Two weeks ago, Andrew published a blog entry suggesting that the crisis-born aversion to Investment spending and resulting lack of demand for capital has a suppressive effect on interest rates, all else equal. Today we examine excess supply of investable funds, caused principally by the ongoing extraordinary actions of central banks, and suggest it is affecting interest rates in the same direction.
As investors, we closely monitor our own investment flows as well as the many flow-of-funds aggregates. Unquestionably, it feels like there is a glut of investable capital looking to earn a return, any return. Some pundits describe the market buoyancy associated with this feeling as the “cash on the sidelines” effect – and that it should drive down yields in fixed income just as it drives up prices for equities and farm land. The skeptics will counter that every transaction has a buyer and seller, such that an inflow into an investable asset is really just a transfer of sideline cash from the buyer to the seller without changing the amount of it. Those folks refer to the “myth of cash on the sidelines.” The truth, we believe, is somewhere in the middle, and obviously the global central banks influence this dynamic heavily in at least two ways. First, QE increases the supply of sideline cash as we’ll discuss below. Second, conventional highly-stimulative monetary policy assigns punitive interest rates to cash-equivalents so that even periods where total cash is fixed, rotation between sideline cash and a static set of investable assets can happen at progressively higher and higher prices if either risk tolerance steadily improves, or the penalty for holding cash is intensified. The most extreme example to date is the negative deposit rate adopted by the ECB in June.
We’ve used the words “capital” and “cash” more-or-less interchangeably, but they are different. Capital ought to represent wealth (positive net worth) whereas cash or money is just a liquid asset which may or may not have a liability encumbering it. Traditionally, when we think of QE, we don’t think of it as wealth creation directly, but rather as liquidity creation. We say “liquidity is abundant” as a result of central bank action, meaning there is plenty of cash around, but theoretically the economy’s liabilities have gone up just as fast as the money printing. The central banks buy bonds with their printed money, which is to say that the central banks are lending, rather than gifting the cash.
Semantics aside, the cash absolutely makes its way into the depths of the real economy, initially via government spending. That cash propagates through the normal channels to households and corporations, a portion of which is saved and perceived to represent genuine capital. This dynamic represents a clear increase in the supply of investable funds over time as QE progresses.
To describe the effect another way, government deficits are set through fiscal policy and must be financed through government bond issuance. In the absence of QE, that bond issuance absorbs a portion of the global supply of available capital. In the presence of QE, some or all of the deficit financing is provided through central bank money printing rather than the actual supply of available capital. There is a crowding out effect, such that the supply of investable funds must be absorbed by fewer assets, and this raises prices / lowers yields all else equal. Hints of the crowding out effect can be seen in the changing dynamics of mutual fund flows pre- and post-Fed Balance Sheet expansion (Chart). Fixed Income funds of all types except government funds experience an upturn in flows:
What’s unclear, and up to a point will remain imperceptible to individual actors in the economy, is what portion of investable funds represents “real capital” versus “new money”. As long as the inflection point is not reached, increased supply of investable funds driven purely by QE should influence interest rates lower just the same as fresh real capital, all else equal. Despite the approaching end of QE in the US, the ECB, Band of Japan (BoJ), and Chinese government are continuing or increasing their balance sheet expansion programs, and that glut of investable cash is making its way into US markets as imported QE.
In our view, the effects of depressed demand for financing are likely to persist for longer as an interest rate suppressant than those of over-supply of investable cash. There should come a point where the dilution of real capital via money creation is no longer imperceptible, and the supply of capital ought to shift in the other direction as inflation concerns take hold. So far though, the inflation has been contained merely to asset prices rather than measured prices of consumables.
Abbreviations: QE: Quantitative Easing; ECB: The European Central Bank; Fed: The US Federal Reserve; BOJ: Bank of Japan; BoE: Bank of England; BEA: PBoC: People’s Bank of China.