TSP Smart: Don’t Look Down


Doug’s reviews of the nation’s Z.1 statements are boring to read, but some of the data is shocking. So we will simply highlight the most interesting data in our summary and let those who dare read through the whole post.

Doug has to have a yardstick to compare market cycles and the best one in this case is the economy as reported as Gross National Product (GDP). Then he compares numbers as a percentage of GDP to see where we are at today in comparison to previous market peaks.

I’m going to start with the one that shocks me the most. It is the Rest of the World (non-US) holdings of US financial assets. You know, what we owe the rest of the world on paper:

1999: 74% of GDP, 2007 108% of GDP, 192% of GDP today ($44 trillion)

Total Equities to GDP is basically the value of the stock market relative to the economy. And remember these numbers are bubble tops that lost over 50% of their value and historically 100% would be a fully valued stock market.

2000 bubble: 210% of GDP, 2007 bubble: 188% of GDP, today: 332% of GDP

And finally, Non-Financial Debt (meaning not including the banks) to GDP. And again, these are peak numbers.

1999: 184% of GDP, 2007: 227% of GDP, today: 278% of GDP

The stock market has always cycled from low valuations to high valuations, but how did we get to this level? Simple, this market cycle the Federal Reserve stepped in every time the market began to cycle down in valuations. And they overdid it each time, and especially in 2020 where we left the old top valuations in the dust.

Debt unfortunately does not go away with a simple bear market. Meaning the stock market can lose 60% of its value and not take balance sheets underwater. The post tech bubble recession was minor compared to the balance sheet recession from the housing bubble.

Anyone who thinks the global central banks have everything under control will be dangerously disappointed one day. They’ve caused this tragedy.

Bipolar and the Q2 2021 Z.1

by Doug Noland

It was a rather glaring warning. Yet it was, of course, taken as just another buying opportunity – a rather easy one at that. It seems to only get easier.

September 22 – Bloomberg: “China Evergrande Group injected a fresh dose of uncertainty into financial markets on Wednesday, issuing a vaguely worded statement on a bond interest payment that left analysts grasping for details. Evergrande’s onshore property unit said in an exchange filing that an interest payment due Sept. 23 on one of its yuan-denominated bonds ‘has been resolved via negotiations off the clearing house.’ While the comment helped trigger knee-jerk gains in some risky assets, Evergrande didn’t specify how much interest would be paid or when. That fueled speculation among some analysts that the developer struck a deal with local bondholders to postpone the payment without having to label the move a default.”

September 24 – Bloomberg (Chester Yung): “China’s central bank continued to pump liquidity into the financial system on Friday as policy makers sought to avoid contagion stemming from China Evergrande Group spreading to domestic markets. The People’s Bank of China has injected a net 460 billion yuan ($71bn) of short-term cash into the banking system in the past five working days, including 70 billion yuan on Friday. That’s helping ensure sufficient liquidity throughout the Evergrande crisis… The cost of borrowing overnight fell to 1.68%, the lowest level since late July, down from 2.28% last week.”

Of course Beijing has everything under control. Talk had it that Beijing was orchestrating a restructuring, one that would ensure Evergrande suppliers get paid and construction resumes on hundreds of thousands of apartments owed to buyers who have put down large deposits. Offshore bond holders will take big haircuts, but officials will ensure Evergrande doesn’t drag down the banks or Chinese economy. The more markets rallied, the louder the bulls scoffed at the notion of Evergrande impacting systemic stability.

And Wednesday from Chair Powell: “In terms of the [Evergrande] implications for us, there’s not a lot of direct United States exposure. The big Chinese banks are not tremendously exposed, but, you know, you would worry that it would affect global financial conditions through confidence channels and that kind of thing.”

Implications appeared more direct Monday: Global “risk off” sparked synchronized de-risking/deleveraging across markets – commodities, currencies, fixed-income, equities and derivatives. It is, after all, one gigantic, interconnected speculative Bubble. At Monday’s intraday lows, the S&P500 was down almost 2.9%.

