Tag: excess reserves

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S&P 500: Rate cuts and employment

Ten-year Treasury yields rallied for the last two weeks but remain in a down-trend. Respect of resistance at 2.60% would warn of another decline.

10-year Treasury yields

Inflation is subdued and it would be difficult for the Fed to motivate a rate cut when inflation is close to its 2.0% target. The consumer price index (CPI) came in at 1.86% for the 12 months to March 2019, while the more stable Core CPI (ex- Food & Energy) remains close to target at 2.04%.

CPI and Core CPI

After price stability, the second part of the Fed’s dual mandate is to maintain maximum sustainable employment. A review of the last three cycles shows the Fed raising the funds rate (FFR) to curb inflation and then being forced to cut (red highlights) when growth in employment slows.

Payroll Changes and Fed Funds Rate

Total non-farm payrolls are currently growing at close to 2.0%. The Fed would normally need payroll growth to slow by at least 1.0% to motivate a rate cut. The exception is if inflation falls below target, then the Fed may act sooner.

The S&P 500 is headed for another test of its high at 2950, while Trend Index (13-week) recovered to signal moderate buying pressure.

S&P 500

The Nasdaq 100 is similarly testing its earlier high at 7700.

Nasdaq 100

Momentum is slowing and we can expect stubborn resistance at the former highs.

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The Fed and Alice in Wonderland

In Lewis Carroll’s Alice in Wonderland a young Alice experiences a series of bizarre adventures after falling down a rabbit hole. The new Fed Chairman Jerome Powell will similarly have to lead global financial markets through a series of bizarre, unprecedented experiences.

Down the Rabbit Hole

In 2008, after the collapse of Lehman Bros, financial markets were in complete disarray and in danger of imploding. The Fed, under chairman Ben Bernanke, embarked on an unprecedented (and unproven) rescue attempt — now known as quantitative easing or QE for short — injecting more than $3.5 trillion into the financial system through purchase of long-term Treasuries and mortgage-backed securities (MBS).

Fed Total Assets

The Fed aimed to drive long-term interest rates down in the belief that this would encourage private sector borrowing and investment and revive the economy. Their efforts failed. Private sector borrowing did not revive. Most of the money injected ended up, unused by the private sector, as $2.5 trillion of excess commercial bank reserves on deposit at the Fed.

Fed Excess Reserves

Richard Koo pointed out that the private sector will under normal cirumstances respond to lower interest rates with increased borrowing but during a financial crisis, when their balance sheets have been destroyed and their liabilities exceed their assets, their sole focus is to restore their balance sheet, using surplus cash flow to pay down debt. The only way to prevent a collapse is for the government to step in and plug the gap, borrowing surplus capital and investing this in infrastructure.

One Pill Makes you Larger

Fortunately Bernanke got the message.

US and Euro Area Public Debt to GDP

… and spread the word.

Japan Public Debt to GDP

And One Pill Makes you Small

Unfortunately, other central banks also followed the Fed’s earlier lead, injecting vast sums into the financial system through quantitative easing (QE).

ECB and BOJ Total Assets

Driving long-term yields to levels even Lewis Carroll would have struggled to imagine.

10-Year Treasury Yields

The Pool of Tears

Then in 2014, another twist in the tale. Long-term yields continued to fall in Europe and Japan, while US rates stabilised as Fed eased off on QE. A large differential appeared between US and European/Japanese rates (observable since 2014 on the above chart), causing a flood of money into the US, in pursuit of higher yields.

….. with an unwanted side-effect. The Dollar strengthened. Capital inflows caused the trade-weighted value of the US Dollar to spike upwards beween 2014 and 2016, damaging US export industries and local manufacturers facing competition from foreign imports.

US Trade-Weighted Dollar Index

The Mad Hatter’s Tea Party

A jobless recovery in manufacturing and low wage growth in turn led to the election of Donald Trump in 2016 promising increased protectionism against global competition.

US Manufacturing Jobs

Then in 2017, to the consternation of many, despite rising interest rates the US Dollar began to fall.

US TW Dollar Index in 2017

Learned analysis followed, ascribing the weakening Dollar to rising commodity prices and a recovery in emerging markets. But something doesn’t quite add up.

International bond investors are a pretty smart bunch. When they look at US bond markets, what do they see? The new Fed Chairman has inherited a massive headache.

Donald Trump is determined to stimulate job growth through tax cuts and infrastructure spending. This will certainly create jobs. But when you stimulate an economy that is already at full employment you get inflation.

Who Stole the Tarts?

Jerome Powell is sitting on a powder keg. More than $2 trillion of excess reserves that commercial banks can withdraw without notice. Demand for bank credit is expected to rise as result of the Trump stimulus. Commercial banks, not known for their restraint, can make like Donkey Kong with their excess reserves provided by the Bernanke Fed.

