If you hadn’t noticed, markets have been skittish lately. Much of the angst relates to rising rate fears and rate sensitive sectors have gotten crushed this year. Here is a sample:
Commentators will tell you raising rates is a subject the Fed has approached cautiously out of concern that any decision to shrink the balance sheet would be seen as a tightening of monetary policy with the predictable impact on asset prices (see table above). We would argue the opposite – that unwinding may not be tantamount to tightening, and there is room for equity markets to continue to run as rates rise.
Why? The answer lies in the arcane and not easily understood world of excess reserves. Excess reserves resulted when the Fed bought up trillions of dollars in securities after 2008 in a bid to keep long-term interest rates low and the economy well-lubricated during the post crisis stress, a strategy you know as quantitative easing.
Excess reserves of the banks at the Fed are presently over $2 trillion and exist only to smooth out the need for reserves in the financial system – crisis management by the Fed in effect. As you can see below, excess reserves were close to zero before the Lehman crisis. But they are still sloshing around the system and Lehman is now a distant memory.
You may have also heard that the yield curve is “flattening” with the usual concerns voiced that a flattening yield curve is a precursor to recession. Near term rates have indeed risen (somewhat dramatically) and the long end hasn’t moved much. But we think the answer is less ominous than recession and relates more to the simple differences between investor bases at the short and long end of the curve.
For example, from the time of the Fed’s 25 basis-point rate hike on Dec 16, 2105 until the eve of U.S. elections on November 8, 2016, the yield on the 10-year US Treasury note actually declined, to 1.8% from 2.3%. This occurred even as markets digested sizeable sales of Treasuries by many emerging markets throughout 2016. In the US, the unwinding of the Fed’s balance sheet did not result in tightening at the long end.
All the Fed is doing is releasing $2 trillion of excess reserves, which is vastly different from tightening. It’s most certainly not a reduction in banking system deposits, (i.e., reserves balances on the liability side of the Fed balance sheet). What do we mean? The Fed is indeed reducing its balance sheet but the banking system is expanding credit creation at the same time (fairly rapidly as you can see below). Commercial loan growth is up 14% but deposit growth is only up 1%. This, to us, is a clear sign that the economy is expanding and that is what is causing the rise in near term rates. We haven’t seen that in so long, we forgot what normal commercial growth looks like. It’s bullish.
More importantly, and a reason why the long end of the curve hasn’t reacted like the short end, is that one of the oft-overlooked effects of the reduction in excess reserves is also a reduction of money in circulation, which is deflationary. That’s why the yield curve looks as it does, not because the economy is slowing with a recession around the corner, but because inflation expectations are benign.
Here is how we would summarize:
- Credit expansion is occurring and with it, the US economy;
- Inflation is not a factor;
- The dollar is likely to remain strong and rates are going up;
- US Small-Caps should outperform with that backdrop.
A leaner central bank balance sheet, because it doesn’t result in tightening, could justify much higher policy rates than currently anticipated. Let the Fed raise rates. Loan activity would support the move. In normal times, and we are getting back to normal times, a lean balance sheet allows a central bank to focus on the core of its mandate, which is smoothing out the bumps. As central banks contemplate the timing of their balance sheet unwind (e.g., not rolling over maturing securities and outright sales thereafter), it may be useful to remember what reducing excess reserves really means.