The Fed, The Banks, Money Creation, Inflation, And the Bond Market

by: John Lombardo, CFA
For more than a year now, we have heard rumblings that the bond market is the next bubble about to burst, following on the heels of the U.S. equity, credit and housing bubbles. In what can only be described as a classic twist of irony, bond funds have experienced massive inflows of capital in the wake of a collapsing credit bubble and high yield bonds have been one of the best performing asset classes over the trailing three and five-year periods.
As all of this was occurring, US Treasury debt surged as a massive decline in tax receipts and fiscal stimulus on a heretofore unknown scale blew a gaping hole in the federal budget. While the total value of money in mutual funds declined modestly over the three years ending in 2010, bond fund assets climbed dramatically (Chart 1). With interest rates at historical lows, the Fed printing money at warp-speed, isn’t inflation right around the corner? If so, won’t the Fed then have to raise rates rapidly, resulting in the collapse of the bond bubble?
That certainly seems to be the consensus. Yet the situation is far more nuanced than bond bubble adherents would have one believe. True, bond funds have experienced massive inflows over the last three years. As the global economy continues to recover, they are likely to experience outflows as investor confidence grows, risk appetites increase, and investors seek higher returns.
Yet there is unlikely to be a dearth of buyers for investment grade fixed income securities. The deleveraging of consumer balance sheets has resulted in an increase in the personal savings rate from less than 1.5% in the middle of 2005 to roughly 5.5% last year. After a 20-year decline to the lows of 2005, we expect the US savings rate to average 5-7% for the foreseeable future. Personal savings will likely gravitate to relatively safe instruments such as money markets and short-intermediate bond funds. Additionally, retiring baby-boomers, whose nest eggs are far smaller than they had anticipated following two brutal bear markets in the last decade, are likely to be willing buyers of investment grade fixed income securities. Finally, the financial sector, particularly insurers that need to match the duration of their liabilities and assets, will remain significant buyers of fixed income securities.
Importantly, despite the Fed’s gargantuan efforts to re-ignite the US economy, the risk of rampant inflation, fed tightening, and rapidly rising interest rates has been vastly overstated. There are a number of issues keeping inflation at bay. First, the unemployment rate, currently at 9%, is likely to remain elevated for at least the next two to three years and is unlikely to drop to pre-recession levels for at least another five years. Elevated unemployment and consumer deleveraging will make it hard for companies to push cost increases through to consumers. Second, while commodity prices have been increasing, they are a far smaller percentage of the final cost of goods in the U.S. than in emerging countries, and therefore have a smaller impact on US inflation levels. This is especially true for core inflation, the Fed’s preferred measure of prices, which strips out food and energy inflation. Finally, while capacity utilization rates increased meaningfully in 2010, they remain well below the median level of the last 40 years (Chart 2). As such, companies can significantly increase output without generating upward pressure on prices.

As important as these factors are, we are mindful of Milton Freidman’s statement that “Inflation is always and everywhere a monetary phenomenon.” Yet we note that while the Fed may technically create money, the real power behind money creation is fractional reserve banking. In a very real sense it is the banks rather than the Fed that control the creation of money and, to a significant extent, the velocity of money (how quickly money changes hands). Fed policy largely alters the costs and benefits to banks of doing so. Over the last three years the Fed has massively increased the monetary base, which includes cash and currency that is held by the public, held in bank vaults, and held as reserves at the Fed. Yet the vast majority of this enormous increase in the monetary base remains on reserve (Chart 3).
To truly understand the degree to which the Fed’s monetary largesse has not filtered into the economy, one must look not only at the absolute change in the monetary base and the reserves of financial institutions, but the change in reserves as a percentage of monetary aggregates. M1 consists of the monetary base, travelers checks, demand deposits, and other checkable deposits. Not surprisingly, reserves as a percentage of M1 were nearly halved as financial institutions roughly doubled their leverage ratios from the mid 1980s through the mid 2000s. Reserves as a percentage of M1, typically slightly north of 5% in the mid 1980s, fell to 3.05% in January 2007. As the credit crisis peaked in the fall of 2008, the ratio rose from 3.31% in August to more than 51% in December 2008. It is higher still today, ending 2010 at nearly 60% (Chart 4). In data dating to 1959, the maximum level prior to the crisis was 8.03%.
Simply put, the Fed’s printing press is ineffective without the express participation of the banking system. The real power to create money lies not in the Fed’s ability to print it, but in the multiplier effect of fractional reserve banking. Despite the Fed’s best efforts, banks have largely chosen to keep money idle and on reserve, a process that is unlikely to end soon. Bank leverage ratios, which jumped from historical norms of 12:1 to 25:1 over the 20 years prior to the crisis, will likely continue to decline for another three to five years. As such, reserves are likely to remain well above historical norms and inflation is likely to remain reasonably in check. We have no expectation that the Fed will perfectly time their exit strategy, and we fully expect inflation to ultimately rise-- possibly significantly. Yet it is unlikely to do so in the next three years.
With inflation reasonably well in check, employment growth likely to remain modest, and slack in capacity utilization, the Fed is unlikely to raise interest rates in 2011. When they begin raising rates, they are likely to telegraph the initial rate hike as they did in 2004, and are likely to raise rates slowly-- at least initially.
With the 2-10-year spread wider than two standard deviations from its mean over the last 35 years, when the Fed begins raising rates we are very likely to experience a bear flattening of the yield curve, in which short rates rise more rapidly than long rates. On the whole, the yield on the 10-year Treasury, currently around 3.60%, is likely to hold the 4% level better than many currently expect. We would suggest that the bond market has significantly priced eventual normalization into the long-end of the curve over the last four months.
At the end of the day, while a nearly 30-year secular bull market in bonds is over, we are definitively not in a bond bubble. Investment grade, intermediate bond portfolios are likely to offer investors annualized returns of 2.50-3.00% over the next three to five years. That may be nothing to write home about, yet it is far from a collapse of epic proportion.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.