Finding reason in Monetary Policy and Quantitative Easing

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Introduction

Since the Great Recession, central banks have taken both conventional and unconventional (Quantitative Easing) monetary policy measures to fight the economic slowdown and maneuver the economy out of a recession. Key central bank interest rates were slashed, and new unparalleled programs were taken on both in Europe and the US. This has lead to a lot of complexities in different markets, as central bankers continue to scratch their heads to realize what it is that they have done.

In this Learn to Trade article I will try to give some context and reason to the actions of central bankers and how they influence the markets and the economy as a whole, the way I see it. I hope in turn, this helps your understanding of the current matters in the economy and in turn, your trading.

The relationship between central banks and commercial banks

The relationship between central banks’ actions and commercial banks is complex. However, it can be simplified into more understandable terms. Banks compete for deposits, offering an interest rate on the money you hold with a bank. Usually, it is a short term interest rate in nature. Banks compete for deposits in order to be able to make loans. Loans are typically longer-term in nature. Think about mortgages, car loans, business loans. They usually have a maturity of several years to even a few decades. All in all, that’s how banks make their profits – borrowing at the short end of the spectrum, and lending out at the longer end.

Typically, short term interest rates are affected mostly by central bank actions. What central banks will do is, they will target short term or even overnight bank to bank markets. This, in a mechanism in itself, will lead to lower LIBOR rates and affect deposit (and some loan) rates banks offer to customers.

In a usual setting, short term rates are lower than long term rates in the markets. Usually, in investors’ minds, this is calculated by subtracting an interest rate on short term bonds from the interest rate on long term bonds. Think 10-year Treasuries rate minus 1-year Treasuries rate. This spread very much relates to what is called the yield curve, which represents different interest rates at different maturities. Typically, when short term rates are smaller than longer-term rates, this results in a “normal” yield curve, looking something like this:

Normal Yield curve:

quantitative easing

The higher interest rate on longer-term maturities reflects the risk associated with longer-term investments. The longer the time period, the more risk, and investors want to be rewarded for that time risk. In other words, much more can happen within 10 years than in 1 year, and there is much more uncertainty. Hence, investors require a higher interest rate to compensate for that risk. For bond investors, a major risk is inflation, which erodes monetary value from their investment. For banks, a major risk is that short term interest rates will be higher in the future than what banks lend at today. If banks lend out at 5% today, for 10 years, and the short term interest rate (the rate banks pay for deposits) changes to 6% tomorrow, for the duration of the next 10 years, the bank will be losing 1% every year.

That is why banks typically charge you a semi-fixed interest rate. That is an interest rate comprising of a fixed component, together with a variable one. The variable component is typically a short term LIBOR rate, which is affected by the central bank policy rate. The fixed-rate is the bank’s “true” profit margin. Or, what they want to make and what they charge you for their service.

However, in recent years the yield curve has flattened, and in recent months, it had inverted. That is, long term interest rates have become lower than short term rates. This can be depicted in the following animation, showing the US yield curve throughout recent times:

Source: CNBC

 

The flattening and the inversion of the yield curve

Why did the yield curve flatten, and even invert? Many investors and traders today think the yield curve inversion has to do with the fact that investors foresee a recession coming. The inverted yield curve generally reflects the fact that investors expect low inflation, and short term interest rates to be lower in the far future. That is why generally, the yield inversion would come about in every recession. As the economy expands and reaches a late stage, central banks usually raise short term interest rates. They worry that the economy might overheat, and this would lead to high inflation.

Since one of the mandates of a central bank is to fight inflation, they raise short term rates. What does that do to the yield curve? It flattens it. Short term rates rise, and long term rates remain relatively unchanged. This leads to a flattened or even an inverted yield curve. Since most late-stage economic expansions are followed by a recession, investors nowadays point to the yield curve as the best predictor of recessions. In fact, the yield curve inversion has predicted the last 7 recessions, right?

Source: Gurufocus

And it can be a kind of a self-fulfilling prophecy in a way. However, I argue that the inversion of the yield curve has to do with many other factors, other than a “certain” coming recession. It surely can happen, but I think there are other reasons why the yield curve has flattened and inverted.

Plausible reasons as to why the yield curve has flattened and had inverted

Let’s start answering this question by clarifying one thing. As mentioned, generally, the inversion of the yield curve is a result of central banks raising short term interest rates to fight inflation. No large central bank (including the Fed) raised rates in 2019, however, the yield curve inversion still happened. Plus, both short term and long term interest rates plunged to extremely low levels.

