Friday, June 12, 2009

The deleveraging trap and QE

From MacroMan an interesting coverage of household debt ratios from the FED flow of funds report.

The good news from the report, at least if you are a member of the Church of the Second Derivative, is that the pace of decline in household wealth and home equity slowed in Q1. Net wealth fell by "only" $1.3 trillion last quarter, while home equity declined by $450 billion. That compares favourably with losses of $4.8 trillion and $673 billion, respectively, in Q4 of last year. Hey, even the y/y chart has started turning up....good news, right?
Maybe, but when looked at in absolute dollar terms the chart is less encouraging. The wealth destruction in the household sector is breathtaking and providesd an obvious explanation as to why savings have incerased (and, in Macro Man's view, will continue to do so.)

Of course, net wealth may well stabilize in the current quarter courtesy of the stock market rally. Of course, what Mr. Market giveth, he can also taketh away. Meanwhile, another interesting note in the flow of funds report was a continued rise in the household debt-servicing burden as a percentage of net wealth ahs reached all time highs.

So it was interesting to observe that the US household sector did a little asset-liability matching in Q1, dramatically increasing its dierct holdings of Treasury securities by nearly $400 billion.
There are a couple of notable things about this. The first is that households' nominal Treasury holdings remain comfortably below their all-time highs notched in the mid-90's, suggesting that there is ample room for households to buy more. The second is that the Q1 quarterly rise in household Treasury holdings was nearly as large as the top three quarterly rises in Fed custody holdings for central banks combined.

This has led Macro Man to wonder....what if the household sector financed the budget deficit by taking down the issuance? The market seems to subscribe to the view that foreign central banks are the only entity that could possible take the other side of the Treasury's all-too-frequent auction calendar, but this seems misplaced. A steady rise in savings and a rebalance of household asset towards fixed income could easily take down the Treasury's entire auction calendar.

In that vein, it was interesting to see that the mjuch-feared 30 year auction came off without a hitch yesterday, delivering a solid bid-to-cover and nary a whisker of a tail. In the follow-through, bonds put in an impressive bounce, forming a key day reversal pattern on the charts in the process....a rather bullish development.

To me the signals are bullish and bearish.

1/ The US households are buying FED debt, indicating that domestic savings are going to finance the US government deficits. This is a bullish sign showing that the consumer is tapped out of Prada bags and cell phones but not of infrastructure development.
2/ The debt ratio is at an all time high. This is known as the deleveraging trap. As the ratio of debt to asset soars and becomes un-bearable from a cash-flow standpoint (you can't pay mortgage), you deleverage by selling assets sending the assets prices in a tailspin. So your remaining assets are worth less. If you sold 10% of your assets and the price is going down by 15% you end up -5 and your ratio of debt to assets further increases in nominal terms. That is the paradox, clearly identified by Fisher during the great depression: as you try to get out of debt you get further into it in ratio terms.
3/ QE. But what QE is doing is increasing the monetary mass out of nothing and lifting numbers. This is what MM describes as "Mr Market doing good". We are not doing good or bad, we are just inflating numbers. So we break the ratio, which is a good thing from a psychological standpoint and we break the negative spiral of delevaraging. This last psychological point, the root of negative feedback loops in asset prices is the most important in explaining QE. QE is there to break us out of the cycle and Bernanke et al. may well be succeeding there.
4/ With ratios at an all time high and unemployment high, the debt burden remains heavy and what got us into the mess in the first place is still there. The good news is that we may be on route to re-establish liquidity in securitized markets which would further lift asset prices.

We will see. I am not as bullish as MM, in fact I have taken MM as a contra-indicator in Q2. But short term panic seems to have gone down. The FED has expanded its mandate from consumer price stability to asset price stability.

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