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Most of the headlines this morning blame yesterday’s market fallout on expectations of Fed tapering. Many are citing the improvement in US economic data as evidence the Fed doesn’t need to keep its bond and MBS purchases going.

Critics have rightly lumped blame on the Fed’s QE policies for failing to directly and efficiently energize the real economy. But it’s hard to argue against the influence it’s had on investor sentiment over time.

That slow improvement in sentiment seems to have finally restored confidence enough to generate legitimate new loan activity. Here is a chart of US commercial & industrial loans: 

Since 2011 it’s been a steady climb and this metric is approaching the 2009 peak level. It took two years and two rounds of QE, but demand for C&I loans returned.

That this data is on the verge of retaking pre-crisis levels can be cited as additional evidence the US economy can stand on its own without the Fed’s omnipresence. Of course, a Fed exit could generate nervousness and create a relapse that sees the credit markets seize up again. After all, willingness to lend and borrowing was at the heart of the financial crisis (it was not so much a matter of banks’ ability, or inability, to lend.)

So, what’s my point?

Well, I think the Fed is still worried about conditions outside the US, namely Eurozone banks, as it considers its exit strategy.

So I went to the European Central Bank’s website this morning to find their equivalent of commercial & industrial loan activity. Here it is, monetary and financial loans to non-financial corporations: 

Not only is this metric not approaching its pre-crisis peak, it’s actually at its lowest level since the crisis hit in 2008/09. And it goes to the point that Europe is not out of the woods.

Despite the relative improvement in Eurozone economic sentiment in recent weeks, the potential for its economy and debt levels to improve remain poor. Jack sent me this chart from The Wall Street Journal earlier today:

Needless to say, Europe’s financial system remains vulnerable. Quality collateral is an issue as its banks seek to bolster their balance sheets in an environment where demand for loans that drive economic growth is wallowing.

There is a scarcity of quality collateral that necessitates new collateral creation of less quality … as well as a system willing to accept it. The problem here resides in the resulting increased interconnectedness between collateral and financial markets. As the banking system becomes more tightly coupled with the markets and securitization through this new collateral, the impact from a market shock is intensified and and spurs a negative feedback loop where quality collateral becomes more scarce.

Considering how much money the Federal Reserve is providing to foreign banks (more than $1 trillion and more than to US banks, YTD as of July 31) you have to think it harbors significant concern for European banks in particular. The Fed realizes its departure from QE could very easily and very likely generate a sharp drop in the market, even if the decline is relatively short-lived and the US economy is truly on solid footing.

But even those who think Europe’s economic decline is moderating won’t dare suggest Europe is on solid footing. So what type of contagion will spread from Europe if a Fed-induced market shock sends their financial system, the largest in the world, reeling?

Certainly not any type the Fed welcomes (unless of course the Fed truly wants to end the global dependency and untintended consequences of its monetary policy — ha!)

I suppose the Fed is between a rock and a hard place — succumb to the pressures from the BIS who cited growing risked from increased QE … or risk contagion from a European banking system that’s left to fend for itself (so to speak)?

Considering their “do something, do anything, to mend the global economy” track record, I suspect they’ll err on the side of keeping QE in play so as to manage the markets and bide more time for Europe.

It’s be interesting to see how this experiment works out …