Specializing in economics, Macro, Portfolio Strategy, Bonds
Contributor Since 2017
Eric Basmajian is an economic cycle analyst and the Founder of EPB Macro Research, an economics-based research firm focusing on inflection points in economic growth and the impact on asset prices.
Prior to EPB Macro Research, Eric worked on the buy-side of the financial sector as an analyst at Panorama Partners, a quantitative hedge fund specializing in equity derivatives.
Eric holds a Bachelor’s degree in economics from New York University.
EPB Macro Research offers premium economic cycle research on Seeking Alpha.
I wanted to run through some data on my dashboard this weekend and remind you that there are only two days left to sign up for EPB Macro Research for free using a 14-day free trial. The free trial will only be available until tomorrow, November 26th.
The yield curve continues to contract at an accelerating pace. This contraction is going to put severe downward pressure on bank lending as there is little profitability left with such a tight spread.
Bank lending is already contracting down to 1% from over 10% in 2015. This massive change in lending, from 10% to 1% growth, is directly related to the flattening of the yield curve and therefore less profitable loans.
Treasury Yield Curve:
With fractional-reserve banking, money creation follows a two-stage process. First, a central bank introduces new reserves into the economy by purchasing financial assets from or lending money to financial institutions. Commercial banks multiply the new reserves presented by the central bank due to the process of fractional reserve banking; this expands the amount of broad money (i.e., cash plus demand deposits) in the economy so that it is a multiple of the amount initially created by the central bank. Money is in essence pushed from central banks to commercial banks, and then to borrowers.
The issue that arises is that money cannot be pushed from the central bank to borrowers if they do not wish to borrow.
Commercial banks extend loans, and borrowers take out loans, both parties believe this loan to be profitable. The borrower expects to make a higher rate of return on his investment than the loan and the bank makes a profit by charging a 'spread' over their cost for not lending it out (a proxy for this profitability spread is the 10-2 treasury curve).
These loans must, in turn, be backed by reserves. This is a legal requirement. Otherwise, banks could print unlimited quantities of money – and banks are allowed to extend as loans some multiple of reserves: in a fractional-reserve banking system banks are allowed to extend more loans than they have reserves (the ratio is called the money multiplier, and is greater than 1. This ratio is calculated as M2/Monetary Base (Reserves). That ratio is currently 3.5 down from 8 in the early 2000's.
Central banks can limit money creation by either limiting the amount of reserves they create thus denying reserves and preventing commercial banks from extending further loans. They also can limit money supply growth by raising the interest rates paid on reserves, thus making loans less profitable for the bank (contracting the spread between longer-dated bonds and shorter-dated bonds 10-2 Spread).
While relaxing these constraints can encourage money creation, central banks cannot force commercial banks to extend credit – monetary policy can pull but not push.
If there is unmet demand for credit money, then credit money is pulling, and monetary policy can be effective. If, conversely, all demand for credit money is being met, either because banks do not wish to lend (finding it too risky or unprofitable) or borrowers do not wish to borrow (having zero use for added debt, such as due to lack of business opportunities), then monetary policy is ineffective.
The central bank can encourage bank lending and money creation but not force it.
The rate of bank lending is falling drastically indicating that there is a lack of demand for loans and future money supply will contract.
Total Loan Growth:
Over the past two years, loan growth has fallen from 12% down to 0.74%. In dollar terms, loans creation was $200 billion in 2015. The annual figure is down to $15 billion dollars a year as of this past Friday's update.
Total Loan Growth:
This was an exerpt from the full Weekend Dashboard I posted for subscribers.
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