Compass July 2014

In this issue:

Compass is the quarterly newsletter of Creekside Partners. All information is obtained from sources deemed to be reliable, but is not guaranteed as to accuracy. Nothing in this newsletter should be construed as financial or investment advice to any reader. All material herein is the copyright of Creekside Partners.

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Fed Tapering: Removing the Mystery

Since about a year ago, the Federal Reserve has consistently made clear its intent to slow its purchase of bonds. Most commentary speculates that this will lead directly to rising interest rates. A more careful examination leads us to think…not necessarily.

First, realize that the short-term overnight lending rate that is the Fed’s principal target is set in the open, free market by banks. Banks have a regulatory need for a certain amount of “reserves.” Reserves consist of cash in the bank vault (which is a tiny part of the whole), plus the bank’s balance in its account at the Fed (which is the only part that really matters). The amount of required reserves is roughly scaled to the size of the bank; bigger banks need bigger reserves. If a given bank grows by lending more and taking on more deposits, it needs more reserves. Over time, as the economy grows, bank reserves need to grow — pretty much endlessly.

If a bank takes in a bunch of new deposits, and writes new loans, it needs more reserves. The bank can acquire these reserves literally overnight by borrowing another bank’s excess reserves. Bank A needs a million dollars of reserves; Bank B has an extra million that particular day, and a deal is made.

If system-wide bank lending is expanding, the entire banking system is simultaneously seeking excess reserves, and the interest rate on these overnight deals goes up. That overnight interest rate is the Fed’s main policy target. By watching that rate carefully, Fed staffers will have a good feel for what is happening out in the world of banking, in real time, and without having to wait for monthly or quarterly reports.

The total amount of reserves drifts higher as a natural consequence of government spending. When the government spends, it does so by depositing newly created electronic money into the banks’ Fed reserve accounts. The opposite happens when we pay our taxes via our bank accounts. That money disappears into the federal maw. The net amount — i.e., the deficit — is left behind to increase bank reserves. With the amount that our government usually runs in deficits, bank reserves would grow far faster than banks need reserves. With excess reserves throughout the banking system, most banks would not need to borrow any, and the interest rate on overnight reserve lending will collapse downward.

Low interest rates might seem like a good thing, but overnight rates that are too low can result in an overstimulated economy—and inflation.

So, the Fed and the Treasury, acting in concert, need to “drain” these excess reserves from the banking system. That will keep banks competing for overnight deals, and prop up short term interest rates to a more reasonable level. The most straightforward way to drain reserves is to sell Treasury bonds. While the Fed is technically not a direct part of the federal government, it is better to think of it as an independent entity within the Treasury. In normal times, the Treasury sells a steady supply of bonds, equal in amount to the federal deficit. These sales serve to reduce excess bank reserves since such sales are “settled” via banks’ reserve accounts, and as those funds reach the government, the banks’ reserves are reduced. In normal times, all this balances out rather nicely, and the banking system marches steadily forward.

Here is a simple example of normal times, using imaginary numbers:

Activities Increasing Reserves
Federal Spending +$1,000 Billion
Activities Reducing Reserves
Tax Receipts ($800 Billion)
Net Change in Reserves +$200 Billion

But the banking system doesn’t need $200 billion in new reserves. It only needs $2 billion. So…

Activities Reducing Reserves
Treasury Sells Bonds ($200 Billion)
Activities Increasing Reserves
Fed Buys Bonds +$2 Billion
Net Change in Reserves +$2 Billion

The Treasury sale fully offsets the gap between spending and taxes; the Fed merely buys the amount it needs on the open market. (Keep in mind a dirty little secret about federal spending: The government doesn’t have to borrow to cover a deficit; it can spend by merely depositing “money” into bank reserve accounts. The only reason it must sell bonds is to drain those bank reserves and keep the economy from overheating and triggering runaway inflation.)

