Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

How QE Is Impeding the Economic Recovery


The problems that are impeding the economic recovery are not due to the lack of federal agency-backed mortgage loans that wind up in securities, but rather the continued contraction of US bank balance sheets.

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.

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.

The problems that are impeding the economic recovery are not due to the lack of federal agency-backed mortgage loans that wind up in securities. What is impeding the recovery is the continued contraction of US bank balance sheets. For lenders to extend credit they must weigh three basic risk variables that make up the total cost of credit: credit risk, interest rate risk, and collateral risk. What Bernanke doesn't seem to appreciate about this equation is that the benefit of a negative real interest rate to the borrower is the cost to the lender in a negative real return.

The lower interest rates fall, the higher the interest rate risk becomes. By reducing credit risk in the form of low interest rates Bernanke has raised interest rate risk. From a lender's perspective the balance sheet risk is the same. So perhaps it's not credit and collateral risk that is holding back lending; it's interest rate risk. Maybe bank balance sheets continue to contract because they can't earn a positive risk-adjusted real return by making a loan.

Back on October 15 in Precipitous Drop Off in Demand for Money May Signal Repricing of Risk Assets I went through my various credit market metrics that were all pointing to a contraction. One of the most important indicators I follow is the activity in the Eurodollar pit at the CME. Having traded "euros" in a former life I can tell you this is one of the deepest and most liquid markets in the world.
In the 90 day LIBOR futures market, which is the eurodollar pit at the CME, the commitment of traders shows commercial hedgers (which are large money center banks) have gone from net long $1 trillion notional at the end of last year to currently being net short $1 trillion. From a historical perspective that is a huge swing. When you are long a Eurodollar contract you are hedging against falling rates and when short you are hedging against rising rates. Therefore the net position of commercial hedgers is indicative of the composition of the banking system's aggregate balance sheet.

Banks hedge assets from falling interest rates and liabilities from rising rates. The fact that hedgers have seen such a big swing in their net indicates there has been a collapse in the need to hedge credit assets on their balance sheets.

As I wrote back on June 18 In the Parallel Universe, Credit Risk Is Interest Rate Risk Tom McClellan of McClellan Oscillator fame has identified a correlation between the Eurodollar commercial hedgers net position and the S&P 500 (INDEXSP:.INX) with a one-year lag. It's not perfect but the correlation has been remarkably consistent in identifying turns in the stock market. After analyzing the correlation with the S&P I have since identified a couple more correlations both directly and with a lag. I believe these correlations show up because they are related to the extension or lack of extension of credit in the economy.
No positions in stocks mentioned.

Busy? Subscribe to our free newsletter!