Farewell, QEII. Lusitania, ahoy!

There has been a great deal of misplaced commentary about how the presence of some $1.6 trillion in commercial banking deposits with the Fed has somehow meant that its QE programmes were NOT  increasing they money supply (they have been, by around 30% since the panic first broke out) but were merely effecting some kind of wholly neutral ‘asset swap’ (yes, but the point is the Fed has been helping its counterparties swap bonds for MONEY!).

We have often tried to point out that while this excess reserve accumulation may mean that the classic, fractional reserve multiplication of the Fed’s injections has not been taking place to its theoretical maximum, the Fed’s programmes were, nonetheless exerting sufficient inflationary impetus all by themselves—albeit with the severe impediment that they were funding government-sponsored profligacy and zombiehood, rather than aiding the recuperation of a vibrant private commercial and industrial sector.

A breakdown of the cash ‘hoarding’ by bank origin further reinforces the point, for here we find that much of the extraordinary rise in precautionary cash holding has been undertaken by foreign, not domestic, banks.

After the salutary lesson given to banks across the word when they suddenly found they could no longer roll over their short-date eurodollar funding at the height of the LEH-AIG crisis, this is hardly inexplicable.

Further to this point, you will note that if you were to look at the two placed side by side, you would see the pattern of reserve holdings for this group would make for a passable a facsimile of the chart of the path of European sovereign CDS prices!

Meanwhile, US banks are notable in having added nothing more to their own backstop over the last two years or so, meaning THEY are not really holding up American creditisation to the extent some would have us believe.

To make the contrast even more clear, note that while large, domestically-chartered banks have cash assets of some $509 billion v non-cash ones of $6,840 billion (a ratio of around 8%), and small domestics hold $293 billion in cash against $3,595 billion in non-cash (a similar ratio of approx 9%), foreign banks have the startling sum of $940 billion piled up against estimated non-cash assets of $1,900 billion for a ratio of close to a half.

Put another way: despite the fact that all domestics’ combined non-cash assets amount to just more than five times those of foreign banks ($9,633 billion v c.$1,900 billion), they actually hold 15% LESS cash ($803 billion v $940).

Barely a year before the crisis fully broke (i.e., in the third quarter of 2007), both large and small domestic banks’ cash:non-cash ratios stood just above their historic lows at around 2.7%. Since then, they have been more or less tripled to an average of 8.3%, thus restoring them to where they stood before the Greenspan Fed starting reducing mandatory reserve requirements in the early 1990s.

Foreign bank equivalents, however, have rocketed 28-fold in absolute terms and have moved proportionately from a late-‘07/early-‘08 low of circa 2.5% to the 50% cited above—with $1/2 trillion being added to their hoard just since the end of February—as they have turned from being large net lenders to their non-US branches of more than $600 billion at the pre-Crisis peak around to being net borrowers from them to the tune of around $75 billion now.

[NB: due to a foible of the Fed’s reporting process, weekly interbank exposures are booked as net liabilities, with gross ones only available in the quarterly FOF accounts. Since this practice artificially reduces the figure recorded for total assets, a certain amount of interpolation is involved in the above reckoning. Nonetheless, the absolute size of the shift shows us that the effect on the ratios cannot fail to have been similarly dramatic]

While much of the focus has been on the fall in total bank lending from the (take-over boosted) peak of autumn 2008 of some $750-800 billion (or 7-8%), notable within this has been the generalized collapse in the interbank component across all three categories, from the eve-of-Lehman peak of $485 billion to the present $135-40 billion, levels last seen as far back as 1985.

Here, again, we see clear evidence that the pig-on-pork world of bank-bank pyramiding (as well as the pig-on-spam one of bank:non-bank financial kiting) has been dealt a serious blow–if one that only bank shareholders can honestly rue.

Overall, though, the lesson is that for all they owe to their local central banks, trust-deficient, balance sheet-impaired, European banks have a lot for which to thank Mr. Bernanke, too!

Less obvious is what good it is doing anyone else to continue to obfuscate the scale of the problems. For all the horror being expressed at the German idea that everyone would be better of if we were to torpedo this ship of fools—writing off irrecoverable debts, cleaning up the books, recapitalising, and moving on—we suspect that the Lusitania moment would do more to promote long-term recovery prospects than QEII has ever done. As it is, the banks themselves are succumbing everywhere to the effects of gravity, losing ground to the broader equity indexes in nearly every major centre you care to examine.

Europe may be making most headlines with its open conspiracy problems with sovereign debt loans, but the US banks not only look like they have large derivatives exposures in the same quarter, but it appears that they may also be at risk of a further deterioration emanating from the domestic property market, too (e.g., California home sales down 13.3% yoy, with prices off by 10.4% in May).

Though the cycle may not have turned decisively enough for a full disclosure of errors committed in emerging markets, these cannot be too far behind given the inordinate expansion of lending which has taken place in several key economies there. Indeed, so bad are matters presently in China that some banks have become sufficiently desperate to meet their required loan-to-deposit ratios at month end, that they are paying what amounts to 40%+ annualized in interest to accomplish such mindless window-dressing.

