Inflation in the 21st century is a supply-side phenomenon

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“For example, it is habitually assumed that whenever there is a greater amount of money in the country, or in existence, a rise of prices must necessarily follow. But this is by no means an inevitable consequence. In no commodity is it the quantity in existence, but the quantity offered for sale, that determines the value. Whatever may be the quantity of money in the country, only that part of it will affect prices, which goes into the market commodities, and is there actually exchanged against goods. Whatever increases the amount of this portion of the money in the country, tends to raise prices. But money hoarded does not act on prices. Money kept in reserve by individuals to meet contingencies which do not occur, does not act on prices. The money in the coffers of the Bank, or retained as a reserve by private bankers, does not act on prices until drawn out, nor even then unless drawn out to be expended in commodities.”

John Stuart Mill, Book III, Chapter VIII, Par.17, p.20

In his latest Global Strategy Weekly, Albert Edwards explains why he thinks the surge in the money supply is deflationary. As usual he is going against the consensus here even though he gives credit to people like Russell Napier who correctly identifies the changing nature of US money supply but concludes that this is highly inflationary. I think Albert is right for the wrong reasons, and Russell is wrong for the right reasons.

Albert Edwards is right when he says that ‘despite massive stimulus, deflation will nimble on for a while yet until capacity constraints become binding further down the road’ (emphasis mine). Yet in his view, deflation will persist because of keeping zombie companies alive by cheap credit. While, I have no doubt that this is invariably true, its effect on the deflation-inflation dynamics is weak because credit creation is now a much smaller part of the money supply than in the past.

Which is where Russell Napier comes in.  He is right in his view that ‘politicians have gained control of money supply’ but wrong to believe that this will inevitably cause a rapid rise in inflation unless, indeed, capacity does become binding.

Reality is that money supply is now turned around on its head. While in the past, pre-2008, the delta of money supply consisted mostly of loans, after 2008 and during QE 1,2,3, it moved to loans plus QE-generated deposits. During the Covid crisis, it shifted further away from loans by adding even Government-generated deposits to the QE-time mix.

It is ironic that we had to go through QE, when the power of loan creation on money supply started to wane, for us to truly acknowledge their significance in the process of money creation in the first place. Loans create deposits – yes. But under QE, if Fed buys from a non-bank, the proceeds go in a deposit at a bank without the corresponding increase in loans. If it buys from a bank, reserves at the Fed go up.

Source: FRB H.8

Things get more complicated when the government hands out free cash as it also goes on a deposit (Government-generated deposits) with no corresponding loan creation.

Source: FRED, FRB H.8

Of those bank credits, actually, only about half are loans, the other half are securities. So, in fact loans have created only about 1/6 of the money supply YTD (would be even less if measured after the Fed/Treasury initiated their programs in March).

Source: FRB H.8

What about inflation? Difficult to see how this massive rise of money supply can produce any meaningful push in inflation given that the majority of that cash is simply being saved/invested in the market rather than consumed.

Moreover, this crisis is hitting the service sector much more than any other crisis in the past. And unlike the manufacturing sector, which tends to be more cyclical, this decline in services may be structural as the virus changes our consumer preferences in general, but also in light of the new social distancing requirements. Some of these services are never coming back. This is deflationary, or at minimum it is dis-inflationary overall for the economy.

Services price inflation tends to be much higher than manufacturing price inflation. This paper from the ECB has documented that this is a feature for both EU and US economy and has been prevalent for the past 20 years.

However, as the paper demonstrates, the gap between the services and good price inflation has been narrowing recently, starting with the 2008 crisis. I believe that after the Covid crisis, the gap may even disappear completely.

For a sustained rise in inflation, we need a ‘permanent’ rise in free government handouts as that would increase the chance of some of it eventually hitting the real economy. Reality is that, even if this happens, the output gap is so big that inflation may take a lot longer to materialize than people expect. However, anything that shrinks the supply side of the economy (supply chains breakdown, regulations, natural disasters, social disorder, etc.) would have a much bigger and direct effect on inflation.

