The $8.9 trillion blip on our 711 year journey to zero rates
Image: AV Photography Edward
More than seven hundred years ago and well before the U.S. was a thing, the Bank of England recorded interest rates in the vicinity of 35%.
Today, the world’s reserve currency (the USD) has a cost (official interest rate) of 0.25% to 0.50% and up until 16 March 2022 it was 0.00%.
During that period there have been many mini cycles of inflation and disinflation, however each time the cycle ended with deflation - with demographics, technology, exigent money creation, wars and debt refinancing ripples being responsible for a lot of it.
Having potentially started another mini ‘up’ cycle in March 2022, the U.S. Federal Reserve (Fed) is set to raise the cost of money again and withdraw liquidity from credit markets, in an attempt to cool the economy and kill off inflation.
But it’s important to note that the length and amplitude of this rate rise cycle will depend on how long it takes for inflation to fade and for peace to return to Europe.
Bond and share prices have been reacting for some time now with secondary market yields increasing in anticipation of quantitative tightening (QT) and a recession that might have to occur if the inflation bogey remains President Biden’s number one objective.
But sitting here today after last night’s U.S. inflation print for March of 8.5% and expectations for a 0.5% rate hike, I wanted to suggest why yields have not already risen (and equities have not fallen) to levels that would counteract that level of inflation.
And that is that cyclical inflation always fades (yup, transitory) as the 711 year secular trend of lowering interest rates and money debasement continues to chug along.
If you’re onboard with that and looking beyond this year, it probably has implications for how you might wish to grow/fund your business, and protect your personal portfolios.
So, as we zoom out and ignore main stream press warnings, here are some big picture ramblings from yours truly for your consideration.
Back in the days of gold florins and alum
Back in the day, and I’m talking the 1300s, history tells us that King Edward III borrowed a large amount of Florins from Simon van Halen and others, at an interest rate of 35%.
We are told his motivation was to refinance loans he took from the Florentine Peruzzi family (600,000 gold florins) and the Bardi family (900,000 gold florins) to finance his Hundred Years War - these were at rates of up to 40%!
Notably, the Bardi’s married into the Medici family and the Medici Bank not only ruled Florence on and off (mainly on) for another 400 years, but it influenced the cost of money in Europe and the rest of the world for centuries.
But ever since the time when interest rates were first recorded by the Bank of England, the cost of money has been in long term decline, and for the last couple of years it’s been hovering around 0%.
Here’s a truly funky chart which tracks the suprasecular cost of money over the 708 years ending in 2018, thanks to the Bank or England.
Page 13, Staff Working Paper No. 845: Eight centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311–2018, Paul Schmelzing, January 2020
The chart shows a number of fascinating things. But mostly, it tells us that money has effectively been debased to zero as evidenced by interest rates declining at an annual real rate trend of -1.96 basis points each year.
You can easily see it’s not been a straight line down. On occasions it’s taken 60 to 70 years for a cycle to complete and the amplitudes vary widely.
But overall, the 700 plus year trend has been one of deflation.
Today, cyclical inflation has lit a fire under the ‘changing narrative’ narrative. With the Fed guiding markets with impending rate hikes and balance sheet lap band surgery, the length of this wave will be dictated by how long it takes for the current inflationary forces to fade.
Why? Because that’s how it’s worked for over 700 years.
6 months more, or 2 years, or more? No one really knows.
But first, let’s see where we are today in terms of liquidity in the market and the cost of that liquidity.
$8.9 trillion @ 0.50%
The chart below shows total assets held by the U.S. Federal Reserve as of 6 April 2022.
That wasn’t the peak though - the peak (for now) occurred on Wednesday 23 March 2022 at a level of $8,962,424,000,000, just under $9 trillion.
That’s a number for posterity, but let’s not be too quick to file it away because we might return to and surpass that level in the months and years ahead.
And if not, and if that really was the peak, we need to keep an eye on fiscal transfer payments that may become a substitute for more QE. Time will tell.
The shaded areas in chronological order represent the GFC and COVID shocks.
The chart also shows what the balance sheet looked like before Fed Chair Bernanke’s liquidity injection to smooth over the GFC.
And you can clearly see that pre-2008, the balance sheet was less than $1 trillion, and in 2008 the federal funds rate was 5.25%.
