How the Fed Could Kill the 'Melt Up'

A reason for concern from an 'eternal optimist'... The economy is heating up... What the media is missing... How the Fed could kill the 'Melt Up'... Following the clues to their likely conclusion... What to watch next...

I (C. Scott Garliss) may be the biggest stock market and economic optimist at Stansberry Research...

I've called for an economic rebound since March 2020. And boy, are we getting it...

You can take your pick of the data today... We've shared a lot of relevant indicators in the Stansberry NewsWire lately. (As a reminder, you can follow me and my team over there for free every day for the latest on what news is moving the markets.)

For one, on the back of quickening COVID-19 vaccine distribution, retail sales numbers in the U.S. – a good indicator of spending – rose 9.8% in March, compared with February's 2.9% decline.

For another example, nonfarm payrolls (a measure of the number of workers in the U.S., minus farm workers and a handful of other jobs) increased by 916,000 in March... That's well above the average loss of 560,000 over the past 12 months.

And another... first-quarter gross domestic product ("GDP") in 2021 gained 6.4% versus the 4.3% gain we saw in the fourth quarter of 2020. And jobless claims hit a COVID-19 pandemic low of 498,000 earlier this morning.

All of these data points confirm economic activity is heating up...

But here's the important thing when it comes to what this all means for the stock market...

The stock market looks ahead while economic data show what happened in the past.

So, even I – the eternal optimist – recognize that a strongly rebounding economy means that some of the easiest gains in the equity market are behind us... the U.S. Federal Reserve's easy-money policies are moving closer to winding down... and a round of profit-taking may lie ahead.

And when all that happens, the "Melt Up" – as our colleague and True Wealth editor Dr. Steve Sjuggerud describes today's market environment, one propped up by previously unimaginable government support – may finally end.

You see, many of the Fed's current policies – such as zero interest rates and $120 billion of monthly asset purchases – were put in place at the start of the pandemic last year.

Back then, the economy looked like it was falling apart... Pretty much every asset class was selling off as people panicked.

But now, indicators tell us the picture is rapidly changing in the other direction.

A strong economy is what we want, of course...

It means companies are making more money, job growth is on the rise, and people are spending more.

The stronger that economic cycle is, the less help it needs from the central bank or the federal government. This is, of course, at the heart of what fuels the incredible asset prices that are part of Steve's Melt Up thesis.

And that's why we need to be paying attention to the cues on when the economic support will be removed.

Now, we're not the only people aware of this concept. But I think many folks are missing some important indicators right now...

Last week, most of the media reports about the Fed's latest meeting focused on how policy wasn't changing...

Bloomberg, the Wall Street Journal, and all of the other big media outlets seemed to have the takeaway that the Fed is simply going to keep pumping support into the economy.

The main reason I believe that happened is because Fed Chair Jerome Powell came out of the gates in his regular post-meeting press conference with an angry bent, saying that the Fed wasn't talking about making moves to tighten its policy.

But anyone who was listening more closely past his first few answers, like me – or anyone who knew how to read between the lines – would have heard clues that things could be changing sooner than you might think...

Powell actually talked about when the Fed will start tapering asset purchases (I'll explain what this means in a second), along with describing unexpected economic resilience, and his outlook on inflation moving forward...

In other words, what I heard for the first time is that the Federal Open Market Committee ("FOMC") – which makes key decisions about interest rates and the U.S. money supply – will slow its stimulus spending if the economy continues to heat up.

These are not insignificant breadcrumbs, if you will, leading to what will ultimately be decisions the Fed will make. Here's what we mean...

We learned the first thing the Fed will likely do is 'taper' asset purchases...

This would also be known as reducing its balance sheet expansion.

You see, the Fed is strongly committed to achieving its Congressionally mandated goals of "maximum employment" and "price stability."

And the two biggest tools it has to use today are managing interest rates (the benchmark federal funds rate is near zero today) and growing the size of its own balance sheet to help push liquidity throughout the financial system...

It has been doing the latter by purchasing billions of dollars' worth of assets each month. That is primarily what Powell has meant over the past year when he has publicly said the central bank will do all it can to support the economy.

The Fed's current asset-purchasing program includes $120 billion worth of monthly purchases. The breakdown is $80 billion in U.S. Treasurys and $40 billion in mortgage-backed securities.

You see, bonds and interest rates have an inverse relationship. When bond prices rise, the rate of yield falls. And when bond prices fall, the rate of yield goes up.

The idea is that by buying up these bonds on a continual basis, the central bank is managing interest rates without having to adjust its headline federal funds rate.

