Federal Reserve Q2 2006 Z.1 “flow of funds” report.
One might find occasion to be encouraged by this week’s Flow of Funds data. Total Non-Financial Debt growth did slow from the first quarter’s torrid 9.5% rate down to 6.4% seasonally-adjusted and annualized (SAA) - consistent with the slowdown in the real economy (nominal GDP slowing from Q1’s 9.0% to Q2’s 6.3%). It is worth noting however, that federal government borrowings declined 2.4% SAA during the quarter, a sharp reversal of Q1’s 11.3% increase. At 9.1%, Total Household Borrowings remain robust, although down somewhat from the first quarter’s 9.6%. Corporate debt growth slowed to 6.7% from the previous quarter’s 8.8%, while State & Local borrowings accelerated from a 3.5% rate to 6.6%.
I’m anything but encouraged by the Credit data. For one, Financial Sector Credit Market Borrowings actually accelerated – rising from Q1’s 8.6% pace to a notable 10.2% SAA. This confirms that financial conditions remain extraordinarily loose, as well as suggests that expectations for weaker economic activity only promote greater financial sector leveraging and speculating. In nominal SAA dollars, Financial Sector Credit Market Borrowings expanded at a $1.342 TN pace, up from Q1’s $1.110 TN and Q2 2005’s $1.171 TN. By major instrument category, “Open Market Paper” expanded at $309 billion SAA (18.0% annualized) to $1.475 TN; “GSE Issues” $300 billion SAA (11.5% annualized) to $2.686 TN; “Agency- and GSE-backed Mortgage Pools” $308 billion SAA (6.5% annualized) to $3.814 TN; and “Corporate Bonds” $406 billion (9.7% annualized) SAA to $4.559 TN.
Over the past year, Financial Sector Borrowings increased 9.1%. By Instrument, Open Market Paper expanded 21%, GSE Issues 3.9%, Agency MBS 6.9%, and Corporate Bonds 11.5%. It is worth noting that the pace of Financial Sector Borrowings over the past year has been more than double that of M2 growth (4.4%). With Commercial Paper leading the surge in “Open Market Paper” and the ABS boom driving “Corporate Bond” issuance, key components of the current Monetary Inflation are outside the ambit of the “narrow” M2 monetary aggregate. Money Market Fund Assets expanded at a 10.6% rate during the quarter to $2.014 TN, with a one-year gain of 12.9%. Institutional Money Funds (and old M3 component) are the rapidly expanding category, so M2 (which includes only Retail Money Funds) has been capturing very little of the intermediation of the booming CP and ABS markets noted above.
Recall that the majority of Bank Liabilities – including Deposits and “Federal Funds and Security RPs” - are classified by the Fed as outside the category “Credit Market Borrowings.” Banking Assets expanded at a SAA $941.4 billion during the quarter to $9.771 TN. For comparison, Bank Assets expanded $350 billion during 2001, $477 billion in 2002, $507 billion in 2003, $748 billion in 2004, and $763 billion during 2005. Bank Credit expanded at a blistering 11.8% pace during the quarter to $7.894 TN, up from Q1’s 11.3% and Q2 2005’s 9.5% - providing additional testament to the U.S. financial sector’s growing disconnect with the real economy.
On the Bank Asset side, Loans increased at a 10.3% pace during the quarter to $5.670 TN, down slightly from Q1’s 10.5%, with Mortgages expanding at a 14.2% rate to $3.132 TN (up from Q1’s 8.8%); U.S. Government Securities holdings increased at a 14.6% pace (vs. Q1’s 13%) to $1.269 TN; and Corporate Bonds expanded at a 21% rate (vs. Q1’s 13.8%) to $747 billion. On the Liability side, Total Deposits expanded at an 8.9% rate during the quarter to $5.730 Trillion; Fed Funds & Securities RPs rose at 22.9% rate to $1.196 TN; Credit Market Instruments increased 25% annualized to $890 billion and Miscellaneous Liabilities 9.4% to $1.761 Trillion. Over the past four quarters, Total Deposits expanded 9.8%, Fed Funds & Securities RPs 11.2%, and Credit Market Borrowings 12.3%.
And if the historic Bank Credit expansion does not fully explain continued over-liquefied markets, look no further than the ongoing Wall Street Bubble. Broker/Dealer Assets expanded $552 billion SAA during the quarter, a rate of 17.6%, to 2.409 TN. For comparison, Broker/Dealer Assets increased $278 during 2003, $232 billion in 2004, and $299 billion during 2005. Broker/Dealer Assets expanded 17.5% over the past year and 46% over two years. During Q2, Miscellaneous Assets were up $469 billion annualized (37% pace) to $1.454 TN, with a one-year gain of $315 billion, or 27.6%. On the Liability Side, Security Credit expanded at an 18.1% rate to $895 billion; Security RPs 11.3% annualized to $840 billion; and Due to Affiliates 16% annualized to $1.015 Trillion. Over four quarters, Security Credit is up 11.7%, Due to Affiliates 7.1%, and Securities RPs 23.4%.
