Fed's Fake Stock Markets
The US stock markets soared in 2019, blasting to dozens of new all-time-record highs. Euphoric traders attributed these massive gains to strong corporate fundamentals and US-China trade-war progress. But the real driver of stocks' astounding ascent was the Federal Reserve's epic extreme easing. A panicking Fed pulled out all the stops to goose and levitate stocks, leaving fake artificially-inflated markets in its wake.
This year's huge stock-market rally delighted nearly everyone, generating widespread euphoria. That made Americans feel wealthier, leading them to spend more freely. That pushed corporate sales and profits higher than they otherwise would've been. Speculators and investors loved the easy largely-one-sided gains. And stocks' biggest fan, Trump, reveled in what lofty record stock markets implied about his policies.
With the flagship US S&P 500 stock index (SPX) rocketing up an amazing 28.6% year-to-date at best by late December, everything looked awesome. Record-high stock markets must mean the US economy is booming, the best of times. But under that happy-headline facade, the real stock-market picture is deeply troubling. The SPX's monster gains have been directly driven by an American central bank terrified of a recession.
Some background context is necessary to understand 2019's stunning stock-market action. Back in late 2008, the US stock markets were slammed by the first true panic in 101 years. The SPX plummeted 30.0% in a single month, which proved part of a larger 56.8% bear. That threatened a severe recession if not an outright depression due to stock markets' powerful wealth effect. The Fed rushed to mitigate those risks.
Its primary monetary-policy tool, the overnight federal-funds rate it controls, was already down at 2.00% heading into October 2008's brutal stock panic. The Fed still slashed the FFR by 50 basis points twice within that month, cutting it to 1.00%! With spending and economic activity collapsing in response to that stock-market plummeting, soon after in mid-December the Fed enacted its first-ever zero-interest-rate policy.
Once a central bank runs out of rate cuts, its options for further easing are limited. It can then either force rates negative or start printing money. Since NIRP has even worse collateral damage than ZIRP, the Fed chose the latter option. Because conjuring new fiat money out of thin air to monetize debt has a disastrous historical track record, the Fed obscured its huge inflating in the benign euphemism "quantitative easing".
The Fed was spinning up QE during that stock panic even before it went ZIRP. When the Fed wishes new money into existence to use to buy bonds, they show up on its balance sheet. In late August 2008 just before that stock panic, the Fed's total assets ran $898.6b. Over the next 17 weeks into slashing the FFR to zero, they skyrocketed a mind-boggling 150.9% higher to $2255.0b! That money printing was crazy.
While the SPX finally bottomed in March 2009, kicking off what would grow into the longest bull market in US history, the Fed kept the pedal to the metal. It kept ZIRP in place continuously for 7.0 years before finally mustering the courage to make a tentative rate hike in mid-December 2015, its first in 9.5 years. It was ridiculous for the Fed to wait so long to start normalizing rates, as the SPX soared 135.3% during ZIRP!
That mighty stock-market bull closely mirrored the Fed's epic balance-sheet expansion, as it continued to evoke new money to buy more bonds through several QE campaigns. QE1, QE2, and QE3 were each followed by their own expansions. The Fed's assets finally peaked at $4516.1b in mid-January 2015, up a ludicrous 402.6% since just before late 2008's stock panic! All together total QE clocked in at $3617.5b!
Keeping rates artificially low and bonds monetized artificially high was risky and foolish. At some point another recession was inevitable, and the Fed had virtually no ammunition left to fight it. It had to start hiking rates to make room for future cuts, and whittling down its horrendously-bloated balance sheet to reload for future QE campaigns. The Fed's timing on that long-overdue normalization sure looked political.
After that initial December 2015 hike, the Fed sat on its hands heading into the November 2016 elections. Rate hikes weigh on stock markets, and the better stock markets perform in the final few months before a presidential election the greater the odds the incumbent party will win. The hyper-easy Fed chair then was Janet Yellen, a lifelong Democrat. And Republican lawmakers were heavily attacking her ZIRP and QE.
After Trump's surprise election victory, the Fed radically accelerated its rate hikes. It boosted its FFR target range a second time in mid-December 2016. And then late each quarter between early 2017 to late 2018, it raised rates again ultimately taking the total hikes to 9. Obama only saw 1 rate hike, while Trump had to deal with 8! The only quarter the Fed didn't hike was Q3'17, when it introduced quantitative tightening.
