Author: Lee Adler

The last time we looked at the Composite Liquidity Indicator (CLI), 4 months ago, I warned that the process of flattening the indicator was beginning, and that that would lead to bad things happening. Those bad things have been under way for a couple of months, but they have barely scratched the surface of the potential of what’s to come as this line turns flat. See chart (subscriber version).

The stock market is approaching the low side of its normal band of motion from the CLI. If history is any guide, the stock market will remain vulnerable to further severe declines until a week or two after the line representing the S&P 500 penetrates the bottom of the normal range of motion from the liquidity line.

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Then we face the prospect that liquidity could be even tighter than during the period of October 2017 to September 2019 when the Yellen Fed was temporarily “normalizing” its balance sheet. See chart (subscriber version).  The Fed is again threatening to begin shrinking the balance sheet. But this time around the market must absorb a far higher amount of new Treasury supply than it did in 2017-19, when the Fed last tightened.

Shrinking the Fed’s balance sheet now would pull cash out of the banking system, causing deposits to at least turn flat, if not shrink outright. I would have to bet that the Fed will never get to that point. The effects of merely holding QE at zero will be bad enough.

As for the War in Ukraine, it’s not helping, but stocks were already down nearly 9% the day that Putin attacked. Furthermore, historically, periods of war have been bullish for stocks. That’s because central banks have typically printed reams of money during wartime. Today, the Fed doesn’t have that luxury, with the  CPI headline print almost 8%, and actual inflation at least 13%.

Wars don’t drive asset price trends. Central bank policy drives asset prices. Today, central banks simply cannot be easy during this wartime because of the devastating inflation already under way.

Under these conditions, where systemic liquidity stays flat, at best, my bet would be that we will see cataclysmic selloffs in stocks at times. Violent rallies will follow, but will inevitably result in lower highs.

Led by the Fed, the world’s biggest central banks have painted themselves, and us, into a corner. They can no longer continue to tilt the playing field in favor of the continuation of a long-running secular bubble. The consequences would simply be too dire.

On the other hand, there will be equally terrible consequences for maintaining tight policy. And I’m not talking about how much they raise interest rates. That’s a sideshow that is an effect of tight money. The market will tell the Fed what to announce about rates. It must simply rubber stamp the market, lest the public realize that the Fed doesn’t control rates the way that it wants the public to think that it does.

Now the Fed is not printing enough money to absorb virtually all new Treasury issuance, with additional cash left over to support stock prices. If it sticks to this new policy of no QE, money rates will rise. Bond prices will fall and yields rise, margin calls will go out. Stock prices will fall. More margin calls will go out. And so on.

But only when consumer prices start to fall will the Fed be able to resume QE. By then, asset prices should be much lower than they are today. Therefore, I will continue to focus on looking for good short to intermediate term stock xxxx xxxxx (subscriber version).. I would continue to xxxx xxxxx (subscriber version). the bond market xxxx xxxxx.

Even bondholders who hold to maturity will get robbed. Inflation will eat them alive.

Will gold be a long term hedge for all of it? In theory, it should be, but we all know about the difference between theory and practice. Meanwhile, the long term charts of gold and some gold mining stocks look more bullish.

I’ll continue to use technical analysis in the Gold Trader reports to try to identify when this gold bull breakout is overdone. And I’ll continue to look for good entry points for getting long the mining stocks.

Meanwhile, none of this has come as a surprise. We were forewarned.

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Federal tax collections looked strong for the full month in February.

Don’t be fooled. It was an illusion due to a calendar effect and inflation.

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That’s a sudden, dramatic sea change from the strong growth path of the past 6 months or so.

This bodes ill for my expectation that a booming economy would boost tax revenues to help offset the amount of new Treasury issuance that the market would need to absorb. Even taking that optimistic assessment of tax collections into account, I had expected the market to still be unable to digest all the new supply without the Fed doing the lion’s share of it. I had still expected an ongoing bear market in Treasuries.

Now the situation looks even worse, and the short term flight to safety rally isn’t helping the situation.

Here’s why (subscriber version).

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I’ve been doom scrolling my newsfeeds for the past few days, not getting much work done. What a catastrophe. War in Europe, just 120 miles from where I was living a few short weeks ago.

I just communicated with a Ukrainian friend who lives in Kyiv and owns a number of apartments there. She left the city with her family on Thursday, for what she felt was greater safety in the west of the country. She said that the Russians are shelling and firing missiles at civilian targets indiscriminately, and that many ordinary people have died. She called Putin crazy. Then she noted how proud she was of her countrymen for their firm resistance.

I made several friends in Eastern Europe during my 26 months living there. I got to know their attitudes toward Putin and the Russians. My friends are all older people. They lived for decades under Russian domination. They love freedom and they hate the Russians viscerally. They will never surrender, even if Russia finally dominates in this conflict and subjugates them.

The question for us here is how this will impact monetary policy. We already know that the Russian central bank will be blocked from moving money, and that some Russian banks will be blocked from accessing the international payments system. No doubt this chaos will trigger a roundabout detour in the Fed’s tightening policy.

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But will they actually reverse and return to QE? We’ll have to see what’s next. I would suspect that most of the easing would be directed at their cohort, the ECB, and other central banks. My guess is that they won’t immediately return to outright QE, pumping money into Primary Dealer accounts again, at least not right away.

The Fed is boxed in. It faces the prospect of an international financial crisis. It faces the reality of 40 year record inflation that has the prospect of worsening. We’ll watch what the Fed says because it will lead us to what they’ll probably do. Although in emergencies, the doing comes first. And markets respond to the doing, not the talking, despite what the Fed and the high priests of Wall Street want you to think.

So unless they pump money directly back into the markets via buying securities from Primary Dealers, it won’t reverse the course of the financial markets. Bond prices will still xxxx xxxxx (subscriber version). and yields xxxx xxxxx. Stock prices will have their usual April seasonal bump from tax revenues being used to pay down Treasury debt for a few weeks. Then they’ll xxxx xxxx.

I believe that unless the Fed returns to buying paper from the dealers, that course is set. If they do return to QE, I’ll wait and see what the market response is. Normally I’d say it would be a go, bullish. But the dealers still have the option of simply paying down debt with the proceeds of selling their Treasuries and MBS to the Fed. If they were to do that, game over.

Meanwhile, I say what I’ve been saying for the past 18 months. I would continue to xxxx xxxxx (subscriber version) bond market. If I had any long term bonds in my portfolio, which I don’t, I’d xxxx xxxxx.

There are, of course, ways to xxxx xxxxx the bond market. I’d rather xxxx xxxxx stocks. Just my preference.

Stocks will have rallies. I’ll use the TA to xxxx stocks for swing trades when they look good for that. I’ll continue to report weekly on that, and the overall technical market outlook in the Technical Trader reports.

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