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UPDATE: To Buy, Or Not To Buy- An Investors Guide to QE 4

In our RIA Pro article, To Buy, Or Not To Buy- An Investors Guide To QE4, we studied asset performance returns during the first three episodes of QE. We then normalized the data for the duration and amount of QE to project how QE4 might affect various assets.  

With a month of QE4 under our belt, we update you on the pacing of this latest version of extreme monetary policy and review how various assets are performing versus our projections. Further, we share some recent comments from Fed speakers and analyze trading in the Fed Funds market to provide some unique thoughts about the future of QE4.

QE4

Since October 14th, when QE4 was announced by Fed Chairman Jerome Powell, the Fed’s balance sheet has increased by approximately $100 billion. The graph below compares the current weekly balance sheet growth with the initial growth that occurred during the three prior iterations of QE.  

Data Courtesy St. Louis Federal Reserve

As shown above, the Fed is supplying liquidity at a pace greater than QE2 but slightly off the pace of QE 1 and 3. What is not shown is the $190 billion of growth in the Fed’s balance sheet that occurred in the weeks before announcing QE4. When this amount is considered along with the amount shown since October 14th, the current pacing is much larger than the other three instances of QE.

To put this in context, take a step back and consider the circumstances under which QE1 occurred. When the Fed initiated QE1 in November of 2008, markets were plummeting, major financial institutions had already failed with many others on the brink, and the domestic and global economy was broadly in recession. The Fed was trying to stop the worst financial crisis since the Great Depression from worsening.

Today, U.S. equity markets sit at all-time highs, the economic expansion has extended to an all-time record 126 months, unemployment at 3.6% is at levels not seen since the 1960s, and banks are posting record profits.

The introduction of QE4 against this backdrop reveals the possibility that one of two things is occurring, or quite possibly both.

One, there could be or could have been a major bank struggling to borrow or in financial trouble. The Fed, via repo operations and QE, may be providing liquidity either to the institution directly or indirectly via other banks to forestall the ramifications of a potential banking related default.

Two, the markets are struggling to absorb the massive amount of Treasury debt issued since July when Congress extended the debt cap. From August through October 2019, the amount of Treasury debt outstanding grew by $1 trillion. Importantly, foreign entities are now net sellers of Treasury debt, which is worsening the problem. For more read our recent article, Who Is Funding Uncle Sam?

The bottom line is that the Fed has taken massive steps over the last few months to provide liquidity to the financial markets. As we saw in prior QEs, this liquidity distorts financial markets.  

QE4 Projections and Updates

The following table provides the original return projections by asset class as well as performance returns since October 14th.  The rankings are based on projected performance by asset class and total.  

Here are a few takeaways about performance during QE4 thus far:

  • Value is outperforming growth by 1.67% (5.95% vs. 4.28%)
  • There is general uniformity amongst the equity indexes
  • Equity indices have captured at least 50%, and in the case of value and large caps (S&P 100) over 100% of the expected gains, despite being only one-sixth of the way through QE4
  • The sharp variation in sector returns is contradictory to the relatively consistent returns at the index level
  • Discretionary stocks are trading poorly when compared to other sectors and to the expected performance forecast for discretionary stocks
  • Defensive sectors are trading relatively weaker as occurred during prior QE
  • The healthcare sector has been the best performing sector within the S&P as well as versus every index and commodity in the tables
  • The yield curve steepened as expected
  • In the commodity sector, precious metals are weaker, but oil and copper are positive

Are Adjustments to QE4 Coming?

The Fed has recently made public statements that lead us to believe they are concerned with rising debt levels. In particular, a few Fed speakers have noted the sharp rise in corporate and federal debt levels both on an absolute basis and versus earnings and GDP. The increase in leverage is made possible in part by low interest rates and QE. In addition, some Fed speakers over the last year or two have grumbled about higher than normal equity valuations.

It was for these very reasons that in 2013, Jerome Powell voiced concerns about the consequences of asset purchases (QE). To wit: 

“What of the potential costs or risks of the asset purchases? A variety of concerns have been raised over time. With inflation in check, the most important potential risk, in my view, is that of financial instability. One concern is that our policies might drive excessive risk-taking or create bubbles in financial assets or housing.”

Earlier this month, Jerome Powell, in Congressional testimony said:

“The debt is growing faster than the economy. It’s as simple as that. That is by definition unsustainable. And it is growing faster in the United States by a significant margin.”

With more leverage in the financial system and higher valuations in the equity and credit markets, how does Fed Chairman Powell reconcile those comments with where we are today? It further serves to highlight that political expediency has thus far trumped the long-run health of the economy and the financial system.

Based on the Fed’s prior and current warnings about debt and valuations, we believe they are trying to fix funding issues without promoting greater excesses in the financial markets. To thread this needle, they must supply just enough liquidity to restore financing markets to normal but not over stimulate them. This task is much easier said than done due to the markets’ Pavlovian response to QE.

Where the fed funds effective rate sits within the Fed’s target range can be a useful gauge of the over or undersupplying of liquidity. Based on this measure, it appears the Fed is currently oversupplying liquidity as seen in the following chart. For the first time in at least two years, as circled, the effective Fed Funds rate has been consistently below the midpoint of the Fed’s target range.

If the Fed is concerned with debt levels and equity valuations and is comfortable that they have provided sufficient liquidity, might they halt QE4, reduce monthly amounts, or switch to a more flexible model of QE?

We think all of these options are possible.

Any effort to curtail QE will be negative for markets that have been feasting on the additional liquidity. Given the symbiotic relationship between markets and QE, the Fed will be cautious in making changes. As always, the first whisper of change could upset the apple cart.

