The Fed’s “Three Steps and a Stumble” Rule

The Fed’s “Three Steps and a Stumble” Rule by Dennis Slothower

Publisher’s Note: I’m pleased to announce the addition of a new editor to Outsider Club: Mr. Dennis Slothower. Dennis has joined me in co-editing Wall Street Underground. He also writes a daily premium newsletter called Stealth Stocks Daily. Dennis is a contrarian and a skeptic, as are we — so he’ll fit right in. His daily newsletter was MarketWatch’s Letter of the Year in 2011 for not only helping his readers avoid the financial crash, but being ranked as the Hulbert Financial Digest’s top performer during it. We’re glad to have him, and you will be too.

Call it like you see it,

Nick Hodge Signature

Nick Hodge
Publisher, Outsider Club

The Federal Reserve chose to not raise interest rates at the end of January’s FOMC meeting.

That may well have to do with the threat of China selling more U.S. Treasury bond reserves.

Another rate hike would have supported upward pressure on the U.S. dollar, hurting U.S. exports and angering China, whose currency is pegged to the dollar.

China has been dumping U.S. Treasury bonds to raise cash to force a deep discount in its currency relative to the dollar.

This is why we are close to a trade war with them.

China’s banks are on the verge of collapse, so it is desperate to keep capital from fleeing the country.

Derivatives of Banks

And it’s not just China, but the entire world banking system….

Banks now have over $242 trillion in derivatives. For example, Goldman Sachs has over $45 trillion in derivatives against $880 billion in assets. Keep in mind the entire U.S. GDP was $18 trillion in 2015.

Yet it has been Goldman Sachs’s own stock that has led this Trump rally, along with reforms that look to be at least several quarters away from being a reality.

Then there is this: The “Three Steps and a Stumble” Rule.

It argues that should the Federal Reserve raise the discount rate three times in succession, a bear market in stocks follows!

In the 12 times over the last 80 years when the Fed has tightened like this, the stock market has fallen into a bear market.

The Fed raised rates in December 2015, then again in December 2016 — and the Fed has promised three more rate hikes in 2017 to counter Trump’s “pro-growth” policies.

Another interest rate hike by the Fed would trigger this rule in 2017. Yet it is U.S. long-term Treasury bonds, particularly relative to the Dow, that have now become extremely dangerous.

The following chart illustrates a ratio of the relative strength of the 30-year U.S. Treasury bond compared to the Dow 30:

high risk indicator
This relative strength ratio is now at record-low levels, even more than we saw ahead of the 2000 and 2008 recessions, when the stock market fell into vicious bear markets.

Since the presidential election, this ratio has reached the lowest level in over 20 years, signaling extreme “bubble” danger.

If U.S. Treasuries continue to plunge and the Fed keeps pumping up the Dow, get ready for the next housing bust and recession, as soaring mortgage rates duplicate the financial crisis of 2008.

You’ve been warned.

To your wealth,

Dennis Slothower Signature

Dennis Slothower
Editor, Outsider Club

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Jimmy is a managing editor for Outsider Club and the Investment Director of the personal finance advisory The Crow's Nest. You may also know him as the architect behind the wildly popular finance and investing website Wealth Wire, where he's brought readers the stories behind the mainstream financial news each and every day. For more on Jimmy, check out his editor's page.