"REAL ECONOMY SPHERE VS. FINANCIAL SPHERE" Q1 ´25 Z.1 / CREDIT BUBBLE BULLETIN

“Real Economy Sphere vs. Financial Sphere” Q1 '25 Z.1

Doug Nolan 

Marines deployed to Los Angeles. 

A U.S. Senator wrestled to the ground and handcuffed. 

Israel executing a surprise decapitation attack on Iran’s military leadership and nuclear capabilities, with retaliatory missile launches forcing citizens across Israel into emergency shelters. 

One more unnerving week with that ominous feeling things could spiral out of control. 

A tense weekend awaits, with new war developments, a Washington military parade, and millions of protestors spread across the country.

Not as conspicuous, but finance is beset with its own precariousness. 

During the mortgage finance Bubble period, I occasionally referenced a long-term chart of total system Credit. 

Total Credit was expanding exponentially, in the most vertical rise since the “Roaring Twenties.” 

Most economists and analysts have issues with total system Credit, arguing that it double counts actual debt levels. 

System Credit, after all, combines non-financial and financial debt, with financial debt basically comprising borrowings within the financial sector to hold debt originated in the real economy (i.e., government, household, and corporate).

For example, Fannie Mae borrows (issues financial debt) to finance holdings of household mortgages (non-financial debt). 

Conventional analysis focuses on non-financial (real economy) debt, dismissing the relevance of financial sector borrowings.

Analyzing new Q1 Z.1 Credit data, my thoughts returned to my “real economy sphere versus financial sphere” analytical construct from the early CBB years. 

Differing dynamics of the two “spheres” require distinct analytical frameworks. 

Total system Credit absolutely provides valuable insight, capturing growth dynamics from both. 

Basically, the mortgage finance and “Roaring Twenties” Bubbles experienced historic financial sector expansions, largely explaining the two periods' corresponding exponential growth in total system Credit.

Importantly, major financial sector expansions are part and parcel of financial excess. 

In simple terms, financial sector booms are typically fueled by aggressive lending, speculative leveraging, and risk intermediation. 

Banks, brokers, and finance and insurance companies might lend aggressively. 

They could also borrow excessively to speculate in bonds and other financial assets, in the process distorting market pricing and liquidity dynamics.

Less straightforward, yet fundamental to major Bubble inflations, rapid financial sector expansion is indicative of aggressive risk intermediation. 

Especially late in the mortgage financial Bubble period, financial institutions (i.e., banks, brokers, the GSEs, insurance companies…) were intermediating huge amounts of risky mortgage Credit into perceived safe and liquid money-like instruments (i.e., “AAA” securities, repos, CDOs, myriad derivatives…). 

This “Wall Street alchemy” was instrumental in extending both financial and economic booms – precariously prolonging “terminal phase excess.” 

The colossal divergence between actual and perceived risk – coupled with deep economic structural maladjustment - came home to roost in 2008.

It's not that I simply forgot about “real economy sphere versus financial sphere” analysis. 

For the most part, global government finance (as opposed to mortgages) Bubble excess didn’t require aggressive financial sector intermediation. 

After all, Treasuries (and sovereign debt generally) are perceived as safe and liquid “money” (benefiting from insatiable demand). 

“Wall Street alchemy” not required, or more accurately, WAS not required.

Analyzing the latest Z.1, there’s evidence of a financial sector increasingly challenged to intermediate massive (risky) Treasury issuance into perceived money-like instruments (chiefly repo and money funds deposits). 

The first quarter was notable for a slowing of non-financial (“real economy”) debt concurrent with extraordinary ongoing inflation in “repo”, the Wall Street firms, and the money market fund complex.

Non-Financial Debt expanded at a 2.82% rate during Q1, down from Q4’s 4.46% and Q1 ‘24’s 4.57%. 

Most of the decline is explained by an anomalous drop in federal borrowings to 1.95% from Q4’s 8.41% and Q1 ‘24’s 6.20%. 

But Household debt growth slowed to 1.85% from Q4’s 3.34% (Q1 ’24’s 3.01%). 

Corporate debt growth accelerated to 6.30% from negative 0.55% (Q1 ‘23’s 5.18%).

Domestic Financial Sector debt growth surged to 6.08%, from 0.67% (1.91%). 

Even more interesting, Rest of World (ROW) borrowings surged to 12.22%, from 6.12% (4.52%).

In seasonally-adjusted and annualized (SAAR) dollars, NFD expanded $2.162 TN during the quarter, down from $3.404 TN – for the second weakest quarterly growth since before the pandemic. 

Meanwhile, Financial Sector debt expanded SAAR $1.230 TN, up from $134 billion (Q1 ’24’s $376bn). 

For perspective, over the past 17 years, annual Financial Sector debt growth exceeded $1.0 TN only once (2023’s $1.60 TN).