QT was necessary to start unwinding that gargantuan $3617.5b of QE that accrued over 6.4 years starting during that stock panic. Between the Fed's peak assets in January 2015 to it finally birthing QT in late September 2017, the Fed's balance sheet never contracted by more than 1.5% total! Despite the SPX's enormous ZIRP- and QE-goosed bull-to-date gains of 270.8% by then, doing QT still scared the Fed.
So it decided to gradually phase in QT mechanically, starting with a trivial $10b-per-month pace in Q4'17. As bonds within that limit matured, the Fed wouldn't buy new ones effectively destroying that bit of QE-conjured money. Each quarter QT would ratchet up $10b per month until it hit its terminal pace of $50b per month starting in Q4'18. The SPX surged to record highs before that, despite the ramping QT and 8 rate hikes.
The Fed's monster SPX bull extended to 333.2% gains heading into Q4'18, leading to rampant euphoria and complacency. I took the contrarian view then, in one of my most-read essays ever. Titled "Fed QT is Bull's Death Knell", I argued an anomalous QE-fueled stock bull couldn't survive QT intact. QT going full bore at $50b per month for 30 months even to unwind merely half of all that QE would slaughter stocks!
The complacent Fed didn't look worried, as the SPX had levitated on Republicans' corporate tax cuts and US-China trade-deal hopes for most of the year QT was ramping up. But all hell was about to break loose as QT hit terminal velocity. This chart superimposes the SPX over the Fed's total assets in recent years. All the FFR hikes, rate cuts, QT, and QE changes are noted. This fully explains 2019's huge SPX rally.
Trump's new Fed chair Jerome Powell had taken the helm in February 2018. By October 3rd he was getting cocky, as the SPX had mostly gone straight up despite that QT ramp and rate hikes under his watch. In a speech he flipped on the hawkish afterburners, saying rates were "a long way from neutral at this point" and "we may go past neutral". That's when the SPX started selling off, rolling over hard out of euphoria.
With QT killing $50b per month of QE, the SPX dropped 12.7% between just before the Fed's 8th rate hike in late September to just before its 9th one in mid-December. That was in correction territory over 10%, but didn't look particularly threatening. So the Fed made the 9th rate hike of its tightening cycle as traders expected on December 19th, 2018. The SPX wilted on that, plunging another 7.7% over 4 trading days!
That forecast hike wasn't the problem, it was top Fed officials' collective outlook on future rate hikes. That is quantified quarterly at every other Federal Open Market Committee meeting in a part of its Summary of Economic Projections known as the dot plot. That day the Fed policymakers were forecasting 3 more rate hikes, only striking a single one. Traders had expected a more-dovish outlook after that sizable SPX selloff.
The reaction was swift and violent, the SPX plunged 1.8% from intraday highs within 15 minutes of that release! The aftermath took the SPX's total correction to a serious 19.8% in just 3.1 months, right on the verge of a new bear market at 20%+. The Fed was rightfully blamed for that, although traders overlooked the fact the stock bull never would've run anywhere near as long or large without all those years of ZIRP and QE.
Powell gives press conferences after FOMC decisions, and he said something after that mid-December one that further spooked traders. He declared the Fed was sticking with its original plan to keep QT "on automatic pilot" at $50b per month. The Fed would only change the FFR to make monetary policy, not alter the balance-sheet runoff. With the SPX sharply lower, the formerly-ignored QT was becoming big news.
That was 2019's setup, a wounded stock bull teetering on the edge of a new bear after a hawkish Fed shot it! With Trump attacking the Fed every chance he got for not cutting rates, it couldn't risk the political fallout for being blamed for killing a bull and spawning a bear. The resulting negative wealth effect would trigger a severe recession if not depression. So 2019's whole story is the Fed doing a massive turn-one-eight!
As usual after a sharp plunge, the SPX was due to bounce proportionally into January 2019. After that Christmas Eve near-bear low a few trading days after that FOMC decision, Powell was eager to tell stock traders exactly what they wanted to hear. Right out of the gates on January 4th, he started goosing the SPX with a speech in Atlanta. He totally backtracked on his QT-autopilot statement, saying the polar opposite.
The SPX rocketed 3.4% higher that day alone after Powell said "there is no preset path for policy" and the Fed is "prepared to adjust policy quickly and flexibly". He explicitly said QT could be changed "if needed", and assured the Fed was "listening carefully to markets". That began a long year of high Fed officials doing and saying everything they could to lift stock markets. They radically shifted from hawkish to uber-dovish.
