The 24-hour news cycle, financial media, and blogosphere has to fill a lot of empty space, resulting in chronic information sensory overload. The vast majority of time is spent offering interpretations of cause and effect in the markets. It seems these days much of the focus is more specifically on the cause of monetary policy and effect in stimulating the markets. This didn’t just begin with the recent initiatives of quantitative easing (QE) and zero interest rate policy (ZIRP); it began with the bailout of Long Term Capital Management in 1998 that introduced the Fed’s put option and launched the era of easy money. Sadly, most market participants today only know and thus rely on this monetary cause and effect reality.
Recently there has been much debate and even more confusion as the true impact the Fed’s QE and ZIRP is having on the various markets is seen. As has been the case for the past decade, most of the analysis predicated on an elementary cause and effect conclusion.
The bond bullish thesis presented by many who are long risk-free assets goes like this: The Fed is buying Treasuries and mortgage backed securities (MBSs), interest rates are low, so the Fed’s purchases are successfully driving interest rates lower, and as long as the Fed continues to buy, bond yields will remain low.
The equity bullish thesis presented by many who are long risk assets goes like this: The Fed is printing money to inject into the capital markets, the USD is weak, junk bonds and stocks are at new highs, therefore the Fed is successfully reflating risk assets and further purchases will only drive more risk behavior.
Whether you believe the Fed is holding bond yields low or reflating risk assets, you've probably come to the same conclusion. Eventually the Fed will be successful in stimulating nominal GDP to a growth rate that sustains job creation, at which point the Fed will reduce QE and interest rates will begin to rise.
Instead of following blowhard pundits and analysts, most of whom are not even managing money much less understand the nuances of the bond market, do yourself a favor and make a habit of reading Hoisington Investment Management's Quarterly Review and Outlook
written by Van Hoisington and Dr. Lacy Hunt. In simple, concise explanations, Hoisington and Hunt break down the basics of what drives trends in economic growth, inflation, and interest rates. You will find that most analysis that portends to explain and forecast bond market trends using fancy models and formulas shares what I believe to be a fundamental flaw in assuming the Federal Reserve controls interest rates. I prefer the basic economic and market principles employed by Hoisington and Hunt that supersede models based on monetary policy.
Hoisington and Hunt have long been very bullish on bond market duration and have made incredible returns for their investors yet their thesis isn’t predicated on the Federal Reserve’s QE or ZIRP holding long term interest rates down. In fact you might even say they are bullish despite monetary policy. In Hoisington’s 2012 Fourth Quarter Review and Outlook
QE wasn't mentioned until basically the last page, and it was not exactly a ringing endorsement (emphasis mine).
In 2008, the Fed increased its liabilities by almost 1800%. This Fed process of paying for purchased securities is a mere accounting exercise. With a stroke of a bookkeeper’s pen it “creates” funds to pay for the purchased securities. This fund creation is assumed to be inflationary as it is often mislabeled and referred to in many articles as printing money. Increased Fed liabilities and an equivalent rise in Fed assets are not really money. However, it does create the potential for increased money. These Fed actions raise inflationary expectations which result in rising financial speculation and increasing interest rates. Recently, during QE infinity, long-term interest rates have risen, replicating the experience in QE1&2.
Despite the fact that most market participants expected higher inflation after the 2008 monetary explosion, the contrary has occurred. It has now been more than five years since the near 1800% increase in the Fed’s balance sheet, yet the economy languishes, and prices remain under downward pressure. Why? The Fed does not control the amount of money circulating in the economy nor the speed at which it turns over.
Bingo! Back on November 19, 2012 in How QE is Impeding the Economic Recovery
I recapped a recurring theme of mine. Contrary to what many participants believe, the true intent of QE is not to lower the cost of money but rather to increase its velocity.
There has been much discussion on the intentions and effectiveness of QE. It has been my contention that the main objective is not to reflate asset prices but rather to stimulate credit creation and the velocity of money. According the Fed’s H.8 Release
banks are holding over $2.6 trillion in cash that's sitting idle on their balance sheets in securities portfolios.
[Ben] Bernanke is trying to flush the banking system out of these bloated securities positions and into extending credit by lowering bond yields to levels where banks can no longer afford to hold them. As banks replace securities with loans credit expands, the velocity of money increases which in turn will increase economic activity, employment, and corporate profitability.
Is It Working?
When the Fed launched QE the aggregate loan-to-deposit ratio (LTD) of the US banking system was 90% with most of the balance of their assets in securities. As a comparison, in 2008 the LTD was over 100% and banks held very little in securities. Despite three rounds of QE and Operation Twist that was designed to flatten the yield curve today, the LTD is 79% -- the lowest in over 30 years of tracking it -- and continuing to fall. Not coincidentally, in Q3 2012 the velocity of money (M2) made a 50-year low.
Below the LTD and velocity of M2 shows the relationship between the implied carry banks can earn by holding securities (using MBSs current coupon less 90 day LIBOR as a proxy) and the amount of securities they hold as a percentage of total credit on their balance sheet. You can see over the past 25 years as the carry spread narrowed banks tended to decrease their holdings of securities and vice versa. However during the past couple of years despite bond yields continuing to fall narrowing carry banks have actually continued to increase holdings of securities. In turn their loan-to-deposit ratio and thus velocity remains depressed.
