Q1 '23 Z1: Shedding Light on Liquidity Dislocation
Doug Nolan
Not surprisingly, considering the March banking crisis, Non-Financial Debt (NFD) growth was tepid for the second straight quarter.
At a 3.50% rate, Q1 NFD growth (from the Fed’s Z1 report) was up somewhat from Q4’s 3.19%, though it was notably slower than the annual rates in 2022 (5.72%), 2021 (6.35%) and 2020 (12.40%).
In seasonally-adjusted and annualized amounts, Q1 NFD growth of $2.409 TN compares to 2022’s growth of $3.728 TN, 2021’s $3.891 TN and 2020’s record $6.760 TN.
And while the NFD growth rate was steady, there were notable shifts.
Household debt growth slowed from Q3’s 6.43% and Q4’s 3.33% to a rate of 2.20%. Household Mortgage debt growth slumped to 2.45% from the year ago (Q1 ’22) 8.79%.
Consumer Credit had been holding up better, with Q4 growth of 7.43%.
But it slowed markedly to 4.27% during Q1.
Meanwhile, Corporate debt growth bounced back from Q4’s weak 1.78% to 4.81%.
Mortgage lending stalled across the board.
Household mortgage debt expanded only $50 billion (nominal) during Q1, down from Q2 '22’s peak $281 billion and Q4’s $164 billion.
Commercial Mortgage growth dropped from Q4’s $56 billion and Q2 22’s all-time record $94 billion to $30 billion.
And Multifamily Mortgage growth dropped from Q4’s $40 billion and Q2’s record $65 billion to only $10 billion.
The historic bank lending boom came to a screeching halt.
Loan growth slumped to only $31 billion, down from Q4’s $356 billion and Q2’s near-record $549 billion (second only to Q1 ‘20’s $561bn).
Loan growth had averaged an unprecedented $370 billion quarterly over the preceding five quarters – which was just above the $363 billion annual average from 2000 through 2019.
The rapid Credit slowdown would typically be associated with recessionary conditions.
But there’s a second key storyline from Q1’s Z1 data: Financial Sector debt growth jumped to a 12.3% annual pace – up from Q4’s already heady 10.5%.
For perspective, 2022’s 9.80% growth in Financial Sector borrowings was the strongest since 2007’s 13.50% - and compares to a 10-year annual average (2012-2021) of 2.67%.
This line of analysis tends to turn complex and confusing.
It’s also critical for deeper understanding of today’s extraordinary economic, financial and market environments.
Think in terms of a banking system crisis of confidence, tightened bank standards, and a rapid slowdown in (non-financial) lending to the real economy.
Meanwhile, the financial sector is in flux, with hugely impactful shifts in financial flows, Fed and GSE liquidity injections, and changes in financial sector risk intermediation.
Importantly, the hasty expansion of financial sector borrowings created liquidity excesses to further distort highly speculative markets.
While bank lending slowed sharply, this was more than offset by the powerful nexus of Federal Reserve and FHLB liquidity, the money market funds, the repurchase agreement (“repo”) marketplace, and the Broker/Dealers.
Federal Reserve “Financial Assets” jumped $244 billion during Q1 to $7.747 TN, the first expansion in five quarters.
The Fed’s “Interbank Loans” surged $319 billion – with “Discount Window” borrowings up $65 billion, the new “Bank Term Funding Program” rising $65 billion, and “Other Credit Extensions” jumping $180 billion.
The asset “Security Repurchase Agreements” (Fed lending in the “repo” market) increased from zero to $45 billion.
On the liability side of the Fed’s balance sheet, “Depository Institution Reserves” surged $499 billion to $3.184 TN, while “Due to Federal Government” dropped $269 billion to $178 billion.
The Fed’s “Repo” liability fell $147 billion to $2.743 TN.
Extraordinary GSE (government-sponsored enterprises) growth is worthy of close examination.
GSE assets expanded a record $352 billion during Q1 to an all-time high $9.540 TN.
This surpassed the previous record increase of $325 billion during pandemic crisis Q1 2020.
The pre-pandemic record was tumultuous (subprime crisis) Q3 2007’s $144 billion, which exceeded the previous record $136 billion during Russia/LTCM crisis period Q4 1998 - that had eclipsed the previous $60 billion quarterly high from bond/derivative/Mexico crisis period Q4 1994.
GSE assets inflated a record $1.022 TN, or 12.0%, over the past four quarters.
This was double peak one-year growth from 2020 ($523bn).
Record pre-Covid peak one-year growth was Q2 2008’s $418 billion, which exceeded Q3 1999’s one-year gain of $353 billion, and trounced Q4 1994’s at the time record $151 billion.
The bottom line is that GSE growth has been nothing short of phenomenal.
GSE assets surged $1.248 TN, or 15%, over five quarters, and $2.410 TN, or 33.8%, since the start of the pandemic (13 quarters).
FHLB (Federal Home Loan Banks) Loans/Advances surged a record $222 billion during the quarter to a record $1.042 TN.
But, as informed by FHLB financial statements, booming Q1 growth was not limited to loans/advances to member banks.
Strong expansions in “repo” and “Fed fund” assets – other key avenues for adding system liquidity – powered record ($317 billion) growth to an all-time high $1.564 TN of total assets (having doubled year-over-year).
With its AAA rating and attractive liquidity profile (especially during crisis periods!), GSE obligations are the perfect asset for money market funds.
Moreover, with flows gravitating to the perceived safety of money funds during risk averse market backdrops, the money market fund complex becomes a powerful mechanism for system Credit and liquidity expansion.