Summary

Equity markets have been rising on an almost daily basis despite benign economic reports, negative trade and tariff headlines, and Presidential impeachment proceedings, among other worrisome factors. We have little doubt that investors have caught QE fever again, and they are more concerned with the FOMO than fundamentals.

As the fresh round of liquidity provided by the Fed leaks into the markets, it only further advances more misallocation of capital, such as excessive borrowing by zombie companies and borrowing to further fund unproductive stock buybacks. Like dogs drooling at the sound of a ringing bell, most investors expect the bull run to continue. It may, but there is certainly reason for more caution this time around as the contours of the economy and the market are vastly different from prior rounds. Add to this the incoherence of this policy action in light of the record expansion, benign inflation readings, and low unemployment rate and we have more questions about QE4 than feasible answers.

To Buy, Or Not To Buy- An Investors Guide to QE 4

In no sense is this QE” – Jerome Powell

On October 9, 2019, the Federal Reserve announced a resumption of quantitative easing (QE). Fed Chairman Jerome Powell went to great lengths to make sure he characterized the new operation as something different than QE. Like QE 1, 2, and 3, this new action involves a series of large asset purchases of Treasury securities conducted by the Fed. The action is designed to pump liquidity and reserves into the banking system.

Regardless of the nomenclature, what matters to investors is whether this new action will have an effect on asset prices similar to prior rounds of QE. For the remainder of this article, we refer to the latest action as QE 4.

To quantify what a similar effect may mean, we start by examining the performance of various equity indexes, equity sectors, commodities, and yields during the three prior QE operations. We then normalize the data for the duration and amount of QE to project what QE 4 might hold in store for the assets.

Equally important, we present several factors that are unique to QE 4 and may result in different outcomes. While no one has the answers, we hope that the quantitative data and the qualitative commentary we provide arms you with a better appreciation for asset return possibilities during this latest round of QE. 

How QE 1, 2, and 3 affected the markets

The following series of tables, separated by asset class, breaks down price performance for each episode of QE. The first table for each asset class shows the absolute price return for the respective assets along with the maximum and minimum returns from the start of each QE. The smaller table below it normalizes these returns, making them comparable across the three QE operations. To normalize the data, we annualize the respective QE returns and then scale the returns per $100 billion of QE. For instance, if the S&P 500 returned 10% annualized and the Fed bought $500 billion of assets during a particular QE, then the normalized return would be 2% per $100 billion of QE.

Data in the tables are from Bloomberg.  Click on any of the tables to enlarge.

QE 4 potential returns

If we assume that assets will perform similarly under QE 4, we can easily forecast returns using the normalized data from above. The following three tables show these forecasts. Below the tables are rankings by asset class as well as in aggregate. For purposes of this exercise, we assume, based on the Fed’s guidance, that they will purchase $60 billion a month for six months ($360 billion) of U.S. Treasury Bills.

Takeaways

The following list provides a summarization of the tables.

  • Higher volatility and higher beta equity indexes generally outperformed during the first three rounds of QE.
  • Defensive equity sectors underperformed during QE.
  • On average, growth stocks slightly outperformed value stocks during QE. Over the last decade, inclusive of non-QE periods, growth stocks have significantly outperformed value stocks.
  • Longer-term bond yields generally rose while shorter-term yields were flat, resulting in steeper yield curves in all three instances. 
  • Copper, crude oil, and silver outperformed the S&P 500, although the exceptional returns primarily occurred during QE 1 for copper and crude and QE 1 and 2 for Silver.
  • On a normalized basis, Silver’s 10.17% return per $100bn in QE 2, is head and shoulders above all other normalized returns in all three prior instances of QE.
  • In general, assets were at or near their peak returns as QE 1 and 3 ended. During QE 2, a significant percentage of early gains were relinquished before QE ended.
  • QE 2 was much shorter in duration and involved significantly fewer purchases by the Fed.
  • The expected top five performers during QE4 on a normalized basis from highest to lowest are: Silver, S&P 400, Discretionary stocks, S&P 600, and Crude Oil. 
  • Projected returns for QE 4 are about two-thirds lower than the average of prior QE. The lesser expectations are, in large part, a function of our assumption of a smaller size for QE4. If the actual amount of QE 4 is larger than current expectations, the forecasts will rise.

QE, but in a different environment

While it is tempting to use the tables above and assume the future will look like the past, we would be remiss if we didn’t point out that the current environment surrounding QE 4 is different from prior QE periods. The following bullet points highlight some of the more important differences.

  • As currently planned, the Fed will only buy Treasury Bills during QE 4, while the other QE programs included the purchase of both short and long term Treasury securities as well as mortgages backed securities and agency debt. 
  • Fed Funds are currently targeted at 1.75-2.00%, leaving the Fed multiple opportunities to reduce rates during QE 4. In the other instances of QE, the Fed Funds rate was pegged at zero. 
  • QE 4 is intended to provide the banking system needed bank reserves to fill the apparent shortfall evidenced by high overnight repo funding rates in September 2019. Prior instances of QE, especially the second and third programs, supplied banks with truly excess reserves. These excess reserves helped fuel asset prices.
  • Equity valuations are significantly higher today than during QE 1, 2, and 3.
  • The amount of government and corporate debt outstanding is much higher today, especially as compared with the QE 1 and 2 timeframes.
  • Having achieved a record-breaking duration, the current economic expansion is old and best described as “late-cycle”.

Déjà vu all over again?

The prior QE operations helped asset prices for three reasons.

  • The Fed removed a significant amount of securities from the market, which forced investors to buy other assets. Because the securities removed were the least risky available in the market, investors, in general, moved into riskier assets. This had a circular effect pushing investors further and further into riskier assets.
  • QE 4 appears to be providing the banks with needed reserves. Assuming that true excess reserves in the system do not rise sharply, as they did in prior QE, the banks will probably not use these reserves for proprietary trading and investing. 
  • Because the Fed is only purchasing Treasury Bills, the boost of liquidity and reserves is relatively temporary and will only be in the banking system for months, not years or even decades like QE 1, 2, and 3.

