The Fed's Latest Dirty QE Trick

Written by Dennis Slothower
Posted September 30, 2017

Tax Reform Party Begins

The broad market indexes have crept back to all-time highs, while the tech indexes and small cap indexes blew skyward on the Trump Tax Reform announcement. Was this premature pleasure for those traders willing to gamble it away?

Risk was favored, and in typical fashion the volatility index VIX dropped below 10 again.

In other words, practically no one is afraid to dump their money into stocks even though they have been hovering at all-time highs for almost two weeks now.

The Trump Tax Reform package announced Thursday could be given credit for bringing out the gamblers, who are likely looking for a short-term bump as the media plays up the benefits of tax cuts for almost everyone, especially businesses.

The problem comes when you look longer-term. Will any part of Trump’s Tax Reform package make it through congress? We emphatically say no, it won’t.

There is too slim of a margin for the Republican-dominated Congress to achieve a win for any of Trump’s fiscal policies, no matter how attractive they seem on the surface. We said this when he was elected, and it remains true today.

The Senate is the problem and everyone knows it, except the gambling traders. It is clear that Sen. McCain (Arizona), who lost in his own presidential bid, is bitter about Trump’s perceived slight of him as a captured POW during the election campaign. He will never give Trump a win on anything.

Sen. Collins (Maine), along with Sen. Murkowski (Alaska), are both essentially Democrats who will also refuse anything that looks like a Trump win. This version of Trump Tax Reform is already dead, just like Obamacare repeal and replace has been from the start — and for the same reasons.

Believe me, there are also a lot more Republicans in hiding who want to deny Trump a win, but still look like they are faithful to his agenda. When push comes to shove, they will work to avoid any kind of tax reform package that resembles Trump’s version.

The revenue problem is huge with this kind of tax reform. It is estimated to have a revenue shortfall of $3-4 trillion over 10 years. This will destroy the budget plan being worked on in Congress right now.

Either the congressional budgets must be revised to allow for much greater deficits or the tax reform cuts in this package need to be trimmed.

Remember, the biggest place for cutting spending to accommodate this much revenue shortfall is in entitlements. Do you think any Democrats or recalcitrant Republicans who dislike Trump are going to go on the record for denying entitlement benefits to seniors and the poor among us (think Social Security, Medicare, and Medicaid)? It ain’t gonna happen!

This tax reform package will be debated and sliced-and-diced into something that is a mere reflection of tax reform when it finally goes through. At best, we are likely to see a small tax cut for middle-class Americans and a small drop in the corporate tax rate. And it all won’t happen until well after the 2018 elections.

So, traders can celebrate today — but reality will soon settle in.

Federal Reserve Math

We just passed the last trading day of September and we're sitting at all-time highs. Now we'll be in October the next time the markets open, the month where the Federal Reserve has already announced the beginning of quantitative tightening.

The Fed members are not dumb — they might not care much for the American people, but they don’t want their plans to fail right out of the gate.

So, they will only sell off $10 billion in bonds at first. Then they will add $10 billion in bond sales each month until they get to $50 billion per month (during February, 2018)

After that they will commence on a 78-month schedule of $50 trillion per month in bond sales until their bloated balance sheet returns to “normal.” They will also continue numerous rate hikes in 2018, 2019, and 2020 until their interest rates are also “normalized.”

This is all part of unwinding the massive intervention they implemented beginning in late 2008 to climb out of the “Great Recession.” It was called quantitative easing and there were many rounds of it for almost a decade now.

If the stock market is any indicator, and some judge the economy solely on how the stock market is doing, the Fed could have shut down its quantitative easing in 2012.

Instead, it has pushed the market into the greatest bubble in history. And now it is ready to gently let some air out. At least, that is the hope it is conveying.

Let’s talk for a moment about who is going to buy an extra $50 billion in bonds each and every month. Do any of you really believe that our government is sufficiently close to running on a balanced budget that over the next 78 months we will no longer need to have so many new government bonds being issued?

There is no evidence of this remotely happening.

And yet, the Fed believes there is a market for an extra $50 billion sale of bonds each and every month for 78 months or so. Does the math add up?

It is said that net savings flows, i.e., individual savings and business savings less government deficit spending, is somewhere around $350 billion a year. The reported savings flow rate was at least twice this high at the turn of the century, and rebounded back by 2014 as business stuffed retained earnings into coffers rather than reinvest it.

Now the savings flow rate is on a steep decline again, much like it was heading into the 2008 financial crisis.

70927-Net-Savings

Why is the savings flow in our country so low? Part of it is high spending by federal, state, and local governments. But even private/individual savings flows and corporate savings flows are also on the decline.

It is easy to answer this question. With interest rates near zero since 2009, the Fed has literally forced savings money flows into avenues where returns can be realized. The Federal Reserve has essentially guaranteed that the equity market is an ideal place for that money to go.

And since the equity market has become the primary barometer for economic recovery, the Federal Reserve naturally feels real good about its intervention effort — and it has let the public know this over and over again.

Let’s suppose we could allocate all of that $350 billion in savings flow to the purchase of these extra bonds. Those savings would be gone in seven months. But you and I both know that barely a portion of this savings flow will actually go toward these new Fed bond sales.

So, there is a huge shortfall of money to buy up the Federal Reserve $50-billion-per-month bond sales. Then where could the money come from to buy these extra bond sales from the Federal Reserve’s balance sheet?

Well, if low interest rates moved money from deposit accounts into the stock market, then could higher interest rates move money from the stock market back into deposit accounts and into bargain bonds being sold by the Fed? You bet!

That is what happens with quantitative tightening, folks. The Fed drives the money where it wants it — 401K plans and IRA accounts be damned. Yes, stock market be damned, too.

And, conveniently, it harms the newly-elected Republican administration and Republican-controlled congress, suggesting that Democrats will get their turn again simply because the coming recession and market crash will be blamed on the Republicans. It’s déjà vu, huh?

That’s it — either the Federal Reserve’s math does not work or it's fooling itself and us and will never really reduce its balance sheet... or the stock market and the economy are going to take a big hit. Maybe it will be some of each.

While it is happening at a pretty slow rate, it is happening and the effects will be noticed more and more each month. The stock market will soon be starved of incoming cash flows... then prices will drop... and then traders will begin to panic as the safe-haven equity market will no longer be safe!

And then Trump will really be in trouble — just like the Democrats and many Republicans and the Federal Reserve want.

To your wealth,

Dennis Slothower Signature

Dennis Slothower
Editor, Wall Street Underground Profits

Dennis Slothower has been leading a small but profitable group of investors to some extraordinary profits in both good markets and bad over the course of a 38+ year investment career, starting as a stock broker in 1979. In 2011 Dennis was named the top performer by Hulbert Financial Digest for avoiding the Crash of 2008. Now, he is bringing his extensive experience to the public through Outsider Club and Wall Street Underground Profits. For more about Dennis, check out his editor page.

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