Market Review Q219: Dollars and Nonsense, Part 1
If there was one message to be taken away from the first half of 2019, it was that the Fed still reigns supreme in the minds of investors as to what drives markets. After a remarkably strong first quarter during which the Fed flipped its position on rate increases, performance remained very respectable in the second even though fundamentals began eroding and the yield curve inverted.
Such attention to plans for rate decreases belies another reality that is far more important for long-term investors. The global financial system has grown in complexity and this complicates the Fed's ability to control US dollar liquidity. High levels of government debt further impinge on its ability to nurture economic growth. Now, after ten years of interventionist monetary policy, it is a good time for investors to turn their focus away from the nonsense of short-term machinations and to start considering the longer-term consequences.
For many investors and analysts, money is a dull subject that wreaks of tedium and only serves to distract from more interesting investment analysis. As Chris Martenson describes in his Crash Course, "Money is something that we live with so intimately on a daily basis that it probably has escaped our close attention."
This is potentially a blind spot for many investors. For those who may have learned about money and money supply in a college economics class years ago, things have changed a lot and the global financial system has evolved considerably. For those who never paid much attention to the subject, liquidity has become a more important component of the overall investment equation.
In order to fully understand some of the changes, it helps to refresh the basics. For starters, Martenson captures the essence of money with a practical notion: "Money is a claim on human labor."
"With a very few minor exceptions, pretty much anything you can think of that you might spend your money on will involve human labor to bring it there. I say it’s a claim rather than a store, because the human labor in question might have happened in the past, or it might not have happened yet."
Wikipedia provides a good account of how those claims come into existence with a definition of money supply:
"The money supply of a country consists of currency (banknotes and coins) and, depending on the particular definition used, one or more types of bank money (the balances held in checking accounts, savings accounts, and other types of bank accounts). Bank money, which consists only of records (mostly computerized in modern banking), forms by far the largest part of broad money in developed countries."
Money is originally created by the Fed or another central bank. As Martenson describes, "Money is created ... [when] the Federal Reserve buys a Treasury bond from a bank." In this case, the money "literally comes out of thin air" as the money is created simply by the act of the Fed buying the debt. In order to validate the message, Martenson quotes the Federal Reserve publication, “Putting it Simply”:
"When you or I write a check there must be sufficient funds in our account to cover the check, but when the Federal Reserve writes a check there is no bank deposit on which that check is drawn. When the Federal Reserve writes a check, it is creating money."
The money the Fed creates then serves as the foundation from which bank lending can further expand money supply. Since banks are only required to maintain a fraction of loans outstanding in reserve, any loans in excess of those reserves constitutes money creation. In short, "money is loaned into existence."
This constitutes the basic traditional perspective of money and money supply. Banks are responsible for the bulk of money supply through the provision of credit. This system tends to be procyclical, but those tendencies are checked by close regulatory scrutiny and the ability of regulators to shut down banks when they become insolvent.
As shadow banking emerged, however, it became harder to track and control money supply because operations occurred primarily outside of the authority of banking regulators. Wikipedia provides a good working definition of shadow banking that was given by Ben Bernanke:
"Shadow banking, as usually defined, comprises a diverse set of institutions and markets that, collectively, carry out traditional banking functions — but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions. Examples of important components of the shadow banking system include securitization vehicles, asset-backed commercial paper [ABCP] conduits, money market funds, markets for repurchase agreements, investment banks, and mortgage companies"
Cross Borders Capital elaborates on the concept of shadow banking in its report, "Why has global liquidity crashed again?": "What shadow banks do is to transform these bank assets and liabilities by re-financing them in longer and more complex intermediation chains" As a result, the overwhelming practical effect of shadow banking is not so much to provide new sources of credit, although that can happen, but rather to "increase the elasticity of the traditional banking system."
One of the key differences between shadow banks and traditional banks is that shadow banks do not have access to funding via customer deposits. As a result, shadow banks are entirely reliant upon wholesale funding. In other words, their operations depend entirely on capital markets, which at times can be quite volatile.
Another important monetary development, that emerged alongside shadow banking, has been the Eurodollar system. Wikipedia defines Eurodollars as "time deposits denominated in U.S. dollars at banks outside the United States". Jeffrey P. Snider, from Alhambra Partners, has discussed the Eurodollar system extensively [here] and emphasizes that the Eurodollar system is "much broader than the standard definition" and is not "a technically precise term".
Snider instead describes Eurodollars as a "system of interbank liabilities" that real economy participants use "in order to accomplish real-world activity." In other words, it includes "the transformation of banking into a wholesale model often free of deposits altogether."
The Eurodollar system is especially notable because:
"[It] is a system that operates in the shadows and creates supply of US dollars and creates all kinds of complex transactions in US dollars that the US central bank, the Federal Reserve doesn't really know about because it's outside of their regulatory purview." Further, "the use of these Eurodollars is theoretically unlimited."
A very basic takeaway from all of this, then, is that the monetary system has expanded beyond the traditional model of fractional reserve banking. Therefore, it is important to understand the ways in which shadow banking and the Eurodollar system are different in order to understand the implications for money supply and monetary policy.
