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posted on 04 July 2017

Why Quantitative Tightening Will Fail

from Daily Reckoning

-- this post authored by James Rickard

After nine years of unconventional quantitative easing (QE) policy the Federal Reserve is now setting out on a new path for quantitative tightening (QT).

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QE was a policy of money printing. The Fed did this by buying bonds from the big banks. The banks would then deliver bonds to the Fed, and the Fed would in turn pay them with money from thin air. QT takes a different approach.

Instead, the Fed will set out policy that allows the old bonds to mature, while not buy new ones from the banks. That way the money will shrink the balance sheets ahead of any potential crisis.

For years leaders at the Federal Reserve have been rolling over the balance sheet to keep it at $4.5 trillion.

Here’s what the Fed wants you to believe.

The Fed wants you to think that QT will not have any impact. Fed leadership speaks in code and has a word for this which you’ll hear called “background." The Fed wants this to run on background. Think of running on background like someone using a computer to access email while downloading something on background.

This is complete nonsense. They’ve spent eight years saying that quantitative easing was stimulative. Now they want the public to believe that a change to quantitative tightening is not going to slow the economy.

They continue to push that conditions are sustainable when printing money, but when they make money disappear, it will not have any impact. This approach falls down on its face - and it will have a big impact.

Markets continue to not be fully discounted because they don’t have enough information. Contradictions coming from the Fed’s happy talk wants us to believe that QT is not a contractionary policy, but it is.

My estimate is that every $500 billion of quantitative tightening could be equivalent to one 25 basis point rate hike. The Fed is about to embark on a policy to let the balance sheet run down. While I don’t know the figure, let’s give a rough estimate that they lower balance sheets at a rate of $10 billion a month, or $120 billion a year. I would expect for the long-term they’ll look to increase the tempo, which could even reach $20 billion a month or higher.

Under that estimate, it would be the equivalent of half a 25 basis point rate hike just in the first year alone, with expectations of Fed increases from there.

The Fed has pushed that hiking rates will have the same effect as QT. While they might attempt to say that this method is just going to “run on background," don’t believe it.

The problem continues to be that the stock market is overpriced.

Go back to the days following the November 8th presidential election of Donald Trump. What happened the next day? Stocks went up and then immediately they went down.

The Dow Jones went down 800 points following the election. Until Carl Icahn, who was with Trump in Trump Tower on election night, went out and bought $2 billion worth of stocks in the middle of the night.

By the end of the next day, November 9th, the market was up, and then it went up from there. The Dow Jones went up a thousand points in November, December and January based on the expectation of Trump tax cuts. He’s only cutting taxes once, he’s not cutting them three times.

When I saw that, it immediately indicated that this is a bubble. This is bubble behavior, and it has even gone up a little bit from there. The market seems to have nearly peaked as of March 1st.

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Now that it’s apparent that the Trump agenda’s not going to be enacted, the market’s ready for a fall on its own.

Quantitative Tightening, Wall Street and Gold

Where are estimates headed for 2018? Many in the Wall Street crowd have extrapolated that analysis from the S&P projected earnings charts shows numbers going vertical. That’s not going to happen if the Fed’s doing quantitative tightening and raising rates, which they are headed toward. The stock market’s set up for a fall.

The one thing to know about bubbles is they last longer than you think and they pop when you least expect it. Under such conditions, it’s usually when the last guy throws in the towel that the bubble pops. We’re not there yet.

While the current environment might not show that stocks are going to go down in the next few weeks, the question still remains on whether this is a bubble? Is this thing ready to pop? Absolutely, and QT could be just the thing to do it.

I would say the market is fundamentally set up for a fall. When you throw in the fact that the Fed continues to have no idea what they’re doing, and has taken a dangerous course anyways. I would expect a very severe stock market correction coming sooner than later.

This is where taking multi-step analysis comes into play. In the very short run, you say see that the Fed’s raising rates, they’re going to do QT, and the economy’s slowing and tends to make the dollar stronger by giving deflationary actions.

All those things historically are bad for gold.

Yet while everything described is bad for gold, you will notice that gold’s going up anyway. While it may go up and down some weeks, if you look at charts going back to December 15th, 2016, gold is up significantly. It is in a zigzag pattern where it will go up then back down repeatedly. Every high is higher than the one before, and every low is higher than the one before.

In other words, this is a step pattern. That pattern of higher highs and higher lows is very bullish for gold. I’m actually surprised that gold is as strong as it is - given all the headwinds described. That’s part of the bull case for gold.

The stock market seems to be correcting and the Fed will eventually have to reverse course. The Fed believes they’re going to be able to continue on a rate raising path, but this won’t be the case for long because the economy’s going to hit stall speed. They’re going to have to go into the vast toolkit yet again and likely apply forward guidance.

That’s when the Fed is going to find out the hard way that raising rates in September will be difficult because they’re slowing the economy. When the market sees that the Fed has decided to flip from tightening to an easing policy and the Federal Reserve decides it must apply forward guidance yet again - look for severe corrections.

Expect the price of gold to go to the moon because that kind of easing will be extremely bullish for gold.

What’s surprising about gold currently is that it has performed well in an adverse environment. When you flip to a positive or a favorable environment, it’s going to do even better.

Instead of watching the tape or short-term, my advice is to stay focused on the long-term trends.

That’s how you’ll make the most money and preserve wealth in adversity.

I would expect gold to be doing very well in the second half of the year.

About the Author

James Rickards James G. Rickards is the editor of Strategic Intelligence, the latest newsletter from Agora Financial. He is an American lawyer, economist, and investment banker with 35 years of experience working in capital markets on Wall Street. He was the principal negotiator of the rescue of Long-Term Capital Management L.P. (LTCM) by the U.S Federal Reserve in 1998. His clients include institutional investors and government directorates. His work is regularly featured in the Financial Times, Evening Standard, New York Times, The Telegraph, and Washington Post, and he is frequently a guest on BBC, RTE Irish National Radio, CNN, NPR, CSPAN, CNBC, Bloomberg, Fox, and The Wall Street Journal. He has contributed as an advisor on capital markets to the U.S. intelligence community, and at the Office of the Secretary of Defense in the Pentagon. Rickards is the author of The New Case for Gold (April 2016), and three New York Times best sellers, The Death of Money (2014), Currency Wars (2011), The Road to Ruin (2016) from Penguin Random House.

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