Q4 2018 Z.1 "FLOW OF FUNDS" / CREDIT BUBBLE BULLETIN

Q4 2018 Z.1 "Flow of Funds"

Doug Nolan


I’ve been anxiously awaiting the Fed’s Q4 2018 Z.1 “flow of funds” report. It provided the first comprehensive look at how the period’s market instability affected various sectors within the financial system. From ballooning Broker/Dealer balance sheets to surging “repo” lending to record Bank loan growth – it’s chock-full of intriguing data. All in all, and despite a Q4 slowdown, 2018 posted the strongest Credit growth since before the crisis – led, of course, by our spendthrift federal government.

Non-Financial Debt (NFD) rose $2.524 TN during 2018 (5.1%), exceeding 2007’s $2.478 TN and second only to 2004’s $2.915 TN growth. NFD closed 2018 at a record 253% of GDP, compared to 230% to end of 2007 and 189% to conclude the nineties. By major category, Federal borrowings expanded $1.258 TN during the year, up from 2017’s $599 billion, and the strongest growth since 2010’s $1.646 TN. Year-over-year growth in Total Household borrowings slowed ($488bn vs. $570bn), led by a drop in Home Mortgages ($285bn vs. $312bn). Total Corporate borrowings slowed to $532 billion from 2017’s $769 billion. Foreign U.S. borrowings slowed to $207 billion from 2017’s $389 billion.

On a percentage basis, NFD increased 4.51% in 2018, up from 2017’s 4.10%. Federal debt grew 7.58%, almost double 2017’s 3.74%, to the strongest percentage growth since 2012 (10.12%). Household debt growth slowed to 3.22% (from 3.90%), with Mortgage borrowings up 2.83% (from 3.19%) and Consumer Credit growth easing slightly to 4.88% (from 5.04%). Total Corporate Debt growth slowed meaningfully from 2017’s 5.71% to 3.69%.

For Q4, on a seasonally-adjusted and annualized basis (SAAR), Non-Financial Debt (NFD) expanded $1.390 TN, the slowest expansion since Q4 2016 (SAAR $941bn). This is largely explained by the sharp drop-off in Federal borrowings (SAAR $444bn vs. Q3’s SAAR $1.180 TN).

Outstanding Treasury Securities ended 2018 at a record $17.842 TN, up $1.411 TN (8.6%) for the year to 85% of GDP. Treasuries have surged $11.791 TN, or 195%, since the end of 2007. Agency Securities (debt and MBS) rose $245 billion during 2018 to a record $9.113 TN (2yr gain $592bn). In total, Treasury and Agency Securities surged $1.656 TN last year – accounting for a full two-thirds of total Non-Financial Debt growth. Combined Treasury and Agency debt ended 2018 at a record $26,955 TN, or 129% of GDP (vs. 2007’s $14.685 TN, or 92%).

Broker/Dealer assets surged nominal $165 billion, or 21% annualized, during the quarter, the biggest quarterly gain since Q1 2010. For the year, Broker/Dealer assets jumped $262 billion (8.4%) to $3.359 TN, the largest annual increase since 2007. Debt Securities holdings jumped by $147 billion during Q4, led by a $162 billion increase in Treasuries to $251 billion (more than doubling y-o-y).

The Household Balance Sheet remains a key Bubble manifestation, during the quarter providing a hint of how quickly perceived household wealth will evaporate during a bear market. Household Assets dropped $3.056 TN during Q4 to $120.9 TN, led by a $3.883 TN decline in total equities holdings (Equities and Mutual Funds). And with Liabilities increasing $133 billion during Q4, Household Net Worth fell $3.190 TN (the largest drop since Q4 2008’s $3.835 TN) to $104.869 TN. Household Real Estate holdings rose $279 billion during the quarter and were up $1.319 TN for 2018.

As large as Q4’s drop in Net Worth was, it erased only somewhat less than the previous six month’s gain. For all of 2018, Household Net Worth increased $1.876 TN, with a gain of $47.586 TN, or 65%, since the end of 2008. With equities already regaining the majority of Q4 losses, I don’t want to read too much into Q4 ratios. But it’s worth noting that Net Worth as a percentage of GDP dropped to 512% from Q3’s record 523%, yet remains significantly above previous cycle peaks (484% in Q1 2007 and 435% to end 1999).

The Rest of World (ROW) balance sheet is also fundamental to Bubble Analysis. For the year, ROW U.S. asset holdings declined $192 billion, the first drop since 2008. And while ROW holdings of total Equities declined $650 billion (mostly on lower prices), Corporate Debt fell $283 billion (also largest drop since 2008). Notable as well, ROW Treasury holdings declined $63bn (to $6.222 TN) in 2018 after jumping $282 billion in 2017.

Q4 market instability left its mark in Z.1 data. Broker/Dealer Assets surged SAAR $544 billion ($165bn nominal), the biggest quarterly gain since Q1 2010. Broker/Dealer Treasury holdings jumped nominal $162 billion (SAAR $685bn), the largest rise since the unstable global backdrop of Q4 2011. The Asset “Security Repurchase Agreements” (Repos) jumped nominal $150 billion (SAAR $602bn) to $1.315 TN, the high since Q4 2013. This was the largest gain since tumultuous Q3 2011. Repo Liabilities jumped $213bn (SAAR $851bn) to $1.698 TN – the high since Q1 2014. Q4’s Repo Liabilities increase was the largest going all the way back to Q1 2010.

