Excerpts from June 15th speech by J. Alfred Broaddus, Jr., President, Federal Reserve Bank of Richmond:
"…many "new economy" adherents apparently believe that rising labor productivity growth has restrained increases in labor costs and hence reduced the risk of a renewal of inflation and reduced the need for preemptive monetary restraint by the Fed. It is true that accelerated productivity growth temporarily limits labor cost increases in the interval before increased demand for workers forces wages up, and the initial increase in the output of goods and services can temporarily restrain price increases. I don’t believe, however, that new economy advocates have thought this matter through fully…"
"The long bull market in U.S. stocks reflects higher expected future business earnings growth. And I can assure you that my two grown sons and their friends and associates expect lifetime incomes and living standards well above their parents'. Again, neither my sons, other households, or business firms typically think explicitly of their expected higher future income as the result of an increase in trend productivity growth. But their expectations and - as I will indicate momentarily - the actions they take based on these expectations make it clear that they perceive the increase implicitly.
What do all these developments in the "real" economy have to do with monetary policy? The answer is that U.S. households are now borrowing quite liberally against their higher expected future incomes to consume today. They are buying new homes, adding on to existing homes, and buying consumer durables such as new cars, furniture and electronic equipment. Similarly, firms are borrowing against their higher expected future earnings to invest in new plant and equipment.
The problem posed for monetary policy by all this is that the higher expected future income driving the increased current demand for goods and services is not yet available in the form of increased current output of goods and services. This mismatch between expected future resources and currently available resources, in my view, is the principal factor creating the present aggregate demand-supply imbalance in the U.S. economy I discussed earlier. The excess demand has been satisfied to date by imports and progressively tighter labor markets. But demand is now rising more rapidly here in Europe and elsewhere around the world, which may soon put upward pressure on the dollar prices of imports. And labor shortages are now widely reported in a number of sectors and industries. On their present course, U.S. labor markets will eventually tighten to the point where competition for workers will cause wages to rise more rapidly than productivity, which sooner or later would induce businesses to pass the higher costs on in higher prices. As I suggested earlier, there is evidence in some of the latest U.S. price and labor cost data that an inflationary process of this sort may now be beginning.
The implication of this analysis, as I indicated at the outset, is that the apparently higher trend productivity growth in the U.S. economy - whether one labels it a "new paradigm" or not - requires higher real interest rates to maintain macroeconomic balance. In order to prevent a reemergence of inflationary pressures and, in doing so, to sustain the expansion, U.S. monetary policy must allow short-term real interest rates to rise to induce households and business firms to be patient and defer spending until the higher expected future income is actually available, in the aggregate, in the form of higher domestic output."
It was another disjointed week, although one that ended bearishly. For the day, the Semiconductors added more than 2%, while the S&P Bank index dropped 6%. For the week, the Dow dropped about 1% and the S&P 500 added less than 1%. The economically sensitive stocks were hit hardest, with the Morgan Stanley Cyclical index dropping almost 3% and the Transports sliding 4%. Both the Morgan Stanley Consumer index and the Utilities were largely unchanged. Technology stocks were mixed, as the NASDAQ100 added 1%, while the Morgan Stanley High Tech index and the Semiconductors declined less than 1%. The Street.com Internet index dropped 5% and the NASDAQ Telecommunications index was unchanged. The Biotech index increased 2%, and the small cap Russell 2000 declined about 2%. The financial stocks were strange, with the AMEX Broker/Dealer index gaining 4% while the S&P Bank index was clobbered for a 10% loss on bad news from Wachovia.
Gold stocks showed a bit of life this week, rising almost 3% as the commodity jumped almost $5. The dollar had another poor week, dropping about 2% against the Swiss franc and 1% versus the euro. The bond market had a positive week and swap spreads narrowed, in some case sharply. The key 10-year dollar swap narrowed 8 basis points to 120, and mortgage-back spreads generally narrowed about 6 basis points. The TED spread was the exception, as it was largely unchanged for the week as it continues to signal heightened systemic risk.
