Monday, 7 October 2013

U.S. Money, Credit & Treasuries Review (as of 18 September 2013)

For the bi-weekly period ending 18 September, the US Monetary Base expanded by 1.09% according to the most recent data released by FRED. The base is now 30.32% higher than the end of last year and 33.53% higher than the same period last year. As the Fed decided not to reduce the scale of its asset purchase programme on 18 September, the base will continue to expand by about USD 85 billion a month until the Fed decides to taper. As I've explained in this report previously (e.g. here), there are good reasons to believe the Fed will not start tapering any time soon and that it will be very moderate if it decides to. One major obstacle to tapering is that it likely could pop the US government bond bubble (as the Fed has been the marginal buyer of US government treasuries) leading to rocketing interest rates, declining bond, equity and real estate prices and perhaps even more importantly, a corresponding increase in interest payments for the US government at a time when the debt to GDP ratio is more than 100 percent (as of Q2 2013).

Graph of Federal Debt: Total Public Debt as Percent of Gross Domestic Product

Now, it is my view that the Fed should start tapering as all it has been doing post the Lehman collapse is allowing the US government to get into a debt situation it will prove difficult to get out of in addition to blowing new bubbles and bailing out bust banks (and other "too big to fail" companies) that should have been allowed to go bankrupt. As this should not have been allowed to happen in the first place as it only makes matters worse, the sooner it is ended the better.

But the Fed and their economic illiterate army of macro economic interventionists see things differently and it wouldn't have gone unnoticed what happened with interest rates since Bernanke first discussed "tapering" with Congress in late May this year: the 10-Year Treasury Yield increased by 93 basis (46.7%!) points from 24 May to 13 September. As I've said before, a central bank (and a country) can print itself into economic problems, but never out of them! Bottom line? The Fed has spent the last five years printing the US economy into even deeper economic problems and could very well spend the next five sinking it even deeper. John P. Cochrane, in his article Bernanke: A Tenure of Failure, summarises some of the problems with the monetary policy we've become accustomed to as follows:
Policy before the crisis expanded created credit, kept rates too low for too long, generating a second, but this time catastrophic, boom-bust cycle. Since then, the Fed’s dovish policy of low interest rates and quantitative easing has retarded recovery by:
1. Keeping interest rates from tracking market levels which would better redirect resources to highest value uses;
2. Making it easier for firms to avoid necessary liquidation and reallocation of resources; and
3. Adding to the policy uncertainty which, coupled with the extreme regime uncertainty, is the main cause of the continuing Bush-Obama Great Stagnation.
So how does the US government and the Fed get out of these problems? Gary North suggests by default, and not by hyperinflation as many seem to think (here),
This is why I am not persuaded by those people who say that hyperinflation in the United States is inevitable. I don't think it is. I think default is inevitable, but I don't think it needs to be default by hyperinflation. That is because the government cannot get out of its obligations by fiat money. It cannot default by using hyperinflation, because hyperinflation will only last a few years, but the obligations last for the next 75 years.
In the meantime, politicians will keep kicking the can further down the road and attempt to leave it to future politicians to clean up the mess. I expect the debt ceiling to be raised before the October 17 deadline which will make it even more difficult for the Fed to start tapering. And I would not be surprised if the debt ceiling is raised many more times in the coming years, still facilitated by QE Infinity. Money printing is the path of least resistance (if you can print, you will print!), with the ignorant majority not being aware of their gradual loss of purchasing power (while they will notice tax increases or reductions in entitlements and benefits).

The M1 Money Supply contracted 6.28% on two weeks ago while the M2 increased 0.78% and the two money supply measures are now up 8.41% and 6.37% on the same period last year, respectively.

Bank Credit and Loans & Leases in Bank Credit expanded 0.24% and 0.31% respectively on two weeks ago. Since the end of last year, bank credit has however contracted by 0.29%, but is 1.90% higher than the same period last year.

All money supply and bank credit measures, except for M1 and Bank Credit, are currently at all-time highs.

