For years the Fed Funds rate has been the sacred measure that investors followed to determine if the Federal Reserve was promoting an accommodative or restrictive policy. Fed rate hikes were a signal that the market was a little too juiced on the punch, and margin calls or a reduction in lending in the market was considered prudent.
What about today? The Fed Funds rate has been at 0% since December 2008 yielding the rate meaningless in understanding just how Fed policy is influencing the financial markets, much less the economy as a whole. I separate the stock market from the economy because increasingly, and particularly since the new Fed policy of using excessive amounts of QE as a tool in its policy, the two have diverged in correlation. In fact, from a pure numbers standpoint, it can be argued that over the last 6 years, Fed policy has been an outstanding success in pumping up the stock market. Stocks have risen from the depths of 666 on the S&P500 to over 2000. Economic growth, however, has struggled to exceed 2% in real terms, and 3%-4% nominally.
The Fed has announced that it will now end for the foreseeable future, its bond buying program known as QE3 in the market (the program followed QE1 in early 2009 and QE2 in early 2011). Stocks went progressively higher with QE as a backstop. With the QE program ending for the time being, will the stock market suffer from the change? Logically given the correlation one might suspect trouble; but what indicators should an investor monitor?
The answer to these questions is completely up to what happens to the bubble the Fed has created on its balance sheet, and correspondingly the high level of excess liquidity that it has created within the U.S. banking system. One such indicator that is likely to become useful in the post QE3 distorted financial market is the level of excess reserves in the U.S. banking system. (Excess Reserves of Depository Institutions)
Excess Reserves Up, Stocks Up
The question on many investors' minds is what is the vulnerability of stocks to a stoppage in the current Fed QE policy? Stocks have risen steadily from the lows in March 2009 to the recent all-time high levels in Q3 2014. The fact that the rise in stocks has been highly correlated to the Federal Reserve liquidity machine has not gone unnoticed, even to very novice investors.
The graph below has been created to show the high relative relationship between the past six year run in stocks, and the Fed QE policy. However, instead of looking at the run-up in stocks relative to absolute size of Fed balance sheet increase, the increase in stocks is charted relative to the increase in excess reserves held at the Fed by banking institutions. What the excess reserve figure represents is the amount of debt (U.S. Treasury and Government-Backed MBS) the Federal Reserve has purchased off the market and turned into cash which has not been re-cycled into the U.S. economy as an investable asset (yet?).
Interestingly, the more Treasury and MBS debt the Federal Reserve has removed from the open market, the higher the U.S. major market stock indexes have increased. Why?
One theory is that the Fed action has artificially de-leveraged, at least temporarily, the U.S. government and removed the incentive for many investors to buy Treasury debt due to scarcity and negative real rates. QE "pushed investors in the back" to allocate more investment funds to riskier assets in order to achieve a return on assets.
But there is an additional effect which is driving stock valuations which can be traced more directly to how QE influences the financial system, namely by re-directing leverage. QE creates cash reserves on financial institution balance sheets, which, if not put to work, earn only the rate the Fed is willing to pay. Up until the financial crisis, the Fed could not pay interest on reserves. Now, the Fed has the ability to incent banks not to lend the high-powered cash reserves on their balance sheets, $2.7T as of October 15 2014, by effectively paying them a rate higher than they might otherwise expect to receive by lending the money (capital regulations also play a role in the bank incentives). Currently the overnight rate paid (known as ONFR) is between 0% and .25%. In the future, this rate will change if the Fed feels that the reserves in the system are not high enough. In other words, investors now need to watch the excess reserve levels in the banking system and the interest rate being charge to determine whether the financial system is loose or tight.
Excess Reserves and the rate paid on excess reserves, not the Fed Funds rate, is the new barometer for Fed Policy. Is the $2.7T level of excess reserves in the system a good or bad number? My observation is that I do not think anyone in the market or Federal Reserve really knows - we are in uncharted territory. But, every market participant is being affected by and reacting to the oversized magnitude of the reserve balance. Currently there is $2.7T of idle reserves, but the Fed has increased its balance sheet by a much higher sum since 2008. In other words, a lot of cash in the form of new leverage has been added to the U.S. financial system over the past six years. What may surprise many investors is just how much money the financial system has put to work, particularly since the advent of QE3. In this regard, the stock market has gotten a particularly large dose of its typical "go juice" from margin debt.
Margin Debt and Excessive Liquidity
The graph below has been compiled to show the behavioral activity in the stock market, increasingly financing stocks with higher margin balances, at the same time that the Fed has been removing a large tranche of investable assets (U.S. Treasuries and Government MBS) from the U.S. financial system. The correlation between margin debt and stock valuations historically runs at .96. In the analysis below, excess bank reserves since 2008 have been almost as good a predictor of what will happen to the value of stocks over time, showing an r value of .82 and an r-square of .68.
Interestingly, the stock market movement since early 2009 has corresponded with movements up in excess reserves and margin debt expansion as new reserves created by the Fed money printing are put to work by financial institutions. Likewise, the tendency has been for stocks values to suffer and margin debt to recede as bank excess reserves fall.
