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Dow will reach 25,000 because QE4 is coming: analyst

The Federal Reserve has a big problem on its hands. It hooked U.S. stocks on six years of ultra-cheap liquidity, and it now faces blowback after removing the proverbial punch bowl.

Today, the Federal Reserve commences its two-day meeting of the Federal Open Market Committee, which decides U.S. monetary policy. While no one expects the Fed to announce another rate raise, analysts will be parsing the announcement for clues as to the pace of future rate raises.

The problem is that when the Fed has begun to raise rates in the past, the economy was growing at a much more rapid pace than it is now. An expanding economy can absorb a series of rate increases—at least for a time. Today, year-over-year GDP growth is stagnating at 3.0%. The last time the Fed commenced a rate hike cycle in 2004, GDP growth was over double the current amount.

Source: Federal Reserve
Source: Federal Reserve

Accordingly, many analysts doubt the ability of risk markets to absorb future rate increases. They blame the current weakness on the Fed either acting too soon or too late.

Yves Lamoureux, president of macroeconomic research firm Lamoureux & Co., believes the latter. He says, “We're paying a price for the first mistake of the Fed, which was raising rates…They could have done that over a year ago.” He continues, “The Fed did that way too late when money was contracting, and we’re paying a very hefty price for that right now.”

Quantifying crowd behavior: Dow 25,000 by 2020

Lamoureux’s firm specializes in the field of behavioral institutional analysis, which quantifies crowd action and behaviors.

“We've built this model that tells us if we are at a state of complete panic, which we believe we are in, with the big drop in the Dow,” says Lamoureux. “And where we do our best work is when we get a sense mathematically of the extreme…If the crowd is too much one side of the boat, then we know the boat is about to tip over,” he says.

Lamoureux believes the boat is about to tip over and that U.S. equities are at a turning point. He says, “We don't know where the bottom is going to be…But if you start to step in the market, and you do this gradually over the next couple of weeks, we think we're at one of the major entry points that will carry the [Dow Jones] for the next 3 to 4 years past 25,000.”

Bond market weakness

In order for this to occur, the Fed would need to reverse its current tightening stance and expand its balance sheet again with more quantitative easing. This would require a tremendous shock because the Fed does not want to lose credibility by reversing monetary policy too soon.

Lamoureux believes this shock will come from a U.S. government bond market implosion, which in turn will stem from the Fed’s second mistake—draining money from the economy too quickly.

Since September 2014, the amount of money that banks park at the Fed, called excess reserves, has dropped by $370 billion.

Source: Federal Reserve
Source: Federal Reserve

Lamoureux believes this money has temporarily plugged a hole in the bond market, which is teetering on the precipice of collapse.

Historically, foreign central banks, sovereign wealth funds, as well as international banks and broker-dealers, have been large purchasers of U.S. debt. However, a number of factors have reversed this trend recently.

“From a behavioral aspect, primary dealers [sic U.S. government bond dealers] are not picking up bond inventory anymore…Central banks caught with low oil need money, so they dump U.S. bonds,” says Lamoureux.

In addition, new rules in recent years have made it more costly for banks and broker-dealers to hold the large supply of bonds they historically carried. This has caused them to shrink inventories substantially. Without a large marginal purchaser, demand for U.S. bonds dries up and yields go higher, which makes it more expensive for the U.S. government to issue debt.

Although the Fed is supposed to be politically neutral, Lamoureux believes it will step into the market again to pick up the slack. He says, "The Fed will have to expand its balance sheet to get us to grow again—especially this year, an election year...Stock holders should not fear this great buying opportunity, but bond holders should fear what comes next.”