Talk in the financial markets about the return of inflation has picked up substantially over the past month. Now that Trump has been elected president, the speculation that inflation will return seems to have moved from maybe to a sure thing. The market expectation change has coincided with a spike in US Treasury rates, particularly in longer maturities.
The move upward in rates accelerated post the Trump election victory, attributed to his more aggressive fiscal plan of tax cuts and infrastructure spending. But as evidenced by the upward slope in the graph, rates have been trending higher since the lows reached in July of 2016. Inflationary expectations are one key driver of the path Treasury rates take thru time. However, where is the evidence that backs up the expectations at this time, and more importantly, does the evidence point to a situation that is manageable or one that is likely to get out of control? Based on the data presented in this article, the out of control scenario for the Federal Reserve is now in play as the policy path of the past eight years gets "Trumped."
Key Variable to Watch - Excess Reserves
Over the past eight years since Obama took office, the Fed strolled down a path of historical in magnitude unconventional monetary policies. In the process, a new balance sheet item grew ever larger in size, until it suddenly did not. It is known as Excess Reserves of Deposits held at the Fed.
Excess Reserves are a liability in the Federal Reserve Banking system, not an asset.
As the Fed implemented its massive bond buying programs (QE1, QE2 and QE3) from 2010 through 2014, the Excess Reserve balance grew to over $2.7T. Investors that sold bonds to the Fed parked the funds in cash accounts as they were crowded out of suitable investments. Banks, rather than lending the entire cache of newly minted cash deposits, far too big in scope to find immediate places to be lent, choose instead to deposit the funds at the Fed. They were incented to do so by a new law passed during the 2008 financial crisis which allowed the Fed to pay interest to banks on excess reserves.
Much of the attention in the business press which followed the Fed was focused on the size of the Fed balance sheet as it grew to almost $4.5T at the end of 2014 when QE3 was completed. Since the QE program ended, attention shifted to when the Fed would raise interest rates. But the real issue that the financial press is not paying attention to is the changing composition of the liability side of the Fed balance sheet. The change shows the Fed has positioned the U.S. financial system to experience much higher inflation going forward, particularly when combined with the fiscal policy changes the new Trump administration plans to implement.
Take a look at the chart below. Since interest rates were first taken above 0% in December of 2015, the Excess Reserve balances at the Fed have plummeted over $400B. Such a large dose of high powered money being flushed into the economy rather than just being parked in cash at the Fed can have dramatic economic effect - either in terms of economic growth, or inflation-driven stagflation.
The question that is now very pertinent is how will the Fed respond as the Excess Reserves are being drawn down at a much faster pace?
I will make one other observation about the management of Excess Reserves on the Fed balance sheet; the account is extremely volatile in size, week to week. To say it is being managed is questionable. More likely the Fed at best is trying to react to its downward path, and the faster it plummets, the greater the force it applies to the economy in terms of price pressures.
In open market operations, the Fed has a stated intention to "mop" up the excess flow of money in the financial system as the Excess Reserves are unleashed through Reverse Re-purchase Agreements (RRPs). RRPs are also a Fed liability, created by the Fed loaning part of its Treasury portfolio to select institutions (domestic and foreign) with an agreement to buy the Treasuries back at a later date with interest. The RRP process is a "back door" policy tool which is intended to pull cash out of the financial system. In other words, the Fed is expected to simultaneously tighten through the RRP market as the "market" is withdrawing its cash parked in the system for new economic activity.
However, as you can see from the chart below, the Fed so far in 2016 has chosen not to tighten through the RRP market nearly as fast as Excess Reserves have been going down. The divergence between the balances in these two accounts, as Excess Reserves have fallen much faster than RRPs have increased, is how the Fed has been able to "open" the monetary spigot very wide over the past year. So wide, in fact, that I question how much control it really has over its own monetary policy at the present time.
There is still $2T in Excess Reserves sitting in cash in the Federal Reserve System which could be put to work as "high powered" money in the financial system. Some of the cash is known to be stored overseas on corporate balance sheets, and Washington, through the Trump plan, has sights on getting that money back into the US economy rather than being hoarded overseas. The question is, can the Excess Reserve monetary policy regime keep up with what is very likely to unfold in the market as the US government is about spend "big", to use a Trump term, and needs new funding for the "huge" Trump fiscal plan?
