WEAK LINK / CREDIT BUBBLE BULLETIN

Weak Link

Doug Nolan



Last week from The Institute of International Finance (IIF) (a summary from a members-only report): “Global debt has topped $250 billion – 320% of GDP: emerging market debt hits a new record of $71.4 trillion (220% of GDP); With limited room for further easing, debt service costs will be an increasing constraint on fiscal policy… USD hovering at record highs despite Fed rate cuts this year: persistent growth in demand for U.S. liquidity as dollar debt across EM and mature markets hits record highs. Non-U.S. banks are increasingly reliant on USD funding.”

The IIF estimated that global debt would end the year at $255 TN – “nearly $32,500 for each of the 7.7 billion people on planet” (as noted by Reuters’ Marc Jones). Global debt expanded $7.5 TN during the first half of the year, led by China and the U.S. From Reuters (Marc Jones): “Separate analysis from Bank of America Merrill Lynch… calculated that since the collapse of U.S. investment bank Lehman Brothers, governments have borrowed $30 trillion, companies have taken on $25 trillion, households $9 trillion and banks $2 trillion.”

Looking back, total U.S. Non-Financial Debt expanded 8.16% in 2007, strong growth that few found alarming. It was, after all, down from 2006’s 8.53%, 2005’s 8.77% and 2004’s 9.15%. Conventional thinking had it that the Fed was successfully orchestrating a “soft landing.”

Yields were said to remain relatively low in the face of booming Credit demand because of the so-called “global saving glut.”

Financial Sector debt growth at the time was signaling something momentous, though most conventional analysts at the time chose to disregard financial sector expansion (arguing that such analysis would be “double-counting” Credit already included in household, corporate and government sector tabulations). Financial Sector borrowings expanded at a 13.66% pace in 2007, up from 2006’s 10.35% and 2005’s 9.01%.

I have in previous CBBs highlighted the two-year $1.114 TN, or 27%, increase in (Z.1 category) “Fed Funds and Repurchase Agreements” that culminated with a $319 billion jump during Q1 2008. This data series was emblematic of the extreme speculative leveraging that had taken hold during mortgage finance Bubble “Terminal Phase” excess.

While conventional retrospective focuses on risky mortgage lending and housing market excess, the epicenter of the Bubble was in “repo” finance and myriad instruments (CDO’s, ABS, special purpose vehicles, derivatives and such) financed directly and indirectly in short-term market-based lending markets. It was the Bubble in speculative leverage that kept mortgage rates low in the face of historic borrowing demand.

The decade-old “global government finance Bubble” has notable differences - as well as clear similarities - to the previous Bubble. I have posited that global sovereign debt and central bank Credit have been the key sources of Bubble excess (as opposed to U.S. mortgage Credit). In general, interest rates (along with market yields) have been held at historically low levels, a dynamic that has trimmed overall rates of debt expansion.

This cycle has experienced unprecedented growth in central bank balance sheets that analytically should be viewed similarly to financial sector leveraging from the previous cycle.

Moreover, I would argue securities finance and speculative leveraging have evolved from a U.S. phenomenon to now comprise “repo” funding markets spanning the globe – “developed” markets, “developing” and, certainly, the “off-shore financial centers.”

The rapid expansions in global “Non-Bank Financial Institutions” and “off-shore” Credit indicate extreme speculative leveraging (akin to U.S. “repos” in 2007). Overall global Credit continues to outpace GDP growth, this despite historically low market yields that significantly reduced debt service costs. Indeed, the unrelenting rapid expansion of debt (and speculative leveraging) in the face of waning global growth dynamics portends difficult times ahead.

From the Bank for International Settlement’s “Statistical Release: BIS International Banking Statistics at end-June 2019.”

Under the headline, “Lending to [Non-Bank Financial Institutions] (NBFI) Continued to Lead Growth in Cross-Border Claims:” “The BIS locational banking statistics show that global cross-border bank claims rose by $365 billion during the second quarter of 2019, to reach $31 trillion by end-June. Their annual growth rate, which averaged around 0% since the Great Financial Crisis, reached a post-crisis high of 6%... Growth in lending to all major sectors increased. Claims on non-bank financial institutions continued to expand the most rapidly (13% year over year).”

Global cross-border bank claims (lending) surged $1.735 TN during the first half, the strongest six-month growth since pre-crisis Q4 ’07 to Q1 ’08. This compares to first-half growth of $324 billion during 2018 and $341 billion in 2017. Over two years, cross-border bank claims surged $2.520 TN, or 9%, to $30.98 TN. The second quarter’s 13% growth in lending to Non-Bank Financial Institutions was the strongest in the five-year history of the data. Notably, growth accelerated from Q1’s 11.7%, Q4 18’s 8.2% and Q3 18’s 6.4% pace.

BIS: “Reporting banks’ cross-border claims on all major sectors expanded during Q2 2019. The $190 billion expansion in claims on non-banks accounted for more than a half of the overall quarterly increase in global cross-border claims. This, in turn, was mostly driven by claims on non-bank financial institutions (NBFIs include entities such as insurance companies, pension funds, hedge funds and money market funds), which increased by $172 billion, resulting in an annual growth rate of 13%. The majority of this new lending to NBFIs was directed towards a few financial centres, such as the Cayman Islands ($37 billion), the United Kingdom ($34 billion) and Luxembourg ($24 billion).”

The $172 billion increase in lending to Non-Bank Financial Institutions followed Q1’s (record for the series) $468 billion surge, putting first-half growth at $641 billion.
BIS: “The latest increase in lending to NBFIs is part of a longer trend. Over the past five years, cross-border claims on that sector have grown at an average annual pace of 7% (compared with 1% for claims on all sectors), reaching $7 trillion at mid-2019.”

BIS: “Lending to offshore financial centres (OFCs) remained strong. It grew at 6% year over year and stood at $5 trillion as of end-June 2019, mostly to the benefit of NBFIs. Banks reported large increases in their claims on the Cayman Islands (+$45 billion), Jersey (+$9 billion) and Hong Kong SAR (+$8 billion).”

The surge in the “offshore financial centers” began in 2013, concurrent with the ramp up of global QE following the European bond crisis. After ending Q2 2013 at $3.5 TN, the “offshore financial centers” over six years surged $1.5 TN, or 43%, to $5.0 TN. I’ll assume this data capture only a segment of bubbling global markets funding financial speculation.

I also presume this surge in lending has been instrumental in the global collapse in sovereign yields (in the face of massive issuance) that has fueled broad-based inflation in real and financial assets around the world.

We won’t know all the crazy leverage and derivative strategies spawned during this period until the next big de-risking/deleveraging period. If recent articles pointing to the unwind of hedge funds trades as responsible for a jump in Japanese bond yields are accurate, we can assume at this point virtually everything is levered up. Who would have ever thought of leveraging negative-yielding bonds?

BIS: “…Cross-border lending to borrowers in developing Asia-Pacific rose by $27 billion, bringing the annual growth rate to 4%. Claims on China, up by $25 billion, accounted for almost the whole increase. Those claims have grown from a recent low of $699 billion (at end-March 2016) to $990 billion (at end-June 2019).”

Clearly, the Cayman Islands, the UK and Luxembourg are major sources of cheap finance for the global leveraged speculating community. But I ponder how much speculative finance during this cycle has emanated out of the likes of Hong Kong and Singapore - and flowed freely into higher-yielding Chinese Credit instruments.

After all, the world has never seen such a Bubble in “subprime” Credit. I have argued China is the great global Credit Bubble’s Weak Link. But, at this point, perhaps it’s Asian finance more generally.

The backdrop is increasingly conducive to heightened currency market instability.