Money, Banking, and Markets - Connecting the Dots
Money, Banking, and Markets - Connecting the Dots

Money, Banking, and Markets - Connecting the Dots

Investors are often told that the trillions of dollars of quantitative easing “supported” the economy by encouraging bank lending. They might be surprised to learn that despite the most aggressive monetary policy in U.S. history, commercial bank lending since 2008 has grown at just 3.4% annually, easily the slowest rate in data since 1947. (View Highlight)

Investors are often told that there is an enormous amount of “money on the sidelines” just waiting to go “into” the stock market. Yet they don’t seem to recognize that all that money is there because the Fed put it there (by buying government debt securities and paying for them by creating dollars). Nor do they seem to recognize that the instant a buyer puts a dollar “into” the stock market, a seller takes that dollar right back “out”; that every dollar, once created by the Federal Reserve, must be held by someone, as a dollar, and as nothing other than a dollar, until the Federal Reserve retires it. (View Highlight)

Even members of the Federal Reserve itself don’t seem to understand that the reason the banking system is bloated with $8 trillion in uninsured deposits is because the Federal Reserve put those deposits there. (View Highlight)

The primary assets of a bank are loans, securities, and cash reserves. The primary liabilities of a bank are deposits and borrowings (debt). If you take the assets and subtract the liabilities, what’s left is “equity capital,” which belongs to the shareholders. (View Highlight)

If we lend some of our cash to Charlie, a borrower who wants to build a house, our bank now owns an IOU from Charlie (in this case a mortgage), and the cash goes to Charlie’s bank. While bank lending is sometimes described as “creating money,” it’s more accurate to say our bank has intermediated money. There’s no more cash than there was before. (View Highlight)

In the banking system as a whole, loans have increased (Charlie’s mortgage), and deposits have increased by the same amount (Charlie’s deposit). (View Highlight)

Across history, deposits and loans in the banking system grew hand-in-hand, until the Fed launched quantitative easing in 2008. (View Highlight)

Our bank could also use the money on the asset side of our balance sheet to buy some securities, like Treasury bonds. These will fluctuate in value, of course, so we’d better be sure that we’ve got enough capital to absorb losses, while still honoring our liabilities to depositors and bondholders. Banks are subject to capital requirements for exactly that reason. (View Highlight)

How does Federal Reserve’s policy of quantitative easing affect the banking system? The mechanics are very straightforward. The Federal Reserve buys interest-bearing government securities – mainly Treasury and mortgage bonds – that were previously held by the public, and it pays for those bonds by creating its own liabilities called “reserves.” (View Highlight)

The assets are mainly loans, securities, and cash reserves. The liabilities are mainly deposits (owed to depositors), borrowings (owed to the Fed), and debt (owed to bondholders). (View Highlight)

The primary achievement of quantitative easing has been to force trillions of deposits into the banking system, backed not by loans, but by Fed-created cash reserves. (View Highlight)

For most of the period since 2008, those reserves earned zero interest. As investors attempted to get rid of their zero-interest deposits, they chased every kind of speculative asset in a frantic attempt to earn something more than zero. But the iron law of equilibrium is that every security, including Fed-created liquidity, must be held by someone at every moment in time, from the moment it is issued until the moment it is retired. (View Highlight)

As I detailed in last month’s comment, Fabricated Fairy Tales and Section 2A, there is a well-defined relationship between Fed liabilities (as a share of GDP) and the level of short-term interest rates. (View Highlight)

Once the amount of Fed-created reserves reaches about 16% of GDP, it’s simply more cash than the economy needs. People frantically try to get rid of it, which reliably drives interest rates to zero. As a result, the only way the Fed has been able to set an interest rate target above zero in the past two years has been to explicitly pay interest to banks, currently 5.1% annually, on those reserves. (View Highlight)

That, in turn, requires another special “facility.” See, if banks are being paid interest on their cash without passing it on to their depositors, people tend to move the deposits to money market funds. (View Highlight)

On the asset side, the Fed holds mainly Treasury and U.S. government agency debt. On the liability side, the Fed’s primary obligations are: a) reserves created by the Fed and held by banks as cash; b) liquidity created by the Fed and held in money market funds, on which the Fed pays interest using overnight “reverse repurchase” transactions; c) currency in circulation created by the Fed; and d) the Treasury general account, comprising bank deposits transferred to the Treasury by taxpayers and bond buyers, and held on account with the Fed. (View Highlight)

That difference, as I simultaneously hold back laughter and tears, is what the Fed reports as “capital.” But see, the Fed books the securities it holds at “amortized cost” – which gradually moves their prices toward face value as the securities mature, regardless of the actual market value of those securities. If the Fed was to value its assets at actual market value, its balance sheet would be deeply insolvent. (View Highlight)

In practice, since that interest has already been paid over to the Treasury, the Fed’s actual balance sheet is roughly $1.5 trillion in the hole. All the Federal Reserve’s short-lived capital gains have been wiped out, along with all of the interest income since 2008 (View Highlight)

Notice the slight stabilization in recent months, as Treasury bond yields have retreated from their highs. My impression is that the recent stabilization of banking strains reflects, and is dependent on, the same retreat in long-term yields. (View Highlight)

Historically, the weighted average of core inflation, nominal GDP growth, and T-bill yields has acted as something of a lower bound for long-term bond yields. Indeed, in market cycles across history, the entire total return of Treasury bonds – over-and-above T-bill returns – has accrued when bond yields were above the red benchmark in the chart below. The takeaway here is that depressed long-term bond yields already assume and rely on the expectation that inflation and nominal GDP growth will quickly subside, and that the Fed will be cutting rates in no time. (View Highlight)

