[This blog post is an excerpt from a TSI commentary published on 24th February]

Based on the par value of maturing securities on its balance sheet there was scope for the Fed to withdraw as much as $43B from the financial markets on 15th February. A week ago we noted that this ‘liquidity drain’ had no effect on the stock market, possibly because the effect would occur on the next trading day (Tuesday 19th February) or because the Fed chose to withdraw a lot less money than it could have. Now that the Fed has issued its latest weekly balance sheet update we can see why there was no effect from this potential bout of “quantitative tightening” (QT). We can also see that the general perception of what the Fed is doing has deviated in a big way from what the Fed actually is doing.

During the 7-day period from 13th to 20th February the Fed’s securities portfolio fell by $31B. In other words, the Fed implemented $31B of a potential maximum $43B of QT. Over the same period, however, the amount of money in the US federal government’s account at the Fed fell by $44B. This means that there was a $31B withdrawal of liquidity by the Fed in parallel with a $44B injection of liquidity by the government, resulting in a net liquidity ADDITION of $13B. No wonder there wasn’t a noticeable negative effect on the stock market from the Fed’s actions.

The difference between a Fed liquidity injection and a government liquidity injection is that whereas the Fed can inject new money, the government can only recycle existing money (the government returns to the economy the money it previously removed via borrowing or taxation). Government liquidity injections therefore are not inflationary, but their short-term effects can be similar to Fed liquidity injections.

Note that at 20th February the government had about $330B in its account at the Fed. This means that the government currently has the ability to inject up to $330B into the economy, but depending on the size of its desired cash float it may or may not make additional injections in the short-term.

Also note that notwithstanding all of the ‘dovish’ talk that has emanated from the Fed over the past two months, the QT program has continued. From 2nd January to 20th February the Fed removed $63B from the economy as part of its “balance sheet normalisation”. The pace of the liquidity removal is slower than the Fed’s self-imposed $50B/month limit, but it is not correct to say — as some pundits have said — that the Fed has stopped tightening. The Fed is still pulling on the monetary reins.

That the Fed is still tightening means that there is a substantial mismatch at the moment between perception and reality. The general perception is that the Fed is now either on hold or preparing to loosen, but, as mentioned above, this most definitely is not the case. Consequently, bullish speculators in the stock, commodity and gold markets are getting ahead of themselves.

It’s possible that the Fed will end its monetary tightening within the next few months, but that’s only going to happen if there’s another pronounced shift away from risk. To put it another way, the more the markets discount an easing of monetary policy the less chance the easing will occur. In fact, if the stock market extends its upward trend into May-June then the Fed probably will resume its rate-hiking in June.

Like every other financial market in world history, the gold market is manipulated. However, anyone who believes that manipulation of the gold market is an important influence on major gold-price trends does not understand the true fundamental drivers of the gold price.

To paraphrase Jim Grant, gold’s market value is the reciprocal of confidence — in the banking system (including the central bank), the economy and the government. In other words, gold should do relatively well when confidence is on the decline and relatively poorly when confidence is on the rise.

By comparing the gold/commodity ratio with measures of monetary and/or economic confidence it can be shown that gold generally does exactly what it should do. There are periods of divergence, but these tend to be short (no more than a few months) and barely noticeable on long-term charts.

The point outlined above can be illustrated by comparing the gold/commodity (gold/GNX) ratio with the IEF/HYG ratio, which I’ve done in the following chart.

The IEF/HYG ratio is fit for our purpose because it is a measure of what’s happening to credit spreads, and because the economy-wide credit-spread trend is one of the best indicators of economic confidence. Specifically, the IEF/HYG ratio increases when credit spreads are widening (indicating declining economic confidence) and decreases when credit spreads are narrowing (indicating rising economic confidence).

Therefore, it is fair to say that the following chart compares the gold/commodity ratio with the reciprocal of confidence in the US economy.

Lo and behold, the two lines on the chart track each other quite closely.

[This blog post is an excerpt from a commentary posted at TSI about three weeks ago]

TARGET2 is the system set up in the euro-zone to clear inter-bank payments. The Bundesbank (Germany’s central bank) describes it as a payment system that enables the speedy and final settlement of national and cross-border payments. The problem is that often there is no “final settlement” under TARGET2. Instead, credits and debits can build up indefinitely.

