What the Fed really said, and the great short squeeze

The market rallied on Thursday after the release of the minutes from the latest FOMC meeting in September. With the market oversold, and sentiment bearish in short-term, the rally was not unexpected as I discussed over the last couple of weeks. However, what did the markets see in the minutes that gave the emboldened the bulls?

To put this into context, you must first understand WHY the Fed raises or lowers interest rates.

Increasing interest rates raises the cost of borrowing money within the economy. Therefore, the higher borrowing costs rise, ultimately the lower the demand for credit in the economy. As the demand for credit falls in an economy, economic growth will slow subsequently bringing down inflationary pressures. The opposite occurs when the Fed lowers interest rates.

The problem is that Fed actions do not occur in a vacuum. As shown in the chart below, this is why monetary interventions by the Fed have consistently led to booms and busts.

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As discussed on Thursday, the economic backdrop in the U.S. is very weak and potentially in the early throws of a recessionary onset. However, we won't know that for sure until the backward revisions to the data occur next year. 

"Importantly, as with the GDPNow indicator, the CFNAI is showing that the economy is running weaker than headlines have suggested.

Despite Central Bank interventions, suppressed interest rates, and a surging stock market, the economy has failed to gain any significant traction. This is an anomaly that we can also see in the CFNAI data.

If we break the CFNAI down into a "supply" and "demand" model we see a very interesting, and telling, picture emerge."

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"As shown the supply side of the index has historically had an extremely high correlation to the demand side. That ended with the financial crisis. Since then the supply components have far outpaced the actual underlying demand in the economy. This goes a long way to explaning the ongoing weakness in economic growth as the lack of aggregate demand continues to weigh on labor and wage growth."

This is clear evidence as to why DE-flation continues to rule the economic backdrop and why the Federal Reserve remains trapped at the zero bound for interest rates. To wit from the latest minutes:

"Nevertheless, in part because of the risks to the outlook for economic activity and inflation, the Committee decided that it was prudent to wait for additional information confirming that the economic outlook had not deteriorated and bolstering members' confidence that inflation would gradually move up toward 2 percent over the medium term."

"Members noted that recent global and financial market developments might restrain economic activity somewhat as a result of the higher level of the dollar and possible effects of slower economic growth in China and in a number of emerging market and commodity producing economies."

While the Federal Reserve is still "hoping" that economic conditions will improve by year end to increase interest rates, the reality is such will NOT be the case. That reality was immediately reflected in Fed Funds Futures which implied a sharp drop in the potential for a tightening of monetary policy by year-end. 

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While much of the mainstream bullish media continue to suggest that increases in interest rates are NOT a problem for stocks, the truth is quite the opposite. Tighter monetary policy will reduce economic growth and inflationary expectations making already overvalued stocks even more overvalued on a relative basis. REMEMBER - the primary bullish argument for stocks has been the low level of interest rates.  Remove the low level of rates and you have a problem. 

This was fuel needed by the "bulls."Continued "accommodative" policy by the Fed is good for stocks in the short-term. The long-term consequence of being trapped at zero rates, is an entirely different story and an article in the near future. 

For the Federal Reserve, stock price action is very important. A decline in asset prices reduces consumer confidence and as such impacts economic growth. Such a negative event will keep the Fed trapped at zero. This was noted in the FOMC minutes:

"During the discussion of economic conditions and monetary policy, participants indicated that they did not see the changes in asset prices during the intermeeting period as bearing significantly on their policy choice except insofar as they affected the outlook for achieving the Committee's macroeconomic objectives and the risks associated with that outlook."

As I showed in last week's missive, this is why the Fed has been once again expanding their balance sheet which flows directly into financial assets. 

"As shown in the chart below, the Federal Reserve has already once again began to quietly expand their balance sheet following the recent downturn. Not surprisingly, the market has responded in kind with the recent push higher. My suspicion is that if such minor interventions fail to stabilize the market, a more aggressive posture could be taken."

Unfortunately, for the Fed, this is the "trap" they have gotten themselves into.

The threat of higher short-term rates causes the dollar to strengthen which causes global funding stresses. Those stresses then create conditions that cause external economic weakness which cycles back into the U.S. economy. Then the Fed says they can't hike rates due to the global economic weakness. 

As I have repeatedly stated for the last 18 months. It is highly unlikely the Fed will raise this year. The problem for the Fed is that as the realization occurs they are indeed caught in a "liquidity trap" - the conversation won't be about higher rates, but negative rates of interest. 

This is economically a very bad thing. 

Short squeeze from hell

While the FOMC minutes gave the "bulls" some confidence - it is the massive amount of short-interest (people betting on markets to fall) that provided the fuel. 

The chart below, from ZeroHedge, shows the massive jump in short-interest that has to be covered as stock rise. When players that are "short the market" are forced to cover - it fuels additional buying in the market which requires more shorts to cover. So forth and so on until that "fuel" is exhausted. This is why market rebounds tend to be extremely sharp and fast, but also fade just as quickly. 

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Importantly, there is a big difference between a fundamentally based "bull market" rally and a short-covering rally in a "bear market" cycle. While it is too early to say that we are indeed in a bear market, there are many indications that may well be the case.

Therefore, as stated above, it is likely wise to use the current rally to take some action in portfolios for now. Remember, it is always easier to get back into the market once the path higher is clear. It is much harder using the next rally simply to make up previous losses.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.