Q3 2010 Flow of Funds

By: Doug Noland | Fri, Dec 17, 2010
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For the week, the S&P500 added 0.3% (up 11.6% y-t-d), and the Dow gained 0.7% (up 10.2%). The S&P 400 Mid-Caps added 0.4% (up 24.2%), and the small cap Russell 2000 increased 0.3% (up 24.6%). The Morgan Stanley Consumer index rose 1.4% (up 11.6%), and the Utilities gained 1.1% (up 0.3%). The Banks declined 1.7% (up 17.3%), and the Broker/Dealers slipped 0.4% (up 2.9%). The Morgan Stanley Cyclicals gained 1.1% (up 24.0%), while the Transports declined 0.9% (up 23.2%). The Nasdaq100 increased 0.1% (up 19.2%), while the Morgan Stanley High Tech index dipped 0.2% (up 14.0%). The Semiconductors declined 0.3% (up 14.3%). The InteractiveWeek Internet index fell 1.4% (up 32.7%). The Biotechs jumped 10.1%, boosting 2010 gains to 38.1%. With bullion giving back $10, the HUI gold index dropped 2.4% (up 29.6%).

One-month Treasury bill rates ended the week at 5 bps and three-month bills closed at 11 bps. Two-year government yields declined 4 bps to 0.60%. Five-year T-note yields ended the week 2 bps lower to 1.96%. Ten-year yields added one basis point to 3.33%. Long bond yields ended the week little changed at 4.44%. Benchmark Fannie MBS yields were up 3 bps to 4.19%. The spread between 10-year Treasury yields and benchmark MBS yields widened 2 bps to 86 bps. Agency 10-yr debt spreads were little changed at 19 bps. The implied yield on December 2011 eurodollar futures declined 4.5 bps to 0.84%. The 10-year dollar swap spread declined 1.25 to 9.75 bps. The 30-year swap spread increased 2.75 to negative 28 bps. Corporate bond spreads narrowed somewhat. An index of investment grade bond risk declined one to to 86 bps. An index of junk bond risk declined 12 to 446 bps.

Investment grade issuers included Occidental Petroleum $2.6bn, Bank of America $1.5bn, IBM $1.0bn, CR Bard $750 million, SAIC $750 million, First Horizon National $500 million, Caterpillar $500 million, Huntington National $300 million, and Brown-Forman $250 million.

Junk bond funds saw inflows of $403 million (from Lipper). Junk issuers included Swift Services $500 million, Syniverse $475 million, Atkore International $410 million, US Airways $340 million, Conseco $275 million, Tyco Electronics $250 million, Briggs & Stratton $225 million, Aurora Diagnostics $200 million, Res-Care $200 million, Scotts Miracle Grow $200 million, Kansas City Southern $185 million, FCC Holdings $100 million and Landry's Restaurant $87 million.

Converts issues included Home Inns Hotel Management $184 million.

International dollar debt sales included ANZ International $750 million, Agrium $500 million, Aeropuertos $300 million.

U.K. 10-year gilt yields rose 4 bps this week to 3.55%, and German bund yields rose 6 bps to 3.02%. Ireland yields jumped 35 bps to 8.43%. Greek 10-year bond yields rose 22 bps to 11.90%. Ten-year Portuguese yields rose 20 bps to 6.44%. The German DAX equities index slipped 0.3% (up 17.2% y-t-d). Japanese 10-year "JGB" yields were little changed at 1.19%. The Nikkei 225 gained 0.9% (down 2.3%). Emerging markets were mostly higher. For the week, Brazil's Bovespa equities index dipped 0.5% (down 0.9%), while Mexico's Bolsa rose 0.8% to a 2010 high (up 18.3%). South Korea's Kospi index gained 2.0% (up 20.4%). India's equities index gained 1.8% (up 13.7%). China's Shanghai Exchange rallied 1.9% (down 11.7%). Brazil's benchmark dollar bond yields jumped 25 bps to 4.59%, and Mexico's benchmark bond yields rose 26 bps to 4.55%.

Freddie Mac 30-year fixed mortgage rates jumped 22bps last week to 4.83% (down 11bps y-o-y). Fifteen-year fixed rates surged 21 bps to 4.17% (down 21bps y-o-y). One-year ARMs rose 8 bps to 3.35% (down 99bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates jumping 17 bps to 5.63% (down 28bps y-o-y).

Federal Reserve Credit jumped $22.8bn to a record $2.374 TN (6-wk gain of $93.6bn). Fed Credit was up $154.4bn y-t-d (7.2% annualized) and $183.7bn, or 8.4%, from a year ago. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 12/15) slipped $3.6bn to $3.337 TN. "Custody holdings" have increased $381.7bn y-t-d (13.4% annualized), with a one-year rise of $388.5bn, or 13.2%.

