(Part 2 of a part 3 series. Click here for part 1)
Many forecasters expected Chairman Bernanke to announce some sort of QE3 at August’s Jackson Holeconference, but were unclear what it would entail or how it would help. Would adding another $500 billion in excess reserves to the current $1.6 trillion do any more to induce lending and borrowing? In any event, at that conference, Bernanke proposed no new measures, but said that the Fed still has “a range of tools that could be used.”
The Fed Chairman seems to be admitting that the Fed is out of bailout buckets with federal funds now at zero and quantitative easing anything but a raging success. It’s also true that except for bailouts of specific banks, monetary policy is very unspecific. Cutting interest rates may or may not encourage borrowing and investing, but it’s up to the lenders and creditworthy borrowers to decide where any loans get spent. QE2 temporarily helped the upper tier holders of stocks and commodities, but hurt the lower tier at which it probably was aimed by pushing up grocery and gasoline prices, as noted earlier. In contrast, fiscal policy measures can be quite precise. Helping the unemployed by extending jobless benefits does put money in their specific pockets.
These zero interest rates create problems for the central bank itself. Reaching the zero federal funds rate forced the central bank into the quantitative easing business with unexpected poor results. This and earlier non-interest rate actions also pushed the Fed uncomfortably close to fiscal policy, which threatened its independence at this is the domain of the president and Congress.
This zero federal funds target also led to the strange negative return on 1 month Treasury bills on August 4 during the stampede for liquidity. Investors were paying the Treasury to lend it their money! A zero federal funds rate leaves the Fed no room to cut it when the next recession looms.
Many observers believe that low, zero short-term rates have forced investors into longer term Treasuries, which has pushed yields down and prices up.
U.S.banks are paying almost nothing for deposits, which continue to rise in a mad stampede for safety and liquidity. 2.5% Since December 2007, domestic deposits have leaped $1.1 trillion to $8.1 trillion. The Bank of New York Mellon last month began charging a fee for corporate cash deposits of over $50 billion, and others may be contemplating similar moves. The reason is that even cheap deposits which on average pay 0.79% aren’t profitable to banks unless they can be lent at margins big enough to cover costs. And that’s increasingly difficult as the yield curve flattens.
The squeeze on bank interest rate margins couldn’t come at a worse time for banks. With the sluggish economy, total loan demand has been subdued. That weakness is across the board, including commercial and industrial loans to business and consumer credit card borrowing. And with another recession in prospect, loan demand is destined to fall considerably.
Bank yields on assets are in a distinctly downward trend, which will no doubt persist as the Fed continues to keep short rates at zero for two more years and as the likely recession unfolds. No wonder that all of the six largest U.S. bank stocks recently traded at less than their net worth.
U.S.banks also have considerable exposure to the sovereign dent troubles in Europe. Of their global total exposure, 26% is in the Eurozone and it’s 45% if the U.K.is included. European banks, of course, are in worse shape due to their heavy ownership of the sovereign debt of Eurozone countries.
The zero federal funds rate measures the Fed’s reaction to persistent economic weakness and financial woes here and abroad. These same realities resulted in the seemingly surprise reaction in Treasury bonds when S&P cut its rating on government obligations. This anticipated announcement was expected by many to result in a collapse in bond prices as Americans and foreigners abandoned tarnished Treasuries.
Instead, when trading opened treasuries continued in the same direction – up. That day, 1-month and 3-month Treasury bills yielded a mere 0.02%. Why? The downgrades enhanced the global rush for safety and liquidity that had already started in reaction to the European sovereign debt crisis and slowing global economic growth. On the same day the Dow Jones Industrial Average fell 5.5%, the biggest drop since December 2008. All 30 Dow stocks fell and all 500 stocks in the S&P 500 Index suffered losses and corporate bonds and commodities were dumped.