But without these purchases, rates could be significantly higher.

Since pandemic measures were put in place, the central bank's balance sheet has risen from roughly $4.2 trillion to nearly $7.8 trillion. That jump has taken roughly 14 months...

This is big stuff...

That's why when reporters at the press conference asked Powell whether it was time for the FOMC to begin discussing tapering asset purchases, at first the Fed chair shut them down completely... and then hedged.

Yes, the data show economic activity is strengthening, he said... And yes, COVID-19 vaccine distribution is facilitating a move back toward normal. (At the end of 2020, only 3 million shots had been administered. As of yesterday, roughly 32% of Americans are fully vaccinated, and 45% have received at least their first dose.)

But Powell said the future of the pandemic is still not yet determined and that until then, policy will remain unchanged. He said the Fed remains focused on the economic outcomes, not projections. And that the FOMC needs to have more clarity on the rate of COVID-19 infections.

Until individuals can safely reengage in normal daily activities once more, the economy can't fully recover, and the Fed won't change course on policy.

But then, as I mentioned earlier, during his press conference, Powell acknowledged the potential for tapering...

This is what the media missed...

Powell said the Fed would like to see more employment gains like the million jobs it saw in March.

He's hopeful there will be a string of several months similar to that. And if this were to happen, it would put the central bank closer to achieving its goals.

At that point in time, the FOMC would start the discussion about pulling back its easy-money policy.

Reading the tea leaves, using a simple process of elimination, and looking at history... that means first reducing asset purchases rather than hiking interest rates – a move that the central bank has typically made to fight inflation, or "cool" the economy.

About inflation...

Regular Digest readers know we've spilled a lot of ink here about the inflation discussion – and for good reason.

At the same time, Powell indicated last week that fears of inflation forcing the Fed to raise interest rates and choke off growth may be overhyped by many market observers. (We can agree or disagree, but the point here is what the Fed thinks and will do.)

The central bank anticipates that in the near term, the base effects of our sudden economic rebound will cause a roughly 1% spike in inflation readings... but that those effects will ease in a few months.

Similarly, it said supply-chain bottlenecks in the nation's ports and transportation hubs – which are impacting prices – will be temporary, as well.

Powell doesn't expect he'll need to counter any inflation pressures, meaning raising rates. But again, he said the Fed is prepared to take appropriate measures to preserve economic growth and stability.

So if necessary, it will try to anchor inflation around 2%, its target rate. That way, things won't get out of control. But again, odds are that raising rates would come after reducing balance-sheet expansion.

As of now, the central bank governors don't anticipate a rate hike before the start of 2024...

That doesn't mean that these projections won't change... (U.S. Treasury Secretary and former Fed Chair Janet Yellen just said on Tuesday that higher rates might be needed to chill a rebounding economy if more spending packages are passed.)

But the last time a similar scenario took place as the economy started to take off years after the financial crisis, the Fed started pulling back on asset purchases at the end of 2013 and raised interest rates in December 2015.

Using that history as a useful indicator and the Fed's current projection that the first interest rate hike would happen in January 2024, one could conclude the bond tapering will begin around January 2022.

And here's one more clue that Powell gave us about the Fed's plans...

Powell said economic resilience is in good shape...

A big part of the reason the Fed has been patient with its policies as the economy has started to rebound is that it can afford to...

When the pandemic first hit our shores last year, the FOMC was concerned about permanent scarring being done to the growth outlook. So, it "went big" with massive programs to help the economy through...

But the downside the central bank envisioned at the time never happened. And now, the worst-case scenario is behind us.

For example, Powell isn't worried about the housing market imploding, which is what typically brings an end to economic cycles. Consumers' finances are in better shape today... So are banks' balance sheets.

And the Fed isn't seeing the risky loans it saw during the housing crisis over a decade ago. As a result, it's confident the current boom in the industry doesn't present any risks to the economy.

Here's what I see happening next...

The central bank's monetary support of the U.S. economy isn't going away right now – or even in the weeks ahead. Current easy-money policies will likely stick around until the fall... until the jobs numbers the Fed wants to see are achieved.

But if we see those job gains and other indicators of a consistently strengthening economy in the coming months, the Fed could start considering monetary policy changes around July or August.

The Kansas City Fed's Annual Economic Symposium in Jackson Hole, Wyoming, could be the perfect event for having the discussion. It's held every August.

With that said, we've already seen two "rescue" measures withdrawn. As we discussed last month in our Stansberry Portfolio Solutions products...

