Fed Interference Makes Markets Hard To Predict (NASDAQ:TBIL)

In the course of stamping out every flickering brush fire on Wall Street over the past couple of years, the Fed has engineered at least two backdoor QEs—one in the form of large bank bailouts and another in the form of generous Overnight Repo Facility subsidies. In addition, the Fed has pumped up investor confidence on Wall Street by repeatedly promising (though not yet delivering) somewhere between 3 to 5 rate cuts this year.

While some of the Fed’s moves were telegraphed far in advance—like quantitative tightening and raising interest rates—other maneuvers that had just as much, if not more, impact on the stock market were done either subtly, or in near secrecy.

The Biden administration has also gotten into the game by selling off nearly half of the US oil reserves. This policy didn’t just inject further artificial liquidity into the economy, it distorted the entire energy landscape.

The Fed’s Trillion Dollar Subsidies for the Overnight Repo Market

One of the vital organs in the body of our nation’s economy is the overnight reverse purchase facility, which provides a sort of trading post for short-term repurchase agreements. Large financial institutions, usually banks, borrow money in the form of Treasuries overnight and pay the loan back first thing in the morning in addition to prorated interest, usually at the Federal Funds rate.

Most of the borrowers and lenders are financial institutions. Usually, the Fed plays a minor role in this facility.

Fig. 1

On March 3, 2021, the Fed had just $500 million of Treasuries in the overnight reverse purchase market before it flooded the operation with liquidity. The following month, the Fed began generously subsidizing this financial apparatus. As you can see from the chart above, this infusion of liquidity crescendoed until it reached $2.55 trillion by December of 2022.

It’s likely the Fed intended to buffer whatever shock quantitative tightening might induce in the stock market. However, this unannounced back-door QE likely distorted the market by inducing the surge in stock prices that began in the fall of 2022, just as the Fed’s infusion of liquidity was reaching its zenith.

The Rate Cut Mirage

The Fed’s oft repeated promises of rate cuts in 2024, while clearly intended to stabilize the stock market and overall economy, could likely turn out to be a mirage.

The mere fact that the US government is selling a record amount of Treasuries to finance a record-high budget for 2024 has already driven the 10-Year Treasury 18 percent higher (3.9%-4.6%) since the beginning of the year. This should come as no surprise, as the 10 Year is simply following through on a 4-year trend line that began during the pandemic.

Fig. 2

Meanwhile, the stock market soared 11% in just 3 months from January 2024, likely in anticipation of further liquidity. But when March came and went with none of the promised rate cuts, it appears reality sank in as the S&P slid 232 points as shown in the chart below.

Fig. 3

Bank Bailouts of April 2023

When Silicon Valley Bank, Signature Bank, and several other large banks geared toward venture capitalists veered off into uncharted territory to explore a new business model, one can only wonder if they assumed the Fed would rescue them if their high-risk gambit suddenly unraveled.

In this unique business model, these banks encouraged their clients to deposit billions of dollars into their accounts to create a large pool of money that other bank clients could draw upon to either expand their businesses or fund new ones. There was one glaring flaw in this banking model. All deposits over $250,000 are not backed by the FDIC, which means these financial institutions were vulnerable to the proverbial run on the bank, something we haven’t seen since the Great Depression, largely because of the FDIC.

To give some perspective, the very reason US Treasuries are popular around the world is because they’re a secure way to park billions of dollars with very little risk, unlike piling it into an unsecured bank account.

When the Fed finally began quantitative tightening in March 2023, even though the disruption to the standard banks—wherein nearly all deposits were backed by the FDIC—was minimal, the disruption to the new banking model that Signature and Silicon Valley Bank had embraced was severe. A surge in demand for large loans caused some high-value depositors to get cold feet and withdraw their unsecured funds from the bank. The sudden higher demand for large loans, quickly followed by even larger withdrawals, caused an old-fashioned run on these venture capitalist-style banks. Because the amounts involved were so huge, the Fed feared that if they didn’t intervene, the contagion could spill out into the entire banking sector, and from there, to the national and even global economy.

So, with little to no concern that they were once again rewarding malfeasance in the banking sector, the Fed rushed to the rescue with a program known as the Bank Term Funding Program (BTFP) which lasted from March 15, 2023 to March 11, 2024.

In March 2024, just before the Fed ended the program, the outstanding balance of the BTFP was $167 billion. So far, all of the banks that tapped into the BTFP have had no trouble repaying their loans. But since these loans have one-year terms, most of them are still outstanding. Whether all of the banks that tapped into this pool of money are now solvent remains to be seen.

