Do Not Fight The Fed!

One of the first lessons we learned back in our early bond trading days was "don't fight the Fed!". For all of us mere mortals, that is trader speak for understanding the ramifications of U.S. Federal Reserve Monetary Policy (or any central bank for that matter, but the Fed certainly has the greatest clout). 

If the Fed is tending toward easy monetary policy, generally speaking, that is good for asset (bonds and stock) prices as they add liquidity to the financial system and (as in the above chart) the monetary base (gold line) grows (more money sloshing around in the system). If it is extraordinary easy monetary policy, as it was in the post financial crisis days with "Quantitative Easing", it was a breeze for asset prices to rise (as the S&P 500 did through to the middle of 2015): all that money had to be put somewhere.

On the other hand, if the Fed is tightening and removing liquidity, there is a tendency for asset prices to move lower as there is less money in the system chasing  asset prices. The Fed has been reversing QE since 2016, effectively tightening, and at the same time, raising interest rates as well.

The Trump tax cut, fiscal or government stimulus (as opposed to monetary stimulus), provided a temporary offset to the Fed tightening, generally masking the shrinking monetary base and giving stock investors a rather false sense of security to go on their early and mid 2018 buying sprees. 

It all fell apart when liquidity became an issue in the last quarter of 2018 and heading into year-end many realized that they needed to raise cash and ouch, reality bit. Hard! Assets were for sale, especially expensive stocks.

Just because the Fed has adopted a more conciliatory tone does not mean that they are finished tightening. They still have an enormously large balance sheet to unwind, reducing liquidity and the monetary base and that will continue even if they pause hiking interest rates. Oh and just to add another wee twist, at the same time the European Central Bank is ending their version of QE.

As is clear in the above chart, the monetary base is going to lead equity markets over the longer-term. Stock investors who have been on a recent (and very short-term) buying spree may find themselves a little early to the party.

One of the most widely watched economic forecasting agencies, the International Monetary Fund (IMF) announced yesterday that they were lowering their global growth forecasts. Just in time to throw a little cold water on the early 2019 stock rally party.

And, in case you have not noticed, the record U.S. government shutdown continues and is adding to the gloomier economic outlook.

However, it is the week of that famous Scottish bard, Robbie Burns birthday and vast quantities of Haggis and single malt scotch are likely to consumed to console those who are somewhat over indulging in the U.S. equity market!

Ae fond kiss, and then we sever; 
Ae fareweel, and then for ever!
Deep in heart-wrung tears I'll pledge thee, 
Warring sighs and groans I'll wage thee. 
Who shall say that Fortune grieves him, 
While the star of hope she leaves him? 
Me, nae cheerful twinkle lights me; 
Dark despair around benights me.