Under Janet Yellen the Fed mapped out a program to withdraw excess reserves from the market by selling down Treasuries and MBS at the rate of $100 billion in 2018 and $200 billion each year thereafter. But at that rate it will take 10 years to remove the excess.

Bond markets are worried about what will happen to inflation in the mean time.

Off With His Head

The new Fed Chair has made all the right noises about being hawkish on inflation. But can he walk the talk? Especially with his $2 trillion headache.

….and the Red Queen, easily recognizable from Lewis Carroll’s tale, tweeting “off with his head” if a hawkish Fed threatens to spoil the party.

One pill makes you larger
And one pill makes you small
And the ones that mother gives you
Don’t do anything at all
Go ask Alice
When she’s ten feet tall

….When the men on the chessboard
Get up and tell you where to go
And you’ve just had some kind of mushroom
And your mind is moving low….

When logic and proportion
Have fallen sloppy dead
And the White Knight is talking backwards
And the Red Queen’s off with her head
Remember what the dormouse said
Feed your head
Feed your head

~ White Rabbit by Grace Slick from Jefferson Airplane (1967)

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Fed flunks econ 101?

Caroline Baum’s opinion on the Fed’s approach to inflation:

For all the sturm und drang about the Fed debasing the dollar and sowing the seeds of the next great inflation, the public’s demand for money has increased. The increased desire to hold cash and checkable deposits has risen to meet the increased supply. Velocity, or the rate at which money turns over, has plummeted.

The Fed has two choices. It can adopt the Dr. Strangelove approach and learn to stop worrying and live with low inflation and low unemployment. Or it can do something about it, which runs counter to its stated intention to raise the funds rate and reduce the size of its balance sheet.

Option #1 involves learning to live with a low, stable inflation rate about 0.5 percentage point below the Fed’s explicit 2% target.

Not only has the Fed has achieved price stability in objective terms, but it has also fulfilled former Fed Chairman Alan Greenspan’s subjective definition of price stability: a rate of inflation low enough that it is not a factor in business or household decision-making.

Option #2 means taking some additional actions to increase the money supply by lowering interest rates or resuming bond purchases. The Fed is taking the opposite approach. It began its balance sheet normalization this month, allowing $10 billion of securities to mature each month and gradually increasing the amount every quarter. And it has guided markets to expect another 25-basis-point rate increase in December….

The Fed faces a delicate balancing act. Unemployment is low but capacity utilization is also low, indicating an absence of inflationary pressure.

Capacity Utilization

Janet Yellen understandably wants to normalize interest rates ahead of the next recession but she can afford to take her time. The economy is unlikely to tip into recession unless the Fed hikes rates too quickly, causing a monetary contraction.

I believe the Fed chair is relying on the outflow from more than $2 trillion of excess reserves held by banks on deposit with the Fed to offset the contractionary effect of any rate hikes.

Capacity Utilization

If pushed, the Fed could lower the interest rate paid on excess reserves in order to encourage banks to withdraw excess deposits. But so far this hasn’t been necessary. The attraction of higher interest rates in financial markets has been sufficient to encourage a steady outflow from excess reserves, keeping the monetary base (net of reserves) growing at a steady clip of close to 7.5% p.a. despite rate hikes so far.

Capacity Utilization

Makes you wonder why Donald Trump would even consider replacing the Fed chair when she is doing a great job of managing the recovery.

Source: Fed flunks econ 101: understanding inflation – MarketWatch

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The big shrink commences

“The Federal Reserve left its benchmark interest rate unchanged and said Wednesday that it would begin to withdraw some of the trillions of dollars that it invested in the US economy after the 2008 financial crisis.” ~ Binyamin Applebaum

The Federal Reserve balance sheet ballooned in the last decade to current holdings of $2.5 trillion of US Treasury securities and $1.8 trillion of mortgage-backed securities.

Hourly Wage Growth

Fed total assets of $4.5 trillion (the red line on the above chart) does not give the full picture. Of the cash injected into the economy, $2.2 trillion found its way back to the Fed by way of excess reserves deposited by banks (the blue line). These deposits earn interest at the rate of 1.25% p.a., providing a secure return on surplus funds. What this means is that the net effect of the balance sheet expansion is the difference between the two lines, or $2.3 trillion.

Even $2.3 trillion is a big number and any meaningful sale of securities by the Fed would contract the supply of money, tipping the economy into recession. So how does the Fed propose to manage “normalization of its balance sheet” without disrupting the economy?

Firstly, the Fed does not intend to sell securities. It will simply decrease the “reinvestment of principal repayments it receives from securities held” according to its June 2017 Normalization Plan.

The amount withheld from reinvestment will commence at $10 billion per month ($6bn US Treasuries and $4bn MBS) and step up by $10 billion each quarter until it reaches a total of $50 billion per quarter.

