Q2 2019 Z.1 AND REPOS / CREDIT BUBBLE BULLETIN

Q2 2019 Z.1 and Repos

Doug Nolan


Non-Financial Debt (NFD) expanded $408 billion during Q1 to a record $53.015 TN. This was down from Q1’s $765 billion expansion. On a seasonally-adjusted and annualized (SAAR) basis, Q2 NFD growth slowed to $1.652 TN from Q1’s booming $3.061 TN.

The slowdown was chiefly explained by the timing of federal government borrowings. Federal debt expanded SAAR $1.751 TN during Q1 and then slowed markedly to $382 billion during Q2.

Averaging the two quarters, NFD expanded SAAR $2.360 TN.

This compares to 2018’s annual $2.274 growth in NFD, the strongest annual Credit expansion since 2007’s $2.518 TN.

As a percentage of GDP, NFD slipped to 248% from 249% during the quarter. NFD ended 1999 at 183% of GDP and 2007 at 226%.

On a seasonally-adjusted and annualized basis, Household borrowings expanded SAAR $668 billion, up from Q1’s SAAR $323 billion, to a record $15.834 TN.

Household mortgage debt expanded SAAR $330 billion, up from Q1’s SAAR $226 billion, to a record $10.440 TN.

Total Business debt growth slowed to SAAR $680 billion, down from Q1’s booming $1.023 TN (strongest since Q1 ’16), to a record $15.744 TN. State & Local debt contracted SAAR $77 billion, after declining SAAR $36 billion during Q1, to $3.039 TN. Foreign U.S. borrowings expanded nominal $231 billion for the quarter (to $4.291 TN), the strongest foreign debt growth since Q1 ’17.

Considering recent “repo” market tumult, let’s take a deeper-than-usual dive into the Z.1 category, “Federal Funds and Securities Repurchase Agreements” (aka “repo”). “Repo” Liabilities jumped $239 billion (nominal) during the quarter, or 24% annualized.

This pushed growth over the past three quarters to $710 billion, or 27% annualized. This was the largest nine-month growth since the first three quarters of 2006. At $4.280 TN, “repo” ended June at the highest level since Q3 2008.

It’s no coincidence that the $710 billion nine-month increase in “repo” corresponded with a spectacular 106 bps decline in 10-year Treasury yields. I’ll assume repo market ballooning continued into early-September, as yields dropped another 44 bps.

The expansion of securities Credit (the “repo” market being a key component) generates new marketplace liquidity.

Moreover, the concurrent expansion of “repo” Credit and system liquidity is in today’s highly speculative global environment powerfully self-reinforcing.

September 26 – Bloomberg (Vivien Lou Chen): “It may take as much as $500 billion in Treasury purchases by the Federal Reserve to fix all of the cracks exposed last week in the more than $2 trillion U.S. repo market. Estimates from analysts at TD Securities, Morgan Stanley, BMO Capital Markets and Pictet Wealth Management range from roughly $200 billion to half a trillion dollars. They’re not alone. Two former Fed officials said Thursday that the central bank might need to do $250 billion of outright Treasury purchases to prevent further pain in U.S. money markets. There’s a growing consensus that the central bank’s daily efforts to restore order in the short-term funding market are falling short of what’s needed: a much larger effort to build up a substantial buffer of bank reserves…”

As we’ve witnessed over the past two weeks, the unwind of securities Credit and the attendant contraction of liquidity turns immediately problematic.

A Thursday afternoon Bloomberg headline (from the above article) resonated: “Repo-Market Cure May Take $500 Billion of Fed Treasuries Buying,” referring to Wall Street estimates of the scope of Fed intervention necessary to stabilize funding markets.

I have posited a serious globalized de-risking/deleveraging episode would require multi-Trillion expansions of Federal Reserve and global central bank balance sheets.

“Brokers & Dealers” is the largest borrower by Z.1 category, with “repo” Liabilities up $92 billion during Q2 to $1.781 TN (high since Q3 ’13). Broker “repo” Liabilities surged $296 billion over three quarters, or 27% annualized.

As the second largest borrower, Rest of World (ROW) “repo” Liabilities increased $10 billion during the quarter to a record $1.102 TN. ROW “repo” Liabilities surged $254 billion over the past three quarters, or 40% annualized. ROW “repo” peaked at $857 billion during the previous cycle (Q1 ’08).

