21 December 2008

Continued Monetary Disorder assured ~ Nolan

The Fed and other G7 monetary authorities have kept the system alive via massive hits to the balance sheets of their central banks as they absorb collateral.

"As I have highlighted in the past, Total Non-Financial Credit (NFC) expanded $578bn in 1994. By 1998, annual NFC growth exceeded $1.0 TN for the first time. After year 2000’s pullback, by 2002 NFC growth was up to a record $1.412 TN, followed by 2003’s $1.677 TN, 2004’s $1.991 TN, 2005’s $2.322 TN, 2006’s $2.422 TN, and 2007’s $2.523 TN. From my analytical perspective, it has always been a case of the inevitable 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 Reserves 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 to 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. State & 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 struggling mightily, public finance really took 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 TN during the quarter – a quantity of new finance that would be in the analytical ballpark (down only marginally from $2007’s $2.5 TN growth) to restrain the forces of systemic collapse. But of this amount, Federal Government borrowings accounted for SAAR $2.079 TN, or almost 90% of Q3’s Credit expansion.

With even an unsustainable $2.0 TN annual pace of federal borrowings failing to reverse the downward economic spiral, the Federal Reserve this 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 TN during Q3. This unprecedented ballooning accommodated deleveraging and helped offset a sharp decline in lending through the financial sector. “Fed Funds and Repos” contracted SAAR $969bn during the quarter, while “Open Market Paper” declined SAAR $580bn. Savings Institutions reduced assets at SAAR $1.281 TN, bank Credit at “Foreign Banking Offices in U.S.” contracted at SAAR $415bn, and lending at Finance Companies dropped SAAR $113bn. The Asset-Backed Securities (ABS) market shrank at SAAR $419bn during Q3. After Q2’s SAAR $913bn contraction, Security Brokers and Dealers expanded SAAR $12.6bn.

Yet the Fed was not all by its lonesome expanding system Credit. Total Bank Credit actually expanded at a robust SAAR $1.365 TN - at least somewhat receptive to the “buyer of last resort” roll for Open Market Paper (SAAR $413bn) and Mortgages (SAAR $688bn). On the Liability side, “Net Interbank Liabilities” expanded at an unprecedented SAAR $897bn, of which SAAR $515bn was borrowed from the Fed. Elsewhere, the GSEs expanded assets SAAR $85bn (about 2.5% annualized), and Agency MBS surged SAAR $508bn (11.2% annualized). Notably, Total Bank Assets were up $1.385 TN, 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 whatever is necessary to ensure sufficient system Credit will be forthcoming – a quantity that for our purposes is in the, say, $2.0 TN annual range. The dilemma for the Fed (and markets) is that while such an enormous amount of Credit would do little more than steady our maladjusted “Bubble Economy,” it would 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 U.S. and global downturns and restructuring periods.

During Q3, Rest of World (ROW) accumulated U.S. financial assets at SAAR $816bn. Over the past year, ROW holdings increased a staggering $1.224 TN to $16.772 TN. 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%.

It is also worth nothing that ROW Treasury holdings expanded SAAR $819bn during the quarter and were up $674bn, or 30%, over the past year to $2.913 TN. Ominously, ROW reduced holdings of U.S. Credit Market Instruments SAAR $547bn during Q3, with Commercial Paper down SAAR $273bn and Bonds down SAAR $291bn. Holdings of Agency Securities declined SAAR $241bn, reducing the one-year increase to $246bn. ROW holdings of “Security Repurchase Agreements” contracted SAAR $368bn during Q3, with a one-year drop of $254bn (22%). We continue to witness the astounding market extremes fostered by ROW risk aversion (zero T-bill yields vs. hopeless illiquidity in many risk markets).

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.

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 assume that fiscal and monetary policies will succeed in generating $2.0 TN 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 likely still be mired in recession, short-term rates would remain near zero, and our Current Account Deficit would remain in the $600bn to $650bn range. Including 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 U.S. securities by the Chinese (and to a lesser extent the OPEC, 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 the return of their appetite for U.S. securitizations, corporate bonds, and “repos” anytime soon. 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 U.S. securities while hedging underlying currency exposure in the derivatives market. And, at today’s pitiful yields, there is 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."


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