“I’m not in this world to live up to your expectations and you’re not in this world to live up to mine.” – Bruce Lee
“The Federal Reserve has a responsibility to ensure the safety and soundness of financial institutions and to contain systemic risks in financial markets.” – Bernie Sanders
In this week’s piece we discuss the possibility of the Federal Reserve ending quantitative tightening sooner than the markets expect. We also briefly touch upon precious metals, Amazon’s growing advertising business and potential short candidates in the advertising space.
The Fed’s Permanently Big Balance Sheet
From the Wall Street Journal:
Federal Reserve officials are close to deciding they will maintain a larger portfolio of Treasury securities than they’d expected when they began shrinking those holdings two years ago, putting an end to the central bank’s portfolio wind-down closer into sight.
Officials are still resolving details of their strategy and how to communicate it to the public, according to their recent public comments and interviews. With interest rate increases on hold for now, planning for the bond portfolio could take center stage at a two-day policy meeting of the central bank’s Federal Open Market Committee next week.
From the Financial Times:
Some cracks have emerged in short-term lending markets that lubricate the supply of dollars through the financial system, said analysts. After the crisis, the Fed bought assets by crediting banks’ reserve accounts, increasing the cash available for short-dated lending activity. As the Fed’s assets decline, so do bank reserves, reducing the money available for things such as overnight repo trades, where cash is lent in return for Treasuries, or commercial paper issuance, where corporates can borrow cash for short periods.
The fed funds market used to be US dollars 250 billion in size prior to the Global Financial Crisis. US banks were active participants in the market on a daily basis to secure funds to meet on-going regulatory reserve requirements.
Since the crisis the market has shrunk to about US dollars 50 to 60 billion today. Following the introduction of quantitative easing and as US banks built up excess reserves held with the Fed, there was no incentive left for US banks to borrow as there were no reserve requirements to meet. On top of that, the introduction of Basel III and its stringent liquidity coverage requirements means that banks are now penalised for lending in the unsecured inter-bank market.
The fed funds market is now primarily limited to transactions between Federal Home Loan Banks (FHLBs), as lenders, and a handful of US and foreign banks, as borrowers.
Before the Fed started shrinking its balance sheet, the US and foreign banks were borrowing from FHLBs, amongst other reasons, to arbitrage the difference between the fed funds rate and the interest rate on excess reserves (IOER) paid by the Fed.
Since the Fed started shrinking its balance sheet – swapping banks’ reserve accounts with Treasury and mortgage backed securities – it has become apparent that the majority of the excess reserves held with the Fed were not truly ‘excess’. The implementation of the Basel III framework has made high levels of reserves a permanent fixture within banks’ balance sheets. And by extension, the big Fed balance sheet is here to stay.
In the chart below the yellow and magenta lines are the fed funds rate and the IOER, respectively. In the years when reserves were in excess, there is a gap between the feds fund rate and the IOER. This gap was exploited by the banks borrowing from FHLBS and depositing with the Fed. In 2018, the fed funds rate converged with the IOER – indicating that a need for reserves not arbitrage were now driving the fed funds market.
US Federal Funds Rate, Target Rate and Interest Rate on Excess Reserves
Source: Bloomberg
In response to the convergence between the two rates, the Fed placed the IOER below the upper bound of it the fed funds target rate – the IOER had always been at the upper end of the target range prior the move in the summer of last year. The issue with this move, however, is that if banks are no longer active in the fed funds market for arbitrage purposes but rather to meet reserve requirements then the IOER is unlikely to act as a cap on rates. Rather, a deficiency of reserves, which banks cannot afford to have at any cost, could well push the fed funds rate beyond the upper bound, not only IOER.
The fed funds rate pushing through the upper bound is likely to send a signal that the Fed is losing control of short-term interest rates. Something we are certain none of the member of FOMC want. For this reason, and not due to the sharp drop in S&P 500, do we think that Chairman Jay Powell may hint at, as the Wall Street Journal suggests, ending quantitative tightening sooner than the market expects when the Fed meets this week.
If the Fed does indeed hint as much, we think it is likely to spur risk-appetite and be one more reason to be long emerging markets.
Precious Metals Update
Following up on a discussion from late last year, gold having briefly dipped below its 48-month moving average has moved back above it and started to created some distance.
We see little reason not to own precious metals, or miners if you have the stomach for it, especially if silver manages to move above its 48-month moving average – something it has failed to do since it dropped below it during the first quarter of 2013.
Amazon’s Advertising Flex
From the New York Times:
Ads sold by Amazon, once a limited offering at the company, can now be considered a third major pillar of its business, along with e-commerce and cloud computing. Amazon’s advertising business is worth about $125 billion, more than Nike or IBM, Morgan Stanley estimates.
Eyeballs combined with targeting capabilities based on actual spending patterns – ask any data-centric advertising professional and they are likely to tell you that that is the ‘holy grail’ of advertising. And Amazon has it.
While there are bound to be repercussions for Google and Facebook from the outgrowth of Amazon’s advertising business, we think it is likely to prove much worse for the more conventional advertising businesses. Many of these businesses are probably zeros in the long-run.
We think the following advertising companies are potential short-candidates:
- Clear Channel Outdoor Holdings $CCO – outdoor advertising company.
- JCDecaux SA $DEC.FP – Paris-listed outdoor advertising company with a stronghold on advertising across public transport networks including airports, business, and train stations.
- The Intepublic Group of Companies $IPG – a consortium of advertising agencies and marketing services companies.
- Omnicom Group $OMC – a group of advertising and market agencies.
- Telaria Inc $TLRA – digital video advertising services provider.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
Source: Bloomberg
Source: Bloomberg