Fed Intervention Has Completely Destroyed The Markets

Investment Research Dynamics

Federal Reserve intervention has killed natural market processes.  The Fed is also starting to lose control of its ability to manipulate the markets.  Today is a good example.  The S&P and Dow are negative as I write this (2:30 EST) after staging a big early day rally.  Most sub-indices, like retail and housing, are also red. BUT, the infamous “FANG” (Facebook, Amazon, Netflix, Google) stocks + Apple are up anywhere from .2% (AMZN) to over 3% (AAPL). These stocks are the largest stocks in the SPX by market-cap and are part of the “tool kit” the Fed has been using to keep the S&P 500 and Dow from spiraling lower.

Since late 2012, the Fed has been able to orchestrate the markets with heavy doses of direct and indirect interventionary tactics.   It’s used a combination of money printing, plunge protection and propaganda to keep the stock market propped up, interest rates near zero and the price of gold suppressed.

But, if the action over the last four trading days are any indication, the Fed is increasingly losing its ability to control the markets.  This is most evident in the apparent break-down in market sector correlations.

From roughly late 2012 through early 2016, the Fed has been the US$/yen as a “lever” with which to push the S&P 500 up and the price of gold down.  If you study these three graphs, you can see the correlations from 2012 to 2016 and the breakdown of the correlations in 2016:          Weekly $/Yen           Weekly SPX           Weekly Gold

I happened to notice on Friday and yesterday (Tues, Sept 13) that, despite a move higher in the $/yen (the yen falling hard vs. the dollar), which is the level the Fed had been using to manipulate stocks, the stock market experienced steep sell-offs.  Typically the $/yen and the U.S. stock market move in near-perfect correlation. Today they are inversely correlated.

Even more interesting, the bond market, even at the short end, also sold off (yields rose).   This is unusual  because typically when stocks get bombed, the money coming out of stocks floods into very short maturity T-bills and the dollar rises.  Yesterday EVERYTHING was down except a few agricultural commodities and the dollar index.  I have no idea where the money that came of stocks was parked.

Regardless, it was clear that hedge funds were selling everything that was not nailed down yesterday  and Friday.  At some point, as volatility increases, a significant portion of the money coming of stocks and bonds will be flowing into the precious metals sector.   If you review the trading patterns in 2008 before and after the October, you’ll see that initially the metals/miners were correlated with the S&P 500.  Subsequent to the end of October, the precious metals sectors dislocated from the stock market and moved higher while stocks continued to decline.

I believe all of this activity, especially the dislocation in correlations among the sectors as discussed above reflects the Fed’s increasing inability to manipulate the financial system. There are just too many factors for which they can not account.   One perfect example is the disintegration of energy exploration and production sector assets.  Debt recoveries in E&P bankruptcy  restructurings have been averaging 21% – LINK.  This means that lenders are getting back, in general 21 cents on every dollar lent to these companies. Some tranches received close to zero.   Part of this “recovery value” no doubt includes some partially random value attributed to stock distributed to bagholders.

This is a problem because the big Too Big To Fail Banks were stuck holding a lot of this debt.   In other words, the melt-down in the energy sector has the potential to blow big holes in bank balance sheets (this among many other deteriorating assets).  If the Fed hikes rates, it will likely force recovery rates even lower.  In fact, it will lower the value of collateral securitizing most bank debt deals, especially mortgages.

It’s a common notion that the Fed has “backed itself into a corner” with interest rates and its monetary policy.  But there are several ways in which Fed has backed itself into a corner. These factors are beginning to emerge and they are removing the ability of the Fed to treat the financial system like its puppet.

Expect a lot more volatility in all market sectors going forward.  The economy is clearly headed into a recession, if not already in one.  An interest rate hike next week has the potential to trigger a plethora of unforeseeable chaos in the markets and I believe the Fed will once again defer on its threat to hike rates.