by Doug Noland at The Credit Bubble Bulletin
The Federal Reserve is flailing and global currency markets are in disarray. Notably, the Brazilian real dropped more than 10% in five sessions, before Thursday’s sharp recovery reversed much of the week’s loss. This week the Colombian peso dropped 3.0%, and the Chilean peso fell 3.1%. The Mexican peso dropped 1.9%. The Malaysian ringgit sank 4.5% for the week, with the South Korean won down 2.7% and the Indonesia rupiah losing 2.2%. The Singapore dollar fell 1.8%. The South African rand sank 4.4% and the Turkish lira fell 1.4%. Notably, market dislocation was not limited to EM. The Norwegian krone was hit for 4.4%, and the Swedish krona lost 2.0%. The British pound declined 2.3%. The Australian dollar also lost 2.3%.
Apparently alarmed by the market’s poor reaction to last week’s no hike decision, the Ultra-Dovish Fed this week attempted to slip on a little hawk attire. It’s looking really awkward. On Thursday evening, chair Yellen did her best to backtrack from last week’s FOMC statement with its focus on global issues. The markets are doing their best not to panic.
Securities markets have over the years grown too accustomed to knowing almost precisely what the Fed’s (and global central bankers) next move would be and what indicators were driving the decision-making (and timing) process. Transparency and clarity are hallmarks of New Age central banking. But chairman Bernanke back in 2013 significantly muddied the waters with his comments that the Fed was ready to push back against a “tightening of financial conditions.” Markets celebrated short-term ramifications: the Fed was overtly signaling it would react to “risk off” speculative dynamics.
And for more than two years, global market Bubble vulnerabilities ensured the Fed stayed firmly planted at zero. Meanwhile, the U.S. unemployment rate dropped to 5.1%. Stock prices shot to record highs, with conspicuous signs of speculative excess (biotech and tech!) The U.S. recovery soldiered on, Bubble excesses and imbalances on clear display.
At least to the adults on the FOMC, crisis-period zero rates some time ago became inappropriate. So it’s time to at least attempt a semblance of responsible central banking. There is, however, no thought of really tightening policy. Just a baby-step – or perhaps two – so history won’t look back and say the Fed sat back, watched the Bubble inflate and did absolutely nothing. The problem today is that even 25 bps will upset the fragile apple cart.
The global Bubble is bursting – hence financial conditions are tightening. Bubbles never provide a convenient time to tighten monetary policy. Best practices would require central bankers to tighten early before Bubble Dynamics take firm hold. Central bankers instead nurture and accommodate Bubble excess. It ensures a policy dead end.
As the unfolding EM crisis gathered further momentum this week, the transmission mechanism to the U.S. has begun to clearly show itself. While “full retreat” may be a little too strong at this point, the global leveraged speculating community is backpedaling. Biotech stocks suffered double-digit losses this week, as a significant Bubble deflates in earnest. It’s also worth noting that the broader market underperformed. The speculator Crowd hiding out in the small caps on the thesis that these companies were largely immune to global maladies must be feeling uncomfortable. The small cap universe is a dangerous place in the midst of de-leveraging/de-risking.
There was a new Z.1 “flow of funds” report released from the Fed last week. The “flow of funds” always turns fascinating at inflection points.
Total Non-Financial Debt (NFD) expanded at a 4.4% rate during Q2 2015, up from Q1’s 2.5%. Corporate debt growth accelerated to a notable 8.7% growth rate, up from Q1’s 8.4% to the fastest rate since Q3 2013. Household Debt expanded at a 3.9% pace, up from Q1’s 1.7% to the quickest pace since Q2 2014. Buoyed by strong boom-time receipts, Federal borrowings expanded at a modest 2.4% pace.
In seasonally-adjusted and annualized (SAAR) dollars, Non-Financial Debt expanded $1.936 TN during Q2, up from Q1’s SAAR $1.074 TN – and in the ballpark of the $2.0 Trillion bogey I’ve used as sufficient Credit growth to power Bubble reflation.
Credit and flow analysis always requires dissecting the data by key sectors, attempting to discern current excesses and vulnerabilities. This type of analysis becomes critical at key cycle inflection points.
During Q2, Total Business Borrowings (TBB) expanded at an extraordinary SAAR $1.009 TN, up from Q1’s already elevated $863bn. For perspective, Total Business borrowings expanded $707bn in 2014, $555 billion in 2013, $489 billion in 2012 and $298 billion in 2011. Importantly, Business borrowings are highly cyclical, and I would strongly argue especially vulnerable to an abrupt change in market sentiment. After expanding a record $1.115 TN in 2007, Business borrowings were almost cut in half ($587bn) in 2008, before contracting in 2009 ($455bn) and 2010 ($90bn).
