Sunday, May 13, 2018

Monetization Trumps Fundamentals


When I'm wrong, it's best to just admit it.  I thought the market would be tanking soon into another '00 or '09 like collapse based on what I anticipated banks would be doing with their excess reserves.  I believed the process of the Fed reducing its balance sheet coupled with rising interest paid on excess reserves (IOER) would entice the largest banks to keep their nearly two trillion of reserves fallow and instead take the free billions in interest for taking no risk and making no loans...and thus the flow of monetization would be shut off or put into reverse.


Apparently, I was wrong.  In fact, banks continue to draw down their excess reserves and are doing so significantly faster than the Federal Reserve raises IOER's or reduces its balance sheet.  The discrepancy is the ongoing flow of hot money entering the financial system looking for a home, almost surely with significant leverage.

The Details

Below, the Federal Reserve balance sheet versus bank excess reserves withheld at the Federal Reserve plus the interest rate paid to banks on those excess reserves.  Excess reserves peaked in August of 2014 and have been falling since, declining by about $800 billion so far versus a reduction in the Fed's balance sheet of about $140 billion (from peak).
What you may notice is the large discrepancy between the dollars conjured by the Federal Reserve to buy assets from the banks versus the bank excess reserves held at the Federal Reserve...that yellow line is about a $1.6 trillion discrepancy called monetization.  What is apparent is that the impact of QE entering the economy has been ongoing and essentially continuous since QE ended 3 years ago with the banks acting as a sponge slowing releasing the cash (likely with significant leverage...easily turning $1.6 trillion into $3 trillion to $15 trillion in purchasing power).
Making a quick detour, the chart below shows the strong correlation of total disposable personal income (all annual personal income from all sources that remains after all taxation is paid) and all publicly traded US equity (Wilshire 5000).  They are essentially equivalent from '71 through '95.  However, from '95 onward, large fluctuations in equity prices ensue while total DPI continues to plod along as before.
Fast forward to 1995 and the '00 and '08 bubbles rise and then return to or fall through the support of total DPI.  But in '09, QE is initiated and the market follows the timing and quantity of monetization rather than DPI or QE itself.  (FYR- The chart has an added red dashed line showing annual 7.5% returns so necessary to meet redemptions).

Pulling in a little tighter from '08 through '18, below.  The correlation between the timing and quantity of monetization entering the financial system versus the performance of the Wilshire 5000 seems to have far greater impact than the far slower growing DPI or the size of the Fed's balance sheet.  Each disruption in the flow of new monetization was subsequently followed by a "market" correction and subsequent re-start to the flow of monetization.

I had thought banks would cease withdrawing their excess reserves...but in fact they are withdrawing those reserves even faster.  So the takeaways should be; (1) financial valuations are way out of whack with their long term relationship with DPI but (2) as long as banks are more interested in employing excess reserves than taking the rising interest paid on excess reserves...and continue to pull their reserves significantly faster than the Fed reduces its balance sheet, then financial assets are likely to continue rising as the hot money looks for a home.  Of course, further rate hikes, accelerations in reducing the balance sheet, or lemming like risk aversion...and this trend could turn on a dime.


So long as monetization continues, the impacts will be enriching the minority with significantly higher asset valuations and rental income while impoverishing the vast majority as costs rise significantly faster than most incomes.  The flipside of zero or negative monetization appears to be a fall back to the support of the real economy represented by disposable personal income (about 50% from here...but of course, a repeat of '29 with assets falling up to 90% is easily in the realm).  The options appear to be a slow and painful cancer or a sudden crash...pick your poison well but know you won't recover from the cancer...but you may get better after the crash.