We all knew this day would come…
After five years of a rocket-like arc on the stock market, the chickens are coming home to roost. Here’s the S&P since the 2009 crash:
And here’s what happened to start the month…
On Thursday July 31st, the Dow fell over 300 points, practically erasing all the gains for the entire year. The S&P dropped 2.7%, which was its worse drop in over two years.
I’ve been anxiously awaiting days like that, and I think many more are to come. It’s a crack in the hull. A chink in the armor. A canary in the coal mine. While the market clawed back from the bulk of those losses, the fundamental issues remain the same, and we can expect more and more of these mini-market crashes as the year goes on.
Now, I’ll be the first to say I’m happy to have made a lot of money on that trip up. But I’m not about to watch it all wash away once the Fed’s jig is up. And that time could be coming very soon. Not only could the next serious market correction wipe out much of our portfolio gains, but it could also bring an end to the Federal Reserve as we know it…
One Federal Reserve insider has even said that another crash could be the event that finally brings the Fed to its knees. The man who was called upon to execute QE has just dropped some bombshells regarding the upcoming market correction.
So let’s have a look at exactly what will happen when that inevitable reversal comes… and how you can protect yourself before it happens.
QE-eeeek!
Andrew Huszar was an architect of the Fed’s quantitative easing program — where the Fed essentially prints money to lend out to banks for free as part of the zero–interest rate policy: ZIRP, as in zip, ziltch, nada. Free money for Wall Street.
After leaving the Fed, he has become a whistleblower on the Fed’s tactics. He has called QE “the greatest backdoor Wall Street bailout of all time.”
This is no disgruntled bureaucrat: he was also Managing Director and U.S. Head of OTC Derivatives Client Clearing for Morgan Stanley. So he knows what he’s doing on both the Wall Street side and the Fed side.
And he is really, really scared of what’s about to go down; he even thinks that the next big stock crash will essentially destroy the Fed as we know it. In an explosive interview with King World News (which I urge you to listen to in full), Huszar breaks down exactly how unprecedented the Fed’s actions were after the 2008 crash, and how it can possibly go on as an independent agency after the next crash…
First, let’s take a look at the Fed’s largest financial stimulus in world history.
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Before the recession, the Fed held between $700-$800 billion of Treasury notes on its balance sheet. Today, the Fed has $4.5 trillion on its balance sheet.
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Last year, the Fed paid $8 billion in interest to big Wall Street banks.
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Banks reaped an estimated $13 billion of income by taking advantage of the Fed’s below-market rates.
And what did we get for that insane amount of money?
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“Too Big to Fail” banks are now 34% bigger than they were in 2007.
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0.2% of U.S. banks control 70% of industry assets.
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The top 1% of Americans have reaped 90% of the income gains since 2009.
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In 2008 we were the number one confident economy, now we are 5th.
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The U.S. is 70% dependent on consumer spending. But now, the bulk of main street Americans have less wages and have basically maxed out their credit. All told, Americans are a measly 10% less indebted than they were before the crisis.
Not exactly a holistic recovery…
So what happens when it’s time to unwind QE and start getting rid of that historically massive balance sheet? Huszar argues that when it’s time to pay the piper, the Fed is going to have a hell of a time justifying itself once it starts posting record losses on its assets.
“As interest rates rise, the funding costs on those deposits will rise in connection. There could come a time when interest rates get to 4, 4.5% where the Fed begins generating huge losses on its portfolio. That really would be the first time the Fed has ever actually generated losses, and it will open the Fed up to massive congressional criticism and may fundamentally cause the Fed to change — losing their independence in the political system.”
So, the Fed has pumped a record amount of cash into the market. It’s easy to print the money, but not nearly as easy to carefully shuffle it off of its portfolio. When interest rates rise, they may be stuck with “interest on excess reserves” that may be enough to sink them.
“Right now more than half of that is sitting on the sidelines. There’s a real risk that when Wall Street begins to lend that money out, the Fed may have to try to figure out how to pull that money back in.”
The Fed has never tried to do anything like this before, and the reality is the Fed doesn’t have the tools to soak that money back into the system.
So what are its options? The money must go somewhere…
The End of the Fed as We Know It?
The Fed has precious few options to get all of these excess reserves off of its balance sheet. According to Huszar it could sell of its assets, but that’s incredibly unlikely. The problem is the Fed simply can’t find anyone to sell to!
“The likelihood of the Fed selling anything is ZERO. I think the real issue is…whether the Fed ultimately has to deploy so much cash to try to deal with the unintended consequences of QE that it starts generating losses and whether those losses, for the first time in its history, cause it to have to actually borrow money from Congress, in which case we could see some real fireworks.”
The other options is that the Fed can engage in “reverse repos”. The Wall Street Journal defines a reverse repo like this:
The Fed “sells” securities that are part of its enormous, $4.4 trillion balance sheet to a host of financial institutions, while it simultaneously agrees to “repurchase” those assets the next day while paying the institutions a slight return (currently 0.01% to 0.05%).
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Ironically, faced with a more acute liquidity crisis, the Fed would likely have to use the funds it is borrowing through reverse repos to provide a lifeline to the very markets that suffered. For investors seeking safety, the Fed would become the borrower of first resort. For borrowers affected by the resulting diversion of funding, the Fed would become the backstop lender.
While it sounds like a program that could be a last resort, there is no historical precedent for unwinding a program this huge. So if the Fed can’t find a backdoor way to unwind the stimulus, it could be forced to go to Congress with its hands out, begging for money to bail it out!
Team the Fed up with this Congress and you have the most volatile relationship since Ike and Tina Turner. That would create such a loss of confidence in the Fed that the market reaction could be catastrophic.
“There would be constant unease and panic…” Huszar notes.
The Fed is the main financial player in town. You drag it in front of fired-up congressmen looking to hold its feet to the flames, it would amount to a firing squad. Believe me, they are already licking their lips and lining up to take on the Fed. And — while we’ve always said that a flood light needs to be shined on the Federal Reserve — we know that it won’t be pretty for the stock market.
It would be a bloodbath….
“The reality is, I personally believe we’re in line for some tough times for the financial markets,” Huszar predicts.
I’d say that is an understatement. While we’d all be thrilled to see the Fed taken down, it won’t be easy … and many of us will lose our shirts if we’re not careful.
“We heard these very same words being uttered in 2007, 2008…I don’t know what the next crisis will look like, but I believe that we do have this potential for pretty significant selloffs in the financial markets. Again, people need to be very careful about their investment strategies and really hold things they have confidence in terms of longer term.”
This is the time to start taking those Fed-drunk gains, loading up on precious metals and giving the Volatility Index (CBOE: VIX) a spin.
After the crash, there will be plenty of time to start plucking up discount stocks. Next week, we’ll look at exactly which industries could really take a hit. In the meantime, batten down the hatches…
