Transcription
Okay, so there's been quite a lot happening in the market, so I think it's a good time for us to review what's been happening so far and review our investment strategy. Now, while I may be a bit late in covering the stuff I'm about to talk about today, the reason I'm doing this video is because I saw a lot of YouTubers just giving simple facts like, oh, the Fed is ending the QT, and just stopping there. I didn't see anybody who's actually explaining in detail why the Fed is taking such actions. I'm just, okay, most YouTubers are just reading news articles for you, which I don't think is that helpful.
Okay, let's look at some key data which came out after our last market update. Federal Reserve balance sheet: 6.59 trillion versus 6.60 trillion last period. S&P Global Manufacturing PMI for October: 52.2 versus 51.9 forecast versus 52.0 last month. S&P Global Services PMI for October: 55.2 versus 53.5 forecast versus 54.2 last month. Now, the data which everyone was waiting for also came out, which is CPI core CPI for September: 3.0% versus 3.1% forecast versus 3.1% last month. CPI for September: 3.0% versus 3.1% forecast versus 2.9% last month.
Okay, so looking at the data, I can pretty much see that the Federal Reserve balance sheet has been somewhat plateaued. Manufacturing and services PMI are stable, and CPI has slightly calmed down, which is a good sign for the market.
Now, the main topic I wanted to deal with today is Jerome Powell's speech at the annual meeting of the National Association for Business Economics on October 14th. Here's a quote from Powell: "While the unemployment rate remained low through August, payroll gains have slowed sharply, in part due to a decline in labor force growth due to lower immigration and labor force participation. In this less dynamic and somewhat softer labor market, the downside risks to employment appear to have risen."
Okay, now let's look at the second quote. "Available data and surveys continue to show that goods price increases primarily reflect tariffs rather than broader inflationary pressures. Consistent with these effects, near-term inflation expectations have generally increased this year, while most longer-term expectation measures remain aligned with our 2% goal."
Okay, let's take a look at another quote from Powell. "Our long-standing plan is to stop balance sheet runoff when reserves are somewhat above the level we judge consistent with ample reserve conditions. We may approach that point in coming months, and we're closely monitoring a wide range of indicators to inform this decision. Some signs have begun to emerge that liquidity conditions are gradually tightening, including a general firming of repo rates along with more noticeable but temporary pressures on selected dates."
Okay, so those three quotes are the ones which I wanted to focus on. Now, speaking in plain English, Powell is saying three things. Number one, the Fed is quite worried about the unemployment situation. While unemployment rate is low, the balance is still curious, and the balance may break if things go wrong. Number two, yes, CPI is rather high at around 2.9%, which is well above our 2% target. However, we all know it's because of tariffs, which is only a one-off impact. In the long term, the inflation will cool down. Number three, now, because the Fed is very worried about unemployment and not worried as much about inflation, we'll end quantitative tightening in a few months' time.
Okay, so that's basically what Powell is saying. Now, as I explained multiple times to you guys, quantitative easing, i.e., QE, is what provides liquidity to the market. The Fed would purchase bond securities such as MBS and treasuries from financial institutions in return for cash. When the financial institutions sell the bonds to the Fed, those institutions become loaded with cash and become extremely eager to lend money, which brings interest rates lower, making it easy for everyone to borrow money. These money would flow into the market and would generally lead to a favorable market environment, including stocks. Now, quantitative tapering is the opposite, where the Fed would sell the bonds to the financial institutions in return for cash or just let the bonds mature. This would gradually drain the money out of the system and is not favorable to the market. I explained this mechanism in detail in my "Should Companies Be Bailed Out" video. Please refer to the video for more details.
Okay. So, the Fed has been conducting quantitative tapering, i.e., the QT, since June of 2022. They reduced the balance sheet by around $2.2 trillion, which went down from around 35% of GDP to under 22% of GDP. Now, after conducting the QT for over three years, Powell is basically saying they're planning to end it. Now, why is this? Okay, so Powell already noted the obvious reasons in his statement. He basically thinks that draining more liquidity out of the market would be dangerous for the job market, and also, while CPI may be an issue, if QT stops, it's not a big problem, given inflation will cool down soon. Now, these are very obvious reasons. A lot of you may agree or disagree with what Powell said, but given that's what the Fed believes, we have to play along with what they're saying.
Okay, so what other reasons could there be? To get a sense of what the main issue is, we need to pay attention to Powell's last quote again. Powell said that the Fed's plan is to stop the QT when there are ample reserve conditions. He also said that there are some signs of liquidity conditions gradually tightening. Okay, so what does this mean?
Okay, so to understand the situation, we need to understand two things about QT and the Fed's balance sheet. Number one, QE or QT leads to changes in market interest rates. Now, when the Fed conducts QE, which is the opposite of QT, as I explained earlier, this may lead to a significant swing in the interest rate. This interest rate may go below the level which the Fed wants, and the Fed generally wants to prevent that from happening because the Fed is the entity which provides guidance on the rates. Now, this generally doesn't happen when the Fed conducts QE because, generally, when QE happens, the Fed is very aggressive in trying to provide liquidity in the market, targeting a zero or near-zero interest rate. Now, when the Fed conducts QT, as I explained earlier, the Fed is draining liquidity from financial institutions, including banks, which would generally lead to a decrease in bank reserves. Basically, banks need to keep a certain amount of cash reserves to operate their normal course of business. But when QT happens, because the Fed is selling the bonds to these financial institutions, it would generally lead to a decrease in the cash reserves. Now, when there are so few reserves left at the banks, the banks would become very protective about their cash and may increase the interest rate significantly when lending money because they want to keep the cash. The Fed generally does not want this happening. And what Powell is saying is that the Fed has done enough of QT because the banks are now left with just the right amount of reserves to operate. Now, QT may bring the bank reserves below the threshold, and this would not be ideal for the Fed in controlling the interest rate.
