Fed Bombshell Minutes Indicate Balance Sheet Reductions, Suggest Markets are Overvalued

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The following is a summary of our recent interview with market technician Gary Dorsch, which can be accessed on our site here or on iTunes here.

With the recent Fed minutes confirming the central bank is contemplating shrinking its balance sheet, many are wondering where that leaves markets and interest rate policy going forward.

This time on Financial Sense, we spoke with Gary Dorsch, editor of Global Money Trends magazine, for his take on the Fed’s next move and what we can expect for the economy.

Markets Overvalued

Ever since the S&P hit its all-time high of 2400 on March 1, the day after President Trump gave his much-lauded speech to Congress, we’ve seen it decline to near the 2354 level. Also, the Dow Industrial’s current reading of 20,600 is about 500 points off its all-time highs.

The market was overvalued on a P/E ratio, Dorsch noted, with the S&P trading at 25 times its 12-month trailing earnings, well above its historical levels.

“There are some doubts now as to whether Mr. Trump can get his grandiose fiscal policies through Congress,” Dorsch added. “There are also doubts about how much tax cutting can come about … and whether he has the pull on Capital Hill to get his policies through.”
In fact, the Fed made an effort to warn traders in the first week of March that they were moving up their rate hike schedule and reiterated that they still intend to raise the Fed Funds rate two more times between now and the end of the year.

Fed Minutes Indicate Balance Sheet Reductions Coming

Also, the Fed minutes from the March meeting hit us with a bombshell: The central bank is actively talking about reducing the size of its portfolio of bonds and mortgage notes, which total about $4.5 trillion currently.

Federal Reserve Chief John Williams would like to see the Fed start to reduce its portfolio in the second half of this year, with a goal of taking it down by $2.5 trillion over the next 5 years.

“(The figure of) $500 billion a year is probably the equivalent of an increase of 1 percent on the Fed Funds rate,” Dorsch said. “That’s about how much the Fed would have to drain out of money markets in order to sustain a 1 percent increase in short-term interest rates.”

Whether the Fed raises the Fed Funds rate outright or allows its portfolio to run off without reinvesting the proceeds of maturing debt, the result is a drainage of excess liquidity, Dorsch noted.

“We all know to a large extent this 8-year bull market on Wall Street has been fueled by a tsunami of ultra-easy money, not just from the Fed but from the Bank of Japan and the European Central Bank have all conspired to lift the value of the stock market by $21 trillion in the last 8 years,” Dorsch said.

We might finally be at an end to this era, however, with the Fed signaling that it’s going to start draining liquidity, and warning traders that the stock market was overvalued.

“It’s out of character (for the Fed) to talk about the stock market, so the fact that they put that in there is an implicit warning that it could get tougher … in the months ahead for stock market investors,” Dorsch said.

Auto Sales and Real Estate Canaries in the Coal Mine

Tighter Fed policy would lead to a significantly higher cost of borrowing for both real estate and auto loans, Dorsch noted. Worries about higher interest rates are fueling endless concerns we’re seeing a plateau and retrenchment in auto sales.

If we continue to see further deterioration in auto sales over the next several months, Dorsch suspects this would be the first signal that the US economic expansion is starting to sputter out. We’ll likely see very slow growth of anywhere from 1 to 1.5 percent under that scenario, which is much less than what the stock market is anticipating.

“Of course, real estate is the other major pillar of the US economy,” he said. “Should housing prices start to flatten out or even turn lower — something we haven’t seen for the last 4 or 5 years, we’ve been on an uptrend since 2012 for housing prices —that would be very negative for consumer confidence and also … for the economy.”

Soft Data Divergence

If we were to suddenly see a 5 to 15 percent drop in the stock market as a hypothetical example, Dorsch believes soft-data sentiment surveys would turn radically lower and confidence levels would fall.

“I think the Fed is going to be guided by how the stock market reacts to its moves,” he said. “I think they also want to tighten up, at least in the short term, because they are concerned the market is becoming overvalued.”

It will be fascinating because we’ve had an easy-money policy for 8 years, and now we’ll have to watch how the market reacts when liquidity is tightened.

Corporate QE in the form of company stock buybacks will continue to support the market, Dorsch stated. We will also still get quite a bit of QE from Japan and Europe, which is supporting markets as well.

“I would not expect a major decline, therefore,” Dorsch said. “The most I’m looking for is a drop to the 20,000 level over the next several months … with more of a flattening type of pattern.”

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