After the Federal Reserve made their historic pivot earlier this year, moving from three additional rate hikes plus Quantitative Tightening (QT) on “auto-pilot” to zero rate hikes and ending QT, the conventional narrative is that the Fed is back to an accommodative stance. This is untrue.
Many market participants and analysts use the stock market to form a narrative or an opinion on monetary policy or an economic outlook without looking at some of the key metrics that the Fed actually has an influence over, rather than areas of the market in which the Fed cannot control.
The Federal Reserve is still currently in a phase of monetary deceleration as I will outline below. Monetary deceleration refers to contractions in the growth rate of both credit and monetary aggregates. Monetary accelerations and decelerations work with long and variable lags so seeing this immediately unfold in asset prices should not be expected. As Milton Friedman proved, and despite popular opinion, monetary accelerations lead to higher long-term interest rates and monetary decelerations lead to lower long-term interest rates. It is for this reason, the decline in long-term interest rates should have come as no surprise once the Fed commenced what the data shows was a highly aggressive monetary deceleration that is having unintended consequences. Let’s have a look.
First, I want to start with the effective Federal Funds rate (EFFR) which has gained media attention now that the EFFR has surged 4 bps to 2.44%, pushing towards the upper channel of the target range.
The reason this has gained much attention and is concerning is because the Federal Reserve is starting to lose control of this rate. When the Federal Reserve sets the EFFR, they don’t magically move the rate. They shift the supply of credit to cut the demand curve at a different price. When the Fed has a large balance sheet, this process becomes easier. As the balance sheet shrinks and the quantity of reserves shrinks, the Fed loses control.
This is precisely the reason the Fed is ending QT. This is not for economic reasons but for structural reasons. Back in late 2018, when the Fed made the “auto-pilot” statement, I was writing that the Fed was going to announce the end of QT at the beginning of 2019 as excess reserves were far too low for the modern day banking system.
Due to new regulations, including Basel III, the banks are legally required to hold large quantities of reserves, the same reserves the Fed was removing via QT. As reserve balances decline but the demand for reserves remained elevated due to structural reasons and regulations, the demand for reserves started to exceed the supply and thus, the short-term rates pushed higher.
We now have seen the EFFR push above interest on excess reserves (IOER).
This may not seem like it is important, but the spread between the EFFR and IOER is at the highest level of this economic cycle which shows just how tight the demand for reserves is relative to the quantity. Furthermore, QT will continue through September which will continue to make this problem even worse.
The cessation of QT was easy to spot based on these dynamics and it is for this very reason that the Fed, at some point, will have to re-expand the balance sheet, likely in the form of QE, even if the economy improves and the stock market continues to rise which will be a political challenge. The Fed cannot shrink excess reserves anymore because they risk losing control of the rate even more than they already have. The demand for cash is very high.
Furthermore, due to increased Treasury issuance based on massive deficits, dealers need to borrow cash in the repo market to take down the increased supply, further increasing the demand for cash and with less cash available to lend, this is pushing ST rates up once more.
The Fed has contracted excess reserves by over $1T. Banks are required to hold more reserves than at previous points in history due to new regulations.
To further emphasize how contractionary monetary policy has been, we can look at the money supply. While stock markets are rising, not many remain focused on critical monetary aggregates. The Fed has contracted the money supply (M2) growth from a rate of nearly 8% to 3.8% as of the latest update.
Even more noticeable is the rate of contraction in M1 growth, falling from a rate of nearly 12% in 2014 to 1.9% today. If we adjust the rate of M1 growth with the rate of inflation to see real M1 growth, the rate has contracted from nearly 16% in 2012 to below zero today.
This has been a very significant monetary deceleration. Moving to the credit aggregates, we can see the aggregate level of loans and leases in bank credit growth, a $9T segment of the economy, contract from a growth rate of roughly 8% to a rate below 5% today.
The most aggressive contraction in loan growth has come in real estate which is the largest category of bank loans at over $4T.
The growth rate in real estate loans has contracted from nearly 8% year over year to 2.60% year over year as of the latest reading.
Consensus has also been incorrectly positioned for the move in the US dollar. Back in March of 2018, I started to position bullishly for a move in the USD based on the inflection in the US and global growth. As global growth slows, the USD typically rises. (I can provide links to these SA notes)
I don’t look at the DXY as that is mainly the USDEUR and doesn’t tell much of the story. Looking at the USD vs. EM currencies shows the dollar is starting to move materially higher. Last night, South Korea printed the worst QoQ GDP number since the great recession and the USDKRW took off.
The dollar had every reason to go down with the Fed going “triple dovish;” canceling rate hikes, ending QT and now pricing in a rate cut.
It is my opinion that the global Treasury market is aware of these dynamics and the need for monetary policy to get even easier which is why the odds of a rate cut are increasing, even with the stock market hitting a new all-time high.
Treasury rates out to 7-years are below the EFFR, and the 10-year rate is just 8 basis points above the EFFR as of this writing. The front end of the yield curve remains inverted out to 7-years and the odds of a rate cut by December, based on Fed Funds futures, has increased to 62%.
I agree with Avi in the sense that the Fed listens to the market. History suggests 70%-75% priced-in is the line in the sand for the Fed. If the market expects a move with greater than 75% probability, the Fed acts. At 62% it is still a coin toss for December but should these odds creep up due to a stock market sell-off, further stress due to QT in the EFFR, or continued deterioration in the economic data, a rate cut will occur before year-end.
While the stock market is at a new all-time high, another data point to consider is that the broad average has only increased 2% in the past 15 months, very much consistent with monetary decelerations and economic turning points. Some sectors (regional banks) remain lower by over 13% in the past 16 months and 17% from their 52-week high.
Monetary policy remains tight, the monetary and credit aggregates continue to compress in growth rate terms, and the Fed is having difficulty controlling the EFFR. These factors point towards an easier monetary policy which is why the market is pricing that in despite the stock market rising. Re-expanding the balance sheet will have to occur for non-economic reasons, which is why we have heard recent statements from the Fed including “QE may become a regular tool, not a tool just for emergencies.”