The Federal Reserve members bid farewell to Ben Bernanke at his last formal FOMC meeting on January 29th, 2014. The story surrounding his departure as Fed Chairman for me is what he has taught the investing community about the power and limitations of Federal Reserve policy. In addition, the forming story is that investors are beginning to adjust their portfolio to deal with the 800-lb gorilla he is leaving behind for Chairwoman Janet Yellen to manage. His legacy, in my opinion, will be shaped by what happens to the $2.4 Trillion dollars (and still growing) in excess reserves currently on deposit at the Fed in the U.S. banking system.
Lesson 1 - QE is not the primary cause of Consumer Price Inflationary
Through the years that I have followed Ben Bernanke, a consistent aspect of his testimonies has been his contention that the unconventionally large Fed asset purchases would not be inflationary. Many astute investors listened to his comments in disbelief, riding the gold momentum trade up to $1700, and then back down to $1200.
As it turns out, Ben Bernanke was precisely right, at least so far, as you can see in the chart below.
The inflation trend line since the 2008 crisis, despite the increase in the Federal Reserve balance sheet from $1T pre-crisis, to over $4T today, has continued to move downward. This trend is a continuation of a long term cycle that began with the reign of Paul Volcker as Fed chairman back in 1980. What the information highlights for me in researching the enigma of inflation is that price levels are indeed a monetary phenomenon, but if the money is constrained from reaching the general economy, then consumer price inflation will struggle to ignite.
Although I recall Bernanke being very confident that inflation would not be a problem, I do not recall any clarity about why this would be the case other than a vague concept of "extinguishing reserves". In reviewing the last several years of data, in the spirit of Fed transparency, I believe he could have been a bit clearer. The prior testimonies could have read, "As monetary system overseer, the Fed is going to inject Trillions of dollars into the banking system and simultaneously pay banks 25 basis points to hold assets they did not previously have on their balance sheet. Additionally we intend to tightly regulate lending so that the money supply does not run rapidly out of control."
Lesson 2: High QE plus Zero Interest Rates does not Equal Bank Lending
For evidence of the efficacy in the banking regulation mechanism in constraining lending, I looked into the aggregate statistics for the U.S. banking system since January of 2008. In the chart below you will see that total bank assets grew from $11T at the beginning of 2008 to $14.1T at year end 2013. The growth in total assets was 28.1%.
However, bank credit expansion over the same time period was $9.0T to $10.1T, or only 12.2%. The growth in banking system assets in large part was a function of the Federal Reserve buying Treasury and Mortgage Backed Securities in the financial market, and then placing a cash deposit on the balance sheet of a Federal Reserve Bank to complete the transaction. These excess reserves theoretically could be loaned back into the market; however, one has to figure that market and / or the regulatory environment have not been conducive to rapid credit expansion. Whether you buy the idea that loan demand in a deleveraging market environment is lacking is up to you. What I find interesting is the level of constraint in the banking system. I have little doubt there are plenty of small and medium-size businesses across the country that would benefit from expanded low-interest rate credit facilities; however, the data reflect a crowding out of the sector in favor of cash accumulation.
How can these banks make more money by holding excess cash reserves paying 25 basis points rather than lending the reserves out into the general economy? Welcome to the world of shadow banking…
Lesson 3: QE is a Magical Stock Market Elixir
Even though the direct lending market has not shown a rapid expansion of credit since the end of 2008, the margined equivalent of the securities being purchased by the Fed is still reaching the stock markets. As evidenced below, the correlation of returns in the major market indexes (DIA) (SPY) (QQQ) to the expansion of the Fed balance sheet from 2008 through 2013 was very high, as exhibited in the following graph.
The correlation exhibited over the past 5 years, although not historically unprecedented, cannot be expected to go on indefinitely. For instance, from mid 1997 through mid 2007 the correlation statistic was only .58. The question that investors should be asking is how long will the magical elixir continue to push up market values, and what could change the correlation?
One change that has recently gone into effect is the Volker rule which shut down the ability of a bank to obtain securities on a bank proprietary trading account. This rule, however, has not completely shut down the real avenue used to increase the margin level in risky asset markets.
The real profits for the banks are being derived from re-hypothecating the cash liability, created by the new cash deposits created by the Fed security purchases, into collateral which an outside firm (hedge fund) can use to initially margin a security purchase or other risky asset position. Re-hypothecation is widely used by prime brokers involved in the collateralization of derivatives transactions with hedge funds. As long as the market keeps moving higher as more liquidity is pumped into the market by Fed asset purchases, the process is profitable for all market participants. However, if the Fed decides to stop or reverse its current policy, the effect is likely to be an immediate collapse of the stock market as the collateral chain is reversed. Anyone that remembers the housing bubble will recall that the same marginal funding process was used to build up and eventually tear down the mortgage market.
The paradox for the current stock market and by inference the general economy, is that to achieve real sustainable growth, the Fed will need to stop QE and banks will have to actually commit capital to real cash flow positive economic projects. Such activity would be in direct contrast to the current process of increasingly margining a progressively smaller pool of available shares which are being pumped higher through levered equity transactions and share buy-backs. The de-leveraging of this asset bubble could be painfully quick as history shows when the Japanese stock market collapsed 24% in April and May of 2006 when the BOJ began to withdraw from its 2001 to 2006 QE program.
Signs the 800-lb Gorilla is Escaping into the Financial Markets
To use an analogy, the problem in dealing with gorillas or any wild animal is that as long as they are caged and under control, there are few issues. However, once the gorilla is running lose, wrestling it back into submission can be a painful experience.
The biggest risk for equity investors now is when and how the Federal Reserve will actually alleviate the heightened financial market risk the $2.4T and growing excess bank reserves in the U.S. banking system is placing on world financial markets.
