It’s been over five years since the Fed began engaging in easy monetary policy. Over that time the Fed’s balance sheet has grown to a record $4+ trillion from less than $1 trillion (See Figure 9). More than half of the balance sheet expansion is now in the form of interest baring bank reserves held at the Fed, which stand at over $2.4 trillion (See Figure 10). By building up bank reserves, the Fed has essentially removed the burden of reserve requirements without actually removing the reserve requirements. With excess reserves, banks can create loans and make subsequent deposits without the need to borrow at the inter-bank rate to cover their reserve requirement. [A reserve requirement is the minimum amount of money that a bank must hold against its deposits, which adjusts as new credit is created and deposited.]
Figure 9 – Total Assets of Federal Reserve, 2004-Present
Figure 10 – Total Reserves Held At Federal Reserve, 2004-Present
Even after five years of the Fed’s most aggressive accommodative policy in history, there is still a lack of hoped for quality credit creation in the economy, which could be a sign that the greatest deleveraging of the U.S. economy since the Great Depression is still not complete. The Fed’s unrelenting dovish policy appears to support this concern.
Today, looking into specific trends in credit creation, what appears to be strong commercial and industrial loan growth (see Figures 3, 4) is primarily the result of lower lending standards as desperate banks compete for business by offering weaker covenant structures. Also, a large portion of C&I loans are being used to refinance existing loans and to pay for regular business maintenance, not new growth and expansion. Consumer lending by large banks (see Figure 5) has been non-existent ever since an initial spike back in late 2009, and consumer lending by small banks (see Figure 6) is still declining at the same pace as it was in the heart of the deleveraging period. Mortgage lending by large (see Figure 7) and small banks (see Figure 8) has still not shown any indication of growth over the last five years.
While the Fed’s policy has arguably failed to create the kind of credit and confidence needed for real job growth and meaningful economic expansion, the policy has driven large-cap stock prices, measured by the S&P 500 to an all-time high. However, it is important to note that stock valuations are rising at a faster pace than corporate revenues, meaning that a lot of the stock price appreciation has been the result of price/earnings multiples expanding, not revenue growth. Bottom-line corporate profits of S&P 500 components have improved from 2008/09 levels, but frequently at the expense of unsustainable cost cutting, which is counter-supportive of future growth. Nominal stock prices at this level can be misleading without proper analysis.
Very low interest rate environments have historically drawn money from bonds and into stocks. Potential stock returns appear appealing on a relative basis when compared to bonds with low single digit returns or less. An aggressive rotation into stocks has historically occurred in recent very low interest rate environments such as the tech bubble of the late 1990s and in the most recent housing bubble. In both of these examples, stocks had run ups lasting approximately five years following highly accommodative Federal Reserve policy, before consequently crashing. The most recent stock market rally, having commenced in March 2009, is almost five years in the works (see Figure 11).
Figure 11 – S&P 500, 1994-Present
If history is a guide, as deleveraging completes, creditworthiness returns; confidence picks up; the last 10 years are forgotten (as is human nature); and excess borrowing fueled by too-easy Fed policy once again becomes the social norm. Current stock prices and C&I loan activity appear to be indicative of this pattern. The current Fed policy incentivizes cheap borrowing, resulting in risky spread trading, chasing already inflated stocks and other higher yielding assets. In the past the Fed has not been able to reverse policy fast enough to combat rising prices before over speculation ensues and borrowing and prices are pushed to unsustainable levels, and then bust. So far, this time around does not appear to be any different.