Follow-on downgrades of government-controlled Fannie Mae and Freddie Mac as well as five triple-A insurers that tend to have sizable Treasury holdings also enhanced the stampede to Treasuries and other safe havens. The $2.9 billion loss for Fannie on home mortgages in the second quarter, up from $1.2 billion a year earlier, and its request for $2.8 billion more in government bailout money didn’t help either.
Without doubt, there is a huge global crisis of confidence at present. It essentially results from the realization that governments, through their monetary and fiscal policies, have no magic bullets they can fire to return the economy to the 1980s-1990s salad days of rapid growth and soaring stocks.
This is The Age of Deleveraging, and all the government efforts to date pale in relation to the deleveraging in the private sector.
Since early 2006, U.S.federal plus state and local debt has jumped from around 3% of GDP to 9.6% in the first quarter, or about a seven percentage point rise. But during the same time, the private sector delivered from about 16% borrowing-to-GDP to -0.5%, a 16 percentage point drop. So all the government deficits that lay behind that borrowing and the fiscal stimulus they represent offset less than half the deleveraging of the private sector.
A key reason why monetary and fiscal policymakers are out of ammo is because of the questionable effects of earlier efforts. Quantitative easing by the Fed piled up $1.6 trillion in excess bank reserves that lie idle while pushing up grocery and gasoline prices for lower-tier consumers, the very people the Fed aimed to help. Fiscal stimuli added over $1 trillion to federal deficits and debt, spawning such a public and political outcry that further massive programs are off Washington’s table.
In Europe, it’s becoming clear that the Eurozone either breaks up or moves toward more unity with more bailouts. Combining the Teutonic North with the Club Med South under a common currency with no central fiscal control or prospect of it has inherent weaknesses. The current hope is to that they create a Eurobond to finance sovereign debts for which the Eurozone as a whole will be responsible.
But that would require central control over national tax and spending policies, a difficult change for all countries to agree to. It also means that the strong countries, led by a reluctant Germany, would continually subsidize the Club Med set. At present, the Eurozone fiscal deficit as a whole is about 4.4% of GDP, not that bad since it’s held down by the north’s fiscal discipline, and debt-to-GDP is around 87%.
So the Eurozone as a whole would be a strong borrower. But how much more debt could be piled on the underlying backs of Germany, the Netherlands, Finlandand other strong economies before Eurobonds become junk? Furthermore, eurozone economies are slipping toward recession, as evidenced by the nosedives in consumer and business confidence.
The reality is that governments, which escalated their monetary and fiscal leverage to bail out financial markets and other private sectors, are now being forced to join those private economic units in deleveraging. Attempts to hold back the tide, such as the limits on selling stocks short in France, Italy, Spain and Belgium, are ineffective attempts to blame market weakness on rumor mongers or the speculation of traders.
This is not to say that all the earlier monetary and fiscal stimuli here and abroad was in vain, even though it didn’t offset the massive private sector deleveraging and return economies and finance markets to health. The basic data shows that from the beginning of the recession in December 2007 through July 2011, disposable (after-tax) personal income rose $960 billion, $705 billion from increases in government transfers and tax reductions. From the $960 billion, 31% was saved, much more than the current average saving rate of 5%, but 78% was spent. With the global crisis of confidence has come a universal dash for cash.
Greek banks on the other hand are being stressed by massive withdrawals and a move towards safe deposit boxes and storing valuables under mattresses. One unlucky saver stashed cash in a brick wall but rats ate it. The joke is he may have not lost that much after debasing the currency. About half of these withdrawals fled the country.
The Greek bank withdrawals have led to a bank liquidity shortage and even more reliance from the ECB for funding. Furthermore, Greek banks have heavy exposure to Greek government bonds, now rated junk, so they’re frozen out of the interbank lending market. Piraeus Bank recently announced a €1 billion write down of its bond holdings. The ongoing banking crisis was key to the recent decision of EFG Eurobank Ergasias and Alpha Bank, Greece’s second and third largest banks, to merge into the nation’s largest. The joke here is this is like two drunks leaning on each other in an attempt to keep each other standing.
Trade with a plan