QE4 Begins - Fed Printed An Extra $161.7 Billion Last Week

by: Avery Goodman


- Fiction seems to be turning into fact as the Federal Reserve follows the ECB in reactivating the money printing presses.

- The Federal Reserve announced that it will print $165 billion by the end of this week, but denies that it is "QE" by claiming it is a "temporary" measure.

- Precious metals prices and mining shares will continue to rise, whereas the general stock market is probably near its highs.
Fiction Turns Into Fact
Jose Arias is a fictional character from the thriller novel, "The Synod". Yet, he makes some very relevant comments when a friend asks him to help find information needed to defeat the plots of a group of murderous gold manipulators:
"...Try the week of March 18th, 2009. It was just before the Fed first announced its multi-trillion dollar “QE” money printing program. That morning, they mercilessly attacked the price of gold..."
Fast forward to 2019. The ECB's announced, on September 12, 2019, a new program of QE. On September 4, 2019, a little over a week before the announcement, the spot price of gold reached a high of $1,546 per ounce at the London close, after rising for several months. Suddenly, and for no apparent reason, on September 5, 2019, gold prices began to plummet.
This culminated with a low on September 11, 2019 of around $1,490 when the ECB made its announcement. No news supported the price decline, but "technical analysts" claimed that it happened because the metal was "overbought."
Gold Price Chart for Sept 11th Chart courtesy of Kitco.com
Is it all a coincidence? On the very day gold reached its lowest low, the ECB announced that it would be revving up its printing presses.
That should have driven gold much higher. In fact, that's exactly what happened for a very short time.
Gold prices rose by some $20. Then, they were hammered down by midday. Market pundits claimed that investors had decided the ECB's promise, to print $22 billion euros every month for a year, was insignificant.
Is that true? I guess we'll never know for sure. But, one thing is certainly true. No central bank can suppress the price of anything forever.

There's more here than meets the eye. The ECB announcement was open and obvious. Central banks usually try to avoid being obvious.
They only act in obvious ways when they want to send out a message.
In the case of open and obvious money printing, generally speaking, they only admit to it when the banks they serve are close to insolvency.
At such times, as was the case in 2009, when the Federal Reserve began QE1, the benefit that an overt promise to print new money provides, in terms of reassuring bank executives, exceeds the cost of being accused of being a "counterfeiter" of money.
An overt QE announcement, like the one just made by the ECB, is a solemn promise that the insolvent banks won't be forced to turn to the free market for funds.
Both Permanent And 'Temporary' Open Market Operations Result In Newly Printed Money

The Federal Reserve hasn't been open and obvious about returning to printing money.
However, about a week later the ECB announcement, it covertly announced the resumption of money printing.

Modern central banks print money via "open market operations". "An open market money printing operation (OMO) occurs when a central bank gives money to a commercial bank or group of banks."

The money is newly created by the central bank for the purpose of bank assets that might, otherwise, be hard to sell.
Open market operations can be classified as either "temporary" or "permanent". An OMO that the central bank claims is temporary is known as a "temporary open market operation" or TOMO for short.

But, if the central bank is willing to admit it never expects to be repaid, the operation is known as a "permanent open market operation" or POMO.

TOMOs and POMOs essentially do the same thing, however, in that both increase the money supply.

A series of POMOs, for an extended period of time, is known as quantitative easing ("QE").
It seems obvious that the ECB made its open announcement that it would reopen the printing presses with the aim of reassuring one or more insolvent European banks.

Some speculate that the actions of the ECB and, now, those of the Federal Reserve, as we are about to discuss, are all about the alleged insolvency of Deutsche Bank.

This is not the first time that the Fed printed money via TOMOs.

From 2001 to 2009, the Fed refrained from permanent open market operations (POMOs).

As a result, no one accused it of "printing money."

The operations were, supposedly, "loans" with an obligatory "next day", "next week" or "in a few weeks" repayment date.

In practice, the running total of overnight, week long, and multi-week supposed "loans", was never repaid until QE began in March 2009.

But, the amount rose from a few billion in 2001 to hundreds of billions of dollars by the time they were finally repaid.
The Fed Has Already Resumed 'QE' But Calls It Another Name
On September 17, 2019, the New York Federal Reserve announced that it would issue "overnight" TOMOs in the amount of $53.15 billion dollars.

The next day, September 18, 2019, when those alleged "loans" (a/k/a gifts) were due to be repaid, instead of demanding the money back, the Fed reissued the $53.15 billion and added billions more, bringing the total loan to $75 billion.

The next day, September 19, 2019, instead of getting its money back, the Fed renewed all $75 billion again.

Then, on September 20, 2019, it did the same thing.
The weekend came and went, and Monday, September 23, 2019 arrived.

The Fed reissued only $65 billion worth of new money that day. We can only assume that the borrower(s) managed to repay $10 billion for the first time, although it is possible that the numbers were massaged by sleight of hand accounting.

But, regardless, by the very next day, Tuesday, September 24, 2019, the Fed had not only reissued the original $75 billion worth of "overnight" loans, but added $30 billion in two week "loans", for a grand total of $105 billion.

It announced it will issue two more $30 billion dollar TOMOs before the end of the week.
On September 25, 2019, the Federal Reserve announced that it would increase the amount of the 1 day TOMOs from $75 to $100 billion, and the size of the two week TOMOs from $30 billion to $60 billion!

Potentially, the running total TOMOs could have run up to $280 billion.

Thankfully, the printing press didn't reached that lofty potential... not yet, at least.

As of Friday, September 27, 2019, Federal Reserve money printing operations included $30 billion supposedly due back on October 8th, $60 billion supposedly due back on October 10th, $49 billion supposedly due back on October 11th, and $22.7 billion supposedly due back on September 30th.

In summary, it added an extra $161.7 billion dollars to its balance sheet in one week alone.

It appears from the counterparty list that 2 banks received the TOMO "loans". We have no idea how the TOMOs were distributed.

One bank could have taken $1 and the other could have taken billions. Will the bank(s) be able to pay it back in a timely manner?

They never have in the past, so it's not likely now.

You can be sure that when the bank(s) can't come up with the money as payment time arrives, unlike the treatment you or I would get from our creditors, the Fed will renew and expand the loans without limit.
The Fed Obviously Doesn't Want To Admit That It Has Returned To Printing Money But Something Is Very Wrong
The Fed is refusing to call the TOMOs "QE" and continues to insist that the endlessly renewable "overnight" and "week long" loans are merely "temporary" measures.

This isn't the first time for that.

These TOMOs will be as endlessly renewable as the ones from 2001 to 2009.

All the while, you can be sure that the Fed will claim they are addressing nothing more than "temporary" issues in the money market.

The borrowing bank(s) will be called upon to repay only when the Fed decides that the coast is clear.

Then, the "loans" will be converted into POMOs (a/k/a "QE"), as in 2009, and the banks will "repay" the funny money with permanent money given to them by the central bank.
The difference between now and then is solely in the sheer enormity of the transactions.

The opening salvo is ten to fifteen times higher than it was back in the early part of the 21st century.

If history is any judge, both the frequency by which this new money is released, and the total amount of it, will slowly and steadily build up over time.

It will happen month after month and year after year.

It seems likely that this second round of TOMOs will add up to trillions before it is finished.

It has already mounted to $165 billion and we are just a few days into the process!

This compares to a couple hundreds billion near the end in 2009.
The question is why a bank or group of banks is so desperate for money?

Whoever it is can't get anyone to lend to them in the free market in spite of the fact that big American primary dealer banks are sitting on trillions of dollars in reserve deposits, created during ten years of QE.

Instead, the big banks are allowing the NY Federal Reserve branch (which they closely control) to do the "lending".

The banks in question are not in the charity business.

Therefore, the most likely reason is that failure of an insolvent bank(s) would cause their intricate web of hundreds of trillions worth of cross guaranteed derivatives to fail.

The end result would put JP Morgan Chase, Goldman Sachs, Morgan Stanley, and Citibank into bankruptcy too.

An insolvency of Deutsche Bank would fit the bill.

In any event, the Federal Reserve's debasement of the US dollar, regardless of the name they give to the vehicle that causes it, will cause precious metals prices to react very similarly to the way they reacted when the dollar was being debased in the early part of this century.

Precious metals prices are going to rise as they did then.

But, the rise will be more dramatic this time because we're now dealing with a lot of central banks printing money at the same time.
During the early years of the 21st century, as you may recall, the ECB was a mere babe, steeped in the innocence of her birth. Now, it is heavily printing.

The Bank of England, the Japanese Central Bank, the Chinese Central Bank and many other central banks will all follow and contribute to the tidal wave of new funny-money.

I expect the printing extravaganza to take precious metals and mining share prices on a fantastic ride upward.

The bottom line is that the money supply is, once again, increasing at a fantastic rate.

