ONLY FOR WONKS / PRUDENTBEAR.COM

Only for Wonks

September 19, 2014 

 by Doug Noland

A week of really interesting market action and a new Z.1 "flow of funds" report - all overshadowed by Alibaba. I appreciate Bill Gross’ August Investment Outlook, “For Wonks Only,” and recommend reading (and pondering) it in its entirety.

From Gross: “A credit-based financial economy (as opposed to pure cash) depends on an ever-expanding outstanding level of credit for its survival. Without additional credit, interest on previously issued liabilities cannot be paid absent the sale of existing assets, which in turn would lead to a vicious cycle of debt deflation, recession and ultimately depression. It is this expansion of private and public market credit which the Fed and the BOE have successfully engineered over the past five years, while their contemporaries (the ECB and BOJ) have until now failed, at least in terms of stimulating economic growth. The unmodeled (for lack of historical example) experiment that all major central banks are now engaged in is to ask and then answer: What growth rate of credit is enough to pay prior bills, and what policy rate/amount of Quantitative Easing (QE) is necessary to generate that growth rate? Assuming that the interest rate on outstanding debt in the U.S. is approximately 4.5% (admittedly a slight stab in the dark because of shadow debt obligations), a Fed governor using this template would want credit to expand by at least 4.5% per year in order to prevent the necessary sale of existing assets (debt and equity) to cover annual interest costs… How are they doing? Chart 1 shows outstanding credit growth for recent quarters and all quarters since January 2004. The chart’s definition of credit includes the standard Fed definition of private non-financial credit (corporations, households, mortgages), public liabilities (government debt), as well as financial credit. The current outstanding total approximates $58 trillion and has been expanding at an average annual rate of 2% for the past five years, and 3.5% for the most recent 12 months. Put simply, if credit needs to expand at 4.5% per year, then the private and public sectors in combination must create approximately $2.5 trillion of additional debt per year to pay for outstanding interesting.”

Bill Gross’ number is “approximately $2.5 trillion” to ensure sufficient new system Credit to service existing system debt. I’ve posited the U.S. system needs in the neighborhood of $2.0 TN of annual non-financial debt growth. Gross refers to a “credit-based financial economy.” Fair enough, although I believe it is also crucial to appreciate that the U.S. economy has evolved over time to be dominated by a consumption and services-based economic structure. From my analytical framework, annual $2.0 TN (non-financial) Credit growth is required to generate sufficient system-wide purchasing power to sustain various inflated price levels - certainly including incomes, corporate cash-flows, imports, investment and asset prices. An inflated/maladjusted services and consumption economic structure survives on ever-abundant cheap finance.

From the Fed’s Q2 2014 Z.1 “flow of funds” data, we see that total system Credit expanded at a seasonally-adjusted and annualized (SAAR) rate of $2.321 TN during the quarter to a record $57.529 TN. Non-financial market borrowings increased SAAR $1.542 TN (to $40.435 TN); Financial Sector market borrowings rose SAAR $353bn (to $13.954 TN); and Rest of World (ROW) market borrowings expanded SAAR $426bn.
It’s kind of a love/hate thing for me. I love the subject matter of money and Credit. I’m fascinated by monetary history, and always challenging analysis makes my heart go pitter-patter. Yet I admittedly rather despise contemporary finance – today’s “money” and Credit. The 2008/9 crisis offered another glimpse of its inherent danger to all. I believe strongly that sound money and Credit provide the bedrock for Capitalism, economies and societies. An understanding and appreciation for what constitutes stable finance (money and Credit) are fundamental to financial system, economic and social stability. Most regrettably, finance has become so complex, sophisticated and convoluted that basically no one today can feel comfortable that they really grasp what’s going on with “money.”

Mr. Gross aptly titled his piece “For Wonks Only.” And I actually think he simplified his analysis in an effort for it to at least be assessable to so-called “wonks.” He calculates $2.5 TN of required system Credit growth on total outstanding (non-financial and financial) debt of approximately $58 TN. Out of necessity, my analysis focuses on non-financial debt growth of $2.0 TN on outstanding of debt of $40.4 TN.

Analysis of Financial sector borrowings – or “Credit Market Debt Owed by Financial Sectors” – is fraught with myriad challenges. During lending Bubbles – especially booms in risky Credits – financial sector borrowings can reflect layers of financial/risk intermediation. For example, Financial Sector borrowings surged $1.336 TN (10.3%) in 2006 and another $1.834 TN (12.9%) in 2007, with outstanding GSE debt, MBS and ABS swelling as record mortgage lending was intermediated (“Wall Street alchemy”). Financial Credit then contracted $1.663 TN during the 2009 mortgage Credit dislocation.