While the Fed is able to obscure its capital losses by valuing its assets at cost, there’s one item the Fed isn’t able to completely bury in its balance sheet accounting (View Highlight)

Now that the Fed is paying banks more interest than it receives – another cost the public bears for the Fed’s luxuriously deranged balance sheet – the Fed is essentially creating money (a liability to the Fed) without any backing by a corresponding asset. (View Highlight)

The resulting deficit will be recovered by the Fed over time, by retaining interest that it receives on its government bond holdings, rather than transferring it to the Treasury for public benefit (View Highlight)

As we’ve seen, most of the explosion in U.S. commercial bank deposits since 2008 is not the result of loan growth, but instead the result of cash reserves forced into the banking system by the Federal Reserve. The chart below illustrates what’s going on. (View Highlight)

In what form do banks hold those excess deposits? Look at the red line. Those deposits are primarily held as cash (reserves created by the Fed), and a smaller amount as securities (mainly Treasury debt). (View Highlight)

One might imagine that at least these excess deposits must be insured by the FDIC, which would reduce the risk of bank runs. (View Highlight)

Notice that in the fourth quarter of 2022, the U.S. banking system had domestic deposits of nearly $18 trillion. Yet only about $10 trillion of those deposits were insured. The excess deposits are there because the Fed put trillions of dollars of needless reserves there (View Highlight)

They’re also captive in the banking system unless they are withdrawn as currency or transferred to money market funds on reverse-repo with the Fed. (View Highlight)

Quantitative easing didn’t encourage greater bank lending. It encouraged greater bank speculation in securities. (View Highlight)

If anyone is surprised that uninsured bank depositors are now making runs on banks that have significant amounts of exposure to Treasury securities, they’re not connecting the dots. (View Highlight)

If rich valuations alone were sufficient to drive the equity market lower, it would have been impossible for valuations to reach speculative extremes like 1929, 2000, 2007, and 2022, because prices would have collapsed from much lesser valuations. (View Highlight)

Second, our most reliable gauge of speculation versus risk-aversion is the uniformity of market internals across thousands of individual stocks, industries, sectors, and security-types, including debt securities of varying creditworthiness. The chart below presents the cumulative total return of the S&P 500 in periods where our measures of market internals have been favorable, accruing Treasury bill interest otherwise. (View Highlight)

It is constantly repeated on CNBC and elsewhere that investors should be aggressively positioned in stocks, in advance of a “pivot” by the Fed to lower interest rates. It seems to escape investors that while the Fed “pivot” on January 3, 2001 was greeted by investors with a 5% advance in the S&P 500, the market would extend that advance by less than 2% over the next few weeks, followed by a 43% plunge. (View Highlight)

See, when investors are risk-averse, they treat safe liquidity as a desirable asset rather than an inferior one, so creating more of the stuff doesn’t support speculation or stock prices. Easy money only reliably supports stocks when Fed easing is joined by favorable internals. (View Highlight)

Regardless of the level of valuations, an improvement in the uniformity of market internals would defer our presently bearish outlook. For now, without that sort of improvement, I continue to view stock market conditions as a “trap door” situation. The increasingly ragged behavior of market internals is most clearly evident in the recent performance gap between the broad market and very large capitalization glamour stocks. For example, the Russell 2000 Index is nearly unchanged year-to-date, as is the index of equal-weighted S&P 500 components. While the capitalization-weighted S&P 500 has advanced, the year-to-date gain is attributable to the very largest components. (View Highlight)

When extreme valuations are joined by ragged internals, the collapses come seemingly out of nowhere – the phrase “trap door” is intentional. (View Highlight)

In effect, MarketCap/GVA acts as a broad, apples-to-apples price/revenue ratio for nonfinancial corporations. At present, this measure is higher than at any point in history prior to October 2020, except for a few months surrounding the 1929 market peak, and two weeks in April 1930 that marked the peak of the post-crash rebound. (View Highlight)

As I showed last month, we also associate current valuations with a potential market loss on the order of -60% over the completion of this cycle. I know that seems preposterous, but that’s a reflection of preposterous speculation generated by more than a decade of preposterous monetary policy. (View Highlight)

It is a very bad habit of Wall Street to value stocks on the basis of a single year of earnings, without considering how variable corporate profit margins are over time. The main drivers of corporate profit margins, even in recent years, are not mysterious. (View Highlight)

Every deficit of government results in a mirror image surplus in other sectors – households, businesses, and foreign trading partners – where their income exceeds their consumption and net investment in U.S. goods and services. (View Highlight)

Instead, investors are currently pricing stocks based on the expectation that today’s operating margin of 11.3% will increase to about 12.5% a year from now. That would push the S&P 500 operating margin just shy of the highest extreme in history, exceeded only by the margins observed at the early-2022 market peak. (View Highlight)

While it seems to be “common knowledge” that rate hikes cause recessions, and recessions cause inflation to collapse, the relationships between interest rates hikes, unemployment, and general price inflation are remarkably weak and unreliable – certainly not enough to form an operational toolkit. (View Highlight)

My impression is that much of the belief regarding recessions and inflation is driven by the behavior of headline inflation, including food and energy. It’s true that recessions tend to hold down increases in food and energy prices (though even that wasn’t true in the 1973-74 recession). (View Highlight)

In my view, inflation isn’t brought under control by throwing the economy into recession, but by restoring monetary credibility. Credibility, in turn, is created by following systematic policy, and most importantly, by ensuring that financial quantities are kept in line with real economic quantities. (View Highlight)

Every financial security that is issued has to be held by someone until it is retired, and the returns on that asset will ultimately be determined by the cash flows available to service that security. Every dollar of Fed liquidity that is created has to be held by someone, in that form, until it is retired. (View Highlight)