While not at the same level as the Wall Street firms or ROW, Real Estate Investment Trusts (REITs) have as well been notably aggressive “repo” borrowers. REIT “repo” Liabilities rose $30.3 billion during Q2 to a record $369 billion. REIT “repo” Liabilities were up $107 billion, or 41%, over the past year and $150 billion, or 69%, over two years. REIT “repo” Liabilities posted a previous cycle peak during Q2 2007 at $106 billion.

Money Market Funds (MMF) are a large holder of “repo” Assets (second only to Brokers & Dealers). MMF “repo” holdings jumped an eye-opening $153 billion during Q2 to a record $1.133 TN, with a gain over three quarters of $213bn, or 23%. It’s worth noting MMF “repo” holdings peaked at $618 billion during Q4 2007 (having doubled over the preceding two years).

It’s worth noting the Fed’s balance sheet contracted $58 billion during the quarter to $4.140 TN. Some have been confounded by the lack of impact to system liquidity from the Fed somewhat drawing down its securities portfolio. But with securities Credit expanding by multiples of the decline in Fed Credit, marketplace liquidity has been dominated by securities speculating and leveraging.

As I often repeat, contemporary finance works miraculously on the upside. Fear the downside.

The Fed’s balance sheet expanded as much over past week as it contracted during the second quarter.

Bank (“Private Depository Institutions”) assets increased $203 billion during the quarter to a record $19.506 TN, this despite a $159 billion decline in “Reserves at Federal Reserve”. Bank Loans jumped $192 billion during the quarter, or 6.8% annualized, bouncing back strongly after Q1’s slight contraction (and ahead of Q2 ‘18’s $174bn). Bank Loans were up $550 billion, or 5.0%, year-over-year. Bank Mortgage Loans expanded $76 billion (5.5% annualized) during the quarter to a record $5.540 TN, the strongest expansion in two years.

Bank holdings of Debt Securities jumped $112 billion, or 10% annualized, to a record $4.505 TN (one-year gain of $320 billion, or 7.7%). Debt Securities holdings were below $3.0 TN going into the 2008 crisis. Bank Agency/GSE MBS holdings jumped a huge $82.2 billion during the quarter, the largest increased since Q1 ’12. Over the past three quarters, Banks boosted Agency Securities by $217 billion, or almost 10%, to a record $2.588 TN.

Banks’ Agency Securities holdings are about double the level from the crisis. Bank Holdings of Treasuries rose $34 billion during Q2 to a record $771 billion, jumping $121 billion over three quarters. Treasury holdings were up 22% y-o-y. For Comparison, Banks’ Corporate Bond holdings increased $25 billion y-o-y, or 3.9%, to $664 billion.

Broker/Dealer Assets jumped $132 billion during Q2, or 16% annualized, to $3.487 TN (high since Q2 ’13). This was a sharp reversal from Q1’s small ($4bn) contraction. Broker/Dealer Assets were up a notable $349 billion, or 11.1%, over the past year.

Repo Assets jumped $227 billion y-o-y, or 20.0%. Over this period, “repo” Liabilities surged $326 billion, or 22.4%, to $1.781 TN. This was the highest level of “repo” Liabilities going back to Q3 2013, a period that corresponded with a sharp upside reversal in market yields and contraction in “repo” securities Credit.

Total system Debt Securities increased nominal $304 billion during Q2 to a record $45.771 TN.

This boosted the gain since the end of 2008 to $14.825 TN, or 48%. As a percentage of GDP, Debt Securities ended Q2 at 214% (record 223% Q1 ’13).

Equities jumped $1.602 TN to $49.799 TN, ending Q2 slightly below Q3 ‘18’s all-time record ($49.799 TN). Equities ended Q2 at 233% of GDP (record Q3 ’18 243%).

Total (Debt and Equities) Securities jumped $1.906 TN during Q2 ($7.51 TN during the first half) to a record $95.569 TN.

Total Securities-to-GDP ended June at 448% (record Q3 ’18 458%). Previous cycle peaks were 379% during Q3 ’07 and 359% in Q1 ’00. Total Securities-to-GDP began the eighties at 44% and the nineties at 67%.

I view the “repo” market expansion as indicative of overall speculative leverage. The rapid growth of Bank and Broker/Dealer debt securities holdings is symptomatic of speculative excess and likely associated with derivative-related trading activities.

To simplistically connect the dots, the expansion of “repo” securities Credit along with ballooning Bank and Broker/Dealer securities holdings generate the liquidity abundance and speculative impulses for a general inflation of securities market prices (debt and equities).

The inflation of perceived wealth then feeds into the real economy through strong consumer and business spending.

Accordingly, the Household Balance Sheet remains a Bubble Analysis Focal Point.

