Below are the titles of the last 9 posts we have shared with newsletter subscribers (not posted to the website):

  • Sep 30 – S&P 500 at Record Highs – What’s Going to Drive it Higher?
  • Sep 29 – Why the Fed May Not Hike Rates in December
  • Sep 27 – A Less Hawkish Fed is Good for Stocks
  • Sep 25 – Weekly Chart Review for S&P 500 and XJO
  • Sep 23 – The Implications of Unwinding QE – Part I
  • Sep 21 – Howard Marks: “Move Forward with Caution”
  • Sep 20 – Natural Law of Gravity for Stocks is Up!
  • Sep 19 – Aussie Mortgage Stress Rising (Despite Low Rates)
  • Sep 18 – Will Higher Oil Influence the Fed on Rates?

I’ve been traveling a lot lately… with very little time to update the website.

However, those who subscribe are able to enjoy my missives in newsletter format (much easier for me to do).

Maintaining a website is not difficult – it just takes time! Graphics, layouts, html etc etc… all time consuming.

These days, I update the site perhaps once a week (weekends mostly). I select a random post shared with subscribers. If you want to know what I am thinking, watching or even trading – then subscribe. It doesn’t cost you anything!

Today I am going to share “The Implications of Unwinding QE – Part I” (sent to readers Sept 23)


  • Fed “Finally” Begins to “Normalise”
  • Rates will start to rise but they are still accommodative
  • Time to be watchful… but not to alarmist

Greeting from the SilverKris lounge in Singapore…

I am in the air again this weekend – heading to San Francisco. Apologies in advance for any lack of writing over the coming couple of weeks. I head back to Singapore October 5th.

I will try and get this post out within an hour – however don’t like my chances.

There is a bit to get through but will try and keep it concise (apologies for the typos in advance – there might be a few more than normal!)

As an aside, my brother-in-law was asking me how it takes me to write a post as we enjoyed dinner at the Sofitel Sentosa last night (nice spot to go if you get the chance). I said anywhere between 1 and 2 hours.

Most of the time is spent reading what’s happening. That is, digesting the news and then putting it together in a way that makes sense to folks not as familiar.

Generally I will frame the post in my mind – and then as I write – other questions generally surface.

This Saturday morning – I wanted to touch on the Fed.

They are finally about to unwind their balance sheet.

It’s been a long time coming and perhaps the biggest question mark hanging over markets (apart from Trump’s proposed tax reform).

And whilst I think rate normalisation is a very good thing – it will have implications for market.

Long story short – rates will rise. Let’s take a closer look using the charts…

Normalising Rates and Unwinding QE

When the Fed delivered their minutes this week about their intent — it shook a few investors nerves.

In fact, my post yesterday was well timed… with Howard Marks suggesting to folks “they continue to move forward but with some caution”

We also say a move in bond markets following the Fed’s news… for example, take a look at 10-year yields: 

10-Year Bond Yield

They are moving higher (again) which suggests bond prices are falling. And when bond prices fall, long-term rates rise (which is what impacts the commercial market; ie your mortgage).

The 10-year is now trading around 2.3%.

It’s still very low by historical standards – however you can be sure a few eyebrows will be raised if this starts to push 3% or more. As an aside, 2.6% is what Bond King Bill Gross’ suggested would be “lights out” for equities.

With respect to the short-end, it would appear the Fed are not going to lift the cash rate until December (if at all)

And that’s what we expected…

With all that baked into the cake – we saw gold fall a bit (naturally) and the US dollar catch a bid. Note – again this is what we said to expect recently.

But here’s the thing:

Whilst the Fed are finally beginning the path to normalisation – this is not something that will happen quickly.

It will take them years to this – several years.

For example, they told us that their plan to start selling US$6 billion per month of Treasuries and $4 billion per month of mortgage back securities.

Note: to be more specific – selling is not quite the right word. They are not renewing these instruments.

That is a very slow drop when you consider their balance sheet sits at a whopping $4.5 Trillion (nb: of which something like $2.2M is excess reserves held by banks)

Again, growth is very modest. We talked to this recently. The Fed will be mindful not to derail what it only a very tepid recovery post 2008.

What they are signalling is they are going to take a very cautious approach to normalisation as they strengthen the demand for money (eg via raising the interest rate it pays on excess reserve now that there are increasing signs that money demand (ie need for safe securities) is beginning to ease).

This is important to understand.

You see, as long as the Fed can balance the demand and supply for money — inflation stays in check. And to date – this is going along ok.

However, should the demand for money fall too quickly, then inflation has the potential to get out of the bag. Again, this is not a risk today with inflation still extremely low (and not expected to go anywhere soon)

Adjusted Cash Rate v’s 5-Year TIPS

I first read about this concept many years ago from Scott Grannis.

He was explaining the role of the Fed during the GFC – and how the Fed satisfied the demand for safe assets.

Grannis argued that what the Fed’s actions around QE were not necessarily stimulative (that’s more fiscal policy) – but rather providing important liquidity opposite the demand for money.

And I very much agree…

Below is a chart the Grannis posted recently which is an important one (and rarely discussed): 

5-Year TIPS versus Risk Free Yields

Here we see two charts:

(a) in blue the inflation-adjusted Fed funds rate; and
(b) in red the 5-year Treasury Inflation Protected Securities (or TIPS as they are known)

Since the recession of 2008 – all the way through until today – the inflation adjusted Fed funds rate (or cash rate) has been below zero.

Put another way – things are still extremely accommodative for risk assets (a point we often make).