Will QE 4 have the same effect on asset prices as QE 1, 2, and 3?

Will the bullish market spirits that persisted during prior episodes of QE emerge again during QE 4?

We do not have the answers, but we caution that this version of QE is different for the reasons pointed out above. That said, QE 4 can certainly morph into something bigger and more akin to prior QE. The Fed can continue this round beyond the second quarter of 2020, an end date they provided in their recent announcement. They can also buy more securities than they currently allude to or extend their purchases to longer maturity Treasuries or both. If the economy stumbles, the Fed will find the justification to expand QE4 into whatever they wish.

The Fed is sensitive to market returns, and while they may not want excessive valuations to keep rising, they will do anything in their power to stop valuations from returning to more normal levels. We do not think investors can blindly buy on QE 4, as the various wrinkles in Fed execution and the environment leave too many unanswered questions. Investors will need to closely follow Fed meetings and Fed speakers for clues on expectations and guidance around QE 4.

The framework above should afford the basis for critical evaluation and prudent decision-making. The main consideration of this analysis is the benchmark it provides for asset prices going forward. Should the market disappoint despite QE 4 that would be a critically important contrarian signal.

In The Fed We TRUST – Part 2: What is Money?

Part one of this article can be found HERE.

President Trump recently nominated Judy Shelton to fill an open seat on the Federal Reserve Board. She was recently quoted by the Washington Post as follows: “(I) would lower rates as fast, as efficiently, and as expeditiously as possible.” From a political perspective there is no doubting that Shelton is conservative.

Janet Yellen, a Ph.D. economist from Brooklyn, New York, appointed by President Barack Obama, was the most liberal Fed Chairman in the last thirty years.

Despite what appears to be polar opposite political views, Mrs. Shelton and Mrs. Yellen have nearly identical approaches regarding their philosophy in prescribing monetary policy. Simply put, they are uber-liberal when it comes to monetary policy, making them consistent with past chairmen such as Ben Bernanke and Alan Greenspan and current chairman Jay Powell.

In fact, it was Fed Chairman Paul Volcker (1979 to 1987), a Democrat appointed by President Jimmy Carter, who last demonstrated a conservative approach towards monetary policy. During his term, Volcker defied presidential “advice” on multiple occasions and raised interest rates aggressively to choke off inflation. In the short-term, he harmed the markets and cooled economic activity. In the long run, his actions arrested double-digit inflation that was crippling the nation and laid the foundation for a 20-year economic expansion.

Today, there are no conservative monetary policy makers at the Fed. Since Volcker, the Fed has been run by self-described liberals and conservatives preaching easy money from the same pulpit. Their extraordinary policies of the last 20 years are based almost entirely on creating more debt to support the debt of yesteryear as well as economic and market activity today. These economic leaders show little to no regard for tomorrow and the consequences that arise from their policies. They are clearly focused on political expediency.

Different Roads but the Same Path –Government

Bernie Sanders, Alexandria Ocasio-Cortez, Elizabeth Warren, and a host of others from the left-wing of the Democrat party are pushing for more social spending. To support their platform they promote an economic policy called Modern Monetary Theory (MMT). Read HERE and HERE for our thoughts on MMT. 

In general, MMT would authorize the Fed to print money to support government spending with the intention of boosting economic activity. The idealized outcome of this scheme is greater prosperity for all U.S. citizens. The critical part of MMT is that it would enable the government to spend well beyond tax revenue yet not owe a dime.   

President Trump blamed the Fed for employing conservative monetary policy and limiting economic growth when he opined, “Frankly, if we didn’t have somebody that would raise interest rates and do quantitative tightening (Powell), we would have been at over 4 instead of a 3.1.” 

Since President Trump took office, U.S government debt has risen by approximately $1 trillion per year. The remainder of the post-financial crisis period saw increases in U.S. government debt outstanding of less than half that amount. Despite what appears to be polar opposite views on just about everything, under both Republican and Democratic leadership, Congress has not done anything to slow spending or even consider the unsustainable fiscal path we are on. The last time the government ran such exorbitant deficits while the economy was at full employment and growing was during the Lyndon B. Johnson administration. The inflationary mess it created were those that Fed Chairman Volcker was charged with cleaning up.

From the top down, the U.S. government is and has been stacked with fiscal policymakers who, despite their political leanings, are far too undisciplined on the fiscal front.

We frequently assume that a candidate of a certain political party has views corresponding with those traditionally associated with their party. However, in the realm of fiscal and monetary policy, any such distinctions have long since been abandoned.

TRUST

Now consider the current stance of Democratic and Republican fiscal and monetary policy within the TRUST framework. Government leaders are pushing for unprecedented doses of economic stimulus. Their secondary goal is to maximize growth via debt-driven spending. Such policies are fully supported by the Fed who keeps interest rates well below what would be considered normal. The primary goal of these policies is to retain power.

To keep interest rates lower than a healthy market would prescribe, the Fed prints money. When policy consistently leans toward lower than normal rates, as has been the case, the money supply rises. In the wake of the described Fed-Government partnership lies a currency declining in value. As discussed in prior articles, inflation, which damages the value of a currency, is always the result of monetary policy decisions.

If the value of a currency rests on its limited supply, are we now entering a phase where the value of the dollar will begin to get questioned? We don’t have a definitive answer but we know with 100% certainty that the damage is already done and the damage proposed by both political parties increases the odds that the almighty dollar will lose value, and with that, TRUST will erode. Recall the graph of the dollar’s declining purchasing power that we showed in Part 1.

