by Brian Pretti CFA, Contrary Investor. April 15, 2010
In more ways than one? Sure could be. Time to quickly discuss the theoretical end to Fed money printing to buy back mortgage backed securities. As you know, there’s plenty of thought on the Street that mortgage rates will pop immediately when this wondrous and oh-so experimental program comes to an abrupt end as is now the case. We’ve seen a bit of a pop in rates so far, maybe 30 basis points or so, but we’ll just have to see what happens from here. Moreover, the Fannie and Freddie fan club surely have a few cards up their collective sleeves in terms of being able to finance the purchase of mortgages from the private underwriters at favorable rates. Longer-term mortgage rates ultimately up? You bet. But there's simply too much riding on an “orderly transition” to believe anything dangerously abrupt will occur with rates, especially because residential real estate looks like it’s going down for the count again as per the NAHB numbers, lack of acceleration in mortgage apps and still very substantial foreclosure activity. Let’s face it, these days just where isn’t the “fix” in?
Anyway, the point of this portion of the discussion is to look ahead and try to anticipate a Fed return to the printing press, which I’m suggesting will be inevitable. First a quick look back at some current and prior year numbers from none other than the Fed’s own balance sheet. Below is a peek at the major components of the Fed’s balance sheet as of mid-March and twelve months ago.
|Primary Components Of The Fed Balance Sheet ($billions)|
|Component||Balance 3/18/10||Balance 3/19/09||Change|
|US Treasuries||$ 776.6||$ 474.7||$ 301.9|
|Total||$ 2,101.5||$ 759.3||$ 1,251.2|
What has transpired is clear. The printing presses have been on full tilt. But the issue is this. When the Fed prints money out of thin air and buys back either Treasuries, MBS or agency debt from non-banking system holders of the paper (think the Bill Gross’ of the world), the money supply expands plain and simple as for a non-bank seller of paper to the Fed, the Fed creates an official deposit to effect the transaction. That’s money supply expansion 101. The big problem for our analysis is that we cannot get the numbers for what the Fed bought from non-banks versus banks, but it is not inconsequential by a long shot. You'll remember Gross crowing about selling his MBS (implicitly to the Fed) a while back. So as we look at the numbers and see Fed actions for the twelve-month period ended, a simple question arises. Why hasn't the money supply expanded?
Before pressing on, in the spirit of honesty and integrity, we need to consider another integral portion of the Fed’s balance sheet over the prior year. You’ll remember that back when it looked like the world was coming to an end, banks flatly refused to trust each other. That always instills confidence, no? As we all know, maybe they knew a bit too much about Repo 105 (the apparent Lehman H bomb) and other yet undiscovered vehicles such as this. Anyway, in late 2008 and early 2009, the Fed almost became the commercial paper market itself and provided for liquidity swaps, the term auction facility, etc. Collectively these accounted for close to $1 trillion of “liquidity facilities” that for all intents and purposes are no longer on the Fed balance sheet today (some still exist in small amounts). That trillion surely was used to fund the MBS, Treasury and agency securities purchased. There are just a few issues here. First, the commercial paper market today now absent the Fed is a ghost of its former self and very much reflective of the implosion in the asset backed securities markets. CP outstandings are pushing decade lows as we speak. Secondly, as part of this larger swapping of short term credit/liquidity facilities for primarily MBS, the Fed has lengthened the maturity (or duration) of its balance sheet like there is no tomorrow and in the process had no incremental effect on money supply growth over the prior twelve months. Between mid-2008 and early 2009 the money supply grew in a big way with the initial funding actions by the Fed, but with the economic “recovery” we have seen over the prior year, money growth has been anemic at best due to lack of credit cycle expansion. The question now stands as the Fed winds down the printing for now, who will be the big buyer of longer maturity fixed income assets (other than the public piling into long duration bond funds)? And right to the point, how will the money supply expand when the Fed has only been able to keep it even over the last year?
Also as per the latest numbers, M2 in the US as a measure of money supply is up all of roughly $70 billion over the last twelve months (through mid-March) during this Fed duration (average bond maturity) swap. So let’s see if we have this straight, the Fed has purchased $1.25 trillion of paper using out of thin air printed money over the last twelve months funded by the wind down of CP, liquidity swaps and term auction paper, but the official M2 number is up all of $70 billion? What the heck is going on here? Why hasn’t money supply grown? We already know folks like Gross at PIMCO were apparently big time sellers of MBS paper. Of course the answer to this question is that despite the money print, which surely would have explosively juiced M2 had it sparked credit acceleration, credit (money) destruction in the economy broadly has been subtractive from the money supply. Just have a look at the following chart, which provides very clear visual perspective. The chart recounts the drop in bank loans since the prior cycle peak in 2008. But also very important is what has been happening in the beleaguered asset backed markets since their own asset value peak in 2007. This is money destruction 101 as it applies to defaulted commercial and consumer credits. And as you can see, the most recent data is showing us that the (money) destruction has not stopped at all. In fact in the Fed Flow of Funds report for 4Q that hit the Street a few weeks back, the contraction in the asset backed securities market for the 4Q 2009 period was only rivaled by what happened in the second quarter of last year when the world was supposedly coming to an end.
