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The Big Conversation

Episode 75: Have banks been overrun by QE? 

This week we look at the sudden rise in reserves that banks are depositing with the Federal Reserve. Is there too much cash, or too few things to buy? There is something wrong with the system and it could be that commercial banks are reaching their QE limits. In this week’s Chatter, Oliver Dancel-Fiszer discusses the growing investor optimism for opportunities in Africa, where demographics, trade agreements, and technology are helping to build a new set of businesses that are breaking these economies away from their historical reliance on commodities.

  • Roger Hirst: After weeks of uninterrupted rises across a large part of the commodity complex, Chinese authorities have started to verbally intervene in their markets in an attempt to reign in the excess. The US federal reserve on the other hand, apparently wants the US economy to overshoot. The current real fed funds rate is close to the 40-year lows, they have moved to an average inflation target of 2%, and this gives them leeway to let inflation exceed their target for an unspecified amount of time. The US Dollar Is closing in on a critical level whilst the Fed's efforts are again starting to cause unusual dislocations in the funding markets. The world's current policy mix is at a critical juncture, but will the world's monetary authorities start taking their foot off the gas? That's the critical question. We'll tackle in this week's big conversation. The Chinese authorities are trying to take some of the heat out of the commodities market. The year on year change in credit provision has already seen a steep decline year on year, despite this many of the industrial commodities that they've been buying into last year dips have actually started to accelerate higher in recent weeks, creating concerns that speculative access was accentuating the moves. Over the last few sessions however, there've been some significant declines from the recent peaks Dalian Iron ore futures have fallen 25% from their peak on an intraday basis with similar declines in thermal coal and steel futures contracts. Although most of these declines have only taken prices back to where they were just over a month ago. Whilst these declines are smaller than the general scheme of things, Chinese policymakers have again, signalled their intent that this is not a growth at any cost scenario, because they're still trying to manage down the significant non-performing loans across many of their old industries. In the US, commodity prices are also having a significant impact on some measures of inflation. The current biggest movers within CPI data will however, be transitory in nature, but that doesn't mean the ongoing fiscal and monetary excess is not storing up additional pressures for the future. Bottlenecks, in addition to base effects are still the primary source of today's surge in US spot inflation. Used car prices have taken off in absolute terms because of a loss in the productive capacity of new vehicles. The Manheim used car index has surged well over 50% year on year, more than double the previous record coming out of the great financial crash in 2009. But the current surge in US CPI is less about essentials and more about discretionary expenditures, which should make today's consumers a little bit more tolerance. The inflation of the early 1970s was particularly painful because of the huge impact it had on food and clothing, which were double the weighting then when compared to today. Mortgage prices also surged in the 1970s and we're again, a primary driver of resurgent inflation in the early 1980s. That doesn't mean we won't see a surge in future food and mortgage prices, and most people are bracing themselves for a few more months of elevated CPI data. But to hit the heights of the 1970s in a way that creates consumer discomfort in essential items, well that's going to require some particularly outlandish price action, even by today's standards. Currently the fed is distorting bonds and funding markets through their QE programs while also holding back from raising rates. But before we get any rate hikes, the fed will first taper their bond purchases. If this starts to drive yields higher, then we can also expect them to implement some form of yield curve control. Therefore today's mortgage rates are unlikely to go higher and less banks start decoupling their offerings from government yields. Financial conditions are close to their lows. But the fed actions have created such a loose backdrop. It's now a source of other issues because of the sheer size of their operations is starting to overwhelm market participants. There's been a surge in reverse repo operations with the majority of this increase coming from the overnight funding markets. Which added nearly 200 billion in additional activity over the last week. The current levels of activity are the highest ever not to be linked to quarter or year end. The increase in this facility is mainly down to issues that look likely to become even more acute. The source of this surge is the ongoing scale of the Fed's QE policy. During this process, the fed buys bonds from the banks and credits them back with reserves. The banks get a small amount of interest on these reserves. Large amounts of reserves however require more capital because the tighter regulations put in place after the banking bust of 2008. And because the return on these reserves is so low banks like to reduce them in favor of assets that produce a better return. But if these banking reserves are building up faster than the availability of quality bonds that can be used as collateral for other loans, then yields will fall pushing them down to the front end of the U S government yield curve. And that's despite the significant rise of spot inflation. US