Data Courtesy St. Louis Federal Reserve

Got Money? 

If the value of the dollar and other fiat currencies are under liberal monetary and fiscal policy assault and at risk of losing the valued TRUST on which they are 100% dependent, we must consider protective measures for our hard-earned wealth.

With an underlying appreciation of the TRUST supporting our dollars, the definition of terms becomes critically important. What, precisely, is the difference between currency and money? 

Gold is defined as natural element number 79 on the periodic table, but what interests us is not its definition but its use. Although gold is and has been used for many things, its chief purpose throughout the 5,000-year history of civilization has been as money.

In testimony to Congress on December 18, 1912, J.P. Morgan stated: “Money is gold, and nothing else.” Notably, what he intentionally did not say was money is the dollar or the pound sterling. What his statement reveals, which has long since been forgotten, is that people are paid for their labor through a process that is the backbone of our capitalist society. “Money,” properly defined, is a store of labor and only gold is money.

In the same way that cut glass or cubic zirconium may be made to look like diamonds and offer the appearance of wealth, they are not diamonds and are not valued as such. What we commonly confuse for money today – dollars, yen, euro, pounds – are money-substitutes. Under an evolution of legal tender laws since 1933, global fiat currencies have displaced the use of gold as currency. Banker-generated currencies like the dollar and euro are not based on expended labor; they are based on credit. In other words, they do not rely on labor and time to produce anything. Unlike the efforts required to mine gold from the ground, currencies are nearly costless to produce and are purely backed by a promise to deliver value in exchange for labor.

Merchants and workers are willing to accept paper currency in exchange for their goods and services in part because they are required by law to do so. We must TRUST that we are being compensated in a paper currency that will be equally TRUSTed by others, domestically, and internationally. But, unlike money, credit includes the uncertainty of “value” and repayment.

Currency is a bank liability which explains why failing banks with large loan losses are not able to fully redeem the savings of those who have their currency deposited there. Gold does not have that risk as there is no intermediary between it and value (i.e., the U.S. government or the Japanese government). Gold is money and harbors none of these risks, while currency is credit. Said again for emphasis, only gold is money, currency is credit.

There is a reason gold has been the money of choice for the entirety of civilization. The last 90 years is the exception and not the rule.

Despite their actions and words, the value of gold, and disTRUST of the dollar is not lost on Central Bankers. Since 2013, global central banks have bought $140 billion of gold and sold $130 billion of U.S. Treasury bonds. Might we say they are trading TRUST for surety?

Summary

To repeat, currency, whether dollars, pounds, or wampum, are based on nothing more than TRUST. Gold and its 5000 year history as money represents a dependable store of labor and real value; TRUST is not required to hold gold. No currency in the history of humankind, the almighty U.S. dollar included, can boast of the same track record.

TRUST hinges on decision makers who are people of character and integrity and willingness to do what is best for the nation, not the few. Currently, both political parties are taking actions that destroy TRUST to gain votes. While political party narratives are worlds apart, their actions are similar. Deficits do matter because as they accumulate, TRUST withers.

This article is not a call to action to trade all of your currency for gold, but we TRUST this article provokes you to think more about what money is.

QE By Any Other Name

“What’s in a name? That which we call a rose, By any other name would smell as sweet.” – Juliet Capulet in Romeo and Juliet by William Shakespeare

Burgeoning Problem

The short-term repo funding turmoil that cropped up in mid-September continues to be discussed at length. The Federal Reserve quickly addressed soaring overnight funding costs through a special repo financing facility not used since the Great Financial Crisis (GFC). The re-introduction of repo facilities has, thus far, resolved the matter. It remains interesting that so many articles are being written about the problem, including our own. The on-going concern stems from the fact that the world’s most powerful central bank briefly lost control over the one rate they must control.

What seems clear is the Fed measures to calm funding markets, although superficially effective, may not address a bigger underlying set of issues that could reappear. The on-going media attention to such a banal and technical topic could be indicative of deeper problems. People who understand both the complexities and importance of these matters, frankly, are still wringing their hands. The Fed has applied a tourniquet and gauze to a serious wound, but permanent medical attention is still desperately needed.

The Fed is in a difficult position. As discussed in Who Could Have Known – What the Repo Fiasco Entails, they are using temporary tools that require daily and increasingly larger efforts to assuage the problem. Taking more drastic and permanent steps would result in an aggressive easing of monetary policy at a time when the U.S. economy is relatively strong and stable, and such policy is not warranted in our opinion. Such measures could incite the most underrated of all threats, inflationary pressures.

Hamstrung

The Fed is hamstrung by an economy that has enjoyed low interest rates and stimulative fiscal policy and is the strongest in the developed world. By all appearances, the U.S. is also running at full employment. At the same time, they have a hostile President sniping at them to ease policy dramatically and the Federal Reserve board itself has rarely seen internal dissension of the kind recently observed. The current fundamental and political environment is challenging, to be kind.

Two main alternatives to resolve the funding issue are:

  1. More aggressive interest rate cuts to steepen the yield curve and relieve the banks of the negative carry in holding Treasury notes and bonds
  2. Re-initiating quantitative easing (QE) by having the Fed buy Treasury and mortgage-backed securities from primary dealers to re-liquefy the system

Others are putting forth their perspectives on the matter, but the only real “permanent” solution is the second option, re-expanding the Fed balance sheet through QE. The Fed is painted into a financial corner since there is no fundamental justification (remember “we are data-dependent”) for such an action. Further, Powell, when asked, said they would not take monetary policy actions to address the short-term temporary spike in funding. Whether Powell likes it or not, not taking such an action might force the need to take that very same action, and it may come too late.

