Twitter is a weird strange place. On the one hand it is full of trolls and spam. When you turn it on, filtering out the useful information feels a little like trying to drink from a fire hose.
But every now and then you come across someone who makes it all worth while. A couple of months ago I started following Martin Enlund (@enlundm) from Nordea Bank. Martin consistently posts really great original content that makes you think. If you don’t follow him, I highly suggest you start.
Recently I have noticed that Martin has been banging the drum on what he calls Quantitative Tightening. He posted the following tweet to explain his thinking:
Yesterday I set about to understand what Martin was trying to explain with this graph. Maybe it is immediately obvious to others, but it took me a bit to break it down. So in case anyone else is like me and doesn’t immediately grasp the significance of this graph, I am going to walk through it step by step. I think Martin has discovered one of the key market drivers that is being missed by many traders.
Let’s start with the main blue line. I believe that this line represents the excess reserves within the Federal Reserve bank system. These are not Federal Reserve assets, but in essence extra liquidity that is sitting on the banks’ balance sheet. This is the liquidity that the Fed has been shovelling into the system that has not “gone” anywhere. Usually when the Federal Reserve increases liquidity, the banking system lends it out. However ever since the introduction of the Fed’s Quantitative Easing, a fair amount of this extra liquidity has simply sat on the banks’ balance sheet as excess reserves. This is part of the reason that we have not had run away inflation as the Fed has engaged in massive QE. The money has been created but it has not been lent out. This is also why the velocity of money has plunged over the last half dozen years.
If you step back and look at this data series from a longer time frame, you will notice that before 2008 there was basically no excess reserves in the system.
The Federal Reserve has set themselves on a path to normalize rates, but these excess reserves represent a problem. Janet Yellen would probably prefer they would be used by banks to actually make loans, but absent that development, the Federal Reserve needs to find a way to soak up this liquidity.
This excess reserve problem is why the Federal Reserve has introduced two new programs to their monetary toolbox. The Fed has been testing reverse repos as a method of withdrawing liquidity from the system. They have also introduced a Term Deposit Facility to help with the process. Think about this as the Federal Reserve issuing short term notes as a way to sop up the extra liquidity.
Let’s head back to Martin’s graph for a moment. See the section where he has written “The Fed is now absorbing almost USD 500 billion worth of bank reserves?” That sub graph is the amount that the Fed has executed under these two new programs.
The reverse repo program has waffled around between $100 and $200 billion over the last couple of months. I don’t really understand how they decide how much they are going to execute – I can only assume it has something to do with the day to day liquidity situation.
But the Term Deposit Program is a different matter. The Federal Reserve has been steadily cranking this program up. When they started the program in January, they issued $12.8 billion to 31 different participants. Yesterday the Federal Reserve issued $316,020,510 of six day term deposits at an interest rate of 0.28% to 85 different participants!
The Federal Reserve has now withdrawn almost $500 billion from the banking system. Think about that number for a second. At its height I think the most recent QE program was buying $45 billion a month.
This new steady withdrawal of excess reserves from the banking system is much more profound than most market participants realize. Martin calls it Quantitative Tightening and that is a great description.
No wonder the US dollar has been rallying so hard.
When you reduce the supply of something, in this case US dollars, the price of it rises.
Now let’s move on to the bottom half of Martin’s graph. He has measured the 6 month rate of change of excess reserves (the brown line) and then plotted the 5 year forward 5 year break even inflation rate (the preferred long term inflation expectation indicator).
As the Fed has withdrawn liquidity and shrunk the amount of excess reserves, the long run inflation expectations have collapsed. This makes sense if you think about it. Just as inflation expectations rose as the Fed engaged in QE, if they reverse that policy you would expect the opposite result.
I think the real surprise for most market participants is how much Quantitative Tightening the Fed is actually executing. These two new programs – reverse repos and the term deposit facility, are ramping up astonishingly quickly. Given this development, the recent moves in commodities, the US dollar and inflation expectations are much easier to understand.
My only quibble with Martin’s graph is what if the excess reserves start dropping because the banks start lending? So far that has not happened, but I believe that the reason for the drop in excess reserves is crucial to understanding the ensuing market reaction.
If the reserves keep going down because the Fed continues its Quantitative Tightening program, then it would be foolish to expect any of the recent trends to reverse.
Martin is pounding the table on this theme and I agree that not enough people (including me before he showed me the light) understand the significance of the recent Federal Reserve actions. Thanks Martin!
US foreign inflows…
Meanwhile foreign money is flowing into the US at a record pace.
This is the largest inflow of foreign investment that the US has ever experienced. So when you get all bulled up about the prospects of the US outperformance in the coming quarters, ask yourselves how original your idea really is…