Wednesday, March 19, 2014

FOMC moves in the right direction

In a few weeks, according to the report following today's FOMC meeting, the Fed will have "tapered" its purchases of bonds by about one-third (from $85 billion per month in December to $55 billion a month). And lo and behold, the sky has not fallen, nor is it about to. Nevertheless, the market continues to fret that tapering is a form of tightening, since, as the theory goes, the economy has managed to grow only thanks to Fed "stimulus," and that without it, economic activity will grind to a halt.

Never in my many years of Fed watching has there been so much confusion about how Fed policy operates.

The myth persists that QE bond purchases are "stimulative" because it involves the printing of massive amounts of money and the artificial depressing of yields. But this is simply not the case. As the chart above shows, 10-yr yields today are actually higher than they were when the Fed launched its first QE bond purchases. Bond prices have actually fallen despite $3 trillion of bond purchases by the Fed. The chart also makes it clear that yields have actually risen during each episode of QE bond-buying. Operation Twist (OT) was ineffective as well, since 10-yr yields were essentially unchanged during the period in which the Fed was buying 10-yr bonds and selling short-term bonds. The main determinant of yields is not the marginal purchases by the Fed, but the market's willingness to hold the entire stock of bonds (Treasuries, MBS, corporate bonds, etc., totaling many tens of trillions of dollars), since all bonds are priced off of Treasuries. That willingness, in turn, is a function of the market's expectations for inflation and economic growth.

As I've explained before, the Fed is not "printing money" when it buys bonds. When the Fed buys bonds it must buy them from banks. The Fed pays for the bonds by crediting banks' reserve account at the Fed. Bank reserves are not money that can be spent anywhere. They only exist on the Fed's balance sheet. Banks use their reserves to collateralize their deposits and to increase their lending, but to date the growth of the money supply has not been unusually rapid, as the chart above shows—only slightly more than 6% per year for the past 20 years. This is not to say that all will be A-OK forever, since the $2 trillion of excess reserves currently in the system would allow banks to expand their lending—and the money supply—by several orders of magnitude if they so desired.

When the Fed buys bonds, they become part of the Fed's assets. The Fed incurs a corresponding liability in the form of bank reserves. In effect, the Fed buys bonds from banks by borrowing the money from the banks to buy the bonds. The Fed pays the banks interest on their reserves of 0.25%, so from the banks' perspective, they are lending money to the Fed for a modest rate of interest which is actually better than they could get by buying T-bills, which currently yield only 0.05%.

As the chart above shows, the Fed's purchases of $3 trillion of notes and bonds (assets) have been offset by an approximately equal increase in currency (about $0.4 trillion) and bank reserves (about $2.6 trillion).

In addition to saying they will continue to taper their bond purchases, the FOMC decided to drop its 6.5% unemployment rate threshold. They will now consider a range of economic variables when deciding to taper and when and by how much to raise short-term interest rates. It's unfortunate that they have backed off of a rules-based policy and now have more discretion—which creates uncertainty—but at the same time this could give them more flexibility to act more or less aggressively if conditions warrant. Meanwhile, continuing to taper is definitely a step in the right direction since, as I've noted in recent posts, there are signs that the demand for bank reserves is declining and banks' willingness to lend is increasing.


William said...

You have been correct in your analysis for a long time. Congratulations!

Benjamin Cole said...

Scott, Scott, Scott--

Where to start?

Yes, QE depresses yields, but ceteris paribus. It allows lower yields given a level of economic growth.

QE has also stimulated economic growth. The higher expectations of growth pushed yields up.

The banks intermediate the sale of bonds to the Fed, but ultimately it is real people and investors doing the selling to the Fed. Banks are intermediaries.

When the bond-owners sell to the Fed (and not to each other) they get newly created "cash" in their hands, and they can re-invest that cash, spend it, or put it in the bank (where, thanks to FDIC insurance, it is safe and liquid, no interest-rate or credit risk).

The Scott Grannis explanation of QE is incredibly cynical, and thus very appealing and I fear maybe right, but I still think it is wrong.

