Fool Part 2; No Rational Basis

Submitted by Jeffrey Snider  –  Alhambra Investment Partners

Since some markets seem to be waiting on either longer lingering in ZIRP (US) or renewed and heavier QE (Japan, Europe) it is worth examining exactly what they are anticipating. Obviously, that desire doesn’t extend into the real economy since the downward fluctuation in 2015 pretty much dissolves and absolves any direct monetarism correlation. What is left is a high perversion; untethered from any upward economic degree, these markets are betting on purely financial effects. As noted last week in fairly cataloging “inflation”, the New Greater Fool, that isn’t a sound premise, either.

Since QE isn’t truly easing (and is only “quantitative” in the sense central banks pick a number out of model’s “central tendency”) at least as far as one can observe “money printing”, then then what is left is truly just vague transformations that central planners simply hope work, on net after “market” reactions and adjustments, in their favor. Ben Bernanke, as noted last week, admitted as much in his November 2010 op-ed explaining QE2:

Our earlier use of this policy approach had little effect on the amount of currency in circulation or on other broad measures of the money supply, such as bank deposits.

That is and has been true of QE here in the US as well as the European versions (QE launched back in March may be technically different, but the LTRO’s from early 2012, for example, were the same concept carried out only through an alternate path). But that only goes so far, as the key word in Bernanke’s sentence is “broad.” The US has fared only marginally better than Europe in economic terms, to which Bernanke and his follow monetarists attribute “better monetary policy.” He returned to this theme last week within his book tour PR campaign:

It is instructive to compare recent U.S. economic performance with that of Europe, a major industrialized economy of similar size. There are many differences between the U.S. and Europe, but a critical one is that Europe’s economic orthodoxy has until recently largely blocked the use of monetary or fiscal policy to aid recovery. Economic philosophy, not feasibility, is the constraint: Greece might have limited options, but Germany and several other countries don’t. And the European Central Bank has broader monetary powers than the Fed does.

Again, the LTRO’s aren’t monetarily different than QE’s, and the ECB has been expanding its balance sheet in various ways since late 2011 and attempting recirculation and internal redistribution since May 2010 (sterilized or not). It is, again, a weak attempt by an orthodox monetarist to find any picture of success no matter how insufficient in its own right (“the US is bad but Europe is worse” isn’t exactly a point in your favor). But even here, there is the high degree of duplicity that we have come to expect – the major difference between the US and Europe is far more likely the private bond market on this side of the Atlantic (even if doesn’t produce much growth it has kept the US economy from more close downward alignment with the European trend).

Therefore, when examining monetarism in Europe we see no such “interference” and thus a purer reduction as to the monetary effects alone. Taking back to the original premise, “broad” deposit issues, there is a clear disruption due to that European monetarism. As Bernanke suggested in late 2010, that process is not a deviation in the deposit “stream” at all. By all counts in Europe as a whole, household deposit growth remains steadily upward, though clearly subdued post-crisis.

ABOOK Oct 2015 QE Herding HH Deps

As we well know, loan growth has completely stalled meaning that deposit “efficiency” has turned much, much lower. The loan to deposit ratio is threatening a new low (since the euro came into existence) in 2015 close to just 110%.

ABOOK Oct 2015 QE Herding Loan to Deposit

While I spend far more time examining the wholesale aspects of financial systems, and we know a great deal about wholesale dysfunction, revisiting this traditional funding format actually shows another aspect of that continuing disorder. As much as broad deposit growth is uninterrupted or unaided by the ECB’s monetary designs, the deposit system is not a singular mass. Breaking down the household segment by maturity pinpoints the drastic alterations that monetarists leave (often intentionally) unexamined:

ABOOK Oct 2015 QE Herding HH Deps ON

Since the LTRO’s flooded “money markets” and compressed nominal rates for financial factors, households have responded by shifting their deposit mix to overnight. Dating back to when the second LTRO was effected, the household sector has increased itsovernight account balances by more than €700 billion (compared to just €569 billion overall growth). Necessarily, by simple math, that means term deposits have shrunk in absolute terms as well as a greater degree of proportionality during the same time period. Further, the baseline for measuring these changes is not their absolute levels but rather how banks expected that each segment would grow relative to past behavior (because that is what is modeled, variance to past history).

ABOOK Oct 2015 QE Herding HH Deps Term

As you can see above, the maturity transformation post-LTRO was at first limited to Eurostat’s 2-years and below category but has recently begun to impact all term deposit maturities. This is unsurprising as not only did the same occur when the ECB was reducing rates before but as plain common sense – without any compelling return variable, there is simply no reason to hold deposit balances locked into a term maturity.

