Page 1 of 4 CREDIT BUBBLE BULLETIN Q3 2008 'Flow of Funds'
Commentary and weekly watch by Doug Noland
As I have highlighted in the past, in the US Total Non-Financial Credit (NFC)
expanded US$578 billion in 1994. By 1998, annual NFC growth exceeded $1.0
trillion for the first time. After year 2000's recessionary pullback, by 2002
NFC growth was up to a record $1.412 trillion, followed by 2003's $1.677
trillion, 2004's $1.991 trillion, 2005's $2.322 trillion, 2006's $2.422
trillion, and 2007's $2.523 trillion. From my analytical perspective, it has
always been a case of the inevitable (credit and economic bubbles') predicament
of an impaired (post-bubble) credit system not having the capacity to create
sufficient new credit to stem
financial and economic implosion.
To this point, a barrage of unprecedented monetary and fiscal policy responses
has restrained the forces of systemic collapse. On a quarterly basis the
Federal Reserve's Z.1 "Flow of Funds" report will help us better appreciate the
profound effects the bursting of the credit bubble - and resulting policymaking
- are exerting upon the underlying functioning of the credit system and real
economy.
Total Non-Financial Credit expanded at a surprising 7.2% rate during Q3, up
sharply from Q2's 3.1% pace to the most robust credit growth since Q4 2007. By
sector, household debt actually contracted at a 0.8% rate, down from Q2's 0.6%
growth and compared with 2007's annual increase of 6.8%. Household mortgage
debt contracted at an unprecedented 2.4% rate. Corporate borrowings slowed to a
3.7% pace from Q2's 5.6%. This was a marked slowdown from the 13.2% surge in
corporate debt growth for all of 2007. During the quarter, state and local
governments increased borrowings at a 2.9% pace. This was up from Q2's 0.8%,
but was much slower than 2007's 9.3%. With private sector credit growth now
struggling mightily, public finance was forced to really take up the slack.
Federal government debt expanded at a 39.2% pace, playing a decisive role in
generating sufficient system-wide credit expansion.
On a seasonally-adjusted and annualized rate (SAAR), total non-financial credit
expanded $2.348 trillion during the quarter - a quantity of new finance that
would be in the analytical ballpark (down only marginally from 2007's $2.5
trillion growth) to restrain the forces of systemic collapse. But of this
amount, federal government borrowings accounted for SAAR $2.079 trillion, or
almost 90% of the Q3 Credit expansion.
With even an unsustainable $2.0 trillion annual pace of federal borrowings
failing to reverse the downward economic spiral, the Federal Reserve last week
was compelled to signal in no uncertain terms that policymakers "will employ
all available tools to promote the resumption of sustainable economic growth
and to preserve price stability."
In tandem with Treasury efforts, the Federal Reserve expanded Fed credit SAAR
$2.353 trillion during Q3. This unprecedented ballooning accommodated
deleveraging and helped offset a sharp decline in lending throughout the
financial sector. "Fed funds and repos contracted SAAR $969 billion during the
quarter, while open market paper declined SAAR $580 billion. Savings
institutions reduced assets at SAAR $1.281 trillion, partially explained by
assets from troubled savings and loans having been shifted to commercial banks.
Bank credit at foreign banking offices in the US contracted at SAAR $415
billion, and lending at finance companies dropped SAAR $113 billion. The
asset-backed securities (ABS) market shrank SAAR $419 billion during Q3. After
Q2's SAAR $913 billion contraction, security brokers and dealers expanded SAAR
$12.6 billion.
Yet the Fed was not all by its lonesome in expanding system credit. Total bank
credit actually expanded at a robust SAAR $1.365 trillion - at least somewhat
receptive to the "buyer of last resort" roll for open market paper (holdings up
SAAR $413 billion) and mortgages (holdings up SAAR $688 billion). On the
liability side, net interbank liabilities expanded at an unprecedented SAAR
$897 billion, of which SAAR $515 billion was borrowed from the Fed. Elsewhere,
the GSEs expanded assets SAAR $85 billion (about 2.5% annualized), and agency
MBS surged SAAR $508 billion (11.2% annualized). Notably, total bank assets
were up $1.385 trillion, or 12.7%, over the past four quarters.
The dollar was clobbered after Wednesday's bold "employ all available tools"
pronouncement from the Federal Reserve. The way I see it, the Fed board sent a
direct message to the markets that it is resolved to do absolutely whatever is
required to ensure sufficient system credit will be forthcoming - a quantity
that for our purposes is in the, say, $2.0 trillion annual range.
The dilemma for the Fed (and markets) is that while such an enormous amount of
credit would do little more than somewhat steady our maladjusted bubble
economy, it would at the same time perpetuate the massive flow of dollar
finance out to the global financial system. In short, the Fed's determination
to reflate ensures continued monetary disorder. And I would further argue that
ongoing monetary disorder - and associated corruption to various market pricing
mechanisms - will impede system adjustment and extend the lengths of US and
global downturns and restructuring periods.
During Q3, rest of world (ROW) accumulated US financial assets at SAAR $816
billion. Over the past year, ROW holdings increased a staggering $1.224
trillion to $16.772 trillion. And it is this nearly $17 trillion number that I
use in my mind as a rough proxy for what I refer to as the "global pool of
speculative finance" - the source of unwieldy financial flows that continue to
wreak bloody havoc on global markets and market pricing mechanisms. Over just
the past 12 quarters, ROW holdings ballooned more than 50% - and they're still
growing rapidly.
