This week, the US Bureau of Economic Analysis will release the final reading on Q1 GDP. By all accounts, it will reflect that the velocity of money
will be at the lowest level in half a century. The velocity of money is best defined as the ratio of nominal economic growth to the money supply (NGDP/M2) and is the rate at which money is turned over in the economy. There are various reasons behind this falling velocity including high unemployment, consumer deleveraging, and falling home prices, but most of all, it’s a precipitous drop in the banking system’s extension of credit.
As we mentioned last week in In the Parallel Universe, Credit Risk is Interest Rate Risk
, the current aggregate loan to deposit ratio (or LTD) in the US banking system is at historic lows of just over 80%. For a comparison, the LTD in 2008 was over 100%. This is not a big surprise after the collapse of a massive credit bubble where the economy sees increased savings (deposits rising) and reduced borrowing (loans falling), but the extension of Operation Twist is intent on reversing this trend, and I believe it will be successful.
When the Fed slashed interest rates to zero while engaging in quantitative easing
(or QE), there was a massive steepening in the yield curve due to the market’s inflation premium discount. It’s not a coincidence that in July 2011 -- just after the Fed ended QE 2 whereby the Fed printed $600 billion out of thin air to buy US Treasuries -- the yield curve saw record steepness. In fact, using the 5YR/10YR spread as an example, the July peak of 144bps was the widest spread going back 50 years, shattering the previous record in 1976 at 130bps. This historic spread has allowed banks to sit comfortably in risk-free carry trades at healthy net interest margins (NIM = portfolio yield – cost of funds) in lieu of making loans.
When the Fed launched Operation Twist at the September 21 Federal Open Market Committee (or FOMC)
meeting, it was taking a very different path towards monetary policy post-crisis, and my firm believes that this has been very much misunderstood by market participants. Contrary to consensus belief, by deciding to initiate a balance-sheet-neutral policy that is intent on flattening the yield curve by selling the front end in order to finance purchases at the long end after two years of balance sheet expansion that was designed to steepen the yield curve by generating higher inflation, the Fed was actually engaging in a de facto tightening. I addressed this thesis on my blog, The Ex Ante Factor, back in May, and characterized it as Upside Down Monetary Policy. If history is any guide this reverse psychological monetary policy could force the banking system to begin extending credit.
It’s a little known fact, but when the Federal Reserve eases credit conditions in the financial system, it in effect tightens credit in the real economy. When the Fed eases, the yield curve steepens. This reflects increased inflation premiums, which in turn incentivizes banks to buy securities in lieu of making loans. If a bank can earn a similar net interest margin in a highly rated credit instrument, it is more inclined to forego lending to inferior credit at similar returns. Therefore, credit tightens because it sits idle on bank balance sheets in unproductive mostly government-backed securities rather than being extended into the economy.
This preference for securities in lieu of loans is clearly demonstrated by the leading correlation trend between the slope of the yield curve (which is a proxy for a bank’s carry) and the ratio of the banking system’s security assets as a percent of total credit on the balance sheet. As the yield curve steepens (flattens), the ratio of securities rises (falls) with an approximate six to 12 month lag.
Conversely, when the Fed tightens, the curve flattens. This reflects lower inflation premiums, which reduces the carry provided by the bond market and thus removes the banking system’s incentive to buy securities. When the carry is removed, banks look to extend credit to local businesses and consumers to earn a better rate of return than is otherwise provided in the bond market. Therefore credit eases because instead of sitting idle in securities, it is released into the economy where it can earn a productive return.
You might argue that a bank’s deposit money that is invested in federal or state government-backed securities in lieu of loans makes its way into the economy via some transmission mechanism, but it doesn’t show up in one very important metric: the velocity of money.
If there was ever an ironclad argument against Keynesian government financed stimulus as a substitute for banking system financed stimulus, it’s displayed in the very tight positive correlation between the banking system’s LTD ratio and the velocity of money. Simply put, when banks inject credit into the economy by making loans to businesses and consumers (and thus increasing their LTD ratio), velocity rises; when banks make loans to governments by buying securities (and thus decreasing their LTD ratio), velocity falls.