Recall that “risk off” was gathering momentum into the end of Q1, with a serious bout of deleveraging erupting during the first week of April. 

CDS prices (investment-grade, junk, bank) ended March at the highs since early-August market instability.

Broker/Dealer Assets expanded (nominal) $490 billion, or 37.2% annualized, during Q1 to $5.759 TN. 

This was the strongest quarterly growth since Q1 2007 – to the highest level since Q3 2008. 

One-year growth was boosted to $614 billion, or 11.9%, the strongest annual expansion since 2007 ($619bn).

For Q1, Broker/Dealer Repo Assets surged a quarterly record $240 billion, or 56.8% annualized, surpassing (banking crisis) Q1 2023’s $199 billion - to a record $1.930 TN. 

Over 10 quarters, Repo Assets have ballooned $600 billion, or 45%. 

For some perspective, broker/dealer Repo Assets jumped $303 billion, or 21%, over 10 quarters for a September 2008 cycle peak of $1.778 TN.

Broker/Dealer Loan Assets increased $11 billion, or 5.6% annualized, to a 10-quarter high of $764 billion (1-yr growth $75bn, or 10.9%). 

Loans were up $334 billion, or 78%, over 21 quarters. 

Debt Securities holdings surged $145 billion, or 56% annualized, surpassing Q1 2008’s $1.111 TN to a record $1.174 TN (1-yr $233bn, 24.7%). 

Debt Securities were up $523 billion, or 82%, over 21 quarters.

Broker/Dealer Agency Securities holdings ballooned $105 billion (91% ann.) during Q1 and an unprecedented $407 billion (255%) over one year – to a record $566 billion. 

Prior to 2024 ($340bn), 2008’s $100 billion increase in Agency holdings held the annual record. 

Treasury holdings gained $33 billion (29% ann.) during Q1 and $97 billion (25%) y-o-y to a record $488 billion. 

Treasury holdings ballooned $260 billion, or 114%, over 21 quarters. 

Miscellaneous Assets expanded $88 billion, or 23% annualized, during Q1 to $1.616 TN. 

Misc. Assets surged $381 billion, or 31%, over 21 quarters.

So how did Wall Street finance this remarkable balance sheet expansion? 

Repo Liabilities ballooned $361 billion, or 61.8% annualized, during Q1 to $2.697 TN – the high since Q3 2008. 

Repo Liabilities inflated $1.083 TN, or 67%, over 10 quarters. 

For comparison, Broker/Dealer Repo Liabilities expanded $989 billion, or 46%, over 10 quarters to a Q3 2007 cycle peak of $3.132 TN.

Sticking with Repos, total system Repo Assets surged (second only to Q1 ‘23’s $724bn) $717 billion, or 41% annualized, to a record $7.779 TN. 

One-year growth of $1.074 TN compares to peak mortgage finance Bubble 2007’s $655 billion (to $4.541 TN). 

Repo Assets ballooned $2.965 TN, or 62%, over 21 quarters. 

ROW Repo Assets surged $141 billion during Q1 to a record $1.480 TN. 

ROW Repo holdings were up $350 billion, or 31%, over 10 quarters

Money Market Funds (MMF) are the largest holder of Repos. 

MMF Assets rose $155 billion, or 8.5%, during Q1 to a record $7.398 TN – with incredible one-year growth of $957 billion, or 14.9%. 

MMF Assets ballooned $2.314 TN (46%) over 10 quarters and an astounding $3.395 TN, or 85%, over 21 quarters – for one of history’s great monetary inflations. 

MMF Repo holdings surged $201 billion, or 31% annualized, during Q1 to $2.821 TN – with one-year growth of $440 billion, or 19%, and 21-quarter ballooning of $1.579 TN, or 127%. 

MMF Treasury holdings declined $114 billion during Q1 to $2.881 TN, though holdings were up $1.624 TN, or 129%, over 10 quarters.

The banking system (“Depository Institutions”) is certainly part of the booming financial sector. 

Bank Assets jumped $581 billion, or 8.4% annualized, during Q1 to a record $28.388 TN – the largest quarterly growth since Q4 2021 ($702bn). 

Bank Assets ballooned $6.988 TN, or 33%, over 21 quarters.

For Q1, Bank Loans increased (a measly) $52 billion, or 1.4%, to a record $14.926 TN, with one-year growth of $479 billion (3.3%). 

At $18 billion, or 1.0% annualized, Mortgages grew at the slowest pace in two years, with Consumer Credit contracting $65 billion. 

Meanwhile, Repo Assets surged $84 billion, or 48% annualized (strongest since Q4 ‘18), to a record $782 billion – with one-year growth of $147 billion, or 23%. 