The value of the existing stock of currency is just as effectively being diminished as it would be if you called the operations POMOs (a/k/a "QE").
What About American Stock Prices In General?
Obviously, the general stock market is also juiced by any form of money printing.

But, as opposed to precious metals stocks, which are still depressed well below their 2011 highs, the prices for equities in general are historically high.
The overall stock market, as indicated by the S&P 500 index, is now selling for about four times its low in 2009.

And, if we glance back at the period 2001 to 2009, it is plainly obvious that, in the midst of the heavy money printing via TOMOs, there were still a significant recession and heavy stock price pullback because stocks became overvalued from the post dot.com TOMO-based money printing.
Because stock prices climbed so high as a result of QE already, I don't see much upside in the average stocks, at this point in time.

That said, it really depends on how much of a flood of funny money the Fed is willing to create.

It can float all boats if it is big enough, but might also trigger heavy stagflation or hyperinflation at the same time.

Precious metals mining stocks seem to be a very good bet at this point in time, especially those that are still depressed.

All of that having been said, this is not a get-rich-quick scheme.

Remember that whenever there is a sharp increase in prices, as over the last few months, the market for physical metal, which is always price sensitive, will inevitably slow dramatically.
The average emerging market buyer must get used to the newly higher prices and must stop worrying about a return to lower prices before gold and other precious metals can move significantly higher.

Q2 2019 Z.1 and Repos

Doug Nolan

Non-Financial Debt (NFD) expanded $408 billion during Q1 to a record $53.015 TN. This was down from Q1’s $765 billion expansion. On a seasonally-adjusted and annualized (SAAR) basis, Q2 NFD growth slowed to $1.652 TN from Q1’s booming $3.061 TN.

The slowdown was chiefly explained by the timing of federal government borrowings. Federal debt expanded SAAR $1.751 TN during Q1 and then slowed markedly to $382 billion during Q2.

Averaging the two quarters, NFD expanded SAAR $2.360 TN.

This compares to 2018’s annual $2.274 growth in NFD, the strongest annual Credit expansion since 2007’s $2.518 TN.

As a percentage of GDP, NFD slipped to 248% from 249% during the quarter. NFD ended 1999 at 183% of GDP and 2007 at 226%.

On a seasonally-adjusted and annualized basis, Household borrowings expanded SAAR $668 billion, up from Q1’s SAAR $323 billion, to a record $15.834 TN.

Household mortgage debt expanded SAAR $330 billion, up from Q1’s SAAR $226 billion, to a record $10.440 TN.

Total Business debt growth slowed to SAAR $680 billion, down from Q1’s booming $1.023 TN (strongest since Q1 ’16), to a record $15.744 TN. State & Local debt contracted SAAR $77 billion, after declining SAAR $36 billion during Q1, to $3.039 TN. Foreign U.S. borrowings expanded nominal $231 billion for the quarter (to $4.291 TN), the strongest foreign debt growth since Q1 ’17.

Considering recent “repo” market tumult, let’s take a deeper-than-usual dive into the Z.1 category, “Federal Funds and Securities Repurchase Agreements” (aka “repo”). “Repo” Liabilities jumped $239 billion (nominal) during the quarter, or 24% annualized.

This pushed growth over the past three quarters to $710 billion, or 27% annualized. This was the largest nine-month growth since the first three quarters of 2006. At $4.280 TN, “repo” ended June at the highest level since Q3 2008.

It’s no coincidence that the $710 billion nine-month increase in “repo” corresponded with a spectacular 106 bps decline in 10-year Treasury yields. I’ll assume repo market ballooning continued into early-September, as yields dropped another 44 bps.

The expansion of securities Credit (the “repo” market being a key component) generates new marketplace liquidity.

Moreover, the concurrent expansion of “repo” Credit and system liquidity is in today’s highly speculative global environment powerfully self-reinforcing.

September 26 – Bloomberg (Vivien Lou Chen): “It may take as much as $500 billion in Treasury purchases by the Federal Reserve to fix all of the cracks exposed last week in the more than $2 trillion U.S. repo market. Estimates from analysts at TD Securities, Morgan Stanley, BMO Capital Markets and Pictet Wealth Management range from roughly $200 billion to half a trillion dollars. They’re not alone. Two former Fed officials said Thursday that the central bank might need to do $250 billion of outright Treasury purchases to prevent further pain in U.S. money markets. There’s a growing consensus that the central bank’s daily efforts to restore order in the short-term funding market are falling short of what’s needed: a much larger effort to build up a substantial buffer of bank reserves…”

As we’ve witnessed over the past two weeks, the unwind of securities Credit and the attendant contraction of liquidity turns immediately problematic.

A Thursday afternoon Bloomberg headline (from the above article) resonated: “Repo-Market Cure May Take $500 Billion of Fed Treasuries Buying,” referring to Wall Street estimates of the scope of Fed intervention necessary to stabilize funding markets.

I have posited a serious globalized de-risking/deleveraging episode would require multi-Trillion expansions of Federal Reserve and global central bank balance sheets.

“Brokers & Dealers” is the largest borrower by Z.1 category, with “repo” Liabilities up $92 billion during Q2 to $1.781 TN (high since Q3 ’13). Broker “repo” Liabilities surged $296 billion over three quarters, or 27% annualized.

As the second largest borrower, Rest of World (ROW) “repo” Liabilities increased $10 billion during the quarter to a record $1.102 TN. ROW “repo” Liabilities surged $254 billion over the past three quarters, or 40% annualized. ROW “repo” peaked at $857 billion during the previous cycle (Q1 ’08).

While not at the same level as the Wall Street firms or ROW, Real Estate Investment Trusts (REITs) have as well been notably aggressive “repo” borrowers. REIT “repo” Liabilities rose $30.3 billion during Q2 to a record $369 billion. REIT “repo” Liabilities were up $107 billion, or 41%, over the past year and $150 billion, or 69%, over two years. REIT “repo” Liabilities posted a previous cycle peak during Q2 2007 at $106 billion.

Money Market Funds (MMF) are a large holder of “repo” Assets (second only to Brokers & Dealers). MMF “repo” holdings jumped an eye-opening $153 billion during Q2 to a record $1.133 TN, with a gain over three quarters of $213bn, or 23%. It’s worth noting MMF “repo” holdings peaked at $618 billion during Q4 2007 (having doubled over the preceding two years).

It’s worth noting the Fed’s balance sheet contracted $58 billion during the quarter to $4.140 TN. Some have been confounded by the lack of impact to system liquidity from the Fed somewhat drawing down its securities portfolio. But with securities Credit expanding by multiples of the decline in Fed Credit, marketplace liquidity has been dominated by securities speculating and leveraging.

As I often repeat, contemporary finance works miraculously on the upside. Fear the downside.

The Fed’s balance sheet expanded as much over past week as it contracted during the second quarter.

Bank (“Private Depository Institutions”) assets increased $203 billion during the quarter to a record $19.506 TN, this despite a $159 billion decline in “Reserves at Federal Reserve”. Bank Loans jumped $192 billion during the quarter, or 6.8% annualized, bouncing back strongly after Q1’s slight contraction (and ahead of Q2 ‘18’s $174bn). Bank Loans were up $550 billion, or 5.0%, year-over-year. Bank Mortgage Loans expanded $76 billion (5.5% annualized) during the quarter to a record $5.540 TN, the strongest expansion in two years.

Bank holdings of Debt Securities jumped $112 billion, or 10% annualized, to a record $4.505 TN (one-year gain of $320 billion, or 7.7%). Debt Securities holdings were below $3.0 TN going into the 2008 crisis. Bank Agency/GSE MBS holdings jumped a huge $82.2 billion during the quarter, the largest increased since Q1 ’12. Over the past three quarters, Banks boosted Agency Securities by $217 billion, or almost 10%, to a record $2.588 TN.

Banks’ Agency Securities holdings are about double the level from the crisis. Bank Holdings of Treasuries rose $34 billion during Q2 to a record $771 billion, jumping $121 billion over three quarters. Treasury holdings were up 22% y-o-y. For Comparison, Banks’ Corporate Bond holdings increased $25 billion y-o-y, or 3.9%, to $664 billion.

Broker/Dealer Assets jumped $132 billion during Q2, or 16% annualized, to $3.487 TN (high since Q2 ’13). This was a sharp reversal from Q1’s small ($4bn) contraction. Broker/Dealer Assets were up a notable $349 billion, or 11.1%, over the past year.

Repo Assets jumped $227 billion y-o-y, or 20.0%. Over this period, “repo” Liabilities surged $326 billion, or 22.4%, to $1.781 TN. This was the highest level of “repo” Liabilities going back to Q3 2013, a period that corresponded with a sharp upside reversal in market yields and contraction in “repo” securities Credit.

Total system Debt Securities increased nominal $304 billion during Q2 to a record $45.771 TN.