Money still had a cost/worth back then. The capital asset pricing model worked without having to normalise the risk free rate. Earnings multiples were reasonable.
But as you can see the balance sheet swelled again all the way until the 2017-2019 run-off.
In summary, the injections of liquidity since the GFC added too much liquidity, leading to corporate buy-backs and massive increases in almost all financial asset prices. Zero cost of capital buy-backs reduced shares on issue (Apple, Berkshire and others) and investors sought yield and other alternatives further along the risk curve. Crypto and NFTs mooned.
Inflation jumped into assets, once again.
Back in July 2020, when asset prices were mooning, I wrote the following:
“Of course that can’t last, but for the moment, inflation has jumped to assets. When it will jump (or slingshot) back to consumer prices remains an unanswered question.” Mike
Well, we now have the answer.
In less than two years:
(Demand mooned) Irresponsibly large liquidity led to massive balance sheets (wealth effect) bidding up demand for commodities, inputs, materials and finished goods right across the value chain.
(Supply cratered) COVID lockdown policies and industrial capacity underinvestment curtailed supply only to be exacerbated by the effects of Russia’s attack on Ukraine on oil, gas, potash, crops and other commodity supplies as well as the effects of retaliatory sanctions.
The net result has been inflation jumping out of assets and back into consumer prices.
And at the same time, more than ample liquidity was poured into the credit system while massive stimmy/helicopter money was dropped down chimneys with a direct impact on asset speculation (asset inflation) and consumption (the warm up for today’s cyclical inflation).
COVID was the catalyst for all of this largesse.
Pent-up demand and restricted supply from lockdowns came gushing out of the gate.
And now that all of the above has created a cyclical inflation slingshot, the Fed has set out a plan to lift rates from the new level set in March of 0.50%, and shrink the balance sheet from $8.9 trillion to who knows where, if it can.
Let’s have a look at the experience the last time the Fed attempted QT, under Powell.
September 20, 2017 was the last time the Fed got excited about a balance sheet lap band
To try and get the then Rohypnol infused financial Lollapalooza under control back in the 2017-2019 period, the U.S. Fed attempted to run down its balance sheet.
It started for all of the right reasons (if not a little too late) under Fed Chair Janet Yellen. And here’s what I wrote on that topic on September 25, 2017:
“September 20, 2017 was a big day for the US Federal Reserve.
By now you will have noted that the Fed has finally signalled the beginning of quantitative tightening (QT).
While choosing to leave interest rates at bay for the moment, FOMC signalled the start (effective in October) of its much anticipated balance sheet normalisation.
Specifically, FOMC authorised and directed the Open Market Desk to:
undertake open market operations in order to maintain the federal funds rate at 1%-1.25% (i.e., no interest rate rise for the moment);
commence balance sheet normalisation in October by rolling over in auction maturing treasury securities/agency debt and mortgage-backed securities;
run-off reinvestment in those asset classes by reinvesting in securities in excess of adjustable redemption caps, namely $6 billion per month for treasuries/$4 billion per month for agency and mortgage-backed securities; and
step up those redemption caps (i.e., reinvest less, run-off more) by $6 billion/$4 billion every 3 months for a 12 month period (which seems to mean 4 step-ups for each class) until a target level of $50 billion per month in aggregate redemptions (split $30 billion/$20 billion) is reached.
This plan had been signalled some years ago (although it includes a few tweaks) but judging by US equity markets some 5 days thereafter, its timing had not been fully factored in.
No 'end date' or run-off aggregate has been stipulated, however based on the plan it will take a couple of years to run-off the first ~$1 trillion.” Mike
Effectively, the balance sheet run-off was put on auto-pilot.
But it was not to last.
Enter Donald Trump, exit Chair Yellen (now Treasurer Yellen) and enter Trump’s Fed Chair nominee, Jay Powell.
Incidentally, Fed Chair Powell is currently Chair ‘for the time being’ while Washington gets its act together to confirm his next reign. That means QT may start without a formally confirmed Fed Chair.
That said, after his first term confirmation, Jay Powell became Fed Chair Powell and continued the Yellen balance sheet run-off, and he even started a paltry interest rate hike program.
But Trump was not going to have it and neither was the market.