Advice from Those That Caused the Problem

There was an article recently written by a former Fed official now employed by a major hedge fund manager.

Brian Sack is a Director of Global Economics at the D.E. Shaw Group, a hedge fund conglomerate with over $40 billion under management. Prior to joining D.E. Shaw, Sack was head of the New York Federal Reserve Markets Group and manager of the System Open Market Account (SOMA) for the Federal Open Market Committee (FOMC). He also served as a special advisor on monetary policy to President Obama while at the New York Fed.

Sack, along with Joseph Gagnon, another ex-Fed employee and currently a senior fellow at the Peterson Institute for International Economics, argue in their paper LINK that the Fed should first promptly establish a standing fixed-rate repo facility and, second, “aim for a higher level of reserves.” Although Sack and Gagnon would not concede that reserves are “low”, they argue that whatever the minimum level of reserves may be in the banking system, the Fed should “steer well clear of it.” Their recommendation is for the Fed to increase the level of reserves by $250 billion over the next two quarters. Furthermore, they argue for continued expansion of the Fed balance sheet as needed thereafter.

What they recommend is monetary policy slavery. No matter what language they use to rationalize and justify such solutions, it is pure pragmatism and expediency. It may solve short-term funding issues for the time being, but it will leave the U.S. economy and its citizens further enslaved to the consequences of runaway debt and the monetary policies designed to support it.

If It Walks and Quacks Like a Duck…

Sack and Gagnon did not give their recommendation a sophisticated name, but neither did they call it “QE.” Simply put, their recommendation is in fact a resumption of QE regardless of what name it is given.

To them it smells as sweet as QE, but the spin of some other name and rationale may be more palatable to the public. By not calling it QE, it may allow the Fed more leeway to do QE without being in a recession or bringing rates to near zero in attempts to avoid becoming a political lightening rod.

The media appears to be helping with what increasingly looks like a sleight of hand. Joe Weisenthal from Bloomberg proposed the following on Twitter:

To help you form your own opinion let’s look at some facts about QE and balance sheet increases prior to the QE era. From January of 2003 to December of 2007, the Fed’s balance sheet steadily increased by $150 billion, or about $30 billion a year. The new proposal from Sack and Gagnon calls for a $250 billion increase over six months. QE1 lasted six months and increased the Fed’s balance sheet by $265 billion. Maybe its us, but the new proposal appears to be a mirror image of QE.

Summary

The challenge, as we see it, is that these former Fed officials do not realize that the policies they helped create and implement were a big contributor to the financial crisis a decade ago. The ensuing problems the financial system is now enduring are a result of the policies they implemented to address the crisis. Their proposed solutions, regardless of what they call them, are more imprudent policies to address problems caused by imprudent policies since the GFC.

Who Could Have Known: What The Repo Fiasco Entails

Imagine approaching a friend that you think is very wealthy and asking her to borrow ten thousand dollars for just one night. To entice her, you offer as collateral the title to your 2019 Lexus parked in her driveway along with an interest rate that is 5% above that which she is earning in the bank. Shockingly, your friend says she can’t. Given the risk-free nature of the transaction and excellent one-day profit, we can assume that our friend may not be as wealthy as we thought.

On Monday, September 16th, 2019, a similar situation occurred in the overnight repurchase agreement (repo) funding market. On that day, banks were unwilling or unable to lend on a collateralized basis, even with the promise of large risk-free profits. This behavior reveals something very important about the banking system and points to the end of market stimulus that has been around for the past decade.

The Plumbing of the Banking System and Financial Markets

Interbank borrowing is the engine that allows the financial system to run smoothly. Banks routinely borrow and lend to each other on an overnight basis to ensure that all banks have ample funds to meet daily cash flow needs and that banks with excess funds can earn interest on them. Literally, years go by with no problems in the interbank markets and not a mention in the media.

Before proceeding, what follows is a definition of the funding instruments used in the interbank markets.

  • Fed Funds are uncollateralized interbank loans that are almost exclusively done on an overnight basis. Except for a few exceptions, only banks can trade Fed Funds.
  • Repo (repurchase agreements) are collateralized loans. These transactions occur between banks but often involve other non-bank financial institutions such as insurance companies. Repo can be negotiated on an overnight and longer-term basis. General collateral, or “GC,” is a term used to describe Treasury, agency, and mortgage collateral that backs certain repo loans. In a GC repo, the particular securities backing the loan are not determined until after the transaction is agreed upon by the counterparties. The securities delivered must meet certain pre-defined criteria.

On September 16th, overnight GC repo traded as high as 8%, almost 6% higher than the Fed Funds rate, which theoretically should keep repo and other money market rates closely tied to it. The billion-dollar question is, “Why did a firm willing to pay a hefty premium, with risk-free collateral, struggle to borrow money”?  Before the 16th, a premium of 25 to 50 basis points versus Fed Funds would have enticed a mob of financial institutions to lend money via the repo markets. On the 16th, many multiples of that premium were not enticing enough.

Most likely, there was an unexpected cash crunch that left banks and/or financial institutions underfunded. The media has talked up the corporate tax date and a large Treasury bond settlement date as potential reasons. We are not convinced by either excuse as they were easily forecastable weeks in advance.

Regardless of what caused the liquidity crunch, we do know, that in aggregate, banks did not have the capacity to lend money. Given the capacity, they would have done so in a New York minute and at much lower rates.

To highlight the enormity of the aberration, consider the following:

  • Since 2006, the average daily difference between the overnight GC repo rate and the Fed Funds effective rate was .025%.
  • Three standard deviations or 99.5% of the observances should have a spread of .56% or less.
  • 8% is a bewildering 42 standard deviations from the average, or simply impossible assuming a traditional bell curve.

What was revealed on the 16th?