By mid-January the SPX had surged 13.6% out of its recent near-bear lows, but was stalling out after that violent V-bounce. So the Fed rushed to the rescue at its January 30th FOMC meeting, the first since that mid-December one tanked markets. The FOMC-statement reference of "some further gradual increases" in rates was deleted outright. And the Fed extraordinarily issued an entirely separate statement on QT alone!
It assured the FOMC was "prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments". So the SPX surged 1.6% that day alone, and 3.7% over 5 trading days. That extended its total post-severe-correction rebound to +16.4%. Whenever the SPX's momentum started to fade, it seemed top Fed officials would jump in bringing tidings of dovishness.
For example on February 27th, Powell testified before the US Congress that the FOMC was planning on ending QT entirely "sometime later this year"! So much for normalizing the Fed's balance sheet, as the Fed officials caved after a single big SPX correction. Still the blistering SPX surge, which was acting like a bear-market rally despite stock markets just missing bear-dom, was running out of steam again in early March.
So the Fed completely surrendered to traders at its March 20th FOMC meeting. Top Fed officials' dot-pot rate outlook, the first since mid-December's crushed stock markets, slashed 2019's hikes from 2 to 0. And the FOMC declared it would cease QT years early by the end of September! That QT-tapering plan would leave total QT at just $825.0b, or only 22.8% of that enormous $3617.5b of QE piled on over 6.4 years.
The original expectation when QT launched in Q4'17 was for a half unwind, but the cowardly Fed could not even do a quarter after the SPX plunged! That radical shift from QT-on-autopilot-for-years to QT-is-dead goosed the stock markets again, ultimately pushing the SPX to new record highs starting in late April. That entire deep near-bear correction had been erased thanks to exceedingly-dovish Fed jawboning!
But the SPX's colossal 25.3% rocketing over just 4.2 months into late April was absurd, driven solely by Fed talk and not fundamentals. Experienced traders realized that, so the SPX started rolling over hard in May. As June dawned it had fallen 6.8% in just over a month. Even that pullback was unacceptable to a Fed hellbent on levitating stocks. So Jerome Powell short-circuited that selloff with a June 4th Chicago speech.
He declared "recent developments involving trade negotiations" between the US and China could affect the US economy. Thus the Fed was "closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion". Stock traders interpreted that as Powell intended, if the US-China trade war hit stocks the Fed would start cutting rates again.
Powell also laid the groundwork that day for ZIRP and QE to become permanent normal monetary-policy tools, not just the temporary crisis measures they were long promised as! That day alone the SPX surged 2.1% higher, igniting a major 5.2% 5-trading-day rally. Powell's insane dovishness had stopped an SPX pullback threatening to snowball into a correction dead in its tracks. The Fed is the only reason stocks soared.
The FOMC's stunning reversal from hiking to cutting continued at its June 19th meeting. That day's dot plot kept 2019 neutral, but changed 2020's lone future hike to a cut. That effectively staked its 9-hike-old tightening cycle that had been put on hold in mid-December after the SPX plunged. Incidentally that big shift from Fed hiking to cutting is what ignited gold, propelling it to its first bull-market breakout in several years.
The SPX rallied another 1.2% over a couple trading days to hit another record high on that. If the Fed hadn't totally capitulated on QT and rate hikes, there's no way the stock markets would've fully reversed their Q4'18 near-bear losses. That stunning rebound rally was mostly fake, manufactured by extreme Fed dovishness. You'd think killing QT way early and more than restoring the SPX would be mission accomplished.
But it wasn't. Again by mid-December 2018 the FOMC had hiked the FFR 9 times, taking it to a target range between 2.25% to 2.50%. That was still super-low historically, far from being normalized! From late June 2006 to mid-September 2007 for example, the FFR was set at 5.25% continuously. Having just 9 cuts left before going ZIRP again wasn't much precious rate-cutting ammunition to fight the next recession.
The SPX achieved another 8 new record closing highs in July, adding to the 5 before that. With stock markets euphoric and everyone happy, logically the Fed would preserve its mere 9 available cuts. And with Trump relentlessly attacking the Fed as an institution and Powell personally via Twitter, cutting rates would make it look like the FOMC caved to Trump. The idea of cutting rates at record SPX levels was crazy.
