Why the Fed Will Be Powerless During the Coming Supercycle Crash

"Now I ask you: what can be expected of man since he is a being endowed with strange qualities? Shower upon him every earthly blessing, drown him in a sea of happiness, so that nothing but bubbles of bliss can be seen on the surface; give him economic prosperity, such that he should have nothing else to do but sleep, eat cakes and busy himself with the continuation of his species, and even then out of sheer ingratitude, sheer spite, man would play you some nasty trick. He would even risk his cakes and would deliberately desire the most fatal rubbish, the most uneconomical absurdity, simply to introduce into all this positive good sense his fatal fantastic element. 

It is just his fantastic dreams, his vulgar folly that he will desire to retain, simply in order to prove to himself--as though that were so necessary-- that men still are men and not the keys of a piano, which the laws of nature threaten to control so completely that soon one will be able to desire nothing but by the calendar. And that is not all: even if man really were nothing but a piano-key, even if this were proved to him by natural science and mathematics, even then he would not become reasonable, but would purposely do something perverse out of simple ingratitude, simply to gain his point. 

And if he does not find means he will contrive destruction and chaos, will contrive sufferings of all sorts, only to gain his point! He will launch a curse upon the world, and as only man can curse (it is his privilege, the primary distinction between him and other animals), may be by his curse alone he will attain his object--that is, convince himself that he is a man and not a piano-key! If you say that all this, too, can be calculated and tabulated--chaos and darkness and curses, so that the mere possibility of calculating it all beforehand would stop it all, and reason would reassert itself, then man would purposely go mad in order to be rid of reason and gain his point! I believe in it, I answer for it, for the whole work of man really seems to consist in nothing but proving to himself every minute that he is a man and not a piano-key!" 

 --Fyodor Dostoevsky, Notes from the Underground 

The Federal Reserve has at last painted itself into its final corner -- or, to use another, perhaps more apt, metaphor:  The Fed has placed itself on a treadmill from which there is no escape.  There appears to be nothing it can do from here (other than a very modest taper) that won't immediately tank the markets.  Even talk of such things spooks investors, which is why Powell has been so dovish of late.  The Fed must keep rates low.  It must continue QE (in one form or another) and continue buying Treasuries and Mortgage-Backed-Securities.  The Fed cannot do anything but keep running at or near its current pace in perpetuity. 

The Fed's new reality is like a treadmill-based parody of the movie Speed:  If the Fed slows down too much, the market will implode, killing innocent economies in the process.

(on the chart above:  the Fed's balance sheet has now surpassed the $8 trillion mark)

Some pundits have concluded that this means we've entered a period of permanently rising asset prices.  But that conclusion is in error, as it makes the classic mistake of presuming a trouble-free world on a linear trajectory.  It presumes the world will run smoothly into infinity, with no external (or internal) stressors inconveniently appearing to derail the Fed, the Treasury market, the stock market, the economy, or life in general.

The future is guaranteed to no one, not even a Fed governor.  The future is a wave of probability, and not all possible outcomes are desirable.  

Any realistic assessment of the future thus includes allowance for real future risk.

If Covid taught the masses anything, it should have taught us that the universe is (and our leaders are) capable of tearing asunder the best laid plans of mice and men in a New York Minute.  

Recognition of this fundamental truth seems to be lacking in the "bullish new paradigm" model that some have accepted.  The unpleasant truth is:  No matter what the Fed does, markets cannot maintain a trajectory of permanent bullishness, because there are forces acting upon reality that are far more powerful than the Fed.

The advance of civilization is not linear -- it is nonlinear and often asymmetrical.  And while it may appear to have "advanced without ceasing" (at least in terms of technology) from the limited perspective of our brief lifetimes, we know from history that civilizations do not rise endlessly.  They rise for a time, then they contract for a time (this occurred in America as recently as the Great Depression).  

Then they may rise again -- or they may fall entirely.

But either way, they do not advance without ceasing in a steady upwards march.  In part because of outside forces, and in part because of internal forces (outlined in broad strokes herein):  

1. Good times create excesses in the economy, which breeds complacency and arrogance in our leaders
2. Complacency and arrogance lead to short-sighted policies that will, unavoidably, ultimately precipitate bad times
3. Bad times turn old excesses into scarcity and lack, which creates a new mindset of prudence and conscientiousness in our leaders
4. After the old slate has been wiped, prudence and conscientiousness then lead to new growth
5. And the whole cycle repeats

[We've been in stage 2 of this cycle for a while now, as I'll outline directly.]