M2 (narrow) "money" supply added $1.0bn to a record $8.813 TN. Narrow "money" has increased $280bn y-t-d, or 3.5% annualized. Over the past year, M2 grew 3.0%.

Total Money Market Fund assets (from Invest Co Inst) dropped $33.2bn to $2.803 TN. Year-do-date, money fund assets have dropped $491bn, with a one-year decline of $467bn, or 14.3%.

Total Commercial Paper outstanding dropped $26.3bn to $981.7 billion. CP has declined $188bn year-to-date, and was down $168bn from a year ago.

Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg's Alex Tanzi - were up $1.384 TN y-o-y, or 18.9%, to $9.016 TN.

Global Credit Market Watch:

December 15 - Bloomberg (Brendan A. McGrail): "Yields on top-rated tax-exempt securities due in 30 years climbed twice as fast as those on U.S. Treasuries, reaching the highest level in almost 16 months... 'Nobody's bidding,' Tony Shields, a principal in the public-finance department at Williams Capital Group... said... There's 'an avalanche of bid-wanteds, and there is just not enough liquidity to accommodate this much sell-side pressure.'"

December 15 - Bloomberg (Paul Tobin and Emma Ross-Thomas): "Spain's credit rating may be cut from Aa1, Moody's... said, as the government prepares its final bond sale of the year tomorrow amid concern it may follow Greece and Ireland in seeking a bailout. Spain has to raise 170 billion euros ($226 billion) next year, while refinancing needs for its regions total 30 billion euros and for banks around 90 billion euros, Moody's estimates."

December 15 - Bloomberg (Charles Penty and Emma Ross-Thomas): "Spanish banks that helped spur the country's property boom with mortgages and loans to developers may need another 90 billion euros ($120bn) in capital, Moody's... said."

December 15 - Bloomberg (Scott Reyburn): "Sales at the world's three biggest wine auctioneers increased by 88% in 2010 as wealthy Asian buyers dominated the market for prestige French vintages such as Lafite."

Global Government Finance Bubble Watch:

December 15 - Bloomberg (Joshua Zumbrun): "Federal Reserve policy makers indicated that signs of economic strength won't deter them from pumping money into the financial system so long as unemployment remains elevated. The Federal Open Market Committee said... growth is 'insufficient to bring down unemployment' and inflation has 'continued to trend lower.' U.S. central bankers affirmed a plan to buy $600 billion of bonds through June and renewed their pledge for an 'extended period' of low interest rates."

December 13 - Bloomberg (Sapna Maheshwari and Andrew Frye): "U.S. life insurers are boosting their holdings of corporate bonds at the fastest rate in six years in an effort to jolt returns by taking on more credit risk amid near-zero interest rates. Net purchases by the insurers climbed to a seasonally adjusted annual rate of $165.4 billion last quarter from $64.5 billion in the three months ended June 30..."

Currency Watch:

The dollar index increased 0.4% for the week (up 3.2% y-t-d) to 80.36. On the upside for the week, the Swiss franc increased 1.3%, the Swedish krona 1.0%, the Taiwanese dollar 0.9%, the Mexican peso 0.4%, the Norwegian krone 0.3%, and the Australian dollar 0.3%. On the downside, the British pound declined 1.7%, the New Zealand dollar 1.6%, the South Korean won 0.8%, the Singapore dollar 0.5%, the Canadian dollar 0.5%, the Brazilian real 0.4%, the euro 0.3%, and the Danish krone 0.2%.

Commodities Watch:

December 13 - Bloomberg (Luzi Ann Javier): "Consumers of food made from wheat and corn should brace for higher prices, if history is any guide, after bad weather and a shortage of farmland threaten to create supply 'shock waves.' The... price of a basket of grains and palm oil has risen almost 50% since the 50-day moving average passed through the 100-day line. On the two previous times this occurred the past decade, prices about doubled or tripled over the following two years before peaking."

The CRB index rose 1.8% (up 13.1% y-t-d). The Goldman Sachs Commodities Index (GSCI) gained 1.0% (up 16.5% y-t-d). Spot Gold slipped 0.8% to $1,375 (up 25% y-t-d). Silver gained 1.8% to $29.13 (up 73% y-t-d). January Crude added 23 cents to $88.02 (up 11% y-t-d). January Gasoline added 0.4% (up 13% y-t-d), while January Natural Gas sank 7.9% (down 27% y-t-d). March Copper gained 1.1% (up 24% y-t-d). March Wheat declined 2.4% (up 40% y-t-d), while March Corn jumped 3.9% (up 44% y-t-d).