It is also worth nothing that ROW Treasury holdings expanded SAAR $819 billion
during the quarter and were up $674 billion, or 30%, over the past year to
$2.913 trillion. Ominously, ROW reduced holdings of US credit market
instruments fell SAAR $547 billion during Q3, with commercial paper down SAAR
$273 billion and bonds down SAAR $291 billion.
Holdings of agency securities declined SAAR $241 billion, reducing the one-year
increase to $246 billion. ROW holdings of security repurchase agreements
contracted SAAR $368 billion during Q3, with a one-year drop of $254 billion
(22%). We continue to witness the astounding market extremes fostered by ROW
risk aversion (zero T-bill yields versus hopeless illiquidity in many risk
markets). Or stated differently, the attribute of "moneyness" today applies
only to a narrow scope of top tier US financial claims.
The currency markets are shaping up as a major issue for the coming year. The
dollar rallied sharply during the fourth quarter, although much of this gain
was recently wiped away in six tumultuous trading sessions. I view the dollar's
recovery in the context of a bear market rally. The dollar bear had become a
crowded trade, and many were caught on the wrong side of various markets this
year - certainly including the leveraged players in the currency markets (carry
trades in particular).
There is a school of thought out there that the dollar bear has seen its lows.
A consensus view seems to be taking shape that, at the minimum, the dollar wins
(by default) the near-term battle against most currencies. Part of this
analysis is the reasonable proposition that our currency benefits from the
capacity of our policymakers to move earlier and more aggressively than their
global counterparts. The euro-zone, in particular, is seen hamstrung by the
constraints of its strange political and monetary structure.
My analytical framework takes a different approach. Especially after examining
the most recent Flow of Funds report, I contemplate the dollar's prospects from
a global flow of funds perspective. At this point I will presume that fiscal
and monetary policies will succeed in generating $2 trillion or so of new
credit in 2009 (trillion dollar growth each in federal borrowings, the Fed's
balance sheet, and commercial bank credit would push the system much of the way
there). In this scenario, the economy would nonetheless still likely be mired
in recession, short-term rates would remain near zero, and our current account
deficit would remain in the $600 billion to $650 billion range.
Factoring in other financial outflows, the rest of world would be called upon
to purchase another trillion or so of our financial claims next year - and for
years on end.
I will posit that the 2002-2007 dollar bear market did not manifest into a
full-fledged currency crisis simply because of the massive purchases of US
securities by the Chinese (and to a lesser extent the Organization of Petroleum
Exporting Countries, Russia, and India). At this point, I would not want to
count on the Chinese (or others) accumulating another trillion of our IOUs
anytime soon. I don't expect their appetite to return for US securitizations,
corporate bonds, and "repos" anytime soon (market perception of "moneyness" has
been lost).
Indeed, these IOUs have lost their acceptability as a means of global payment
remuneration. It also seems reasonable that this year's market dislocations
have reduced the appeal of the strategy of holding US securities while hedging
underlying currency exposure in the derivatives market. And, at today's pitiful
yields, there would seemingly be little ongoing incentive to continue hording
Treasuries.
It is impossible to know how much remains of the crowded dollar bear unwind.
But if this dollar buying hasn't yet about run its course, when it eventually
does global markets will again face the specter of massive and seemingly
unending dollar liquidity flows. At the end of the day, I expect the dollar to
suffer from its relative dismal position with respect to both financial flows
and our economy's deep structural maladjustment. Years of egregious credit and
spending excesses have left an economic structure uniquely dependent upon, on
the one hand, huge ongoing public sector credit injunctions and, on the other,
huge unending imports. This is a terrible predicament for a currency.
WEEKLY WATCH
For the week, the Dow slipped 0.6% (down 35.3% y-t-d), while the S&P500
added 0.9% (down 39.5%). The broader market was much stronger. The small cap
Russell 2000 jumped 3.8% (down 36.5%), and the S&P400 Mid-caps rose 3.1%
(down 39%). Economically sensitive stocks generally performed well. The
Transports jumped 4.4% (down 25.6%), and the Morgan Stanley Cyclicals gained
2.1% (down 52.6%). The Morgan Stanley Consumer index increased 1.5% (down
26.9%), while the Utilities dipped 0.2% (down 31.5%). The NASDAQ100 added 0.9%
(down 41.6%), and Morgan Stanley High Tech index gained 0.7% (down 44.7%),
while the Semiconductors declined 0.5% (down 48.1%). The Street.com Internet
Index gained 2.7% (down 35.7%), and the NASDAQ Telecommunications index
increased 1.3% (down 42.7%). The Biotechs jumped 4.1%, reducing 2008 losses to
19%. The Broker/Dealers advanced 2.5% (down 63.9%), and the Banks added 0.3%
(down 51.1%). With Bullion gaining $15.60, the HUI Gold index rallied 3.9%
(down 33.7%).
One- and three-month Treasury bill rates ended the week at about zero. Two-year
government yields were volatile but ended little changed at 0.70%. Five-year
T-note yields dropped 18 bps this week to 1.27%. Ten-year yields sank 49 bps to
2.08%, and long-bond yields dropped 42 bps to 2.58%. The implied yield on
3-month December '09 Eurodollars fell 30.5 bps to 1.48%.
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
