June 6, 2014
Signs of an upside dislocation
Total (financial and non-financial) Credit jumped $484bn during Q1 to a record $59.399 TN, or 347% of GDP. Although economic growth faltered during the period, Q1 2014 Total Non-Financial Debt (NFD) expanded at a 5.0% rate. Corporate borrowings grew at a robust 9.3% pace, up from Q4’s 7.7% and Q1 2013’s 7.2%. Federal government debt mounted at a 7.1% rate, down from Q4’s 11.6% and Q1 2013’s 10.1%. Consumer Credit accelerated from Q4’s 5.3% rate to 6.6% - the strongest increase in borrowings since Q2 2012. Consumer Credit expanded 4.1% in 2011, 6.2% in 2012 and 5.9% in 2013. If Q1 consumer borrowing is sustained, 2014 will post the strongest consumer (non-mortgage) debt growth since 2001 (8.6%).
The historic increase in federal debt runs unabated. Recall that federal government debt expanded 24.2% in 2008, 22.7% in 2009, 20.2% in 2010, 11.4% in 2011, 10.9% in 2012 and 6.5% in 2013. Federal debt has increased $9.718 TN, or 145%, in 23 quarters. The ongoing expansion of corporate debt is also noteworthy. Corporate debt expanded 8.3% in 2012 and another 8.9% in 2013 – significantly exceeding the growth in the real economy. We’re in the midst of the strongest corporate debt expansion since the 9.2% in 2006 followed by 13.5% in 2007.
The Household (& Non-profits) Balance Sheet remains key to current Credit Bubble analysis. Household Assets increased $1.506 TN during the quarter to a record $95.549 TN. And with Household Liabilities up only $16.7bn, Household Net Worth jumped another $1.490 TN during the quarter. Over four quarters, Household Assets surged $8.189 TN, or 9.4%, with Liabilities increasing $209bn (1.5%). Household Net Worth surged $7.98 TN, or 10.8%, over the past year.
During the past four years, Household Net Worth has inflated an unprecedented $26.797 TN, or 49%. Over this period, Household holdings of Financial Assets have surged $22.0 TN, or 49%, to a record $67.2 TN. On the back of the QE3 liquidity onslaught, Household Net Worth jumped from 417% of GDP at mid-year 2012 to the recent 478% (and counting!). For comparison, Household Net Worth as a percentage of GDP peaked at 447% during the manic height of the “tech” Bubble (Q1 2000).
Analyzing the Fed's most-recent Z.1 “flow of funds” report recalls 2007 market exuberance. Looking back at the data, Non-financial Debt (NFD) growth increased to a blistering $2.344 TN in ‘07. Total Mortgage Debt growth, while slowing somewhat from the record 2004-2006 period, was still almost $1.1 TN (vs. 90’s average $268bn). Total Business borrowing rose to a record $1.045 TN. It was easy to ignore some subprime tumult with the economy seemingly firing on all cylinders.
Importantly, near-record 2007 NFD growth was matched by record Financial sector debt expansion. Financial sector borrowings increased an unprecedented $1.944 TN (up from ‘06’s $1.30 TN and ‘05’s $1.08 TN) to $17.103 TN. This pushed six-year growth of Financial sector borrowings to $7.077 TN, or 78%. At the time, I saw the “parabolic” financial sector ballooning as a major problem. For one, it was indicative of ever heavier financial sector intermediation – the “Wall Street Alchemy” necessary to transform progressively risky loans into perceived safe/“money”-like instruments. This unrecognized spike in systemic risk was occurring even in the face of initial cracks in mortgage finance. Actually, subprime stench had the markets salivating over imminent monetary accommodation. The Fed cut the discount rate in an unscheduled meeting on August 17th and pushed rates 100bps lower by year-end. The S&P 500 traded to its then all-time high in October 2007, less than a year away from the abyss.
For the year 2007, GSE issues (debt & MBS) increased $887.6bn, up from 2006’s $331bn growth. Outstanding ABS increased $350bn. Net Corporate bond issuance was a strong $709bn. A highly unbalanced financial and economic system was becoming only more vulnerable to what I believed was an imminent market tightening of Credit and resulting mortgage downturn. I saw fragility from a highly leveraged system and a heavily imbalanced real economy addicted to enormous amounts of cheap Credit and liquidity.
There was acute fragility associated with gigantic speculative leverage in securities and instruments with market prices detached from unfolding fundamental developments. Despite record stock prices and a resilient real economy, the risk of a problematic period of speculative de-leveraging was extreme and growing.
I'll try to explain what I see as current parallels. Federal Reserve Credit has been this cycles’ prevailing source of liquidity, “money” distorting pricing, risk perceptions and the flow of finance through both the markets and real economy. Importantly, this key source of financial Credit is supposedly ending in a few short months. And like 2007, highly speculative financial Bubble markets choose to disregard fundamental prospects and instead go into destabilizing blow-off mode. Indeed, deteriorating prospects – along with accompanying shorting and hedging – provide market melt-up fuel.