That means that $100 billion will be withheld in the first year and $200 billion in each year thereafter….”so that the Federal Reserve’s securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.”

Second, the Fed will reduce the level of excess reserves by an appreciable amount in order to soften the impact of the first step. So a $100 billion reduction in investments may only result in a net reduction of say half that figure, after taking into account the decline in reserves.

Third, the federal funds rate will remain the primary tool of monetary policy and will be used to fine tune monetary policy to fit economic conditions.

It appears that the Fed will start quite tentatively, withholding only $30 billion in the first quarter, but the longer term targets seem ambitious.

With currency in circulation now growing at an annual rate of $100 billion, even a $50 billion reduction in the first year (net of excess reserves) could leave a big hole.

Currency in Circulation

This is bound to take some of the heat out of the stock market. The plus side is it may restore some sanity to market valuations, but any sudden moves could cause an overreaction.

Added later:

Even if we compare the reduction to the annual change in M1 money supply, it takes a big bite.

M1 money supply

M1 consists of: (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler’s checks of nonbank issuers; (3) demand deposits; and (4) other checkable deposits (OCDs), which consist primarily of negotiable order of withdrawal (NOW) accounts at depository institutions and credit union share draft accounts.

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Nasdaq and S&P500 meet resistance

July labor stats are out and shows the jobless rate fell to a 16-year low at 4.3%. Unemployment below the long-term natural rate suggests the economy is close to capacity and inflationary pressures should be building.

Unemployment below the long-term natural rate

Source: St Louis Fed, BLS

But hourly wage rates are growing at a modest pace, easing pressure on the Fed to raise interest rates.

Hourly Wage Rates

Source: St Louis Fed, BLS

Fed monetary policy remains accommodative, with the monetary base (net of excess reserves) growing at a robust 7.5% a year.

Hourly Wage Rates

Source: St Louis Fed, FRB

Our forward estimate of real GDP — Nonfarm Payroll * Average Weekly Hours — continues at a slow but steady annual pace of 1.79%.

Real GDP compared to Nonfarm Payroll * Average Weekly Hours

Source: St Louis Fed, BLS & BEA

The Nasdaq 100 has run into resistance at 6000. No doubt readers noticed Amazon [AMZN] and Alphabet [GOOG] both retreated after reaching the $1000 mark. This is natural. Correction back to the rising trendline would take some of the heat out of the market and provide a solid base for further gains. Selling pressure, reflected by declining peaks on Twiggs Money Flow, appears secondary.

Nasdaq 100

The S&P 500 is also running into resistance, below 2500. Bearish divergence on Twiggs Money Flow warns of moderate selling pressure but this again seems to be secondary — in line with a correction rather than a reversal.

S&P 500

Target 2400 + ( 2400 – 2300 ) = 2500

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Lighting a fuse

The Fed quit quantitative easing more than a year ago, limiting total assets on its balance sheet to $4.5 trillion. But more than $2.5 trillion of cash injected into the financial system had been deposited straight back into the Federal Reserve system by banks as excess reserves, earning 0.25% p.a.

Fed Total Assets and Excess Reserves

Fresh money continued to leak into the financial system as banks drew down their excess reserves, highlighted above by the widening gap between Total Assets and Excess Reserves. In December 2015 the Fed doubled the rate payable on excess reserves to 0.50% p.a. The intention is clearly to attract more excess reserves and narrow the gap, or at least slow the rate at which excess reserves are being withdrawn to prevent further widening.

Easy money policies followed by central banks around the world are not achieving the desired result of reviving business investment. If we examine the Fed’s track record over the last two decades, sharp surges in business credit were accompanied by speculative bubbles — stocks ahead of the Dotcom crash and housing ahead of the GFC — with disastrous results. GDP failed to respond.

Business Credit Growth v. Nominal GDP

The latest rally in global markets is also driven by monetary easing, this time in China, with a massive surge in the money supply signaling PBOC intentions to print their way out of trouble (and into an even bigger hole).

Ineffectiveness of monetary policy in solving structural problems has often been described as “like pushing on a string”. But recent experience shows it is more like lighting a fuse.

This is a nightmare, which will pass away with the morning. For the resources of nature and men’s devices are just as fertile and productive as they were. The rate of our progress towards solving the material problems of life is not less rapid. We are as capable as before of affording for everyone a high standard of life …. and will soon learn to afford a standard higher still. We were not previously deceived. But to-day we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time – perhaps for a long time.

~ John Maynard Keynes: The Great Slump of 1930

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Fed: Who Is Holding All the Excess Reserves?

Ben Craig and Sara Millington at FRB Cleveland say “liquidity is not diffusing through the banking system, but is instead staying concentrated on the balance sheets of the largest banks.” Banks from the European Union (EU) have also substantially increased their holdings of excess reserves at the Fed.

