There is a plumbing explanation for the conundrum of lower nominal yields and higher inflation. Many factors affect yields, but they are in part determined by who has money and the investment constraints they face. QE mechanically increases the investible “cash” of investors who are most inclined to buy bonds, and they have been buying bonds. In our two-tiered monetary system $1 of QE creates $2 of money – $1 of reserves (money for banks) and $1 of bank deposits (money for non-banks). On the reserves side, some banks have significantly changed their behavior and begun deploying their reserves into bonds. On the bank deposit side, the wealthy ended up with the bulk of the newly created bank deposits. The wealthy tend to spend their money on assets, and they appear to be rebalancing some of the deposits into bonds. In this post we show how low rates are pressuring banks into adding bonds to their growing regulatory liquidity portfolio, how the skewed ownership distribution of new bank deposits may be leading to more bond buying, and suggest that low yields may not be a reflection of economic conditions.
Bank Portfolio Rebalancing
Banks have not historically been large buyers of Treasuries and Agency MBS, but that is changing. Recall, Basel III regulations require big banks to hold large portfolios of High Quality Liquid Assets (“HQLA”) that have historically been largely comprised of reserves. HQLA eligible assets include include Treasuries, Treasury backed repo, reserves and Agency MBS (with a slight penalty for Fannie/Freddie MBS). When repo rates rose above the interest on reserves, banks massively shifted from reserves into repo for a little extra return. The willingness of banks to substitute between reserves and repo is one of the mechanisms through which QE inevitably pushes money market rates to the policy floor. But now at least some banks are also willing to substitute reserves for longer dated HQLA securities, extending the downward pressure to longer term rates.
QE mechanically increases the size of the banking sector and thus raises the required level of HQLA, while low returns on reserves prompts a shift into higher yielding securities. Bank of America alone has increased its holdings of HQLA securities by $400b over the past year while also decreasing their reserve holdings. Those reserves may end up at on the balance sheet of another bank, forcing them to also rebalance into securities. Note that not all big banks have been employing such a strategy, with JPM noting in their recent earnings call that they are waiting for higher yields before buying securities. If they behave like BoA the purchases could be a few hundred billion.
The Rich Savings Glut
The bulk of QE created bank deposits have ended up in the bank accounts of wealthy entities. The distribution of the money matters because the less wealthy tend to spend their money on goods and services (consumption), while the wealthy tend to spend their money on assets (savings). Historically, QE created bank deposits largely end up in the accounts of the wealthy (see this post). This time around a bit made it into the general public via stimulus payments, but the wealthy still increased their bank deposit holdings by around $3t. Note that this is a conservative number because bank leverage ratio constraints have forced some depositors to move their deposits to a money market fund (see this post).
Wealthy entities tend to buy assets, and any prudent allocation will have at least some allocation into bonds. Bond fund flow data show a surge of $400b in flows year to date, far above the pace of prior years. The combination of massive fiscal spending with massive QE essentially created trillions in free money that is being spent on everything. This puts upward pressure on all prices – cars, houses, stocks, and even bonds.
Priced to Desperation
Printing and spending trillions of dollars is obviously inflationary, but linking that with higher interest rates requires assumptions that are not true. A value investor can use a dividend discount model as a framework and input forecasted earnings to arrive at a valuation for TSLA stock (very overvalued), but it is very different to take price as an input into the model and back out “earnings expectations” (TSLA will take over the world). This is because investors use different investment frameworks that can vary significantly. An investor’s framework for TSLA may even not even have forecasted earnings as an input but instead rely on estimated dealer options positioning, or price momentum. It’s very hard to know what is in the price.
Bond investors also employ a wide range of investment frameworks where sizable investors (like the Fed and some foreign reserve managers) are not even trying to make money and other investors (like banks) are optimizing under stringent regulatory constraints. This is especially true for Treasuries, which are money like dollar assets that many classes of investors must own regardless of price. To be clear, there are also smart investors carefully studying and investing according to perceived economic fundamentals. What is not clear is the extent of their influence on market prices.
Bond prices reflect all these different investment frameworks, so backing out expectations for growth and inflation from yields can be misleading. QE as a first order effect lowers yields via direct purchases, but as a second order effect increases the buying power of bond investors who are less sensitive to economic fundamentals. This is a mechanism that can keep nominal yields low regardless of what happens in the real economy.