This boosted the gain since the end of 2008 to $14.825 TN, or 48%. As a percentage of GDP, Debt Securities ended Q2 at 214% (record 223% Q1 ’13).

Equities jumped $1.602 TN to $49.799 TN, ending Q2 slightly below Q3 ‘18’s all-time record ($49.799 TN). Equities ended Q2 at 233% of GDP (record Q3 ’18 243%).

Total (Debt and Equities) Securities jumped $1.906 TN during Q2 ($7.51 TN during the first half) to a record $95.569 TN.

Total Securities-to-GDP ended June at 448% (record Q3 ’18 458%). Previous cycle peaks were 379% during Q3 ’07 and 359% in Q1 ’00. Total Securities-to-GDP began the eighties at 44% and the nineties at 67%.

I view the “repo” market expansion as indicative of overall speculative leverage. The rapid growth of Bank and Broker/Dealer debt securities holdings is symptomatic of speculative excess and likely associated with derivative-related trading activities.

To simplistically connect the dots, the expansion of “repo” securities Credit along with ballooning Bank and Broker/Dealer securities holdings generate the liquidity abundance and speculative impulses for a general inflation of securities market prices (debt and equities).

The inflation of perceived wealth then feeds into the real economy through strong consumer and business spending.

Accordingly, the Household Balance Sheet remains a Bubble Analysis Focal Point.

Total Household Assets increased $2.024 TN during the quarter to a record $129.671 TN, with a $7.358 TN gain during 2019’s first half. And with Liabilities up $175 billion, Household Net Worth (Assets less Liabilities) jumped $1.949 TN during Q2 to a record $113.463 TN.

Household Net Worth rose $7.177 TN during this year’s first-half, a record six-month advance.

Net Worth rose to a record (matching Q4 ’17) 532% of GDP.

For comparison, Household Net Worth-to-GDP posted cycle peaks of 492% during Q1 2007 and 446% to end Q1 2000. Net Worth-to-GDP began the eighties at 342% and the nineties at 378%.

Household Real Estate holdings increased $257 billion during the quarter, down from Q1’s $707 billion gain (strongest since Q4 ’05). Yet Real Estate jumped $1.692 TN over the past year to a record $32.676 TN (153% of GDP). Real Estate holdings posted a previous cycle peak of $26.466 TN (189% of GDP) during Q4 ’06.

Financial Assets are the unquestionable epicenter of this cycle’s Bubble. Household holdings of Financial Assets jumped $1.700 TN during Q2, after surging $4.544 TN in Q1. Financial Asset holdings ended Q2 at a record $90.689 TN, or 425% of GDP. Financial Assets-to-GDP ended Q3 2007 at 376% and Q1 2000 at 355%. Household Assets began the nineties at 267% of GDP.

Household Total Equities (Equities and Mutual Funds) holdings ended Q1 at record $27.427 TN, or 129% of GDP. The previous two cycles saw Household Equities peak at $14.930 TN (102% of GDP) during Q3 ’07 and $11.742 TN (117% of GDP) in Q1 ’00. Total Equities holdings began the nineties at 47% of GDP.

Rest of World (ROW) is key to Bubble Analysis as well, though with layers of ambiguity and complexity.

ROW holdings of U.S. Financial Assets surged $843 billion during Q2 to a record $32.582 TN. Holdings were up $1.798 TN y-o-y, boosting ROW holdings-to-GDP to a record 153%.

ROW holdings-to-GDP ended 2007 at 108% and 1999 at 74%. ROW holdings of U.S. Debt Securities increased $337 billion during Q2 to a record $11.906 TN.

Debt Securities jumped $728 billion during the first half, with Treasury holdings rising $372 billion to a record $6.637 TN. ROW repo Liabilities jumped $187 billion, or 20%, during the first six months of 2019 to a record $1.102 TN.

Few see the Bubble, yet the Fed’s Z.1 report offers a compelling outline.

This week saw “repo” market instability bumped from the headlines by instability at the White House. Markets reacted to whistleblower allegations and the opening of an impeachment inquiry in typical fashion: “The President under duress is more likely to strike a deal with China.”

In comments Wednesday, the President was happy to play along: “They want to make a deal very badly... It could happen sooner than you think.” President Trump’s tough talk directed at China Tuesday at the U.N. didn’t leave one feeling the administration was softening up for an imminent deal.

And then came the Friday afternoon Bloomberg scoop (Jenny Leonard and Shawn Donnan): “Trump administration officials are discussing ways to limit U.S. investors’ portfolio flows into China in a move that would have repercussions for billions of dollars in investment pegged to major indexes, according to people familiar with the internal deliberations. The discussions are occurring as Washington and Beijing negotiate a potential truce in their trade war that’s rattled the world’s two biggest economies and investors for more than a year… A U.S. crackdown on capital flows would therefore expose a new pressure point in the economic dispute and cause disruption well beyond the hundreds of billions in tariffs the two sides have levied against each other.”

Markets would like to believe the administration is posturing ahead of the next round of trade talks. Bloomberg follow-up articles included comments from Wall Street analysts, including: “This is huge.” “Ludicrous.” “The news opens up a new front in the U.S.-China trade conflict.” “It’s another example of how every time people think this trade war is deescalating, it escalates again.” A Reuters article was on point: “…what would be a radical escalation of U.S.-China trade tensions.”

Chinese company listed ADRs were slammed in Friday U.S. trading. This creates Monday morning Chinese market and currency vulnerability. To this point, it’s been the Teflon President affixed to Teflon markets.

But between “repo” market instability, Washington chaos, the risk of serious trade war escalation – in a world of heightened financial, economic and geopolitically instability – and there is a scenario where the unraveling begins.

Markets have to this point demonstrated astounding faith that the President will ultimately act in their best interest.

As always, markets are a contest of greed and fear. One of the bad scenarios would be the markets fearing an administration resorting to a “scorched earth” gambit.

Chips with everything

How the world will change as computers spread into everyday objects

The “Internet of Things” will fundamentally change the relationship between consumers and producers

ON AUGUST 29TH, as Hurricane Dorian tracked towards America’s east coast, Elon Musk, the boss of Tesla, an electric-car maker, announced that some of his customers in the storm’s path would find that their cars had suddenly developed the ability to drive farther on a single battery charge. Like many modern vehicles, Mr Musk’s products are best thought of as internet-connected computers on wheels.

The cheaper models in Tesla’s line-up have parts of their batteries disabled by the car’s software in order to limit their range. At the tap of a keyboard in Palo Alto, the firm was able to remove those restrictions and give drivers temporary access to the full power of their batteries.

Mr Musk’s computerised cars are just one example of a much broader trend. As computers and connectivity become cheaper, it makes sense to bake them into more and more things that are not, in themselves, computers—from nappies and coffee machines to cows and factory robots—creating an “internet of things”, or IoT.

It is a slow revolution that has been gathering pace for years, as computers have found their way into cars, telephones and televisions. But the transformation is about to go into overdrive.

One forecast is that by 2035 the world will have a trillion connected computers, built into everything from food packaging to bridges and clothes.

Such a world will bring many benefits. Consumers will get convenience, and products that can do things non-computerised versions cannot. Amazon’s Ring smart doorbells, for instance, come equipped with motion sensors and video cameras.

Working together, they can also form what is, in effect, a private CCTV network, allowing the firm to offer its customers a “digital neighbourhood-watch” scheme and pass any interesting video along to the police.

Businesses will get efficiency, as information about the physical world that used to be ephemeral and uncertain becomes concrete and analysable. Smart lighting in buildings saves energy. Computerised machinery can predict its own breakdowns and schedule preventive maintenance.

Connected cows can have their eating habits and vital signs tracked in real time, which means they produce more milk and require less medicine when they fall ill. Such gains are individually small but, compounded again and again across an economy, they are the raw material of growth—potentially a great deal of it.

In the long term, though, the most conspicuous effects of the IoT will be in how the world works. One way to think of it is as the second phase of the internet. This will carry with it the business models that have come to dominate the first phase—all-conquering “platform” monopolies, for instance, or the data-driven approach that critics call “surveillance capitalism”.

Ever more companies will become tech companies; the internet will become all-pervasive. As a result, a series of unresolved arguments about ownership, data, surveillance, competition and security will spill over from the virtual world into the real one.

Start with ownership. As Mr Musk showed, the internet gives firms the ability to stay connected to their products even after they have been sold, transforming them into something closer to services than goods. That has already blurred traditional ideas of ownership. When Microsoft closed its ebook store in July, for instance, its customers lost the ability to read titles they had bought (the firm offered refunds). Some early adopters of “smart home” gadgets have found that they ceased to work after the firms that made them lost interest.

