One Less Thing To Worry About, And One More

By: Michael Ashton | Tue, May 3, 2011
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News overnight that terrorist idol Osama bin Laden had been slain by American soldiers triggered a rare Presidential press conference outside of normal business hours as well as, predictably, a knee-jerk lift to risky assets. Treasuries declined, stocks rallied, and oil prices dropped sharply in what seemed like the obvious trades at the time.

Let this be a lesson to young traders: it does not usually pay to make the trades that are obvious at the time!

In the long run, perhaps the removal of Osama from the top of the evil-instigator food chain is good for risky assets. But I think that is giving him far too much credit. Some people believe that bin Laden had been marginalized in recent years due to continuing pressure of the manhunt; whether that is true or not, it is certainly the case that the major geopolitical risks at the present time are from political unrest and uprisings in MENA rather than from terrorist machinations. Osama's death, while pleasing to the spirit of the average American investor, should have very little real impact on matters.

The equity market seized on the news as an excuse to rally mainly because it was running out of other excuses. The chart below shows the S&P against the Citi US Economic Surprise Index. I suggested back in early February that the surprises were ripe to start coming on the downside, and I was right...but the market has continued to power higher anyway.

S&P against the Citi US Economic Surprise Index
Economists have been unpleasantly surprised. When will that happen to equity investors?

The divergence is pretty stark, but over the long run the relationship isn't super-tight. My main point here is to illustrate that one of the key arguments used by bulls to explain why stocks should rally from September on - the economic data were improving - is no longer true. The other main argument, that the Fed is adding enormous liquidity and that supports all assets, will shortly be untrue as well. I don't call tops and bottoms, generally, but it is fair to point out that the market is valued richly enough (23.6x Shiller earnings) that it would be helpful for the bulls to have a new theme.

On the commodity side, Silver futures tumbled nearly 10%. The decline wasn't matched in other precious metals (Gold dropped 0.6% or so); for silver, the excuse was a small increase in spec margins at the CME. A 13% increase in margins, after a prior 200% increase in margins over the last year, is a pretty thin excuse for a 10% drop in the market, but when a market is overextended all of the excuses need to start being on the same side to keep the rally going. A small excuse to sell is still an excuse to sell!

In equities the buying excuse didn't end up lasting very long, and stocks ended the day down slightly (0.2%) while bonds rallied around 1bp to 3.28%. Osama needs to keep dying to help the equity bulls here!

The unsurprising results of the FOMC meeting last week and the Bernanke press conference/victory lap (as it certainly seemed to be) have many investors thinking that the inflation battle has actually been won. But the victory lap is, I think, premature.

The lags between changes in the money supply and changes in the price level are long. The current level of core inflation is consistent with what has actually happened so far to the important monetary aggregates (e.g., M2, some time ago), but the surprising thing to many worrywarts like myself has been how the massive creation of reserves has caused very little movement in M2. The year-on-year change in M2 is now about 5.6% and still rising, but that's a far cry from what has been done to reserves. If the current $2.5 trillion monetary base was being translated into M2 at the "old normal" multiplier of around 8.5 (see my comment here), then instead of M2 being $8.9 trillion as it currently is, it would be $21.3 trillion. And that would be inflationary.

So we scratch our heads and wonder, "why is this happening?" Because while the Fed might express great confidence that they know exactly what they are doing, so far it appears that they have gotten the result they wanted but not for the reasons they professed to expect it.

I've been mulling this over for a while, and after a number of conversations with friends populating bank treasury functions I have a curious - but I think useful - hypothesis. I have noticed in my conversations that bank managers seem to have little interest in raising money through CD issuance or by attracting deposits. More than once, treasurers have told me "we have more money than we know what to do with," largely as a consequence of there being a huge volume of reserves in the system. Any given bank can try to lend its excess reserves, but no bank will pay anything for them and they have to sit somewhere.

A bank that can't jettison its excess reserves is paying too much for capital. It is under-levered. This is why banks have always strived to get rid of low-yielding reserves at the Fed. Typically the excess reserves were managed to as close to zero as was feasible. But now, that isn't possible because no other bank wants the money either. The bank still needs to get rid of excess reserves, and there are two ways to do this: (1) The bank can greatly increase its business by making huge amounts of loans, so that the reserves it actually has end up being appropriate. Obviously, this is problematic because the bank needs to be concerned about the creditworthiness of the borrower, and there is a shortage of creditworthy borrowers at interest rates that banks are allowed to charge. Also, the pace of origination that would require is outlandish. More probably, (2) The bank can shed customer deposits by paying lower and lower rates on savings accounts and charging higher and higher fees on those accounts. This has happened, but with interest rates so low there is only so much you can "disincentivize" savers (especially since high fees raise the ire of policymakers/legislators). Banks can also de-lever passively, by (for example) not rolling longer bond issuances when they mature. In fact, we have seen this phenomenon as well: most of the 'de-levering' you hear about has been in the category of "domestic financial institutions" category while private borrowers in general haven't de-levered that much. (See Chart below, which I have run before).

Debt De-leveraging
What de-levering there has been has been predominantly domestic financials.

So if this is the case - banks with too many reserves de-lever because they don't need the money - then the story of the last few years until current-day might run something like this:

  1. During the crisis, the Fed adds lots of reserves to counter the plunging money velocity it fears (since MV≡PQ, if V falls it can be compensated for by a large enough increase in M).

  2. In the short run, this works by giving banks the cushion of comfort that they need, obviating the need for them to constrict lending as aggressively as they might otherwise have done.

  3. But in the longer run, the mammoth amount of excess reserves lowers the need for debt and ironically contributes to the de-levering. Because leverage and velocity are related concepts, this means (also ironically) that the volume of reserves might have contributed to the slowdown in money velocity that it was originally designed to offset.

  4. If this is true - and there's certainly no guarantee of that, although this rings plausible to the people I've run it by - then when the Fed stops adding reserves, velocity will probably recover slowly (as banks lend more but don't need to raise more capital to do so, they will re-lever on the asset side)

  5. ...and if the Fed drains reserves, it could also perversely increase velocity at the same time because banks will need to issue their own debt again.

We all know that base money hasn't translated into M2, and that's a big reason we haven't seen inflation. But the other side of it is that money velocity fell in the aftermath of the crisis, although much less than many of us expected. If this actually happened because the Fed's actions affected both the quantity of money and its velocity - something that theorists generally assume they cannot control - then it has interesting implications for monetary policy. Points (3) and (5) above suggest that for large changes in reserves, monetary policy becomes less and less effective! And what is more, adding scads of reserves isn't the inflationary part because while you're increasing money you're decreasing money velocity; the inflationary part might follow the stopping!

(Even more serious effects might ensue with the draining of liquidity. One treasury pro I know thought that money rates might skyrocket once the Fed pulls back on the liquidity and the "easy money" evaporates, especially since banks have higher liquidity thresholds thanks to Basel III - in his view, they will aggressively pay up for deposits and issue debt if they can't raise the deposits; the higher rates will reinforce and accelerate market inflation expectations).

Again, I have to stress that the main point is that we don't know how the monetary system reacts to actions and stresses like this, because no matter what the models say we've never actually tried anything like this. So while Bernanke is "100% certain" that he knows what's going on, I can think of all kinds of ways that it might work differently in practice. And some of this, we are actually seeing in practice.

One thing we know for certain is that the monetary dynamics are about to change again, severely. It is hard to believe that the Fed can aggressively add trillions in liquidity, stop, and eventually reverse, with no important effect on inflation. It is time to think of the outside-the-box ways that this could all make sense, and this is one of them.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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