On the front page of this weekend’s Wall Street Journal,
the article reporting on the employment report was titled, Jobs Rise Enough to Soothe Markets
. I thought to myself, they must not be talking about the bond market because it was anything but soothed.
Turning the page I found Jon Hilsenrath’s
weekly Fed article that had been posted during Friday’s trading session. These late Friday Fed leaks from Hilsenrath are becoming all too common. Apparently the Fed wants to make sure we understand what they aren’t telling us about what they don’ t know. What would market participants do without the service of Hilsenrath? (Emphasis mine.)
Federal Reserve officials are likely to signal at their June policy meeting that they are on track to begin pulling back their $85-billion-a-month bond-buying program later this year, as long as the economy doesn’t disappoint.
A good-but-not-great jobs report Friday ensured officials wouldn’t want to act right away and would instead want to see more data before taking a delicate step toward winding down the program.
Many Fed officials believe the job market and the broader economy have made enough progress to warrant considering a partial pullback in their bond buying, but they still have reservations about the outlook that give them pause.
Officials believe the private sector, aided by a rebounding housing market and solid consumer spending, has enough momentum to drive a pickup in growth later in the year.
But officials run the risk of errors in their forecasts. In every year of the recovery, officials have expected the economy to grow faster than it did.
Who are these “officials” Hilsenrath is citing? Let’s not kid ourselves. This article reads more like a press release than monetary policy analysis and it was obviously a direct communication from Ben Bernanke.
This constant beating around the bush is getting really old, and I’m not sure how much patience the bond market has left. In fact, it's already taking matters into its own hands. This is one of the most important market developments that no one is talking about.
As I wrote in the Yield Curve Adjustment Process
What I think gets lost in the discussion about the cost/benefit of QE, and more importantly, how long it has gone on, is the fact that there are billions of potentially very volatile long duration low coupons on the balance sheets of investment portfolios. Bond math dictates that for a given duration, the lower the coupon, the more volatile the price. A 2% 10-year is much more price-sensitive than a 4% 10-year. Due to the nature of these low, long duration coupons, the adjustment process is likely to be very chaotic, making last week look like a game of tiddlywinks. This is bound to have a profound impact on portfolios and on sentiment.
With QE “calling,” all higher coupons from the market investors have had no choice but to reinvest into lower -- and in some cases, negative -- coupons. A modest normalization in real yields would result in a discounting of these coupons in effect trapping capital on leveraged balance sheets. Thus even a slight rise in yields could broadly tighten credit market conditions.
To find the market tightening you have to look no further than at the rise on real yields as reflected in TIPS (treasury inflation protected securities) yields. Since the cycle lows the yield on the 5-year and 10-year TIPS (Treasury Inflated Protected Securities) have risen 95bps and 90bps respectively. On Friday the 10-year TIPS yield traded just shy of zero after spending the past year in negative territory. Real yields rising is by definition tightening credit conditions.
Five-Year and 10-Year TIPS Vs. Nominal Yields
It’s not just in the TIPS market where you see the bond market tightening. TIPS yields have pushed up nominal yields, which in turn ignited a convexity blowout in the MBSs market, unwinding the entire QE III compression and then some.
The move in the MBS market has not only tightened conditions in the mortgage market where rates on 30-year conventional loans has surpassed the 4.0% threshold, but more importantly, it has also tightened conditions in the banking system where so many of these securities are held.
One of the primary targets of QE was bank balance sheets. The bond-buying program was aimed at reducing yields to a level where investable securities become uneconomical for banks to buy in order to redirect capital into credit creation.
From the June 20 2012 FOMC
meeting press conference (emphasis mine):
JENNIFER LIBERTO. Jennifer Liberto, CNNMoney. 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?
CHAIRMAN BERNANKE. Credit to consumers? No, I don’t think so… 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 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, in fact support lending…. 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 household and businesses.
Has QE successfully induced banks to reduce securities position in favor of extending credit to households and businesses? The Fed releases information about the commercial banking system balance sheet composition in their weekly H.8
report. Studying this report provides some very interesting trends that would suggest QE has not had the desired effect in stimulating credit creation.
The asset side of a bank’s balance sheet is primarily made up of credit assets which are the sum of loans and securities. As of the week ended 5/29/13 total banking system credit was $10.022 trillion consisting of $7.282 trillion in loans and $2.739 trillion in securities. The result is a record low loan-to-deposit ratio with banks holding a historical high percentage of assets in securities. These two metrics are not indicative of a robust lending environment to say the least.