So let’s get back to the Fed and what has happened over the past 18 months in the post Lehman environment in terms of very approximate apples to apples money printing and money destruction. In the post Lehman period the asset backed securities markets have witnessed contraction of approximately ($955 billion), a good chunk of which is M2 going to "money heaven" (never to be heard from again). Over the post Lehman period to date total bank loans and leases outstanding have contracted by roughly ($725) billion. Starting to make sense now? Of course it is. The contraction in the banking and ABS markets totals ($1.68 trillion) while the Fed has printed up well over $1 trillion, and the money supply growth (M2) for the total post Lehman period is up $640 billion, only $70 billion of which occurred over the last twelve months. The Fed has offset the debt destruction.
And this is where we need to come full circle back to the March Madness question. For all the printing the Fed has done, over the past year the acceleration in M2 money supply has been negligible at best. Credit cycles are built on M2 growth. So the question becomes, now that they have stopped printing will the money supply magically start growing again or at best even stay flat in the months and quarters ahead? That could only happen under one scenario, and that scenario is that bank loans and leases stop contracting immediately AND losses in the asset backed securities markets literally stop right now. In plain English, that means that we can have no more residential foreclosures, no more commercial real estate foreclosures, no more credit card losses and all home equity lines are now money good. Moreover, to get the money supply moving again, banks need to restart the lending process at a rate in excess of net credit defaults in earnest beginning this week. Just how likely is that to happen? Despite the greatest Fed sponsored monetary expansion in history, M2 is barely breathing in terms of growth and on a six-month rate of change basis we’ve rarely been to levels we now see.
This is essentially why I’ve have been ranting and raving about this concern that the Fed will not be able to stop the print job without private sector credit starting to accelerate right now. US Government borrowing and spending can "offset" the private sector for a time, as has been the case really over the last year. But in the bigger picture the Fed cannot tolerate a contraction in M2. That has to be their worst nightmare. Credit is the key here. Jobs, healthcare, housing, auto sales, retail, etc. are all a sideshow. And as you know, never once in their communiqués does the Fed even bother to mention the term “private sector credit”. The Street is myopically focused on the bigger picture irrelevance of wording like “extended period”, etc. It’s all a diversion. The Fed will NEVER tighten in earnest until private sector credit starts to expand. This is the bottom line. Everything else is just noise.
So in short summation, over the last eighteen months the Fed has printed an unprecedented amount of money. Far and away the bulk of that money has been used to buy mortgage-backed securities post the liquidity facilities wind down and it is crystal clear that the proceeds from these sales by the financial sector have been recycled back into the financial markets (record financial sector “trading profits”). Yet simultaneously we have also experienced an unprecedented amount of "money destruction" via credit defaults in the banking system and asset backed markets. Those defaults have in no way slowed up to the present. Over the past year and one half, these two forces, if you will, have simply offset each other to a point. The money print has in good part negated the money destroyed. So as we look at now passed March month end, supposedly the Fed will stop the money print. But for M2 to avoid further destruction, we have to assume the losses in the banking system and asset backed markets come to a screeching halt. Unfortunately that's not going to happen. So, THE big issue will be to watch M2 as the Fed theoretically stops the printing and asset purchases. The implicit bet here is that the credit losses do not stop, M2 indeed starts to contract, and the Fed is forced to restart the presses and will need to further inflate its balance sheet with asset purchases. Yet the Street appears completely unconcerned and the Fed confident in its asset purchase cessation. Is the very real potential for the Fed to start printing again and soon already being anticipated by a liquidity and momentum driven equity market?
Of course this brings us to needing a quick peek at some further data from the Flow of Funds report. The following is simply an update of a chart I have been using for a few quarters now. It’s a look at quarterly expansion in US private sector credit outstanding. Unprecedented in our careers and lifetimes is what this is. Of course the important data point is the year over year rate of change, which is in negative territory for the first time ever over the period for which “official” Fed data exists (close to six decades). Dare we say this is what’s different this time? And by the way, private sector credit contraction in 4Q of 2009 was the deepest on record in nominal dollar terms for any quarterly period. At least for now, this is not a trend that is getting "less bad”, let alone better, at the exact time the Fed tells us no mas on the printing.
Let’s have a look at private sector and public sector credit numbers in the post Lehman period (3Q 2008 to present). The following table delineates the increase in total public sector borrowing and the decline in total private sector credit outstanding over the entire five-quarter period through year-end 2009. We already know the financial sector is the locus of credit contraction, but the last time we checked these folks accounted for over 40% of total S&P earnings no more than two years ago. Now that mark-to-market is over will it be so again? There should be no surprises in the current cycle as in recent decades the US has emphasized finance over production, trading over manufacturing and debt over equity. In discussions earlier this year, I suggested to you that there was no way the US government would be able to stop borrowing and spending money until the private sector again witnessed reinvigorated credit growth. Given the depth of the 4Q private sector credit contraction, we're still nowhere even near the starting line for positive net private sector credit growth.