Click to enlarge
Friday, Wells Fargo
(NYSE:WFC), one the nation’s largest lenders, reported fourth quarter earnings results that indicated this low loan-to-deposit ratio trend showed no signs of abating. As reported in Saturday’s Wall Street Journal:
A $30 billion rise in deposits during the quarter, to $945.75 billion, underscores an industry-wide struggle to make new loans; credit-worthy borrowers are scarce amid soft employment growth and stagnant incomes.
Wells Fargo currently lends out about 80% of its deposits, while banks typically like their loan-to-deposit ratio to be near 100%. Chief Financial Officer Timothy J. Sloan acknowledged the slow pace of economic growth has affected the bank’s ability to lend. “It’s not where we’d like to be,” he said.
As a result of the deposit inflow, net interest margin – an important gauge of lending profitability – was 3.56%, down from 3.66% in the third quarter and illustrating the impact of low interest rates on profits.
The depressed loan-to-deposit ratio and rising bank demand for securities point to even deeper troubles for the economy going forward. The Fed thinks it is successfully pushing interest rates lower, but in reality the banks themselves are doing the heavy lifting. However we will get to a point where the banks can no longer afford to invest in securities which offer limited carry but unlimited interest rate risk. At that point banks presumably will kick out deposits and shrink their balance sheets rather than invest in securities. In addition these outgoing deposits will likely find their way back into the same securities the banks themselves would have bought anyway, therefore further depressing market interest rates. In an economy dependent on fractional reserve banking this negative feedback loop of contracting bank balance sheets could have an exponential impact on velocity and thus economic activity. Feeling better now? More from Hoisington & Hunt (emphasis mine):
The key ingredient to fostering monetary growth, and thus final demand, is an increase in the kind of borrowing which (1) aids future productivity and income and (2) increases financial innovation. Presently, after 60 months of the most massive Fed balance sheet expansion, no evidence of an inflationary spiral can be found. Nor, in our judgment, is one likely to occur. The process of unwinding debt overhangs is a long one, and unfortunately our society continues to pile on debt at near record amounts. This action is deflationary.
I believe this is the essence of their analysis and is where my thesis based simply on the loan-to-deposit ratio and velocity falls short. The Fed can create reserves but it can’t create money or increase its velocity. Furthermore, it’s not enough just to create credit by itself; it must be productive credit.
This is why the collapse in velocity is not just a credit crisis phenomenon but has been trending lower since the era of easy money began. You can see on the chart that velocity has been on a downward trajectory over the past decade despite the fact that this has coincided with extremely proactive monetary policy that has been constantly trying to calibrate aggregate demand. That is because primarily all of the credit created over the past decade was used for unproductive consumption purposes.
Hoisington & Hunt: The Bottom Line (emphasis mine):
Interest rates may, will and have gone up based on periodic changes in psychology. However, underlying fundamentals have insured they have not been able to remain elevated. The fundamentals of insufficiency of demand and its root cause, over-indebtedness, still point to an environment in which long-term interest rates remain on a path to lower levels.
This past week I ran into a friend of mine who manages a multi-billion-dollar money management operation. We engaged in brief small talk about the markets. He commented about the recent move up in the long end of the curve and said that he was staying short duration for fear of the eventual rise in interest rates. He went on to say that things were starting to feel like they were getting better. With eyebrows raised I responded it feels better because the stock market is at new highs
. He chuckled in agreement and went on his way.
It’s possible the stock market is discounting an acceleration of economic growth, but to corroborate that discount you would need to market interest rates begin to rise significantly, which would signal that banks are expanding credit creation by rotating out of their massive securities holdings and into productive
loans. That does not appear to be happening.
The stock market also went on to a new high as interest rates spiked in the summer of 2007 and stocks went on to make higher highs in the summer as confidence that the Fed’s easy money was coming to the rescue. In Hoisington’s 2007 Fourth Quarter Review and Outlook
you can see they were not fooled (emphasis mine).
Present circumstances suggest that quick resolution by monetary and fiscal authorities to overcome these economic conditions is overrated. Of course, this does not mean a depression or a re-visitation to the conditions of the 1930s. Well over 90% of the population will have jobs; individual companies will profit; innovation will continue; the population will expand; certain prices will rise, and shortages of individual materials will certainly occur. However, persistent excess capacity in both labor and capital will erode aggregate pricing power and put greater downward pressure on corporate profits and inflation. If commodity costs manage to rise in this environment, they increase the risk of recession, not inflation. Finally, the intersection of supply and demand for credit will be lower, suggesting a period of sustained low interest rates.
I think we try to make this too complicated. We get caught up in the cyclical wiggles but lose sight of the underlying secular trend. The continued deleveraging of the unproductive leveraged consumption bubble is not over because stocks made new highs or because interest rates broke out of a trading range. It won’t be over as a result of fiscal or monetary policy. It will be over when excess capacity is absorbed by real demand based on Hoisington and Hunt’s key ingredient.