One likely explanation for this phenomenon is that Wall Street money managers have been front running the Fed program by leveraging risk assets as the Fed QE funneled more buyers into the corral by removing investable interest bearing assets from the market. As the end of the Fed program approached in 2014, margin showed signs of pulling back. This phenomenon can be seen at the end of QE2 and through 2014 as the end of QE3 approached.
Fed QE Withdrawal Being Driven by Hot Lending Markets
Much discussion has transpired in the financial market concerning whether the Fed should extend the current QE3 program (which it did not). The reason the Fed went forward with stopping the QE program is credited primarily to improving economic statistics. However, I will note several banking system parameters that point out that the program definitely needed to be curtailed, and very likely the excess reserves in the banking system will also need to be put into reverse if certain scenarios such as an unexpected rise in government expenditures above the current low rate of growth were to occur. The wildcard of corporate tax reform which also may stress the funding needs of the government is also a very real wildcard.
First, with respect to margin activity in financial markets, current levels have met and exceeded the high water marks relative to U.S. GDP that were witnessed prior to the 2001 and 2008 stock market breakdowns.
What this means is that stocks have been increasingly run up in value using leverage, and higher volatility can be expected as any sudden downtick will increasingly trigger margin calls. The NYSE margin data focuses primarily on major market stocks. My observation is that the debt market is probably even more exposed at the present time, problematic if issuance of the type of debt the Fed holds, primarily government Treasuries, starts to rise and rates have to go up to compete for funds. It is not wise to heavily leverage an asset that is expected to decline in value.
The second aspect of the financial system that is typically a leading indicator of economic growth is a return of lending volume across both the business and consumer sectors. Loan generation, with the exception of mortgage debt, has been robust since the implementation of QE3 and particularly throughout 2014. This measure indicates that an increasing dose of the new reserves that have been created by the Fed QE machine are being put to work through new loans. And, relative to the size of the U.S. economy (NYSEMKT:GDP), the lending volume has reached the same relative levels achieved prior to the 2001 and 2008 stock market downturns.
What this information tells me is that the Fed has the wind at its back with respect to economic activity, at least for the short term, and additional QE would only make its task of controlling the massive pile of excess reserves on its balance sheet harder to manage in the future. The true stimulus in this financial game is the lending activity that is either encouraged or discouraged by the reserves in the banking system. There are ample "excess reserves" in the financial system that could be turned into new economic activity. The data prove that the activity is already well underway.
Based on the trajectory of the current data, the Fed is clearly behind the curve on the appropriate level for interest rates. Presently the Fed is standing by its statement that the rate it pays on excess reserves will not be raised for a considerable time, most likely because the current Federal budget depends on low rates. What this means is that excess capital in the system will continue to leverage remaining assets in the economy until new assets of less risk, higher return materialize. What is the most obvious lower risk asset on the horizon which must increase in supply on the open market? - U.S. Treasuries. (NYSEARCA:TLT) (NYSEARCA:SHY) (NYSEARCA:IEI) (NASDAQ:TAPR) (NYSEARCA:IEF) The true supply requirement of Treasury and MBS securities has been suppressed over the past 6 years by repressive Fed policy. We are about to see what happens as the Fed buying program disappears and these markets return to compete for market funding.
Is a Time Bomb Ticking for Stocks?
So what about stock valuations? Should a growing U.S. economy at this point promote continued excessive returns for stocks? I expect the major investment retail channels to push a positive perspective over the near future, and therefore, the bias in my opinion is going to remain upward at least through year end. However, you should not forget that stocks already priced in very strong economic activity when Wall Street money managers were leveraging up to front run the Fed actions.
What many money managers are looking for now is an avenue to re-balance and take risk off the table. Evidence of this desire has been visible throughout 2014 as runs on NASDAQ (NASDAQ:QQQ), small caps (NYSEARCA:IWM) (NYSEARCA:IJR) (NYSEARCA:VB) and high yield bonds (NYSEARCA:HYG) (NYSEARCA:JNK) (NYSE:BKLN) (NYSEARCA:SJNK) have taken place, while breakdowns in the major indices have remained minor. The brief collapse in mid October of the DOW (NYSEARCA:DIA) and S&P500 (NYSEARCA:SPY) was likely a prelude to further and more severe breakdowns over the intermediate term as the exaggerated Fed policy move is digested and bond buying stops. But in order to make room for the re-balance with rates repressed so low, the broad index stocks are likely to spike upward first. I expect several more episodes of exaggerated equity market spikes up and down in the intermediate term, with an upward bias into year end.
The best strategy if this scenario materializes is to remain positioned to profit from market increases in higher liquidity equity ETFs, but continue to take risk off and steadily accumulate higher cash balances or reduce margin as these spikes provide opportunity to move your portfolio to a less exposed position. My upward bias outlook for stocks will change once the market receives an unexpected spike in rates across the yield curve which causes a corresponding downward move in stocks. Most investors are likely not going to be quick enough to get out of the way when this type of forced de-leveraging happens, so taking gradual steps at opportunistic points in time is a healthy portfolio process.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.