Bottom line is, as the speed of technological advances accelerates, and with no barriers to that, inflation in the 21st century becomes much more a supply-side than a demand-side (monetary) phenomenon.

Record liquidity leads to record net issuance of financial assets

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At $3.2Tn, US Treasury (UST) net issuance YTD (end of June) is running at more than 3x the whole of 2019 and is more than 2x the largest annual UST issuance ever (2010). At $1.4Tn, US corporate bond issuance YTD is double the equivalent last year, and at this pace would easily surpass the largest annual issuance in 2017. According to Renaissance Capital, US IPO proceeds YTD are running at about 25% below last year’s equivalent. But taking into consideration share buybacks, which despite a decent Q1, are expected to fall by 90% going forward, according to Bank of America, net IPOs are still going to be negative this year but much less than in previous years.

Net issuance of financial assets this year is thus likely to reach record levels but so is net liquidity creation by the Fed. The two go together, hand by hand, it is almost as if, one is not possible without the other. In addition, the above trend of positive Fixed Income (FI) issuance (both rates and credit) and negative equity issuance has been a feature since the early 1980s.

For example, cumulative US equity issuance since 1946 is a ($0.5)Tn. Compare this to total liquidity added as well as issuance in USTs and corporate bonds.*

The equity issuance above includes also financial and foreign ADRs. If you strip these two out, the cumulative non-financial US equity issuance is a staggering ($7.4)Tn!

And all of this happened after 1982. Can you guess why? SEC Rule 10b-18 providing ‘safe harbor’ for share buybacks. No net buybacks before that rule, lots of buybacks after-> share count massively down. Cumulative non-financial US equity issuance peaked in 1983 and collapsed after. Here is chart for 1946-1983.

Equity issuance still lower than debt issuance but nothing like what happened after SEC Rule10B-18, 1984-2019.

Buybacks have had an enormous effect on US equity prices on an index basis. It’s not as if all other factors (fundamentals et all) don’t matter, but when the supply of a financial asset massively decreases while the demand (overall liquidity – first chart) massively increases, the price of an asset will go up regardless of what anyone thinks ‘fundamentals’ might be. People will create a narrative to justify that price increase ex post. The only objective data is demand/supply balance.

*Liquidity is measured as Shadow Banking + Traditional Banking Deposits. Issuance does not include other debt instruments (loans, mortgages) + miscellaneous financial assets. Source: Z1 Flow of Funds

Money on the sidelines?

MMF AUM has grown by about $1.1Tn since the beginning of the year. This is not surprising given Fed’s balance sheet growth of $3Tn, bank deposits growth of $2Tn and bank reserves growth of $1.6Tn.

Source: FRED

None of this is money on the sidelines.

This is money which has already been accounted for. The Fed did a liquidity and duration swap – out of UST coupons and MBS (mostly, some corporate credit) into T-Bills/reserves/deposits. That’s all. Ok, maybe some of that money will eventually go into risky assets, but why should it? If it wanted to, it would have gone even before the Fed swap. Obviously, it is not moving at the moment. It would have declined naturally after tax payments go though, but that could possibly be delayed again.

The only thing we see, is a flattening of the growth rate. Total AUM is back to early May level, which is where bank reserves have declined to as well. Again, that’s not surprising.

Is there money on the sidelines?

Yes, the only way to create that is to increase private sector net financial assets. Normally, this is done when the private sector receives income in exchange for work. In the early 1980s, this mechanism, unfortunately stalled, and the majority of the private sector income was generated in exchange of debt, which is kind of like money on the sidelines (net cash ‘creation’ through leverage), but it is a doble-edged weapon as that debt has an expiration and a positive interest rate. We are working on both the former – debt forgiveness, and the latter – interest rates are close to 0% now.

The only entity that can create financial assets without the debt liability, ‘money on the sidelines’, is the government: the Fed only lends money into existence, the Treasury spends it. This is exactly what the US government has done with the CARES Act: the SBA PPP could provide for about $600Bn of loan forgiveness ($112Bn of which has gone through) while the Recovery Rebates provide for about $300Bn of direct family assistance, no strings attached. This is not permanent, but it is an important step towards UBI/Helicopter money. This could change everything.

