Tracking the demand for safe assets

Caution, risk aversion, and a lack of confidence have characterized much of the current recovery. So it is not surprising that the demand for money and safe assets has been strong, just as the public's desire to deleverage has been strong (deleveraging is equivalent to wanting more money and less debt). Savings deposits, despite their near-zero yield, have grown at double-digit rates since 2008. T-bill yields are virtually zero, a sign of extremely strong demand for safe assets. The real yields on TIPS plunged deep into negative territory, as the demand for these default-free and inflation-immune assets proved so strong that investors were willing to accept a guaranteed negative real rate of return. Bond mutual funds have enjoyed exceptionally strong inflows for most of the past four years, while equity mutual funds have suffered massive withdrawals. Household financial asset burdens have declined significantly as households have deleveraged. Gold, the preferred asset for those seeking refuge from inflation, geopolitical risk, and the just-plain-jitters, rose to extraordinary heights over more than a decade, doubtless fueled in part by speculators with access to money at historically low interest rates.

Despite the persistence of doubts and fears, the economy and the financial markets have staged a "reluctant recovery," as I described last November.

The latest source of fear is the approaching tapering and eventual reversal of the Fed's Quantitative Easing. Those who believe that QE has been the essential fuel for our (tepid) recovery and the stock market's rather spectacular gains over the past 4+ years worry that the absence of Fed purchases, followed—at some uncertain point in the future—by the reversal of QE (i.e., the sale by the Fed of the trillions of bonds and MBS it now owns) will surely doom this economy. They reason that the Fed's bond purchases have artificially depressed interest rates, and that this in turn has helped boost the economy—so therefore a reversal of QE will depress the economy.

But as I pointed out in a recent post, "the real point of QE was not to lower bond yields, but to create bank reserves for a world that desperately wanted them." For most of the past four or five years, the world's demand for safe assets has been so strong that there was a relative scarcity of traditional vehicles (the primary one being T-bills). Enter bank reserves, which, thanks to the Fed's decision in 2008 to pay interest on reserves, became functionally equivalent to T-bills, but with a superior yield. In just under five years, banks have accumulated almost $2 trillion of "excess" bank reserves, above and beyond the level required to collateralize their deposits. No one has forced them to accumulate these reserves, and no one has forbade them from using those reserves to massively expand their lending. Yet that is what has happened: the accumulation of reserves for no purpose other than to accumulate safe assets with a positive yield. Clearly, there has been intense demand for bank reserves on the part of banks, arguably because they were functionally equivalent to T-bills, the ultimate safe asset, and because banks were not willing to greatly expand their lending activities—just as the private sector has also been working hard to reduce its debt burdens.

To make a long story short, the Fed's massive QE efforts boil down to a simple transmogrification of Treasury notes, Treasury bonds, and MBS into bank reserves, an exercise that proved necessary to accommodate the world's strong and rising demand for safe assets.

It follows therefore that the "tapering" and the eventual unwinding of QE will be necessary to compensate for the declining demand for safe assets, and not a threat to the financial system. The Fed will stop buying and eventually—in a year or so—start selling bonds as the economic fundamentals improve. When they finally do begin to reverse QE, they will be selling bonds at higher interest rates than we have today (e.g., 10-yr Treasury yields of 4% or so) when the demand for them will be stronger. Indeed, if the Fed does not reduce the supply of bank reserves as the demand for them declines, they will risk igniting what could prove to be a very uncomfortable rise in inflation. That is the risk to worry about—that the Fed fails to reverse to QE in a timely fashion—not the reversal of QE.

The tide of risk-aversion seems to be turning. I have argued before that this process, which includes the return of confidence (lack of confidence breeds demand for safe assets, so the return of confidence should go hand in hand with a decline in the demand for safe assets), is already underway, though still in its early stages.

