A Review of our Liquidity Indicators
(January 30, 2009)
Dear Subscribers and Readers,
As promised, here is a review of our most closely-watched liquidity indicators. I want to start with a review of the US – and then end it with a comment on Chinese liquidity. In this weekend commentary, I will provide a more thorough review of what I see happening around the world as we move forward into 2009. With the Fed's statement on Wednesday, the Fed has indicated that it stands ready to ease conditions further by continuing to purchase agency debt, agency mortgage-backed securities, and to start purchasing long-term Treasuries. Interestingly, US Treasuries sold off on the news, as many investors and traders had assumed that the Fed was purchasing US Treasuries already. My sense is that purchasing long-term Treasuries is not the highest priority of the Federal Reserve, and that it will most probably only buy US Treasuries should long-term Treasury rates spike up. For now, it makes much more sense of the Federal Reserve to continue to support the financial markets by purchasing agency debt, agency MBS, or other “riskier” securities.
Indeed, the Fed has purchased over $69.4 billion of agency mortgage-backed securities since the beginning of this year, with $16.8 billion of that coming in the last week, as shown below (courtesy of the NY Fed's Open Market Operations Desk):
Despite these purchases, the size of the Fed's balance sheet has actually shrunk by about $200 billion since the beginning of this year, after spiking by over $1.3 trillion in the aftermath of the Lehman Brothers' bankruptcy to its peak at the end of last year:
This is mostly due to the recent declines in loans to depository institutions and support to money market funds holding asset-backed commercial paper. While the asset-backed securities market is far from “business as usual,” the run from non-Treasury money market funds that followed the Lehman bankruptcy has already run its course. Because of this, it is no surprise to see the Fed winding down this facility. Moreover, as banks obtain funding from the TARP and as the Fed Funds/LIBOR market eased further, it also made sense of the Fed to wind down its loans to depository institutions.
Going forward, the Fed has maintained that it would “support the functioning of financial markets and stimulate the economy through open market operations and other measures that are likely to keep the size of the Federal Reserve's balance sheet at a high level.” As it continues to wind down its loans to depository institutions, I expect the Fed to step up its funding in the general commercial paper market, the agency debt and MBS market through the outright purchases of those securities, and at some point – the purchase of long-term US Treasuries and US TIPS (the latter of which may coincide with the announcement of a formal inflation target). More importantly, the Fed's Term Asset-Backed Securities Loan Facility (TALF), which is the Fed's plan to improve liquidity in the asset-backed securities market (of up to $200 billion, which in essence would allow consumers to have more access to credit card, auto loan, and auto lease funding), will begin operating next month (although the exact start date has not been announced). For now, this is the most importance aspect of the Fed's plan to provide support to the US financial market and economy, as the TARP and the Treasury have already eased funding concerns in our banking system. Combined with the inevitable announcement (and implementation) of a Treasury-funded “bad bank aggregator” to remove toxic assets off the balance sheets of US banks, there is a good chance that the US financial market will start to function much better again come early Spring.
Indeed, it has become common for analysts and investors alike to opine that the current Fed policy is akin to “pushing on a string” – a term which generally refers to the Fed's powerlessness to staunch the deflationary pressures in our economy. This cannot be further from the truth. Indeed, such comments were made during 2002 and early 2003, as the global economy were still reeling from the deflationary effects of the Asian Crisis, the Russian Crisis, and the dot-com bust. A few years later, the same commentators were blaming the former Fed Chairman Alan Greenspan for running a monetary policy that has been too loose. My point is that the creation of liquidity and credit within the US economy is only bound by our political will, the Fed's willingness to employ unconventional tools such as the TALF, and ultimately, the productivity of our country and the country's true current account position. For now, both the administration and the Federal Reserve have made it clear that they intend to “reliquify” and to bail out the financial system and the economy to their utmost ability. After more than a year of cutting rates aggressively and employing every public-policy making tool (conventional or otherwise) under the sun, do you seriously believe they will now stop?
More encouragingly, the spike in the latest M-2 numbers (year-over-year percentage growth, as shown in the following chart) suggests that the Fed is indeed not “pushing on a string,” as M-2 growth should be much more depressed if the Fed's tools were not working:
Whether the TALF will be successful in reviving the asset-backed securities market will depend on how quickly the Obama administration's plan to recapitalize the banks once and for all is implemented. Absence the latter, the $200 billion TALF is nowhere to being big enough to reliquify the asset-backed securities market. From now till the end of the first quarter, I expect the Fed's balance sheet to revive its growth and to increases by at least $300 billion as it implements the TALF and continues its purchases of agency debt and agency mortgage-backed securities. If the Obama administration's “bad bank aggregator” plan is delayed, then I expect the Fed to start purchasing Treasuries and US TIPS, and to potentially increase the size of the TALF. This could easily the boost the size of the Fed's balance sheet by another $300 billion – taking it beyond $2.6 trillion by the Spring to early Summer period.
In the meantime, I continue to expect the Chinese government and the People's Bank of China to provide support to its economy to try to maintain an 8% growth rate towards the second half of this year. For now, I don't expect the Chinese government to do much – it certainly makes no sense from its steel industry's perspective to see a revival in the next couple of months as it seeks to lock in iron ore prices for 2009. Moreover, as shown in the following chart (courtesy of Goldman Sachs), Chinese loan growth has been quite robust in the last couple of months, suggesting that the Chinese economy is not falling off the cliff (Goldman's China “Financial Conditions Index” has also eased):
After the Chinese steel industry has locked in its iron ore supply prices (early April), I expect the Chinese government and the People's Bank of China to ease further. They certainly have a lot of room to do so – given China's budget surplus and its population's tremendous savings pool (and benign demographics and increasing productivity). For now, the “Black Swan” scenario is still within Europe – an issue which we will tackle in this weekend's commentary instead.
Henry To, CFA