Monetary underwhelms, but fiscal makes all the difference

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Despite the fanfare in the markets, the Federal Reserve’s monetary stimulus, on its own, is rather underwhelming compared to the equivalent during the 2008 financial crisis. What makes a difference this time, is the fiscal stimulus. The 2020 one is bigger than the 2008 one; but more importantly, it actually creates net financial assets for the private sector.

Monetary Stimulus

  • Fed’s balance sheet has increased by 73% since the beginning of 2020. In comparison, it increased by 109% between August’08, the month before Lehman went bust and most major programs started, and March’09, the month when the stock market bottomed. Actually, by the time QE3 ended, in September 2014, Fed’s balance sheet had increased by 385% compared to since before the crisis.
  • Commercial bank reserves were at 9% of their total assets before the Covid crisis and are sitting at 15% now, a 94% increase. In the aftermath of the 2008 crisis, on the other hand, bank reserves tripled from August’08 to March’09 and increased 10x by September’14. Relative to banks’ total assets, reserves were just at 3% before the crisis but rose to 20% by the end of QE3.
  • Bank deposits were at 75% of their total assets in January’20 and are at 76% now, a 17% increase. Deposits were at 63% before the 2008 crisis, had declined to 60% by March’09, and eventually rose to 69% of banks total assets. Overall, for this full period, commercial bank deposits rose by 49%.

In percentage terms, Fed’s balance sheet rose less during the 2020 crisis than during the 2008 crisis and its aftermath.

Commercial bank reserves were a much smaller percentage of banks’ total assets before the 2008 crisis than before the 2020 crisis, but by the end of QE in 2014, they were bigger than today.

Banks started deleveraging post the 2008 financial crisis (deposits went up as a percentage of total assets) and continue to deleverage even now.

On the positive side, however, the Fed has introduced four new programs in 2020 that did not exist in 2008, Moreover, unlike 2008, they are directed at the non-financial corporate sector, i.e. much more targeted lending than during the financial crisis.

Nevertheless, very little overall has been used of the facilities currently, both in absolute terms (the new ones), and compared to 2008.

The percentage use of facilities in 2020 vs 2008 ranges from 0% for TALF to 15% for MMMLF, with a weighted average (by size) of about 5% for all facilities. In other words, if one takes financial markets as a marker, very little of these facilities is likely to be used going forward.

In fact, looking at the performance of financial assets, the market is not only telling us we are beyond the worst-case scenario, but, as equities and credit have hit all-time highs, it seems we are discounting a back-to-normal outcome already. It took the US equity market about four years after the 2008 crisis to reach its previous peak in 2007. In the 2020 crisis, it took two moths!

Following the 2020 Covid crisis, monetary policy so far is much less potent than following the 2008 financial crisis. Taking into account the full usage of Fed’s facilities announced in 2020, the growth rate in both Fed’s balance sheet and commercial bank reserves by the end of 2020 will likely match those for the period Auguts’08-March’09. But it has a long way to go to resemble the strength of monetary policy during QE1,2.3. Given that US equities only managed to bottom out by March’09, in an environment of much stronger monetary policy on the margin than today, means that their extraordinary recovery during the Covid crisis has probably borrowed a lot from the future.

Fiscal Stimulus

The Coronavirus Aid, Relief, and Economic Security (CARES) Act of 2020 is much bigger than the American Recovery and Reinvestment (ARR) Act of 2008, both in absolute terms and in percentage of GDP.

However, what really makes the difference, is the fact that the CARES Act has the provision to increase the private sector’s net assets. This is done through two of the programs. The SBA PPP allows for about $642Bn of loans to small businesses. If eligibility criteria are met, the loans can be forgiven. The Recovery Rebates Program allows for the disbursement of $1,200pp ($2,400 per joint filers plus $500 per dependent child). Nothing like this existed during the 2008 financial crisis.

