VALUABLE INSIGHT FROM THE Q2 ´22 Z.1 / CREDIT BUBBLE BULLETIN

Valuable Insight from the Q2 '22 Z.1

Doug Nolan 

Reuters headline: “U.S. Household Wealth Suffers Record Drop in Second Quarter.” 

Bloomberg: “US Household Net Worth Falls Most on Record on Slump in Stocks.” 

Yes, Household Net Worth dropped $6.1 TN during Q2, the largest decline since Q1 2020. 

However, the hit to the Household Balance Sheet was not the most newsworthy facet of an intriguing Fed Q2 2022 Z.1 “flow of funds” report.

I had been anxiously waiting for new Credit data. 

The second quarter was miserable for the securities markets. 

There was the sharp drop in perceived wealth, along with a meaningful tightening of market financial conditions. 

Understandably, focus for many analysts had turned to economic recession. 

Meanwhile, the quarter was notable for an extraordinary surge in price pressures. 

How would these countervailing forces impact lending and Credit growth more generally? 

The Z.1 provides Valuable Insight.

Driven by a sharp reduction in Treasury borrowings (from 10.22% to a 5.56% pace), Non-Financial Debt (NFD) growth slowed from Q1’s 8.32% rate to 6.49%. 

Meanwhile, the Household Mortgage debt growth rate rose to 8.78%, the strongest pace since 2006. 

And not since 2001 has Consumer Credit expanded faster than Q2’s 8.51% rate. 

Corporate Borrowing declined ever so slightly, from 8.09% to 7.93%. 

Excluding pandemic year 2020, 2022 is on track for the fastest pace of corporate Credit growth since 2007. 

That this could unfold in the face of market instability is as extraordinary as it is telling.

For years overshadowed by booming securities markets, an invigorated banking system is puffing its chest. 

While Bank (“Private Depository Institutions”) Assets declined $285 billion during Q2, this was driven by a $642 billion drop in Reserves at the Federal Reserve. 

Meanwhile, Loans surged another $555 billion during the quarter, a slight second to pandemic Q1 2020’s record $561 billion.

For perspective, Loan growth averaged $363 billion annually over the two-decade period 2000 to 2019. 

Q3 2007’s $260 billion was the strongest quarterly growth during the mortgage finance Bubble period. 

Bank Loans expanded at a blistering 17.3% rate during Q2, with Loans up $1.265 TN, or 10.5%, over the past year. 

Only half way through the year, 2022 Loan growth ($721bn) has already exceeded 2005’s record $685 billion.

Bank Loans N.E.C. (not elsewhere classified/chiefly business) expanded $216 billion, or 19.4% annualized, to a record $4.674 TN. 

Loans N.E.C. expanded $568 billion, or 13.8%, over the past year. 

For perspective, 2007’s $318 billion was peak growth during the mortgage finance Bubble period, with 2020’s $362 billion the annual record.

Bank “Consumer Credit” Loans rose $118 billion, or 19.8% annualized, during the quarter to $2.494 TN. 

Consumer Credit rose $281 billion over the past four quarters, or 12.7%, surpassing 2010’s annual record of $269 billion. 

Annual growth averaged $77 billion over the two-decade period 2000-2019. 

Bank Mortgage Loans expanded $222 billion, or 14.9% annualized, surpassing the previous quarterly record of $156 billion from Q2 2004. 

Bank Mortgage Loans rose $417 billion, or 7.3%, over the past year.

Total system Mortgages expanded $415 billion, or 9.1% annualized, to a record $18.718 TN. 

This was only slightly below Q4 2021’s record $418 billion. 

Over four quarters, Mortgages were up $1.433 TN, or 8.4%. 

This is just below 2005’s annual record $1.466 TN. 

Mortgages expanded $2.393 TN over the past eight quarters.

By category, Home Mortgages expanded $281 billion, or 8.8% annualized, to $12.985 TN – the strongest quarterly expansion since Q2 2006. 

This pushed one-year growth to $961 billion, or 8.2% - also the strongest since 2006. 

Commercial Mortgages expanded $92 billion, or 10.9% annualized, second only to Q4 2021 ($98bn). 

One-year growth of $307 billion, or 9.9%, exceeded 2006’s annual record $284 billion. 

Multi-housing Mortgages gained $40 billion, or 8.3% annualized, to a record $1.961 billion, with one-year growth of $153 billion, of 8.6% - exceeding 2019’s annual record of $134 billion.

The GSE (government-sponsored enterprises) boom runs unabated. 

Agency Securities expanded $269 billion, or 9.8% annualized, during the quarter to a record $11.195 TN. 

Agency Securities were up $788 billion (7.6%) over the past year and $1.452 TN (14.9%) over two years. 

It’s worth noting that the strongest annual Agency Securities growth during the period 2009 to 2019 was 2019’s $317 billion.

Treasury issuance dropped dramatically, to only $34 billion during Q2 to a record $26.051 TN. 

Still, one-year growth remained a potent $1.749 TN, or 7.2%. 

Over the past 10 quarters, Treasuries ballooned an astonishing $7.470 TN, or 37.0%. 

Since the end of 2007, outstanding Treasuries have inflated $20.0 TN, or 331%. 