The 1-Year Treasury Yield was unchanged from two weeks ago while the 10-Year Treasury Yield decreased by 15 basis points. Compared to the same period last year, the 1-Year yield is down marginally (6 basis points) while the the 10-Year yield has increased by 97 basis points. As a result, the spread between the two has widened by 103 basis points during the last year.

Taper or no taper, the year on year (YoY) growth rates in M1 and M2 money supply contracted further during the last two weeks as M1 dropped from 8.62% two weeks ago to 8.41% and M2 dropped from 6.66% to 6.37%. 

As has been the case for many weeks now and as I have written about in this report on previous occasions, the most noteworthy development is again the significant contraction in the YoY growth rate in Bank Credit and Loans & Leases in Bank Credit. Though the growth rate of the latter increased somewhat during the last two weeks (from 2.35% to 2.53%), the YoY growth rate is the lowest it's been since 28 December 2011 negatively affecting the growth rates in the various money supply measures (as a deposit, or money, is created when a loan is created). 

Leaving out the period following the Lehman collapse, the YoY growth rate in Loans & Leases in Bank Credit has only previously been this low during two distinct periods (based on data since 1985): 1991-1993 and 2001-2003. On the same basis, the recent YoY growth rate for Bank Credit is even worse as it has never before been this low pre Lehman. As the US economy and its fractional reserve banking system is built on a foundation of credit, the recent historically low growth rates in bank credit (which includes Loans & Leases) reflect a struggling economy where there is either a lack of demand or lack of supply, or some combination of the two, of credit. Having said that, it's perhaps a challenge to argue that banks' ability to lend is the reason for the lack of bank credit growth as the Cash Assets to Total Assets ratio for US commercial banks is now the highest it has ever been (as of 25 September, based on data going back to 1985): 

To sum up: to the extent corporate America is dependent on new bank credit to expand their businesses or to finance ongoing projects, the significant drops in the growth rates of Bank Credit and Loans & Leases in Bank Credit in recent months could be very bad news for corporate profits and hence the stock market. I must emphasis here that though an economy built less on bank credit not backed by voluntary savings is clearly preferable, a reduction in the growth rate in bank credit created out of thin air will lead those addicted to it to struggle financially. This is exactly what happened in September 2008 when Bank Credit had expanded by an annualised rate of 7.8% for the eight year period ending 10 September 2008 and Cash Assets to Total Assets for US commercial banks hit an all-time low of 2.65% on 20 August 2008 (see above chart). This expansion was clearly not sustainable and eventually the financial system crumbled culminating in many banks becoming insolvent (and Lehman being allowed to go bankrupt). 

Things are however different today than just prior to the Lehman collapse. While Bank Credit increased 7.8% annually in the run-up to Lehman as explained above, it has only expanded by an annualised rate of about 2.1% since. On the same basis, Loans & Leases expanded by an annual rate of 8.0% during the eight year period leading up to the Lehman collapse, but has only expanded 1.1% annually since. Comparing apples with apples, the annualised growth rates in Bank Credit and Loans & Leases in Bank Credit during the last eight years (as of 18 September) is 4.2% and 4.1%, respectively. There is today therefore less of a bank credit boom than back then. Moreover, though commercial bank balance sheets are only marginally stronger today than in September 2008 as measured by the Net Assets (equity) to Total Assets ratio (10.62% on 10 September 2008 compared to 10.97% as of 25 September 2013), the commercial bank assets are significantly more liquid today as measured by the Cash Asset to Total Asset ratio. As the chart above shows, the ratio as of 25 September is 17.68% compared to the 2.65% all-time low on 20 August 2008 mentioned above. 

All this does not however mean that we cannot have another financial crisis as what is also different this time around is that US government debt has increased 67.0% during the last five years and the debt to GDP ratio has increased from 67.5% to 100.5%. The combination of dismal growth in bank credit, a slowing down in the growth rates of money supply and high US government debt is a potent one that could wreak havoc with many asset classes.

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