The U.S. and global banking systems revolve around fractional reserve banking. That means banks need only hold a fraction of the cash deposits that they hold in reserve accounts at the Fed. For example, if a bank has $1,000 in deposits (a liability to the bank), they may lend $900 of those funds and retain only 10% in reserves. This is meant to ensure they have enough funding on hand to make payments during the day and also as a buffer against unanticipated liquidity needs. Before 2008, banks held only just as many reserves as were required by the Fed. Holding anything more than the required minimum was a drag on earnings, as excess reserves were unremunerated at the time.

Quantitative Easing (QE) and the need for the Fed to pay interest on newly formed excess reserves changed that. When the Fed conducted QE, they bought U.S. Treasury, agency, and mortgage-backed securities and credited the selling bank’s reserve account. The purpose of QE1 was to ensure that the banking system was sufficiently liquid and equipped to deal with the ramifications of the ongoing financial crisis. Round one of QE was logical given the growing list of bank/financial institution failures. However, additional rounds of QE appear to have had a different motive and influence as banks were highly liquid after QE1 and had shored up their capital as well. That is a story for another day.

The graph below shows how “excess” reserves were close to zero before 2008 and soared by over $2.5 trillion after the three rounds of QE. Before QE, “excess” reserves were tiny, measured in the hundreds of millions. The amount is so small it is not visible on the graph below. The reserves produced by multiple rounds of quantitative easing may have been truly excess, meaning above required reserves, on day one of QE. However, on day two and beyond that is not necessarily true for any particular bank or the system as a whole, as we are about to explain.

Data courtesy: St. Louis Federal Reserve

The Fed, having pushed an enormous amount of reserves on the banks, created a potential problem. The Fed feared that once the smoke cleared from the financial crisis, banks would revert to their pre-crisis practice of keeping only the minimum amount of reserves required. This would leave them an unprecedented surplus of excess funds to buy financial assets and/or create loans which would vastly increase the money supply with inflationary consequences. To combat this problem, they incentivized the banks to keep the reserves locked down by paying them a rate of interest on the reserves that were higher than the Fed funds rates and other prevailing money market rates. This rate is called the IOER or the interest on excess reserves.

The Fed assumed banks would hold excess reserves because they could make risk free profits at no cost. This largely worked, but some reserves were leveraged by the banks and flowed into the financial markets. This was a big factor in driving stock prices higher, credit spreads tighter, and bond yields lower. This form of inflation the Fed seemed to desire as evidenced from their many speeches talking about generating household net worth.

From the banks’ perspective, the excess reserves supplied by the Fed during QE were preferential to traditional uses of excess reserves. Historically, excess bank reserves were invested in the Treasury market or lent on to other banks in the Fed Funds market. Purchasing Treasury securities had no credit risk, but banks are required to mark their Treasury holdings to market and therefore produce unexpected gains and losses. Lending reserves in the interbank market also incurred counterparty risk, as there was always the chance the borrowing bank would be unable to repay the loan, especially in the immediate post-crisis period. Additionally, as QE had produced trillions in excess reserves, there was not much demand from other banks. Therefore, the banks preferred use of excess reserves was leaving them on deposit with the Fed to earn IOER. This resulted in no counterparty risk and no mark to market risk.

Beginning in 2018, the Fed began reducing their balance sheet via QT and the amount of excess reserves held by banks began to decline appreciably.

Solving Our Mystery

It is nearly impossible for the public to figure out how much in excess reserves the banking system is truly carrying. Indeed, even the Fed seems uncertain. It is common knowledge that they have been declining, and over the last six months, clues emerged that the amount of “truly excess reserves,” meaning the amount banks could do without, was possibly approaching zero.  

Clue one came on March 20th, 2019 when the Fed said QT would end in October 2019. Then, on July 31st, 2019, as small problems occurred in the funding markets, the Fed abruptly announced that they would halt the balance sheet reduction in August, two months earlier than originally planned. The QT effort, despite assurances from Bernanke, Yellen, and Powell that it would be uneventful, ended 22 months after it began. The Fed’s balance sheet declined only $800 billion as a result of QT, less than a quarter of what the Fed added to their balance sheet during QE.

Clue two was the declining spread between the IOER rate and the effective Fed Funds rate as the level of excess reserves was declining, as seen in the chart below. The spread between IOER and the Fed Funds rate was narrowing because the Fed was having trouble maintaining the Fed Funds rate within the targeted range. In March 2019, the spread became negative, which was counter to the Fed’s objectives. Not surprisingly, this is when the Fed first announced that QT would end.

Data courtesy: St. Louis Federal Reserve

The third and final clue emerged on September 16, 2019, when overnight repo traded at 7%-8%. If banks truly had excess reserves, they would have lent some of that excess into the repo market and rates would never have gotten close to 7-8%. It seems logical that banks would have been happy to lend on a collateralized basis at 3%, much less 7-8%, when their alternative, leaving excess reserves to the Fed, would have earned them 2.25%.   

Further confirmation that something was amiss occurred on September 17th, 2019, when the Fed Funds effective rate was above the upper end of the Fed’s target range of 2-2.25% at the time. This marked the first time the Fed Funds rate traded above its target since 2008.

On September 17th, the Fed entered the repo markets with a $53 billion overnight repo operation, whereby banks could pledge Treasury collateral to the Fed and receive cash. The temporary liquidity injection worked and brought repo rates back to normal. The following day the Fed pumped $75 billion into the markets. These were the first repo transactions executed by the Fed since the Financial Crisis, as shown below.

These liquidity operations will likely continue as long as there is demand from banks. The Fed will also conduct longer-term repo operations to reduce the amount of daily liquidity they provide.