As I’ve previously explained, the GSEs (chiefly the FHLB of late) issue short-term debt to the money funds.
They use this liquidity to fund member banks' deposit outflows – with much of this liquidity flowing back to the money funds – providing buying power to purchase additional GSE debt (the old “fractional reserve banking” “deposit multiplier” on steroids).
Money Market Funds expanded $470 billion during Q1, to a record $5.693 TN.
This growth was second only to Q1 2020 – while exceeding Q2 2008’s $357 billion pre-pandemic record.
Money Fund assets have ballooned $1.690 TN, or 35.5%, in the 13 quarters since the start of the pandemic.
The “repo” market is integral to this market-based risk intermediation and Credit/liquidity creation mechanism.
“Fed Funds and Security Repurchase Agreements” assets surged a stunning $815 billion, or 46% annualized, during Q1 to a record $7.895 TN.
This growth exceeded Q1 2020’s $474 billion and Q1 2007’s $393 billion.
At a record $3.235 TN, money funds are by far the largest holders/investors in “repo” assets.
Money fund “repo” holdings surged $259 billion during Q1 (34.8% annualized), with one-year growth of $858 billion, or 36.1%.
And for a number worthy of deep contemplation, money fund holdings of “repo” assets ballooned $1.993 TN, or 160%, in the 13 quarters since Covid.
Wall Street is both a key borrower and lender in the “repo” marketplace.
Broker/Dealer “repo” liabilities/borrowings jumped a record $393 billion during Q1 to an all-time high $2.019 TN – exceeding the previous record ($324bn) growth from Q1 2007.
Broker/Dealer “repo” borrowings were up $495 billion, or 32.5%, over four quarters.
Total Broker/Dealer assets jumped $452 billion, or 41.4% annualized, during Q1 to $4.823 TN (the high since Q3 ’08).
“Repo” assets rose a quarterly record $208 billion, or 57% annualized, to an all-time high $1.669 TN.
“Repo” assets were up $345 billion, or 26%, over the past year.
Debt Securities holdings increased $98 billion to $409 billion.
Pondering the data, there’s a strong argument that market-based Credit/liquidity has run completely amuck.
The Nasdaq100 closed this week with a year-to-date (5 months) gain of 33%.
The Household Balance Sheet certainly benefited from the extraordinary inflation of financial sector Credit/liquidity and stock prices.
Household Assets jumped $3.049 TN during Q1 to $168.5 TN, led by a $3.577 TN gain in Financial Assets (to $114.3 TN).
And with Liabilities little changed at $19.619 TN, Household Net Worth surged $3.036 TN to $148.8 TN – just off of Q1 2022’s record $152.6 TN.
While down y-o-y, Household Net Worth has surged $32.2 TN, or 30%, over the past three years.
Household Net Worth-to-GDP ended Q1 at 562%.
This compares to previous cycle peaks 491% for Q1 2007 and 445% to end Q1 2000.
Rest of World (ROW) holding of U.S. Financial Assets jumped $2.434 TN to $43.876 TN, with about a third of the growth explained by the jump in Equities holdings.
ROW assets inflated $11.657 TN, or 36.2%, over 12 quarters.
Treasury holdings jumped $221 billion during Q1 to $7.536 TN, with Agency Securities up $65 billion (to $1.363 TN) and Corporate Bonds rising $141 billion (to $3.881 TN).
On the liability side, “repos” rose $138 billion to $1.299 TN.
Treasury borrowings will now be playing catch up. Treasury Q1 issuance slowed to $124 billion to a record $26.956 TN.
Outstanding Treasury debt surged $7.937 TN, or 41.7%, over the past 13 quarters.
Since the end of 2007, Treasury debt has inflated $20.905 TN, or 345%. After ending 2007 at 41%, Treasury debt closed the quarter at 102% of GDP.
Examining Z.1 data and recent market dynamics leaves me apprehensive.
The massive shot of destabilizing financial sector Credit and liquidity triggered the reemergence of market Bubble Dynamics.
A major ongoing short squeeze is exacerbating liquidity excess.
Meanwhile, a derivatives-induced market melt-up – call options in the big technology stocks and indices, in particular – has fueled a self-reinforcing liquidity-creation dynamic and upside market dislocation.
But this liquidity and speculation bonanza poses serious risk to highly levered bond markets (at home and abroad) – Fed “skip” notwithstanding.
A problematic shift in market liquidity dynamics doesn't seem a low probability scenario.
A spike in yields would spur another bout of liquidity destroying de-risking/deleveraging.
Faltering bonds could spark an equities market reversal, with recent powerful derivatives-related buying abruptly shifting to aggressive selling.
And after months of liquidity abundance and strong markets, risk hedges have either matured or been abandoned throughout the marketplace.
A sudden return on “risk off” would catch many poorly positioned, with a mad rush to re-establish hedges exacerbating market liquidity issues.
June 7 – Bloomberg (Erik Hertzberg and Randy Thanthong-Knight):
“The Bank of Canada defied expectations by restarting its interest-rate tightening campaign, saying the economy is running too hot.
Policymakers led by Governor Tiff Macklem raised the overnight lending rate to 4.75%..., the highest since 2001.
The move was expected by only about one in five economists…, and markets had put the odds at about a coin flip.
‘Overall, excess demand in the economy looks to be more persistent than anticipated,’ the bank said…
‘Monetary policy was not sufficiently restrictive to bring supply and demand into balance and return inflation sustainably to the 2% target,’ the bank said, citing an ‘accumulation of evidence’ that includes stronger-than-expected first quarter output growth, an uptick in inflation and a rebound in housing-market activity.”
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