Fig. 4

Many of these banks will simply roll over their loans, and this is the very reason the Fed has been promising rate cuts. However, the current economic climate—stubborn inflation in the housing, food, and fuel sectors; matched with high employment rates, a soaring stock market, and a record amount of federal debt that must be financed with ever-increasing volumes of Treasury sales—makes rate cuts highly unlikely.

The Fed has been put in the uncomfortable position of choosing between more bank bailouts that could trigger soaring inflation, or keeping inflation in check while risking more bank failures.

As for banks that still need a helping hand with financial liquidity, their lender of choice is Federal Home Loan banks (FHLBs). However, anticipating a rush to their lending window, the FHLBs put out this sharp warning.

“…the role of FHLBanks in providing secured advances must be distinguished from the Federal Reserve’s financing facilities, which are set up to provide emergency financing for troubled financial institutions confronted with immediate liquidity challenges.

The FHLBank System does not have the functional capacity to serve as the lender of last resort for troubled members that could have significant borrowing needs over a short period of time.”

This means if banks are in trouble and need a lender of last resort, they must go to the dreaded Fed Discount Lending window. Banks try to avoid this scenario for a number of reasons, the leading one being that the move appears desperate to their banking colleagues and clients which can cause further damage to their institution. The banks fear that the stigma of tipping their hand by going to the Fed’s Discount Lending Window could send their establishments into a financial tailspin. So far this has not happened, but there are eleven months ahead for such scenarios to play out.

The upshot is that this sugar rush of a back-door QE program provided more artificial stimulus to the stock markets and likely played a big role in the run-up from the summer of 2023 to date. But there is no way of knowing what the final result of this program will be until next year.

Selling Off The US Strategic Oil Reserves

When Russia invaded Ukraine, the US Strategic Oil Reserves had already dropped by 59 million barrels. Over the next few years, as the Biden administration slapped sanctions on Russia, it sold off more than 40 percent of US oil reserves to make up for the Russian oil that was presumably to be taken off the global market.

Fig. 5

This maneuver whipsawed the price of oil. Crude Oil sold at $120 a barrel in June 2022, but over the next three quarters, it dropped 45% to a low of $66 per barrel in March 2023. The government began replacing the oil the following month. Since then, the price has ticked up to $85 per barrel.

Fig. 6

This interference in the global fuel markets has likely played a role in depressing the sale of EVs, which were considerably lower than expected in 2023 and 2024.

This policy created relief for consumers at the gas pump while many Americans continue to complain about rising prices. However, the price drop was artificial. Now that the policy is in reverse, it is likely contributing to those stubborn inflation reports.

The Yield Curve Inversion Chart Is Flashing Red

While many financial analysts are breathing a sigh of relief and declaring a soft landing for the economy, the Yield Curve Inversion charts are telling a different story. One of the most reliable recession indicators available, a yield curve inversion is what happens when short-term Treasuries pay a higher rate of interest than long-term Treasuries as institutional investors pile into the long-term bonds, especially the 10-year, to preserve their clientele’s wealth before an anticipated recession. This strong demand for long-term bonds drives up the price, which drives down the interest rates.

Fig. 7

Short-term Treasury Bills Still the Safest Bet

In February, I predicted that the Fed would likely back-pedal on rate cuts this year for a number of reasons, including a record number of US Treasuries sold at auction to finance a soaring government budget. While the stock market is still providing impressive returns, it is over-heated according to the Shiller PE Ratio. At 33.34 it is roughly double both the mean and the median of the index, which stand at 17.11 and 15.98 respectively. It is also considerably higher than the 27.42 that it was in May of 2007, just before the onset of the Great Recession.

Fig. 8

Considering the risk factors, getting a guaranteed 5% or so from short-term Treasury bills is far safer than gambling with one’s life savings on the stock market, which is taking on the feel of a casino.

The risk factor in short-term rates is missed opportunities on the stock market if it resumes its meteoric rise. Or missing out on locking in these current rates in a longer-term Treasury bond should the Fed finally make good on its promise to cut interest rates.

Summary

The Fed’s repeated interference in the stock market has not just made the financial landscape difficult to predict, it has possibly distorted the markets to the point of destabilization. For this reason, one of the few safe investments is short-term Treasuries which currently pay a respectable 5% or so, and will allow investors to quickly free up their money should the stock market drop and present buying opportunities.