Q2 saw Total Household borrowings expand SAAR $548 billion, up from Q1’s $241 billion to the strongest pace since Q2 2014 ($696bn). Household mortgage borrowings jumped to SAAR $206bn, the largest expansion since the mortgage finance Bubble period.
While much below the Trillion plus annual borrowings from 2008 through 2012, Federal Government borrowings rose to SAAR $350 billion during Q2. Of course, the government’s profound Credit system role is not limited to the issuance of Treasury debt and expanding Fed Credit. The Government-Sponsored Enterprises (GSE) expanded borrowings SAAR $106bn during Q2, a sharp reversal from Q1’s SAAR $135 billion contraction. Moreover, Agency- and GSE-Backed Mortgages Pools expanded SAAR $123 billion, up from Q1’s $5.3 billion. In the past, abrupt expansion in the GSE’s and Agency MBS sectors reflected an incipient tightening of market liquidity conditions (i.e. heightened demand for perceived safe and liquid securities).
Over recent years, “flow of funds” analysis has focused on the Bubble effects of inflating Household perceived wealth. During Q2, Household Assets rose another $828 billion (nominal/not annualized) to a record $99.990 TN. Household sector Financial Assets increased $286 billion and Real Estate gained $499 billion. With Liabilities up $133 billion, Household Net Worth inflated $695 billion during the quarter to a record $85.712 TN. Household Net Worth increased $3.830 TN (4.7%) over the past year and $11.898 TN over two years (16.1%).
It’s worth recalling that Household Assets ended 2007 at $81.1 TN, with Net Worth at $66.7 TN. After declining to $56.5 TN to end 2008, Household Net worth has since then inflated $29.2 TN, or 52%. As a percentage of GDP, Household Net Worth slipped slightly to 390% from Q1’s 394%. For perspective, Household Net Worth ended the eighties at 267%, closed Bubble year 1999 at 361% and Bubble year 2007 at 366% of GDP.
Household sector holdings of Financial Assets ended 1985 at $10.9 TN, or 250% of GDP. These holdings had inflated to $22.8 TN by 1995, or 297% of GDP. By 2005 this number has surged to $45.5 TN, or 347% of GDP. Household holdings of Financial Assets ended Q2 2015 at a record $68.5 TN, a record 395% of GDP.
Inflating securities markets have been fundamental to my government finance Bubble thesis. As a proxy for Total Debt Securities (TDS), I combine Treasury Securities, Agency Securities, Corporate Bonds and Muni Debt. Total Equities is then added for a proxy of Total Securities. TDS ended Q2 at a record $39.31 TN. Total Equities, at $36.82 TN, was down slightly from Q1's record level.
Total Securities ended Q2 at a record $76.13 TN, or 425% of GDP. For perspective, Total Securities began the 1980s at 109% of GDP; the 1990s at 178% of GDP; and the 2000’s at 341% of GDP. Total Securities ended 2007 at 360% of GDP, before dropping to 297% to close out 2008. After ending 2008 at $43.72 TN, Fed-induced market inflation has seen Total Securities surge an astonishing 74%.
Ultra-loose financial conditions spurred resurgent system debt growth. Federal borrowings dominated Credit creation from 2008 through 2012, in the process bolstering household incomes, spending and corporate profits. Of late, corporate debt growth – notably to finance stock buybacks and M&A - has been instrumental in sustaining system reflation. It's central to my analysis that the corporate debt market is increasingly vulnerable to the faltering global Bubble.
“Flow of funds” analysis will now take special interest in the Rest of World (ROW) sector. ROW holdings of U.S. Financial Assets ended Q2 at a record $23.402 TN. For perspective, ROW holdings began the 1990s at $1.74 TN before ending the decade at $5.62 TN. ROW holdings surpassed $10.0 TN for the first time in 2005, before concluding 2007 at $14.56 TN. Since ending 2008 at $13.70 TN, massive post-Bubble U.S. fiscal and monetary inflation (inundating the world with dollar balances) has seen ROW U.S. Financial Asset holdings surge 71%.