Quantitative Easing

So, what are some of the other plausible explanations as to why the yield curve has flattened throughout the last years and had inverted in recent months? For one, since the Great Recession, central banks have not only slashed interest rates dramatically. They have also expanded their balance sheets exponentially by pursuing unconventional monetary policy. As it’s called by the central bankers, large scale asset purchases. Or, Quantitative Easing, as it’s generally known to investors and the public. Or QE in short. What do large scale asset purchases entail exactly?

Well, mostly, it’s simply the process of creating money by book entry and buying different assets from the market. Since the Fed cannot buy Treasuries directly from the government, it does so by going to the secondary market and buying up Treasuries, mostly from large financial institutions, such as commercial banks, pensions funds, etc. Why would they want to do that? Well, for one, during the Great Recession many banks had many illiquid assets, such as Mortgage-Backed Securities (MBS in short). So, central banks wanted to free up their space and give them cash to lend out to consumers. So, what they did was they bought those Mortgage-Backed Securities, and a bunch of Treasuries from the banks, and gave them reserves to lend out. This balance sheet expansion can be depicted nicely by the following chart:

Source: Hutchins Center on Fiscal and Monetary Policy

quantitative easing

The first round of Quantitative Easing (QE1) was an effective solution as it gave banks the necessary reserves to give out loans. However, further Quantitative Easing rounds were much more about depressing interest rates on the long end of the spectrum. The reasoning behind that being, “let’s depress long term rates so consumers get cheaper rates on their mortgages and businesses on their loans, while at the same time giving banks so many reserves, it will be unprofitable for them to hold them unloaned”. This increasing focus on buying longer term maturities can be depicted in the following chart. This shows the maturity composition of US Treasuries owned by the Fed:

As we can see, the average maturity of Treasuries has increased significantly. Before the financial crisis, about half the treasuries were less than 1 year in maturity. However, after the crisis, more than 80% of the Treasuries are now more than 1 year in maturity. Also, keep in mind that all this came with a more than quadrupling of the Fed’s balance sheet. This certainly had a large effect on the markets, and on bond prices, and thus, yields. This, just as intended did have a large effect on the longer-term rates, and in turn, on the yield curve. All things being equal this has significantly flattened the yield curve over the years.

This can be further illustrated by taking the example of the ECB and the German 10 Year Bund yields. The following chart shows the yield on the German 10 Year Bund since 1992:

Since parallel shifts in rates are quite common (correlation between short term rates and long term rates can be as much as 90%), the decline in Bund yields can be explained partly by declining central bank short term key rates:

Source: Tradingeconomics

The chart above shows the ECB main refinancing rate since its inception in 1998. Notice how from the previous chart, since roughly 2012 the yield on the 10 Year German Bunds went down by more than 2.5%. Well, since 2012 the key interest rate has declined by 1% (add also the -0.5% currently on the deposit facility). So, in total, a -1.5% decline in short term interest rates. That was followed by a more than 2.5% decline in long term interest rates. Surely, short term rates are much more responsive to central bank rate changes. However, long term rates declined even more than short term rates over the same period. This obviously contributed to the flattening of the yield curve (in Germany, all of the yield curve is currently negative, that is, below 0%).

Forward guidance and expectations

Other reasons for the yield curve flattening and inversion have to do with forward guidance, and investor expectations of future short term interest rates. What do I mean by forward guidance? Well, simply, the guidance that central bankers give to the markets about what their long term strategy is. When Mr. Draghi of the ECB (soon Lagarde) promises to keep rates at 0 or below 0%, this is forward guidance to the markets that rates will be kept low for long periods of time. This has a flattening effect on the yield curve, since if you expect rates to be unchanged for 10 years? Well, the yield curve will be flat.

Also, due to slower economic growth recently, central bankers, especially in Europe, are expected to pursue an expansionary monetary policy for years to come. Since rates are close to or below 0 already, the only other known measure is to pursue QE. And that’s what investors expect central bankers to keep doing going into the future.

The search for yield and price rallies

The final important reason as to why the yield curve has flattened has to do with the search for yield. Equity valuations are at all-time highs. Investors know this and are wary of the current market rally. They would much rather invest in riskier bonds or hold cash, than risk investing in something with little upside and big downside. Hence, the ever-increasing global market of negative-yielding debt, and generally extremely low bond yields.

As I’ve discussed in my previous article, the market has changed so much that nowadays investors look for yield in equities, and invest in price rallies in bonds. Why? Well, if you’ve got the largest central banks investing in bond markets, which props up bond prices, why not invest in the bond price rally? Also, if you’ve got many large stable companies paying out larger dividends than bond yields, why wouldn’t you invest in equities for yield? Plus, they’re buying back their own shares? Double the benefit!

Implications and effects of Quantitative Easing on the economy

QE 1 did its job and had an immediate effect on bank balance sheets. The limit to lending was lifted as banks had enough reserves to lend out as much as they wanted to. However, with every following round of Quantitive Easing, the effects on the economy seem to have faded. That is, even with bank reserves, and excessive bank reserves at record highs, bank lending did not increase as much as expected.