Back in 2012-13, when the Fed began QE Infinity, I saw that (and the 2013 charts) as bullish for the market (though not as a good idea). But this is no longer 2013.  Now, contrary to those who believe the ongoing Fed intervention will create an endlessly bullish investment landscape, I believe that the opposite is true, and this is no longer cause for bullishness, but cause for significant alarm.  

Maybe not yet, mind you, but in good time.  Allow me to explain what has changed, and why I view the same essential "Fed stimulus plan" so differently now.  

For starters, Covid, or more correctly, our government's response to Covid, has hastened our demise.  The Federal Reserve and the American government's kneejerk reactions led them to "lockdown and debt-up" with abandon.  This destroyed untold thousands of small businesses and buried us in record debt, so we are now left with permanent long-term problems in the wake of those short-term temporary "solutions."  The only way out of this mountain of debt is for the Treasury to inflate its way out (i.e.- pay back yesterday's debt with tomorrow's dollars, which will be worth a fraction of yesterday's dollars, courtesy of inflation).

This means that, regardless of what they tell us, inflation is likely here to stay (for as long as market forces will allow, anyway) -- because it's the government's only way out, and they know it.  

Of course, they do not want the populace to realize that they (our illustrious leaders) want and need inflation, so they continually attempt to misdirect us.  When we hear them say (as one example) "tax the billionaires," they're really hoping to distract us from the mess they themselves have created -- because, hey, if we're busy resenting billionaires, we won't resent our politicians!  But even a cursory examination of the underlying facts proves this tactic to be smoke and mirrors, because the reality is, even if the government confiscated every single dime and every single asset from every single billionaire in America, it would only fund the Federal government for about 9 months.  That's it.  

Then the billionaires are all broke, the money's all gone, and we're right back where we started.

America's debt is now so far beyond sustainable that we can't tax our way out of it.  We've passed the point of no return because, the fact is, a small tax increase isn't going to do squat against that massive iceberg of debt, while a large, broad-reaching tax increase unavoidably causes economic activity to shrink, which leads to "bigger piece of a smaller pie" syndrome.  Big tax increases in a consumer economy thus don't create significantly more government revenue, they just end up creating broke, stifled, and depressed citizens who are itching to vote you out of office.  

Therefore, the only (realistic) way out of this mess is inflation (or to cut government spending massively, but that's not going to happen).  But because inflation hurts the poor and middle class far more than it hurts the rich, we will never hear a politician admit any of this.  "Tax the rich!" they'll yell, as they willfully hurt average Americans, hoping we're too stupid to notice.

So now that we've established the fundamental trap the Federal Reserve and the Federal government have put us in, let me outline my nightmare future scenario.  

The year is (perhaps) still 2021.  It's (perhaps) October-November.  (Or perhaps later -- but I do suspect we're running out of time now.)  Then:

  [Something] happens.  

The market "corrects."  Then a sustained sell-off begins.  Correction turns to panic.  The market starts to waterfall lower.

What can the Federal Reserve do?  They can't cut rates -- rates are already as low as they can go.  They can pump more QE, but how much more debt can we really afford to add at this point?  This ain't 2008.  This is the aftermath.  We fired the QE bullets in 2009, 2010, 2011, 2012, 2013, 2014, 2020, and 2021.  That's 8 shots.  How many more does the magazine even hold?  

What "tools" do they have left now?

The thing about this beast is, the larger the market gets, the more QE is required to keep it propped up.  The total market cap of the S&P 500 was about $7 trillion in early 2009.  Today, it's over $36 trillion.  A trillion dollars of QE just doesn't buy what it used to.  Law of diminishing returns.

So the Fed's only real remaining "tool" is more QE (but they're going to need to keep using the Really Big Wallet for that to work at today's valuations).

What can the federal government do?  Another "stimulus" package, created with more money we don't actually have?  Pile some more on the already-enormous debt, to inflate our way out of later?  

At what point does the public lose confidence in this shell game?  At what point do Treasury buyers lose confidence?

See, the thing is -- and I think this is the key understanding that some pundits have ignored:

We are not in the same position we were when we started this experiment
more than a decade ago.  

We used up our wiggle-room, and we can't do this all over again without debt and QE ballooning into the ludicrous.  We're at the cusp of the ludicrous now.  When we embarked on this journey last time, we were "starting from zero," so to speak.  We're no longer at zero.  It won't work again, not from where we are now.