To show why I believe this is a "train-wreck" in the making in terms of inflation and the eventual level of interest rates in the US, I point interested investors to what happened in the 1960s and 1970s.
What Happened the Last Time the Fed Used an Excess Reserve Based Monetary Policy?
Below is a chart which shows how long it has been since the Fed actively used Excess Reserves in the US monetary system as a policy tool. The reason the policy was used in the 1960s and '70s was primarily to flood the market with banking reserves ahead of each Treasury offerings in order to ensure that the US government was getting the lowest rate possible on its borrowings. It was known as the "Even Keel" policy. When initially implemented, the excess reserves put into the system were intended to be pulled out once the Treasury auction was completed. However, as you can see from the graph, the Excess Reserve balance as a % of the US public debt became larger and larger through the mid-1970s. The Fed, pushed by the Treasury throughout the time period, found it easier just to leave the Reserves in the system rather than tightening after the government auction. But it was during the winding down phase of the policy in the late 1970s that inflation really went into the stratosphere.
Fast forward to the market scenario created today by Fed policy. By comparison, Excess Reserves in the financial system are now four to five times higher on a relative scale to the amount in the system in the 1960s and 1970s. And, just to be clear, the use of Excess Reserves to help the Treasury buy down the interest rate paid by the US government was terminated in the late 1970s because it was found to lead to greater and greater inflation. The path on how the Excess Reserves got into the financial system is different than the 1970s; however, the use of the reserves to inflate the ability of the Federal government spending machine at artificially low interest rates can and will have the same eventual inflationary outcome if the Fed balance sheet is used to create too much new government debt, too quickly. I believe we are about to embark on such a path. The actual fiscal plan implemented after Trump is inaugurated will be monitored very closely by the financial markets for this reason.
Federal Reserve has Finally Hit the Monetary Policy Redline
In this section, I share some research which shows that the Fed has finally hit a policy redline which has historically been shown to lead to much higher rates of inflation.
In the chart below, the red line in the graph is the trailing 12-month average Consumer Price Index (CPI). If you know your US financial history, inflation peaked in the early 1980s, and fell precipitously after Ronald Reagan took office. The primary cause for the decline in the Reagan years can be traced to two events. One, monetary policy shifted from targeting interest rates to the benefit of borrowing costs borne by the US government to targeting the growth in the money supply; and two, a steady decline in the growth rate in fiscal spending accompanied the Reagan tax cut plan. Opening the US economy to foreign wage competition through the 1990s and 2000s eventually added a deflationary price impact beyond the Reagan plan; but, the initial remedy of the inflation "virus" required, in a nutshell, lower direct monetization of ongoing government spending by the Federal Reserve.
How can you tell if the Fed is actually "over-monetizing" the US debt? To answer that question, I have added the blue line on the chart. The blue line shows the effective size of the Fed balance sheet as a % of US national debt. I have measured the "effective size" of the Fed balance sheet through time by netting out the "Excess Reserves" against the total assets owned by the Fed. As of the end of October 2016, the effective size of the Fed balance sheet by this measure was approximately $4.4T - $2.0T, or $2.4T. With a US debt balance of $19.8T, the relative amount of financing of the US debt being provided by Fed policy is over 12%. The 12% mark historically is where monetary policy crosses into the inflationary danger zone relative to fiscal policy. If the Fed balance sheet continues to directly monetize more than 12% of the US debt on a continual basis, and fiscal spending grows faster than normal, high inflation is a near certainty.
The movement of Fed policy into an inflationary position was a recent occurrence, although the seeds have been planted over the past eight years. The reason inflation expectations are growing now from a pure monetary perspective is that the higher rate of run-off in the Excess Reserves on the Fed balance sheet is a very recent change in capital flows, and the high powered money entering the economy at a faster pace is pushing up price expectations.