China Bubble Watch:

December 13 - Bloomberg: "China risks a more abrupt tightening in monetary policy next year after refraining from raising interest rates since October even as inflation accelerated to the fastest pace in more than two years. Consumer prices jumped 5.1% in November... A measure of wholesale costs climbed 6.1%... Even so, the central bank held off over the weekend on the rate move predicted... Policy makers' hesitation may be in part a product of China's policy of holding down the yuan, as higher returns on deposits and loans would boost prospects for inflows of speculative capital that put pressure on the exchange rate."

December 15 - Bloomberg: "Chinese consumers are more concerned about rising prices than at any time in the past decade, underscoring the pressure on policy makers to step up efforts to counter inflation running at a two-year high. A price satisfaction index fell to 13.8 this quarter, the lowest level since data began in the fourth quarter of 1999, the central bank said... The Commerce Ministry said... it will 'closely monitor' prices over the next quarter, especially during holiday periods, and keep releasing stores of pork and sugar."

December 15 - Bloomberg (Kelvin Wong and Bei Hu): "Surging office rents in Hong Kong are prompting firms including Allianz Global Investors to shift out of the city's most expensive towers as competition for prime space heats up along with the region's growth. Prime office rents in the Central business district soared 34% in the six months ended September from a year earlier... according to property broker CB Richard Ellis Group Inc. Office rents in the area may climb as much as 30% next year..."

Japan Watch:

December 16 - Bloomberg (Takahiko Hyuga): "Japanese companies, largely overlooked in China's five-year, $182 billion overseas acquisition spree, are set to become targets as falling valuations increase the allure of brands and technology. China's stock market capitalization swelled about seven times since 2005 to $3.9 trillion, almost closing the gap with Japan, and its economy is set to overtake Japan's as the world's second largest this year."

Asia Bubble Watch:

December 15 - Bloomberg (Eunkyung Seo): "South Korea's unemployment rate unexpectedly fell to a six-month low... The jobless rate fell to 3.2% in November..."

December 15 - Bloomberg (Novrida Manurung): "Indonesia's bank lending may increase 'near' 22% this year, the low end of the central bank's target of 22% to 24%, as banks were 'careful'".

Latin America Watch:

December 16 - Bloomberg (Iuri Dantas and Arnaldo Galvao): "Brazil will cut taxes and provide incentives to stimulate the domestic corporate debt market and supply longer-term credit for infrastructure investments needed to host the 2014 World Cup and 2016 Olympics."

U.S. Bubble Economy Watch:

December 13 - Bloomberg (Tiffany Kary): "Great Atlantic & Pacific Tea Co., which operates almost 400 supermarkets under the Waldbaum's, The Food Emporium and Pathmark names, sought bankruptcy protection..."

Real Estate Bubble Watch:

December 14 - Bloomberg (Jody Shenn): "A slump in government-backed mortgage bonds that's sent yields to the highest level since May is threatening a recovery in the U.S. housing market... Yields on Fannie Mae-guaranteed securities that most affect loan rates jumped as high as 4.21% yesterday, an increase of 1 percentage point from an all-time low in October... Higher loan rates 'won't be fun' for a fragile housing market, said Scott Simon, head of mortgage bonds at... Pacific Investment Management Co.... 'If you were looking at buying a house a few weeks ago, the same house, to you, looks as much as 9% more expensive," he said."

Central Bank Watch:

December 15 - Bloomberg (Gelu Sulugiuc): "Sweden's central bank raised its benchmark repo rate for a fourth time since July and repeated a forecast for more increases as policy makers try to steer the European Union's fastest recovery and curb household borrowing. The... Riksbank raised the seven-day repo rate a quarter of a percentage point to 1.25%..."

California Watch:

December 16 - Bloomberg (Michael B. Marois): "Arnold Schwarzenegger swore after his first month as California governor that he'd rip up the state's credit cards. Instead, the Republican former action- movie hero pushed through at least $52 billion of borrowing. Debt of the world's eighth-largest economy almost tripled... to $91 billion on June 30 from $34 billion in 2003... Californians owed $2,362 per person last year..."

December 15 - Bloomberg (Christopher Palmeri): "California teachers and school administrators asked Governor-elect Jerry Brown to increase taxes and refrain from cutting their budgets at a forum he convened on closing projected deficits of $28.1 billion... The 120,000-member California Federation of Teachers plans to lobby Brown to extend $8 billion in temporary taxes to help limit budget cuts... 'This is a huge challenge, unprecedented in my lifetime,' said Brown... 'I didn't know it was going to be this bad.'"