It is certainly our contention that the present state of the U.S. credit system is absolutely unsustainable. And with credit bubble dynamics dominating, continued strong debt growth is necessary to prolong the dreadfully unsound U.S. economic boom. At the same time, it is our view that truly enormous financial credit growth must be maintained to sustain liquidity throughout the U.S. financial system. At present, there are over $26 trillion of credit market instruments outstanding and another $14 trillion or so in stock certificates. The insurmountable dilemma is that the degree of credit creation necessary to keep the bubble inflated is today highly inflationary, as well as highly distorting to the real economy as it feeds overconsumption and a historic misallocation of resources.
Amazingly, few appreciate the acute fragility of the current credit bubble – particularly the "new era" adherents. In fact, if you began a discussion with a group of mainstream economists by posing the basic question - how much did credit grow last year? – most if not all would likely respond "about $1.12 trillion" - the increase in "domestic non-financial debt." Of this amount, business borrowings were the largest component, increasing $596 billion. This was closely followed by household mortgage debt that increased $411 billion; consumer credit expanded $94 billion; and state and local government added $53 billion. The Federal government actually paid down $71 billion of publicly held debt. And since these are the sectors whose borrowing and spending power the "real" economy, it has traditionally made sense to focus on this component of credit growth. Furthermore, with "domestic non-financial debt" growing at a rate of about 7% last year, mainstream analysts were not taken aback by any obvious signs of dangerous excess.
This traditional analysis, however, completely fails to recognize a most critical component of credit growth – financial credit. This type of credit is created by borrowers comprising the "financial sector," including the banks, savings institutions, finance companies, security broker/dealers, insurance companies, the GSEs, and the mortgage and asset-backed pools that are credit vehicles, etc. Financial sector borrowings are enormous, having increased by almost $1.09 trillion last year, or 17%, and ended the first quarter at almost $7.8 trillion. The vast majority of this financial credit is created as financial sector entities borrow funds enabling the purchase of additional holdings of financial assets. And while traditional analysts largely ignore these borrowings, it is certainly our view that the explosion of financial credit – debt created through the leveraging of the financial sector – is at the heart of the U.S. financial and economic bubble. And while the banking system remains a key player within the financial sector, it should be recognized that the preponderance of financial credit is generated by non-banks borrowing in the money and capital markets, as well as by bank loans that are not held on bank balance sheets (thus not a part of traditional "bank credit"). Interestingly, traditional analysts focus on the corporate and household sectors’ taking on additional "domestic non-financial debt," while at the same time believing that banks have a virtual monopoly on credit creation. This is the only explanation we can muster for why the explosion of financial credit has been completely off the radar screens for most within the economic community.
Looking at the data, the momentous expansion of financial credit began in earnest during 1997. During the final three years of the decade, financial sector borrowings – financial credit - increased almost $2.8 trillion, or an astonishing 58%. To put the enormity of this expansion in perspective, during the same period (but including the first quarter of 2000), Federal Reserve credit expanded by about $110 billion. Commercial banks expanded borrowings by about $1.33 trillion, or 28%. And while the banks were lending aggressively, the non-bank credit providers were involved in an historic leveraging and lending melee, as a new credit structure took hold. Over this three-year period, GSEs increased borrowings $765 billion, or 77%, "Federally-related mortgage pools" $610 billion, or 36%, "Issuers of Asset-backed securities" $802 billion, or 94%, and Security Broker/Dealers $503 billion, or 79%. These numbers should make it clear that those focusing only on traditional bank credit data have missed the bubble.
Admittedly, there may be some double counting that occurs when looking at financial sector borrowings in aggregate. However, the key point to recognize is that much of financial sector borrowings are used directly to fund holdings of financial assets – mortgage loans in the case of the GSEs and mortgage pools, and security credit and other speculations in the case of the brokerages. Recognizing that credit creation is all about creating additional purchasing power, almost by definition, credit excess directed in one area will create price distortions. In the case of financial credit, unprecedented credit excess has fueled enormous inflation in housing and stock prices. Accordingly, financial credit is immensely seductive as it works to raise asset prices and stoke the illusion of endless financial system liquidity, with what at the time seem like very limited negative side effects.
However, after several years of unprecedented financial credit excess, dangerous imbalances and distortions are unmistakable to both the financial system and economy. For one, historic asset inflation has fueled endemic resource misallocation that is becoming increasingly obvious and problematic. On another key front, it is clear that financial credit excess has become increasingly inflationary for the real economy. And, importantly, the bubble in financial credit has created an acutely fragile financial structure.
