March Madness (worth a look for the charts alone)
March Madness?…In more ways than one? Sure could be. We quickly want to discuss the theoretical end to Fed money printing to buy back mortgage backed securities. As you know, there’s plenty of thought on the Street that mortgage rates will pop immediately when this wondrous and oh-so experimental program comes to an abrupt end, as is now the case. We would not bet on that in any meaningful way. At least not yet. Why? Because everyone and their brother (and sister) is expecting it. Moreover, the Fannie and Freddie fan club surely have a few cards up their collective sleeves in terms of being able to finance the purchase of mortgages from the private underwriters at favorable rates. Longer-term mortgage rates ultimately up? You bet. But there's simply too much riding on an “orderly transition” for us to believe anything abrupt will occur with rates, especially because residential real estate looks like it’s going down for the count again as per the NAHB numbers, lack of acceleration in mortgage apps and still very substantial foreclosure activity. Behind the scenes we’re convinced some type of fix is in for a while as perceptions are everything. In fact these days, where isn’t the “fix” in? We don’t quite know anymore.
Anyway, the point of this portion of the discussion is to look ahead and try to anticipate a Fed return to the printing press, which we are suggesting will be inevitable. First a quick look back with some current and prior year numbers from none other than the Fed’s own balance sheet. Below is a peek at the major components of the Fed’s balance sheet as of a few weeks back and twelve months ago.
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So let’s get back to the Fed and what has happened over the past 18 months in the post Lehman environment in terms of very approximate apples to apples money printing and money destruction. In the post Lehman period the asset backed securities markets have witnessed contraction of approximately ($955 billion), a good chunk of which is M2 going to "money heaven" (never to be heard from again). Over the post Lehman period to date total bank loans and leases outstanding have contracted by roughly ($725) billion. Starting to make sense now? Of course it is. The contraction in the banking and ABS markets totals ($1.68 trillion) while the Fed has printed up well over $1 trillion, and the money supply growth (M2) for the total post Lehman period is up $640 billion, only $70 billion of which occurred over the last twelve months. The Fed has offset the debt destruction.
And this is where we come full circle back to the March Madness question. For all the printing the Fed has done, over the past year the acceleration in M2 money supply has been negligible at best. Credit cycles are built on M2 growth. So the question becomes, if they stop printing as they have promised to do in March, will the money supply magically start growing again or at best even stay flat in the months and quarters ahead? That could only happen under one scenario, and that scenario is that bank loans and leases stop contracting immediately AND losses in the asset backed securities markets literally stop right now. In plain English, that means that we can have no more residential foreclosures, no more commercial real estate foreclosures, no more credit card losses and all home equity lines are now money good. Moreover, to get the money supply moving again, banks need to restart the lending process at a rate in excess of net credit defaults in earnest beginning this week. Just how likely is that to happen? Despite the greatest Fed sponsored monetary expansion in history, M2 is barely breathing in terms of growth and on a six-month rate of change basis we’ve rarely been to levels we now see.
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Let’s have a look at private sector and public sector credit numbers in the post Lehman period (3Q 2008 to present). In the following table we delineate the increase in total public sector borrowing and the decline in total private sector credit outstanding over the entire five-quarter period through year-end 2009. We already know the financial sector is the locus of credit contraction, but the last time we checked these folks accounted for over 40% of total S&P earnings no more than two years ago. Now that mark-to-market is over will it be so again? Nothing would surprise us as in recent decades the US has emphasized finance over production, trading over manufacturing and debt over equity. In discussions earlier this year, we suggested to you that there was no way the US government would be able to stop borrowing and spending money until the private sector again witnessed reinvigorated credit growth. Given the depth of the 4Q private sector credit contraction, we're still nowhere even near the starting line for positive net private sector credit growth.
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Over the last eighteen months of historic money printing and asset purchases by the Fed, Fed actions have only been able to offset this absolutely well defined private sector debt destruction reflected in lack of equivalent M2 growth. So if the Fed walks away now on money printing, it seems M2 will decline if private sector credit contraction continues, which is basically a certainty as per the current period trends and numbers. Again, as we see it, the Fed will be back to manning the printing presses before the current cycle is over.
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