Most of the loans through the SBA PPP have already been made, and about $112Bn are forgiven. So, there is another maximum of $532Bn which could still be forgiven (deadline is end of 2020). The Employment Rebate Programs is about $300Bn in size.

Just the size of these two programs can potentially be as big as the ARR Act was, in absolute terms. They create the possibility for the private sector to formally receive ‘income’, even though it is a one-off at the moment, without incurring a liability. Some of the other programs, like Tax Relief, are a version of that, but instead of acquiring an asset, the private sector receives a liability reduction – not exactly the same thing.

This is important. Until now, the private sector could receive income either in exchange for work, or, as it became increasingly more common starting in the late 1990s, with the promise of paying it back (in the form of debt). This now could be changing.

The Fed, for example, can not do that. Its mandate prevents it to ‘spend’ and only to ‘lend’. Until 2020, the Fed’s programs were essentially an exercise of liquidity transformation and a duration switch (the private sector reduced duration – mostly UST, MBS – and increased liquidity – T-Bills and bank reserves). There was no change in net assets on its balance sheet; the change was only in the composition of assets. The more recent programs introduced direct lending to the non-financial sector, still no net creation of financial assets, but a much broader access to the real economy.

In a sense, while the CARES Act comes closer to the concept of Helicopter Money or Universal Basic Income (UBI), the monetary stimulus of 2020 is moving closer to the concept of Modern Monetary Theory (MMT).

In that sense, while the reaction of financial markets to the monetary stimulus may not be deemed warranted, taking into account the innovative structure of the fiscal stimulus, asset prices overreaction becomes easier to understand. Still, I believe the market has discounted way too much into the future.

There is always a dichotomy between financial markets and the economy but, it seems that currently, the gap is quite stark between the two. It could be that the market is comfortable with the idea that, in a worst-case scenario, the authorities have plenty of ammunition to use, in the case of both the existing facilities as well as new stimulus.

I disagree. While 2008 was a financial crisis, in 2020, we are dealing with an exogenous real shock, which is independent of financial market performance. In 2008, the market eventually pulled the economy higher. This year, especially if a second Covid wave hits, as it is now becoming increasingly likely, the authorities will have to come good on all their promises to use these facilities, maybe to the full, or the market would be in trouble.  And therein lies the problem. Will the US political environment allow for that to happen?

I have been in the past quite critical of the prospect of fiscal policy to save the day. Regardless of how financial markets perform going forward, this time, however fiscal policy definitely stands a chance.

Fed’s taper

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Has the Fed really started tapering?

Liquidity is getting tighter. The decline in Fed repos is simply a reflection of their increased cost. Therefore, we will know when things are really getting bad if repo volumes start to pick up. Finally, if the market expected to get a flush of liquidity towards month end from TGA, this is now less likely to happen.

  • First drop in overall Fed’s balance sheet since 02/26. And it is a rather large drop, $74Bn.
  • Third week in a row of declines in bank deposits. Level now is the same as 04/15. The 4-week rolling growth rate is now the lowest since the Fed’s U-turn last September.
  • TGA continues to climb to record highs despite some disbursements towards Fed’s SPVs as new programs get triggered. It is likely that the level of TGA depends on the amount of SBA loans drawn/forgiven and such TGA can stay above $800Bn, Treasury’s target, for some time.
  • CB swap lines decline by $92Bn – first large decline as some of them have matured and no additional USD funding required.
  • Net repos outstanding continue to decline – this has been a feature all of this week as both O/N and term repos have been 0 for USTs. Reason for that is Fed raised the minimum bid on O/N to IOER +5bps and on term to IOER +10bps. This was a surprise, not that it happened (Fed probably made that decision at its April FOMC already), but that it happened ahead of tax receipts day. Commercial banks now must step in to fill in the gap but with their deposits on decline, their flexibility is diminished.
  • Fed bought $83Bn of mortgages – that’s perhaps to compensate for net selling in the previous 3 weeks.