The full category “Federal Funds & Securities Repurchase Agreements” ballooned $317 billion (SAAR $1.235 TN), the largest gain since Q1 2010. Fed Funds and Repo ended 2018 at $3.881 TN – an almost five-year high. Ballooning “repo” Assets and Liabilities – and Broker/Dealer balance sheets more generally – reflected Q4 market instability and illiquidity.

I’ll infer that the Broker/Dealer community was being called upon to provide liquidity – both by buying securities and offering securities Credit to the marketplace (leveraged speculating community, in particular). They were also forced to warehouse leveraged loans and such -awaiting the return of buyers. Moreover, it’s a fair assumption that major trading/liquidity issues were unfolding throughout the derivatives marketplace.

It’s worth noting that Goldman Sachs Credit default swap (5yr CDS) prices ended Q3 at 61 bps. Prices finished 2018 at 106 bps and then spiked to as high as 129 bps on January 3rd – the high since Q1 2016’s China/market tumult. After ending Q3 at 55 bps, Morgan Stanley CDS traded to 106 bps on January 3rd. Over this period, JP Morgan CDS jumped from 40 bps to as high as 78 bps, and Bank of America Merrill Lynch CDS spiked from 45 bps to 83 bps. Investment-grade corporate CDS also traded to highs since 2016, as did junk bond spreads. As I espoused at the time, there’s no mystery why Chairman Powell orchestrated his abrupt U-Turn on January 4th. The system was rapidly approaching the de-risking/deleveraging/derivatives dislocation/market illiquidity precipice.

It wasn’t only the Broker/Dealers and “repo” market that experienced noteworthy quarters. Bank Assets jumped nominal $267 billion, or 5.7% annualized, to a record $19.299 TN. Robust Bank growth was led by a record $263 billion (SAAR $868bn) surge in Loans (almost 10% annualized), surpassing the previous high ($260bn) back in the Bubble heyday Q3 2007. In addition, Bank “repo” assets (lending against securities) jumped a record $161 billion (SAAR $643bn) to $703 billion (high since Q3 ’08). Meanwhile, Debt Securities holdings rose $129 billion (SAAR $286bn), the biggest increase since Q1 2012 (ending the year at a record $4.304 TN). During the quarter, Banks added aggressively to Treasuries (up SAAR $246bn) and Agency- GSE-backed Securities (up SAAR $187bn), while liquidating Corporate Bonds (down SAAR $121bn). Between Broker/Dealer and Bank buying, there’s no mystery surrounding the Q4 collapse in Treasury yields.

Speaking of collapsing yields: German bund yields dropped 11 bps this week to 0.065%, trading to the lowest yields since October 2016. French yields sank 17 bps to 0.41% - also a low since 2016. Italian yields dropped 23 bps this week to 2.50%, the low since July.

March 7 – Reuters (Francesco Canepa, Frank Siebelt and Balazs Koranyi): “European Central Bank President Mario Draghi caught even dovish rate-setters off guard by pushing… for unexpectedly generous stimulus after forecasts showed a large drop in economic growth, four sources familiar with the discussion said. At its policy meeting, the ECB delayed its first post-crisis rate hike into 2020 and offered banks more ultra-cheap loans…”

Yet sinking yields weren’t limited to Europe. Ten-year Treasury yields dropped 12 bps to 2.63% - with yields now down five bps for the year. Japan’s JGB yields declined three bps to negative 0.3%, near early-January market instability lows.

The wide – and widening – divergence between booming risk markets and more than resilient safe haven sovereign bond prices narrowed just a bit this week. The Shanghai Composite was slammed 4.4% Friday (reducing y-t-d gains to 19.1%) on fears Beijing is increasingly alarmed by speculative securities markets. They should be. More dismal data (i.e. February exports down 16.6%) – along with indications that the U.S./China trade deal is not the done deal many have been presuming – pressured markets from China to the U.S. Mixed signals – i.e. paltry February job gains (20k) in the face of a stronger-than-expected ISM Non-Manufacturing index – provide little clarity regarding underlying U.S. economic momentum.

For the most part, markets have been mesmerized by a flock of dovish global central bankers – while ignoring gathering storm clouds. Yet Z.1 data are a reminder of how quickly the markets buckled back in the fourth quarter. By now, I’ll assume the vigorous short squeeze and unwind of hedges have pretty much run their course. It has me pondering the next leg down in the unfolding bear market.

At some point, it’s not going to be as easy for central bankers and Beijing to reverse faltering markets. A big surge in Broker/Dealer assets, “repo” and bank lending would prove problematic if, instead of recovering, markets continue sinking into illiquidity. Financial conditions would tighten dramatically. No junk – or investment-grade issuance. Q4 ETF outflows and derivative issues offered a hint of what’s to come.

Foreign buyers have been losing interest in U.S. securities. And definitely don’t rule out a quick $10 TN drop in Household Net Worth – and attendant major economic ramifications. Silly me. Annual $2.0 Trillion federal deficits effortlessly monetized by our accommodating central bank will cure all ills – financial, economic, social, geopolitical and otherwise.

Global policymakers will regret becoming so adept at stoking speculative excess.