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What Happens If The Fed Doesn't Capitulate On Interest Rates?

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by Tyler Durden
Saturday, Jul 30, 2022 - 01:55 PM

In the past stock markets used to rely on the innovation and profit reports of individual companies, and while there were sometimes all encompassing events that would push equities in one direction or another, in the last decade there has been only one factor that ever really matters:  The Federal Reserve.  

The central bank has positioned itself as the ultimate arbiter of market rallies and corrections.  In fact, most of the world is now placing all their investment bets on a single hope, that the Fed will capitulate on interest rate hikes, ignore the stagflation crisis and ramp up the printing presses once again with wild abandon. 

This is the sad state of most markets around the world and American markets in particular.  Investors have enjoyed what amounts to a free ride for more than a decade based on the simple premise that the Fed will “never” allow stocks to crash again.  This assumption is predicated on the idea that the Fed actually cares about the continued stability of the markets.  

After the latest Fed interest rate hike the speculation mills are swirling that the central bank will back off of rates as soon as November and refresh the easy money punch bowl.  But we need to consider a question that almost no one is out there asking:  What if they stopped caring?  What if they never cared and stimulus measures were actually meant to achieve a separate agenda that is now finished?  What if the Fed doesn't capitulate?  What is they just keep hiking?  

The original rationale given for rate cuts and QE measures was to offset wealth destruction caused by the 2008 credit crash.  The scheme was NOT supposed to continue onward with new stimulus every year or every time stocks lost 10%-20%.  Yet, that is exactly what happened.  Today, 14 years later, market investors are utterly addicted to near-zero rates and an endless supply of cheap fiat.  Stocks cannot sustain their value otherwise.  

The root driver of markets for several years has been the uninterrupted flow of near zero-interest loans into corporate coffers which are then used for stock buybacks (when a company buys their own stock to reduce the number of shares available, thus artificially inflating the value of the shares that are left in circulation).  If the Fed raised rates on these loans and cuts stimulus for an extended period of time, then stocks WILL crash.  It's inevitable. 

Fed Chairman Jerome Powell is well aware of this dynamic.  He even warned about it specifically during the Fed's October 2012 meeting.  He stated:

“I have concerns about more purchases. As others have pointed out, the dealer community is now assuming close to a $4 trillion balance sheet and purchases through the first quarter of 2014. I admit that is a much stronger reaction than I anticipated, and I am uncomfortable with it for a couple of reasons. First, the question, why stop at $4 trillion? The market in most cases will cheer us for doing more. It will never be enough for the market. Our models will always tell us that we are helping the economy, and I will probably always feel that those benefits are overestimated. And we will be able to tell ourselves that market function is not impaired and that inflation expectations are under control. What is to stop us, other than much faster economic growth, which it is probably not in our power to produce?

When it is time for us to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response. So there are a couple of ways to look at it. It is about $1.2 trillion in sales; you take 60 months, you get about $20 billion a month. That is a very doable thing, it sounds like, in a market where the norm by the middle of next year is $80 billion a month. Another way to look at it, though, is that it’s not so much the sale, the duration; it’s also unloading our short volatility position.”

Powell blatantly referred to the Fed's machinations as 'our short volatility position.'  In other words, he admits that stocks have been artificially inflated into a bubble by constant interference in natural price discovery.  And, he even suggests that this is dangerous in the long run as he asks 'what happens when we stop buying?' 

The Fed has now essentially stopped buying and we have seen markets drop around 20% since.  Whenever stocks spike (or at least stop falling) it's only because of rumors that the Fed will reverse course.   This has created a serious potential for a negative feedback loop.  Markets will continue to expect Fed capitulation and investors will buy until November; then, when the Fed hikes rates again, investors will sell in a panic.  The potential for abuse by certain institutions is very high – Anyone with influence in the media could easily plant a rumor that the Fed is about to back off of rates and pump up equities through misinformation.  

The Fed did not reverse course during the Great Depression and this led to an extended period of deflationary crisis.  Of course, back then, they didn't even have a stagflation problem staring them down.  Today, with official price inflation at 40 year highs and unemployment at incredible lows (due over $6 trillion in covid helicopter money), the central bank has every excuse to continue rate hikes well into 2023.  There would have to be a dramatic flood of deflationary indicators and job losses to justify capitulation so soon.  

And, again, what if the Fed stopped caring about stocks?  What if they prefer a crash to occur?  Assuming the Fed has the economy's best interests at heart seems like an epic and foolish mistake.  

The Catch-22 reality of our economy needs to be addressed and this is just not happening.  No one in the mainstream wants to admit that either way the Fed goes, there will be disaster.  They can hike rates and cut stimulus and markets will plunge while job losses explode, or, they can roll over and bring back the money spigot resulting in even higher prices on everything.  There is no third option.  There is no soft landing.  It's all a lie.  

Really, the only way to determine which way the Fed will go is to consider which path makes the Fed look like it TRIED to save the day?  Does cutting rates and pumping out more stimulus make them seem more responsible, or, does continuing on the rate hike path give them deniability as stagflation becomes entrenched?  

The Fed answers to no one when it comes to policy.  Not the White House, not Congress, not the GOA, no one, as Alan Greenspan once openly admitted.  So, it is the Fed that is culpable for the mess we are in, along with all the politicians that protect them from public scrutiny and encourage their degradation of the economy.  It makes sense that at this stage in the game the Fed's only concern will be to make themselves look like battle worn heroes who tried to save the day, but just couldn't overcome the tidal wave of financial collapse.            

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