In the 23 quarters Q3 2008 through Q1 2014, Federal Reserve Credit expanded $3.338 TN, or 351%. Over the final “parabolic” expansion, Fed Credit/liquidity has surged $1.474 TN, or 52%, in the past 82 weeks. The S&P 500 has increased 50% from June 2012 lows – and is now up 122% from March 2009 lows. Over this period, the small caps have gained 140% and the Morgan Stanley High Tech index has surged 215%.
Similar to 2006/07, a huge expansion in Financial sector Credit stokes an ongoing boom in corporate Credit. A replay of Chuck Prince’s “still dancing” lending euphoria ensures a problematic Credit cycle downside. It is these days worth noting that net issuance of Corporate and Foreign Bonds increased $873bn in 2005, $1.242 TN in 2006 and a record $1.251 TN during (an oblivious) 2007. The 2008 Credit dislocation saw Corporate debt contract $215bn – a harsh reminder of how abruptly the Credit cycle can reverse course and bury folks.
It is worth recalling that Non-financial Debt (NFD) growth averaged $720bn annually during the nineties. It jumped to $1.046 TN during bubbling 1999. After a brief slowdown in 2000, aggressive Fed stimulus (and a resulting surge in mortgage borrowings) had NFD growth back in record territory in 2001 at $1.147 TN. NFD growth then jumped to $1.420 TN in 2002 and $1.716 TN by 2003. Fast-forward to 2007 and NFD expansion had jumped to $2.59 TN – more than triple the average from the nineties.
It’s central to my Macro Credit Analytical Framework that prolonged Credit inflations/Bubbles inflate myriad price levels throughout the markets and real economy. After years of Bubble distortions, even the $942bn growth in NFD growth during 2009 was woefully insufficient to sustain real estate, stock and asset prices; as well as incomes, spending and corporate profits in the real economy. Market dislocation abruptly closed the Credit/liquidity spigot for key sectors.
Since the collapse of the mortgage finance Bubble, I have posited that it would require in the neighborhood of $2.0 TN of annual NFD growth to fuel a self-reinforcing recovery in asset prices and economic activity.
While I expected the federal government to run big deficits, it was not obvious at the time that a rapid doubling of Federal debt would be accommodated at historically low borrowing costs. The key has been a previously unimaginable inflation in Federal Reserve Credit - liquidity that has inundated the securities market and inflated asset prices almost across the board.
The Fed did succeed in rejuvenating strong Credit growth. Q1 2014 NFD was reported at a Seasonally-adjusted and Annualized Rate (SAAR) of $2.113 TN – with NFD growth now above my $2.0 TN bogey for two straight quarters. Considering the degree of Credit expansion, the performance of the economy has been most unimpressive (Q1 GDP up SAAR $11.7bn). I’m further troubled by the composition of the recent Credit expansion. Over the past six months, the $2.0 TN bogey has been achieved with federal debt growth of SAAR $1.1 TN and total Business borrowing at about SAAR $940bn. I would argue that large federal borrowings coupled with corporate debt funding M&A and stock buybacks (“financial engineering”) provide the real economy little bang for the Credit buck. Indeed, the massive inflation of Fed Credit has chiefly fueled dangerous speculation and runaway Bubbles in securities and asset prices. The divergence between inflated asset prices and deflating fundamental prospects now widens by the week.
I have repeatedly drawn parallels between the current extraordinarily protracted Credit Cycle and that from the WWI to 1929 period. Both share similar characteristics of profound technological advancement, “globalization,” financial innovation, experimental activism in monetary management and resulting prolonged Credit, speculative and economic cycles.
Late during the “roaring twenties” Bubble period, prices, finance and economic performance all began functioning abnormally. There was confusion. In hindsight, there were obvious warnings. Yet at the time they were so easily drowned out by a boisterous financial mania. There was the camp that accurately recognized and feared the consequences of historic Credit excess. They argued unsuccessfully for policy-makers to rein in the Bubble to save the financial system and economy from catastrophe (Bernanke’s “Bubble poppers”). The Federal Reserve repeatedly acted to reinforce the boom – in the end believing downward pressure on prices and associated economic vulnerability dictated ongoing monetary accommodation.
Our central bank at the time was certainly not unaware of the stock market Bubble. The Fed’s focus turned to trying to ensure Credit was allocated to productive endeavors in the real economy – rather than to the market exchanges. There were two sides to this debate. The “Bubble poppers” were again correct in stating that it was fallacy to expect that Fed measures could ensure Credit was used productively, not when the pricing and profit backdrop in the real economy was so weak compared to the enormous gains being achieved in the booming securities markets.
The ECB this week introduced “targeted long-term refinancing operations” (TLTRO). Despite a historic collapse in sovereign yields and booming stock markets, the Eurozone economy is expected to grow only 1% this year. Many fear that downward pricing pressures are intensifying. In Europe, as around the globe, central bank liquidity has stoked heated financial speculation as economies and prices have continued to cool. The European Central Bank’s plan is to lend to banks specifically to finance loans to business and the real economy. Good luck with that, with feeble return prospects in the real economy paling in comparison to outsized speculative returns so easily achieved in manic securities markets.