A world running hot on easy money needs a continued additional supply of the stuff if it is to skate ahead of its own contradictions. Two further complications arise here: as prices rise, the same increment of money no longer buys the same additional slug of goods, so nominal expansion must run even faster and, furthermore, once people become aware of their predicament and start to incorporate the likelihood of future price hikes into their calculations, even that acceleration must itself be quickened further.

But with the world’s central banks either trying to contain the damage of the past two years of reckless laxity, or reaching the end of their game of poking the sleeping inflationary dragon with a sharp stick in the privates—and with the fiscal position in several of those countries not quite so conducive for government deficits to continue as the medium of monetization of choice as it has been—the travails of the commercial banks imply that they, too, are not in a position to fill the gap in the creation of money and to engineer its multiplication into credit on a large enough scale to keep air in all the tyres at once.

Thus, the clear danger is that the many mispriced commercial and industrial activities which have either been newly undertaken in the false boom or wrongly carried over from the last bust will now be snapped up in the ravening jaws of a margin squeeze, while asset markets—so indiscriminately correlated in the upswing—may topple, one by one, with each faller dislodging the precarious foothold of the next until they are all plunging together.

On the economic side, signs of a slow down are beginning to appear with increasing frequency. Some of this, to this point, is merely a deceleration, rather than an outright reversal, but even this is dangerous for a world relying on there being no diminution of any kind in the slope of the recovery.

Nor is there any relief in sight. China has hiked the RRR once more (and is widely expected to follow through with another rate rise), while India has upped the repo rate by 50bps amid official comments that there might be plenty more where that came from. Output numbers in the developed world have generally been lacklustre.

Thus we see now that not only are sovereign CDS spreads rising, but corporate and financial ones, too. Junk yields have turned unmistakably higher from their double-bottom lows; junk spreads even more decisively so. Even plain vanilla swap spreads are beginning to head north again, as are swaption vols.

Euro/dollar forex risk reversals are again at what can only be called crisis levels and basis swaps between the pair are again falling (implying a greater difficulty for non-US banks to access dollar funds).

In equity markets, for all the tech bubble IPO pops, there have been a series of disappointments and pulled deals elsewhere—not the least of which that involving the mighty Glencore, left floundering at one point some 15% below its first day trading highs.

Indeed, a look around the world in USD, common-currency terms sees a whole host of markets off 10% or more YTD, including those in most of Europe, in Korea, Australia, India, and, selectively, in China.

Key global growth bellwether sectors, such as air freight, marine transport, industrials, paper & forestry, containers & packaging, and semiconductors, are all breaking down from the last two years’ rising trends. Not least among these are commodity equities (e.g., the TR/Jeffries index) where the neckline of a nasty-looking H&S has broken, pointing the way to a further 12%, fib-retracing decline from here. Finally, notice that BRICs are falling relative to both the EM universe and the World index, too.

Of course, the sell side is predictably pulling out all the stops in the attempt to persuade its customers to buy the dips, arguing that every minor pullback in a bull market should be bought.

The problem with this rather transparent strategy is that one only knows one is in such an environment if the dip-buying proves, post hoc, to have been the right thing to do. Otherwise, all such cheerleading does is to re-iterate—in a potentially expensive fashion—the drollery of the late, great Will Rogers who famously declared that investing was easy; one simply bought stocks that went up, and if they didn’t go up, one didn’t buy them.

As has already been made plain here on several prior occasions, we think that—properly measured—we are rather in a very mature, counter-trend phase of a secular, real, bear market for stocks. Hence, our opinion is a little different to that so blithely espoused by the Herd.

We spoke last week of battening down the hatches in the face of a falling barometer and an approaching squall line: nothing that has transpired since last we wrote has in anyway alleviated our sense of caution as we enter into what could be a particularly fraught summer period, one which could just lay the groundwork for one of those bleak autumns of market legend to follow.

2 Comments

  • Tim Lucas says:

    Sean – the difference in behaviour between domestic and foreign banks is intriguing. I suspect that the reason for this is due to the US government providing federal deposit insurance within the US banking system. Hence, overseas banks keep their dollars increasingly within their US susidiaries rather than in the Eurobond market. This would make sense as the leverage ratios you quote for US foreign banks are unlikely in isolation.

    I wonder – is there any way of checking the movement in US$ deposits within the European banking system? If I’m right, this would show up the reverse trends ending with ultra-high US$ leverage ratios.

  • Aftab Singh says:

    There has been a great deal of misplaced commentary about how the presence of some $1.6 trillion in commercial banking deposits with the Fed has somehow meant that its QE programmes were NOT increasing they money supply (they have been, by around 30% since the panic first broke out) but were merely effecting some kind of wholly neutral ‘asset swap’ (yes, but the point is the Fed has been helping its counterparties swap bonds for MONEY!).

    Thank you for saying this! That chat about ‘neutral & benign asset swaps’ was so irritating!!

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