September 20 – Bloomberg (Sam Potter): “The Monday stock swoon risks triggering forced deleveraging by volatility-linked funds, according to… Nomura Securities. As China’s real-estate crisis intensifies and infects global markets, the S&P 500 slumped as much as 1.7% at the New York open to test a key 50-day threshold. That intraday move breaks a level strategist Charlie McElligott warns will force selling from rules-based investors who allocate depending on how much stock prices swing around. A drop of that scale would spur between $15 billion and $40 billion of divestments from this breed of systematic fund, he said on Monday — and more should the ‘volatility expansion’ endure.”

It’s not difficult to envisage how selling could quickly overwhelm the marketplace – another self-reinforcing derivatives “Volmageddon,” an abrupt reversal of ETF flows, hedge funds dashing to the exits, online day trader panic, etc.

Back to Monday’s Warning. Risk premiums widened, notably across the board. Global Credit default swap (CDS) prices gapped higher, in what had all the makings of a destabilizing synchronized market dislocation. I’ll note two CDS moves in particular. China’s sovereign CDS surged 11 to 47 bps, the high since October 2020 – and the largest one-day gain since the start of the pandemic. Thousands of miles away, U.S. investment-grade corporate CDS jumped eight to 54.5 bps, the high since March – and the largest one-day gain since the start of the pandemic.

The global Bubble comprises myriad individual Bubbles. Yet at its core, the “global government finance Bubble” is Bipolar – Beijing and Washington. Abruptly, Monday’s global “risk off” turned systemic, with gap move dislocations in Chinese sovereign and U.S. investment-grade CDS. Preparing for the FOMC meeting, Chair Powell likely didn’t have his eyes fixed on the Bloomberg terminal. At least for a few hours, market links between Evergrande and U.S. finance appeared distressingly direct.

September 20 – Bloomberg (Caleb Mutua): “Corporate America put the brakes on a month-long borrowing binge on Monday as growing concern about spillover effects from property developer China Evergrande Group roiled markets globally. At least eight blue-chip companies that had planned to sell bonds decided to stand down, underwriters said… A key barometer of high-yield investors’ risk aversion, the Markit CDX North American High Yield Index, weakened.”

From Monday’s trading lows to Friday’s close, the S&P500 rallied 3.5% (small caps surged over 5% at Thursday highs). Monday’s close call was quickly forgotten, with bullish imaginations concocting visions of uninterrupted Chinese growth, hundreds of billions of additional monetary inflation (PBOC and Fed), and endless market gains.

After trading down to 1.29% in Monday’s “risk off” session, 10-year Treasury yields surged to 1.46% in Friday trading. There was talk of the “hawkish” Fed “dot plot,” the approaching “taper,” and even the possibility of a rate increase late next year. I’m just not convinced Fed policy is driving U.S. or global bond yields.

The possibility of a bursting Chinese Bubble has pressured global yields lower, despite surging inflationary pressures. Beijing appears committed to reining in Credit and speculative excess, creating a precarious situation for China’s financial and economic systems grossly inflated from years of Credit excess (especially the past two years!). However, if Beijing gets cold feet and resorts again to reflationary measures – bonds have good reason to fear the type of massive monetary inflation necessary to hold China Bubble collapse at bay. Massive monetary inflation in an environment of already powerful inflationary forces should be unnerving to bond markets and us all.

And speaking of (Bipolar) massive monetary inflation, let’s take a look at the Fed’s Q2 2021 Z.1 “flow of funds” report.

Non-Financial Debt (NFD) increased another nominal $1.002 TN during Q2 to a record $63.254 TN. This would have been a pre-pandemic record expansion. On a seasonally adjusted annualized pace, NFD expanded $4.013 TN. For perspective, NFD on average gained $1.842 TN annually for the decade 2010-2019. NFD surged an unprecedented $8.755 TN over just the past six quarters ($1.459 TN quarterly average). While slightly below recent record highs, Q2’s 278% ratio of NFD to GDP compares to previous cycle peaks, 227% to end 2007 and 184% to conclude 1999.

