2023-03-10 10:17:59 ET
Summary
- The Federal Reserve continues with quantitative tightening, but financial markets are not giving consistent signals of how this tightening might impact the economy.
- One problem is that there is so much money in the financial system, placed there during the past two years as the Fed worked to protect the U.S. economy.
- This situation only adds to the radical uncertainty that exists at this time, which is presenting policymakers and investors with an incomplete picture of the future.
- Furthermore, the current government budget situation, with the debt ceiling problem, only adds to the number of unknowns, unknowns that exist and confuse.
The Federal Reserve continues on its path of quantitative tightening 51 weeks after it started the effort.
Since the start of quantitative tightening, the Federal Reserve has reduced its securities portfolio by a little under $600.0 billion.
Reserve balances with Federal Reserve Banks, a proxy for "excess reserves" in the banking system, have declined by almost $1.0 trillion.
Questions are still floating about when will the Federal Reserve stop reducing its securities portfolio and how much of the $5.0 trillion and more injection of funds into the banking system since the start of the Covid-19 pandemic will eventually be removed from the financial system.
So, the Fed's direction, confirmed by Fed chair Jerome Powell in Congressional testimony this past week, is in place, but financial markets still seem to be confused about the future.
Investors in U.S. Treasury securities seem to be thinking recession.
The term structure of interest rates is inverted and has been inverted since July of 2022.
In recent days, the spread between the 2-year Treasury note and the 10-year Treasury note has just reached 100 basis points this week.
The last time this spread was reached was in 1981.
In the stock market...and, to some degree in the corporate bond market...investors seem to be thinking that there are some "good buys" out there and so investing in these areas should be done.
Especially investors in the stock market have questioned the "staying power" of Mr. Powell, judging from their experience with him during his earlier time as the Federal Reserve chair. They feel that Mr. Powell will always try to err on the side of "monetary ease" and so will back off from the current Fed stance, sooner rather than later.
So, we have a dilemma in the financial markets. This is a situation I have been writing about since late last summer and into the early fall.
This, as I have argued, is a time of "radical uncertainty" and in such situations, we often find markets that are "disjointed" and "disorganized."
A situation like this is hard to explain and is hard to invest in.
The Federal Reserve faces a real cloudy future.
A Suggestion
James Mackintosh has provided us with a possible answer to this confused state in the Wall Street Journal .
Mr. Mackintosh suggests that
"There is far too much money floating around."
"Stimulus checks and Fed bond buying filled up bank accounts and boosted corporate profits, and it hasn't all gone away."
"One sign of the spare cash is that money-market funds have banked $2.2 trillion at the Fed via its reverse-repurchase facility."
"Some, of course, was wasted on meme stocks, bitcoin, and exercise bikes, but plenty is invested, helping hold up share prices, junk bond prices, and Treasury prices--and so hold down yields."
It should also be mentioned that the commercial banking system has $3.1 trillion sitting on banks' balance sheets in cash assets and other very short-term assets. (See Federal Reserve statistical release H.8.)
"Short-dated yields are closely tied to Fed interest rates, so there is little effect from investors buying Treasurys there."
"But longer-term yields should be depressed by the weight of money, and seem to be: The New Yor Fed's gauge of the 'the term premium,' the extra yield offered by Treasurys above (or, as now below) the expected path of future interest rates, has been the lowest over the past year of any time since 1962, aside from the pandemic."
Too Much Liquidity Hanging Around
Mr. Mackintosh, in presenting this analysis, pictures something I have been asking questions about since last fall.
The commercial banks...the financial system...has too much money hanging around.
In effect, as I have been arguing, the Federal Reserve created an asset bubble in its efforts to combat the spread of the Covid-19 pandemic and the accompanying economic recession.
The attitude of Mr. Powell and the Federal Reserve leaders emphasized the effort to err on the side of too much monetary expansion so as to avoid any catastrophic mistakes that might "take the system down."
Mr. Powell and the Fed did their job.
Now, more and more analysts are recognizing the fact that their efforts resulted in the current situation where there is now an excessive amount of money in the financial system.
Now, the Federal Reserve is now faced with the problem of reversing its earlier efforts.
But, reducing the size of its securities portfolio by $600.0 billion and reversing the buildup of excess reserves the commercial banking system achieved in 2020 and 2021 is a bigger job than it was originally perceived to return financial markets to some earlier form of stability.
In other words, the job in front of the Federal Reserve is appearing to be greater than was originally expected.
But, this just gets us back into the concerns over radical uncertainty. Is the radical uncertainty we are now facing even greater than was earlier thought?
Mr. Mackintosh ends his review by adding,
"Excess money shoved into stocks shows up as an elevated valuation, even as Wall Street wakes up to the risk of a hit to profits by lowering earnings forecasts."
"High valuations and the risk of recession make it hard to want to take risks, but equally there is plenty of evidence that the economy is strong, so bets on imminent recession are hard."
"Diversify, or pile into the decent yields on cash, ready to take on risk again when prices fall."
Many will argue that with all of the money sloshing around in the financial markets, the recession is hard to perceive.
Many will argue that with all the money sloshing around in the financial markets, the term structure of interest rates should not be so inverted.
But, to my knowledge, the U.S. economy has never gone into a recession with so much money floating around in the world.
And, then there is the federal budget.
Mr. Biden has proposed a fiscal budget narrative where deficits over the next ten years will be reduced by $3.0 trillion.
Will that really change the picture that the Federal Reserve is facing?
I don't think so.
Not unless there are massive business failures that assist the decline in all the money that is now finding a place for itself in the marketplace.
And, we certainly would not want that to happen.
For further details see:
Federal Reserve Watch: So Much Money