three month bills have been dipping in and out of negative territory. The flood of reserves has also been boosted by the drawdown of the treasury checking accounts, the TGA. Pushing these reserves into the commercial banking system, rather than issuing new bonds to fund expenditures. These declining yields, then pressure money market funds, which is where the fed steps in with reverse repo operations to mop up this excess liquidity. Therefore this process actually takes liquidity out of the system, which could be bad for stocks, but it's offset by the lowering of yields at the longer dated maturities. But why is this happening now, when QE has been ongoing for months and reserves have been rising steadily? Well, basically there's either too much cash or too little collateral. The decline in those front-end yields towards zero suggest a lack of collateral is very much part of this problem. When these reserves spiked in March 2020, there was also a flood of bill issuance and the reverse repo facility quickly retreated. Today, there is more QE than the banks can handle, given the lack of available collateral. Maybe therefore a taper is coming sooner than we think and not because the economy has necessarily recovered. Banks are struggling to lend because customers can't find sufficient collateral to back the loans. And even if the fed begins the taper, it only reduces the speed of the purchases, it doesn't stop the buying. The Fed's balance sheet could still grow another $1 trillion or more in the year following the beginning of a taper. When global balance sheets are growing it's been good for the us equity market, but it may be that the fed has to taper far more quickly in order to offset some of the balance sheet pressures that are starting to show up. Within all of this, the direction of the dollar will be a major influence on the direction of global risk assets. The dollar index is closing in on the recent lows, which if broken, will negate a significant bullish, technical formation. For many, the direction of the dollar should be obvious because of the impact of US monetary policy. The Fed's balance sheet is expanding in dramatic fashion. And so the logic is that this is diluting the level of the dollar. But balance sheet expansion remains a relative story. The ECB has been expanding its own balance sheet at a faster pace than the US based on the dilution theory. It should be the Euro and not the dollar that's on the back foot. The ECBs balance sheet as a percentage of GDP is also higher than the feds. So what we can see is that the dollar was strengthening when the fed was expanding its balance sheet more rapidly than the ECB and vice versa. The Euro accounts for about 60% of the dollar index, which is why I'm using it here, but peak in the dollar index at the end of March, coincided with a short term peak in the Fed's balance sheet versus the ECB. Maybe it's the real yield differential that's been driving the dollar. Over the last six months, the dollar has fallen when US real yields have been falling relative to Europe. Basically the US is doing a much better job than Europe of suppressing yields while stimulating inflation. And US real yields are expected to fall further if we're using spot CPI, rather than inflation expectations as the deflator. The fed is therefore winning the battle but at what cost. If they need to taper their purchases at a faster pace, then emerging markets could suffer as they did in 2013. Maybe the dollar will be no longer on the back foot after all. However a key difference today, is that nominal yields have already moved significantly higher off their low base. Inflation expectations have risen much faster than they did in 2013, dragging those yields higher. There should now be no surprises from a taper, given the inflationary forces lurking in every corner. In fact, in our topsy tervy world of unusual economic policy, a reduction of bond purchases may actually allow bond yields to decline from current levels because it would reduce future inflationary concerns. Bond yields have generally fallen during periods where the fed is not buying bonds. If unlike 2013, the taper has already been partially priced in, then yields may drift lower this time. Outside of the monetary and fiscal bottlenecks, the resurgence in corporate buybacks by many US corporations suggested that very few are really buying into long-term growth and would still prefer to support share prices today rather than future earnings growth. If corproates are not planning for future growth and China is starting to target the excesses of the commodity market, then the current bouts of sticky inflation may prove to be surprisingly disappointing unless fiscal policy remains ultra loose. The breakdown in supply chains shows that unfettered fiscal policy is not a growth solution. Emerging markets were once a wholesale beneficiaries of a weaker US dollar and strong Chinese growth. We've already seen recent strength across the emerging market space has become increasingly dispersed. If China continues to step back and the fed is forced to taper earlier and more aggressively, then it's probably the dollar rather than yields that pose a greater risk for this space. But we've already seen some of these markets break free from the shackles of commodities. Whilst many commodity rich countries have not received the benefits of higher prices. The emerging market landscape has started to change with technology breaking down barriers and reducing that reliance on commodities. Markets which were once overlooked can now use technology to provide a new set of opportunities. Africa is one region where that break from the past could be heralding an exciting new future and next up, Oliver Dancel-Fiszer, Refinitiv's Head of Economic Content, outlines the opportunities that many investors are now investigating across that region.