Treasury borrowings continue to command system Credit growth. Outstanding Treasuries gained nominal $359 billion during Q2 to a record $24.302 TN. Treasuries surged $6.487 TN, or 36%, over the past two years. Treasuries to GDP slipped slightly during the quarter to 107%. This ratio ended 2007 at 41% and was up to 87% prior to the pandemic.

Agency (GSE) Securities gained another $181 billion during the quarter to a record $10.408 TN. At $663 billion, one-year growth was the strongest since 2007. Agency Securities jumped $1.144 TN over the past two years. Combined Treasury and Agency Securities swelled an unparalleled $7.631 TN over two years to a record $34,709 TN (153% of GDP).

Total Mortgage borrowings rose $308 billion during the quarter, more than double Q2 2020 growth to the largest increase since Q3 2006 ($343bn). Home Mortgages rose $238 billion during Q2 (strongest since Q3 ’06) and $687 billion for the year (largest since 2006).

Total Debt Securities (TDS) expanded $747 billion during the quarter to a record $54.539 TN. Debt Securities jumped $3.377 TN, or 6.6%, over the past year. Prior to the pandemic, 2007’s $2.671 TN was the largest annual increase in TDS. TDS swelled $8.794 TN, or 19.2%, over two years. At 240%, TDS to GDP compares to 201% to end 2007 and 158% to finish the nineties.

Total Equities surged $5.709 TN during Q2 to a record $75.392 TN. Total Equities were up $23.407 TN, or 45%, over the past year, and $24,624 TN, or 49%, over two years. For comparison, Total Equities peaked at $27.263 TN during Q3 2007 and $20.957 TN during Q1 2000. Ending Q2 at a record 332%, current Total Equities to GDP compares to previous cycle peaks 188% (Q3 ’07) and 210% (Q1 2000).

Total (Debt & Equities) Securities jumped $6.455 TN during the quarter to a record $129.931 TN, ending the quarter at a record 572% of GDP. Total Securities ended Q3 2007 at $56.192 TN (387% of GDP) and 1999 at $35.598 TN (360% of GDP). Total Securities surged $33.418 TN, or 35%, over the past two years.

As I’ve communicated on a quarterly basis, the Household Balance Sheet is a focal point of Credit Bubble analysis. Household Assets jumped $6.196 TN, or 16.2% annualize, during Q2 to a record $159.342 TN. Household Assets inflated $24.269 TN over the past year. Household Liabilities rose $347 billion during the quarter to $17.674 TN, the strongest growth since Q1 2006. Liabilities were up $1.093 TN over four quarters, the strongest annual growth since 2006.

Household Net Worth (Assets less Liabilities) jumped $5.849 TN to a record $141.668 TN. Net Worth surged $23.176 TN, or 19.6%, over the past four quarters. For perspective, Household Net Worth gained $4.501 TN and $3.960 TN in boom years 2006 and 1999. Household Net Worth to GDP ended Q2 at a record $623%, having increased from 537% to end 2019 (pre-pandemic). This compares to previous cycle peaks 491% (Q1 ’07) and 445% (Q1 2000).

House price inflation fueled a $1.218 TN (13% annualized) increase in Household Real Estate holdings during the quarter to a record $38.706 TN. Real Estate holdings jumped $3.901 TN, or 11.2%, over four quarters – surpassing 2006’s record $3.122 TN increase. At 171%, the ratio of Real Estate to GDP is up from cycle trough 125% (Q2 2012) – yet remains below the cycle peak 190% from Q3 2006.

Meanwhile, Household Financial Asset holdings are inflating wildly. Household Assets jumped $4.552 TN during the quarter to a record $113.149 TN, having more than doubled from 2009 trough $46.780 TN – as well as previous cycle peak $54.377 TN (Q3 ’07). Household Financial Assets to GDP ended Q2 at a record 498%, up from cycle peaks 374% (Q3 ‘07) and 354% (Q1 2000).

