Tracking the decline in risk aversion

For most of the past five years I've argued that one of the dominant features of this recovery was risk aversion. The Great Recession so scared and shocked the world that risk aversion became exceptionally high. I've also argued that the main purpose of the Fed's QE program was to supply a very risk averse world with safe securities, by essentially converting ("transmogrifying") notes and bonds into T-bill equivalents (aka bank reserves). The point of QE was not to stimulate the economy, as many have argued, but to accommodate the world's intense demand for safe assets. We can be reasonably sure of this by observing that, despite a massive increase in bank reserves, there has been no excess supply of money, and we know that because inflation has been relatively low and stable and the dollar has also been stable (and is even increasing of late). In short, the Fed's injection of reserves was sufficient to satisfy the world's demand for reserves.

But since early last year things have been changing on the margin. Risk aversion is still to be found (e.g., huge increases in bank savings deposits, zero yields on 3-mo. T-bills), but it is declining. Confidence, the flip side of risk aversion, is slowly rebuilding, but it is still relatively low.

The graph above speaks directly to the existence of declining risk aversion. It shows the price of gold and the inverse of the real yield on 5-yr TIPS (a proxy for the price of TIPS). Both gold and TIPS are refuges for those who worry about inflation and end-of-the-world scenarios, so their prices reflect the intensity of the world's demand for safety. Gold prices maxed out at $1900/oz. a few years ago, which was roughly triple the average inflation-adjusted value of gold over the past century (now THAT's what I call paying a premium). TIPS prices maxed out at a negative real yield of almost 2% early last year, which meant that investors were willing to give up almost 2% of their annual purchasing power in order to capture the U.S. government-guaranteed, inflation-hedging properties of TIPS. In short, people were paying ridiculous prices to minimize risk. But that's changing.

Now it looks like TIPS real yields are on the verge of turning positive, and gold prices are on the verge of making multi-year lows. If gold breaks below $1200 and heads for $1000, and if real yields on 5-yr TIPS break above zero, those would both be signs of a significant decline in risk aversion. They would still be expensive, of course, but a lot less so.

As risk aversion recedes, then the need for QE also recedes. The Fed is on track to finish QE3 late next month, so as far as the market is concerned, QE3 is done. And the sky has not fallen, because the world no longer needs tons of new T-bill equivalents. That's good.

But declining risk aversion poses a risk to the Fed's promise that it will keep short-term interest rates exceptionally low until well into next year and even beyond. If the Fed is slow to react to a significant decline in risk aversion, the result will be higher-than-expected inflation. That's because declining risk aversion will be replaced by a rising appetite for risk. And that will mean a greater demand for loans, and it will mean that banks will be more willing to lend.

With banks today sitting on more than $2.6 trillion of excess reserves, there is effectively no limit to how much they can increase their lending. As the first of the graphs above shows, bank lending tends to track the growth of M2 over time, so a big increase in lending would likely translate into a big increase in the money supply. To date, the M2 money supply and total bank credit have been growing at just over 6% per year for the past 20 years, and that's coincided with moderate economic growth and relatively low inflation. A big increase in money lending from banks at a time when the world doesn't particularly want to hold extra money could give us a lot more inflation (and maybe a bit more growth). As the third graph shows, bank credit growth has already picked up this year after being very sluggish since 2008, so that's another sign of declining risk aversion and rising risk appetite.

Since it would take extraordinary measures to reverse its gigantic balance sheet in a relatively short time frame, the only practical way for the Fed to avoid a significant and unwanted increase in the money supply is to increase the interest it pays on reserves by enough to make banks content to continue to hold the already-massive amount of excess reserves. If risk aversion continues to decline, the Fed is going to have to accelerate its plan to raise short-term interest rates, or risk an unwanted—and potentially huge—increase in inflation.

This is not a call for hyperinflation. But I think we are getting closer to the day when the Fed starts falling behind the inflation curve, and that could prove to be very unsettling. This all bears watching very closely. Keep an eye on real yields, gold prices, and bank lending.