Source: BakerInstitute

The graph above shows total bank loans in blue. The dotted black line shows the expected trajectory of bank loans, had the Great Financial crisis not occur. But it did, and that greatly affected bank lending. At first, it fell, and then started going up again. However, as the dark red line shows us, bank lending did not pick up at the expected rate. Why? Because the red line shows what bank loans should have been if they stayed at a constant percentage of bank assets as prior to the crisis. And bank loans today are lower than that line. We will get into the why’s of that in the next paragraph.

Inflation considerations

Also, many economists and critics thought such “money printing” would immediately lead to high levels of inflation. Their reasoning? Money supply determines inflation. When the money supply grows faster than the economy, inflation is generated. Hence, if you print out money, it is bound to lead to inflation. However, that did not happen. Inflation in the EU and the US is still below the target of 2%.

Why did all those rounds of QE did not lead to inflation? This has to do with how money is truly created. Commercial banks are the main creators of money, via debt. That is, they usually lend out their excess reserves (they are required to keep a small portion of money in reserves, in case many people need to cash out at the same time – a scenario which usually doesn’t happen, well, except bank runs), to earn themselves a nice profit.

The alternative? Well, for example, in the EU, you pay the central bank for depositing your excessive reserves with it. You pay exactly what the current rate on the deposit facility is, which is 0.5% (-0.5% from the central bank’s point of view). So, do you lend out your excess reserves, or do you pay for them sitting in a bank account? The answer seems obvious. And this is why central bankers expected QE to work.

How did QE affect bank lending?

Small vs large business and productivity considerations

There are a few things to differentiate between when talking about bank lending. First, bank loans can be either given out to small businesses or large businesses. Small businesses can have extremely high growth, and be a great addition to the economy, however, they are much riskier than large established businesses. If you were a bank, would you take the risk of lending to a small business if the economic climate is uncertain? It just might be too risky. Of course, government intervention can help, but that’s beside the point.

Secondly, bank lending was meant to spur economic growth. So, not all bank lending is equally efficient and stimulative for an economy. If a company buys a new plant, which needs workers to operate and it would increase its capacity as they see demand picking up in the future, this would be a productive way of spending the borrowed money. This would create jobs, supply additional useful products which are at a high demand for people, and the economy would grow as a result.

However, if a company borrows money and buys a ton of potato chips and a bunch of personal TVs for the employees, this would not increase productivity and economic growth as much. Not only would the employees’ health suffer, but they would be less productive, spending time watching TV, possibly at the expense of work. Maybe one TV in total and one small bag of chips for every employee is enough to entertain them and raise their productivity a tiny notch if your intention was that.

Bank lending for small vs large businesses

I tried to dig up some data on bank lending, and I found one very telling graph. It’s a rather outdated one, but I think it illustrates the point nicely. The following graph shows bank lending for small and large businesses together. That is, put on the same graph and compared. Let’s take a look.

Source: US small business administration (SBA)

There are a few key takeaway points from this graph. First, loans to large businesses have always been larger than those to small businesses. Second, throughout the two decades depicted, bank loans to small businesses have remained relatively steady, albeit higher in 2015 than in 1995. Third, bank loans to large companies have increased rather steadily throughout the years. Fourth, there was a contraction in bank loans to both small businesses and large due to the Great Recession. Finally, it is important to observe that small business loans used to make up a rather large part of total bank loans to businesses. In 2015, since large business loans have expanded, while small business loans have remained rather steady in value, this lead to large business loans making an extremely large part of the total bank to business lending.

It is true that throughout the years there has been a lot of consolidation within the business sector. Large companies becoming even larger, outcompeting smaller competitors due to scale efficiencies. Small businesses cannot compete with extremely low prices. And also, a lot of policy-based decisions favor the large corporations.

However, we will not get into politics in this article. Let’s just simply explore the incentives of bank lending.

Why banks favor lending to large vs small businesses

There are a lot of reasons why banks favor the large. Some of the key ones are the following. First, there is a lower risk associated with lending to a large company. Usually, they have a steady cash flow and are able to pay back the money most of the time. The projects they take up are not as risky as for small companies. Small companies have high risk high reward type of projects, and banks don’t want to risk the small margin they make on not getting their money back. Second, when the economic outlook is gloomy, banks simply think the projects they will lend money to will fail as they expect demand to be weak. This goes for both, large and small businesses, however, much more so the smaller the business is. Large companies are usually better prepared and in a better position to survive the storm.

Why doesn’t increasing bank lending result in higher economic growth than the current GDP growth trajectory in the US?