    Commodities in emerging markets have been closely associated with each other for years, but these relationships are starting to break down and we can no longer take a scattergun approach to investing in these sectors. Africa is obviously a vast continent. But allocators of capital are increasingly turning their attention to these growing opportunities.

    Oliver Dancel-Fiszer: Africa seems to have been doing a really good job of marketing itself as the next big investment hotspot in years to come. I mean, if you take a look at all of the economic indicators, they all seem to be pointed in the right direction. We're likely to see consistently high growth rates across many different African economies. And let's not forget about the recently implemented African free trade deal. That's possibly one of the most important developments to hit Africa in recent years. I'm talking about a continent with 1.2 billion people and a combined GDP of over 3 trillion, definitely an investment opportunity worth investigating.

    Roger Hirst: The growth potential of the continent's demographics helps underpin the outlook, but it's the opportunities in trading new business sectors that are helping to break from the old emerging market investment themes. 

    Oliver Dancel-Fiszer: To really understand the investment potential of Africa. Let's first take a look at some of the major macro economic themes driving the change here. So firstly, I'll cover demographics. If we take a look at the right-hand side of this chart, the key takeaway here is Africa is likely to see an explosion of young people entering the labor market both now and in future, they're relatively inexpensive and a lot of them already speak really good English. That's great for local development, but probably even better for multinational companies and investors. This is in contrast to the rest of the world, which is like to see an increase in the median age as evidence on the left-hand side of this chart. So next are economic and governance factors. What is striking about this chart is just how fast many African economies are likely to grow over the next 10 years, especially when compared to the rest of the world. Here for example, you've got Nigeria and even Ethiopia leading the pack. With annual projected growth rates well in excess of 10%. There's also a perception that corruption is on a decrease, inflation has largely been tamed in many countries and business conditions across many countries have improved significantly, that is already good news for investors. Looking at developments in freight policy, we mentioned the recently implemented African free trade deal, which has been in place since the start of this January. I think it's a really big deal because until now, African countries haven't really tended to trade with each other. So if you look at this chart on the screen of African imports and exports to each of the last year, we can, for example, see that with the exception of South Africa trade between countries has indeed been quite limited. Now, unfortunately, this isn't surprising given the historic lack of road infrastructure and border bureaucracy, but I believe this deal, for example, screams, we Africa are open for business, not just within our countries, but also to the rest of the world. And you know what, this could just be the catalyst to kickstart a move away from commodity like exports, adding to goods and services prime for local markets. Lastly let's talk about the impact of innovation and disruptive technologies. So it's well known that many African economies are some of the most unbanked in the entire world. This chart shows the disparity in its access. What's really interesting is that Africa's largest economy, here you can see Nigeria, even with a population over 200 million and growing, still has 60% of its population without access to a bank account. Now I personally reckon this is all really ripe for disruption. For example, a sizeable proportion of foreign investment in Africa has been in FinTech interestingly, and it's growing year on year. Much of the displacement of things around investment in mining for example. Also to note that in many countries, many countries, for example, are implementing regulatory sandboxes, which provide fertile environments for experimenting and innovation, both for local companies and multinational investors looking to get in on the action. 

    Roger Hirst: Africa is no different from the broader emerging market space. Differentiation is key. And some of the growth opportunities are coming from less expected areas. 

    Oliver Dancel-Fiszer: I don't think there's any shortage of African countries, tempting investors to invest in their economies. For example, Ethiopia has already started opening up many of its former state monopolies to investments from both local and foreign investors. Also in Nigeria, their strategy is very much to move away from their dependence on all exports and instead focus on homegrown manufacturing, and guess what? Even Rwanda, according to the world bank has consistently moved up the rankings in terms of the ease of doing business. And it's mainly in part due to the fact that they put in place a lots of business reforms of the last 10 years. So, you know, if you were to put, for example, mining and ore extraction aside for Angola, you could also even think about some of the more established emerging markets of South Africa and Egypt, both of which already attracts quite a sizeable share of foreign direct investment. 

    Roger Hirst: One of the problems for investors has been picking liquid instruments. There are an increasing number of country-specific ETFs to provide access to the continents markets. Whilst the diversification of businesses and services away from just mining and industry, is also providing greater choice across some of the more liquid stock exchanges. 

    Oliver Dancel-Fiszer: I think if you were to put, for example, oil and mining aside, definitely again, FinTech FinTech has really taken off in a really big way. For example, Microsoft are planning to spend well in excess of a hundred million over the next five years, mainly in Kenya and Nigeria. Facebook and Google, both of which have amazing African accelerator programs for local startups there are going to continue to invest. As is China's Alibaba, which effectively is the Chinese version of Amazon. And, you know, then you've got the sort of main staples, like visa and MasterCard, both of which are continuing to improve their presence in the regions. Now that's kind of for companies, but I guess in terms of individual investors, you know, some of the more mature and develop markets like South Africa, for example, Nigeria, Kenya, they've all got very established stock markets and investors typically can get exposure to African companies, via ETFs with much more likely to choose, in years to come as the world really sort of warms up more to the African, opportunity going forward.

    Roger Hirst: As always today's investors are hungry for data. Especially as they increasingly take control of their own investment decisions. 

    Oliver Dancel-Fiszer: Investors looking to follow the story, over at Refinitiv, our data stream product has recently onboarded in excess of 500,000 nationally sourced time series. That's also alongside international sources, primarily the world bank IMF, so on and so forth. So those analysts and economists and investors looking to do their research can go into the product, have a look what's their basic key and see for themselves what sort of investment trends they can start to pull going forward. And that's probably the best way that investors can get exposure to data on the African side going forward.

    Roger Hirst: There's been a long wait for investment opportunities within Africa. Often the choices were limited to old school extraction and heavy industry. Many of today's changes have been accelerated by technology, which breaks down borders and also the shackles of the old economy. As always investors need to do their homework, but Africa will increasingly become a destination of international capital. As technology opens up these growing populations to diversification of investment possibilities.