On March 20, 2019, the Federal Reserve announced its intentions to cease interest rate hikes for the remainder of 2019. In this article I will analyze the possible consequences of this event.
The first reaction of the market was a drop in long term bond yields, effectively inverting the yield curve up to the 5 year maturities (see chart below from Zerohedge). Investors are fleeing into higher yielding bonds because the Federal Reserve stops hiking rates. An end to rate hikes also implies that the Federal Reserve is worried about growth, which translates into a lower yield on the 10 year treasury bond (the 10 year treasury bond yield can be viewed as the fixed-income market’s assessment of current nominal GDP growth on a year to year basis).
This has a very significant impact on net interest margins for the banks. In one of my previous articles, I forecasted that net interest margins would fall off a cliff in 2019 and this event just accelerated that premise. Lower long term bond yields mean less income for banks, while the effective fed funds rate is still hanging at 2.4%, which means high costs for the banks compared to loan income.
Not only do the banks have high costs now, they will start to get less income from IOER (interest on excess reserves). The Federal Reserve pays the commercial banks via IOER, which currently stands at 2.4%, following the effective fed funds rate (see chart below from FRED).
They pay this interest on excess reserves (see blue chart below from FRED). These excess reserves are shrinking as the Federal Reserve unwinds its balance sheet. The big problem for the banks is that the Federal Reserve intends to keep decreasing its balance sheet until September 2019. During the FOMC meeting on March 20th, Fed chairman Powell said that he intends to shrink the Fed balance sheet to $3.5 trillion. When we look at the chart below, that means that we are only halfway through the quantitative tightening cycle. Excess reserves will need to shrink to about $1 trillion. The implications of this are enormous. Liquidity of the banks will fall, Fed interest payments to the banks will fall, deposit costs will rise and loan income will fall. Taking all this into account, I believe bank stocks are not the place to be at this moment.
Now, why is the Federal Reserve taking this drastic turn? I believe the Federal Reserve is finally starting to run out of bullets.
When we look at the U.S. Treasury balance, we see that a huge drop in the cash balance took place in February 2019, just when the U.S. government shutdown ended. Bills had to be paid and a new debt ceiling crisis is emerging once again. The Treasury Department once again deployed so-called “extraordinary measures” and this time, they have time until September 2019 when the U.S. Treasury will run out of cash reserves.
When we look at remittances to the U.S. Treasury, we can see the relentless drop (see chart below from FRED). In one of my previous articles, I wrote that when these remittances approach $40 billion (which is also the amount of unrealized losses on the securities on the Federal Reserve balance sheet), the Federal Reserve will start to panic. As you can see on the chart, we are approaching that number (currently at $60 billion in remittances).
The conclusion is that the Federal Reserve is cash-strapped while the economy is only growing at 1-2%. They are preparing to restart QE again and this could start as soon as they stop decreasing the Fed balance sheet in September 2019. I also predict that the Federal Reserve will cut interest rates this year, taking into account that the 2 year bond yield is now significantly inverted against the Fed funds rate.
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