To understand the issue it first must be understood that although the 19 countries that comprise the euro-zone use a common currency, the euro-zone isn’t really a unified monetary system. It is more like 19 separate monetary systems, each of which is overseen by a National Central Bank (NCB). These NCBs are, in turn, overseen and coordinated by the ECB. TARGET2 is the means by which money is transferred quickly and efficiently between these 19 separate monetary systems. The transfer may well be quick and efficient, but, as noted above, it often doesn’t result in final settlement.

Further explanation is provided by the Bundesbank, as follows:

“…both the Bundesbank and the Banque de France will be involved in a cross-border payment transaction made in settlement of a German export to France, for instance. That transaction begins when the French importer’s commercial bank in France debits the purchase amount from the importer’s account and submits a credit transfer in TARGET2 to the German exporter’s commercial bank in Germany. The Banque de France then debits the amount from the TARGET2 account it operates for the French commercial bank and posts a liability owed to the Bundesbank. For its part, the Bundesbank posts a claim on the Banque de France and credits the amount to the German commercial bank’s TARGET2 account. The transaction is concluded when the commercial bank credits the amount in question to the account it operates for the German exporter.

At the end of the business day, all the intraday bilateral liabilities and claims are automatically cleared as part of a multilateral netting procedure and transferred to the ECB via novation, leaving a single NCB liability to, or claim on, the ECB.

Viewed in isolation, the transaction used as an example above leaves the Banque de France with a liability to the ECB and the Bundesbank with a claim on the ECB at the end of the business day. These claims on, or liabilities to, the ECB are generally referred to as TARGET2 balances.”

The example given above by the Bundesbank refers to a German export to France, but the same process would apply when someone transfers money from a bank deposit in one EZ country to a bank deposit in another EZ country. For example, the electronic wiring of funds from a commercial bank account in Italy to a commercial bank account in Luxembourg would leave the Banca d’Italia with a liability to the ECB and the Banque Centrale du Luxembourg with a claim on the ECB.

The process described above means that there is never any net clearing of cross border payments at the NCB level. Unless the money flowing in one direction (into Country X) equals the money flowing in the opposite direction (out of Country X), credit/debit balances will build up and there is no limit to how large these balances can become.

As illustrated by the following chart from Yardeni.com, this is not just a hypothetical issue. The NCBs of some EZ countries, most notably Germany and Luxembourg, now have huge positive TARGET2 balances, and the NCBs of some other EZ countries, most notably Italy and Spain, now have huge negative TARGET2 balances.

As at October-2018, the central bank of Germany was owed 928 billion euros by the TARGET2 system, while together the central banks of Italy and Spain owed 887 billion euros to the TARGET2 system. Is this a problem?

The system is so strange that there doesn’t appear to be a clear-cut answer to the above question, at least not one that we can fathom. It could be a huge problem or it could be no problem at all.

The Bundesbank is sitting there with an asset valued at almost 1 trillion euros that will never pay any interest and cannot be collected. At first blush this appears to be a huge problem. It implies that at some point the asset will have to be written off, perhaps leading to a very expensive bailout funded by German taxpayers. But then again, due to the way the current monetary system works it may well be possible for TARGET2 balances to grow indefinitely with no adverse consequences. That’s why we haven’t devoted any commentary space to this issue in the past.

If we were forced to give an answer to the above question it would be that rising interest rates, burgeoning government debt levels and private bank failures will become system-threatening issues in the EZ long before the TARGET2 balances pose a major threat.

Bank reserves are a throwback to a time when the amount of receipts for money (gold) that could be issued by a bank was limited by the amount of money (gold) the bank held in reserve. Under the current monetary system bank reserves have no real meaning, since it isn’t possible for a dollar in a bank deposit to be genuinely backed by a dollar held somewhere else. The dollar can’t back itself! However, it is still important to understand what today’s bank reserves are/aren’t and how changes in the reserves quantity are linked to changes in the economy-wide money supply. Remarkably, these bank-reserve basics are misunderstood by almost everyone who comments on the topic.

