move in the S&P 500. It would also mean inflation comes back, and the Fed will get blamed for goosing the stock market at the expense of ordinary folk suffering from higher prices.
QE now would also kickstart the wage-price spiral, leading to run away, uncontrollable inflation like we saw in the ‘70s.
The Fed is trapped.
The only way out is to keep cutting rates, but stick to quantitative tightening, and hope that credit growth stalls at the commercial bank level.
Bitcoin at $94k and SPX at 6000 shows this is the only way out. If the melt-up is allowed to continue, everyone’s going to quit their day job and start speculating.
Robinhood’s assets under custody are up a stunning 89% year-on-year. Nvidia ($3.6 trillion market cap) and crypto ($3.2 trillion market cap) are collectively worth as much as the Fed’s balance sheet. Valuations of all assets have gotten to insane levels, levels that can only be sustained by the Fed’s balance sheet growing to multiples of its current size. Which is unlikely at least until next year when Trump takes office and tries to fire Powell.
The next two months is going to be disinflationary. The Fed’s tightening is going to finally have the intended effect. Credit growth will reverse, valuations will mean revert, and euphoria will be tamed.
The “money printer go brr” meme is just wrong. The market is running on fumes. There’s no point in asking me to speculate on the catalyst. It could be Nvidia, crypto, the Japanese Yen, or some black swan. But once it happens, the correction will be swift.
I have moved my crypto portfolio to 100% cash, taken cash out of all my trading accounts, and am loaded for bear while I let the rest of this mania wash over me.
The Fed’s balance sheet is back at May 2020 levels. It’s a long way down for overvalued assets.
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Good Trading!
Kashyap