Upside Down Monetary Policy

we think one of the more interesting aspects of monetary policy is that conventional wisdom thinks the Fed controls interest rates and stimulates lending but depending on how you look at it, the bond market and banking system are often doing quite the opposite as what the Fed’s policy intends.

From a simple perspective, if you look at the yield curve, the market tends to counter balance Fed policy.  The curve steepens when the Fed is perceived to be too easy and flattens when the Fed is too tight.

In addition to the curve the banking system seems to respond in a counter balance.  As you can see in the chart, when the Fed lowers interest rates the loan to deposit ratio falls and when they tighten it rises.  So when the Fed eases, banks decrease lending and when they tighten, banks increase lending.  In addition, when the Fed eases and the curve steepens, banks in lieu of making more loans buy more securities to take advantage of the carry.  When the Fed tightens and the curve flattens banks rotate back into loans.

Chart: Bloomberg

taking this evidence you would conclude that the Fed is constantly working against themselves.  If they truly wanted to stimulate lending, looking at these trends they should raise interest rates, flatten the curve and flush the banks out of their carry trades.  Of course that has its own ramifications with the loads of negative coupon negative convexity positions currently on bank balance sheets.  Nevertheless, with the loan-t0-deposit ratio near previous lows and the curve already flattening due to the compression from Operation Twist, ironically the Fed is actually quasi tightening and making the carry trade less attractive so the demand for securities by the banking system may be finally starting to wane.


About exantefactor

capital market veteran of over 15 years covering multiple asset classes. Focused on analyzying markets ex ante (before the event).
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