That tilts the balance of power from the customer to the seller. John Deere, an American maker of high-tech tractors, has been embroiled in a row over software restrictions that prevent its customers from repairing their tractors themselves. And since software is not sold but licensed, the firm has even argued that, in some circumstances, a tractor-buyer may not be buying a product at all, instead receiving only a licence to operate it.

Virtual business models will jar in the physical world. Tech firms are generally happy to move fast and break things. But you cannot release the beta version of a fridge. Apple, a smartphone-maker, provides updates for its phones for only five years or so after their release; users of Android smartphones are lucky to get two. But goods such as washing machines or industrial machinery can have lifespans of a decade or more. Firms will need to work out how to support complicated computerised devices long after their original programmers have moved on.

Data will be another flashpoint. For much of the internet the business model is to offer “free” services that are paid for with valuable and intimate user data, collected with consent that is half-informed at best. That is true of the IoT as well. Smart mattresses track sleep. Medical implants observe and modify heartbeats and insulin levels, with varying degrees of transparency.

The insurance industry is experimenting with using data from cars or fitness trackers to adjust customers’ premiums. In the virtual world, arguments about what should be tracked, and who owns the resulting data, can seem airy and theoretical. In the real one, they will feel more urgent.

Then there is competition. Flows of data from IoT gadgets are just as valuable as those gleaned from Facebook posts or a Google search history. The logic of data-driven businesses, which do ever better as they collect and process more information, will replicate the market dynamics that have seen the rise of giant platform companies on the internet. The need for standards, and for IoT devices to talk to each other, will add to the leaders’ advantages—as will consumer fears, some of them justified, over the vulnerability of internet-connected cars, medical implants and other devices to hacking.

Predicting the consequences of any technology is hard—especially one as universal as computing. The advent of the consumer internet, 25 years ago, was met with starry-eyed optimism. These days it is the internet’s defects, from monopoly power to corporate snooping and online radicalisation, that dominate the headlines. The trick with the IoT, as with anything, will be to maximise the benefits while minimising the harms.

That will not be easy. But the people thinking about how to do it have the advantage of having lived through the first internet revolution—which should give them some idea of what to expect.

‘Why Were They Surprised?’ Repo Market Turmoil Tests New York Fed Chief

After years of calm, the financial regulator under chief John Williams must show it can tamp down unexpected turbulence

By Nick Timiraos

The Federal Reserve Bank of New York on Sept. 17, when the short-term ‘repo’ rate spiked as high as 10%. Claudio Papapietro for The Wall Street Journal

John Williams, a Ph.D. economist and Federal Reserve lifer, made his mark inside the central bank with his deep knowledge of interest-rate theory and a solid record as a policy maker and communicator.

When Mr. Williams won a big promotion to Federal Reserve Bank of New York president last year, senior officials didn’t see his lack of financial-markets experience as a liability. He was so new to the markets side of the job that, in his first month in New York, he received an hourlong tutorial on using a Bloomberg data terminal, Wall Street’s ubiquitous trading-desk tool.

Now his market savvy is being put to the test.

After years of calm, the New York Fed is tamping down an unexpected bout of turbulence in money markets that caught officials and investors off guard this month. A sudden shortage of cash caused interest rates to spike unexpectedly on very short-term loans banks make to each other overnight, called repurchase or “repo” agreements.

The Fed’s response, flooding the system with temporary funding, soothed markets. But some economists and financial analysts say the Fed was caught flat-footed and slow to respond to dysfunction that threatened to jam the transmission of central-bank policy decisions to the broader economy.

“There is a serious question about why they didn’t foresee it,” saidNathan Sheets,chief economist at investment-advisory firm PGIM Fixed Income, who previously held senior Fed and Treasury Department posts. “Why were they surprised? What did they miss? And was that a reflection of something not happening at the New York Fed on the desk or elsewhere?”

In an interview, Mr. Williams rejected the idea that the central bank was behind the curve in responding to the market volatility. The New York Fed followed a “consistent approach of assessment, coming up very quickly with an appropriate plan, and executing that,” he said. “This is really the Fed at its best.

The Fed’s approach will be tested Monday, when the third quarter ends and banks may refrain from overnight lending in order to show strong balance sheets. Reduced lending could put pressure on the repo market and create more volatility.

The New York Fed said it plans to keep injecting funds through Oct. 10 and has increased the sizes of these injections in recent days.

Mr. Williams and his colleagues must also solve the mystery behind the money-market dysfunction: Why did banks, seemingly flush with reserves, choose not to lend as rising repo rates created a quick profit opportunity? Officials are studying the role of new regulations and other postcrisis market structure issues. Regardless of the cause, such volatility isn’t good—in stressed conditions, it could force hedge funds and others that rely heavily on short-term loans to dump assets, disrupting markets and impairing the flow of credit to the economy.

The New York Fed, in a castle-like fortress two blocks from Wall Street, serves as the central bank’s nexus between the financial markets and the economy. It provides the U.S. government’s real-time eyes and ears on trillions of dollars that flow through global markets daily. Its staff played critical roles designing rescue programs and monitoring banks when broken credit markets sent the financial system to the brink of collapse between 2007 and 2009.

‘This is really the Fed at its best,’ says New York Fed chief John Williams, here in August, about its response to the money-market volatility. Photo: David Paul Morris/Bloomberg News 

Mr. Williams took the helm in June 2018 after a career as an economist at the Washington-based board of governors and then the San Francisco Fed, where he became president in 2011. His predecessor in New York,William Dudley, had overseen markets operations after serving as chief economist at Goldman Sachs .

Mr. Williams co-wrote seminal research on policy-setting rules and models to estimate a theoretical neutral level of interest that neither spurs nor slows growth, something economists call “r-star.”

A punk and classic-rock music aficionado, he sprinkled speeches with lyrical references to Led Zeppelin and The Clash. When he left San Francisco, staffers presented him with an “R-Star” T-shirt with the gothic lettering of the rock band AC/DC’s logo.
Funding pressure

This month’s trouble bubbled up Monday, Sept. 16. Mr. Williams and Lorie Logan, the executive who is interim manager of the Fed’s portfolio, had traveled to Washington with other senior staffers ahead of the central bank’s two-day rate-setting policy meeting.

Potential for funding pressures in money markets had been building for months due to regulatory changes, rising Treasury bond issuance and steady declines in deposits banks hold at the Fed—known as reserves—the result of the Fed’s 2017 decision to shrink its balance sheet.

The Fed had been surveying banks for months about their demand for reserves but didn’t think they were near this point that would lead to funding pressures.

Officials knew some large payments of corporate taxes and Treasury auction settlements on Sept. 16 would result in a large transfer of cash from banks to the government. But they believed money markets could digest them because similar payment dates in April and June hadn’t roiled markets.

A cash crunch began building that afternoon in repo rates. This year, rates on repurchase agreements usually have been no more than a 10th of a percentage point above the effective fed-funds rate, or around 2.2% in August and early September. They reached 5% on Sept. 16.

Pressure intensified when repo desks began rolling over loans early Tuesday, Sept. 17, with the repo rate rising as high as 10%. Even then banks refused to lend, passing up big profits to hold on to their cash.

The dysfunction led the Fed’s benchmark federal-funds rate to rise to 2.3%—above its 2%-to-2.25% target range—going outside of the target range for the first time since the central bank began setting a range during the 2008 crisis.

From temporary offices at Fed headquarters in Washington, Mr. Williams, Ms. Logan and their team assessed what was roiling markets and what operations were needed to restore liquidity. They decided to inject $75 billion in cash into money markets, the first such move since the crisis.

Traders didn’t hear anything from the Fed until 9:15 that morning, several hours after rates began spiking, minutes before the U.S. stock market opened and an hour before the Fed’s policy meeting would start.

“Market confidence in the New York Fed markets desk is critical, and a series of events here have, let’s say, dinged confidence in the operations,” saidWard McCarthy,chief financial economist at financial-services company JefferiesLLC. “It’s important that the confidence issue be addressed before it becomes a more significant problem.”

Mr. Williams in the interview defended the bank’s response, saying, “We diagnosed it right, and Lorie and her team worked with others to get that done and get it done quickly.”

Some analysts said that the Fed ultimately made the right calls but that the incident showed officials had miscalculated the quantity of reserves needed in the system and how tight funding markets would get as a result.

“The lack of response on Monday was unnerving,” saidMark Cabana,head of short-term interest-rate strategy research at Bank of America Merrill Lynch. “They came in on Tuesday, but they came in too late.”

Mr. Williams’s team was making its moves without key leadership after he ousted two veterans. In late May, Mr. Williams announced the departure ofSimon Potter,head of the markets desk since 2012, andRichard Dzina,head of financial services. They had joined the New York Fed in 1998 and 1991, respectively. People familiar with the matter said the exits had less to do with particular policy disputes than with tension over day-to-day management issues.