Not surprisingly (from the perspective of a faltering global Bubble), Q2 ROW activity was notable. Rest of World holdings of U.S. Financial Assets increased SAAR $1.145 TN. Curiously, ROW Securities Repo holdings contracted SAAR $245 billion, Net Inter-Bank Assets contracted SAAR $115 billion, and Time & Checkable Deposits contracted SAAR $92 billion. Meanwhile, during the quarter holdings of Treasuries surged SAAR $565 billion, Agency Securities increased SAAR $128 billion and holdings of Corporate bonds jumped an eye-catching SAAR $705 billion. It's worth noting that ROW holdings of Corporate debt increased an unprecedented $266 billion over the past year. This data confirm highly unstable global financial flows.
Current dynamics in the corporate debt market recall the pivotal 2007 to 2008 inflection point period in the mortgage finance Bubble. Recall how the initial crack in subprime (spring 2007) actually spurred a loosening of conditions in prime (GSE) mortgage Credit and the corporate debt market. This worked to extend “Terminal Phase” excesses and vulnerabilities that would come home to roost later in 2008.
I do not know the sources of extraordinary Rest of World demand for U.S. corporate bonds and other securities. I suspect there is a speculative component – “carry trades,” and other “hot money” flows seeking refuge in the perceived safety of U.S. securities markets. I would also posit that, similar to late-2008 dynamics, there is now potential for an abrupt reversal of speculative flows as the faltering Bubble takes increasing aim at The Core.
Looking back to Q4 2007, even in the midst of a faltering Bubble, Non-Financial Debt (NFD) growth remained at an elevated SAAR $2.50 TN pace. Importantly, system Credit expansion (and fragilities) was being dominated by late-cycle excesses throughout mortgage and corporate finance. And by Q2 2008, NFD had sunk to SAAR $1.13 TN. Mortgage borrowings had collapsed and Corporate borrowings had fallen by more than half.
The U.S. corporate debt market is increasingly impinged by the forces of a faltering global Bubble and a resulting “risk off” speculative dynamic. Financial conditions have tightened meaningfully in the energy and commodities sectors. More generally, the market is now looking at leveraged balance sheets with rising trepidation. And as financial conditions tighten more generally and equities succumb to harsh new realities, I would expect corporate Treasurers to approach borrowing for stock buybacks with newfound caution. Heightened global economic and market risk should also prick the M&A Bubble. Heightened risk aversion, slowing stock buybacks and less M&A combine for a much less hospitable backdrop for equities. Faltering equities will further weigh on fragile sentiment in corporate debt markets. And faltering markets will hit Household wealth and spending.
Anticipating Fed policy moves has become tricky business. A faltering global Bubble will surely at some point pressure the Fed into additional QE. After all, who will be on the other side of a major cycle of speculative deleveraging? By default, it will be our and global central banks. Meanwhile, the Fed currently believes the market prefers a Fed rate increase. I suspect this preference will prove transitory.
Markets have been fearing a disorderly unwind of global leveraged “carry trades.” In particular, bouts of dollar weakness were pressuring short positions in the yen and euro (used to finance speculative bets in higher-yielding currencies). The Ultra-Dovish Fed statement pressured the dollar along with de-risking/deleveraging. And while Fed backtracking this past week did bolster the dollar, it came at the expense of increasingly disorderly EM and currency markets more generally.
I actually believe the faltering global Bubble has progressed beyond the point where Fed rate policy has much impact. Yet the Fed is determined to “push back against a tightening of financial conditions.” But are so-called “financial conditions” being tightened by happenings in China? Or is the culprit pressure on yen and euro short positions? Could it be because of a panicked “hot money” exit from EM – exposing Trillions of problematic dollar-denominated debt? How about an unwind of “risk parity” and other leveraged strategies that will not perform well in the New World Disorder of liquidity-challenged and unstable currency and financial markets? What about the possibility that the global leveraged speculating community is in increasing disarray? How about fears of potential counter-party issues in the convoluted world of derivatives trading? Could it be because of mounting fears of a crisis of confidence in Chinese and EM banking systems? Analysts and the media always like to pick a culprit du jour.
Perhaps chair Yellen and the FOMC is beginning to appreciate that it is not in control of the markets – and is certainly not in control of the faltering global Bubble. And Chinese officials are not in control – nor the BOJ nor ECB. EM central bankers, facing a currency crisis, have certainly lost control. And with European and U.S. equities Bubbles succumbing, the unfolding global crisis has penetrated The Core. Things turn even more serious when contagion begins impinging liquidity in the U.S. corporate debt market. I fear I will be writing about this dynamic in relative short order.