"When the Fed buys bonds, they become part of the Fed's assets. The Fed incurs a corresponding liability in the form of bank reserves. In effect, the Fed buys bonds from banks by borrowing the money from the banks to buy the bonds. The Fed pays the banks interest on their reserves of 0.25%, so from the banks' perspective, they are lending money to the Fed for a modest rate of interest which is actually better than they could get by buying T-bills, which currently yield only 0.05%."--Scott Grannis.

Well, that means monetary policy is nothing but a gag to put more profits into the hands of banks and has no stimulative impact.

Well, yes, a central bank can be expected to make a policy that is good for banks, just as if you ask the USDA to make farm policy, you will also get certain results, and they won't be bad for farmers.

Still, not all Fed or USDA policies are fraudulent, and in this case I think our central bank is doing the right thing.

Proving anything in economics is impossible, but QE has been associated with an increase in economic activity (both here and in Japan), but we have yet to see much inflation associated with QE in either country. In fact, inflation has been falling in the USA.

That suggests the Fed should try harder. The Japanomy is not where you want to be, as an investor. Investors will lose money for the next 20 years, if that is our role model.

BTW, the amount of hysteria in the right-wing press (not Scott Grannis, he is right-wing but also he is Scott Grannis) bespeaks of a monomania, maybe even a dementia regarding inflation.

Now right-wingers (my usual roost, btw, I am embarrassed to say) are worrying that we might, maybe, it could be, it might be possible that in a certain way there might be inflation somewhere out in the future is you have a telescope and a microscope you can see it...or surely hyperinflation is happening later today. By tonight a Big Mac will cost $52...get out your wheelbarrows to fill with cash to buy din-din tomorrow night....

Before we hyper-ventilate about inflation, please, can we have some boom times first?

Bring on Fat City, let the good times roll baby, belly up to the bar with me, and then maybe let's worry about inflation tomorrow, if then.

Play it as it lies.

So far inflation is dead and dancing with Elvis.

Will Elvis come back?

Benjamin Cole said...

Okay, let me add to the confusion.

This is a list of "primary dealers," these are the guys who can sell bonds to the Fed, including US Treasuries.

Bank of Nova Scotia, New York Agency
BMO Capital Markets Corp.
BNP Paribas Securities Corp.
Barclays Capital Inc.
Cantor Fitzgerald & Co.
Citigroup Global Markets Inc.
Credit Suisse Securities (USA) LLC
Daiwa Capital Markets America Inc.
Deutsche Bank Securities Inc.
Goldman, Sachs & Co.
HSBC Securities (USA) Inc.
Jefferies LLC
J.P. Morgan Securities LLC
Merrill Lynch, Pierce, Fenner & Smith Incorporated
Mizuho Securities USA Inc.
Morgan Stanley & Co. LLC
Nomura Securities International, Inc.
RBC Capital Markets, LLC
RBS Securities Inc.
SG Americas Securities, LLC
TD Securities (USA) LLC
UBS Securities LLC.

Now, with no more Glass-Steagall, yes some blurring here, but what I see is a lot of security brokerages, not commercial banks, selling bonds to the Fed.

Okay, you got your Jefferies selling bonds to the Fed.

So, how does the money end up in the commercial banks, in the form of reserves?

Answer: The bond sellers put the money into bank deposits.

Is this wrong?

I am not trying to be clever, I am asking this.

theyenguy said...

Both Equity Investments and Credit Investments turned lower on March 19, 2014, after the US Fed FOMC Meeting, as the bond vigilantes called the Interest Rate on the US Ten Year Note, ^TNX, higher to 2.77%, on the exhaustion of the world central bank’s monetary authority, as the US Fed and other central banks have crossed the rubicon of sound monetary policy. Global ZIRP, and its excessive credit, working through the speculative leveraged investment community, has full matured money manager capitalism, and finally made “money good” investments bad.

With Disney, DIS, trading lower, the age of Disney and credit and inflationism, is over, through, finished and done. The world has entered into the age of austerity, debt servitude and destructionism.