Note: this is why I suggest today’s approx 17.7x forward PE ratio for the S&P 500 is not excessively priced

This is the the most important monetary variable for the economy, since it sets the floor for the true cost of borrowing and the true “benefit” to saving.

In other words, today there is little to no benefit to saving, you are actually losing money (again, an intentional strategy from the Fed).

Note: when Yellen was pressed on this years ago about the impact to Pensioners – her language was along the lines of “… there are trade-offs”. I digress…

Today, the Fed funds rate is 1.25% and the inflation rate is about 1.5% (ie we are slightly negative in real terms)

We will get a better read on this at the end of the month (it’s expected to be around 1.5%)

However, as you can see, things are a lot less negative now than it has been for nearly a decade (and hence why the big-end of town are starting to suggest some caution in markets).

But as Marks was telling us recently — the good times (ie free money) cannot go on forever.

As such (and as described by Grannis)… should the Fed holds the real funds rate to an unreasonably low level (eg below zero) that would inevitably result in an imbalance between the supply and demand for money, and that in turn would result in rising inflation, a weaker dollar, and rising gold and commodity prices.

This is the balancing game being carefully managed.

The red line is the real yield on 5-Year TIPS. This is what the market expects for what the real Fed funds rate will average over the next 5 years.

That that real yield is only 0.1%… however current real yield on the Fed funds rate is about -0.15% to -0.25%.

What does all this mean?

Today the market expects only very modest “tightening” from the Fed over the next 5 years.

Second, to that, the market is also not optimistic on economic growth exceeding not much more than 2% to 3% over the next few years.

The Fed are in no rush here…. something the market has factored in… and something we have stressed previously.

But as Grannis points out — what’s important to watch is whether the nominal funds rate exceed the 5-yr real TIPS yield.

This could be troubling… as it’s the market’s way of saying the Fed are now starting to get “too tight” and it will impact growth.

Yield Curve: 2-Year and 10-Year Yield Spread

Time check! I have less than 30 minutes to board my plane… let’s see how we go.

The other chart I like to share with readers (and related to the above) is the delta between the yield of the 2-year treasury (as a proxy for the Fed funds rate) and the 10-year yield:

This is also key…

What it shows is that every recession in the past 60 years has been preceded by a substantial tightening of monetary policy.

Every single one — no exceptions.

Yield Curve

Note: we talked a little about this the other day when discussing long (40 year) credit cycles and the shorter-cycles with that. I have a good video I will share on this during the week from Ray Dalio – he summarises the theory beautifully.

Monetary policy is tight when the Fed funds rate (in this case – 2-year yield proxy) exceeds that of the yield on the 10-year yield (orange line).

Again, there is no cause for alarm today but something we are watching now that the gap is starting to close from levels seen in recent years.

Economic Growth Expectations… 

Two more charts before I close this post and pick this up for part II

First up, economic growth and the 5-Year TIPS (as a proxy for growth):

I really like this chart… 

In short, what we see is the very low level of real interest rates is consistent with real GDP growth of about 2%.

Why I like this chart is if the market were convinced economic growth was about to surge – we would be seeing this trend much higher (ie real rates).

But the market is not optimistic on growth (again echoing Howard Marks). In anything – the market is cautious.

The market also believes that CPI (inflation) is only likely to be very modest over the next few years (note — CPI is up 1.9% in the past 12 months, and the Core CPI is up 1.7%). Both are below the Fed’s target of 2.0%

Translation of the above chart:

If the market was worried that the Fed are being too aggressive with unwinding its balance sheet — then inflation expectations would be declining. They are not. 

Gold and Inflation… 

It’s almost time to board so one last chart before I hit send… take a look at gold as it trades against the 5-Year TIPS:

Gold v 5-Year TIPS

I like to call this chart “Lake Louise”

For those not familiar, it’s one of my favourite places in Canada. Lake Louise offers the most amazing reflective photos of snow-capped mountains against the still water.

When I look at this chart, I see a near perfect reflection. In other words, if I inverted the 5-Year TIPS yield, it would parallel what we see with gold.

It’s amazing that these two completely different assets mirror each other.

What it suggests is relevant to how you play gold:

That is, strong economic growth (ie higher TIPS – as we saw with GDP) will depresses demand for gold; and weak growth (ie lower TIPS) increases the demand for gold.

And for me, that tells me that buying gold today (if you are inclined) is a hedge against a weaker economy.

Putting it All Together… 

I don’t have time to proofread this post and I know it’s littered with typos!

“What’s new” say most (forgiving) readers (I am the world’s worst typist)

I have updated my weekly charts for the XJO and S&P 500 and I will get to these when I get to San Francisco over the weekend (eg I’ll have some time Sunday night).

In closing, it’s good news they are finally look to normalise. This is important.

However, what’s also important is how you use the charts to interpret how the market is taking it.

For example, bond markets were a little “jumpy” on the news (with the 10-year yield spiking) but there is no need for panic (not yet). We are still at just ~2.3%

We will continue to watch the yield curve and things like 5-Year TIPS (as they related to the inflation adjusted cash rate – which sits just below zero)

Let’s see if this climbs back above TIPS… then things might be getting “tight”.

At some point, the tide will turn. The good times (ie free money) will not last forever. Nothing ever does.

And when that times come – and the monetary conditions change for the worse — a recession will follow and equities will correct.

Nothing is more certain.

But from my lens, there is nothing to worry about in the near-term.

5 minutes to spare and time to hit send!

Adrian Tout

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