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Misunderstandings about Fed money creation, bank reserves and bank lending

The first two false beliefs on our list of economics myths remain very popular, even within the ranks of people who are generally knowledgeable about economics. We are referring to the beliefs that the amount of US bank lending is determined by or at least influenced by the amount of bank reserves, and that the Fed's QE boosts bank reserves but does not directly boost the money supply. In response to their appearance in two recent articles penned by people who are otherwise quite knowledgeable, we are now going to briefly revisit these wrongheaded notions.

One of the articles that prompted us to revisit this topic was "Long Term Parking" by Ben Hunt. Here's the relevant excerpt:

"...the massive debt racked up by the Fed in its QE purchases of US sovereign debt and mortgage-backed securities doesn't work like household or corporate debt. The money for this buying spree never actually enters the real economy, but instead sits in the reserve accounts of the big banks. And that's where it sits, and sits, and sits ... until the big banks use those reserves to make private loans to households or corporations that want to use that money for some sort of real-world economic activity. This private lending activity is what turns reserves into money, and the cascading usage of that money -- where it flows through multiple hands making real economic purchases -- is what turns money into inflationary pressures and expectations."

This is completely wrong. Firstly, for every dollar of assets purchased by the Fed as part of its QE, one dollar is added to bank reserves at the Fed and one dollar is added to demand deposits within the economy (the demand deposits of the securities dealers that sell the assets to the Fed). In other words, the money for the Fed's buying spree definitely does enter the economy and therefore does create inflationary pressures. However, sometimes the inflationary pressures are focused on financial assets, thus rendering them invisible to most analysts. Secondly, banks do not use reserves to make loans. The volume of bank lending is mostly determined by the availability of borrowers that are both willing and qualified. That's why there has been no correlation over the past few decades between US bank lending and US bank reserves. Thirdly, reserves cannot be turned into money via bank lending. Reserves at the Fed will remain at the Fed until they are either removed by the Fed (via 'quantitative tightening') or are converted to notes/coins in response to the public's increased demand for physical currency.

The other catalyst for our decision to revisit the QE and bank-reserve myths was "The Fed's Stealth Tightening" by Casey Research's Bud Conrad. Here's the relevant excerpt:

"The Fed funded and continues to fund its quantitative easing programs with bank deposits. Here's the rundown on how that works:

1. The Fed creates cash from thin air.

2. The Fed buys Treasuries and mortgage-backed securities (MBS) from banks with that freshly minted cash.

The Fed pays banks 0.25% interest as an incentive to keep the new cash on deposit at the Fed.

That huge $2.8 trillion in deposits [bank reserves held at the Fed] is a risk source, because the financial institutions could withdraw those funds at any time, if they think they can generate better returns than the 0.25% interest that the Fed pays."

This is wrong in two important ways:

First, the Fed doesn't buy Treasuries and MBS from banks; it buys them from Primary Dealers (PDs). Although some PDs are subsidiaries of commercial banks, the distinction is not trivial. Due to the mechanics of the Fed's QE process, the monetisation of assets results in dollars being added one for one to bank reserves at the Fed and demand deposits within the economy (the demand deposits of the PDs).

Second, banks cannot withdraw their huge deposits of reserves held at the Fed. Banks can lend reserves to other banks, but the banking system as a whole cannot reduce its reserves. As we stated above, reserves at the Fed will remain at the Fed until they are either removed by the Fed (via 'quantitative tightening') or are converted to notes/coins in response to the public's increased demand for physical currency.

Since the banking system cannot withdraw its reserves, the 0.25% interest rate paid on reserves is not an incentive to keep the 'cash' at the Fed. Even if the interest rate were negative, that is, even if the Fed started charging the banks on their reserve balances, the commercial banking system would be powerless to reduce the total quantity of its reserves. Why, then, did the Fed start paying interest on reserves a few years ago?

As far as we can tell, there were two reasons. The minor reason was to give bank balance sheets a boost, but the main reason was to enable the Fed to maintain control of the Fed Funds Rate (FFR) at a time when banks are inundated with "excess" reserves. If not for its relatively new ability to pay interest on reserves, the Fed would be unable to hike the FFR in the future without massively contracting the quantity of reserves.

We'll end with a question for the many analysts who continue to labour under the false belief that the Fed's QE boosts bank reserves, but not the money supply, and the related false belief that bank lending is the only means by which money gets injected into the economy. The question is: Given that US True Money Supply* has increased by about $4.7T over the past six years and that US commercial bank credit has only increased by about $1.4T over the same period, where has all the new money come from?

    *The sum of physical currency in circulation, demand deposits at private depository institutions and savings deposits at private depository institutions

The Stock Market

Dow 44,000 and speculating on the possibility of a crash

A mainstream financial analyst has come out with a prediction that the Dow Industrials Index is on its way to 44,000. This is the type of prediction that gets made near the end of a bull market and reminded us of the "Dow 36000" book that was published in 1999. That being said, the recent "Dow 44000" prediction is not remotely as nonsensical as the "Dow 36000" prediction of 1999. This is because "Dow 44000" is a guestimate of where the Dow will be in 10 years' time assuming that a secular bull market began in early 2009. It implies an average gain of about 10% per year over the coming decade. The "Dow 36000" book, on the other hand, attempted to make the case that fair value for the Dow was 36000 way back in 1999.