Hat tip to Barry Ritholz

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Gold breaks trendline

Treasury yields remain weak, with the 10-year yield testing support at 2.0 percent. Declining interest rates improve demand for gold but a subdued inflation outlook has the opposite effect.

10-Year Treasury Yields

The Fed has stopped QE, with total assets leveling off around $4.5 Trillion. Expansion of excess bank reserves on deposit with the Fed, which softened the inflationary impact of QE, halted a little earlier.

Fed Total Assets compared to Excess Reserves

The latter is contracting at a slightly faster pace, so the net effect (change in Total Assets minus Excess Reserves) remains stimulatory. Reversal below zero on the chart below would warn of a contraction.

Fed Total Assets minus Excess Reserves

The Dollar is weakening in line with interest rates, with the Dollar Index headed for a test of support at 93. 13-Week Twiggs Momentum crossed below zero, warning of a primary down-trend. Breach of primary support at 93 would confirm.

Dollar Index

A weaker Dollar would drive up gold. Spot gold broke its long-term descending trendline and is headed for a test of resistance at $1200/ounce. Recovery of 13-week Twiggs Momentum above zero would suggest a primary up-trend, but it would be prudent to wait for confirmation from a trough above zero and breakout above $1200.

Spot Gold

* Target calculation: 1200 – ( 1400 – 1200 ) = 1000

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Will falling commodity prices cause deflation?

Some readers expressed concern about falling commodity prices, especially crude oil, and whether this will cause global deflation. This confuses the cause with the symptom.

Crude

Falling prices are largely benign except where caused by a contraction of the money supply. Commodity prices may fall when there is an excess of supply over demand, but this is soon absorbed by changes in consumer behavior. Discretionary spending will rise in response to the savings, so that aggregate demand is unaffected.

A contraction in the money supply, however, is far more serious. Slow growth in the monetary base (below growth of real GDP) results in less money chasing the same goods, driving down prices. Supply and demand in this case are unchanged, but prices fall because of a contraction in the money supply. Wages, however, are sticky and do not fall in line with prices, leading to falling profits, cuts in production and job layoffs. Falling income from lower profits and fewer jobs leads to a contraction in aggregate demand, causing further cuts to production and income.

Contraction of the money supply also places pressure on banks to reduce lending. This danger was highlighted by Irving Fisher in the 1930s. Contracting credit reduces not only new investment but forces existing borrowers to liquidate some of their assets, mainly stocks and property. The surge of selling, and limited availability of credit, drives down asset prices. A feedback loop results, with falling asset prices prompting banks to further contract lending — in turn causing more price falls. That is the central bankers’ equivalent of a perfect storm. The graph below shows how close we came in 2009 to a deflationary spiral.

Working Monetary Base

Slow growth in the monetary base caused a sharp contraction in bank lending (below zero) in 2009. Only prompt action by the Fed averted a 1930’s-style collapse of the financial system.

The Fed indicated in October that it will curtail QE and no longer expand its balance sheet to support money supply growth. Should we expect another contraction of the money supply as in 2008?

The answer is: NO. When we look at the graph of the Fed balance sheet below, we can see that total asset growth [red] is slowing. But bank deposits at the Fed — excess reserves that earn interest at 0.25% p.a. — are slowing at an even faster rate. That means that the actual amount of money flowing into the banking system is not contracting, but increasing.

Fed Total Assets and Excess Reserves

The following graph shows a net growth rate (of Total Assets minus Excess Reserves on Deposit) of more than 20 percent. Expect growth to slow over time, but the Fed can adjust the interest rate payable on excess reserves to ensure that it remains positive.

Fed Total Assets minus Excess Reserves

Deflation is a far bigger problem for the Euro. After a “whatever it takes” surge in 2012, the ECB attempted to contract its balance sheet far too soon — withdrawing treatment before the patient had fully recovered. They also do not have excess reserves on deposit, like the Fed, which could soften the impact.

ECB Total Assets

The result has been faltering economic growth and price levels falling dangerously close to deflation.

ECB Total Assets

The ECB appears to have recognized its error, indicating that it will expand its balance sheet if necessary to avert a monetary contraction. If they learn from their past mistakes, the ECB should be able to avoid any threat of deflation.

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Fed excess reserves shrinking

Commentators have highlighted the fact that bank excess reserves held on deposit at the Fed — and on which banks are paid interest at 0.25% p.a. — are declining. This would suggest that bank lending is rising, increasing inflationary pressure.

Fed Excess Reserves- Weekly

The Fed is well aware of the situation

Fed Excess Reserves and Total Assets

…and has responded to the recent slow-down by scaling back asset purchases (quantitative easing). They are likely to track the decline of excess reserves to ensure that the impact on the working monetary base (monetary base minus excess reserves) is contained — along with inflationary pressures.

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