The way Mr. Williams executed the abrupt departures rattled upper management and sank staff morale, current and former staffers said. Mr. Potter learned of the decision from Mr. Williams shortly before he was to deliver a keynote address in Hong Kong that had already been announced.

At a going-away party at the New York Fed’s headquarters, Messrs. Potter and Dzina received an extended ovation that kept Mr. Williams waiting offstage to address attendees. “It was maybe three minutes,” said one attendee. “It is hard to describe how awkward the air felt.”

Last month, the New York Fed said Mr. Williams planned to break the top job of overseeing markets into two positions—one to oversee the central bank’s securities portfolio and implement monetary-policy decisions, another to handle market operations, outreach and technology.  

Federal Reserve Bank of New York in Lower Manhattan. Photo: Claudio Papapietro for The Wall Street Journal

Mr. Williams, in the interview, said the leadership vacancies were “in no way interfering with the work we’re doing, and our ability to do our very best.”

Mr. Williams himself had previously roiled markets, unintentionally, in a July 18 public speech on the eve of the central bank’s quiet period before its July policy meeting. He expounded on 20 years of research that called for more aggressive and pre-emptive action to shore up the economy at any sign of weakness.

He had delivered similar comments before. But the context of these remarks—from a top lieutenant to Fed ChairmanJerome Powelljust before the Fed’s first rate cut in a decade—led markets to change their expectations about what the Fed would do. Markets began anticipating the Fed would cut interest rates by a half-percentage-point, instead of a quarter point, at the July 30-31 meeting.

Hours later, the New York Fed issued a rare clarification that markets had misunderstood the speech. Mr. Williams hadn’t meant to send a signal about the size of the coming rate cut.

Mr. Williams and Mr. Powell must now lead their colleagues through a series of decisions, including:

• when to let the Fed’s asset portfolio begin growing again;

• whether to add additional reserves, which would require larger purchases of Treasurys;

• what mix of Treasury securities to add;

• whether to replace the Fed’s benchmark rate with something more widely traded;

• whether to launch a new tool that could alleviate cash crunches without daily ad hoc injections, and how to design it.

“Where the Fed left itself vulnerable,” saidJim Vogel,a rates strategist at fixed-income broker FTN Financial, “was to postpone all of those decisions, and to do it so publicly.”

—Liz Hoffman and Akane Otani contributed to this article.

HK protesters clash with police ahead of national day

Brutal weekend of violence as Beijing prepares for 70th anniversary of communist rule

Nicolle Liu in Hong Kong

Police detain a protestor in Hong Kong, Sunday, Sept. 29, 2019. Riot police fired tear gas Sunday after a large crowd of protesters at a Hong Kong shopping district ignored warnings to disperse in a second straight day of clashes, sparking fears of more violence ahead of China's National Day. (AP Photo/Kin Cheung)
Police made a series of arrests on Sunday, ahead of mass demonstrations to mark the 70th anniversary of communist rule in China on Tuesday. © Kin Cheung/AP

Pro-democracy protesters in Hong Kong clashed with police for the third day running on Sunday as they gear up for what are expected to be mass demonstrations to mark the 70th anniversary of communist rule in China on October 1.

The brutal scenes — in which police at one point fired a warning shot with live ammunition, according to a witness — came as supporters of Hong Kong’s pro-democracy movement rallied in other cities around the world over the weekend, including Sydney, Berlin and London.

Protesters in the Asian financial hub on Sunday threw Molotov cocktails and vandalised government buildings and underground railway stations. Some also burned banners put up to mark the forthcoming national day of the People’s Republic of China. Police responded with tear gas, pepper spray and water cannons.

“Just as Mao Zedong said, when there is suppression, there will be resistance,” said a protester who identified himself only as Ken. He was standing with a group of about 70 people waving the flags of various countries. “We are here to tell the world we have to fight against authoritarian rule.”

The Communist party is planning to mark the 70th anniversary of its regime with its biggest ever military parade to show its citizens and the rest of the world China’s growing military prowess.

Mandatory Credit: Photo by FAZRY ISMAIL/EPA-EFE/Shutterstock (10429552v) An anti-government protester holds a baton during a Global Anti Totalitarianism Rally in Hong Kong, China, 29 September 2019. Hong Kong has entered its fourth month of mass protests, originally triggered by a now suspended extradition bill to mainland China, that have turned into a wider pro-democracy movement. Global anti-totalitarianism march in Hong Kong, China - 29 Sep 2019
Protesters on Sunday hurled bricks at government buildings and vandalised stations of the city’s underground railway operator. © FAZRY ISMAIL/EPA-EFE/Shutterstock

But even as the power of China’s President Xi Jinping reaches its zenith, the Hong Kong protests are emerging as the biggest pro-democracy rebellion on Chinese soil since the 1989 Tiananmen Square demonstrations.

The protests started as opposition to an extradition bill that would have allowed suspects to be sent to China for trial but have grown to include demands for universal suffrage for the city.

Carrie Lam, Hong Kong’s chief executive, who will lead an elite government delegation from the territory to join in the national day celebrations in Beijing, has withdrawn the bill and tried to start a dialogue with pro-democracy activists. But this has failed to satisfy protesters.

“We are not afraid of being arrested,” said a protester on Sunday, who was preparing petrol bombs with a group on a flyover next to Hong Kong’s central government office complex.

The violence on Sunday followed fierce clashes a day earlier, when protesters gathered to mark the fifth anniversary of the territory’s last major pro-democracy campaign, the so-called Umbrella Movement.

“We’re here tonight because we regret not standing up earlier and because we want the world to know we won’t give up on Hong Kong, our home,” said Andy, 25, an accountant who attended the Saturday protests.

Mandatory Credit: Photo by FAZRY ISMAIL/EPA-EFE/Shutterstock (10428835k) A general view shows anti-government protesters take part in a flash mob commemorating the 5th anniversary of the 'Umbrella Revolution' in Hong Kong, China, 28 September 2019. In 2014 the series and sit-ins and protests, nicknamed the Umbrella Revolution or Umbrella Movement, began after China's Standing Committee of the National People's Congress issued a decision regarding proposed reforms to the Hong Kong electoral system. Hong Kong has entered its fourth month of mass protests, originally triggered by a now suspended extradition bill to mainland China that have turned into a wider pro-democracy movement. Protests in Hong Kong, China - 06 Feb 2019
Anti-government protesters take part in a flash mob commemorating the 5th anniversary of the 'Umbrella Revolution' in Hong Kong © FAZRY ISMAIL/EPA-EFE/Shutterstock

China has desisted so far from overt military intervention in Hong Kong. Nevertheless, some protesters had a sense of foreboding.

“Hong Kong and mainland China are like two parallel worlds, so different,” said Geoff Wong, a social worker, at Saturday’s protest. “But China cannot allow this to continue and they are already increasing their control over Hong Kong.”

A fireworks display organised for the 70th anniversary has already been cancelled, with the Hong Kong government citing public safety concerns.

Additional reporting by Ravi Mattu, Sue-Lin Wong and George Hammond in Hong Kong

Blockchain: disillusionment descends on financial services

Too many projects started with the technology rather than the solution

Jemima Kelly

The blockchain concept in database management. Financial, data.
The financial services sector has been ploughing $1.7bn a year into the technology © Elnur/Dreamstime

Blockchain was going to make banks irrelevant and allow the world to “be [its] own bank”.

Then, it was going to help those very same banks save tens of billions of dollars a year in infrastructure costs, transform the way they process transactions, and create new revenue streams. Some even claimed it would be bigger than the internet.

But despite a great deal of excitement — and an even greater number of press releases — the technology has not lived up to its promise and there are signs the hype is fading.

Blockchain is the technology that underpins cryptocurrencies like bitcoin. It is, in effect, a database system that records and processes transactions via a distributed network of computers, with no need for a centralised entity to verify them.

At various points since its inception more than a decade ago, enthusiasts have claimed that blockchain could replace central banks, wipe out post-trade intermediaries like clearing houses, and become the backbone of cross-border payments. (And that is just in banking — outside the financial sector the claims become even more grandiose, with the technology purportedly having potential to cure cancer and bring about world peace.)

The financial services sector has ploughed huge amounts of money into blockchain, totalling some $1.7bn a year, according to research firm Greenwich Associates. And yet, so far, beyond the wild and volatile world of cryptocurrencies, blockchain has had little to no discernible impact.

Germany’s Bundesbank spent two years working with Deutsche Börse building prototypes for blockchain-based securities settlement. Yet earlier this year, the president of the central bank Jens Weidmann said “a real breakthrough in application is missing so far”.

Outside of blockchain, the broader world of fintech has started to have a real impact on the financial sector, forcing banks and other firms to bring their technology — and their user experience, in particular — into the twenty-first century.