Yet inexplicably at the FOMC's next meeting on July 31st, it cut the FFR by 25 basis points! That officially staked the previous hiking cycle, and spoiled stock traders expecting it to be the start of a cutting cycle. The Fed had cowardly kowtowed to them and Trump with a not-economically-warrantedcut. Powell tried to say that was one-off, calling it a "midcycle adjustment" and not "the beginning of a lengthy cutting cycle".
How dare he! Even after 7 months straight of epic Fed dovishness, stock traders threw a temper tantrum and hammered the SPX 2.0% lower intraday on that. It fell 1.1% on close, its worst down day in 8 weeks, on Powell's meek stand. That selling cascaded after Trump hit China with another round of tariffs, driving the SPX into a 6.1% pullback. While Fed officials were quiet, FOMC-meeting minutes helped turn that around.
3 weeks after each FOMC meeting, the Fed publishes their minutes. That July 31st one with the FOMC's first rate cut in 10.6 years also had a discussion hinting QE might soon return! The last expanded QE3 had been finally wound down way back in October 2014. Yet even with the SPX near record highs, the top Fed officials were pondering launching QE4 mentioning "asset purchases" a half-dozen times in those minutes.
Despite the SPX hovering over 3000, 2.6% above September 2018's pre-full-speed-QT peak, the FOMC cut a second time at its mid-September meeting. It had squandered 2 of its 9 rate cuts it should save for the next recession! The Fed was also trying to counter rates blowing out in the overnight repurchase-agreements market, which impaired its ability to set the federal-funds rate. So it launched emergency repo ops.
These were huge, starting at $75b per day. At his press conference, Powell declared the Fed would "be assessing the question of when it will be appropriate to resume the organic growth of our balance sheet. And I'm sure we'll be revisiting that question during this intervening period and certainly at our next meeting." That was Fedspeak for the Fed was considering birthing QE4 as soon as late October's FOMC meeting!
Fed officials believed the repo-market chaos resulted from its balance sheet sinking too low. QT was fully tapered off at the end of August, pushing the Fed's total assets down to a 5.9-year low of $3759.9b. Yet that was still 4.2x higher than pre-stock-panic levels! That pegged total QT as just $756.1b, or merely 20.9% of the total QE. The Fed was starting to panic again after unwinding just 1/5th of its QE bond buying.
Why on earth was QE4 being discussed with record stock markets? Repo-market rates were forcing the FFR above its target range, so the Fed was losing control. But resuming QE bond monetizations was just as foolish as rate cuts, squandering more recession-fighting ammo. The SPX actually slumped 4.0% in the couple weeks after that mid-September FOMC meeting, as traders wondered why the Fed was so scared.
While the Fed's huge daily emergency repo ops continued and grew, they were supposedly temporary. Yet the Fed's balance sheet started surging higher again. The Fed reports that data each Wednesday, and by October 9th 6 weeks after that QT-ending secular low the Fed's total assets had soared 5.1% or $190.0b higher! QE4 looked to be already underway in stealth mode, to keep from embarrassing the Fed.
As the Fed's newly-exploding balance sheet became more widely known, Powell was forced to explain it between FOMC meetings. He gave a speech in early October pre-announcing QE4, but wouldn't call it QE. "I want to emphasize that growth of our balance sheet for reserve management purposes should in no way be confused with the large-scale asset purchase programs that we deployed after the financial crisis."
Oddly on October 11th, several weeks before its next formal meeting, the FOMC released a statement birthing QE4. It was massive, definitely large-scale despite Powell's protests. The Fed was going to "purchase Treasury bills at an initial pace of approximately $60 billion per month, starting with the period from mid-October to mid-November" and "purchase Treasury bills at least into the second quarter of next year".
If that runs to mid-Q2'20, and that $60b-per-month pace is maintained, QE4 was initially tracking at $420b of Treasury monetizations! That $60b tempo was 50% larger than QE3 at launch, although that was soon expanded to $85b monthly. But only $45b per month of QE3 was in Treasuries, compared to all $60b for QE4! QE3's overall final size weighed in at $1590b, so if not expanded QE4 will clock in at over a quarter of that.
The SPX started surging again as the Fed's balance sheet exploded vertically. QE inflation is rocket fuel for stock markets, wildly bullish. The peak-QE3 year, and peak-QE-in-generalyear, was 2013. The Fed conjured $1125.3b out of thin air to buy bonds that year, catapulting its balance sheet 38.7% higher! The SPX's reaction was incredible, rocketing 29.6% higher closely mirroring the Fed's balance-sheet expansion!