As I have pointed out in my previous article on stock buybacks, a lot of buybacks are funded by debt (also, they have been increasing to record highs as of late and are bound to reach record levels again in 2019.). And there is a very high correlation between net borrowings and net equity buybacks.

Companies have two basic ways of borrowing. One, they can issue debt by way of corporate bonds. Second, they go to a bank and borrow money, take out a loan. When writing my buybacks article I was sure that buybacks could only be funded by debt by way of corporate bonds. In other words, it did not even occur to me that banks would or would be allowed to lend for stock buyback purposes to companies. However, as colleague Matthias Denecke pointed out, at least in the US, banks are allowed and do lend money to companies who want to buy back their stock.

Stock buybacks vs investment

It is speculation, however, it does make sense that if a large part of buybacks is being funded by debt, (some sources even say it’s more than 50%) then the same could be true for bank loans. If this were the case, it’s easy to see why increasing bank lending to large companies did not result in productivity and economic growth. To base my point on something, I took a look at capital goods investment by manufacturing companies (nondefence, excluding aircraft) throughout time.

(What is this capital goods investment exactly? As per Investing.com, “Nondefense capital goods include among other things: small arms; farm machinery and equipment; construction machinery; turbines, generators, and other power transmission equipment; electronic computers; communications equipment; heavy-duty trucks; office and institutional furniture; and medical materials and supplies.” So, think things which increase capacity, and efficiency in your business) I’ve also added QE timelines for visual purposes. Here’s how it looks like:

As we can see, the usual pattern for expansion is a gradual rise in capital goods orders, followed by a sharp decline. There indeed was an uptick in new capital goods orders just after the Great Recession (possibly due to QE1 and/or/and QE2 taking off bad assets and injecting cash into the banking system?). However, it was not followed by more growth, as new capital goods orders fluctuated within a range. It indeed has been the longest US economic expansion in history, albeit the slowest too.

So, could all of this mean that banks, instead of lending to small businesses, or funding productive large business projects, actually ended up funding a lot of the buybacks that took place recently? Maybe some other unproductive projects? This obviously is speculation, and more research is needed on this specific topic, however, there is logic to back this premise.

How does all of this relate to monetary policy, quantitative easing and the yield curve?

This paragraph will probably be a bit of a critique of the recent central bank actions, however, I think there are many takeaway points to take home from it. So far, we have established that QE was not as effective in promoting bank lending as expected. Or at least, possibly not as effective in promoting the kind of productivity-increasing lending. Instead, what happened was some lending that took place, possibly ended in stock buybacks, which do not increase productivity as much.

Having all the right stats in front of their eyes, it’s quite bizarre central bankers did not see this coming. I mean, think of Amazon, Apple, Alphabet. Do they really need more loans from the bank? Especially if they are already buying back their stock. They are full of cash flow they don’t know where to put. Large companies probably simply don’t see as many profitable projects, and it does not matter to them if the interest rates are at 2% or at 0%. They still will not take the risk and will not invest, will not borrow if they see them as not profitable. So, why would you want to pursue QE and buy all those Treasuries off of the balance sheets of banks?

A final critique of QE

First, banks will not increase lending as much because, as mentioned, they profit from the yield curve. And now it’s flat. QE and forward guidance have basically made the yield curve flat, which dwarfs bank profitability considerably. Plus, why would you not want to increase small business lending instead? They are the ones that are most in need of borrowing and have the largest potential for growth. Central banks have lowered rates to induce lending, that didn’t work as much as planned. They’ve then turned to QE for help. That diminished long term rates reduced bank profitability and basically incentivizes more stock buybacks when they really want the economy to start growing and banks to be lending to production increasing projects. The logic seems rather flawed.

I don’t want to sound too pessimistic, but it does seem like step by step, the US and the EU are approaching the scenario of Japan, where they eventually started directly owning the stock market, and having a zombie economy that does not grow.

Conclusion

In this rather long Learn to Trade article we’ve taken a look at many related and relevant subjects in today’s markets and the economy. The yield, curve, monetary policy, quantitative easing, and how it relates to the yield curve and bank profitability. We have taken a look at how banks make their profits, and how this translates into loans being made to the larger economy. We have also seen that much of the slowdown in bank lending has to do with the yield curve.

Additionally, the loans that have been made did not translate into as much economic growth as expected since it did not translate into new investment. Instead, a very plausible scenario is that they actually ended up in stock buybacks. We ended the article by a critique of central bank actions. I do not have a good enough proposition of how to go about fixing the economy, however, I believe it’s very important to know the why’s and the how’s before pursuing important decisions. Let’s hope central bankers and policymakers do connect the dots better and come up with good decisions to promote economic growth. I also hope readers took away something from this article and that it helps your trading/investing pursuits.

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