Watch What They Do, Not What They Say

On Wednesday Kremlinologists were treated to the bizarre spectacle of the release of the Fed minutes (abridged version) again. It has recently been argued that the market has been buffeted by alternately being led to believe that administered interest rates may rise sooner than expected (Ms. Yellen hinted in her March press conference at '6 months after QE ends'), or later than expected (she corrected herself on a subsequent occasion).

The Fed minutes released yesterday seemed to indicate – at least that was the interpretation, i.e., the effect of market participants hearing what they wanted to hear – that 'later' it shall be. Surprise, surprise, the Fed is dovish! Who would have thought? What an unexpected turn of events!

However, people already know (or should know) that the central bank will forever err in favor of easy monetary policy. When was the last time it has done otherwise? That was a brief period most of today's market participants don't even remember, namely 1979-1980. The Fed is always reactive, and as such it remains perennially 'behind the curve'. What is discussed in its meetings today is meaningless – it has precisely zero bearing on its policy decisions of tomorrow.

In short, what they say is irrelevant. From the perspective of market participants, the only thing worth doing is to watch the rate of growth of the money supply (money proper + circulation credit). With regard to this a trend could be observed over the past 30 years: it takes an ever lower level of short term interest rates to arrest money supply growth. Moreover, since the commercial banking system's de facto insolvency was unexpectedly and suddenly revealed in 2008, money supply growth has become almost entirely dependent on the Fed's deployment of 'extraordinary policy measures', this is to say, quantitative easing (a.k.a. outright money printing).

The broad US money supply TMS-2, excluding memorandum items. The difference is very small, as memorandum items amount to very little relative to the total. In this way we can construct a more up-to-date chart, as the main components of TMS-2 are updated on a weekly basis -click to enlarge.

Recent gyrations in treasury note yields of various maturities (10,5 and one year) in reaction to various Fed statements. The chart at the bottom shows the ratio of the 10 year to the one year note yield, a measure of whether the yield curve is flattening or steepening -click to enlarge.

The  Debtberg's Legacy

How can it be explained that money supply growth has tended to falter at ever lower levels of interest rates?

The amount of outstanding unproductive debt has grown exponentially since the adoption of a pure fiat money system in the wake of Nixon's 1971 gold default. This legacy debt load needs to be serviced, and the larger it becomes, the more onerous debt service costs will be at a given level of interest rates.

US total credit market debt – the bigger this debtberg becomes, the more difficult servicing the debt is at a given level of interest rates -click to enlarge.

Note that we have deliberately used the term 'unproductive' when describing the nature of much of today's outstanding credit market debt. For instance, every cent of debt on the treasury's balance sheet is the leftover of an unfortunate waste of money in the past, which burdens the treasury now and in the future (and by extension, burdens those the government must loot to service and pay its debt).

Total federal government debt. The fiat money system has enabled funding of the welfare/warfare state seemingly without limit. However, there is in fact a limit given by the scarcity of capital -click to enlarge.

In the private sector, there is also a large amount of unsound debt outstanding, as the policy-induced credit booms of the past several decades have provoked malinvestment on a truly gigantic scale. Note as an aside to this that the vast growth in student debt in recent years is highly likely to largely represent capital malinvestment as well – only, in this case the malinvestment is concentrated in 'human capital'.

Student loans issued by the federal government. There has been exorbitant growth since the 2008 financial crisis. We strongly doubt that this money is actually invested wisely -click to enlarge.

Many of these investments are on artificial life support, which the acceleration in monetary expansion since 2008 has provided. That this is the case becomes perfectly clear when considering that a great many issuers of junk bonds only survive by means of Ponzi finance, i.e., because the current manic buying of anything with a yield that is not paper-thin allows them to continually refinance their debt as it comes due. Many no longer even need to provide debt service payments in the form of cash – instead they can simply issue even more debt (via 'payment-in-kind' bonds).

Junk bond magic: yields on securities rated CCC or lower -click to enlarge.

This rickety structure – best likened to a growing sand pile that will eventually become unstable and collapse – survives solely by dint of the Fed's zero interest rate policy and the truly massive money supply expansion of recent years.

The Fed's Extraordinary Policies and the Banking System

Today, commercial banks are no doubt in considerably better shape than they were at the time of the 2008 crisis. They have raised equity capital, they have written off a portion of their toxic assets and last but not least have been handed so much 'free money' courtesy of the Fed's war on savers, that only bankers denser than fence posts can possibly have failed to improve the financial position of their institutions.