It’s no coincidence that today’s 50-year low in velocity corresponds to a historic low LTD ratio.
Surely Chairman Bernanke understands that velocity has collapsed under QE and he knows that there is $2.6 trillion in liquidity sitting idle in securities on bank balance sheets. This is likely the principal motivation for engaging in and extending Operation Twist versus opting for more QE. Operation Twist isn’t as much about lowering the nominal level of interest rates; rather, it is about flattening the yield curve to flush the banks out of their carry trades.
During Wednesday’s post FOMC press conference
, the Chairman had the following exchange that my firm believes gets to the heart of the matter:
Q: Jennifer Liberto
, CNN Money
: Chairman, are you at all concerned that Operation Twist could affect banks' earnings and their willingness to lend? Does it undercut your ability to increase credit to consumers?
A: Mr. Bernanke: Credit to consumers? No, I don't think so.
If -- take for example, I've heard the argument that by lowering interest rates, you make it unattractive to lend. I don't think that's quite right. What we're lowering is the safe interest rate, the Treasury rate. That should make it even more attractive for banks, rather than to hold securities, to look for -- to look for -- to look for borrowers and to earn the spread between the safe rate and what they can earn by lending to households and businesses. So I think that macro policy and monetary policy can affect support lending.
Now, the question arises in some context whether there are other barriers to lending as it exists -- for example, in some parts of the mortgage market. But lower interest rates on securities and other types of assets, all else equal, would induce banks to look for higher-yielding returns, higher-yielding assets in the form of loans to households and businesses.
Translation: Mr. Banker, we gave you a healthy carry trade to earn your way out of the crisis, but now the party is over and you are about to start lending again because I’m not stopping until you do.
As an investor, you have to be cognizant of what the result of this policy to flatten the curve will look like ex ante
. The miserable economic data we have seen lately is the direct result of the Fed’s inflationary policy that drove the dollar lower and the costs of raw materials higher. The policies to inflate via QE 2 has trickled through to the economic data we are receiving today, However, if there has been one noticeable trend since Operation Twist was initiated back in October 2011, it’s the trend towards a stronger dollar.
What does a flat curve and strong dollar both signify?
Low market discounted inflation premiums, which have certainly been playing out in collapsing crude oil, lower gasoline, and other dollar-sensitive commodity prices. The implication is that the economy is finally starting to absorb the excess liquidity injected by QE. The result is that businesses have lower input cost volatility, which provides better visibility. Additionally, individuals have more discretionary income, which provides more consumption. Both are bullish for real growth and valuation multiples.
my firm pointed to the positive relationship between commercial bank hedging activity and equity prices a year later. If the Fed is successful in driving the banking system out of their carry trades, we could see an explosion in credit extension, which could initiate a powerful positive feedback loop in the markets and economy. As we said, the banks are sitting on $2.6 trillion in liquidity and as bonds get called and MBS get paid down, banks will have a decision to make: Do I take this cash and buy a bond that earns negative carry, or do I go make a loan that earns positive carry?
If you talk to many bankers, they will tell you there is no demand for money. But I suspect equally that there is no supply of money because it’s been locked up in securities. It comes down to a simple cost benefit analysis. There is no supply of money at 3.25% (Prime) when a bank can earn that in risk-free securities. This was the case up until July 2011 -- but since then, that has drastically changed as the curve has flattened and continues to do so. With 5YR duration paper inside most banks’ cost of funds, now suddenly that 3.25% loan doesn’t look so bad.
We aren’t sure if Bernanke is a genius or a mad scientist.
It sure seems that if he wanted to flush the banks out of carry trades, he could have achieved the same objective by raising rates by a few bps -- but he’s decided to go at it from the long end. In so doing, he risks a very delicate balancing act between when the bond market begins to discount this increase in economic activity and when the banks can unload their securities to create new credit. With the banking system loaded with negative coupon and negative convex long duration assets, it’s unlikely he will be able to navigate the transition without volatility and he’s been prone to blowing up his own trades.
So far, we’d say he’s three for three. Let’s just hope this monetary policy doesn’t achieve escape velocity before the bond market beats him to it.