Bank Loan to Deposit Ratio Vs. Securities
In the 30 years between May 1973 and May 2003, total credit assets grew by $5.262 trillion, consisting of $$3.845 trillion in loans representing 73% of the credit growth and $1.416 trillion in securities representing 27%. Between May 2003 and May 2008, during the five-year credit bubble, total banking system credit grew by $3.128 trillion, consisting of $2.638 trillion in loan growth, representing 84.5% of total credit growth with only $489 billion in securities representing 15.5%.
In the five years since May 2008, total credit has grown by $1.014 trillion with loan growth consisting of only $357 billion or 35% of total credit growth, while securities have grown by $657 billion, representing a whopping 65% of the total credit growth. Breaking down this same period since August 2010 when QE II was announced shows how MBSs have grown to take a larger share of bank credit assets. Of the $818 billion in credit growth since QE II was announced, MBSs have accounted for $318 billion of the $361 billion in securities growth with loans representing a mere $457 billion. That is remarkable.
Since the initial QE III targeted MBSs, banks backed off a bit, and with total credit growing by $235 billion, MBSs have only accounted for $23 billion of the $96 billion in securities. However it is notable that most of this MBS purchasing has occurred in 2013, and when you break down the YTD allocation of securities, the results show that MBS purchases remain a major allocation for bank credit.
Total bank credit has only grown by $17 billion YTD broken down into loan growth of $14.8 billion and securities of only $2.3 billion. The securities portfolio can be easily broken down into US Government securities including MBSs and Non-MBS agencies and Other securities. Of the $2.3 billion, the Treasury breakdown reflects a $26 billion increase in MBSs and a $43 billion decrease in Non-MBS agencies for a net negative $17 billion. The Other securities classification grew by $19 billion, which gets you to the $2.3 billion net number.
This breakdown highlights the aforementioned reinvestment risk banks have been facing during QE. The decline in Non-MBS agencies was likely not sales but rather redemptions in the form of maturities and calls. Ideally, in a robust lending environment the $43 billion in proceeds would have been rotated into loan demand, but banks have instead opted to buy bonds. In fact, the YTD $26 billion increase in MBS holdings exceeds the $14.8 billion in total loan growth. Again this is remarkable.
Despite an exhausting and unprecedented attempt by monetary policy, the data does not show that QE has had any positive impact on stimulating bank lending. Arguably, the bigger impact of QE has been increased balance sheet risk in the banking system. This dynamic has no doubt been at play with recent pressure in the MBS market, which has borne the brunt of the rise in real yields.
When the Fed opted to forgo an extension of QE II in June of 2011, the risk markets responded with a vicious unwinding of the reflation correlation trade, producing a massive flight to quality that pushed bond yields to record lows. This rally provided a nice windfall for banks as their unrealized gain on portfolios nearly doubled in two months from $17 billion at the end of July to $32 billion in September.
Throughout 2012 this gain continued to rise, and when QE III was announced, MBS yields and spreads collapsed the unrealized gain peaked at $43.5 billion in October. During the 2009 financial crisis reversal this line item showed an unrealized loss of over $50 billion, so this was a big swing for the banking system’s capital position. However, what the bond market giveth, the bond market taketh away. Friday’s H.8 release showed the unrealized gain had declined by 32% to $29.4 billion representing only a 1.07% profit cushion on the $2.7 trillion securities portfolio.
What gets lost in the cost benefit analysis of QE is that the benefit to the borrower in lower interest rates is a cost to the lender in lower coupons. The negative real rate regime has not induced lending and banks have continued to increase their allocation to securities. To complicate matters, the length of the program has, in effect, loaded the banking system full of their largest allocation to securities at the highest price with the most market risk. As much of a benefit QE was on liquefying capital in the banking system, as yields fell, there is potentially a greater cost in how the resulting low coupons will make this capital exponentially more illiquid as yields rise. This is Bernanke’s Pyrrhic victory.
Between now and the June FOMC meeting, you are going to hear a lot about whether the Fed is going to taper QE, by how much, and when. You are going to be told that tapering isn’t an exit from QE nor is it a tightening of monetary policy. Well none of that matters. The only thing that matters is whether the bond market is tightening. In a relatively short period of time, and with no change in monetary policy, the bond market has raised real interest rates by nearly 100bps. This has been a rapid tightening of credit conditions, and if I am correct, then it won’t take long for this tightening to filter through the banking system and in into the real economy.