Household Equities (Equities & Mutual Funds) holdings ended Q2 at a record $42.780 TN, having increased $3.188 TN for the quarter and $13.239 TN, or 44.8%, over the past year. Equities holdings dropped to a cycle trough $7.768 TN during Q1 2009, following cycle peaks $15.023 TN (Q3 2007) and $11.532 TN (Q1 2000). Household Equities holdings ended Q2 at a record 188% of GDP – having risen from 142% to end 2019 – and up huge from previous cycle peaks 104% (Q2 ’07) and 115% (Q1 2000).

Banking (“Private Depository Institutions”) system Assets expanded $227 billion during the quarter, or 3.8% annualized. Loans expanded $48 billion, with Mortgage loans up $50 billion and Consumer Credit surging $84 billion (2nd strongest Q ever). Meanwhile, Loans (not elsewhere classified/business) sank $87 billion.

Why lend when it’s easier to simply own securities? Banking Debt Securities holdings surged $265 billion (17% annualized) during the quarter to a record $6.453 TN, with Agency/MBS up $125 billion (to $3.730 TN), Corporate bonds up $33 billion (to $833bn), and Treasuries up $93 billion (to $1.349 TN). Debt Securities holdings were up $1.224 TN, or 23%, over four quarters, led by an $809 billion jump in Agency Securities.

Banking’s Repurchase Agreement (“Repo”) Asset sank $295 billion during the quarter (to $577bn), as the marketplace shifted to the Fed’s repo facility.

On the Bank Liability side, Total Deposits expanded $232 billion during the quarter to a record $19.938 TN. Total Deposits were up a stunning $4.4 TN, or 28.4%, over six quarters.

Federal Reserve Assets jumped $489 billion during Q2, the largest expansion in a year, to a record $8.258 TN. Treasury holdings rose $323 billion (to $5.597 TN) and Agency Securities jumped $143 billion (to $2.414 TN). Fed Assets were up $894 billion y-o-y (Treasuries up $789bn and Agencies rising $378bn) and $4.248 TN over eight quarters (Treasuries $3.281 TN and Agencies $829bn). Fed Assets have gained $7.307 TN, or 768%, since mid-2008.

The Liability side of the Fed’s balance sheet has become intriguing. The Treasury’s account at the Fed (“Due to Federal Govt”) dropped $270 billion during the quarter and $877 billion through the first half. Meanwhile, the Fed’s Security Repurchase Agreement (“Repo”) Liability surged $909 billion during the quarter (to $1.261 TN) and $1.045 TN during the first half. In simple terms, the Treasury has spent funds held at the Fed, “money” dispersed throughout the markets and economy only to be recirculated back into “Repos” held at the Fed. The Fed’s “Repo” facility has basically allowed Fed-created liquidity to be intermediated directly back through the Fed, bypassing the typical process of liquidity funneled to the banking system, where it would then be converted into bank “Reserves” held at the Fed.

Rest of World (ROW) holdings of U.S. Financial Assets surged $2.542 TN during Q2 to a record $43.592 TN. Amazingly, ROW holdings began year 2000 at $7.310 TN and first surpassed $10 TN in Q3 2004. ROW holdings to GDP ended Q2 at a record 192%, up from 161% to end 2019. This ratio was at 108% at the end of 2007 and 74% to conclude the nineties. ROW holdings of Treasuries ($7.202 TN), Agency Securities ($1.145 TN), Corporate bonds ($4.435 TN), and Total Equities ($13.321 TN) all ended Q2 at all-time records. In yet another incredible data point, ROW holdings of U.S. Financial Assets inflated $13.625 TN, or 46%, in just 10 quarters.

As always, Z.1 data are invaluable in shedding light on the historic U.S. Credit Bubble.

Categories: Doug Noland