|Components Of Private And Public Sector Debt ($billions)|
|Component||Growth In Debt Since 3Q 2008 (post Lehman) To 4Q 2009|
|Federal Govt.||$ 2,004.8|
|State and Local Govt.||116.6|
|Total Public Sector||$ 2,121.4|
|Total Private Sector||$(1,466.9)|
And again let’s swing back to the issue of the Fed ending the money print policy. Over each quarter of 2009, here is the nominal dollar contraction in US private sector credit outstanding.
|US Private Sector Credit|
Activity In 2009 (billions)
Certainly 4Q may have been heavy last year as financial institutions look to clear the decks a bit at year end. But you can see the average credit contraction experience by quarter was close to $300 billion over the entire year. If the Fed stops the printing accommodation, will banks pick up the slack and lend $300 billion+ each quarter to just keep the money supply stable? My wonderful little prediction of life is that as the Fed stops the balance sheet expansion, at the first sign of M2 contraction the Fed will have a very tough time simply standing back and watching. Remember, it's not really even which assets they buy that's important, it's just that they create (deposit) balances for the non-banking sector so their actions are additive to M2 that is the key issue. You already know that academically, money contraction is deflationary. Something we have not lived with really since the 1930's Depression. And our friend Mr. Bernanke has assured us that will never happen again. So we can only assume the money print will. And of course THE important issue is what that event will mean for investor behavior, asset class movement, etc.
Even if we strip away the financial sector and look at households singularly, the question of credit cycle reconciliation looms very large. The following is simply an update of a combo chart I have shown you in the past, but absolutely speaks to the fact that it appears we are only in the early innings of household balance sheet reconciliation. In the recession of the early 1980’s, household debt relative to GDP was less than 50%. In the 2001 recession it was roughly 65% and at the peak during the most recent recession, it was above 95%. I’ve drawn in what I believe to be an appropriate trend line for the entire period and would not be surprised at all if this ratio at least fell to that line in the current cycle. That’s a long way down. If debt is to be repaid, then that’s a lot of dollars that could have gone into consumption or investment. But if some or a good portion is defaulted upon, then the downward pressure on M2 will be significant.
The top clip shows us that from 1946 (at least) through 1999, households held more cash than they had liabilities. It was only from 2000 to the present that this number has been negative. It’s simply representative of the dramatic leverage households took on over the last decade. And now that the asset side of their balance sheet has been hit hard I expect meaningful reconciliation still to come as we have really only so far come up off of extreme lows. Lows probably thought totally improbable even ten years ago. Please remember that my personal definition of cash includes everything from household bank accounts to CD’s to all household bond holdings (record purchases in 2009), etc. Essentially loading the proverbial boat in terms of defining cash and really only excluding equity, pension balances, insurance policies and real estate in the definition. And still the numbers are eye opening. Point being, it’s a good bet households will continue to exert very meaningful downward pressure on M2. Again, just how on Earth the Fed can stop printing money when financial sector and household balance sheet reconciliation is only modestly down from record levels and nowhere even near longer term averages since 1980 (forget going all the way back to the 40’s or 50’s)?
Final updated chart that has little to do with leverage specifically, but a lot to do with what got households to lever up so maniacally over the past decade. You’re looking at household net worth as a percentage of disposable personal income. The numbers go all the way back to 1946 and I’ve calculated two averages – one over the entire period and one during the conservative period from 1946 through 1994. Of course I’ve drawn in these two averages as a range (the dotted lines). Magically we find ourselves right in that historical average range right now. Exactly as one would expect over longer-term cycle movement.
So what does all this mean? What this means is that it took asset bubbles to induce households to embark on a generational leverage binge. It took household net worth going off the historical charts relative to income to produce an increase in household leverage that went off of the historical charts. First equities, then residential real estate. And of course the housing part of the equation was “net worth” that households could lever and monetize for here and now consumption, making leverage acceleration all the more enticing. So again as we look ahead, the obvious question stands out like a sore thumb – in the absence of another household asset bubble forming, just what will induce households to leverage up well beyond historical averages, and essentially support M2 growth in the process of leverage expansion? I do not know the answer. This is exactly why the Fed/Treasury/Administration are hell bent on reflation. No matter what, that’s not going to stop unless the global capital markets call the tune.
Okay, I’ve dragged you through enough data for one discussion. You get the picture. The process of leverage reconciliation necessarily involving credit defaults is not over in the private sector, especially at the household and financial sector levels. Moreover, it’s very hard to argue that either households or the financial sector are ready to embark on any type of renewed leverage/credit cycle expansion. Neither of these two sets of circumstances will be supportive of M2 growth. Over the last eighteen months of historic money printing and asset purchases by the Fed, Fed actions have only been able to offset this absolutely well defined private sector debt destruction reflected in lack of equivalent M2 growth. So if the Fed walks away now on money printing, it seems M2 will decline if private sector credit contraction continues, which is basically a certainty as per the current period trends and numbers. Will the Fed be back to manning the printing presses before the current cycle is over? Very good bet.
© 2010 Brian Pretti