AS equity and to a lesser extent credit markets seem to be driven by Euro Summits and " The Hunt for More QE " , note the following consideration for why the FED may avoid outright QE 3 this year ( and even if QE 3 occurred , why lending actually may be curtailed )

http://soberlook.com/2012/07/investors-betting-on-qe3-may-find.html

SUNDAY, JULY 22, 2012

Investors betting on QE3 may find themselves in a crowded trade

Leveraged investors such as hedge funds are piling into longer term treasuries and other rate product in anticipation of QE3. The speculative long positions are near records.

Source: JPMorgan

But the Fed may choose to avoid outright QE3 this year for the following reasons:

1. A spike in commodity prices that is now taking place could be exacerbated by outright asset purchases (as happened in early 2011). Higher commodity prices will make additional QE counterproductive.
2. Increases in US residential rents and rising commodity prices are yet to flow through to the CPI. The Fed will be cautions about stoking inflationary pressures.
3. Bank credit in the US is actually expanding, which was not the case prior to QE2, when the environment looked deflationary.
4. The Fed has other tools it will want to exhaust before commencing outright purchases. The Fed will save outright purchases as the last bullet in case of an extreme event such as the Eurozone losing one of its member states in a disorderly manner.

That means that these leveraged investors could find themselves on the wrong side of a crowded trade if the Fed sticks to some form of Maturity Extension Program rather than outright QE. And the unwind of this trade could end up being quite violent, pushing treasury yields considerably higher.

http://soberlook.com/2012/07/outright-asset-purchases-by-fed-will.html

MONDAY, JULY 23, 2012

Outright asset purchases by the Fed will increase US banking system leverage ratios and potentially limit lending

There seems to be quite a bit of confusion about the impact of US banks' deposits at the Fed on the overall bank credit. People are asking "how can US banks be lending when they are keeping all this money in excess reserves (deposits) with the Federal Reserve"? "They are just hoarding cash, etc." But as discussed in this post on the ECB Deposit Facility, bank excess reserves are a function of the central bank's balance sheet, and have nothing to do with how much banks are lending. If banks in the US for example double their lending today, the deposit amount at the Fed would stay constant.

That's because if you borrow dollars from Bank A, you are going to deposit your cash at another bank (Bank B) or pay someone who will deposit this money at their bank (Bank C). Let's say Bank C buys securities with that money. But now whoever they bought securities from has that cash on deposit with Bank D, etc. Sooner or later some US bank will end up with that money and "deposit" it with the Fed - there is simply no other way around it. Here is a good quote from JPMorgan on how this works in practice:

"... increased (or decreased) lending will not change the amount of aggregate reserves within the banking system. For example, Bank A lends money to a business by writing that business a check. The business deposits that check in its own bank, Bank B, which presents that check to the Fed. The Fed then debits the reserves of Bank A and credits the reserves of Bank B. Reserves have been neither created nor destroyed, they have just changed hands. The Fed is the only institution that can change the aggregate amount of reserves."

When the Fed buys a security outright, it credits some bank the cost of the security (say X dollars) and the chain above begins until some bank (or multiple banks) ends up with that X dollars on deposit at the Fed, increasing total reserves. The only thing that could change this direct relationship between the Fed's balance sheet and bank reserves is the amount of physical cash notes under people's mattresses or in bank vaults. But that amount is small relative to the overall monetary base (total dollars) and tends to grow very gradually.

JPMorgan: - "The only thing a bank’s reserves can become—other than another bank’s reserves—is [physical] cash. ... the demand for cash changes slowly, so increasing vault cash will only increase banks’ storage and handling costs."

Fed's balance sheet vs. bank deposits at the Fed (reserves)

This means that as the Fed increases its balance sheet, it automatically raises bank reserves (deposits at the Fed) by roughly the same amount. And by doing so, the Fed grows the balance sheets of the US banking system (by increasing the amount of this particular asset banks hold). Even though deposits at the Fed do not require any regulatory capital (zero risk weighted assets), banks' reported leverage would increase, potentially causing them to limit lending activities.

JPMorgan: - "Although this asset has zero-weighted risk, it will increase banks’ leverage ratios. For this reason, banks may be inclined to reduce other forms of credit."

This is yet another reason the Fed will try avoiding outright asset purchases (QE3) for as long as possible, developing other easing alternatives instead.

http://soberlook.com/2012/07/more-on-qe-raising-bank-leverage.html

TUESDAY, JULY 24, 2012

More on QE raising bank leverage

An earlier post on how additional QE would cause bank leverage to increase, potentially curbing lending seems to have started quite a discussion, particularly on Twitter. Here is the complete quote from JPMorgan, who describe the process quite clearly:

Potential issues for the banking system

When assets on the Fed’s balance sheet increase, its liabilities will necessarily increase as well. Those liabilities are primarily reserves. Reserves can only be held by banks. Once reserves enter the banking system, no action on the part of the banks will decrease the aggregate amount of reserves. To see how this could become an issue for the banking system, consider if the Fed wished to buy $5 trillion in securities. This would imply that the aggregate balance sheet of the banking system would now have $5 trillion more of cash assets, namely, reserves. If the securities are purchases directly from the banks, there will be no change in bank balance sheets [though reserves will still go up]. However, securities purchased from nonbank investors will cause bank balance sheets to expand, as the funding will again be through reserves that cannot leave the banking system. Although this asset has zero-weighted risk, it will increase banks’ leverage ratios. For this reason, banks may be inclined to reduce other forms of credit. 

Thus far, the increase in reserves has been limited enough not to be a problem. Given that much of the expansion of the Fed’s balance sheet has filled in vacuums left when banks shied away from interbank and other forms of lending, the growth in cash assets on bank balance sheets has likely simply filled in holes on the asset side of bank balance sheets. A massive further increase in Fed lending or securities purchases could be more problematic. Because TALF and, to a certain extent, the mortgage purchase programs are filling in for gaps in the “shadow banking system,” the reserves created would not necessarily supplant a contraction in bank credit.