Examining the smaller sectors, Finance Company Assets declined at a 0.8% rate during the quarter to $1.854 TN, Funding Corps down 5% annualized to $1.981 TN, Savings Institutions up at a 7.3% rate to $873 billion, Credit Unions down 0.2% annualized to $703 billion, and REITs up 19.8% annualized to $573 billion. REIT assets were up 20.9% over the past year.
Mortgages remain the asset of choice for Financial Sector leveraging. Total Mortgage Debt increased $1.168 TN SAA during the quarter to $12.758 TN, down from Q1’s $1.313 TN. Still, this compares to the ‘90’s annual average Total Mortgage debt growth of $269 billion and average growth of $889 billion during the first 5 years of the current decade. During Q2, Home Mortgage debt growth slowed to a 9.6% rate (down from Q1’s 9.7% and Q4 ‘05’s 12.9%) to $9.839 TN, while Commercial Mortgage debt growth accelerated to a 13.5% pace (vs. Q1’s 11.5%). Total Mortgage Debt has inflated 12.7% over the past year, 30% over two years, and an astonishing 112% over seven years.
Rest of World (ROW) accumulation of U.S. financial assets has supplanted housing inflation as today’s prominent Inflationary Manifestation (emanating from ongoing Credit Inflation). ROW holdings of U.S. Assets expanded at SAA $1.319 TN pace to $11.606 TN, down somewhat from Q1’s SAA $1.470 TN, but up from Q2 2005’s $1.001 TN. ROW Holdings were up $962 billion, or 9.0%, over the past year and an astonishing $3.017 TN, or 35%, in just 10 quarters. By category, ROW increased holdings of U.S. Credit Market Instruments SAA $854 billion, including Open Market Paper SAA $207 billion, Agency- and GSE-backed Securities SAA $234 billion, and U.S. Corporate Bonds SAA $397 billion. U.S. Time Deposits increased SAA $227 billion, while Net Interbank Asset dropped SAA $150 billion. ROW holdings of Miscellaneous Assets rose a SAA $311 billion, with Foreign Direct Investment up a SAA $194 billion. The increase in ROW holdings of Open Market Paper represented 82% of total net issuance during the quarter, 92% of Corporate Bond issuance and almost 50% of Agency Debt and MBS issuance. Little wonder markets remain extraordinarily liquid.
Examining the Household (and Non-Profit) Sector Balance Sheet: Liabilities increased at an 8.9% rate, while Assets expanded a modest 2.0% pace. Yet, in nominal dollars, Household Net Worth actually increased $54 billion during the quarter to a record $53.326 TN. Asset values inflated $332 billion to $66.045 TN, while Liabilities increased $278 billion to $12.719 TN. In true Bubble Economy fashion, Household Net Worth inflated $3.892 TN over the past year (7.9%) and $7.934 TN (17.5%) over two years. The value of Household Real Estate assets increased $402 billion during Q2 (7.4% annualized) and $2.131 TN (10.6%) over the past year. The value of Financial Asset holdings actually declined $128 billion (1.3% annualized) during the quarter, yet were up $2.780 TN during the past year.
Providing further evidence of Bubble Economy Dynamics, Federal Government Receipts expanded at an 11% rate during the quarter to $2.559 TN. Second quarter Federal Receipts were up 14.2% from Q2 2005. Federal Expenditures increased at a 7.4% rate during the quarter to $2.687 TN, with a y-o-y gain of 6.2%. State & Local Receipts expanded at a 9.5% rate during the quarter, with Expenditures increasing at a 6.1% pace. Booming tax receipts have been driven by extraordinary income growth. Second Quarter National Income was up 8.7% from Q2 2005 to $11.739 TN, with “Compensation of Employees” up 8.3% to $7.532 TN. One has to return all the way to 1984’s 10.4% (emerging from a prolonged recession!) to surpass recent Compensation growth. Income Inflation goes a long way toward explaining Home Prices resiliency in the face of weak sales and waning confidence.
Since the Fed began cutting rates aggressively in early 2001, Total Credit Market Debt has increased $15.8 TN, or 58%, to $42.67 TN (320% of GDP!). The bond market turned giddy this week with the happy notion that Fed policy will soon be poised to once again inflate the market value of the ever-more-massive stockpile of U.S. fixed-income securities, instruments and their derivatives. We’re now witnessing a consequence of the Fed’s flawed “tightening” stance, focusing on economic vulnerability while disregarding precariously loose financial conditions.
As is reflected in the Q2 2006 Flow of Funds, there remains an overwhelming bias within the financial sector to leverage existing assets (chiefly government, agency, and mortgage-related securities). This bias has intensified greatly during the third quarter. Ironically, the housing and economic decelerations are to this point engendering only a moderate slowdown in Non-Financial debt growth, while Financial Sector Expansion Goes into Overdrive. The system’s liquidity mechanism has not only become detached from the actual financing needs of the real economy, there is today a Powerful Propensity for Financial Excess to Accelerate Rapidly as the Economy Decelerates Only Moderately (too many waiting patiently to profit from another round of Fed largesse). This is a very important development.