Muni Watch:

December 15 - Bloomberg (Ashley Lutz): "U.S. municipal debt sales may total $499.5 billion in 2011, according to a survey that was conducted before it became unlikely that the Build America Bonds program would be extended by another year. The number reflects an increase from the 2010 issuance estimate of $492.2 billion, the Securities Industry and Financial Markets Association said..."

December 13 - Bloomberg (Brendan A. McGrail): "Municipal-bond issuance may drop 20% next year to about $340 billion, in part because of a likely decline in advance refundings, Citigroup Inc. analysts said... The 30 new governors entering office next month and possible 'fiscal conservatism' related to the Tea Party's influence may help slow municipal sales, according to the research note."

December 15 - Bloomberg (Simone Baribeau): "Florida's projected 2012 budget deficit is at least $3.5 billion, $1 billion more than officials estimated in September, the Legislature's chief economist said."

December 16 - Bloomberg (Alison Vekshin): "Governor Christine Gregoire of Washington, who yesterday proposed $4.1 billion in savings and reductions to state programs, said she wants an additional $400 million cut before that budget cycle starts."


Q3 2010 Flow of Funds

The rate of total Non-financial debt growth slowed to 4.2% in the third quarter, down from Q2's 4.7% but strong in comparison to Q3 2009's 2.1%. Similar to the year ago period, federal borrowings slowed markedly during the quarter. After expanding at a 24.4% pace in Q2, federal debt expansion slowed to a still robust 16.0% pace (and it is poised to accelerate again during Q4). Interestingly, state&local debt growth jumped to 5.2% (Build America Bonds?) compared to Q2's 1.5% contraction. In the private sector, Household debt contracted at a 1.7% pace, down from Q2's 2.2% decline and Q1's 2.1%. Corporate borrowings expanded at a 4.5% pace, up from Q2's 3.7%.

In seasonally adjusted annual rates (SAAR), total Non-financial debt growth slowed to $1.473 TN, down from Q2's 1.663 TN. I have posited that our maladjusted economic structure requires in the neighborhood of $2.0 TN of non-financial growth to stimulate self-reinforcing growth in asset prices, incomes and employment. But with household mortgage borrowings contracting SAAR $256bn and total corporate borrowings expanding only SAAR $185bn, even massive government debt growth has been insufficient from the total system Credit perspective. During Q3, federal borrowings expanded SAAR $1.396 TN (down from Q2's $2.003 TN) and state&local grew SAAR $124bn (up from Q2's $37bn contraction).

This year will mark the second consecutive year where federal borrowings will have actually expanded more than the growth of total Non-financial borrowings. Nothing similar to this has happened in the post-WWII period. For perspective, even during the deficit-prone 1970s, total federal borrowings were only 16% of total Non-financial debt growth during the decade (the annual high was 1975's 50.8%). Federal borrowings equaled 22% of total Non-financial debt growth during the eighties (1982 high of 42.9%). The nineties saw total federal borrowing for the decade drop to 14.4% of total Non-financial debt growth (1991 high at 66.8%).

It is worth highlighting that even during the height of the mortgage finance Bubble, the annual expansion of mortgage Credit as a percentage of total Non-financial debt growth did not exceed 64% - although this ratio had about doubled from pre-Bubble levels. Total mortgage debt doubled in the seven years 2001 through 2007 - with mortgage Credit growth accounting for 57% of the expansion in total Non-financial Credit during this period. Such unbalanced flows of finance foment market distortions and economic imbalances. The overwhelming expansion of mortgage Credit certainly set the stage for one tumultuous period in the financial markets and real economy when this source of (unstable) Credit growth abruptly ended (with the bursting of the Bubble).

In just 9 quarters, total federal liabilities have ballooned $4.013 TN, or 60%. After doubling mortgage Credit in less than 7 years, our system is now on track to double federal debt in about four years. Federal expenditures jumped to a record SAAR $3.760 TN during the third quarter, up 6.4% from Q3 2009; up 19% from Q3 2008; and 29% higher than Q3 2007. Federal expenditures increased to 25.5% of GDP during the quarter, up from 20.8% in Q3 2007. During the quarter, combined federal and state&local expenditures reached almost 40% of GDP (vs. 34.4% during Q3 2007).

On the back of massive governmental borrowing and spending, Q3 annualized National Income was up 5.7% y-o-y to a record $12.903 TN, with total Compensation increasing 3.0% y-o-y to $8.032 TN. Total compensation is now within 0.5% of the all-time high posted during Q3 2008.