These new QE4 Treasury monetizations would happen twice a week at $7.5b each. Not surprisingly with the Fed injecting $60b per month of brand-new fiat money into the markets again, the SPX took off like a bat out of hell. In the 7 weeks after QE4 was announced, the SPX blasted 7.3% higher to achieve 13 new all-time-record highs! Overall between late August to mid-December, the Fed's assets soared 10.0% or $377.1b!
That balance-sheet growth rate was astounding, the fastest by far since January 2014 when QE3 was still running full steam. The Fed's claims that this was all normal reserve management were total crap. It reminds me of that famous Jean-Claude Juncker quote. When heading the European Union, he once said "When it becomes serious, you have to lie." The Fed has inarguably been panicking in recent months!
The FOMC's late-October meeting in the midst of that QE4 balance-sheet explosion drove that point home. With a firehose of QE capital injections deluging into the markets, the SPX right at all-time-record highs, and Trump attacking the Fed and Powell mercilessly, the Fed still inexplicably cut the FFR for the third time in just 3.0 months! Why did it waste fully 1/3rd of its recession-fighting ammo if everything was awesome?
The last FOMC meeting of the year came in mid-December. While the Fed didn't cut again, top Fed officials continued capitulating on their rate outlook. Their median FFR forecasts for 2020, 2021, and 2022 all fell by a quarter point. Because the heavy-handed Fed so moves markets, I've carefully studied its actions and their market results for decades. Believe me, 2019 was an extraordinarily dovish year for it!
The US stock markets' monster rally this past year had nothing to do with fundamentals. US corporate earnings actually slumped in 2019, with Q1, Q2, and Q3 dropping 0.3%, 0.4%, and 2.3% year-over-year! By late November, Q4 earnings estimates were running down 1.5%. The SPX would've drifted lower in 2019 had it been following underlying fundamentals. Valuations verify this, climbing through the entire year.
At the end of 2018 right near those full-bore-QT-driven near-bear correction lows in the SPX, its 500 elite companies averaged trailing-twelve-month price-to-earnings ratios of 26.1x. By the end of November, the latest month-end data before this essay was published, that key metric had expanded to 28.0x which is back in formal bubble territory! That big 7.3% multiple expansion proves earnings didn't justify 2019's rally.
US-China trade-war progress wasn't the driver either, as there was virtually none until mid-December at best. Throughout 2019 Trump raised tariffs on China, and China refused to make any of the big changes the US was demanding. The phase-one deal announced in recent weeks is a joke, China allegedly agreeing to restore its US farm-goods purchases in return for Trump cutting tariffs. And it hasn't even been signed!
The sole reason the SPX rocketed 28.6% higher at best this year, hitting 33 new all-time-record closing highs, was an unbelievably-dovish panicking Fed. If you carefully break down the SPX gains, the lion's share of them happened soon after the Fed's major policy changes outlined in this essay. If the Fed had stayed its prudent and wise normalization course it was on in late 2018, 2019 would've looked radically different.
And 2020 isn't going to enjoy those same epic Fed tailwinds. The FOMC can't prematurely kill QT again, and can't shift from hiking to cutting again. It only has 6 quarter-point rate cuts left between here and ZIRP, not much ammo left to dissipate. It can keep monetizing Treasuries with QE4, even upping those huge inflationary injections. But the longer and bigger QE4 runs, the more its implied necessity will scare traders.
If these bubble-valued stock markets required epic Fed easing to soar in 2019, what happens to them in 2020 as that vanishes? At best SPX gains will be far more subdued, at worst the stock markets will sell off sharply and roll over into their Fed-delayed bear. But make no mistake, today's lofty stock-market levels are totally fake. They are wildly distorted, directly conjured by the Federal Reserve's incessant manipulations.
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The bottom line is 2019's stunning stock-market rally was fake, conjured by an absurdly-dovish Federal Reserve. Panicking after late 2018's deep near-bear correction it spawned, the Fed killed QT years early, shifted its rate outlook from hiking to cutting, slashed rates 3 times in 3 months, and launched QE4 with large-scale Treasury monetizations! That made 2019 one of the biggest Fed-easing years imaginable.
The massive stock-market gains mostly came soon after these key Fed decisions. In a year where US corporate earnings shrank and the US-China trade war really intensified, it was epic extreme Fed easing that levitated the stock markets. 2020 will look way different since the Fed is running out of room to keep cutting. Ultimately the Fed-spawned bubble valuations will overpower the Fed's egregious market distortions.
Dec 27, 2019
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