Almost everyone is getting the interest rate outlook wrong

The shift between commercial bank credit to "support" from excessive US Government spending is highly inflationary

Almost every broker’s analysis is forecasting lower interest rates. This is essentially a common view based on Keynesian and monetarist macroeconomic theory in the face of a widely anticipated economic recession. Keynesians argue that declining consumer demand leads to lower prices, ignoring the fact that production output always declines first. And monetarists simply link a contracting money supply to prospective rates of price inflation. These mathematical theories dominate contemporary thinking and to an extent can act as self-fulfilling prophesies, until the economic reality corrects them — usually violently.

Both disciplines ignore the subjectivity factor which is inherent in the value of any medium of exchange that depends entirely upon the users’ faith in it. They have failed in their mathematics to adjust from the days when currencies’ values were anchored however loosely to real, legal international money with no counterparty risk — which is only gold. Furthermore, they fail to understand the wider market realities of contracting bank credit, which even under a solid gold standard makes up the vast bulk of a circulating medium. And they make the simple error of not understanding that in a recession it is not demand for credit which declines, leading to lower interest rates, but bankers perceiving heightened lending risk and restricting the availability of credit leading to higher borrowing rates.

The reality is simple: if the banks restrict the expansion of credit, then borrowers face having to pay up in order to secure credit. And to accommodate increased lending risk, banks widen their margins by increasing interest paid to depositors as little as possible. Does this not describe current bank credit conditions? So long as it remains the case, whatever a central bank says interest rates will remain stubbornly high.

Nevertheless, the situation over US bank credit does require more detailed examination, partly because regulatory changes have distorted money supply statistics. We must start with a simple definition of modern money supply: it is entirely comprised of credit in the form of central and commercial bank credit liabilities to the general public. But recently, the Fed has been taking in credit from money funds which would otherwise be recorded as bank deposits. This has come about because under Basel 3 net stable funding rules, large deposits face a haircut of 50% for the purpose of funding balance sheet assets, compared with only 5% for small, insured deposits. And commercial banks are not prepared to cut their interest rate margins to compete for these deposits anyway.

Consequently, the Fed extended its reverse repurchase facility to money funds by using its stock of Treasury and agency collateral in exchange for money funds’ deposits, taking them out of public circulation. This has had the initial effect of reducing apparent money supply growth and then accelerating its decline when money funds reduced their repurchase positions in favour of treasury bills. The sum of bank deposits and reverse repurchase agreements is illustrated in the chart below.

Most of the decline has been due to the fall in reverse repos, which have declined from $2.24 trillion in December 2022 to $681 billion recently, while M2 itself declined by only $340 billion over the same period. The funds tied up in reverse repos have since migrated to the T-Bill market, where 1 month maturities yield 5.4%. Essentially, they have disappeared into the government’s coffers, doubtless further enhanced by banks switching their own loan books and bond holdings into short maturity T-Bills in a general flight away from lending risk. Additionally, total money funds have increased by about $1.4 trillion since last March to nearly $6 trillion all of which have also disappeared into T-Bills.

The extent to which the Biden administration is sucking credit out of the US financial system is truly remarkable. While indicating that its own finances are in crisis, it shows that the level of risk aversion in private credit availability from the banking system is considerably greater than generally realised.

While the credit shortage for the private sector is acute, a combination of money fund flows and banks de-risking their balance sheets has allowed the US Government to borrow $2.6 trillion since this time last year, allowing for changes in its general account at the Fed. These funds are leaking back into the economy through government spending, none of which is productive in the sense that it is freely demanded. In other words, far from being deflationary as the monetarists suggest, by being taken out of the commercial banking system and redirected into government hands the apparent contraction of the sum of bank deposits and reverse repos is a more inflationary deployment of credit.

These are precisely the credit dynamics which fuelled stagflationary conditions in the 1970s. They lead to the opposite conditions currently discounted in financial markets. Therefore, far from an outlook for stable, lower interest rates and bond yields, the opposite is in prospect. And with the economic outlook deteriorating, even tighter credit conditions for businesses and consumers are certain. Furthermore, they are sure to lead to higher interest rates and bond yields reflecting higher inflation, and a severe bear market in equities as well.

This much will become increasingly obvious in the coming months.