Confidence, though still relatively low, is rising. Savings deposit inflows, though still heady, are slowing. The price of uncertainty has declined to near-normal levels. Real yields, though still low, have jumped. Gold, still quite expensive, has suffered a 30% decline. Equity funds are beginning to see inflows instead of outflows, and bond funds are beginning to suffer outflows. All of these market-based indicators are consistent with a decline in risk aversion which goes hand in hand with a decline in the demand for safe assets. If these trends continue, the Fed will have a clear path—indeed, a mandate—to first taper, then reverse, its Quantitative Easing program.

What follows is a series of charts which track the return of confidence, the decline in the demand for safe assets, and the beginnings of a trend toward taking on more risk. All of these suggest that a tapering of QE is appropriate.

Consumer confidence has been rising irregularly for the past several years, but it is still depressed from an historical perspective. There are still plenty of concerns out there, but they are slowly fading.

U.S. banks have been the recipients of $3 trillion in savings deposit inflows since the onset of the financial crisis in 2008. The growth rate of savings deposits was 10-15% per year from 2009 through last year, but that has now cooled off to a 9% rate. That's still fast, but no longer galloping. The evolution of savings deposits—which pay almost no interest currently—bears close watching. Banks have funneled most of their deposit inflows into bank reserves. A tapering of Fed bond purchases should dovetail nicely with a slowing in the growth of deposit inflows and a lessening of banks' desire to accumulate reserves.

The Vix index measures the implied volatility of equity options, and is thus a proxy for the market's level of uncertainty, fear and doubt. (You pay more for an option when you are uncertain, because owning options limits your downside risk.) Currently, the Vix is close to levels that might be considered "normal." As I interpret this, the market is now relatively confident in the outlook for the U.S. economy; not necessarily excited or optimistic about the outlook, but just reasonably confident that not much is going to change: more slow growth ahead, but much less risk of a another recession. (The Vix has jumped to 14.5 today as the market worries that QE tapering is rapidly approaching.)

Gold has tracked commodity prices pretty well for the past several decades, although it has been much more volatile (note that the scale of the right y-axis is almost twice as large as the one on the left). Gold surged ahead of commodities in 2009, as the world worried about another recession, Eurozone defaults, and the potential for QE to trigger a collapse of the dollar and a surge of inflation. In other words, gold surged as fears and speculation mounted, and as confidence declined. The recent 30% decline in gold prices marks a significant change in this dynamic.

Real yields on 5-yr TIPS have a strong tendency to track the market's expectations for real economic growth. When real yields fell to -1.8%, that was a clear sign that the bond market was very fearful that U.S. economic growth would stagnate, and that another recession was a disturbing possibility. The jump in real yields in recent months is an excellent sign that the market is becoming less pessimistic about the prospects for economic growth, and less anxious to pay a huge premium for the relative safety of short- and intermediate-maturity TIPS.

Gold's decline from the stratospheric heights of $1900/oz. has tracked pretty well with the rise in real yields on TIPS. Both are clear indicators of a decline in the demand for safe assets.

It's probably too early to say that the tide has turned here, but net equity flows in the past seven months have been positive.

The PE ratio of the S&P 500 is about average, having risen from decidedly below-average levels in the past few years. This shows that investors' confidence in the future of corporate profits has improved, although it is still relatively subdued considering that interest rates are still at very low levels from an historical perspective.

Bond funds have seen major outflows in recent months, eclipsing anything seen in the past several years. The demand for the relative safety of bonds has definitely weakened.

The nation's major home builders haven't been this confident about the future of their industry for over 7 years.

U.S. households have been working very hard to reduce their financial burdens and improve the health of their balance sheets (aka deleveraging). As a result, financial burdens (monthly payments relative to disposable income) are as low today as they have been for over 30 years. Risk aversion has been significant in recent years, but it's now possible that households are ready to start taking on more risk.

All things considered, it looks to me like the market is over-reacting to the prospect of a tapering of Fed bond purchases. When it does begin tapering, the Fed will be responding in a responsible fashion to the world's declining demand for safe assets. This is not something to fear, it's something to cheer.