by okie1
So for the third time in a year, people are celebrating because they think this time rates have finally peaked, and I tend to think this is actually shaping up to be yet another, bigger fakeout.
Yes, the fed’s balance sheet is growing again. Something like 300 billion in just a few days. And normally that has in the past been associated with a jump in money supply.
BUT…it’s also always been associated with a jump in deposits, which we’ve yet to see. And if you know how the monetary system works, then you know deposits are synonymous with money supply growth, which is synonymous with bond demand, which brings rates down.
Side note: Hopefully the last week has once and for all dispelled the myth in everyone’s mind that the fed controls rates. The fed has not pivoted and yet rates crashed hard last week, and it was due 100% to insane demand for t bills. Last week, there people paying full face for t bills at auction, which means zero percent. The thing you have to understand about t bills is that they’re Wall Street’s equivalent to cash in the mattress. When institutional investors don’t trust financial institutions to store their money, t bills are what they use to replace their bank. And honestly, they can be used a lot like cash in the financial system. But I digress…
Back to the fed’s balance sheet. I don’t think there’s as much causation as correlation in the relationship between the fed’s balance sheet and money supply growth in the past. That is, I’m starting to think that the one doesn’t have to necessarily go hand in hand with the other. Just like we learned that markets can go down while rates go up, and hard, we might be about to learn that the fed’s balance sheet can explode even as monetary conditions continue to tighten, or even accelerate said tightening.
What we can say about the fed’s balance sheet is that when it goes up it means that banks are in trouble and need cash. When the banks can’t meet other’s needs in the overnight market, and all the banks are needing cash at the same time, the fed steps in as lender of last resort.
That does mean that bank reserves will increase, assuming the money isn’t just replacing outgoing reserves (which could very well be the case right now). The data series for reserve balances hasn’t been published since the jump in overnight lending occurred, so we’ll have to wait and see. I tend to think the banks aren’t using the fed’s new facility unless they have dire need for cash. I can’t think where it would be advantageous for them to borrow money and let it sit in a reserve account at the fed, if just letting the bond mature were an option. Then again, I don’t know that much about banking. We shall see.
Even if reserves are increasing, though, that doesn’t just automatically mean that the money supply will start increasing. That takes borrowers. That means we need a bunch of credit worthy people who can take on more debt. And we seem to be fresh out of those atm…
I think it goes like this:
When markets peak and roll over, banks get themselves in trouble and need to leverage their assets for cash, which makes the fed’s balance sheet go up. In times past, market peaks have been associated with interest rate peaks, because as prices come down, it makes assets attainable for more people. And as more people reenter the market and borrow money to buy assets, the resulting increase in money supply does two things. One, it stimulates the economy and enables others to then take out loans, as a result of new jobs, increased business, etc. And two, it increases the amount of money available to lend, increasing demand for debt, which means more lenders bidding up the same debt, meaning lower rates.
So right now we have one component of that. Markets aren’t doing well, and the result has caused banks to have to leverage their assets for cash to cover reserve requirements. What we don’t have is the second component, where people start borrowing money back into the economy.
It is in fact the shrinking money supply and resulting shrinkage in deposits that has sent the banks begging to the fed. We know this. People are having to service existing loans, and are spending their deposits, and new loans aren’t being written fast enough to replace the outgoing money. There’s also a lot of defaults going on, which also destroys money. So it seems like this lull in rates is temporary, and is driven by demand for cash equivalents in the financial system, merely as a vehicle to move money around to fill holes in the system. But I don’t see the money supply growing, and thus bringing back demand for bonds in general, and thus bringing rates down. I see the money supply continuing to shrink, and that lowering demand for bonds, sending rates higher.
So crazy as it sounds, I think there’s a very real chance that rates have not peaked, and will in fact launch higher still. Again, we’ll see.