The other side of that, however, is not so flippant. Banks view “on demand” and overnight deposits far different in their liability equations than they do term deposits (again, straight common sense). A term deposit is far more stable and thus is treated exactly that way in the mathematics of balance sheet mechanics. In response to a higher proportion of overnight deposits, the bank would not only become more restrained on its asset side it would be far more likely to engage in wholesale liability management for that greater potential deposit variability.

The link to the ECB’s monetary efforts is thus obvious, especially when exactly replicated in also the corporate deposit structure (which is growing faster than household deposits; a separate topic of dysfunction related to QE’s and monetarisms).

ABOOK Oct 2015 QE Herding Corp Deps ON

By all counts, banks have seen their overall deposit funding allocations turn far, far more overnight, apportioned by interest rate “controls” into the “on demand” liability bucket. Since bank balance sheets are really just attempts to manage various portfolios on both the asset and liability sides, liquidity matching in this aspect would be heightened. That is one reason the asset side has been purged of everything but government securities. Banks hold greater “cash” balances with the ECB while repositioning assets under those conditions because of what is really a strictly liquidity issue.

Since LTRO1, banks have purchased almost half a trillion euros in government securities while their overall holdings of securities have declined by almost €300 billion; like the deposit structure, this asset side view is far more liquid since sovereign bond markets are (or thought to be) much deeper and tradeable than even the corporate sectors (especially in terms of quality differences).

ABOOK Oct 2015 QE Herding Govt Secs

Going back to the start of this transformation, November 2008, these shifts are truly staggering and dramatic. Total deposits have increase by €1.7 trillion (all of which have been distributed as overnight) while total lending has fallen by about €31 billion. Government securities balances have increased by €615 billion – and here is the European sovereign bond bubble.

ABOOK Oct 2015 QE Herding Overall Cycle

This is not to suggest that the asset mix on bank balance sheets is being totally determined by deposit liquidity concerns, as clearly that is not the case. Instead, what this shows is how QE or monetarism-driven changes in the name of “stimulus” has disruptive properties that certainly align more so with those negative impressions than of any positive boost to bank construction and forward activity. If credit concerns and wholesale disruption is responsible for the sovereign bond bubble in Europe, it is at least amplified by QE/LTRO alterations in deposit conditions if not outright partially as responsible.

The net result is what we see of Europe as a whole in both economic and financial terms; being heavily bank dependent (really overbanked as Japan) where bank balance sheets are far more inefficient isn’t going to produce a credit-led recovery. It is, in fact, absurd to think it even possible. Monetary theory asserts that low interest rates spur borrowing, which is already questionable across a more realistically broad range of economic circumstances, but actually irrational when factoring efficiency concerns among debt and lending “supply.”

With the exact same deposit transformation occurring in US domestic banking (small time deposits have declined from $1.43 trillion in November 2008 to just $443 billion in August; large time deposits from about $2 trillion to $1.68 trillion), we can make the same interpretations couched in US circumstances. Thus, US banks have exhibited the same kind of behavior though we have to account for QE’s byproducts which are a form of deposit balance (the loan to deposit ratio in the US was 102.8% in November 2008 and just 77.5% for August 2015; adjusting for excess bank “reserve” balances from QE activities, the loan to deposit ratio in November 2008 was 111.6% and just 101.3% in August). By that count, the US banking system is more inefficient now than when QE started, which again suggests monetary impacts as far more uniform on both sides of the Atlantic than Bernanke would admit – leaving, again, the junk bond bubble outside of banking and far more so related to unanchored and now disproven perceptions about what QE might someday do in myth.

In other words, like inflation, there is no “money printing” by central banks. What actually occurs on the internals of financial systems is totally susceptible to bank balance sheet mechanics and multi-dimensional portfolio considerations (across both assets and liabilities), a fact that central bankers either gloss over in trying to appeal to those “market” perceptions or don’t understand at all. In the end, I think you get mostly a mix of those two as rational expectations theory accounts for much of what central banks intend, so much so that they often care so very little for the specifics of how A is really supposed to get to B (and it often shows). Economists and policymakers talk about the “money supply” as if it were that simple; it isn’t. Further counting on such simplicity in late 2015 heading into 2016, as some markets have done recently despite being shown directly the disproving agency of banking and global finance, is not rational.