Forget the Fed’s QE. “QT” Means Money is ALREADY Getting Tighter

Market Roundup Dow +293.03 to 16,351.38 S&P +35.01 to 1,948.86 NASDAQ +113.87 to 4,749.98 10-YR Yield +0.021 to 2.193% Gold -$6.60 to $1,133.20 Oil +$0.67 to $46.08

Wild volatility … again. That was the story of today’s markets, considering stocks rallied sharply at the open, faded dramatically, then ripped higher into the close. The Dow finished 293 points higher, while the Nasdaq gained almost 2.5%. But neither the Industrials nor the S&P 500 recouped yesterday’s losses.

So where do we go next? The Federal Reserve meets precisely two weeks from now. The debate over what policymakers will do is reaching a fever pitch, with the battle lines clearly drawn on Wall Street.

But guess what? Money is ALREADY getting tighter around the world, Fed or no Fed.

You now, can see it in the rising junk bond spreads I told you about a couple weeks ago. You can see it in the collapse of the carry trade index I highlighted a few days ago. And according to fresh research from Deutsche Bank, things are only getting worse – with “Quantitative Tightening” (QT) rapidly replacing “Quantitative Easing” (QE).

What’s QT? The systematic bleeding out of the huge liquidity reserves that foreign central banks built up in the last decade and a half.

Those reserves already shrank by around $55 billion between mid-2014 and the first quarter of this year.

For example, “petrodollar” countries like Saudi Arabia have been forced to spend billions of dollars per week in additional funds just to fill gaps in their budgets.

“Petrodollar” countries like Saudi Arabia have been forced to spend billions of dollars in additional funds to fill budget gaps.

Meanwhile, China is reportedly blowing through reserves at an annualized pace of as much as $500 billion now. That’s because global and domestic investors are yanking capital out of the country amid fears of currency devaluation, falling markets, and a slumping economy.

Deutsche Bank’s conclusion? “This force is likely to be a persistent headwind … and the path to ‘normalization’ will likely remain slow and fraught with difficulty.”

My take: More QT means less “funny money” floating around to inflate global asset prices.

We’re going to see upward pressure on Treasury bond yields.

We’re going to see downward pressure on risky bonds.

We’re going to see more stock market liquidation.

And we’re going to see more panicky moves in the currency and volatility markets.

“We’re going to see more panicky moves in the currency and volatility markets.”

That doesn’t preclude short-term rallies. It doesn’t mean markets will crash further overnight. But it offers even more confirmation of the forecast I shared with you a while ago:

You need to get more cautious with your investments … and pay much closer attention to evolving trends, too.

So what do you think? Is QT more powerful than QE? How will policymakers respond to the draining away of easy money? What about investors like you? How will you respond and adapt now that the autopilot market is over? Let me hear about it at the Money and Markets website.

Our Readers Speak

After another plunge of several hundred points in the Dow Industrials, many of you shared your opinion of what’s going on, and what you expect to see next.

Reader Ted F. said the chaos now is an inevitable consequence of what pushed stocks so high in the first place: Too much easy money. His view:

“How much of the market’s past highs for the last few years were floating on the Fed’s funny money, AKA QE? How much overseas was likewise floating on hot air? The Chinese were spending huge amounts on construction of unneeded cities.

“FDR during the 1930s spent massive (at the time) amounts on construction but it was dams, airports, and roads, plus public buildings. Now much of that construction is falling apart and the governments concerned are too far in debt to fund reconstruction of that. How much of the QE funny money should have been spent there, instead of bailing out the banks and corporate America?”

Reader Chuck B. offered this view on how far stocks could fall: “In 2008-09, the Dow retrenched about 50%. If that happened again, it would put the Dow in the 9000s. Play that for what it’s worth. Maybe – maybe not. But it does argue a good bit more of a drop is possible.”

A decline of that magnitude would seem tailor-made for hedge vehicles like inverse ETFs, but Reader Erick T. asked whether they’re appropriate: “There are those who are pointing out that the Inverse ETFs you recommend as a hedge are also susceptible to volatile markets as much as the regular ETFs. Have you any opinion concerning these particular investment instruments related to risk?”

Thanks for your opinions on market direction and inverse ETFs. It’s obvious that in the past few years, all the easy money pumped into the system here and overseas inflated asset prices beyond fundamental value. They also inflated shares far beyond what other indicators of value – like junk bonds, carry trade indices, economic data, etc. – suggested they should trade at.

The widening gulf between fantasy and reality was a major reason I got much more cautious earlier this summer, BEFORE market volatility exploded and stocks tanked. And it’s why I started legging my subscribers back into inverse ETFs, also before stocks suffered the worst of their declines.

As for whether they work, it depends on which inverse ETFs you’re talking about and which underlying sectors they target. The more leverage, and the more volatile the underlying sector, the worse the long-term tracking error gets – and vice versa.

So if you have a 3X leveraged, inverse ETF on a volatile sector like technology, you’re best off trading it actively and only holding for shorter-term time frames. If you’re using an unleveraged, inverse ETF on something like the Dow Industrials, you can buy and hold for much longer periods of time to profit in a down market because the tracking error is much smaller.

(Editor’s note: Mike’s latest Safe Money Report issues and Flash Alerts go into much more detail on this, and contain actionable “Buy” and “Sell” recommendations of inverse ETFs.)

Reader Ken F. sounded ready to throw up his hands on the website, saying: “The small retail investor has no chance in this market. Hedge funds, computer trading, and insider front running has made it impossible to buy and sell stocks based on value.”

My take: I know it’s easy to get frustrated in a market like this. But you most definitely DO have a chance … if you’re getting much better guidance than the usual useless platitudes spewed by Wall Street.

Anything else I didn’t cover here? Anything I said that you strongly agree or disagree with? Then let me hear about it at the website.

Other Developments of the Day

We got the early look at August job creation from the ADP Research Institute today. The private firm said U.S. companies added 190,000 jobs last month, slightly less than the 200,000 that was forecast. July’s reading was also revised lower by 8,000. But the figures certainly weren’t enough of a disaster to push the Federal Reserve off its policy tightening path.

The European Central Bank meets tomorrow, and many investors are counting on some kind of increase in Euro-QE, according to the Wall Street Journal. But European bonds are pricing in less and less expected inflation each day, and Europe’s economy is just muddling along.

That means the ECB’s 1-trillion-euro QE program isn’t working anymore just a few short months after it was launched in March. So it’s reasonable to ask what some new move would accomplish, and whether markets will even care if one is announced.

Regardless of whether you agree with it, the Iranian nuclear deal that President Obama pushed through looks like it will survive any Congressional challenges. That’s because Obama appears to have lined up enough support in the Senate to override any veto of the agreement.

World peace may be hard to achieve. But fast food chain Burger King is trying. The company said it would work with other chains to roll out a “Peace Day Burger” on the International Day of Peace on Sept. 21. McDonald’s (MCD) rebuffed BK’s advance, however, showing that the burger wars are still far from over.

So what do you think the ECB will do, and will markets even react given the failure of past Euro-QE to accomplish anything there? What are your thoughts about the American jobs picture? Or the apparent bullet-proof nature of the Iranian accord? Hit up the website and let me hear your opinions on these or other topics.

Until next time,

Mike Larson