At 105%, the ratio of Treasuries-to-GDP is down from Q4 2020’s peak of 110%. 

But it compares to 55% at the end of 2007; 59% to end the nineties; 63% to close the eighties; and 50% to finish up the seventies.

Not surprising considering the market backdrop, Corporate Bond growth was muted. 

Q2’s $54 billion growth reversed Q1’s $28 billion contraction, with one-year growth of $370 billion, or 2.5%. 

Recall that Corporate Bonds expanded by over $1 TN during the pandemic year Q2 2000 to Q2 2001.

Total Debt Securities (TDS) growth slowed to $312 billion during the quarter, or 2.2%, to a record $57.507 TN. 

As a percentage of GDP, Total Debt Securities declined to 231%, down from the Q2 2020 peak 263%. 

For perspective, TDS-to-GDP ended 2007 at 201%; 1999 at 158%; and 1989 at 124%. 

But as Securities-to-GDP dropped, the ratio of Bank Assets-to-GDP jumped from 92% to 102% since the end of 2019.

Broker/Dealer Assets declined $140 billion, or 12.3% annualized, during Q2 to $4.433 TN. 

Miscellaneous Assets fell $108 billion to $1.763 TN. Debt Securities Assets increased $37 billion to $176 billion. 

“Repo” Assets added $21 billion to $1.346 TN, while “Repo” Liabilities increased $10 billion to $1.534 TN.

System “Repo” (“Federal Funds and Securities Repurchase Agreements”) surged another $435 billion, or 30% annualized, to a record $6.150 TN. 

“Repo” expanded $1.315 TN, or 27.2%, over the past year. 

Money Market Funds’ “Repo” Asset increased $219 billion to $2.596 TN, with extraordinary one-year growth of $881 billion, or 51.4%. 

Federal Reserve “Reverse Repo” Liabilities jumped $448 billion during the quarter to $2.330 TN, with one-year growth of $1.338 TN, or 135%.

To put the enormous growth in Fed “Repo” Liabilities (reverse-repo) into some perspective, we must factor in the corresponding drop in banking system reserves held at the Fed. 

The Fed’s “Depository Institution Reserves” sank $642 billion during the quarter to $2.955 TN.

When the Fed purchases securities (i.e. QE), it pays for these transactions by issuing “immediately available funds” – or Fed “IOUs” – that circulate through the banking system, where those funds become reserves held at the Fed. 

Five Trillion of QE inundated the banking system with funds/reserves.

With the introduction of its “reverse repo” instrument, the Fed essentially created a new IOU that would circulate outside the banking system. 

Rather than Fed liquidity being processed through the banking system (where it became additional bank reserves), Wall Street firms, money market funds and GSEs could simply exchange immediately available funds for the Federal Reserve IOU “reverse repo.” 

It’s essentially the Fed exchanging one IOU for another. 

Over three quarters, “Reverse Repo” expanded $725 billion, while “Depository Institution Reserves” contracted $904 billion.

Total Fed Liabilities declined $43 billion during Q2 to $8.918 TN, with one-year growth of $830 billion, or 10.3%. 

In one of history’s most spectacular monetary inflations, Fed Liabilities surged an unprecedented $4.7 TN, or 111%, over the past 10 quarters.

As noted above, Household Net Worth declined $6.1 TN during Q2 to $143.763 TN. 

Yet Net Worth is still up $27 TN, or 23%, since the end of 2019. 

And while Net Worth-to-GDP has dropped to 578% from the Q4 2021 peak of 625%, this ratio remains highly inflated historically. 

Net Worth-to-GDP posted cycle peaks of 491% during Q1 2007 and 445% at Q1 2000. 

Net Worth-to-GDP began the nineties at 376%.

And while Net Worth took a hit from sinking stock prices, it’s worth noting that Household Real Estate holdings inflated $1.422 TN during the quarter to a record $45.531 TN. 

Real Estate increased an unprecedented $6.058 TN over the past year. 

At 183%, Household Real Estate-to-GDP is approaching the Q3 2006 Bubble peak of 190%.

The bottom line: despite pockets of weakness in securities finance, a historic system Credit inflation runs unabated. 

On a seasonally-adjusted and annualized basis (SAAR), Non-Financial Debt expanded at a $4.316 TN pace during Q2. 

This was more than double the $1.846 TN annual average for the decade 2010 to 2019, while almost 50% ahead of 2004’s cycle peak $2.899 TN - that was not exceeded until 2020’s insane $6.796 TN Credit splurge.

There are powerful inflationary biases percolating throughout the economy - unlike anything experienced in decades. 

Importantly, securities markets no longer completely dominate and dictate system financial conditions. 

Lending and bank Credit have become powerful drivers of Credit growth, along with ongoing deficit spending and the expansionary GSEs.

While it’s mum’s the word when it comes to Credit growth, Fed officials undoubtedly know the numbers. 

They must also know that inflation will not be moving back to their 2% target until they orchestrate a marked Credit slowdown (with myriad negative consequences). 

They’ve been forced to abandon the notion that tinkering with market financial conditions would do the trick. 

Now, it’s press ahead with a major tightening cycle until something works. 

And between the Z.1 and recent speculative market dynamics, there is certainly no reason to backtrack from the “they’ll hike until something breaks” thesis.