Okay, so that's what's happening between the banks and the Fed. Now, moving on. Number two, at the same time, the Fed's on RRP balance was getting squeezed. Okay, so in order to understand what was happening, we need to understand repo and reverse repo. Now, when we take a look at the Fed's balance sheet, there are a couple of components in the balance sheet which act as tools to keep the market interest rate in a certain band. Basically, the Federal Reserve either lends or borrows money every day against financial institutions. And by conducting these lending and borrowing activities at certain interest rates, the Fed can directly control the market interest rate and guide it towards the direction they want. Now, on the Fed's asset side, there's a thing called a repo. This is basically the Fed lending money to eligible firms like money market funds, banks, and primary dealers overnight against treasuries and MBS as collateral. Basically, this tool provides liquidity to institutions when they need some cash. Now, a reverse repo is the other way around. When firms like money market funds have a lot of cash, they would lend the money to the Fed and receive a certain interest rate. Now, as you may all know, the main objective of the Fed doing this is not to make money. They're doing this to keep the lending and borrowing rates within a certain band to control the market. Now, the term ON RRP stands for overnight reverse repurchase agreement facility, which is the same as reverse repo. I'll just call it reverse repo or RRP.
Okay. So, having that said, what happened very recently is that the Fed's reverse repo balance fell to almost zero. Now, take a look at this chart to take a look at what happened. Okay, so the reason the Fed's reverse repo balance fell to almost zero is due to the recent events that took place with the US's debt ceiling. The US's debt ceiling was very recently lifted, and that allowed the US to issue a huge amount of T-bills, i.e., short-term Treasury bonds, given that they haven't been able to issue it for a while now. When the huge issuance happened, because there were limited institutions and investors who could buy all those huge amounts of T-bills, the interest rate which was paid on T-bills temporarily increased even higher than the Fed's reverse repo rate which was offered to institutions. Now, this led all the money market funds rushing towards buying T-bills for short-term gains, which led the RRP balance falling to almost zero. Basically, nobody was lending to the Fed because the interest rate was lower than T-bills.
Okay. Now, the reverse repo balance falling to almost zero raises some concerns for the Fed. Number one, if no money market funds or other institutions are using the Fed's reverse repo and rushing to other options, the Fed will gradually lose control of setting the market interest rate. Number two, overnight rates can get quite jumpy, which may lead to market instability. Number three, the private repo market may gain more control. Now, just like what the Fed does, there are also private institutions which provide overnight lending. And these private institutions may gain more power to set the price.
Okay. So, there are many more side effects of the RRP balance falling to near zero. So, what the Fed is also trying to do here is to stop the QT and indirectly steer the money back into their RRP so that the Fed can maintain control of the overnight lending rates. Now, while stopping QE doesn't have a direct relationship with rebounding the RRP balance, if QT stops, it'll stop the decline in bank reserves, which can make the repo market less jumpy, which will stabilize the rates on the front end and also gradually stabilize the rates in the overall market. Okay, so that's why the Fed is planning to stop the QE.
Okay, so let's move on to the more important topics, implications, and predictions. Okay. So, as I say all the time, in my mind, the two most important factors impacting the markets are number one, the interest rate, and number two, the Federal Reserve balance sheet. Now, we already know that the interest rate is on a downward trajectory, and now even the Fed balance sheet is going to stop tapering. Now, based on the foreclosure matrix which I showed you guys all the time, we're not in section A, but we're now much more firmly in section C, i.e., a more liquid market. Now, based on where we stand, my prediction is that two more rate cuts within the year is almost guaranteed, and three rate cuts may also be a possibility. I think the market also knows this and is pricing this in already to some extent. Now, based on the circumstances, I think this gives us further comfort to hold on to our investments and avoid selling any of our positions.
Now, as you guys all know, since early April until late September, I've been saying that we should continuously buy into the market whenever the market showed some small to corrections. However, in late September, I told you guys that I plan to hold on to my investment while refraining from buying more. Now, I just want to make a clarification on this point. A lot of you guys were saying, why would I not buy more into the market when I'm saying that the market is transitioning into a more liquid environment? Also, some of you guys commented that if you don't buy into the market, we won't make any money. Okay, guys, I just want to make a few things clear. Since early April, I've been very aggressive in buying into the market. The positions I already have are quite significant in size, and if I were to buy more, I'll need to tap into my cash reserves, which I don't want to touch. I also like to maintain a certain cash balance just to keep my mind at peace, and I'm quite happy with the positions I accumulated in the past six months. This is why I'm now buying more into the market. The current market is an okay one, and I still do have concerns over inflation and valuation, and if I get some more clarity on those fronts, I'll happily buy more. What I'm trying to say is that the current market is an okay one, but not a perfect one to the extent where I would tap into my minimum cash reserves. But just to reiterate, the reason I can make this decision is because I already have a sizable investment in the market already.
Now, for those of you who are still not in the market, I would carefully suggest you to at least buy into the market in piecemeal whenever there are small to corrections. A lot of people argue that we're in a bubble and this bubble may pop soon, but generally, when the market is heading towards a more liquid environment and considering the sentiment around Trump's administration, I don't see a significant crash in the market happening at least in the near future.
Okay, so that's all I wanted to cover today. I hope you enjoy the video, and I'll be back with more videos very soon.