On January 30 2019, the market chucked a tantrum, Powell pivoted (backflipped) and interest rate hikes were put on pause and the balance sheet run-off was taken off auto-pilot and put in reverse.
After the 2017-2019 attempt, the balance sheet grew to it’s largest ever and the federal funds rate returned to zero-0.25%, as a result of COVID.
I imagine Janet Yellen was none too impressed given it was Yellen who warned markets about the punchbowl being left out too long, saying that rates had to go up to provide additional headroom in the event of another crisis.
Yellen was right. A few years later COVID hit and all the Fed to play with was a percentage point. That’s why Powell had to throw the balance sheet at it.
But when Russia invaded Ukraine the proverbial really hit the fan because it exacerbated the supply side destruction already caused by COVID.
Surely you’d have to think that Russia had been planning this for some time and timed it to inflict the most damage possible?
However, the point is that the 2017-2019 normalisation was attempted when the balance sheet was less than half the size it is today and when interest rates were more than twice as high as they are now (albeit, even way too low back then).
It failed. And yet this program is bigger, quicker and later along the deflationary curve.
Once more unto the breach, dear friends, once more
The 2017-2019 program was killed for political reasons (hint: the Fed is not independent and Trump was on Powell’s back the whole time).
Today’s new attempt was started for political reasons (hint: Biden wants to keep his Presidency and wants inflation under control and Powell wants to keep his job).
Below is the 2022-[unknown] $8.9 trillion balance sheet shrinkage plan, direct from last month’s minutes:
In their discussion, all participants agreed that elevated inflation and tight labor market conditions warranted commencement of balance sheet runoff at a coming meeting, with a faster pace of decline in securities holdings than over the 2017–19 period.
Participants reaffirmed that the Federal Reserve’s securities holdings should be reduced over time in a predictable manner primarily by adjusting the amounts reinvested of principal payments received from securities held in the SOMA.
Principal payments received from securities held in the SOMA would be reinvested to the extent they exceeded monthly caps. Several participants remarked that they would be comfortable with relatively high monthly caps or no caps. Some other participants noted that monthly caps for Treasury securities should take into consideration potential risks to market functioning.
Participants generally agreed that monthly caps of about $60 billion for Treasury securities and about $35 billion for agency MBS would likely be appropriate. Participants also generally agreed that the caps could be phased in over a period of three months or modestly longer if market conditions warrant.
Source: Federal Reserve Open Market Committee Meeting Minutes, March 15-16, 2022.
Will it start and stop after a few months, or will it continue until Powell’s Fed breaks a market or two and either the Fed (QE) or the Treasury (stimmys/transfer payments) or both, have to step in?
No one knows, but with over seven centuries of evidence one thing is certain, high interest rates, if they happen won’t last.
Putting Powell in a proper seven centuries context
Powell’s plan is for $95 billion of liquidity to be withdrawn from the credit markets every month for however long QT is in place. That’s a starting level that’s nearly double the finishing level of the 2017-2019 attempt.
And for interest rates, the plan is to increase presumably up to the latest Fed dot plot levels which appear to be around 1.8% for 2022 and 2.8% for 2023.
It’s an ambitious plan and may appear scary to some given not even $1 trillion of was wiped off the balance sheet before the end of the 2017-2019 run-off.
But as a lagging actor the Fed is starting from way way behind the curve and needs to catch up and prove to markets that it’s serious.
And yet, bond markets so far have not demanded sufficient return to compensate for 8.5% inflation, as that would require short end of the curve bond yields to be bid up to ~9% - back up the truck, right?
No, yields are still relatively low and that suggests that so far the bond market believes inflation will be brought under control, and let’s not forget that most of the work done by the Fed is actually talk/guidance and not necessarily massive action unless there is an emergency.
The U.S. may need higher interest rates, less liquidity and a recession to destroy a sufficient amount of demand to tame 8.5% inflation (or more if soft and hard commodities remain in short supply), but the length and extent of this up cycle in official interest rates will depend on how long it takes for inflation to fade and for peace to return to Europe.
And once that happens, we will continue to follow the downward sloping deflationary line which has been trending south for over seven centuries of pandemics, wars and good times.
Mike
Next Level Corporate Advisory is a leading M&A and capital markets advisor with a 20 year track record of delivering the highest quality of independent financial advice as well as strategic transactions to help clients level-up.
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