One of blockchain’s biggest problems is that it was approached badly. Rather than beginning with the challenges banks were trying to solve and then seeing whether blockchain could be applied to them, too many projects started with the technology, tried to discern how to make money from it, and worked from there.

“Blockchain’s failed promises could be a mandatory class in business school for how not to build a sustainable organisation,” says Tim Swanson, head of market intelligence at blockchain company Clearmatics. He adds that, in most cases, entrepreneurs have just recast the same market, but with their technology the centre.

Now, a degree of disillusionment has set in. A couple of years ago, when cryptocurrencies were booming, blockchain panels at fintech summits and other financial conferences were packed to the rafters, but these days they attract smaller crowds.

“The hype of the last few years, followed by the disappointment that many people are feeling now, is evidence that you need to understand the problems that need to be solved and then look for an answer, rather than throwing a technology at business problems before you’ve understood them,” says Martin Walker, director for banking and finance at the Center for Evidence-Based Management.

Now, what Mr Walker calls “blockchain fatigue” has also chipped away at the PR value that the word once bestowed on any company that attached itself to the technology.

Digital Asset Holdings, for example, was once considered a leading player — with its former chief executive Blythe Masters seen as a flag-bearer for the technology. It had planned to transform the world of securities settlement, but has since pivoted away from blockchain. Instead, it is focusing on “smart contracts”, a kind of computer programming function that does not require blockchain to work.
NEW YORK, NY - OCTOBER 25: Digital Asset CEO Blythe Masters speaks onstage at Yahoo Finance All Markets Summit on October 25, 2017 in New York City. (Photo by Cindy Ord/Getty Images for Yahoo)
Blythe Masters, former chief executive of Digital Asset Holdings © 2017 Getty Images

Digital Asset Holdings now talks about “distributed ledger technology”, or DLT, rather than blockchain. The terms are often used interchangeably, but Colin Platt, an independent cryptocurrency and DLT consultant who previously worked on blockchain projects at French banking group BNP Paribas, says there is a key difference: in a blockchain, everyone on the network can see all the transactions, whereas with DLT that is not necessarily the case.
 For Mr Platt, while there is not much use for blockchain in the world of finance — even a so-called “permissioned blockchain”, where the number or parties who are allowed on to the network is limited — there could be some uses for DLT, such as for interest rate swaps and other derivatives, because they do not have one obvious trading centre. But, he adds, these new tools will not come quickly and are unlikely to be earth-shattering.

“I don’t believe that I’ve ever seen a case where a blockchain — that shares everything with everyone — in a permissioned sense was justified,” he says. “But I’d argue [that] for the things that may need a DLT, we haven’t given it enough time.”

For now, DLT has yet to prove itself and blockchain’s graduation into the mainstream remains a pipe dream. Even if you could use blockchain to run some banking processes, there is usually a better, quicker, cheaper and more efficient way to do so.

“It’s not so much what’s wrong with the technology, it’s just that the tool has to fit the problem,” Mr Walker says.

 “Would you try to open a can of beans with a sledge hammer, or a machine gun? You could do it, but would you want to?”

The Coming Crisis of China’s One-Party Regime

In 2012, Chinese President Xi Jinping promised that the Communist Party would deliver great successes in advance of two upcoming centennials, in 2021 and 2049. But no amount of nationalist posturing can change the fact that the fall of the CPC appears closer than at any time since the end of the Mao era.

Minxin Pei

pei54_Feng LiGetty Images_china ccp

CLAREMONT – On October 1, to mark the 70th anniversary of the People’s Republic, Chinese President Xi Jinping will deliver a speech that unreservedly celebrates the Communist Party of China’s record since 1949. But, despite Xi’s apparent confidence and optimism, the CPC’s rank and file are increasingly concerned about the regime’s future prospects – with good reason.

In 2012, when Xi took the reins of the CPC, he promised that the Party would strive to deliver great successes in advance of two upcoming centennials, marking the founding of the CPC in 1921 and the People’s Republic. But a persistent economic slowdown and rising tensions with the United States will likely sour the CPC’s mood during the 2021 celebrations. And the one-party regime may not even survive until 2049.

While there is technically no time limit on dictatorship, the CPC is approaching the longevity frontier for one-party regimes. Mexico’s Institutional Revolutionary Party retained power for 71 years (1929-2000); the Communist Party of the Soviet Union ruled for 74 years (1917-1991); and Taiwan’s Kuomintang held on for 73 years (from 1927 to 1949 on the mainland and from 1949 to 2000 in Taiwan). The North Korean regime, a Stalinist family dynasty that has ruled for 71 years, is China’s only contemporary competition.

But historical patterns are not the only reason the CPC has to be worried. The conditions that enabled the regime to recover from the self-inflicted disasters of Maoism and to prosper over the last four decades have largely been replaced by a less favorable – and in some senses more hostile – environment.

The greatest threat to the Party’s long-term survival lies in the unfolding cold war with the US.

During most of the post-Mao era, China’s leaders kept a low profile on the international stage, painstakingly avoiding conflict while building strength at home. But by 2010, China had become an economic powerhouse, pursuing an increasingly muscular foreign policy. This drew the ire of the US, which began gradually to shift from a policy of engagement toward the confrontational approach evident today.

With its superior military capabilities, technology, economic efficiency, and alliance networks (which remain robust, despite President Donald Trump’s destructive leadership), the US is far more likely to prevail in the Sino-American cold war than China. Though an American victory could be Pyrrhic, it would more than likely seal the CPC’s fate.

The CPC also faces strong economic headwinds. The so-called Chinese miracle was fueled by a large and youthful labor force, rapid urbanization, large-scale infrastructure investment, market liberalization, and globalization – all factors that have either diminished or disappeared.1

Radical reforms – in particular, the privatization of inefficient state-owned enterprises (SOEs) and the end of neo-mercantilist trading practices – could sustain growth. But, despite paying lip service to further market reforms, the CPC has been reluctant to implement them, instead clinging to policies that favor SOEs at the expense of private entrepreneurs. Because the state-owned sector forms the economic foundation of one-party rule, the prospect that CPC leaders will suddenly embrace radical economic reform is dim.

Domestic political trends are similarly worrying. Under Xi, the CPC has abandoned the pragmatism, ideological flexibility, and collective leadership that served it so well in the past.

With the Party’s neo-Maoist turn – including strict ideological conformity, rigid organizational discipline, and fear-based strongman rule – the risks of catastrophic policy mistakes are rising.

To be sure, the CPC will not go down without a fight. As its grip on power weakens, it will probably attempt to stoke nationalism among its supporters, while intensifying repression of its opponents.

But this strategy cannot save China’s one-party regime. While nationalism may boost support for the CPC in the short term, its energy will eventually dissipate, especially if the Party fails to deliver continued improvement in living standards. And a regime that is dependent on coercion and violence will pay dearly in the form of depressed economic activity, rising popular resistance, escalating security costs, and international isolation.

This is hardly the uplifting picture Xi will present to the Chinese people on October 1. But no amount of nationalist posturing can change the fact that the unraveling of the CPC’s rule appears closer than at any time since the end of the Mao era.

Minxin Pei is a professor of government at Claremont McKenna College and a non-resident senior fellow at the German Marshall Fund of the United States.

The Recession Approaches: Fed Or No Fed, Deal Or No Deal

by: Victor Dergunov


- The S&P 500 is approaching new all-time highs, while the economic atmosphere is extremely murky right now.

- The Fed may not be as accommodative as many market participants perceive going forward.

- Many key forward-looking economic readings are worsening.

- There are numerous red flags that suggest a recession in the U.S. is approaching.

Fed or no Fed, deal or no deal, a recession in the U.S. may occur within the next 6-12 months.
Bear Market Source: CNBC.com

The Recession Approaches: Fed or No Fed, Deal or No Deal
The S&P 500 (SP500)/SPX and U.S. stocks in general are at a crucial inflection point once again.
Despite a great deal of uncertainty surrounding markets today, the S&P 500 is approaching new all-time highs once again.
S&P 500 Image Source: StockCharts.com
However, despite the rise in equity prices there are still a lot of unknowns. Most notably, it's not clear just how accommodative the Fed will be with regard to supporting markets, and there's still plenty of uncertainty regarding the U.S./China trade deal.
Moreover, clear red flags are continuing to materialize surrounding the overall health and growth prospects of the U.S. economy. Some of the recent economic data is coming in much worse than expected and is highly suggestive of a potential substantial slowdown in the U.S.
Sector and individual stock forward P/E ratios appear too optimistic in many sectors.
Furthermore, we continue to see relatively bearish sector rotation and inverting yields, which are typically precursors to a recession.

