The Fed’s tightening is hitting the markets. It has sent bond prices plunging and yields soaring. And it has stopped the bull market in stocks in its tracks. Is it also beginning to show up in banking indicators? Well, maybe not yet, but that’s no reason to be complacent. Bankers and borrowers are often the last to get the news and feel the pinch.
First, let’s consider just how dangerous the current situation is. We know in retrospect, and some of us were well aware at the time, that there was a raging credit bubble in the 2004-07 period. If that was a bubble, what’s today? I’ll let you be the judge. Here’s a chart of total bank loans through early May. This is from weekly data published by the Fed.
That chart includes loans to nonbank financial institutions, a large portion of which are used to finance securities purchases. Take that out (chart below) and we can see that loan growth collapsed after the election of Trump in November 2018. I’m not sure there’s a connection there. Maybe it’s a coincidence.
But then loan growth began picking up in Q4 2017. What happened in Q4? The Fed started its financial system bloodletting program, calling it balance sheet “normalization.” Borrowers started thinking that they had better borrow now to beat the higher rates that were certain to come.
Bank loans edged to a new high in early May. The annual growth rate is now 4%. It was around this rate for most of 2017. That is much slower than the period from mid 2014 to early 2017. It’s down from 6.5% in December 2016 and from a peak growth rate of 8.5% in early 2016.
Bank loans should continue to rise as the Fed continues to drain funds from the system. This increase in borrowing as rates rise is nothing new.
Rising rates are actually stimulate borrowing until rates become punitive. That’s a long way off. 2%, or 3% or even 4 or 5% aren’t going to punish anyone. People will keep borrowing until the interest rate exceeds the expected rate of return on a business or personal investment. And with still plenty of excess reserves in the system, there will be no restrictions on the supply of loans until reserves become tight.
Think of it this way. Housing prices are inflating at an annual rate of around 6%. Assuming your income qualifies you for the payment, you would rationally be willing to take out a mortgage at rates up to that. Likewise, a business might expect an ROI of 15-20% on a project to grow the business. They could keep borrowing until rates are well into double digits. In fact, that is what happened in the late 1970s. Credit didn’t seize up until the prime rate was in the high teens.
We had raging consumer inflation then, so today doesn’t compare. But as the Fed raises rates, history tells us that inflation will also pick up until rates materially exceed the actual inflation rate, which today is somewhere around 3-4%, not the 2-3% reported in official measures.
So rates can, and probably will, rise a long way for a long time before there’s any slowing in borrowing. There are still plenty of excess reserves around to allow the supply of new loans to readily meet demand. Nothing will change until rates become punitive and reserves become tight. That’s probably 2 years away. I’ll show you how that works later in this post.
Meanwhile, the Fed will keep sucking money out of the banking system. That will hurt the financial markets.
As Tightening Continues, Banking Indicators Show Building Systemic Risk
Regular bank reserve deposits
Regular bank reserve deposits, called “Other deposits held by depository institutions” fell $44.5 billion to $2.02 trillion over the 4 weeks ended May 16. $9 billion of that simply moved into the Reverse Repo (RRP) line item, which is just another way for banks to hold cash at the Fed. $3.8 billion was converted to Federal Reserve Notes (aka cash) outstanding to the public. But the rest was right in line with the Fed published schedule of balance sheet reductions.
Loans to nonbanks to finance carry trades
The Fed publishes weekly data on loans to non-bank financial institutions. It represents shadow banking and investment institutions. It’s a real time proxy for loans used to finance securities purchases by nonbanks. We can see a seasonal downtick at the beginning of each year, but the trend is still up. It was at least partially responsible for the stock market bubble blowoff last year. And while that borrowing resumed in April, we can see that it has not returned to trend. We can also see that bonds are being sold via the inverse Treasury yield graph, and that stocks have lost their mojo.
Bond prices rose in concert with shadow bank borrowing through August 2017, but bond prices fell and yields have risen since then. This created an unprecedented divergence between bond prices and shadow bank financing. We can see where the money went however. It went toward financing the epic stock market blowoff of the third and fourth quarters of last year. The break of the uptrend line from 2015 suggests that the speculative frenzy that drove the bubble is beginning to subside. However, in the short run, these loans made a new high before turning down in the week ended May 18.
The liquidity that has driven the recent short term rallies in stocks has come from an increase in borrowing. If asset prices don’t follow through on the upside, this increase in leverage will be unwound quickly and the markets will have a sharp selloff. The plunge in bond prices over the past couple of weeks is a case in point. That could trigger more selling as the excess leverage pressures the borrowers.
This surge of financial leverage to new highs runs counter to the Fed pulling money from the system. ZIRP (zero interest rates) was essentially still in force while this financial leverage was increasing. When money is free, speculation runs rampant. With money rates now steadily rising, the pressure will build on speculators to close out positions if they are not moving up quickly enough.
Bank loan loss reserves
Banks’ loan loss reserves reached another post crisis record low as a percentage of loans outstanding in early January and they have stayed there since. There has been virtually no growth in total loss reserves since Q4, 2016. Apparently bankers think that there’s no risk in the system.
This is just another symptom of the steadily building systemic risk inherent in bubble behavior. Imprudent behavior goes hand in hand with confidence increasing to the point of irrationality.
Bankers are counting on a growing economy to keep the loans they have issued for the past few years from going sour. A growing bubble can hide a multitude of sins. Once that growth stops, those sins are uncovered in the form of non performing loans and they can wreak havoc.
At Maximum Tightness, Expect A 27% Crash – Or Worse
The Fed has shed $132 billion in assets since mid October 2017, just before the first cuts under the Fed’s bloodletting or balance sheet “normalization.” It started at the rate of $10 billion a month in October, and is increasing that by $10 billion per month every quarter. It’s now $30 billion per month, going to $40 billion in July and $50 billion in October, where it is scheduled to remain for the duration of the program.
About $31 billion in reserves on the Fed’s balance sheet was simply extinguished over the past 4 weeks as the Fed drained money from the banking system. By the end of the year the Fed will have withdrawn $450 billion from the banking system. The annual bloodletting will then plateau at $600 billion per year until the balance sheet reaches a tight reserve position. That should happen when reserve balances fall to around $1 trillion, which will be in mid 2020 based on the Fed’s published bloodletting schedule.
As the Fed accelerates its withdrawal of reserves from the system, stock prices should fall along with that. This chart may not show the true extent of the damage we could face. When the ball gets rolling on the downside, stocks usually overshoot, particularly when preceded by a bubble. This chart suggests only a 27% decline from current levels. My bet will be that that would be a best case scenario.
But even if things get no worse than that on average, many stocks will do much worse. And I think that we would be very lucky indeed to see a mere 27% drop.
As the Fed pulls money out of the system in the months ahead, it runs the risk of starting a self-feeding, chain reaction, downward spiral in the prices of stocks and bonds. Yields will soar, and Treasury notes and bonds will crowd out other investment choices. And as rates and yields rise, the Treasury’s borrowing needs will increase even more. Margin calls will go out to leveraged speculators. At some point, possibly later this year or in 2019, the markets face the increased potential of a crash.
If that’s a risk that you are willing to take, then by all means, stay in the market.
As always, if you’re interested in making profits on the downside of the market, in addition to our ideas here, you can check out Shah Gilani’s put play recommendations in Zenith Trading Circle.