Recognizing the vulnerability on both the financial and economic fronts, we have of course been keenly focused on spreads and other indications of heightened systemic stress. During the first quarter, spreads widened sharply and credit market liquidity waned. But at the same time, this dislocation has yet to develop into "1998/LTCM-style" market tumult. With first quarter financial sector data now available, there are definitely some interesting clues that help to explain both what transpired within the credit system and what may be in store going forward. First, and not surprisingly, throughout much of the financial sector, credit growth slowed sharply during the quarter. Commercial bank holdings of financial assets increased by $53 billion, or at an annualized rate of 4%. The GSEs, after expanding credit by more than $300 billion during each of the previous two years, increased credit by $33 billion during the quarter, or at an 8% annualized rate. The "Federally-related mortgage pools" increased credit by $30 billion, or 5% annualized, and the "Issuers of asset-backed securities" extended $35 billion of credit, or 9% annualized. Importantly, however, moderated growth by key financial credit providers was offset by a huge increase in credit provided by Wall Street - the Security Brokers and Dealers.
According to Federal Reserve data, the brokerage firms increased holdings of financial assets by a staggering $140 billion, or at an annualized rate of 56%, to $1.1 trillion. Holdings of "credit market instruments" jumped $42 billion to $210 billion, growing at an annualized rate of 107%. Elsewhere, security credit increased $59 billion to $282 billion, "misc. assets" increased $32 billion to $556 billion, and equity holdings increased $8 billion to $74 billion (note the relatively minor role of "equities" as a percentage of total financial assets - that is precisely why we refer to this as a Credit Bubble!). Digging a bit deeper into the astounding growth in "credit market instruments," we see that while corporate and foreign bond positions increased about $16 billion, or 16% during the quarter, the largest change in positions was a dramatic reduction in a short position in Treasury securities that had been growing over the past few years. In fact, a short position of $43.5 billion was reduced to $4.7 billion during the first quarter, certainly in response to spread trades "blowing up." If there was confusion as to the true dynamics behind the dramatic out-performance of Treasuries, the securities firms apparently purchased almost $39 billion during the first quarter.
In some respects, this year’s financial dislocation has been a replay of 1998. Burned by the dramatic widening of spreads, the leveraged speculators were forced to "unwind" trades. But there appear to have been a most critical difference: When LTCM and other hedge funds were stung by spread speculations gone wrong, they not only covered their shorts but were also forced to sell longs – or at least a problematic liquidation was in process before the Fed was forced to orchestrate a bailout/reliquefication. This time around, however, things have thus far progressed differently. Wall Street apparently covered much of its Treasury short but chose to ADD to its long position. We see this as the key factor that has thus far kept a market dislocation from developing into a full-scale liquidity crisis. Keep in mind that the financial sector - through financial credit creation – is the dominant supplier of lendable funds. This works fine and dandy when the financial sector is aggressively leveraging, but doesn’t work well at all if financial credit growth slows. Moreover, as was certainly the case with the hedge funds in 1998, credit system liquidity vanishes abruptly at any point when key players within the financial arena are forced to liquidate positions. When the financial sector is forced to "liquidate," the game is over.
Let’s get back to the Brokerages’ extraordinary first quarter. After covering their Treasury short that had been financing higher-yielding securities, instead of liquidating longs (a situation that would have certainly led to market liquidity problems and heightened systemic risk), the brokerages instead turned into aggressive creators of financial credit. In fact, they added to net financial asset holdings to the tune of $140 billion. To finance this extraordinary growth of financial credit, the security firms found alternative means of financing to their Treasury short. During the quarter, "repos" increased $46 billion to $293 billion, borrowings from customers expanded $49 billion to $368 billion, bank borrowings increased $19 billion to $143 billion, and "due to affiliates" increased $25.4 billion to $395 billion. It is now clearer to us why the credit system maintained a semblance of liquidity, particularly in the securitization marketplace, despite a problematic market dislocation.