The bullish consensus sticks confidently to the view that economic recovery will boost tax receipts and over time reduce the scope of government fiscal shortfalls. It remains my view that only the expansion of private sector Credit will create government net receipts - receipts not offset by government expenditures - that would work to shrink deficits. And it would take a massive increase in private Credit to get anywhere close to a balanced budget situation.

The government sector cannot inflate its way to fiscal health. And today, in the post-housing mania backdrop, there is no impetus to expanding private sector mortgage borrowings. Housing prices are down and transaction levels are significantly below Bubble levels. Moreover, with deposit and "money" rates at near zero, the Federal Reserve has created strong incentive for savers to use savings to pay down mortgage borrowings. Meanwhile, corporate America is sitting on a huge cash hoard and has little incentive to borrow. For nine quarters now, government finance has completely dominated system Credit creation. There is little indicating that this extraordinary circumstance will change anytime soon.

For the quarter, Total Mortgage debt contracted $115bn, or 3.3% annualized, to $13.947 TN. Household mortgage borrowings shrank at a 2.7% pace (to $10.612 TN) and Commercial mortgages declined at a 6.8% pace (to $2.356 TN). Total Mortgage debt was down 3.5% y-o-y, with a two-year drop of 5.0%.

Financial sector borrowings contracted SAAR $585bn during the quarter, which was actually down sharply from Q1 and Q2 and was the smallest contraction in seven quarters. GSE assets contracted at a 7.5% annualized pace, and the ABS markets shrank at a 14.8% annualized rate. Bucking the trend, agency MBS grew $49bn, or at an 18% pace. Broker/Dealer assets expanded at a 23% pace, although this was only a recovery of Q2's decline. Broker/Dealer assets were up 1% y-o-y to $2.083 TN (after peaking at $3.244 TN Q1 2008).

Bank Credit actually increased (nominal) $120bn during the quarter, the largest gain in several years. Yet, corporate Bank Loans and Consumer Credit both declined, while Mortgages posted only a small gain. Meanwhile, holdings of Treasury and agency securities jumped $120bn during the quarter (up $261bn y-o-y). Bank Credit was up $296bn year-over-year, of which increases in Treasury and agency holdings accounted for $261bn. Corporate bank loans were down 6.2% y-o-y and Mortgages were down 3.2%.

Elsewhere, Credit Unions expanded at a 2.2% pace the Q3 (to $907bn). Funding Corps expanded at a 1.0% pace to $2.271 TN, while Fed Funds & Repos were flat ($1.313 TN). Finance Company assets contracted at a 7.2% pace (to $1.613 TN) and Savings Institutions declined at an 8.7% rate (to $1.564 TN). REIT borrowings declined at a 1.9% pace (to $491bn).

Household sector Net Worth increased $1.188 TN during the quarter to $54.891 TN. Inflating net worth and incomes help explain the American household's spending resurgence. Or another way to look at it: with the existing economic structure and cultural biases, throw trillions of new government-created purchasing power at the U.S. economy and it's sure to boost consumption. For the quarter, Household Assets increased $1.180 TN to $68.834 TN. Holdings of Financial Assets increased $1.861 TN (17% annualized) to 45.682 TN, while Real Estate declined $698bn to $18.266 TN. Household Liabilities were little changed during the quarter at $13.942 TN. Over the past year, Household Assets were up 2.3%, with Net Worth rising 3.3%.

Rest of World (ROW) holdings of U.S. financial assets jumped during Q3. On a SAAR basis, foreign holders increased holdings $1.335 TN to a record $16.626 TN. This was the largest increase since the financial crisis. The vast majority of this increase (SAAR $1.017 TN) was explained by increased purchases of Treasury securities. In contrast, Foreign Direct Investment is stuck as depressed levels (SAAR $110bn).

The Fed's Z.1 "flow of funds" report provides the best quarterly snapshot of the U.S. Credit system. It was instrumental in illuminating the sources of Credit excess and attendant destabilizing financial flows throughout the mortgage finance Bubble period. These days, it assists in both the analysis of the post-mortgage Bubble landscape and the unfolding government finance Bubble. On a quarter-by-quarter basis, the U.S. economy (household incomes and net worth, corporate revenues, and GDP) and asset markets become increasingly dependent upon governmental borrowings and expenditures. On a quarterly basis, the government sector shows no borrowing restraint - and the markets, so far, accommodate.

I saw nothing in the Q3 Flow of Funds that is counter to my thesis of a very problematic inflation of government finance - with an inevitable crisis of confidence and fiscal train wreck. And as one would expect from such a historic Bubble Dynamic, the longer this Bubble is prolonged the greater the unavoidable financial, economic and social dislocation.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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