The simplest way for me to deal with the common misunderstandings about bank reserves is in point form, so that’s how I’ll do it. Here goes:

1) Bank reserves aren’t money, that is, they are not considered to be general media of exchange and are not counted in the True Money Supply (TMS). Instead, they provide ‘backing’ for part of the money supply.

2) A corollary of the above is that banks can’t use their reserves to buy things outside the Federal Reserve system.

3) Banks can lend their reserves to other banks, but the banking industry as a whole cannot expand or shrink its reserves. In other words, the banking industry has no control over its collective reserves. The central bank has total control.

4) Bank reserves can be shifted around within accounts at the Fed, but the only way that reserves can leave the Fed and enter the economy is via the withdrawal, by the public, of physical currency from banks. For example, when $100 is withdrawn from an ATM, $100 is converted from deposit currency to physical currency. This doesn’t alter the money supply, but it causes the bank to lose a $100 liability (the bank customer’s deposit) and a $100 asset (the physical currency held in the bank’s vault). When the quantity of physical currency held in a bank’s vault gets too small, the bank will replenish its supply by withdrawing reserves from the Fed in the form of new paper dollars. Although it may appear that this imposes some sort of limit on the supply of physical dollars, the Fed stands ready, willing and able to meet any increase in demand. This is further discussed in point 5).

5) Under the current monetary system, reserves effectively are created out of nothing. To be more precise, the Fed creates reserves when it purchases bonds and other assets. Since there is no limit to the dollar value of assets that can be purchased by the Fed, the banking system will never run short of the reserves it needs to meet the public’s demand for physical currency. Also, the Fed can remove reserves whenever it wants by selling bonds and other assets.

6) Except for the siphoning of reserves in response to the public’s increasing demand for physical currency, it is accurate to say that reserves at the Fed stay at the Fed until they are removed by the Fed. A corollary — as already mentioned in point 3) — is that the commercial banking industry cannot draw-down its reserves.

7) The Fed pays interest on ALL reserves, not just so-called “excess reserves”. In any case and as outlined below, for all intents and purposes all US bank reserves, with the exception of the relatively small portion required to meet any increase in the demand for physical currency, are now excess and have been for the past few decades.

8) The way the US monetary system now works it is fair to say that all reserves are excess. The reason is that the quantity of bank reserves has no bearing on the amount by which banks expand/contract credit. In effect, the US now has a zero-reserve fractional reserve banking system. That’s why it was possible for the greatest expansion of bank credit in modern US history, which took place during 1990-2007, to happen while the commercial banking industry had almost no reserves. During this period total bank credit rose by $6 trillion, from $2.5T to $8.5T, while bank reserves at the Fed dwindled from $64B to $40B.

9) Further to point 8), bank lending doesn’t ‘piggy-back’ on bank reserves. It possibly did 40 years ago, but it hasn’t for at least the past 25 years. Hopefully, economics textbooks eventually will be updated to reflect this reality.

10) An implication of points 7) and 8) is that interest payments on reserves are neither an incentive nor a disincentive to bank lending. When a bank makes a loan to a customer it doesn’t lose any reserves and therefore continues to collect the same interest-on-reserves payment from the Fed.

11) The sole purpose of paying interest on reserves is to enable the Fed to hike the Fed Funds Rate during a period when the banks are inundated with reserves, without having to massively reduce the quantity of reserves. This was discussed in previous blog posts, for example HERE.

12) When the Fed was ‘quantitatively easing’ many pundits wrote that it was adding to bank reserves but not the money supply. This is wrong. When the Fed buys X$ of securities as part of a QE program it adds X$ to bank reserves AND it adds X$ to the economy-wide money supply. I previously described the process HERE.

13) By the same token, now that the Fed is ‘quantitatively tightening’ it is not just removing bank reserves. When the Fed sells X$ of securities as part of what it refers to as its balance-sheet normalisation program it removes X$ from bank reserves AND it removes X$ from the economy-wide money supply. In essence, it’s the process I described in the above-linked post (point 12) in reverse. That’s why the balance-sheet normalisation program is vastly more important, as far as monetary conditions are concerned, than the rate-hiking program.