Equity Investments, US Real Estate, IYR, Global Real Estate, DRW, and Casinos and Resorts, BJK, led World Stocks, VT, Nation Investment, EFA, such as Greece, GREK, and Ireland, EIRL, Global Financials, IXG, such as the European Financials, EUFN, and Dividends Excluding Financials, DTN, traded lower, as investors deleveraged out of EUR/JPY currency carry trade investments, such as AIXG, LUX, ALU, CRH, and NVO, and derisked out of debt trades such as ALU, OAK, FSRV, PUK, NM, and HEES.

Credit Investments, Junk Bonds, JNK, International Treasury Bonds, BWX, International Corporate Bonds, PICB, and US Government Bonds, GOVT, such as US Treasuries, TLT, and Mortgage Backed Bonds, MBB, led Aggregate Credit, AGG, lower, on the higher Benchmark Interest Rate, ^TNX.

Major World Currencies, DBV and Emerging Market Currencies, CEW, traded lower; the US Dollar, $USD, traded higher; with the result that Gold, $GOLD, traded lower. I recommend that now with a trade lower in the price of Gold, $GOLD, from $1380, one start to dollar cost average, an investment in the physical possession of Gold Bullion.

The investment principle is “In a bull market, like the one currently in Gold, GLD, one buys in dips, but in a bear market, one sells into pips.

Of note, gold mining stocks, GDX, are trading strongly lower in value; and with a PE of 34, are greatly overvalued.

Gold is going to experience great price inflation, as an investment demand for gold will commence, as competitive currency devaluation creates a see saw destruction of equity investments and credit investments. Gold is the defacto safe haven invesment in times of economic uncertainty and destabilization. Of note, gold mining stocks, GDX, are trading strongly lower in value; and with a PE of 34, are greatly overvalued and overbought.

Global economic crisis is coming soon from the failure of money and credit on investment derisking and deleveraging stemming the failure of the world central banks’ monetary policies to stimulate global growth and trade as well out of geopolitical risks throughout the world.

Out of chaos, the beast regime of regional economic governance will rise to rule in policies of diktat in each of the world’s ten regions, and to occupy in schemes of totalitarian collectivism in every one of mankind’s seven institutions, as revealed in Bible Prophecy of Revelation 13:1-4.

Young Saver said...

Good morning Scott – thank you for the posts. I’ve really enjoyed learning a significant amount from this blog. Could you please clear something up for me?

You’ve said that the Fed has attempted to fulfill the market’s almost insatiable appetite for “riskless” securities, and that it has done this by exchanging bank reserves for bonds. Banks enjoy this 0.25% yield on bank reserves (T-bill equivalent) because it trumps the 0.05% yield on T-bills they would get otherwise. You go on to point out that “never in my many years of Fed watching has there been so much confusion about how Fed policy operates,” referring to the misconception that the Fed has printed a ton of money to stimulate the economy.

Could it be this misconception that ‘QE = printing money’ that caused the rise in 10-yr Treasury yields during each round of QE? I think you’re saying main determinant of yields is inflation and economic growth expectations by the investing public. To me this says the investing public increases their inflation/growth expectations when the Fed enters a new round of QE based on the “printing money” and “stimulus” misconceptions – is this strong logic? That’s why yields have fallen since tapering began --- the investing public either sees lower growth potential with less Fed support or lower inflation expectations because Yellen won’t overtly ignore inflation to get unemployment below 6.5%. Do you agree?

Scott Grannis said...

Young Saver: You're on the right track. I note that since yesterday morning the biggest change in the market so far is a 27 bps jump in real yields on 5-yr TIPS. 5-yr Treasury yields are up only 17 bps, which means that inflation expectations have dropped by 10 bps. This market action suggests that the market views the FOMC announcement as improving the outlook for growth modestly, while reducing the risk of inflation modestly. That's a welcome reaction.

L.A. said...

So what happens with the $2 T in reserves from here forward? Does it sit stagnant? Or do banks go hog wild and enter we another debt crisis?