May 8, 2018

With the best first quarter for earnings in 24 years, the stock market continues to shrug off the good numbers and is focusing on the rising number of distractions such as the U.S. President, including his flip-flopping on key statements, trade frictions with China, and even indications that the U.S. may withdraw from the Iran nuclear deal. The Federal Reserve, which should be in the forefront of investors’ minds, has somehow been left behind the smokescreen of some significantly more colorful distractions.

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

Still, the fact that the Treasury market has calmed down somewhat does not mean that it cannot quickly become front-page news again as Treasury issuance is accelerating, the federal budget deficit is exploding, and interest rates are rising at the same time the Federal Reserve plans to hike the fed funds rate and let more and more bonds run off its balance sheet.

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

The present runoff rate from the Fed’s balance sheet is $30 billion a month. In January that rate was $20 billion per month. When the balance sheet reduction started in 2017 the initial was $10 billion per month.

The Fed balance sheet runoff rate has tripled in a short period of time. It is not inconceivable that the runoff rate will be $50 billion per month at the end of the year and the Fed would have run off more than $200 billion from its balance sheet. The runoff rate – the amount of bonds the Fed lets mature and does not reinvest on its balance sheet – is not preset and can be left constant if deemed appropriate.

Still, the fact remains that the runoff rate is now accelerating as the federal budget deficit is exploding courtesy of the Trump tax cuts and rapidly rising spending programs. It is ironic that those very same Trump tax cuts that caused in big part the late-cycle earnings growth acceleration in the stock market may add to an interest rate spike that could kill the very growth cycle they were supposed to stimulate. It is not hard to see how bond yields can overshoot and create quite the panic in financial markets.

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

While the stock market is currently worried more about trade frictions, leaving the Fed’s balance sheet shrinkage on the back burner, the dollar has definitely noticed and has started to move rather aggressively higher. As I suggested in December 2017, I would not be surprised if we rise above 100 on the U.S. Dollar Index by year end. I know from experience that when the currency markets start moving they can do so rather aggressively, similar to what happened from mid-2014 to the first quarter of 2015 when the U.S. Dollar Index moved from 80 to 100 in just nine months. That means that if the Treasury market overshoots by the end of 2018, the U.S. Dollar Index can overshoot, too.

The Awe of Unelected Central Banking Power

When central bank activity in the U.S. starts to accelerate, as it is doing at the moment, I always remember the words of one of my favorite graduate school finance professors, who said more than once throughout several courses he taught that the Chairman of the Federal Reserve, in his opinion, held more power over the economy than the President of the United States. While this sounded like a bombastic statement that was easy to dismiss when I was 25, I no longer think it is so bombastic, two decades later. I have come around 180 degrees on this issue and I basically agree that my finance professor was right on the money.

If the Chairman of the Federal Reserve wanted to, he could drive the U.S. President out of office by simply pressing harder on the balance sheet runoff rate accelerator and creating a spike in long-term interest rates and the dollar. Such spikes, if they happen quickly, can hurt the healthy earnings growth environment and crash the economy into a recession due to the high amounts of financial leverage U.S. business activity is used to. Such a scenario will undoubtedly cause the Blue Wave anticipated in the mid-term elections this year to become a Blue Tsunami, which could very well lead to an impeachment given the divisive nature of the President’s rhetoric towards the Democratic Party. And he used to be a registered Democrat!

The last thing I want to see is an impeachment mess driven by a super spike in long-term interest rates and the dollar, but to borrow the eloquent phrase used recently by former FBI Director Comey when discussing the Russia investigation, “It’s possible, however unlikely” that this could happen this year.

The Damocles sword over President Trump’s head may not be held by the hand of Special Counsel Robert Mueller, but by that of Fed Chairman Jerome Powell.

About The Author

Ivan Martchev
INVESTMENT STRATEGIST

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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