The Fed can continue to resort to the pre-QE era tactics and use temporary daily operations to help target overnight borrowing rates. They can also reduce the reserve requirements which would, at least for some time, provide the system with excess reserves. Lastly, they can permanently add reserves with QE. Recent rhetoric from Fed Chairman Powell and New York Fed President Williams suggests a resumption of QE in some form may be closer than we think.

Why should we care?

The QE-related excess reserves were used to invest in financial assets. While the investments were probably high-grade liquid assets, they essentially crowded out investors, pushing them into slightly riskier assets. This domino effect helped lift all asset prices from the most risk-free and liquid to those that are risky and illiquid. Keep in mind the Fed removed about $3.6 trillion of Treasury and mortgage securities from the market which had a similar effect.

The bottom line is that the role excess reserves played in stimulating the markets over the last decade is gone. There are many other factors driving asset prices higher such as passive investing, stock buybacks, and a broad-based, euphoric investment atmosphere, all of which are byproducts of extraordinary monetary policies. The new modus operandi is not necessarily a cause for concern, but it does present a new demand curve for the markets that is different from what we have become accustomed to.

Summary

Short-term funding is never sexy and rarely if ever, the most exciting part of the capital markets. A brief recollection of 2008 serves as a reminder that, when it is exciting, it is usually a harbinger of volatility and disruption.

In a Washington Post article from 2010, Bernanke stated, “We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time.”

Much more recently, Jay Powell stated, “We’ve been operating in this regime for a full decade. It’s designed specifically so that we do not expect to be conducting frequent open market operations to keep fed fund [sic] rates in the target range.” 

Today, a decade after the financial crisis, we see that Bernanke and Powell have little appreciation for the inner-workings of the financial system. 

In the Wisdom of Peter Fisher, an RIA Pro article released in July, we discussed the insight of Peter Fisher, a former Treasury, and Federal Reserve official. Unlike most other Fed members and politicians, he discussed how hard getting back to normal will be. As we are learning, it turns out that Fisher’s wisdom from 2017 was visionary.

“As Fisher stated in his remarks, The challenge of normalizing policy will be to undo bad habits that have developed in how monetary policy is explained and understood.” He continues, “…the Fed will have to walk back from their early assurances that the “exit would be easy.”

Prophetic indeed.

The Wisdom of Peter Fisher

“In recent years, numerous major central banks announced objectives of achieving more rapid rates of inflation as strategies for fostering higher standards of living. All of them have failed to achieve their objectives.” – Jerry Jordan, former Cleveland Federal Reserve Bank President

In March 2017, former Treasury and Federal Reserve (Fed) official, Peter R. Fisher, delivered a speech at the Grant’s Interest Rate Observer Spring Conference entitled Undoing Extraordinary Monetary Policy. It is one of the most insightful and compelling assessments of the Fed’s post-financial crisis policy actions available.

Now a professor at the Tuck School of Business at Dartmouth, Fisher is a true insider with experience in the government and private sector that affords him unique insight. Given the recent policy “pivot” by Chairman Powell and all members of the Fed, Fisher’s comments from two years ago take on fresh relevance worth revisiting.

In the past, when Fed leadership discussed normalizing the Fed’s post-crisis policy actions, they exuded confidence that it can and will be done smoothly and without any implications for the economy or markets. Specifically, in a Washington Post article from 2010, Bernanke stated, “We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time.” More recently, Janet Yellen and others have echoed those sentiments. Current Fed Chairman Jerome Powell, tasked with normalizing policy, appears to be finding out differently.

Define “Normal”

Taking a step back, there are important issues at stake if the Fed truly wants to unshackle the market economy from the influences of extreme monetary policy and the harm it may be causing. To normalize policy, the Fed first needs to explicitly define “normal.”

For instance:

  • The Fed should take steps to raise interest rates to what is considered “normal” levels. Normal can be characterized as a Federal Funds target rate in line with the average of the past 30 years or it might be a level that reflects sufficient “dry powder” were the Fed to need that policy tool in a future economic slowdown.
  • The Fed should reduce the size of their balance sheet. In this case, normal under reasonable logic would be the size of the balance sheet before the financial crisis either in absolute terms or as a percentage of nominal gross domestic production (GDP). Despite some reductions, it is not close on either count.

The Fed consistently feeds investors’ guessing games about what they deem appropriate. There appears to be little rigor, debate, or transparency about the substance of those decisions. Neither Ben Bernanke nor Janet Yellen offered details about how they would accurately characterize “normal” in either context. The reason for this seems obvious enough. If they were to establish reasonable parameters that defined normal levels in either case, they would be held accountable for differences from their prescribed benchmarks. It might force them to take actions that, while productive and proper in the long-run, may be disruptive to the financial markets in the short run. How inconvenient.

In most instances, normal is defined as something that conforms to a standard or that which has been common under historical experience. Begin by looking at the Fed Funds target rate. A Fed Funds rate of 0.0% for seven years is not normal, nor is the current rate range of 2.25-2.50%.

As illustrated in the chart below, in each of the past three recessions dating back to 1989, the Fed cut the fed funds rate by an average of 5.83%. In that context, and now resting at less than half the average historical pre-recession level, a Fed Funds rate of 2.25-2.50% is clearly abnormal and of greater concern, insufficient to combat a downturn.

Interest rates should mimic the structural growth rate of the economy. As we have illustrated in prior analysis and articles, particularly Wicksell’s Elegant Model, using a 7-year cycle for economic growth reflective of historical expansions, that time-frame should offer a reasonable proxy for “structural” economic growth. The issue of greater concern is that, contrary to the statement above, structural growth appears to be imitating the level of interest rates meaning the more the Fed suppresses interest rates, the more growth languishes.

