Is This the Beginning of the End for the Bull Market?

1 | By Shah Gilani

There’s a problem with the bull market’s fairy godmother, the Federal Reserve.

It looks like it’s out of magic dust – what it uses to manipulate interest rates.

In the first of this two-part series, I’ll tell you what you need to know, why this is important, and what could make the lows of October to December look like a day at the beach…

The Fed’s Fairy Dust

The Federal Reserve credits itself (and most everyone agrees) with saving the financial system, then spiking the economy and bond and equity markets higher by keeping interest rates artificially low for years.

Never mind that the Fed actually caused the financial crisis by keeping rates too low for too long.

That’s apparently not important to sycophant Fed flunkies after they acted like hero firefighters putting out the great conflagration they started.

What’s important is the everyday tool the Fed uses to manipulate interest rates: the federal funds rate.

That tool (AKA the Fed’s fairy dust) has been sprinkled too far and wide, and it’s losing its magic.

In other words, the Fed may be losing control of its ability to control interest rates via targeting the fed funds rate.

If interest rates start rising more than the Fed wants them to, meaning they trade above the top end of the fed funds target range, markets will see the Fed’s lost control of its primary tool to influence interest rates, and rates may spike higher and sooner on their own (shot up by bond vigilantes) and sink both bond and stock markets.

Newsflash, it’s started.

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The fed funds rate is the overnight rate big banks charge each other when they lend each other money.

Every day banks must tally their reserves and make sure they have enough by closing time. If they’ve lent out a lot, seen outflows of deposits, or have other liquidity events, they may need to borrow some money overnight to meet their reserve requirements.

They call up each other and ask who has money to lend and what will they charge.

Generally, the fed funds rate is the prevailing rate.

That rate is supposedly determined, within a band most of the time, by the Fed.

If the Fed wants to raise rates across the economy, they will raise the fed funds rate.

They don’t just mandate the fed funds rate by announcing what it is they want it to be. They perform “open market operations,” which amounts to buying and selling Treasury securities with counterparty banks, known as their primary dealers.

Buying and selling is done through repurchase agreements and reverse repurchase agreements. (See sidebar.)

Repurchase and Reverse Repurchase Transactions

The Fed uses repurchase agreements, also called ‘RPs’ or ‘repos’, to make collateralized loans to primary dealers. In a reverse repo or ‘RRP”, the Fed borrows money from primary dealers. The typical term of these operations is overnight, but the Fed can conduct these operations with terms out to 65 business days.

The Fed uses these two types of transactions to offset temporary swings in bank reserves; a repo temporarily adds reserve balances to the banking system, while reverse repos temporarily drains balances from the system.

Repos and reverse repos are conducted with primary dealers via auction. In a repo, dealers bid on borrowing money versus various types of general collateral. In a reverse repo, dealers offer interest rates at which they would lend money to the Fed versus the Fed’s Treasury general collateral, typically Treasury bills.

Among the tools used by the Federal Reserve System to achieve its monetary policy objectives is the temporary addition or subtraction of reserve balances via repurchase and reverse repurchase agreements in the open market. These operations have a short-term, self-reversing effect on bank reserves.

Repurchase agreements are made at the initiative of the trading desk at the New York Fed (“the Desk”). The Desk implements monetary policy for the Federal Reserve System at the behest of the Federal Open Market Committee (FOMC).


When banks buy and sell between each other, they also call those transactions repos and reverse repos.

If the Fed wants to raise interest rates across the economy, maybe to slow the growth of inflation, it starts by raising the most basic interest rate, the rate that banks charge each other, the fed funds rate.

The Fed would raise the fed funds rate by conducting reverse repos, borrowing money from banks to take it out of circulation. If banks have less money to lend out because the Fed borrows it, they’d start charging each other more for overnight loans. That’s how the Fed actually controls the fed funds rate.

If the Fed wants to lower rates it would lend money to banks via repurchase agreements, lending them money temporarily and agreeing to repurchase the loan it made the next day or over a longer “term.”

Everyone knows the Fed kept rates low for a long time and that they started to raise the fed funds rate.

It’s a big deal when they announce they’re going to raise rates.

Bond markets and stock markets have been the beneficiaries of low interest rates since 2009. Raising them poses all kinds of questions, mostly having to do with how companies will fare if costs of financing their businesses rises too much.

As long as the Fed has control of the fed funds market, they can manage rates so they don’t rise too quickly and freak out investors.

They made that mistake last year. Last October through December, as the fed raised rates, investors worried that everything that spurred the great rallies in bonds and stocks was ending.

Of course, the Fed backed down when they saw the market selloff, telling the world they’d done enough raising already and that they’d revisit how they managed their balance sheet.

And stocks went right back up, and so did bond prices.

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But what if the Fed wants to keep fed funds at some level markets like, but rates rise anyway?

The general theory is that’s not possible. That’s because the Fed controls the fed funds rate.

Well, they do and they don’t.

They move rates up and down through open market operations, through repos and reverse repos. But the market, supply and demand forces for money, including overnight loans, impacts rates, too.

If for whatever reason, and I’ll get to those scary reasons, the demand for money forces the fed funds rate higher than what the Fed calls for it to be at the upper level of the range they announce to the world is the rate they mandate, investors are going to get very nervous, very quickly.

If the Fed loses control of its ability to manipulate interest rates, there’s no telling where they could go.

And that means investors won’t have any idea how high they could go if the forces that are now moving them above the fed funds upper bounds keep moving them higher.

That’s going to make what happened from October to December look like a day at the beach.

On Friday, I’ll tell you what’s happening with the fed funds rate – and you better pay attention if you have any money in stocks or bonds.



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