Sterilize This!
Peter is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Given the state of capital markets I thought it might be a good idea to review what the Federal Reserve is doing versus what we think is happening or is going to happen. The never-ending question of whether or not the Fed will engage in another round of Quantitative Easing misses the point of what is happening right now.
Because, right now, looking at the monetary statistics, the Fed has been tightening for months, pulling itself back as the primary provider of credit in the banking system and allowing the banks to resume their normal role of providing the market with credit. Federal Reserve Chairman Ben Bernanke has always maintained that it was his intention to sterilize the gross expansion of the Fed’s balance sheet and its closest proxy, the Adjusted Monetary Base (AMB). Historically, the AMB is the monetary measure that most tracks with the CPI and since we know that Bernanke is obsessed with headline CPI inflation, this is the most important of statistics.
Adjusting the Base
So, let’s start there. Since July of 2011 the Fed has been attempting to shrink the monetary base. One should note that that the two peaks in AMB correspond perfectly with the last two major peaks in the price of Gold (SPDR Gold Shares (NYSEMKT: GLD). The correlation between gold and the AMB historically is not so tight, but these are not normal times. In both cases about a month before the gold peak, the Fed began pulling back on the monetary base. Gold’s peak was marked with the announcement of Operation Twist 2.
Inflation expectations of bond traders fell and with it the price of gold and other commodities. The chart of total Fed Credit looks remarkably similar to the chart of the AMB. So, the Fed on the one hand is tightening credit, but it is doing so because of the data coming out of the banking sector.
Total credit in the banking sector has risen 5.5% in the past year. This is the only period of sustained credit growth in the U.S. since the financial crisis of 2008. So, now that the banks are lending again, the Fed is pulling back, or at least attempting to. But, look at the markets today, every time Bernanke and The Fed attempt to extricate themselves from the credit markets, reality takes over. The over-leveraged banking system begins to shake again and another round of monetary expansion is warranted to forestall an implosion. The expansion of bank credit is not enough to overcome the Fed’s injection of liquidity into the credit markets and the effects are a falling stock market amidst sovereign debt deterioration. The S&P 500 (SPDR S&P 500 (NYSEMKT: SPY) is essentially flat since the Fed embarked on this course of action around the beginning of July 2011, the end of QE2.
All other monetary statistics, M1, M2 and MZM have been rising steadily over the past year, along a similar trajectory as total bank credit, nothing interesting there. Credit is expanding and so is the money supply. Even the M1 multiplier has put in its most stable 1 year period of growth since the Lehman Moment.
And that’s what should have everyone worried.
The $1.6 trillion in excess reserves that were handed to the banks to prop up their balance sheets and stave off an historic collapse is the source of this new lending. The banks are feeling more confident in their lending prospects. This is the first sustained period of credit expansion and excess reserve reduction since this period began and it is exactly what Bernanke and the Fed have been hoping would happen.
Be Careful What You Wish for
From the start of the financial crisis Bernanke has beaten us over the head with the concept of sterilization of all of this money creation. He has said that the money created can just be withdrawn when necessary and that there would be no long-lasting effect except to stave off the worst possible outcome, a collapse of the banking system. Of course, that collapse is bad if you’re a banker. If you are anyone other than a banker you have to suffer through negative interest rates, no savings, volatile equity markets and a fixed income yield that can only be found with a microscope.
The resultant instability has created a bull run in bonds to historic low yields. iShares Barclay’s 20+ Yr Treasury Bond ETF (NYSEMKT: TLT) is up more than 30% since the Fed began tightening the base in July of 2011 and buying up the long end of the yield curve, not including monthly 0.3% dividends.
In many ways Bernanke’s Zero Interest Rate Policy is the new estate tax, except it’s being collected before the person dies. This is the real problem. For all of this new credit is not going into new businesses. More than 20% of it has gone into loans owned by the Federal Government itself, mostly student loans.
Most of the theses surrounding the advent of QE 3 revolve around the Fed having to come in and save the equity markets from crashing. The announcement of coordinated swap lines in November and various LTRO issuances by the ECB have spread the responsibility of keeping the banks afloat around while the Fed re-balances its portfolio of U. S. Treasuries and provides stealth QE that is politically favorable.
Lighting the Fuse
But, now we have a situation that can be explosive. The banks are lending again, credit is expanding and the money flow is rising and yet there is still need for more QE. The Fed is trying to sterilize its past money printing but it can’t, meaning the system is even more fragile than anyone is admitting. The last round of QE ignited an historic run in gold and nearly sent oil back to pre-crisis levels. Gold is trading counter-intuitively right now, testing the $1535 area while the markets are in risk-off mode. Moreover, since November, the Fed’s interventions into the market have created a disconnect between the inflation expectations of bond traders (the spread between the 90 OIS rate and the 10 year TIPS yield) and the price of gold.
Regardless of your view of gold and its place in the monetary system, its primary role is as a hedge against future inflation. This indicator has served me well for years to mechanically trade gold. Something is not right here. Either the Fed is reaching its moment where it will let the entire banking system implode or it will announce another round of QE which will wipe out this arbitrage.
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