However, we simply cannot tell with any degree of certainty how healthy the banks really are. Readers may recall that a major factor in turning the markets around and restoring a misplaced sense of confidence was the early 2009 decision by the FASB (Financial Accounting Standards Board) to bow to heavy political pressure after much hemming and hawing and amend 'mark-to-market' accounting rules. As long as 'mark-to-market' produced windfalls in the form of artificial and entirely illusory accounting profits, the banks were all in favor of it. As soon as these accounting profits were unmasked as the inflationary illusions they actually were and became growing losses, they duly discovered the many flaws of marking to market, and began to lobby for a rule change.

Undoubtedly apocalyptic scenarios of a looming total financial and economic collapse were painted in lurid colors to convince politicians and the FASB of the need for this rule change. The same method had already worked exceedingly well in producing everything from giant tax payer bailouts to an unprecedented shower of money from thin air courtesy of the Fed. In the case of AIG's possibly fraudulent credit insurance operations (see 'AIG – Was its CDS Business a Scam from the Outset?' for details on this sordid affair), the banks were even able to completely avoid taking the slightest haircut on their claims against the bankrupt insurer. In this general atmosphere of turning failure into success with the help of other people's money, pushing through a change in accounting rules must have looked like a piece of cake. After a show of token resistance by the FASB, that is precisely what it turned out to be.

Allow us to mention in this context how banks actually should account for their assets. It is quite simple actually: at cost or at market value, whichever is lower. Anything else is not conservative enough and contributes to overly risky behavior.

Anyway, the upshot of this rule change was that bank balance sheets became even more opaque than they already were. Even before the change in mark-to-market rules, banks assets were differentiated according to which 'level' they belong to, with only one of these levels referring to market prices in active markets (for details on how level 1, 2 and 3 assets are defined, see here). Level 3 assets specifically have to be evaluated by employing 'unobservable inputs', i.e., they are valued according to management estimates. It should be pointed out that the percentage of total assets consisting of level 3 assets at major US banks has declined significantly, partly due to asset sales and write-downs, but mainly because the banks have loaded up mightily on treasury and agency bonds in recent years, while at the same time sharply reducing the pace of inflationary lending to the private sector.

Treasury and agency securities held by commercial banks -click to enlarge.

A slightly dated chart showing level 3 assets as a percentage of total bank equity at four large US institutions from 2009 to the end of 2012 (via Market Realist) -click to enlarge.

Outsiders who want to understand bank balance sheets are forced to wade through hundreds of pages and hundreds of explanatory footnotes. Few  people actually have the time to do that. Moreover, every balance sheet is but a snapshot of a specific point of time in the past. If it can be interpreted at a quick glance, it may be useful to outside observers, but that is simply not possible with bank balance sheets. Since the banks' earnings and various financial ratios are also based on assets that are no longer marked-to-market, the informational value of such data must be doubted. Lastly, although 'QE' has markedly increased the percentage of the money supply consisting of covered money substitutes (money substitutes for which reserves in the form of standard money actually exist), they still amount to less than 30% of all money substitutes outstanding.

However, it can be assumed that bankers themselves have a good idea of the actual value of their assets. Many are probably also alive to the fact that it is an ephemeral magnitude that is bound to change rapidly once the Bernanke echo bubble deflates. Hence they are reluctant to lend to anyone but the 'safest' debtors – chief among them the federal government.  A result of this behavior has been – so far anyway – that banks have not increased their inflationary lending much since the crisis. There have often been quarters during which there was massive growth in covered money substitutes thanks to 'QE', while uncovered money substitutes concurrently contracted, as more credit was actually paid back than extended. For instance, in the final quarter of 2013, currency grew by 6.5% annualized, covered money substitutes grew by about 56% annualized, while uncovered money substitutes declined at a 1.6% annualized rate.

Conclusion

We can tentatively conclude from this that a rise in short term interest rates is  no longer needed to substantially decrease the pace of money supply growth – all it should take is a cessation of 'QE'. In other words, the short term interest rate level at which money supply growth stalls out these days actually seems to be close to zero. It should therefore be no surprise that the Fed is reluctant to even talk about normalizing short term rates. If QE were immediately stopped and the federal funds rate were hiked tomorrow, it is a good bet that money supply growth would quickly turn negative. However, the enormous bubble in corporate debt and equities can only be sustained if money supply growth is not only positive, but remains above a certain threshold level (the precise level is unknowable). In other words, a mere slowdown in money supply growth will suffice to eventually prick the bubble.

A major question is of course whether banks will be willing to increase the pace of their lending from here on out. That remains to be seen, but our guess at this point is that private sector credit growth will remain subdued, especially as the economy is already greatly imbalanced and structurally impaired due to the vast money supply expansion since 2008.

Charts by: Stockcharts, St. Louis Fed, Market Realist