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posted on 28 September 2017

Will Unwinding Become Unraveling?

Written by , Clarity Financial

The problem for the Fed, despite their jawboning, is their ability to actually accomplish the “Great Balance Sheet Unwinding Of 2018."

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The guys at Knowledge Leaders summed the problem up well:

“If the Fed starts shedding assets at $10 billion/month, ramping to $50 billion/month by 2019, can the private sector absorb these securities at the same the government budget deficit is set to widen by perhaps $100-$150 billion in the next couple years?

Not to state the obvious, but all else equal, if the fed started shedding assets at $30 billion a month (or $360 billion a year), they would exhaust the entire stock of private savings. This doesn’t allow for larger government deficits. Given the current savings level, it is mathematically impossible for the Fed to shed assets at $50 billion/month. By 2019, as we are farther out from peak net savings rates set in 2015, it is likely the stock of private savings is smaller still, and hence the ability for the Fed to shed assets at a rate of $50 billion/month is utterly impossible. Net savings have fallen in the last 2 years from a peak of just over $700 billion to the current $355 billion. Will savings halve again in the next two years? If so, there is no mathematical way in the world the Fed can shed assets at the rate it outlined yesterday."

That bit of analysis supports the comments made by BofA on Friday:

This point can be summarized simply as follows: there is $1 trillion in excess TSY supply coming down the line, and either yields will have to jump for the net issuance to be absorbed, or equities will have to plunge 30% for the incremental demand to appear."

“An unwind of the Fed’s balance sheet also increases UST supply to the public. Ultimately, the Treasury needs to borrow from the public to pay back principal to the Fed resulting in an increase in marketable issuance. We estimate the Treasury’s borrowing needs will increase roughly by $1tn over the next five years due to the Fed roll offs. However, not all increases in UST supply are made equal. This will be the first time UST supply is projected to increase when EM reserve growth likely remains benign.

Our analysis suggests this would necessitate a significant rise in yields or a notable correction in equity markets to trigger the two largest remaining sources (pensions or mutual funds) to step up to meet the demand shortfall. Again, this is a slower moving trigger that tightens financial conditions either by necessitating higher yields or lower equities."

Given that household savings as a percent of GDP, and interest rates, have a long history of correlation, the analysis above suggests that both interest rates and equities will be lower in the months ahead.

Potentially, substantially so.

This is particularly the case given that D.C. may be the “reality that bites" this market right in the @$$.

With John McCain confirming on Friday that he will NOT support the latest attempt to “repeal and replace" the Affordable Care Act (ACA), this leaves little chance for the bill to pass the Senate.

As I have repeatedly stated previously, the problem with the lack of repeal of the ACA is the $900 billion in taxes embedded in the legislation. This makes the passage of tax reform, on which the market is clinging to support earnings growth and valuations, nearly impossible to pass under the “reconciliation" process.

Furthermore, the inability to come to an agreement to repeal and replace the ACA just goes to show how problematic passing legislation, even in a majority controlled Administration, has become. Since tax reform legislation is even more complicated and contentious than health care, it is not surprising why it has been 30-years since the last reform was completed.

Given that Democrats will oppose any legislative agenda of the current President, and given there are a sufficient number of moderate Republicans who will vote against a more “nationalistic agenda," the probability of aggressive tax cut/reform legislation getting passed in Washington this year has fallen to virtually zero.

What will likely wind up being passed are temporary tax cuts, no real substantive reforms, and a grab bag bull of temporary “gimmes" which will likely disappoint the market’s future “earnings growth hopes."

Pay attention to the D.C. intrigue next week as we are likely to see the first release of the proposed tax reform legislation.

It could very well be a “buy the rumor, sell the news" scenario.

Market Clings To 2500

However, that is for another article down the road.

The short-term analysis of the market remains broadly positive with both the ongoing bullish trend and recent break above 2500 remaining intact through the close on Friday. As I noted last weekend:

“Since the election, there has been a concerted effort to push stocks higher on the hopes of tax reform, ACA repeal, and infrastructure building which would lead to strongly improving earnings for U.S. companies. Now, eleven months later, stocks have been breaching the psychologically important levels of 2200 in December, 2300 in February and finally 2400 in May. 2500 is the next target.

As shown below, the market is pushing a short-term “buy" signal. However, now at 2-standard deviations above the 75-dma, as seen previously, the market likely has limited upside from here."

While the market does remain bullish in the short-term, keeping our portfolios tilted toward equities, we remain exceedingly cautious due to the chart below. (I know this is a little busy, but bear with me.)

The chart above looks a market complacency as it relates to market risk. When “complacency" has reached previous extremes, above the red bar, markets have often been close to a corrective process or have struggled to make further gains. With the volatility index back to historic lows, we are reticent to increase equity exposure at these levels further at this juncture.

More importantly, the blue dashed trend line has been solid SUPPORT for the bull market advance since the beginning of 2016. The recent violation of that trendline, has now turned that previous support into overhead resistance. That resistance is currently weighing on attempts for the market to advance solidly above 2500.

With complacency elevated, markets very overbought and sentiment excessively bullish, as discussed last week, we are already cautious. A failure next week to hold 2500 will turn us even more cautious.

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