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Analysts Missing Key Ingredient of Economic Growth

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Most analysis that portends to forecast bond market trends using fancy models and formulas shares a fundamental flaw: It assumes the Fed controls interest rates.

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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
Source: Bloomberg


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.
No positions in stocks mentioned.
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