1. The Fed is returning leftover pandemic funds from the U.S. Treasury's initial 2020 economic stimulus package last spring.

2. And it recently let the supplementary leverage ratio ("SLR") exemption expire. SLR is the minimum amount of liquid funds that a commercial bank must keep on hand. In April 2020, the central bank estimated that temporarily exempting the banks from this requirement would create $1.6 trillion in leveraged lending capacity. Now, it's pulling that extra liquidity back out of the system.

That means the Fed now only has two tools that it's using for economic support – the two I talked about today... asset purchases and low interest rates.

And here's what most people don't consider... As the economy moves back toward – and potentially above – pre-pandemic levels, the Fed will increasingly want to retool its arsenal for fighting the next economic downturn.

Powell said this way back in the depths of the pandemic, saying the ultimate goal would be to raise interest rates again while making projections about near zero percent for years to come, too.

This all tells me that in the coming months, the Fed will first end new bond purchases, not reinvest funds when bonds it currently owns mature... and eventually, raise interest rates once more.

As I said, the economy is growing. And there's potential for it to grow a lot more.

But at some point, the economy's going to have to stand on its own...

And when it does, we should be prepared for a round of profit-taking, especially from Wall Street, as the easy-money gains come to an end.

When that happens, the selling could have an unintended effect on all those euphoric traders we've been telling you about this year who have enjoyed an incredible bull market run since last March.

Said another way, could the Fed's next few moves be what tops off today's Melt Up – as Steve is expecting later this year? It very well could be... That's why you'll want to make sure you listen to Steve's latest message as the Melt Up enters its next stage.

As he says, we're in a time of great risk and great reward... if you play things right, know what assets to own, and what places to stay away from.

And this is why we'll keep a close watch on what the Fed says in the second half of 2021... Because as much as the central bank can give the good times, it can take them away, too.

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In today's mailbag, feedback on yesterday's Digest about U.S. Treasury Secretary Janet Yellen's remarks about higher interest rates... and two more views on what kind of company Tesla (TSLA) is – or will be in the future. Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com. We'd love to hear from you.

"Corey, Dan: Again you have hit the nail on the head with your essay. If Yellen keeps 'yellin' and the markets tank, who does she think will pay for her boss's preposterous trillion dollar welfare package and the results of no southern border protection and the new drug trade and more welfare recipients that come with it all.

"We may pay if the markets go down and we incur losses, but they will pay as well when we don't pay taxes on our losses. Let's just form alliances with Russia, China and Cuba, govern according to the currently planned agenda and see how that works out." – Paid-up subscriber Tim L.

"Dan's assessment of Tesla is timely and on point to many (myself included) who view Tesla as a modern marvel pioneering tech company utilizing every advantage in the corporate welfare program provided by the U.S. Government.

"No one can argue that Elon Musk and Tesla have defied the odds, analysts and critics with tremendous success while providing jobs, careers and wealth beyond belief. I certainly admire Elon Musk and Tesla for the success and EV advancements accomplished in a short period of time. However, we would be naïve to believe this party can go on forever as the day of Truth will come when the major automobile companies (VW, Toyota, Ford, GM, Fiat/Chrysler, Honda, Mazda, Nissan, Subaru, Hyundai, KIA, Audi, BMW, Volvo, Mercedes) start rolling out their EV's next year. Not to mention, all the Chinese EV companies.

"Kudos to Dan's rebuttal response to Rock P. who stated Tesla is a software company. Seriously, Tesla a software company??? Facts & Photos outweigh Fantasy and the substance Rock P. is inhaling. Tesla is no more a software company than Ford, GM, VW and Toyota are SaaS Cloud companies. Automobiles, electric motors and Batteries don't magically come off the production line from a keystroke, mouse click and lines of software code.

"As Dan stated, the auto industry is a live breathing, low margin, capital, equipment and labor intensive industry." – Paid-up subscriber Jeff P.

"Tesla is a technology company (a bit more than just software). Surprisingly, you wrote a brilliant and amusing article to show how Musk, the ultimate showman, orchestrated Tesla's financials to show a profit, but failed to realize that Musk is pandering to the view that Tesla is a car company.

"You wait until Musk sells the 'car company' with all its expensive bricks-and-mortar, and keeps the software, which he will then license out on a non-exclusive basis – turning Tesla into a genuinely profitable company (at a considerably lower multiple)." – Stansberry Alliance member Nick A.

Regards,

C. Scott Garliss
Baltimore, Maryland
May 6, 2021