Total Household Assets increased $2.024 TN during the quarter to a record $129.671 TN, with a $7.358 TN gain during 2019’s first half. And with Liabilities up $175 billion, Household Net Worth (Assets less Liabilities) jumped $1.949 TN during Q2 to a record $113.463 TN.

Household Net Worth rose $7.177 TN during this year’s first-half, a record six-month advance.

Net Worth rose to a record (matching Q4 ’17) 532% of GDP.

For comparison, Household Net Worth-to-GDP posted cycle peaks of 492% during Q1 2007 and 446% to end Q1 2000. Net Worth-to-GDP began the eighties at 342% and the nineties at 378%.

Household Real Estate holdings increased $257 billion during the quarter, down from Q1’s $707 billion gain (strongest since Q4 ’05). Yet Real Estate jumped $1.692 TN over the past year to a record $32.676 TN (153% of GDP). Real Estate holdings posted a previous cycle peak of $26.466 TN (189% of GDP) during Q4 ’06.

Financial Assets are the unquestionable epicenter of this cycle’s Bubble. Household holdings of Financial Assets jumped $1.700 TN during Q2, after surging $4.544 TN in Q1. Financial Asset holdings ended Q2 at a record $90.689 TN, or 425% of GDP. Financial Assets-to-GDP ended Q3 2007 at 376% and Q1 2000 at 355%. Household Assets began the nineties at 267% of GDP.

Household Total Equities (Equities and Mutual Funds) holdings ended Q1 at record $27.427 TN, or 129% of GDP. The previous two cycles saw Household Equities peak at $14.930 TN (102% of GDP) during Q3 ’07 and $11.742 TN (117% of GDP) in Q1 ’00. Total Equities holdings began the nineties at 47% of GDP.

Rest of World (ROW) is key to Bubble Analysis as well, though with layers of ambiguity and complexity.

ROW holdings of U.S. Financial Assets surged $843 billion during Q2 to a record $32.582 TN. Holdings were up $1.798 TN y-o-y, boosting ROW holdings-to-GDP to a record 153%.

ROW holdings-to-GDP ended 2007 at 108% and 1999 at 74%. ROW holdings of U.S. Debt Securities increased $337 billion during Q2 to a record $11.906 TN.

Debt Securities jumped $728 billion during the first half, with Treasury holdings rising $372 billion to a record $6.637 TN. ROW repo Liabilities jumped $187 billion, or 20%, during the first six months of 2019 to a record $1.102 TN.

Few see the Bubble, yet the Fed’s Z.1 report offers a compelling outline.

This week saw “repo” market instability bumped from the headlines by instability at the White House. Markets reacted to whistleblower allegations and the opening of an impeachment inquiry in typical fashion: “The President under duress is more likely to strike a deal with China.”

In comments Wednesday, the President was happy to play along: “They want to make a deal very badly... It could happen sooner than you think.” President Trump’s tough talk directed at China Tuesday at the U.N. didn’t leave one feeling the administration was softening up for an imminent deal.

And then came the Friday afternoon Bloomberg scoop (Jenny Leonard and Shawn Donnan): “Trump administration officials are discussing ways to limit U.S. investors’ portfolio flows into China in a move that would have repercussions for billions of dollars in investment pegged to major indexes, according to people familiar with the internal deliberations. The discussions are occurring as Washington and Beijing negotiate a potential truce in their trade war that’s rattled the world’s two biggest economies and investors for more than a year… A U.S. crackdown on capital flows would therefore expose a new pressure point in the economic dispute and cause disruption well beyond the hundreds of billions in tariffs the two sides have levied against each other.”

Markets would like to believe the administration is posturing ahead of the next round of trade talks. Bloomberg follow-up articles included comments from Wall Street analysts, including: “This is huge.” “Ludicrous.” “The news opens up a new front in the U.S.-China trade conflict.” “It’s another example of how every time people think this trade war is deescalating, it escalates again.” A Reuters article was on point: “…what would be a radical escalation of U.S.-China trade tensions.”

Chinese company listed ADRs were slammed in Friday U.S. trading. This creates Monday morning Chinese market and currency vulnerability. To this point, it’s been the Teflon President affixed to Teflon markets.

But between “repo” market instability, Washington chaos, the risk of serious trade war escalation – in a world of heightened financial, economic and geopolitically instability – and there is a scenario where the unraveling begins.

Markets have to this point demonstrated astounding faith that the President will ultimately act in their best interest.

As always, markets are a contest of greed and fear. One of the bad scenarios would be the markets fearing an administration resorting to a “scorched earth” gambit.