Extra liquidity is getting withdrawn. That’s it. Market is not in distress yet. For that, we will know it when Fed repo volumes start picking up again and O/N rates shoot up. But for sure, on the margin, there is less liquidity to go around. Markets are not reflecting this yet. Perhaps, waiting for a sign, that all this surplus liquidity has been withdrawn, to react.

April TIC data: Continuous foreign selling of US assets

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April TIC data released.

  • Heavy foreign UST selling continues.
  • Foreign selling starts to pick up also in US equities and agencies.

March broke the record for Total foreign monthly outflow.

This happened largely on the back of a record Private foreign sector outflow.

April still saw a large net foreign outflow, though not as big as March. Nevertheless, this time, the Official foreign flow reached an all-time low.

This is significant because the 12-month rolling cumulative total foreign flow in US turned negative by a large amount. This is very, very unusual.

Foreigners are still focused at the moment on selling primarily USTs.

While in the past, private foreign accounts may have bought USTs even when official foreign accounts were selling, in the last two months (April-March), private foreign money turned sellers in size. In fact, their outflows have been several times bigger than the official foreign account outflows. This most recent selling put the 12-month rolling UST private foreign flow in negative territory in March. It reached an all-time low in April. The 12-month rolling UST official foreign money flow is also close to its all-time record low, reached in November 2016.

On the US equities side, unlike in March, though, this time foreigners were net sellers. The total outflow was not that large by historical standards, but the official foreign outflow was.

Foreigners continued to buy US corporate bonds, especially official foreign money. Nothing new there.

Finally, on the agencies side, official foreign accounts were a rather unusual and large seller.

Conclusion: The continuous high level of total foreign US assets outflows in April is interesting and could herald a change in trend of previous USD inflows. We can see that by looking at the rolling 12-month data which turned negative in March and is accelerating lower. In theory, there shouldn’t have been any forced pressure on foreign accounts to exit US assets in April, as Fed/Other Central Banks swap and repo lines were already in place. If this continues, the USD may be in bigger trouble than initially thought. See here, here and here.

Buying bankrupt company shares: eventually it hertz

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General Motors Corp. filed for bankruptcy protection, got kicked off the New York Stock Exchange and out of the Dow Jones industrial average. And its stock has mostly been rising ever since. In fact, GM has been one of the hottest issues on Wall Street over the last six trading sessions, surging from 61 cents totoday’s closing price of $1.59 in the electronic pinksheets.com market – a gain of 161%. (…) As I’ve written before, there’s a universe of traders out there who love to play around with big-name stocks that end up in bankruptcy. You can’t explain the action based on any fundamentals. It’s just a minute-to-minute, hour-to-hour trading game. (…) We know how this will end. But between now and then, for some gamblers playing GM is better than a trip to Vegas.”

“GM’s stock keeps trading but it is probably worthless” Tom Petruno, Los Angeles Times, June 10, 2009

The price action in Hertz shares post-bankruptcy is quite normal (up to “Bankrupt Hertz granted approval to sell up to $1Bn in shares”, but that is another, important, story). The elevated activity of retail investors in trading the shares of bankrupt companies is a feature of this particular market. For a lot of them it ends badly, but most of them are doing it for the fun of gambling anyway.

I am not a bankruptcy expert or a bankruptcy lawyer and I have never been involved in a company restructuring (plenty of bond restructurings though). Let’s say that before Hertz, I knew nothing about bankruptcies. What I found fascinating with that recent episode, though, is that even people who should know about corporate bankruptcy (equity portfolio managers) did not know much either. I was intrigued by the Hertz case as it looked quite bizarre and indeed the price action seemed against all common sense.

As I embarked on researching the topic, it turned out that even the academic literature on this is quite scarce. Of course, there is a lot that addresses bankruptcy cases and issues but there is little on trading, valuations or performance of stocks which have entered bankruptcy. There are a few reasons for this perhaps. First, most bankrupt stocks are delisted from major exchanges before or around bankruptcy filings. Second, institutional ownership declines massively post-bankruptcy, with 90% of shares owned by retail thereafter. Third, research coverage drops as a result. And fourth, yes, the market for bankruptcy shares, it turns out, is quite inefficient, for example, very difficult to short (inability to source borrowing) and very wide bid-offer spread (all due to thin institutional involvement).