One of those ways in which things have changed is, as the Federal Reserve Bank of New York's report "Money, liquidity, and monetary policy" notes, "the growing importance of the capital market in the supply of credit." More specifically:
"The balance sheet growth of broker-dealers provides a sense of the availability of credit. Contractions of broker-dealer balance sheets have tended to precede declines in real economic growth, even before the current turmoil. For this reason, balance sheet quantities of market-based financial intermediaries are important macroeconomic state variables for the conduct of monetary policy."
The Eurodollar system and shadow banks also differ from fractional reserve banking in that they operate outside the "regulatory purview" of central banks. This makes it far harder for central banks to monitor their activity and even harder to control it. As a result, the mechanics of liquidity, and therefore of monetary policy, have also changed. Cross Borders Capital notes:
"Liquidity is consequently a more general concept than textbook money supply measures because it extends beyond traditional domestic retail deposit-taking banks into cross-border and wholesale-funded shadow banks ... Textbook economics also fails to understand the inherent system-wide risks because it sees every credit as a debt (debit) and every debt as a credit."
The risks are amplified because "wholesale funding is collateral-based and highly pro-cyclical, and it has the potential to feed-back negatively on to the funding as well as the lending activity of traditional banks." In other words, the addition of shadow banking and the Eurodollar system to the traditional banking system is like adding cocaine to a human body. It amps things up in the short-term, but also makes them more erratic and precarious in the longer-term. As Jeffrey Snider describes, "This [Eurodollar] is a dysfunctional system, so we're not really positive about any of this stuff."
At this point it is fair to ask, "Why discuss shadow banking and the Eurodollar system now?" These phenomena have been around for many years and have been reported before for those curious enough to dig into the minutiae. For the last ten years, though, it hasn't mattered. Liquidity has been ample enough and long-term consequences distant enough that the best thing to do has been to completely disregard risk. In the process, many investors have learned exactly the wrong lessons and risk being seriously wrong in the not-too-distant future.
Now, with substantially higher government (and corporate) debt outstanding, with the recession-fighting capacity of central banks vastly reduced, and with the end of a business cycle approaching, the equation has changed. Understanding the mechanics of liquidity and the constraints it places on monetary policy will be crucial for investors to understand in order to weather adversity.
One important lesson is that low rates are not an unalloyed good as many believe. Lower rates can temporarily ease the burden of interest payments for indebted entities and lower rates can temporarily encourage risk-taking.
Lowering rates cannot create wealth, however, and John Hussman explains well the limited efficacy of doing so:
"Tinkering with security valuations doesn’t create aggregate “wealth” – it simply takes future returns and embeds them into current prices. Long-term 'wealth' is largely unchanged, because the actual wealth is in the future cash flows that will be delivered to investors over time, and once a security is issued, somebody has to hold it at every point in time until that security is retired. The only thing elevated investment valuations do is provide an opportunity for current holders to receive a transfer of wealth by selling out to some poor schlub who pays an excessive price for the privilege of holding the bag of low future returns over time."
In addition, the effectiveness of low rates as stimulative monetary policy is contingent on beginning debt levels. As Van Hoisington and Lacy Hunt write in their second quarter review and outlook, a drop in real yields would be a "stimulant to economic activity", but only in the event "debt levels were considerably lower."
As is, in the presence of relatively high levels of debt, low rates ultimately constrict economic activity. They describe the mechanics:
"When real yields are low or negative, investors and entrepreneurs will not earn returns in real terms commensurate with the risk. Accordingly, the funds for physical investment will fall, and productivity gains will continue to erode as will growth prospects."
In other words, accelerating government debt is like a noose on an economy. You might be able to create some space with low rates that can provide some breathing room and some temporarily good news. Longer term, however, natural forces will eventually cause the economy to choke.
Another consequence of keeping rates too low over a long period of time is that it encourages yield-seeking behavior and risks unleashing the shadow and Eurodollar beasts that are "theoretically unlimited". Even though this was a big part of the problem in the 2008 financial crisis, many investors seem to be overlooking the potential for trouble now. The system has not changed in any material way.
So how should investors handicap markets and monetary policy?
The Financial Times reports, "The financial crisis has left many of us hypnotized by existential risks to the banking system." Indeed, much of the monetary policy implemented by major central banks since has been aimed at averting just such an existential event.
Such priorities, however, have created something of a Faustian bargain. Each time monetary authorities intervene to lower rates or to provide additional liquidity, they help prevent a sudden freeze-up in the financial system. In doing so, however, they also create longer term problems. Among those problems, in the words of Steven Alexopoulos, JPMorgan's regional bank analyst, is "a near perfect environment for banks to have let down their guard and become less sensitive to risk."
As the economic recovery gets into the late innings and as more indicators suggest slowing growth, it is useful to remember that "regular non-crisis, non-fatal credit downturns hurt like hell too and this one might be worse than most." Or, in more vivid terms: "Last time we had a heart attack, so this time it will be cancer."
Whether the prognosis for economic "cancer" is correct or not, there are some overarching lessons for long-term investors. One is that placing too much faith in the Fed and short-term ructions from monetary policy comes at the expense of preparing for longer-term consequences. Also, the condition of a high level of government debt constrains the effectiveness of monetary policy. Finally, all of this is happening in a financial system that has greater systemic risk. All signs point to lower exposure to risk assets.