Expanding on our analysis, let’s now ponder some of the possible consequences and ramifications after such a dramatic move by Wall Street. First, Wall Street appears to have taken on significant risk in response to problematic market conditions. This is not a positive development for our financial system. Securities firms were clearly behind the dramatic out-performance of Treasury securities, as well as likely major factors behind the unusual yield curve inversion. Importantly, Wall Street’s move to increase holdings of financial assets created additional financial credit that certainly helped mitigate the unfolding dislocation. We see this as a reasonable explanation as to why something akin to 1998’s system-wide deleveraging has not yet transpired – there has been no real liquidations of risky debt securities from the financial sector. Moreover, if Wall Street tapped foreign borrowing sources (European bank loans? - "due to affiliates" in Europe?) to fund Treasury purchases and expanding positions, this could do much to explain the dollar’s peculiar resiliency in the face of the dislocation in the swaps market and financial instability generally. Yet, such borrowings are unsustainable and only increase exposure to a declining dollar; another key source of greater risk acceptance by the financial sector. Likely, firms with foreign exchange exposure have strategies in place to simply "hedge" this risk in the event of dollar weakness. Of late, it appears that such weakness has commenced, so we would expect that "dynamic hedging" programs could now weigh on the dollar for some time. Such strategies only increase the already significant risk of a precipitous dollar decline.
The fact that Wall Street appears to have taken on considerable risk during the first quarter is quite important in our overall credit bubble analysis. After first quarter maneuvers, we now expect it less likely that Wall Street remains in a position to aggressively leverage and create financial credit over the coming months. As such, the Wall Street firms could soon join the GSEs in a group of previously aggressive institutions now under heightened market scrutiny. And if the GSEs and Wall Street firms are increasingly tempered by market discipline, this leaves the banks and the "mortgage-back pools" and "issuers of asset-back securities" to take up the slack; certainly a very tall order. So far this quarter, as has been noted in recent commentaries, the banks have been expanding credit very aggressively, certainly a critical factor in sustaining the credit system throughout recent market dislocation. The key question becomes: can this be maintained?
With the previous question in mind, it is our view that yesterday’s negative announcement by Wachovia takes on significant importance. "Bellwether Wachovia Girds for Credit Thump – Expects 30% jump in nonperforming loans" was the decidedly nonbullish headline from the American Banker. Wachovia stated that revenues from capital markets, mortgage banking and brokerage would all be below expectations. The shocker, however, was the big jump in problem loans from a bank with "a squeaky clean reputation for managing credit risk." Importantly, it appears at least some of Wachovia’s credit problems are emanating from bank loan syndications; hence this is in no way specific to Wachovia. Indeed, we have for some time expected that previous lending excesses in this area would in time turn quite problematic. It certainly appears that Wachovia’s announcement is a key inflection point – the first of many "shoes to drop." Going forward, we would expect both credit issues and the mega-market for syndicated bank loans to come under heightened scrutiny. And as market participants become increasingly concerned with credit issues, we expect increasingly risk-averse investors to demonstrate much more caution toward the asset-backed security marketplace generally. Moreover, the banking system and Wall Street have also created hundreds of "funding corporations" and other structures/entities comprising $100’s of billions of assets that are now much more susceptible to changing market perceptions. We don’t think it a coincidence the stocks of JP Morgan, Chase Manhattan, and Bank of America have been under intense selling pressure the past two days. These three are leading players in both bank syndications and "structured finance."
So, to answer the question from above: can the banks continue to "take up the slack," aggressively creating the degree of financial credit necessary to keep the bubble inflated? We don’t think so. Certainly, if the syndicated bank loan market and other bank-related financing arrangements falter, this would be a major "domino" to fall - one we don’t think the already impaired U.S. credit system could absorb. Perhaps, this is precisely what the recent rally in the bond market is signaling and, quite possibly, these developments are also a factor in recent dollar weakness. After all, when the credit system finally buckles, the acutely vulnerable economy will falter and there will be a rush to sell dollar assets. As such, we expect that the dollar will be a key issue going forward. At the end of the first quarter, "The rest of the World" owned $6.4 trillion of U.S. financial assets, including $2.8 trillion of credit market instruments and almost $1.4 trillion of U.S. equities. Foreigners were also aggressive buyers of both U.S. debt and equity securities during the first quarter. This was a week of decidedly bearish fundamental developments. Can the confidence game withstand these developments for much longer?