To do my research I relied extensively on two papers: 1. “Investing on Chapter 11 stocks: Trading, value, and performance” by Yuanzhi Li and Zhaodong Zhong 2. “Gambling on the market: who buys the stock of bankrupt companies?” by Luis Coelho and Richard Taffler. The below is my summary of some of the topics discussed in these as they pertain to markets.

There are quite a few misunderstandings about bankruptcy procedure. First, when companies get delisted, they don’t just disappear but continue to trade on the Pink Sheets, which is an electronic quotation system. Second, even though there are quite a few limitations, as mentioned above, trading activity is quite brisk. Third, it is quite common for prices to bounce immediately after bankruptcy announcements as institutional shareholders tend to choose to cover their shorts on the major exchanges than go through the Pink Sheets or indeed through the bankruptcy proceedings. Fourth, although in the majority of cases shareholders do get zero, there are precedents where shareholders gain, sometimes substantially, when buying the stocks immediately after bankruptcy announcements.

So, the fact that Hertz share price rose in these circumstances should not be a surprise given that the company was one of the most shorted stocks on the main exchanges for a number of years before. Moreover, it is quite common for share prices to rise immediately after declaring bankruptcy, even independent of short covering, on the back of a phenomenon called violation of APR (absolute priority rule) which occurs “when creditors are not fully satisfied before shareholders get any payments”.

There are two main reasons to do that.  One is rational: there is value in buying cheap and deep out of the money call options on a company’s assets, operations, brand, etc. (some of them, some of the time, will pay off handsomely). There are examples of companies exiting bankruptcy with the original shareholders having gained from owning the shares from the day bankruptcy was officially announced.

The second reason is irrational. There is a massive non-linearity in the return: you get either zero or a lot. And who doesn’t like a cheap lottery ticket! The average price of bankrupt company shares is actually around $2 (yes, Hertz is well within that price range at the moment) in the month immediately post-bankruptcy, which to a lot of retail investors, looks, yes, irrationally, cheap.

The human propensity to gamble seems to be able, at least partially, to explain why stocks of bankrupt firms continue to be actively traded by retail investor even after the formal announcement of bankruptcy.”

But don’t be deluded. There is only an ‘illusory profit opportunity’. The average return on holding the shares of bankrupt companies into the actual process of restructuring is a negative 28%. Limited possibility of short selling and not enough company disclosure, contributes to share prices reflecting a more optimistic scenario than actual reality and being much higher initially than, perhaps, ‘fundamental value’. That is why, there is a persistence of negative returns from a buy-and-hold strategy in bankrupt company shares: at the end of the bankruptcy proceedings, the true value of the stock is revealed. That does not mean though that buyers can not make money buying and selling the stock while still in the Pink Sheets.

Trading in the stocks of bankrupt companies whether immediately post-bankruptcy, as with Hertz, or in the Pink Sheets, is much more ‘suitable’ for retail investors, who, unlike institutional investors are more prone to overvalue risky assets and to prefer lottery-like payoffs. The current stock market activity, in general, was dominated by retail investors even before Hertz to an extent last observed probably during the dotcom boom. So, perhaps we are focusing too much on this phenomenon, and, in the process, exaggerating the effect retail investors have on the market, away from what that normally is.

Liquidity down, equities up, Fed around the corner

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Repo volumes are rising in a similar fashion to the beginning of the crisis in February. Liquidity is leaving the system. Last two days, repos (O/N and term) rose above $100Bn. S&P500 topped on February 19 while repo volumes were about half of what we are seeing today. By the time we hit $100Bn in repos (March 3), the index had dropped 10%.

We had about two weeks (March 3-March 22) of repos printing about $128Bn on average per day. S&P 500 bottomed on March 23 as the Fed started stepping in with its various programs. Repos went down below $50Bn on average a day. More importantly liquidity started flooding the system. Reverse repos skyrocketed from $5bn on average per day to $143Bn a day by mid-April! Equities rallied in due course.

