I warned coming into 2010 that the withdrawal of monetary stimulus by global central banks and rising bond yields would create turbulence in asset markets in H1, particularly in emerging market equities, high-yield debt and commodities. Where China has led in tightening policy, to the surprise of the overwhelming consensus, the Fed will now likely follow. Current US monetary stimulus is almost certainly inflationary over the next 3-5 years, by providing excess liquidity above that required by underlying growth prospects. The steep US yield curve reflects market expectations of Fed normalization, although to still modest levels historically. Imputed 10-year Treasury yields imply that the Fed funds rate will average 3.5% over the next 10 years. The steep curve, aside from being a useful way to re-liquefy bank balance sheets also implies that the only real uncertainty is precisely when the Fed begins to raise rates. Implied 10 year US CPI inflation as embodied in the TIPS market has risen from zero to over 2% in a year, still low by historical standards but incompatible with a sustained zero rate policy.
The stunning rally in US corporate bonds over the last year reflects not only panic default assumptions last spring exceeding the 1930’s experience, but also Fed policy since, which by buying ‘safe’ assets like Treasuries and MBS from institutions has displaced their cash into risky ones, taking IG spreads back to late 2007 levels at the tail-end of an historic credit bubble. The $1 trillion expansion of the Federal Reserve's Balance Sheet that occurred from Sept. '08 through end 2009 is probably the biggest monetary gamble the history of the U.S. Prior to this crisis, commercial bank reserves totaled sub $100bn and hadn't grown since 2003; now they stand at $1.2 trn. The Fed, responding to a flight to safety in the dollar and Treasuries post the implosion of Lehman bought over a trillion dollars worth of securities (mostly Treasuries and MBS) from banks. The Fed paid for these purchases by electronically crediting the accounts of its member banks with reserves, which is the type of 'virtual' money only the Fed can create. Buying and selling securities is the traditional way that the Fed increases or reduces the supply of money to the banking system, but never before on this scale. This radical action was appropriate, since the alternative would have resulted in a monetary deflation of the sort that exacerbated the 1930's depression.
Banks as of yet haven't used any of their extra reserves to expand their lending. The reserves are sitting idle at the Fed in the form of "excess reserves," which currently total $1.1 trillion. The Fed has massively increased the lending capacity of banks , but this hasn't created a flood of extra liquidity or a burst of inflation as that lending capacity is 'trapped'. The demand for loans is still weak. In aggregate, bank lending is weak in part because many consumers and corporates are still trying to deleverage. At the same time, banks aren't particularly anxious to lend either. After throwing credit standards out the window in the boom, they have been relentlessly raising their lending standards since. Banks have gone from being recklessly hungry for risk to being risk averse as they nurse their balance sheet wounds. But if they were to resume lending as economic confidence grew, that $1 trillion of excess reserves could potentially support about $10 trn of new credit creation, which is clearly inflationary. In principle, the Fed would just sell Treasuries and MBS in exchange for taking back the trillion dollars of excess reserves, but that could push interest rates sky-high and undermine the recovery.
