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Very Scary

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The correction in US stocks has begun. It’s likely to become significantly worse during the months ahead. In this new age of fiat money, Liquidity determines the direction in which asset prices move and Liquidity is drying up. That is because the third round of Quantitative Easing is coming to an end this month. When the first round of Quantitative Easing ended, stocks fell. When the second round of Quantitative Easing ended, stocks fell. Therefore, it should not surprise anyone that stocks have begun to fall again this time.

There is more at stake here than just stock prices, however. If stocks continue to slide, the United States could fall back into severe recession; and economic contraction in the US would almost certainly throw the global economy back into crisis. Here’s how things stand.

Since the end of 2008, the Fed has printed $3.5 trillion and injected it into the financial markets by buying government bonds and mortgage-backed securities. This injection of new money artificially inflated stock prices and property prices. Household sector Net Worth rose by $25 trillion (or by 46%) as a result. Consequently, many people felt richer and they spent more. In this way, the Fed boosted consumption and drove economic growth.

With QE 3 now ending, the force of gravity is reasserting itself and stock prices have begun to fall back to earth. Bloomberg News reported that approximately $744 billion has evaporated from equity values since October 8th. And this could be just the beginning. If the stock market selloff continues, then Net Worth will contract significantly; people will feel poorer and spend less. And that will send the US back into recession. Keep in mind, the US economy is none too strong to begin with. As I wrote last time, the economy only expanded at an annualized rate of 1.2% during the first half of this year.

Any slowdown in the US economy would deal a very severe blow to the rest of the world. Last week, the IMF lowered its forecast for global economic growth yet again. It has cut its current-year growth forecasts nine out of 12 times in the last three years. Europe is on the brink of recession. Even Germany has stopped growing. Deflation in Europe may only be a few months away. The inflation rate has been moving down steadily to an annual rate of only 0.3% last month. Japan’s economy has not grown over the past 12 months despite very aggressive money creation by the Bank of Japan. China is slowing rapidly and the world has begun to pray that the great China bubble doesn’t implode in the near future. Brazil and Russia are in recession. Global commodity prices are plunging. Brent Oil slid 4% yesterday to the lowest level since 2010, after the International Energy Agency cut its forecasts for oil demand growth to its weakest in five years. And, remember, all of this weakness in the global economy was occurring before the recent selloff in US stocks began. Imagine how ugly things will become if US stocks fall a further 20% from here.

The Fed had better think twice – or even three or four times – before it allows that to happen. Indeed, it seems that they have already begun to have second thoughts about ending QE. Today, Reuters reported, “The head of the San Francisco Federal Reserve Bank on Tuesday said he would be open to another round of asset purchases if inflation trends were to fall significantly short of the U.S. central bank’s target.” This was the first hint that the Fed is prepared to launch a new round of Quantitative Easing, QE 4, as I have long suspected that they would be forced to do.

So here’s how it looks most likely to play out to me. Stock prices are likely to continue falling during the next couple of weeks, even with the Fed still injecting roughly $650 million a day into the financial markets until the end of October. If so, the sense of panic among investors will continue to mount. Then, things will become worse after that if the Fed really does stop injecting new money into the markets on October 31st. As stock prices fall and Net Worth evaporates, we will begin to get louder and more frequent hints from the Fed that QE 4 is a growing possibility. And, eventually, the Fed will drop such a strong hint that it will have no choice but to deliver. On that day, US stocks will soar. Soon thereafter, QE 4 will begin. Its scale will be as large as necessary to make the S&P Index move up to new record highs by the end of 2015 or soon thereafter. Higher stock prices will continue to make the global economy expand.

The global economy remains an economic bubble. Without the injection of more Liquidity by the Fed, that bubble will deflate into crisis. Therefore, more Fed-injected Liquidity it will have. Just don’t call this Capitalism.

Happy Halloween!

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Original publish date: October 15, 2014

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