Next, let’s look at the Fed balance sheet. Quantitative tightening began in late 2017 gradually increasing as the Fed allowed their securities bought during QE to mature without replacing them. As shown in the blue shaded area in the chart below, QT reduced the Fed balance sheet by about $500 billion, but it remains absurdly high at nearly $4.0 trillion. As a percentage of GDP, it has dropped from a peak of 25.3% to 19%. Before the point at which QE was initiated in September 2008, the size of the Fed balance sheet was roughly $900 billion or 6% of nominal GDP and was in a tight range around that level for decades. Now, with the Fed halting any further reductions in the balance sheet, are we to assume 20% of GDP to be a normal level? If so, what is the basis for that conclusion?

The bottom line: simple analysis, straight-forward logic, and common sense dictate that monetary policy remains abnormal.

Fisher helps us understand why the Fed is so hesitant to normalize policy, despite their outward confidence in being able to do so.

Second-Order Effects

As Fisher stated in his remarks at the conference, The challenge of normalizing policy will be to undo bad habits that have developed in how monetary policy is explained and understood.” This is a powerfully important statement highlighting second-order effects. He continues, “…the Fed will have to walk back from their early assurances that the “exit would be easy.” Prophetic indeed.

The “easy” part of getting rates and the balance sheet back to “normal” is now proving to be not so easy. What the Fed did not account for when they unleashed unprecedented policy was the habits and behaviors among governments, corporations, households, and investors. Modifying these behaviors will come at a debilitating cost.

Think of it like this: Nobody starts smoking cigarettes with a goal of smoking two packs a day for 30 years, but once introduced, it is difficult to stop. Furthermore, trying to stop smoking can be very painful and expensive. NOT stopping is medically and scientifically proven to be even more so.

Fisher goes on to explain in real-world terms how two households are impacted in an environment of extraordinary policy actions. One household possesses savings; the other does not. Consider their traditional liabilities such as mortgage and auto loans, “but also their future consumption expenditures, their liability to feed and clothe themselves in the future.” The family with savings may feel wealthier from gains in their invested savings and retirement accounts as a result of extraordinary policies pushing financial markets higher, but they also must endure an increase in the cost of living. In the final analysis, they end up where they started. “They may… perceive a wealth effect but, ultimately, there is only a wealth illusion.”

As for the family without savings, they had no investments to go up in value, so there is no wealth effect. This means that their cost of living rose and, wages largely stagnant, it occurred without any form of a commensurate rise in income. That can only mean their standard of living dropped. As Fisher states, given extraordinary policy imposed, “There was no wealth effect, not even a wealth illusion, just a cruel hoax.” He further adds, “…the next time you hear that the net-wealth of American households is at an all-time high, do spend a minute thinking about the present value of the unrecorded future consumption expenditures, particularly of households with no savings.”

What is remarkable about Fisher’s analysis is contrasting it with the statements of Fed officials who say they are acting in the best interest of all U.S. citizens. Quoting from George Orwell’s Animal Farm, “All animals are equal, but some animals are more equal than others.”

A man can easily drown crossing a stream that is on average 3 feet deep. Household wealth as a macro measure of monetary policy success in a period when wealth inequality is at such extremes perfectly illustrates this imperfection. As Fisher states, “Out of both humility and self-preservation, let’s hope the Fed finds a way to stop targeting the level of wealth.”

Linear Extrapolation

Fisher also addresses the issue of Fed forward guidance stating, “Implicit in forward guidance…is the idea that dampening short-term market uncertainty and volatility is a good thing. But removing uncertainty from our capital markets is not, in my view, an unambiguous blessing.”

Forward guidance, whereby the Fed provides expectations about future policy, targets an optimal level of volatility without being clear about what “optimal” means. How does the Fed know what is optimal? As we have stated before, a market made up of millions of buyers and sellers is a much better arbiter of prices, value, and the resulting volatility than is the small group of unelected officials at the Fed. Yet, they do indeed falsely portray an understanding of “optimal” by managing the prices of interest rates but theirs is a guess no better than yours or mine. Based upon their economic track record, we would argue their guess is far worse.

Fisher goes on to reference John Maynard Keynes on the subject of extrapolative expectations which is commonly used as a basis for asset pricing. Referring to it as the “conventional valuation” in his book The General Theory of Employment, Interest and Money, Keynes said this reflects investors’ assumptions “that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change.” Connecting those dots, Fisher states that “forward guidance is the process through which the Fed – through its more explicit influence on the expected rate of interest – becomes the much more explicit owner of the “conventional valuation” of asset prices… the Fed now has a heightened responsibility and sensitivity to asset pricing.

That conclusion is critically important and clarifies the behavior we see coming out of the Eccles Building. In becoming the “explicit owner” of valuations in the stock market, the Fed now must adhere to a pattern of decisions and actions that will ultimately support the prices of risky assets under all circumstances. Far from rigorous scrutiny of doubts and assumptions, the Fed fails in every way to apply the scientific method of analyzing their actions before and after they take them. So desperate are they to manage the expectations of the public, their current posture leaves no latitude for uncertainty. As Fisher further points out, the last time we saw evidence of a similar stance was in 2007 when the Fed rejected the possibility of a nation-wide decline in house prices.

Summary

Fisher fittingly sums up by restating the point he made at the beginning:

“…the Fed and other central banks appear to have avoided being candid about the uncertainty (of extraordinary monetary policies) in order to maintain their credibility. But this is backwards. They cannot regain their credibility unless they are candid about the uncertainty and how they confront it.”

The power of Fisher’s perspectives is in his candor. Now at a time when the Fed is proving him correct on every count, it is worthwhile to refresh our memories. We would encourage investors to read the transcript in full. Given the clarity of the insights he shares, summarized here, their importance cannot be overstated.

Undoing Extraordinary Monetary Policy