Missing Link

How it FITS

Something truly significant happened this week that we didn’t expect. Something that was instrumental in the 1929 and 1987 crashes but, again, understated or not mentioned in most accounts of the historic blowouts and crashes: A destabilisation of the Fed at a crucial time in monetary stock and economic history. This possible domestic tension coincided and now coincides with a deterioration of international relations and is the missing piece of a hitherto accurate 1929-1987-2018 jigsaw.

A flattish week in US indices belies a busy, and potentially significant stream of news. Trade tensions took a back seat, overshadowed by the Trump-Putin summit, domestic unease at the President’s siding with Putin over US intelligence and Jerome Powell’s upbeat take on the US economy. However, on Thursday, Trump opened up a new front to the trade war. With exquisite timing, just as the dollar broke to new 12-month highs above 95.5, he gave a CNBC interview and said he is “not thrilled” with the Fed raising interest rates and noted that the Chinese yuan is “dropping like a rock”. Less than 24 hours later he escalated his message with the following tweet.

Many are now wondering if currencies and yields will be used as new weapons in the trade war. But this partly misses the point. To pursue a possibly more aggressive international policy using financial instruments Donald Trump would need at least the acquiescence of the Fed. Can he get it?

This development also neatly fits at the end of our series on the impact of news on markets and the start of an in-depth audit of our eight year comparison of the 2010s with the 1980s and 1920s. Over the next five weeks we will outline why this analogy is becoming increasingly accurate despite a stable stock market. Indeed, it is the last piece of the jigsaw that fully explains the interaction of all fundamentals, intermarket, technical and sentiment into a crash and why timing should now become easier.

Just as nearly all the similar fundamental-intermarket-technical-sentiment (FITS) conditions for a stock market top have been met, we now have the political triggers for why volatility should start to build for the rest of the year across all asset classes. Understanding the significance of a possible destabilisation of the Fed is important in both an historic and current context.

We previously projected a potential conflict between Donald Trump and the previous Fed Chair Janet Yellen over monetary and USD policy. And therefore, believed such domestic strain would combine with increasing international tension to help trigger a stock market turn as it did in 1929 and 1987.

In 1929, the market was reaching dizzy heights as people borrowed on margin to buy stocks. The Fed was internally conflicted about how to deal with this. Chairman Young opposed NY Fed Harrison’s suggestion to raise rates, but was also ambivalent about a regulatory approach, so much so that he refused to sign the Fed’s 1929 report. The net result was Fed paralysis and no brake was applied. The market was therefore able to resume what it had being doing—buy into a massive blowout which then crashed hard. Ben Bernanke, writing in 2002, accepted that the Fed shared some blame. Although there was no overt political pressure from Washington in 1929, there was no help either from the new and inexperienced President Hoover, who was only seven months in office, and had never held elected office before.

In August 1987, the market had risen 45% since the start of the year (vs 31% to the 1929 September high). Chairman Volcker had been forced out by President Reagan on August 5th to make way for Alan Greenspan, who the President felt would be more accommodating to his policies. The change at the top at this critical point can be seen in retrospect as unwise and may explain how the Fed got so far behind the curve that it felt the need to catch up. The paralysis or lack of clarity allowed the market to resume what it had been doing—buy into a massive blowout. The new Chairman raised rates by 1.25% on September 22nd, but this was too little, too late, (the previous hike had been in December 1986) and four weeks later the market crashed.

When potential conflict between Janet Yellen and President Trump resulted in the Chair’s effective dismissal we assumed the appointment of Jay Powell removed an unstable Fed as a probable cause. The re-emergence of a potential power struggle between the Fed and the President and the possible destabilisation of the Fed and consequent paralysis puts it firmly back on the crash map. The Fed under Jay Powell and a number of hawks are minded to continue raising rates, a policy that is clearly at odds with the President’s expansionist programme. The Fed has raised rates seven times since December 2015 and five more rises are scheduled. This is the most aggressive tightening since Paul Volcker squeezed the US economy into the 1987 crash—funny that! This is also on top of balance sheet reduction that is taking out $50bn a month from the economy to the extent that non-seasonally adjusted money supply (M2) did not grow at all in the second quarter of 2018.

President Trump however is not only unhappy about this but he is actually able to do something about it. The body that sets rates and policy, FOMC comprises 12 members. 7 Governors and 5 district Fed presidents. There are currently 3 Governors, two of whom were already appointed by the President and a further two Trump appointees awaiting Senate confirmation and a final 2 to be nominated. This will mean 6 of the 7 Fed Governors and therefore 12 FOMC members will be Trump appointees. Of the additional 5 district presidents, one (NY Fed Chairman) was nominated by Trump and the other 4 need to be ratified by the President. Given the ‘steady as she goes’ Fed tightening programme but increasing number of Trump appointees, the potential for 1929 and 1987 style stalemate or even conflict will continue to grow. Without a clear steer, the market therefore has the potential to continue or resume what it has been doing and “buy into a massive blowout and then crash hard.”

The timing of this development is important and very useful for our tracking of the Milestones in Mania and how we analyse and trade them.

It provides the potential trigger for the blowout and crash and the necessary collapse in Dividend Yields (to be explained in next weeks article on Fundamental Milestones). It also now explains an important possible and not generally not noticed movement in the 10 year–2 year T-bill yield spread that appears to be a prerequisite of a crash and we don’t mean the much publicised inversion. (to be explained in the following weeks article on Intermarket Relationships).

It also helps explain the last leg of the Dollar Decline that also coincided if not led the 1987 crash.

Last but not least it also coincides with a reorganisation at Matrix where we will now be providing daily short term analysis on forex markets and signalling shorter term trades every day on DAX, US indices, and AAPL (Analysis and Signals). We now have the trigger for the final blowout and crash. We are also now in a much better position to exploit it. (Profit).

Here’s to making the very best.

Good Luck

Ed Matts
Matrix Trade

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