Based on these factors and other economic elements, this is likely a very good time to be very cautious. I also believe that this is a time to actively manage and rebalance portfolios, reduce positions in riskier assets, raise cash positions, and move capital into investment vehicles that are likely to benefit from the upcoming economic environment.
Is the Market Expecting Too Much from The Fed?
Let’s face it, the Fed plays a dominant role in the direction of the SPX, stocks in general, bond rates, gold, silver, as well as many other assets and trading instruments. Late last year the S&P 500 had a correction of roughly 20% primarily because the Fed was on a tightening path and the economy began to show clear signs of a slowdown. In other words, the U.S. economy was no longer able to sustain growth under “normalizing” interest rate conditions.
Image Source: St Louis Fed
We can clearly see that in every subsequent economic cycle the Fed needs to bring rates down lower and hold them lower for longer for the economy to expand. Moreover, in each following cycle the Fed can only “normalize” rates lower and lower before the economy begins to stall. This is due to the enormous amount of debt in the system that simply becomes unsustainable to service when rates rise past a certain point.
You can read about “America’s Impending Debt Crisis” in much more deal in my article here.
Moreover, the Fed funds rate chart shows us a clear correlation between the end of an interest rate hike cycle and the start of a new recession. We can see the funds rate top out in 1989, prior to the 90s recession, a top in 2000, before the 2001 recession, a top in 2007, before the 2008 recession, and we are seeing a top now, probably before a recession that may occur in 2020.

I also want to mention that the Fed has been behind the curve on monetary policy before, and I would not be surprised if the Fed is behind the curve already this time around as well.
After all, who can forget this gem of a quote from the then Fed Chair Ben Bernanke in July of 2007?
July 2007 
BERNANKE: The pace of home sales seems likely to remain sluggish for a time, partly as a result of some tightening in lending standards, and the recent increase in mortgage interest rates. Sales should ultimately be supported by growth in income and employment, as well as by mortgage rates that, despite the recent increase, remain fairly low relative to historical norms. However, even if demand stabilizes as we expect, the pace of construction will probably fall somewhat further, as builders work down the stocks of unsold new homes. Thus, declines in residential construction will likely continue to weigh on economic growth in coming quarters, although the magnitude of the drag on growth should diminish over time. The global economy continues to be strong, supported by solid economic growth abroad. U.S. exports should expand further in coming quarters. Overall, the U.S. economy seems likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy's underlying trend.
Source: Mises.org
Now, I am not saying that we are about to have another housing melt-down, or a 50% stock market crash in the next year, but I can’t help but wonder if the Fed is behind the curve once again.
The Fed is Not About to Bring Out the “Bazooka”
Right now, market expectations are that the Fed is going to lower rates by another 25 basis points on Sept. 18 (91% probability). Will this be enough to keep the economy from contracting further? I have my doubts. Moreover, there's about a 9% chance that the Fed will keep rates as they are today. This would likely be disastrous for equity markets in the short term.

Source: CMEGroup.com
Interestingly, for the most part, the market expects that the funds rate will be between 1-1.75% around six months from now. This is essentially only 25 to 125 basis points lower than where we are today. Will this be enough to revive the U.S. economy? I'm not so sure, as I believe QE is needed to keep this bull market going to prevent the U.S. from falling into a recession.
However, I do not believe that plans for QE will be announced on Sept. 18, which may impact equity prices negatively, in my view.
Some of you might be saying “but the economy appears relatively strong, and the Fed may not need to bring rates down to zero and introduce more QE any time soon.” Well, let’s look at some recent economic indicators and try to put them into context with historical standards.
Red Flags in Recent Economic Data
Concerning the U.S., we saw manufacturing PMI dip below 50, to 49.9 in August. This reading came in worse that the expected 50.5, and lower than July’s 50.4 figure. ISM manufacturing PMI came in at 49.1, vs. the expected 51.1 and prior month’s 51.2 reading. Construction PMI came in at just 45, worse than the expected 45.9 figure. Also, core durable goods orders declined by 0.4% rather than the expected 0.1% rise. These indicators show that the manufacturing base in the U.S. is now officially in contraction mode and the trend is likely to continue.
Perhaps even more troubling, services PMI came in at just 50.9 for August, much worse than the expected 52.9 reading and last month’s 53 figure. This suggests that the services sector in the U.S. is likely about to enter into contraction mode as well.
Other leading indicators like new homes sales came in at just 635K for July, lower than the anticipated 649K figure and much worse than June’s 728K reading. Month-over-month new home sales fell off a cliff in July, down by 12.8%, rather than the expected 0.2% drop. Pending home sales MoM declined by 2.5%, rather than an expected rise of 0.1%.
Now here's where things really start to look troubling - consumer data. Michigan consumer expectations came in at just 79.9 in August, vs. the expected 82.3 figure, and much lower than the prior month’s 82.3 reading. Michigan consumer sentiment fell to just 89.8, vs. the expected and prior month’s 92.1 readings. By the way, this is the lowest reading since 2016. Also, this is not a one month phenomenon, this appears to be a trend now, as the prior month’s consumer sentiment that came in at 92.1 was expected to be 97.2.
A similar phenomenon can be seen with the consumer confidence index CCI that's typically seen as a precursor to recessions. In early 2018 we saw the CCI top out at around 101, and the index recently dipped below 100.5. Additionally, we see what appears to be a head and shoulders pattern developing in the index’s chart.
Image Source: OECD.com

Perhaps more importantly, we can see that just about every major top in the CCI preceded a recession. We see a top in the late 80s, prior to the 1990 recession, we see a top around 2000, prior to the 2001 recession, then another top in 2007, prior to the 2008 recession, and we see what appears to be a top in 2018, possibly prior to the upcoming 2020 recession.
The consumer may be topping out here, and higher prices on goods manufactured in China due to trade tariffs, higher inflation, enormous debt loads, and other detrimental factors are likely to continue to put additional pressure on the U.S. consumer. As the U.S. economy/GDP is roughly 70% consumer based, a decline in consumer sentiment, confidence, and ultimately spending could push the U.S. economy into a recession relatively soon (6-12 months), from now.
Consumer debt in the U.S., (excluding mortgages) is now at an all-time high, over $4 trillion, which appears to be a ticking time bomb. Moreover, while lower interest rates proposed by the Fed may “kick the can down the road” the explosion at the end of this road may be a lot worse than many market participants anticipate, and there may not be that much road ahead.

Let’s Talk About Employment for a Minute
There has been much debate about the recent non-farm payrolls report. Some say that it's not so bad, some say the economy and the employment portion of the economy are doing just fine.
However, the bottom line is that only 130,000 new jobs were created in August vs. an expected 150,000. That’s more than a 13% miss. By the way, did you know that this year’s monthly job gains are at 158,000, sharply down from last year’s 223K figure?
Also, I want to draw your attention to two factors. One is that a lot of the jobs “created” were part time, or secondary jobs, and that 34K of the 130K jobs that were created were government jobs.
Therefore, the private sector created only 96K jobs, the lowest number since February. Also, who's going to pay for all these new government jobs? Yes, you guessed it, the U.S. taxpayer, the consumer. To put it lightly, the jobs trend is not looking nearly as good as it's being advertised on TV.
I also want to draw your attention to the “multi-decade” low unemployment rate. Firstly, the way unemployment data is calculated now is not like it was calculated in the 1950s, 60s and decades ago.
The real unemployment rate is significantly higher than the advertised 3.7%. The U-6 as it is referred to is the unemployment rate that counts people who haven’t looked for work over the past four weeks and other discouraged “workers” was at roughly 7% in July.
But let’s get back to the “official” 3.7% unemployment rate and see how it correlates with prior recessions. It seems that there's an irrefutable correlation with “rock bottom” unemployment rates occurring directly prior to recessions in the U.S.
Let’s look at some charts:
Once again, if we look at recent history, we see that the unemployment rate bottomed in the late 80s, prior to the 1990 recession, then again it bottomed around 2000, prior to the 2001 recession, then again around 2007, prior to the 2008 recession, and it appears to be bottoming right now, which will probably lead to a recession sometime in 2020.
This trend is quite solid and goes back further than the 1980s - just look at this chart here:
Source: Fred.com
Yes, every time the unemployment rate bottomed going back prior to the 1950s a recession followed.
This chart is a bit delayed so the current rate is around where it was in the late 1960s, prior to the recession of the early 1970s.
So, is the Fed Politicized or Not?
I found it almost bizarre what the former New York Fed President Bill Dudley had to say several weeks ago. Dudley essentially urged his former colleagues at the Fed not to “help” President Trump resolve the trade dispute with China. Moreover, Dudley even went as far as to suggest that the Fed try to influence the 2020 election by not cutting rates any further, never mind talk of any QE. Such “Fed policy” would likely help trigger a bear market in equities coupled with a recession in the U.S. just in time for the 2020 Presidential election.

Whether Jerome Powell and other leading members of the Fed knew about the statement ahead of time, or were somehow connected to it remains a mystery. However, Dudley’s statements leave little doubt in my mind that the Fed is as apolitical as it claims to be.

