Asset prices rise when there is more money in the system, but you have to understand what ‘money’ is. M1/M2 is not a good measure as it is heavily influenced by Fed policy, which changes the composition of money rather than the overall quantity (see here for a walkthrough). The vast majority of money we come in contact with are bank deposits (the numbers in your bank account). Bank deposits are created by commercial banks when they either make loans or purchase assets. For the institutional investor, Treasuries are money – risk free, highly liquid, and fairly stable in value. Big money cannot just deposit billions at a bank and take unsecured credit risk. Treasuries are created when the Federal Government (“FedGov”) spends more than it receives in taxes. In essence, FedGov has a money printer and pays for its spending by printing Treasuries (see here). In this post, I briefly recap the moneyness of Treasuries, introduce a real time measure of FedGov printing, and explore asset price implications of the recent surge in spending.
Treasuries are Money
Money is conventionally thought of as a risk free, highly liquid asset with a stable value. Treasuries do not have credit risk (obviously) and can easily be pledged as collateral to buy other assets, or converted to bank deposits for real economy purchases. Treasury market liquidity is supported by a deep cash market of $500b in daily volumes, overnight repo volumes of $900b, and a strong commitment by the Fed.
Recall, last March when the Treasury market became illiquid, the Fed purchased around $1 trillion of Treasuries in just a month and continues to purchase $240b a month. To support the repo market, the Fed established what is essentially an unlimited standing repo facility that is ready to lend against Treasury collateral at IOR + 5bps every afternoon. Treasury market liquidity is fully backstopped by the Fed.
Yield Curve Control Is The Final Piece
Many will note that Treasuries, especially longer dated Treasuries, come with duration risk. This would be painfully obvious to any bond fund manager nursing the mark to market losses from last week. Short-dated Treasuries may well be cash as their value doesn’t fluctuate, but that is not completely true for longer dated Treasuries. Not yet.
Imagine a world where the Fed puts a floor on the price for longer dated Treasuries, just like how the value of a $100 bill is floored at $100. That is yield curve control. At that time, Treasuries will be risk free, liquid, and with a very stable market value throughout the curve. They will be like the 10-year JGB shown below, or, like a $100 bill.
The first QEs were a bold experiment in an era when free market forces were accorded great respect. The Fed would put downward pressure on rates by buying Treasuries, but let the markets play a role as well. Today the policy world is more comfortable with a command economy style management. The BOJ and RBA have shown that YCC works well. Fed discussion of YCC heated up pre-COVID, disappeared when rates plunged, and may re-appear when rates march higher.
YCC is also not just about rate control. The operational simplicity of a YCC framework is becoming more salient as the side effects of forever QE – ever increasing reserve balances – become more apparent. Some banks are running up against SLR constraints, potentially leading to negative deposit rates. A YCC framework would require de minimum QE purchases, as no one would fight the Fed.
The “moneyness” of Treasuries is already very high, but YCC would perfect it.
Equity Injections Trump the Wealth Effect
The goal of QE is to lower interest rates, with the increase in reserve assets/deposit liabilities in the banking system largely incidental. As astute market participants have understood, Treasuries appreciate in value when the rates are lowered, essentially increasing the amount of money in the system. This money can then be pledged to buy equities or sold to buy bigger yachts. The impact of the appreciation can be large when rates are cut from a high level, but diminish as we bump along zero.
The printing of Treasuries is a whole other story. Whereas Fed actions indirectly increase money by raising the value of Treasuries, FedGov deficit spending directly injects money into the system. Government contractors, lobbyists, defense companies, drug companies etc are essentially receiving newly minted money. Equity in the financial system as a whole continues to increase despite the diminishing impact of lower rates, which means households can continue to lever up and party on. All asset prices rise (as they have been).
[Technically, an investor swaps bank deposits for Treasuries, and then the FedGov. spends those bank deposits back into the banking system. At the end of the day the level of bank deposits is unchanged while there are more Treasuries, which can also be spent. Essentially, the FedGov minted new Treasuries to pay for its spending, as if it printed dollars bills.]
The BRIX Says the Market is Going Higher
Back during the Financial Crisis the level of money in the system was set to decline as households were paying down debt (extinguishing bank deposits), and banks were unwilling to create new loans. Prominent economists argued that the government should temporarily step in and spend to boost the economy as everyone else retrenched. The chart below shows commercial banks essentially halting credit creation after 2008 for a few years, and the FedGov stepping in with its money printer. While commercial bank credit creation recovered, the FedGov did not step back, but accelerated (by a lot).
Many market participants perceive a connection between the Fed’s balance sheet and the equity market, where a growing Fed balance sheet causes higher equity prices. I suggest that is not the most important balance sheet to follow. Fed balance size is incidental to its goal of influencing interest rates. It is not the size of the Fed balance sheet that matters, but it’s impact on rates, which raises asset prices. That impact diminishes when rates are already low and trending higher.
A real money printer is one that can outright increase the quantity of money in the financial system. It is a printer that prints money and spends it on goods and services. If you understand that Treasuries are money, then that is what the FedGov is doing.
The BRRR Index (“BRIX”) is an self-updating daily index of deficit financed spending based on the Treasury Daily Statement. (It is comparable to growth in marketable Treasuries, but improves in that Treasury issuance to fund the TGA is excluded. That effect was over $1t last year). The series begins in October 2005, and shows the explosive growth of growth of printing along with the meteoric rise in the S&P 500. The BRIX has the benefit of being much more predictable than the stock market – it’s going to leap up in the coming weeks with the passing of even more stimulus.
Wise men will scratch their beards and say ‘it’s never different,’ and they would be completely correct. But one must know which scenario we are in – is it a late 90s style boom to be followed by a bust, or is it more emerging market style, where booms are followed by bigger booms (with some notable side effects)?