Bank Debt Securities holdings jumped $172 billion, or 11.2% annualized, to $6.342 TN. 

Debt Securities ballooned $1.660 TN, or 35.4%, over 21 quarters. 

Agency Securities holdings jumped $91 billion, or 11.9% annualized, with Corporate Bonds up $71 billion, or 31.9% annualized.

The Wall Street securitization machine still runs hot. Debt Securities expanded $805 billion during Q1 to a record $62.655 TN – with one-year growth of $2.632 TN. 

Over 23 quarters, Debt Securities ballooned $19.625 TN, or 45.6%. 

With stocks posting Q1 losses, Equities Securities declined $3.655 TN to $90.522 TN, though Equities were still up $39.754 TN, or 78%, over 23 quarters. 

Total (Debt and Equities) Securities ended Q1 at $153.176 TN, or 511% of GDP. 

This compares to cycle peaks 375% (Q3 ’07) and 357% (Q1 2000).

Throughout the mortgage finance Bubble, I highlighted the quarterly ballooning of Wall Street “Funding Corps” – name since changed to “Other Financial Business” (“Includes funding subsidiaries, custodial accounts for reinvested collateral of securities lending operations…). 

From Q2 2004 to peak Q4 2008, Funding Corps inflated 50% to $1.504 TN – before post-Bubble contraction shrank assets to $450 billion by the end of 2011. 

Well, they’re back. 

Other Financial Business assets surged $136 billion, or 46% annualized, during Q1 to $1.327 TN – the high since Q4 2008. Assets ballooned $210 billion y-o-y, or 18.8%, and $694 billion, or 110%, over 21 quarters.

Money Market Funds ($530bn) and Debt Securities ($384bn) are the largest Other Financial Business holdings, with Securities Lending ($793bn) the largest liability. 

Interestingly, Open Market (“Commercial”) Paper was the fastest growing individual holding, expanding an unprecedented $69 billion (184% ann.) to a record $219 billion.

Curiously, the category Open Market Paper expanded $140 billion, or 46% annualized, during the quarter (high since Q1 ’09) to $1.355 TN – with 21-quarter growth of $317 billion, or 31%. 

Brings back memories of the $479 billion, or 37%, ballooning over 13 quarters to a Q4 2007 peak of $1.789 TN. 

But I digress…

Declining stocks took a nick out of the grossly inflated Household Balance Sheet. 

With Assets dipping $1.657 TN to $190.083 TN, and Liabilities slipping $62 billion to $20.776 TN, Household Net Worth declined $1.595 TN to $169.307 TN. 

Still, Net Worth was up $6.123 TN y-o-y, $16.819 TN over three years, and $58.304 TN, or 53%, over 20 quarters. 

Net Worth ended the quarter at 565% of GDP, compared to previous cycle peaks 488% (Q1 ’07) and 444% (Q1 2000).

Combined Household Equities and Mutual Funds slipped $1.801 TN during Q1 to $49.948 TN, while Real Estate dipped $227 billion to $51.987 TN. 

Household “money” holdings continue their historic inflation. 

Total bank Deposits jumped $259 billion to a record $14.760 TN, with Money Market Deposits rising $119 billion to a record $4.837 TN. 

Meanwhile, Treasury holdings jumped $132 billion to $2.859 TN, while Agency Securities dropped $86 billion to $1.018 TN. 

Total Household Holdings of Deposits, Money Market Funds, Treasuries, and Agencies rose $423 billion during the quarter to a record $23.474 TN, with one-year growth of $1.317 TN, and 20-quarter growth of an incredible $6.314 TN, or 37%.

Rest of World holdings of U.S. financial assets slipped $475 billion during Q1 to $56.432 TN, though the quarter’s weaker stock market (total equities down $716bn) was entirely to blame. 

Meanwhile, Debt Securities holdings jumped a notable $635 billion (17.5% ann.) to a record $15.177 TN, with one-year growth of $1.188 TN, or 8.5%. 

Treasury holdings surged $500 billion during the quarter to a record $9.013 TN

I remember writing about the same dynamic late in the mortgage finance Bubble. 

Roads full of cars and retail centers bustling with shoppers. 

For the most part, the economic data looks okay. 

Stock prices are only a short distance from record highs.

But there is a serious smoldering issue: finance is malfunctioning. 

Excessive leverage is increasingly destabilizing. 

Risk intermediation is struggling to keep pace with over-issuance of debt of deteriorating quality. 

The widening chasm between the perception of moneyness (safety and liquidity) and the actual quality of underlying debt is untenable. 

Tens of Trillions of perceived wealth lack sufficient backing from underlying economic wealth-producing assets. 

It’s uncomfortably reminiscent of early 2008, except only a lot more ominous. 

Bubbles are so much bigger - and the world frighteningly more precarious.