These have not been normal times. The exploding federal deficit that first showed up in the last fiscal year under President Bush, and continued into the President Obama years, threatened to put so many Treasury bonds into circulation that interest rates would spike. At the same time, deteriorating banking conditions required banks to seek ever-higher amounts of reserves via overnight deals with other banks — also sending rates higher.

So, the Federal Reserve stepped in and bought enormous quantities of bonds. This is a clear example of how the Fed and Treasury effectively act in concert. What matters here is the net sales of Treasuries. If Treasury sells $100 billion in bonds, and the Fed buys half of it, the economy and the banking system see only $50 billion of bonds being floated. The rest of the Federal deficit shows up in bank reserves, creating excess reserves and keeping rates low.

In the example given above, we show that, in normal times, Fed purchases are but a small fraction of Treasury sales. But in the last five quarters, Fed purchases of bonds have exceeded Treasury issuance of bonds by almost $600 billion.

The table on the following page shows the net of Treasury and Fed bond sales/purchases. Remember, Fed purchases offset Treasury sales, bringing the net amount down. It is possible that the Fed buys so many bonds that the net figure is negative. In addition, the Treasury can have net negative issuance. You can see a few quarters where net issuance was, in fact, negative. This has a short-term effect roughly equivalent to a federal budget surplus.

We have added yellow highlights to the chart to show the timeframes of the Fed’s three “QE” programs since 2009. In each of these three periods, the net bond sales dropped sharply immediately upon commencement of the program. And, in the first two periods, bond sales spiked again, requiring renewed buying. In the most recent period, QE III, sales fell sharply…deep into negative territory. QE III is winding down (“tapering”), yet net sales have continued to fall.

This is the reason we now see the Fed tapering the program. They are clearly over-buying. This is why bond interest rates have not spiked.

With the current high level of bank reserves, adding to those bank reserves will have no effect on bank lending or interest rates. It’s like a kid with several giant bags of Halloween candy — do a few more pieces really make him any happier?

The nature of this system also helps to explain why we have not had high inflation. In Econ classes, they teach that, when the Fed buys bonds and adds to bank reserves, banks will immediately lend out as much as 10 times that amount of money, igniting economic activity and sharply expanding the money supply. But, here in the real world, banks don’t increase lending simply because they have high reserve balances. Banks write new loans if good borrowers show up, with good business plans and high prospects for growth and success. Since 2008, that loan application stream has been weak. And so bank lending growth has been mundane, and the money supply has not spiked.
The Fed clearly must taper its bond-buying. With the federal deficit expected to stay down for at least another couple of years, we cannot have the Fed driving net Treasury sales into negative territory.

The outlook for future interest rates remains uncertain. In the fullness of time, the Fed doesn’t set interest rates — private economic forces do. With rates still near historic lows, we are taking a cautious approach and holding average bond maturities down at 5-7 years or shorter. An unexpected spike of inflation, interest rates, or both, will not be kind to long-term bond and stock prices.

Stay Energy Aware and Energy Invested

There has been a lot of talk of America’s future energy independence. We are bit skeptical about these headlines and continue to follow traditional energy markets very closely. As we have mentioned in the past, we are ardent believers in allocating a healthy percentage of investable assets toward natural resources and energy companies. Most of us take energy for granted but, when you really look at our quality of life, it is directly tied to our access to reliable, cheap energy. We have been very lucky to have such access as a nation over the past 150 years and we expect continued technological innovation and more efficient use of energy…but…

With 82% of global energy being provided by Oil, Coal and Natural Gas we would love to see alternative sources continue to grow. As pragmatic investors we continue to recommend exposure to natural resource and energy companies. Especially when you view the chart below.

Year-to-Date Index Returns (ending 6/30/14)

Total Market U.S. Stocks

Foreign Stocks (Developed)

Emerging Market Stocks

Muni Bonds

Taxable Bonds

Inflation (year-over-year)







Wherever possible, we use the returns on Vanguard Index Funds as the benchmark figures for various asset classes.

Readers wishing to review the actual performance record of a composite of our client portfolios should call or email us at