After all, it's not a secret that President Trump has been rather critical of his Fed Chair appointee, and likely wishes he was back in his apprentice chair when it comes to the matter. President Trump can fire just about anyone he pleases in his administration, but he cannot fire the Fed Chair (as the Fed is an independent agency), at least not without due cause, which would likely be very difficult to prove, if not impossible.

Therefore, the market may be too optimistic about what the Fed is prepared to do in the future to support equity markets, and “engineered recession” in 2020 is not out of the question, in my view.

Other Red Flags To Pay Attention To

Bearish Sector Rotation
We continue to see mostly bearish sector rotation - investors piling into “defensive sectors” like utilities, real estate, consumer staples, and some healthcare. For instance, utilities are up by around 18% over the past year and are trading near all-time highs today.
Source: CNBC.com
The problem here is that so much capital has been rotated into this sector is that utilities are now trading at 25.25 times this year’s earnings estimates, which is about double at what this low growth sector typically trades at under “normal market conditions.”
A similar phenomenon can be witnessed in real estate, as this defensive sector is up by about 19% over the past year. This sector also is dramatically overbought as it's trading at 31.27 times last year’s GAAP earnings.
Consumer Staples are up by around 12% over the past year, and are trading at a remarkably high 30.28 times this year’s earnings estimates.
Now let’s look at some more economically sensitive cyclical sectors:
Energy is down by about 18.5% over the past year.
However, it’s trading at around 12.6 times this year’s earnings estimates.
The problem here is that if the global economy continues to slow, oil will likely go lower and so would energy shares.
Nevertheless, for the time being, I believe this sector is deeply oversold and some good companies can have substantial short-term rebounds from current levels.
Financials, another cyclical sector is down slightly for the year, but is trading at just 11 times this year’s earnings estimates. This segment looks relatively attractive compared to most others. However, once you factor in lower interest rates, and the potential for future loan write-offs, this segment too can become a lot “cheaper.”

Healthcare, a relatively defensive segment, is essentially flat for the year, there are some cheap quality names we own in this segment.
Industrials also are essentially flat for the year, but at almost 26 times this year’s earnings estimates seem quite expensive right now.

Materials are down by roughly 4% over the past year and are trading at around 21.5 this year’s earnings estimates. This is not cheap, and this being a very cyclical sector, makes me want to stay away from most names in this segment.

Technology is up by about 8% over the past year, but with the trade war, no earnings growth and trading at 27.5 times this year’s estimates also looks relatively unattractive here.

Consumer discretionary sector is up slightly over the past year, but is trading at nearly 26 times this year’s earnings estimates. This appears expensive considering the “trouble” the U.S. consumer may bump into in the near future.


I also want to draw your attention to the fact that per last year’s GAAP earnings the consumer discretionary segment is trading at a P/E ratio of 25.66. This is lower than the 25.74 this year’s earnings estimate. So, earnings are essentially contracting this year relative to last year’s.
We can see this same phenomenon occurring in other sectors like consumer staples (2018 actual P/E 26.86, this year’s estimate 30.28), in industrials, and in materials. Other sectors are expected to show very little or essentially no earnings growth relative to last year.
The Takeaway
Defensive sectors are clearly outperforming, but are trading at high P/E ratios and are expected to show contractions in earnings or very little growth this year.
Most cyclical sectors are trading at relatively high P/E ratios and are expected to show contractions or very little earnings growth this year.
The only two relatively cheap sectors, energy and financials appear somewhat attractive but if the global slowdown continues, and/or rates continue to decline and loan defaults rise stocks in these sectors should decline as well.
Furthermore, if we look at overall corporate profits this year, Q1 2019 corporate profits came in at $1.79 trillion , a 2.87% decline from last year. While 2019 Q2 profits rose slightly over last year’s Q2 profits, if we combine both quarters, corporate America delivered roughly $3.67 trillion in profits in H1 2018, vs roughly $3.67 in H1 2019, essentially showing no growth in corporate profits thus far year-over-year.

This suggests that corporate profit growth in the U.S. may be topping, and further trade tensions, lower consumer confidence/sentiment, and spending, as well as a continued economic slowdown around the globe may lead the U.S. to a corporate recession relatively soon.

Small Cap Underperformance
Typically, in a healthy economic environment small-cap stocks (Russell 2000) are supposed to lead the market. The opposite is happening right now. In fact, while the SPX is up by about 3.4% over the last year, the Russell 2000 average is down by around 12%.
Russell 2000 ETF (IWM) 1 Year Chart
SPX 1-Year Chart
This implies that market participants have little faith in the growth of the U.S. economy as most small-cap stocks derive most of their revenues and income from the U.S.’s domestic market.
Rate Inversion: A Clear Red Flag

Inverting yields, another typical precursor to a recession, has been sending out troubling signals for a while now. Despite the recent rebound in longer-term Treasuries, we see that the three-month is currently yielding 1.965%, higher than the 1-year, 2-year, 5-year, and even 10-year Treasury. We also, see the 1 and 2-year yielding more than the five-year and the one-year is yielding more than the 10-year. In other words, rates are all over the place, not where they should be in a healthy economic environment.
This shows us that demand for longer term rates is increasing, as market participants expect the Fed will lower rates going forward, possibly down to zero, and quite possibly go negative, like in Europe and in Japan.

Interestingly, if we look at a chart of key rates, we see that inversions typically occur right before recessions and bear markets in equities take place. Once again, we can see rates invert prior to the 1990 bear market, the 2000 meltdown, the crash of 2008, and we are seeing a similar phenomenon transpire right now.
Chart Data by YCharts
China Trade Deal is Far from Certain
President Trump recently acknowledged that "China Policies May Mean Economic Pain" for the U.S.
Furthermore, President Trump essentially capitulated when he moved the deadline on Chinese tariffs.
He feels the pressure from a slowing economy and made a strategic move to delay the tariff deadline to Dec. 15.
In my view, it’s clear the Chinese have the upper hand here. They have a dictator for life that does not need to worry about elections, the government has complete control over the country’s central bank and its policies, and China has an economy that's expanding at over 6%.
Unfortunately, we don’t have any of that. We have President Trump who has a reelection campaign next year, has no control over the Fed, and the U.S. economy will be lucky if it can sustain positive GDP growth this year and in 2020.
Also, President Trump is not the easiest of Presidents for the Chinese to deal with. President Trump wants to equalize the playing field and make China/U.S. trade fairer and more beneficial for the U.S.
The problem is that this is not beneficial for China and time is on China’s side. Furthermore, the best strategy for the Chinese is likely to stall, wait until the outcome of the U.S. election, and see if they can negotiate with a “softer," more accommodative Democratic President.
Therefore, a comprehensive U.S/China trade deal is far from certain (not likely even in my view), and may not even happen at all until after the 2020 election. This will likely put further pressure on the U.S. consumer, U.S. corporate profits, and will likely help tilt the U.S. economy into a recession just in time for the 2020 Presidential election.
The Bottom Line
There are a lot of moving parts right now, and this is not an easy market to navigate. A lot is riding on the Fed and what it will do to support equity markets and the overall economy. The bottom line is that market participants may be expecting too much from the Fed and the Federal Reserve may not do all that much as Mr. Dudley suggested.
Furthermore, we are seeing continued weakness in key economic data, corporate profits are essentially flat YoY (H1 2018 vs H1 2019), we are seeing bearish sector rotation, P/E ratios are relatively high, and most sectors are seeing flat or declining YoY earnings growth. Small cap underperformance is troubling, the China/U.S. trade deal is far from certain, and may even be and unlikely occurrence before the 2020 election.
Additionally, we are seeing an alarming number of red flags, which are typically precursors to a recession. Inverting yields, rock bottom unemployment, worsening consumer sentiment/confidence data, contractions in manufacturing, worsening housing, and other leading economic data, etc.

In my view, the Fed is behind the curve and may not be as accommodative as market participants expect it to be going forward. Furthermore, the U.S. economy appears to be weaker than many market participants perceive. Therefore, Fed or no Fed, deal or no deal, the recession is approaching, and it's likely to arrive within the next 6-12 months, 18 at the most by my calculations.
Is it Possible That the SPX and Stocks in General Move Higher From Here?
Yes, it's possible, but once again the Fed holds the key. If the Fed cuts by at least 25 basis points on Sept. 18, comes out with a dovish statement, hinting at further rate cuts and future rounds of QE, the SPX could run up to the 3,100-3,500 level over the next 6-12 months. This is possible, but not probable in my view.
Furthermore, even if the Fed decides to be ultra accommodative and we see SPX hit new all-time highs, the Fed is not likely to delay the inevitable recession for much longer. It's possible to prolong this bull run, but eventually the Fed-induced bubble will burst and a grizzly bear market will likely cut most stocks in half, in my humble opinion.