April/May, things went back to normal: repo volumes between $0Bn and $50Bn a day and reverse repos averaging about $2-3Bn a day->Goldilocks: liquidity was just about fine. Equities were doing well. Then in the first week of June, repos jumped above $50Bn, and last Friday and today they went above $100Bn. Reverse repos are firmly at $0Bn: they have literally been $0Bn for the last 4 days.

Again, just like in February, liquidity is starting to get drained from the system. By that level of repo volumes in March, equities were already 10% lower from peak. S&P500 is just a couple % below that previous peak, but Nasdaq is above!

I am not sure why the market is here. It could be that, in a perfect Pavlovian way, investors are giving the benefit of the doubt to the Fed that it will announce an increase of its asset purchasing program at this week’s FOMC meeting. If it doesn’t, US equities are a sell.

And don’t be fooled by no YCC or any forward guidance. The Fed needs to step in the UST market big way. YCC on 2-3 year will do nothing. Fed needs to do YCC on at least up to 10yr. As to really address the liquidity leaving the system, Fed needs to at least double its weekly UST purchases.

Fed is facing a dilemma…actually a trilemma

Fed is now probably considering which is worse: a UST flash crash or a risky asset flash crash. Or both if they play their hand wrong.

Looking at the dynamics of the changes in the weekly Fed balance sheet, latest one released last night, a few things spring up which are concerning.

1.The rise in repos for a second week in a row – a very similar development to the March rise in repos (when UST10yr flashed crashed). The Fed’s buying of Treasuries is not enough to cope with the supply hitting the market, which means the private sector needs to pitch in more and more in the buying of USTs (which leads to repos up).

This also ties up with the extraordinarily rise in TGA (US Treasury stock-piling cash). But the build-up there to $1.4Tn is massive: US Treasury has almost double the cash it had planned to have as end of June! Bottom line is that the Fed/UST are ‘worried’ about the proper functioning of the UST market. Next week’s FOMC meeting is super important to gauge Fed’s sensitivity to this development

2.Net-net liquidity has been drained out of the system in the last two weeks despite the massive rise in the Fed balance sheet (because of the bigger rise in TGA). It is strange the Fed did not add to the CP facility this week and bought only $1Bn of corporate bonds ($33Bn the week before, the bulk of the purchases) – why?

Fed’s balance sheet has gone up by $3tn since the beginning of the Covid crisis, but only about half of that has gone in the banking system to improve liquidity. The other half has gone straight to the US Treasury, in its TGA account. That 50% liquidity drain was very similar throughout the Fed’s liquidity injection between Sept’19-Dec’19. And it was very much unlike QE 1,2,3, in which almost 90% of Fed liquidity went into the banking system. See here.  Very different dynamics.

Bottom line is that the market is ‘mis-pricing’ equity risk, just like it did at the end of 2019, because it assumes the Fed is creating more liquidity than in practice, and in fact, financial conditions may already be tightening.  This is independent of developments affecting equities on the back of the Covid crisis. But on top of that, the market is also mis-pricing UST risk because the internals of the UST market are deteriorating. This is on the back of all the supply hitting the market as a result of the Treasury programs for Covid assistance.

The US private sector is too busy buying risky assets at the expense of UST. Fed might think about addressing that ‘imbalance’ unless it wants to see another flash crash in UST. So, are we facing a flash crash in either risky assets or UST?

Ironically, but logically, the precariousness of the UST market should have a higher weight in the decision-making progress of the Fed/US Treasury than risky markets, especially as the latter are trading at ATH. The Fed can ‘afford’ a stumble/tumble in risky assets just to get through the supply in UST that is about to hit the market and before the US elections to please the Treasury. Simple game theory suggest they should actually ‘encourage’ an equity market correction, here and now. Perhaps that is why they did not buy any CP/credit this week?