Overall, Z.1 Financial Sector market borrowings of almost $14.0 TN remain $3.0 TN below peak levels from early 2009. This seeming contraction in Financial borrowings helped to improve ratios of total system debt to GDP, in the process providing ammo for the deleveraging thesis crowd.
Importantly, Financial Sector market debt excludes the almost $4.5 TN of outstanding Federal Reserve Credit (it also excludes Trillions of bank deposit liabilities). Indeed, the almost $3.6 TN six-year expansion of Fed Credit has played a momentous role in U.S. and global system reflation, while remaining conveniently excluded from tallies of system debt.

It would meaningfully change Credit growth calculations if Federal Reserve Credit was part of the analysis. For one, it would more than reverse the $3.0 TN post-crisis contraction in Financial Sector borrowings. More importantly, it significantly alters annual Credit growth numbers/analysis (and is at the heart of my analysis that system deleveraging is a myth). From my perspective, unprecedented inflation in Federal Reserve Credit has been instrumental in inflating U.S. incomes, corporate cash flows, securities and asset prices, spending, imports and tax receipts in the face of insufficient overall Credit expansion in the real economy.

It’s impossible to quantify the various impacts from Fed Credit expansion (“money” printing), so conventional analysis simply disregards it. Most believe that Fed Credit has been sitting inertly on the banking system balance sheet. In reality this torrent of liquidity has been slushing about global securities markets. There should be no doubt that the effects have been profound – in the markets and real economy, at home and abroad.

The Fed is to wind down its “money” printing in a month or so. Markets remain uber-complacent. It remains difficult for me to envisage ongoing Credit growth sufficient to sustain levitated system price levels without the headwinds provided by massive inflation of Fed Credit. Global financial flows remain The Wildcard.

Examining the most recent Z.1, Total Non-Financial Debt expanded SAAR $1.542 TN (3.8%) during Q2, down from Q1’s SAAR $1.692 TN (4.3%). This was the weakest Credit expansion since Q3 2013. Total Household borrowings jumped to SAAR $471bn, the strongest gain since Q1 ’08. Total Business borrowings of SAAR $722bn (6.3%) were up somewhat from Q1’s SAAR $695bn. Federal borrowings grew SAAR $314bn (2.5%), down from Q1’s $741bn.

Federal Reserve Liabilities ended Q2 at a record $4.430 TN. Fed Credit was up $903bn, or 25.6%, year-on-year. Fed Credit inflated $1.546 TN, or 53.6%, over two years. In six years Fed Credit inflated $3.478 TN, or 365%. It’s my view that this unprecedented inflation in Federal Reserve “money” has unleashed major inflationary dynamics upon securities prices, perceived household wealth and incomes, while also provoking highly unstable global financial flows and market Bubbles. Impacts on securities prices, the household balance sheet and incomes are easiest to illustrate.

First of all, Incomes jumped strongly in Q2, indicative of the modest inflationary bias that has taken hold after six years of extreme monetary measures. National Income expanded at a 7.6% pace during the quarter, with one-year gains of $502bn, or 3.5%. Compensation increased at a 5.2% pace in Q2, increasing one-year gains to $389bn, or 4.4%. Chair Yellen should be pleased.

Indicative of a rather immodest inflationary bias, Household Assets increased nominal $1.552 TN during Q2 to a record $95.44 TN. This boosted one-year gains to $8.0 TN, or 9.2% , and two-year gains to $14.511 TN, or 17.9%. With Household Liabilities little changed, Household Net Worth gained $1.391 TN during Q2. Household Net Worth increased $7.679 TN over the past year to a record $81.493 TN (551% of GDP!). For reference, Household Net Worth ended 2007 at a then record $67.832 TN. Amazingly, Household Net Worth has now inflated $24.295 TN, or 42.5%, since the end of 2008.

A brief note on the composition of Household Sector Assets seems appropriate. As a component of total Household Assets, holdings of Equities and Mutual Funds jumped from $9.238 TN at the end of ’08 to $20.995 TN to end Q2 2014. Equities and Mutual Funds have jumped from 20% of total Financial Asset holdings to 31%. For comparison, since the end of ’08 Household holdings of Deposits (bank and money market fund) have increased from $8.172 TN to $9.861 TN.

Federal Reserve monetary inflation has had its most conspicuous impact on securities prices. In past analyses, I’ve combined (Z.1 categories) Treasuries, MBS, Corporate Bonds and Municipal Securities to come to a proxy for total marketable debt, and then added Equities for my proxy of Total Marketable Securities (the Fed made some significant revisions, especially to its tally of Corporate Debt). For the quarter, Total Securities increased $1.590 TN during Q2 to a record $71.184 TN. Total Securities was up $26.349 TN, or 59%, during the past 22 quarters. Total Securities has now inflated to a record 411% of GDP. For comparison, Total Securities ended 2007 at a then record $53.080 TN, or 378% of GDP.

