January 2, 2019

January 2018 started with an unsustainable surge that was driven by $103 billion of record inflows into stocks. February 2018 was a sharp down month driven by the record air pocket created by those same record inflows that caused January to be a big up month. The reason why such air pockets exist in February is because the guidelines for major asset managers are to put new money to work almost immediately. That new money comes from pension funds and other institutional investors which, for various reasons, tends to come in January, creating positive seasonality.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The record air pocket in February was exacerbated by imploding volatility and inverse volatility ETFs and ETNs (dubbed ETPs) that self-destructed. The more the index goes down, the more the VIX futures rally, the more the VIX futures rally the more the leveraged inverse ETPs short the S&P futures which in response creates a surge in VIX futures, which wipes out the inverse leveraged VIX ETPs. That’s the hellish cycle that creates 80%-90% declines in inverse leveraged VIX ETPs – all in a single session of after-hours trading!

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

We got the tax cut in December 2017, which in economic terms can only be described as poorly-timed fiscal stimulus. While I am in favor of lower taxes, I am not in favor of exploding budget deficits. It would have been significantly better to cut spending along with cutting taxes so the deficit won’t explode in a good economy. While in principle I am all for “draining the swamp” and “making America great again,” exploding deficits are not the way to get there, in my professional opinion.

While fiscal policy has to be independent of monetary policy, the last time we had this momentous friction between fiscal expansion and monetary tightening was during the Ronald Reagan years, when the legendary President No. 40 (and his Democratic Congress) spent like drunken sailors and in the process bankrupted the Soviet Union, in effect winning the Cold War. He was of course helped greatly by Mikhail Gorbachev’s policy of perestroika, which undermined the grip of the totalitarian state on the economy and political life and helped communism crumble.

Spending like a drunken sailor without a Cold War is the last thing President Trump wants to do, as well as creating enemies with the Chairman of the Federal Reserve, even though Reagan was not fond of either Paul Volcker or Alan Greenspan. It is President Trump’s poorly-timed fiscal stimulus that caused the Federal Reserve to press harder on the monetary brakes for fear that the economy is running too hot. This caused multiple Twitter attacks against the Fed Chairman, which backfired in the stock market.

The Rookie Fed Chairman Faces the Rookie Politician

If quantitative easing was done in fits and starts and the Federal Reserve felt its way through the twists and turns of the unorthodox monetary policy, how can quantitative tightening be done on “autopilot”? I am sure Fed Chairman Jerome Powell will regret his words from his latest FOMC press conference, if he does not already. The autopilot remarks and the impression that he was more hawkish than he was expected to be caused another leg lower in the stock market creating the worst December since the Great Depression up until Christmas Eve, which was a day of a record decline for a half-trading session.

Treasury Secretary Mnuchin calling banks over the weekend to check on liquidity certainly did not help, nor did the President’s continued Twitter attacks on the Fed Chairman.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The reason why central bank balance sheet reduction can’t be on autopilot is that the Federal Reserve doesn’t fully know how disruptive such policy could be on the economy, the stock market, and other financial markets for that matter. When the Fed balance sheet monthly runoff rate went from $20 billion in January 2018 to $50 billion at present, the stock market began to flip like a fish out of water. There are certainly other factors for the volatility in the stock market, many which emanate from the White House, but such unconventional monetary tightening could be equally disruptive.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Quantitative easing created a lot of excess reserves in order to force-feed credit on a financial system that was going to naturally de-leverage after the implosion of bank balance sheets in 2008. In that regard it was a success. In order for QE to a be a complete success, quantitative tightening needs to be success too, as they are the opposite sides of the same coin.

The reason why QT may be disruptive is that it results in a lot of repurchase agreement activity between the Fed and its primary dealers. Repurchase agreements and reverse repurchase agreements have been part of monetary policy for a long time, but never on the scale that we have seen in 2018. Repurchase agreements suck excess reserves out of the financial system, which is the same as sucking electronic cash out of the financial system. It is entirely possible that this record electronic cash suction rate is contributing in great degree to a weak stock market in an otherwise good economy.

About The Author

Ivan Martchev

Ivan Martchev is an investment strategist with Navellier.  Previously, Ivan served as editorial director at InvestorPlace Media. Ivan was editor of Louis Rukeyser’s Mutual Funds and associate editor of Personal Finance. Ivan is also co-author of The Silk Road to Riches (Financial Times Press). The book provided analysis of geopolitical issues and investment strategy in natural resources and emerging markets with an emphasis on Asia. The book also correctly predicted the collapse in the U.S. real estate market, the rise of precious metals, and the resulting increased investor interest in emerging markets. Ivan’s commentaries have been published by MSNBC, The Motley Fool, MarketWatch, and others. *All content of “Global Mail” represents the opinion of Ivan Martchev*


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