It's extremely unlikely that a secular bull market got underway in 2009. Valuations at that time were nowhere near low enough to set the scene for such an outcome. However, even if we suspected that the US stock market really was five-and-a-bit years into a secular upward trend that was destined to last ten more years, we would be just as concerned as we are today about short-term and intermediate-term downside risk. Our concerns are unrelated to the secular trend. They are related to sentiment and valuation.

Sentiment and valuation were stretched to similar extremes at the same distance into the 1982-2000 secular bull market. The result was the 1987 stock market crash.

The stock market crash of 1987 is now just a 'blip' on the long-term chart, but at the time it was devastating. It resulted in a peak-to-trough decline of around 30% and wiped out all the gains accumulated over the preceding 18 months. It also brought valuations down to a more reasonable level and caused sentiment to become very constructive. In doing so it effectively reset the long-term bull market.

The current bull market's best chance of continuing for a few more years is if it experiences a similar reset, that is, if it suffers a 30% plunge later this year.

Up until now we haven't seriously considered the possibility that the US stock market could crash this year. Instead, our expectation has been that the market would gradually roll over into a choppy multi-year decline. This is still our favoured scenario, but with the S&P500 Index having made it to the middle of the year without a significant short-term correction the probability of a crash has increased to the point where it is a risk worth taking into account.

If a crash is going to occur, the most likely time would be mid-August through to early-October. The most likely price pattern would entail an initial decline of about 10% followed by a rebound to test the high and then a decline to below the low of the initial decline, with the market plummeting immediately after the low of the initial decline was breached.

We have small positions in SSO (ProShares Ultra S&P500) put options and VIX (Volatility Index) call options that we added to over the past three days.

Current Market Situation

The following chart shows that over the past few days the Volatility Index (VIX) made a new 5-year low and came close to its 10-year low. The unusually low volatility reflected by the VIX is a consequence of widespread bullish complacency.

The VIX is now so low that even a routine 10% pullback in the S&P500 Index would probably result in an upward spike in the VIX to roughly double its current level.



Evidence continues to slowly and steadily build in favour of the commodity theme. For example, the following weekly chart shows that the CRX/SPX ratio (commodity-related stocks relative to the S&P500 Index) bottomed in December, broke above its 50-week MA in March, pulled back to test its breakout in June and has recently resumed its advance.



The next weekly chart shows that the HUI/SPX ratio (gold-mining stocks relative to the S&P500) hasn't been as strong as the CRX/SPX ratio, in that HUI/SPX's rally from its December-2013 bottom didn't result in a break above the 50-week MA. However, HUI/SPX appears to have successfully tested its December-2013 bottom earlier this month. We suspect that a break above the 50-week MA will happen in July.



Gold and the Dollar

Gold

Gold is slightly 'overbought' on a short-term basis and has encountered resistance in the $1320s. Breaking above this resistance will add another piece to the puzzle (it will be additional evidence of a major reversal to the upside), but far more important resistance lies at $1350-$1400.

As noted in the latest Weekly Update, we have no opinion on what the gold price will do over the coming two weeks. It could pull back, in which case it would likely find support at $1285-$1290. It could also break above the $1320s and quickly move up to the $1350-$1400 range.

If there is a rise to the $1350-$1400 range within the next couple of weeks it should be viewed as a short-term selling opportunity, whereas a decline to the $1280s should be viewed as a short-term buying opportunity.



Gold Stocks

Our interpretation is that the HUI is close to completing a base that began to form during the second quarter of last year. The top of the base is at 250 or thereabouts. 250 is therefore an important resistance level.

A break above 250 would create a chart-based target of 300-320.



While the HUI didn't quite make it to important resistance at 250 before beginning to consolidate, GDXJ, a proxy for the stocks that are leading the gold-mining sector, reached equivalent resistance last week.

For GDXJ, a daily close above last week's high would create a chart-based target of around $60.



If a routine 1-3 week consolidation (the most that can reasonably be expected at this time) has begun, then it should continue until the daily RSI shown at the bottom of each of the above charts has fallen to 50 and/or the price has pulled back to the vicinity of the 50-day and 200-day moving averages.

As is the case with the HUI and GDXJ, basing patterns of 12 months or longer are clearly evident in the charts of many individual gold stocks. We'll include at least a dozen examples in the coming Weekly Update.

Currency Market Update

The Canadian Dollar (C$) has moved up to intermediate-term resistance in the 93-94 range. There are no surprises here, just more evidence that commodity-related investments are slowly gaining popularity. However, it will be surprising if the C$ breaks above 94 within the next few weeks. As far as we are concerned, that would be too much too soon.

We expect that the C$ will make a short-term top in the 93-94 range and then 'correct' for at least a few weeks. The 50-day MA would be a likely target for a correction low.



The Yen has now essentially flat-lined for five months. We don't recall ever previously seeing a major financial market trade in such a narrow range over such a long period.

We expect that the direction of the Yen's next tradable move will be to the upside, but the move is obviously taking much longer than expected to get underway. A daily close above 99 by the nearest Yen futures contract would be the first sign that a rally has begun.

Updates on Stock Selections

Notes: 1) To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html