The question becomes, is the gorilla actually out of the pen? And more importantly, is it a problem in the eyes of the Federal Reserve?
The irony in the Bernanke monetary policy legacy will be that the expectations for the massive QE printing press rather than leading to rampant CPI inflation, actually led to tighter bank credit and levered equity transaction like buybacks rather than business capital expenditures. The current result is that rather than stemming deflationary pressures as was a stated primary mission for the Ben Bernanke Fed, apparently the risk is still in place, and in my view is even greater. From this standpoint, investors might reason that more QE is coming in order to fix deflation.
The problem with the logic is that Quantitative Easing, in isolation, is not how deflation is remedied. QE creates monetary liquidity, but it does not mean that the liquidity will necessarily get into the hands of the mass market. I share the following graphic which points out the log-jam in releasing the liquidity into the mainstream market being generated by QE from over the past 5 years. And then contrast the metrics of bank lending, bank reserve balances and several other metrics to the high inflation period of the 1970s.
What is so different today compared to the 1970s? We had high QE in the 1970s, but low U.S. debt relative to GDP. We had a high rate of growth in government spending, and high taxes to pay for the spending (not that I am an advocate for high taxes). Today we are experiencing an increase in taxes primarily in the upper income brackets, but by and large with the exception of the healthcare albatross, taxes remain relatively low. Government spending, unless the healthcare and entitlement programs increase dramatically in the coming year continue to be below average in rate of increase compared to any time period since WWII. In other words, most every major macro force that would contribute to creating inflation by putting money in the hands of the mass public other than QE is presently pointed in the opposing direction. QE, at least from an empirical data standpoint, does not correlate highly with the creation of inflation unless there is a corresponding government force.
QE creates asset bubbles in the method described in this article, by allowing too much money to chase too few assets. In order for consumer price inflation to ignite, the $2.4T on the banks balance sheet must be leveraged into the mass consumer market. The Fed can easily see that the current QE program, rather than producing real economic activity, is incenting unsustainable margined transaction behavior on a pool of shrinking investable assets. In other words, the Fed is nearing a point in which they have to slow open market Treasury purchases because their behavior is becoming the fulcrum of risky market behavior. In this sense, the gorilla is indeed escaping into the financial market.
Signs of the growing risk are not just domestic. The emerging markets, with China being the one to watch most carefully because they have an extensive shadow banking market, are exhibiting signs of concern. The financial press seems to be interpreting the present emerging market difficulties as directly correlated with the Fed announcement to taper. This analysis is incomplete. The fact that certain emerging market countries cannot get financing is a trade current account balance problem. This problem would result from the declining U.S. trade deficit, lower U.S. government spending growth and generally low economic growth if linked to actions by the United States.
The Fed tapering actions can only affect the emerging market to the extent that margined financial transactions are being reeled in that are somehow linked to sources of funds margined by U.S. collateral. Fed QE has created one special situation that may be pressuring the emerging markets that is very well understood by technicians, but poorly understood by investors. The removal of almost $3T in U.S. Treasuries from the financial market has displaced a very large pool of lendable collateral. For emerging markets dependent upon the U.S. dollar for trade, the lack of collateral means they may have to increase their interest rates in order to obtain funding to cover their current account deficit - exactly the scenario that transpired in Turkey. Expect this issue to become more prevalent.
Is it possibly that the Fed is actually pushed to sell U.S. Treasuries into the market because the international market is under increasing financial stress? This is a wildcard scenario that I believe would actually lead to the sharp downfall in the U.S. stock market that many investors currently fear. If the Fed actually does reverse even a small portion of the excess reserves by selling Treasuries in the near future, liquidity in the banking system would quickly dry up, and the collateral chain in the stock market would most likely reverse in my opinion.
Major U.S. stock market corrections are usually punctuated by a major disruption instigated from the international financial marketplace forcing the U.S. Federal Reserve to tighten policy. Oil shocks historically have been a useful indicator as they always invoke a tightening of Fed policy. However, energy markets are currently signaling the prospect of price deflation rather than inflation. If the stock market does severely correct at this juncture, it will be under fairly unique circumstances. The Fed taper is an implied reserve requirement tightening which will clamp down on the risk trade across the world. Marginal emerging market countries in need of financing will likely suffer higher interest rates as a result; but equally as likely is that in order to raise USD the price level of products in dollars will fall, laying the groundwork for a deflation led financial market decline.
Portfolio Strategy to Deal with the 800-lb Gorilla
No one can be certain how this will play out, but a change in equity market trajectory is the most probable outcome.
The most effective portfolio strategy to deal with the current growing risk is to re-balance by replacing expensive stocks with positions in sectors that have already been beaten down by a substantial correction.
- Lower exposure to selective riskier stock or ETF positions.
- Do not shy away from higher quality, longer duration debt which will do well in a deflationary scenario.
- Increase gold and oil positions as a hedge. Gold (GLD) (SGOL) (IAU) at $1250 is showing stability after one of its worst year over year performances ever in 2013. The precious metal is now well positioned to protect against any stock downward adjustments. Oil (OIL) (DBO) (USO) positions at current price levels will be valuable in the event U.S. economic growth actually takes a more traditional path and inflation led growth returns.
- Seek a balanced portfolio.
Presently I am not convinced that the increased volatility will ignite a severe U.S. market downturn; therefore I have not suggested that it is time to raise cash balances substantially. But, I equally am not eager to jump into over-valued stocks when many companies are not signaling strong growth ahead. Deflationary pressures may persist over the coming years weighing on market returns until real economic growth picks up. Cash will turn out to be a smart play if deflation is the resulting outcome.