This past Wednesday, the Federal Reserve Board raised interest rate by 0.25%, the fourth increase since last year. At the same time, it announced that it will reduce the size of its balance sheet by USD 30 billion per month, increasing eventually to USD 50 billion per month.
When the FED increases or decreases interest rates, it usually does so continually over a period of months, varying from 10 to 30 months in duration. That is why they are called cycles.
Rate Hike Cycles and Financial Crises
In each of the six previous cycles of interest rate hike since 1980, a financial crisis of varying magnitude followed. Here is the list:
Rates Hike Cycle （Duration） Financial Crisis
1983.2-1984.8 （18 months） Latin American crisis
1986.12-1987.10 (10 months) US Black Monday market crash
1988.2-1989.5 （15 months） Japan markets collapsed
1994.1-1995.3 （13 months） Asian financial crisis
1999.5-2000.4 （11 months） Internet bubble bursted
2004.5-2006.5 （24 months） Subprime crisis
Financial crisis has many causes and interest rate hike is not the only one. There had been financial crises and market collapses that happened without interest rate hikes. What I am pointing out is that in the past six cycles of interest rate hike, somewhere in the world, some markets collapsed. And we are entering another cycle, how long and how steep we do not yet know. Also, this cycle is accompanied by a balance sheet reduction by the FED. So it is a double-whammy. That is why recently many people are predicting a financial crisis within the next six months to a year..
What Is Balance Sheet Reduction？
Most people do not know what “balance sheet reduction” by the central bank means. Simply put, it means the FED will start selling off assets （principally US treasury securities and mortgage-backed securities）and, with the proceeds, retire its debt （instead of buying more assets）. Another thing it will do is to redeem the cash from its holdings of maturing US treasuries and MBS, and not lend it out again. Therefore, its balance sheet shrinks. The bottom-line is: the FED is taking money liquidity out of circulation.
Why does the FED do that？ The official explanation is to bring its balance sheet “closer back to normal”. You see, as a result of the subprime crisis, the FED had to print money, i.e., borrowed from itself, to buy the assets including some garbage from the major financial institutions on Wall Street in order to prevent the collapse of the whole system. Why is that “borrowing from itself”？ Well, have you examined a US dollar bill, what we call cash money？ It is simply a Federal Reserve note, or IOU. So when the FED pulled money from out of the hat, it was simultaneously creating an additional liability, its own. Normally, it would lend that money to its biggest customer, Uncle Sam, who would issue the FED a US treasury note. But in the case of the 2008 crisis, it had to use that money to keep Wall Street solvent. After that, for the next eight years, it had to print even more money （ so-called quantitative easing or QE, but officially, it was called the asset purchase program）to lend to Uncle Sam and Wall Street, in effect buying more US treasuries and banking instruments.
How much did they buy over those years？ According to my friend Lloyd Blankfein, Chairman of Goldman Sachs, the FED balance sheet had approximately USD 900 billion of assets before the 2008 crisis. It now has USD 4.5 trillion！ And how much capital does it have？ Don’t ask. As a bank, it probably has the lowest capital ratio in the history of banks! Just be glad that it is finally beginning to head back to “normal”.
Cycle of Pump-and-Piston
What we must bear in mind is that the US Dollar is the exchange currency for approximately 80% of the world’s capital transactions, and 60% of the world’s trade （particularly in oil and gas）. Nominally, the US suffers chronic trade deficits. But if we look at the US Dollar as a commodity, the country actually “exports” a lot, in the form of money, that is. In order for the US Dollar to be used as the world’s dominant currency, the US banking system has to “supply” it. So is it profitable to do so？ Of course. In fact, it has been so profitable for Wall Street that the country’s best talents have flocked to the highly profitable money business instead of the relatively low-margin real industries. At the same time, capital has flooded the financial sector to the relative neglect of other sectors of the economy. Structurally, that has led to a “hollowing out” of the US economy, with leveraged consumption, services and virtual industries the predominant activities. Donald Trump says he is trying to reverse the trend and try to promote investments that would create jobs in the real sectors of the economy. And he is looking for foreigners to do that. At least that is his schpiel.
One of the most profitable businesses on Wall Street is to arbitrage the cyclical liquidity swings brought about by FED rate adjustments and money supply policy. As a matter of practice, the FED always seems to overshoot the targets when it raises or lowers interest rate, and when it eases or tightens the money supply. It seems to do these things for too long a duration, changing course only when disasters hit. It gives people the impression that the FED pumps too much money into the money market to cause a bubble, only to use a piston to suck the money out to cause the market to collapse on somebody somewhere.
Indeed, the biggest play on Wall Street in the last couple of decades is to short the futures on the potential victims of the FED cycle of pumping-and pistoning. That has been the choice objective of hedge funds, many of which can take on very high leverage. Shorts are their favorite because, to quote John Paulson, one of the biggest player among them, “shorts take less time than longs and reap far greater returns ”.
Fleecing and Slaughtering
Of course, market collapses create a lot of victims. When they happen to US markets, the FED would generally reverse course immediately to reduce the damage. But when they happen to foreign markets, the FED is not bound by national interest to provide relief. On the contrary, in crises after crises, the US is blamed for tightening the screws on the victims. Wall Street would go out to “squeeze” the nations and parties in distress, in a process graphically referred to as “fleecing of the flock” and “slaughtering of the livestock”. I will spare you the details.
For what it is worth, now is the time to make sure you do not fall victim to these invariable market forces or dealt a miserable blow by the hidden hands.