It's like the Fed emptied out its fire extinguisher, but is still standing there holding the empty cannister, saying, "We stand ready to put out any more fires!"  And investors are like, "Okay, cool.  Hey, it worked last time."

Yeah, it worked last time, but we never recharged the damn thing!  The emperor truly has no clothes.  (I realize I'm piling-on with the metaphors here; this is due to inflation and the Law of Diminishing Metaphor Returns.)  And one day, the market is going to realize that, probably all at once.

We shot our bullets.  And sure, they slowed the beast for a time.  But the beast keeps rising back up and advancing relentlessly forward.  And it is no longer the same monster we faced in 2008.  That monster died, but we kept pumping it full of lead anyway, because God forbid the market do anything other than rally.  As a result, the beast has now morphed into something of our own creation.  

Every bullet we've fired has become a bullet the beast will one day fire back at us, because we chose the wrong course of action from the start.  

Even long after the 2008 "financial crisis" had passed, when we had chances to course-correct, we wasted them.  Instead the Fed chose to keep plowing ahead relentlessly with its foot on the accelerator.

The reality that our (yes, I'm going to say it) stupid leaders seem to have forgotten is:  Existence is an endless series of problems.  Problems didn't end yesterday.  But given that we've thrown everything at yesterday's problems and left ourselves nothing in reserve, we are clearly pretending that there will simply be no more problems.  Right?  If our leaders had a realistic outlook on the nature of reality, they would have held at least something back -- you know, just in case.

But they didn't.  They threw it all at:

1.  A "financial crisis," even long after it had ended.

2.  Later, at what was, in point of scientific fact, hardly the worst crisis ever faced by mankind.  In fact, even as far as the "crisis" subcategory that's marked "pandemics" goes, it was (again, in point of scientific fact), relatively mild in historical terms (not in absolute terms, obviously -- just comparatively).  By way of comparison:  Only a hundred years earlier, the 1918-19 Spanish flu, for example, killed more than 10% of those infected (using current numbers as of the time of this writing, that's nearly six times more deadly than Covid, which has had a mortality rate of ~1.76%).  Looking back a little farther in history for true "worst case" pandemics, the Black Death wiped out roughly one-third of Earth's population.

Point is, things could have been much worse -- yet it's hard to imagine our current debt picture being too much worse.  We responded as if we were dealing with a worst-case scenario, and as a result, we have left ourselves completely unprotected in the event of a true (future) worst-case scenario.

To quote Simon and Garfunkel:  "[We] have squandered [our] resistance for a pocket full of mumbles, such are promises."

So we've built a massive asset bubble on top of a mountain of debt on top of the ever-shifting sands of normal existence.

And, in the process, we have left ourselves virtually defenseless against any future problems.  We have left ourselves completely exposed to both the whims of fate and the folly of our fellow man.

We've built a house out of eggshells in the middle of an earthquake zone.

The next crash will take this entire fragile construct down in a fashion that exposes and exploits each and every weakness in the system, known or unknown.  Problems that were papered-over on the way up will compound themselves on the way down, as the entire destructive frenzy feeds upon itself cannabalistically, until it has finally devoured all the excesses we've poured into it.  And more.

Alas, there is nothing the Fed can do to stop this once it begins in earnest.  The Fed likes to talk about its "tools," but all its tools are currently running at full capacity just to keep the market from collapsing under its own weight.  There are no more tools to call upon.  

All it will take is a catalyst.  

Later, people will blame the catalyst as if it were the "cause" (you and I know they will do this because they do it every time) -- but we'll know it was not the cause.  Our short-sighted choices were the cause.  Our inability to recognize, appreciate, and properly manage our good-fortune was the cause.  

In short, we ourselves were the cause.  We have met the enemy, and he is us.

The catalyst will only be the trigger that forces the reckoning.

On the bright side, we're not there yet.  We are still in territory where an extended fifth could manifest, so my advice is to take advantage of whatever time remains, and prepare.  Don't be like the Fed and our government by imagining that the worst has already passed.  The worst has not even entered the building yet.

In other words, they may have built us a house of eggshells, but the earthquake hasn't struck yet.  Use this remaining time to get your own house in order.

Again, on the bright side, if there is one:  When the worst arrives, we'll know it, I suspect.  And when it finally does, we'll be miles ahead of the crowd because we won't delude ourselves with illusions of continued Fed omnipotence.  The Fed is no longer an outside "force" that can step in and act upon the market; the Fed has made itself into just another cog within the machine now. 

The game has changed.  

Trade safe.