Submitted by Matthew Corso
Monetary Policy and Impact on Assets
The last note briefly addressed the benefits associated with the reverse repurchase facility (RRF). Indeed liabilities have increasingly moved from bank balance sheets to the Fed, freeing lending capacity. One must recall reserves are not fungible outside of the banking system (but can act as collateral for margin). With flow decreasing, the opportunity for small relative volume bids spread over a large quantity of transactions (most instances per unit time) decreased with market prices in many asset markets. Is more downside coming?
A cost of QE is high quality debt remains siloed. As previously described, the RRF allows for assets previously purchased by the Fed to serve the market only in a limited capacity. While they are not able to the reused as collateral, they do replace a portion of the demand for high quality assets in the market, leaving relatively more available for reuse. At present, the 5bps paid by the Fed essentially attempts to put a floor under the short-term price for money. The Fed established an overall cap in September, supposedly because MMFs would view the Fed as a more secure counterparty than banks. I take a different view: They Fed is balancing net income from securities lent with the monetary policy goal of keeping rates up. As Stone & McCarthy recently pointed out, demand exceeded the $300 billion cap, limiting the amount paid-out by the Fed at the 5bps rate, with excess bid via Dutch auction. In the recent auction coinciding with quarter-end the low bid hit a price of –20bps (the counterparty receives less than deposited in order to rent the high quality assets from the Fed). While one may count the result as a limited success in controlling the lower bound of short-term interest rates, the Fed controls the cap for the 5bps rate. Interest on reserves (IOR), at 25bps, holds the entire system afloat, where otherwise extreme supply (especially relative to demand) would dictate a lower price; In economic depression even more so. To improve the optics of control, causality is reversed when speaking of the price of money. The interbank interest rate for reserves is set by market forces, and daily, the central bank adjusts reserves to match. Mechanically the Fed’s “target” is just that, and nothing more. Alternatively, with IOR and the RRF, the prices at the each extremis of the corridor are fiat, and impact the Fed balance sheet.
Quantity theory posits price inflation follows from base money creation, meanwhile in developed markets we see the opposite. Investment managers and students of economics need to recognize the quantity theory of money passed away gradually as the link to precious metals was severed. A new paradigm began to unfold with the economic performance leading up to 1968. The market demanded portion of base money, coinage and bank notes, follow from price inflation. Causality between increases in base money and rising prices must does not result from the reserve creation. As Peter Stella pointed out recently [17]:
"The extremely inconvenient fact for the QTM regarding the causal power of the bank reserves component of the monetary base is that—to take the US example—the nominal value of bank reserves held at Federal Reserve Banks between end-1958 and end-2007 fell by 19 percent while the Consumer Price Index rose by 612.5 percent. Therefore, the long-run relationship between US bank reserves and US inflation is actually negative."
What then accounts for the loss in purchasing power outside of the core price inflation metric? From Peter Stella's Exit Path Implications for Collateral Chains [18]:
"In 1951, total commercial bank deposits at the Fed were $20 billion larger than they were at the end of 2006.
Over the same period, total US credit-market assets rose by over 10,000%"
The result is a consolidated approach must be used to ascertain the quantity of effective money. Austrian true money supply (TMS) best captures one part, and as recently explained by none other than the Treasury Borrowing Advisory Committee, the other part is high quality collateral lent in which further credit is extended against in private institutional markets (including reuse).
By using a consolidated view of money the crisis of 2008-2009 can be visualized, where TMS alone is insufficient.
Looking forward, the Fed will cease the flow of reserves, and has the capacity for a “ceremonial rate-rise”. A brief overview of the impact on assets follows. With the mechanics now explained, one can see why the end of previous rounds of QE saw long Treasuries and short equity outperform. As previously forecast, we will see this pattern repeat as yield seeking combined with capital preservation desires finds US sovereign debt heads and shoulders above low effective yields in EU or Japanese sovereign debt. Furthermore, the US Treasury is to cut bill issuance trimming ~$60 billion overfunding through end-2015. Less supply, more demand: higher price (and a lower effective yield). The US dollar outperformed as predicted, and the yen may be next on increasing liquidity and capital preservation concerns. Electrical consumption, rail and airline data from China continue to surprise to the downside. Their bubble dwarfs the US housing crisis, and may prove both an even worse misallocation and the catalyst. There will be a rotation as corporate bond excesses unwind along with many REITs and MLPs. Securities representing companies catering to a tapped out consumer, and capital structure safety will prove prudent over longer terms. Generally speaking, US banking system survives a conflagration (due to recapitalization), while some banks in Europe and Canada may not be as prepared. Commodities will bifurcate over time as drought, industrial collapse and war overpower their common dollar denomination. Short the Australian dollar against the US dollar from 1.05 performed well (now .86) and iron ore was previously cited as vulnerable (mid-2013), they remain so. Oil in mid-2014 priced in demand not considerate of recession alongside the return of intermittent supply. Near $110 I recall saying it “can fall anytime now”. Near $85 a barrel now, $75 is likely and results similar to the last crisis are possible. Escalation in war would maintain, or see a return to a more modern price; therefore if drawdown is tolerable over a medium term, oil can be viewed as insurance. In that vein, the precious metals continue to change hands, facilitated as they are apparently viewed only as a Giffen good by western ideology. Lastly, with palladium and platinum demand being mostly absorbed through economic activity, the former is most overpriced of the two.