The Fed is on a treadmill and the speed button has been ratcheted higher and higher, so the Fed cannot keep up. It’s a dilemma (UST supply vs risky assets) which they cannot easily resolve because now they are buying both. They could YCC but then they are risking the USD if foreigners decide to bail out of US assets. So, it becomes a trilemma. But that is another story.

The Fed needs to make a decision soon.

Mirror, mirror on the wall, who is the wealthiest of them all?

When we talk about the European Union, we often lament that there are no fiscal transfers from the ‘rich countries of the North’ to the ‘poor countries of the South’, assuming that indeed this is so. But is this really so, and how have things changed since the inception of the EUR?

To measure wealth across countries, economists normally use GDP per capita. This is how some of the major EU countries rank according to this measure.


AT=Austria, BL=Belgium, FN=Finland, FR=France, GE=Germany, GR=Greece, IR=Ireland, IT=Italy, NL=Netherlands, PO=Portugal, SP=Spain

More or less, as expected, the bottom is taken by the four Mediterranean countries, while the north and core are at the top. However, GDP is a flow variable, measuring how much economic activity was created during a specific year. It tells us nothing about pre-existing wealth or, in fact, current debts.

A much better measure to use for that purpose, would be CSFB data for net wealth per adult. CSFB publishes two sets of data: mean and median net wealth per adult. Here is the data for the same set of countries as above.

The two data sets give a slightly different view. Looking at the mean net wealth, the bottom three countries in 2000, Finland, Greece and Portugal, are still the bottom three countries in 2019, though in slightly different order. The Netherlands was the wealthiest country in both 2000 and 2019. However, the top three in 2000 was also comprised by Italy and Belgium, while in 2019, they were replaced by France and Austria.

According to median net wealth, however, two things stand out. First, the Netherlands was top three in 2000 but last in 2019 (the data for the Netherlands does look strange; the median net wealth collapses after 2011; I wonder if it is a question of CSFB changing something in their model). Second, Italy was top in 2000 but right in the middle of the rankings in 2019.

The other striking takeaway is that whether we look at mean or median net wealth, Germany is not that rich at all: it is much closer to the bottom of both sets of data. What about the North vs South divide? Portugal and Greece do seem poor but Span and Italy are more often seen in the top half of the rankings than in the bottom.

Part of the confusion when it comes to classification between the ‘rich’ North and the ‘poor’ South comes from looking only at the asset side of household balance sheets. Using BIS data for household debt and World Bank population statistics we can also calculate household debt per capita for each of these countries. This is the ranking according to this measure (the lower debt per capita the better).

The Mediterranean countries are better off than the core and the north as they have much less household debt per capita. This might be almost counterintuitive: the more assets one has, the more liabilities, they might also have.

We can also cross check the CSFB data above by combining the GDP per capita and the household debt per capita data to arrive at an approximation of a net wealth per capita. As discussed, we have to bear in mind that GDP is a flow variable, while debt is a stock variable, so we are not comparing exactly apples to apples. Here is the ranking according to the difference between GDP and Debt per capita.

The Netherlands is bottom just like in the median net wealth data from CSFB. Portugal and Greece bring up the rear which is also consistent with previous findings. The top three are slightly different. Ireland is top here and was second in the median net wealth data from CSFB. But here Germany is third while it was more towards the bottom in the previous case.

And here is the ranking according to ratio of household debt to GDP to capita ratio.

The Netherlands is bottom again, with Portugal and Finland bringing up the rear, so, similar to the CSFB data. The top is a bit more mixed but Ireland still figures in both sets of data.

Bottom line is that there is a much less clear differentiation between the North and the South when it comes to net wealth per adult/capita than what we tend to assume.

How have some of the other major countries fared?

Mean wealth (top table below) in the US is almost twice as big as the average mean wealth of these European countries, but median US wealth (bottom table) is less than that respective average. Japan’s median wealth has barely risen from 2000 (at least compared to any of the other countries shown here) but it is almost twice as big as US’. The median Brit is richer than the average median European but only marginally so compared to the Spanish or Italian. Finally, despite its phenomenal growth since 2000, China is still twice less rich that Greece, which is the ‘poorest’ of the European countries above.