The markets foresee only more central bank liquidity making its way to enticing market Bubbles. Italian 10-year sovereign yields sank 20 bps points this week to a record low 2.76%. Imagine a country with complete economic stagnation and debt-to-GDP approaching 130% - and borrowing at yields below 3%. This week saw Spain’s yields sink another 22 bps to a record low 2.63%. Portuguese yields sank 11 bps to a near-record low 3.52%. With mounting debt and deep economic problems, French yields ended the week at 1.70%. A strong case can be made that the European debt Bubble has inflated into one of history’s greatest mispricings of debt securities. European bonds – and global risk markets more generally – are showing signs of upside dislocation – likely spurred by derivatives and speculative trades gone haywire. The “global government finance Bubble” thesis finds added confirmation on a weekly basis.
June 6 – Bloomberg: “China’s banking regulator vowed to expand loans and cap borrowing costs, seeking to boost the supply of funds to the real economy as growth slows amid a clampdown on shadow financing. Lending to small businesses, major infrastructure projects and first-home buyers will be a priority, the China Banking Regulatory Commission said… To give banks more capacity to lend, the regulator may ease the ratio of loans to deposits by including some stable sources of deposits in the calculation, CBRC Vice Chairman Wang Zhaoxing said… The CBRC will also take measures to rein in bubbles in the nation’s real estate market because reliance of the economy on property and too much credit exposure to the sector could damage the financial system, he said.’”
Predictably, China is also focused on boosting the “supply of Credit to the real economy.” After allowing their Credit and economic Bubbles to run completely out of control, Chinese officials now confront a monumental task. They must attempt to rein in speculative Credit excess and financial fraud, while ensuring that the “real” economy receives sufficient Credit to stave off collapse. Acute addiction to copious cheap finance is a fundamental dilemma associated with drawn-out Credit Bubbles. An inevitable tightening of financial conditions (less Credit Availability and associated higher borrowing costs) exposes previous fraud, malfeasance and mal-investment – in the process spurring the self-reinforcing downside to the Credit cycle.
China still retains unusual capacity to sustain lending and Credit growth. Yet, at this point, only a more damaging “Terminal Phase” of excess is ensured. From my perspective, it will take an enormous amount of ongoing Credit to hold a nasty Chinese financial and economic downside at bay. This portends serious trouble for the Creditworthiness of the now behemoth Chinese banks as well as the sovereign.
Here in the U.S., with our booming markets dragging the listless economy along, there’s not much talk of Credit allocation. With Bubble excess – stocks, bonds, corporate Credit, “tech,” etc. – increasingly hard to ignore, there appears to finally be some concern building at the Fed. The headline from Jon Hilsenrath’s Tuesday WSJ article read “Fed Officials Growing Wary of Market Complacency.” This was toned down from the original Dow Jones Newswire headline: “Fed Worried Calm Markets Forecast A Storm to Come.”
Federal Reserve Bank of Kansas City President Esther George was out again this week with her rational raise rates “sooner and faster” than the dovish consensus. “My concern is that keeping rates very low into late 2016 will continue to incentivize financial markets and investors to reach for yield in an economy operating at full capacity, posing risks to achieving sustainable growth over the longer run.”
Back in 2007, with cracks forming in mortgage finance, I spent a lot of time pondering how the system could possibly generate sufficient Credit to fuel such an unbalanced and maladjusted economic structure. I have similar concerns today. If Fed Credit growth disappears, I just don’t see how the necessary $2.0 TN of non-financial sector debt growth will be sustained. There is little indication that mortgage Credit expansion will provide much help. Federal deficits are supposed to continue to decline, while state & local government borrowings remain minimal. Corporate Credit growth could continue to boom, although the marketplace appears more late-cycle euphoric to me.
Yet there remains a critical unknown. We are, after all, in the midst of the “Granddaddy of all Bubbles” – and when and how this all concludes nobody knows. It’s an important aspect of Bubble Theory that leverage associated with speculative Bubbles creates its own self-reinforcing liquidity. So I will posit that so long as this Bubble continues to inflate at such a fervent pace, the tapering of Fed Credit has little impact. However, the bigger these Bubbles inflate the greater the risk of a destabilizing “risk off” bout of de-risking/de-leveraging. What is a leading catalyst for puncturing a speculative market Bubble? The unsustainability of parabolic “blow off” speculative excess.
The next “risk off” period will find participants contemplating a marketplace without constant Federal Reserve liquidity injections. The markets will fret about life without an open-ended Fed QE backstop. Will the Fed be there with its typical timely reinsurance – or might a divided Fed struggle to live up to Dr. Bernanke’s promises? For now, it’s exuberance – emboldened by the notion that persistent “deflation” risks will keep global central bankers in an accommodating and experimental mood.