Fed Policy is Now Directly Monetizing the US Debt as Foreigners Depart
The Fed holds a large balance sheet of Treasuries and MBS securities funded extensively by Excess Reserves parked throughout the world. The big risk the Fed faces with this liability structure is that the deposit base can be moved at a moment's notice, causing the Fed to either have to print Federal Reserve Notes to monetize the debt, or sell RRPs or Treasuries to tighten the financial system. The problem is becoming more acute now because foreign owners of Treasury securities are selling in large amounts after years of nothing but purchases. At the same time, the monthly US Treasury financing need has been running steadily at $100B per month. Under the Trump fiscal plan, investors should not expect this need to go down; more likely the US Treasury borrowing needs will race even higher in 2017 and 2018.
Where is the money going to come from to finance the U.S. government as the foreigners depart? Foreign entities currently own 43% of the outstanding publicly-traded US debt. With a Trump trade policy, that is expected to be much tougher on exporting countries such as China, Mexico, Japan and many others, the virtuous flow of financing that has returned dollars back into fixed income securities like US Treasuries since the 1990s is now likely to continue to move in reverse. Over the past three months, foreign investors put an additional market burden of over $44B per month on the US debt market to finance the US government's ongoing operations. The sources of the funds were US banks and other US-based investors. No wonder US interest rates are darting higher. No wonder there are capital controls to force banks to own more US Treasuries in their portfolios. And no wonder the Excess Reserve level at the Federal Reserve is also plummeting.
How will the Fed respond to this increasingly unstable financial situation? A December increase in the Fed Funds rate is now considered a virtual lock. But will the increase actually be enough to keep the long end of the yield curve in check? Much will depend on the actual plan put into place once Trump takes office. But my opinion is baby steps in 0.25% increments every six weeks will hardly satisfy the market at this time as it will come to the same conclusion as the data presented in this paper show - the Fed is going to monetize the Trump fiscal plan, and higher inflation is going to follow. Therefore, long-term rates must rise until the Fed is willing to rein in on its unconventional monetary policy.
Barbell Strategy Best Until Unconventional Policy Gets Back to Normal - or the System Breaks
The unconventional policies pursued by the Fed have driven the financial system to the make or break scenario that is now taking shape. Interest rates now must move higher to finance the new fiscal spending path being pursued in the US, and soon to be followed by other western economies around the world. The financing source for the Trump plan is the money chased to the sidelines by ZIRP and NIRP paths chosen by central banks in Europe, Asia and the US over the last eight years.
Now the unwinding of these massive unconventional monetary policies is about to begin. Based on the high volatility I see in the Fed charts which track the Excess Reserve and Reverse Repurchase balances on the Fed balance sheet, don't expect the unwinding to be very orderly. The basic reason for the disorder is simple: the US government because it is so heavily in debt relative to its GDP is a poor candidate for a massive increased line of credit, certainly credit at low interest rates which have been suppressed by Fed policy. To make the bad news worse, the make-believe path of poorer economies funding the path to more debt in exchange for American jobs is also drying up.
The only reasonable short-term portfolio strategy in this brave new world is to sell longer-term risk-free assets (TLT, IEF) and higher-grade US corporate bonds (CIU-OLD, LQD, AGG) which are in the 3- to 30-year maturity category. The re-pricing in the Treasury market, in my opinion, has only just begun. Personally based on the poor condition of the US government balance sheet, I do not see the rate increases leveling off until Treasury rates return to 4% on the 10-year Treasury and 5% or higher on the 30-year. Sticking with short-duration holdings in the credit market (CSJ-OLD, SHY) or inflation-protected Treasuries (TIP) is the only rational "safe" fixed-income option under this expected scenario. To make up for the lost yield, I suggest an overweight in select dividend paying equities or MLPs in the commodity sector (AMLP) or near equity bonds that pay higher interest rates. These holdings will suffer less, and may even increase in value in an interest rate up, inflation expectation driven market.
One precaution, strong upward movements in interest rates have historically almost always capped stock market rallies (SPY, DIA, QQQ, IVV), particularly euphoric driven ones that spike up to all-time highs. Beware if the current risk-on trading pattern reverses and a flight to quality results as the Trump plan is approved in Q1 2017. However, the only way the market will truly plunge, in my opinion, is if the Fed begins to tighten policy much faster than their current path. If the Yellen Fed goes off-tendency in this direction, which I do not expect, batten down the hatches. The foreign ownership selling pattern may be the wild card that forces this hand much quicker than expected.
Daniel Moore is the author of the book Theory of Financial Relativity. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.