Sunday 25 March 2018

QE unwind, Libor and credit demand

For the most part in the West the governments have been the big borrowers in this cycle and the leveraged lenders to them have been banks; commercial and central. The Fed is now selling and that is acting as a transmission mechanism to tighten funding conditions and raise yields in some areas of fixed income. 

The problem some banks have now is negative carry assets and duration losses. DB as of last Dec, for example, seems to have a TSY/ agency portfolio yielding 1.4%, over EUR180bn of fixed-rate loans and overall a EUR630bn financial markets balance sheet. 

The Central Banks have a looming problem, perhaps in 2019 for the Fed, if they go to a neutral interest rate for the real economy they hike the interest bill on the host government (about $150bn cash interest I believe for every 100bps on sub-$4Tn Federal revenues) and cause duration losses for leveraged and real money holders of debt, including pensions and state pension systems. If they dont hike enough rates are still very loose for the real economy. 

Overall I expect them to let rates creep up and Fed balance sheet to shrink until something goes bang. I think that is when Fed funds are over 3%. Then the Fed will be stuck and I think the market sees the 'LBO Whitehouse' for what it is later this year or early next year; keep rates low and grow nominal GDP to get debt/ GDP down and wages as a % of GDP up while avoiding a bad recession at all costs. You can grow nominal GDP over 150% in a decade if you really want to...

Trump's recent spending bill has probably injected $500bn or so of extra demand into the economy at a time of full employment. I think initially that will support demand and corp profits, and looking above at the 1970s, initially, equities rallied. But ultimately wages go up, and when margins fall equities fall; the Wiltshire index above fell about 50% in its bear market and never really performed well vs inflation after that until Volker hiked interest rates to kill inflation in the early 1980's.  

It is interesting that the Fed tax cuts and spending bill have come at a time when demand for bank credit has stalled or even started shrinking: 

So far the first to shrink has been marketable securities, obviously. But business credit is hardly growing, the consumer is holding up so far though.

They really need the wage inflation to come through to support the economy from here, otherwise the hiking cycle will end in a recession when corporates cut back. After a good start last year, the last 9 months have been really subdued for wages though. 

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