There’s another crucial “balance sheet” especially worthy of contemplation these days. Rest of World (ROW) holdings of U.S. Financial Assets increased another $634bn during Q2 to a record $22.277 TN, with a notable one-year gain of $2.344 TN, or 11.8% (second only to 2006’s $2.49 TN). ROW holdings have jumped over $6.0 TN in four years, with flows almost equaling the levels from the 2004-2007 Bubble period. I view ROW flows as a good proxy for global “hot money” speculative flows.

I believe the Fed and global central bank QE has unleashed Trillions of liquidity into global securities markets. Moreover, extreme monetary measures (zero rates and QE) coupled with assurances of market liquidity backstops has incited unprecedented global leveraged speculation. This speculative leveraging has likely created Trillions additional liquidity that has worked surreptitiously to precariously inflate global securities markets.

This liquidity bonanza has played a crucial if unappreciated economic role. In the U.S., it has been integral in the inflation of securities markets, in the process inflating perceived wealth, spending and general economic activity. In the Emerging Markets (EM), this liquidity was instrumental in inflating domestic Credit and financing financial and economic Bubbles. With faltering economies and fragile Credit systems, EM is now acutely vulnerable to a destabilizing reversal of these investment and speculative (“hot money”) flows.

And here’s where the analysis turns even more challenging. Global QE incited strong inflationary biases throughout global securities markets. Meanwhile, the liquidity bonanza and the powerful magnetism of speculative securities Bubbles worked (perversely) to place further downward pressure on global commodities and manufactured good prices. At the same time, the Fed’s QE3 coupled with global flows ensured a general inflationary bias for both U.S. securities markets and the services/consumption U.S. economy. The inflationary U.S. backdrop in the face of strengthening global disinflationary forces has incited an increasingly self-reinforcing King Dollar Dynamic.

Thus far, King Dollar has bolstered the bullish viewpoint for U.S. economic and stock market prospects. Increasingly, however, the King is fostering instability. Commodity prices were under further pressure this week, while EM fragility becomes a bigger market worry by the day. The Brazilian real’s 1.2% decline this week pushed the currency to within easy striking distance of multi-year lows. The week saw Russian ruble decline 1.8%, the Indonesian rupiah 1.2%, the Philippine peso 1.2% and the Malaysian ringgit 1.1%. The Goldman Sachs Commodities Index declined another 0.5% to the low since the summer of 2012. Venezuela CDS jumped another 178 bps to 1,615. Wheat traded to a new four-year low and corn to a five-year low.

Helping to explain market complacency, this is clearly not the first instance in recent years that EM Bubbles appeared vulnerable. The Fed’s QE2 worked its magic for the EMs back in 2011. The reemergence of acute stress in 2012 was reversed by Draghi’s “do whatever it takes” and open-ended QE from the Fed and BOJ. Bernanke’s “the Fed will push back…” did the trick in mid-2013.

Of late, talk has been that the ECB’s balance sheet would come to the rescue. Count me as deeply skeptical of all the bullish ECB “QE” liquidity propaganda. As such, I see a world of somewhat waning liquidity abundance with an increasingly destabilizing King Dollar bias. There’s risk that escalating EM stress and attendant “hot money” outflows lead to a self-reinforcing de-risking/de-leveraging dynamic. EM companies and countries at this point have way too much dollar-denominated debt. At some point, contagion might negatively impact market expectations for the global economy at large, perhaps leading to a more generalized global “risk off” backdrop.

From the Z.1 we know that Security Credit was up $161bn year-over-year, or 13.7%, to a record $1.333 TN. Fed Funds and Repurchase Agreements were little changed y-o-y at $3.792 TN. Security Broker/Dealer Assets were actually down about 5% y-o-y to $3.388 TN. Funding Corps were down 3.3% y-o-y to $1.312 TN. Clearly, securities leveraging remains integral to overall U.S. Credit system operations.

At the same time, there are important sources of global leverage outside the purview of Fed monitoring and Z.1 reporting. There are myriad avenues for “carry trades,” securities shorting and “off-shore” securities financing vehicles, not to mention the murky world of (hundreds of Trillions of) derivatives. And it wouldn’t surprise me in the least if this is where the surprise lurks, especially now that currency markets have turned notably unstable. Seth (“Truman Show”) Klarman was said to have written that “we are recreating the markets of 2007.” For me, the world today is a whole lot scarier.