Going into the weekend I wanted to write about data that showed household net worth was the highest since 2007, and more specifically, examine how we got back to that $66 trillion level. Then on Friday with news that the US Treasury had requested information of all 10-year note holders above $2 billion in assets, I thought about speculating on what was behind the recent 10-year note repo squeeze. I came to realize they were both part of the same story.
When the Fed’s Flow of Funds
data was released two weeks ago, the focus was not on how many US Treasuries the Fed held as a percent of the outstanding stock, as I wrote about last week in Quantitative Easing: The Greatest Con Ever Sold,
but rather about the rise in household net worth to 2007 levels. I wanted to look under the hood and see what exactly caused that increase in “nominal” wealth and what asset allocation trends implied about investor behavior.
Household Net Worth – Financial Assets
In 2006, the first of the baby boomers turned 60 and household net worth was $65.6 trillion. The Flow of Funds breaks down between financial (investments) and non-financial (real estate) assets further breaking down those two assets classes. In 2006 households had 75% of the net worth allocated in financial assets which include savings deposits, bonds, stocks, mutual and pension funds. In 2006 those subsets were allocated as follows: 14.33% in savings deposits, 9.48% in bonds, 19.73% in equities, 8.41% in mutual funds and 25.95% in pension fund reserves equaling 77.9% of household financial assets.
Since 2006 household net worth has climbed by only $455 billion with the value of non-financial assets falling by $4.4501 trillion and financial assets growing by $4.939 trillion. At the end of 2012 financial assets represent 82.32% of net worth vs. 75% in 2006.
If you listened to the Fed you would assume that their easy-money monetary policy is responsible for the growth in net worth. However between 2006 and 2012 the allocation to corporate equities only grew by $12.7 billion. The category that carried the biggest share of the increase in net worth was liquid deposits, which at $2.2 trillion accounted for 45% of the total growth in financial assets. The other two allocations with large increases since 2006 were mutual fund assets, which accounted for $1.1 trillion or 23% of the growth with pension reserves increasing by $1.2 trillion accounting for 25.71% of the growth.
Mutual and pension funds obviously benefit from rising asset prices but they also benefit from the consistency of paycheck contributions still representing a form of increased savings. However it’s the increase in liquid savings deposits in a zero interest rate environment that is the real outlier.
To demonstrate the changing trend you only have to look at deposits and equities. In 2006 households held $9.75 trillion in corporate equities and $6.8 trillion in deposits. Today households have increased deposits to $9.045 trillion while equities have maintained roughly the same value of $9.7 trillion. The $455 billion household net worth increase isn’t due to growth in asset prices as much as it’s due to growth in savings. Contrary to what Fed policy would have you believe, household net worth is not growing because
of zero interest rates and QE, it’s growing despite of it.
I believe this is the inevitable cycle of baby boomers increasing their savings to finance retirement. We can look at the boomer financial evolution in three stages, investment, consumption and savings all dominating US economic and market trends. In 2000 the market saw the top of the baby boomers' investment cycle. In 2008 the market saw the top of the baby boomers' consumption cycle. Now we are on the other side of the investment and consumption cycles as we witness the baby boomers' cycle of savings. I think this cycle where investors favor liquid short term in lieu of illiquid long term assets is in the early innings, and with balance sheets already stretched, it’s not clear to me that the system has the capacity to accommodate much more savings. Just as baby boomers overwhelmed the asset side of bank balance sheets during the consumption cycle, we may now see the cycle of savings overwhelm the liability side.
In a zero rate environment with rising capital ratio requirements, are banks going to expand their balance sheets to meet this demand for liquidity? As I wrote in Bond Market Strength Forged in the Fires of Adversity
, this is a symptom of the Structural Trap that the boys over at the contrarian corner have been writing about (here
). I argued that the banking system needs to shrink as credit capacity is simply too large in relation to the demand for money.
In August 2011 the IMF published a report by Zoltan Pozsar titled Institutional Cash Pools and the Triffin Dilemma of the US Banking System
. Pozsar take a contrarian view of the so-called shadow banking system in that he believes it was demand driven by the massive amount of corporate cash looking for insured deposit alternatives for which the system is not able to accommodate (emphasis mine):
The Triffin dilemma is often used to articulate the US dollar’s problems as the global reserve currency under the Bretton Woods system. Namely, as US dollars became more and more widely used as the world’s reserve currency in the 1960s, their volume in circulation grew to exceed the amount of gold actually backing them. This was unsustainable and the dilemma was “solved” by President Nixon taking the dollar off gold in 1971.
In the present context, Treasury bills (or more broadly, short-term government guaranteed instruments) are like gold. Just as in the 1960s there were too many dollars relative to US gold reserves, today there is too much demand for safe, short-term and liquid instruments relative to the volume of (i) short-term, government guaranteed instruments; (ii) high-quality collateral to “manufacture” alternatives to short-term, government guaranteed instruments; and (iii) capital to support the safety, short maturity and liquidity of such alternatives.
These examples demonstrate that not unlike the soaring volume of US dollars relative to the volume of US gold reserves stretched the convertibility of the dollar in the 1960s, the rise of institutional cash pools and their safety preferences stretched the US banking system to its limits in its ability to guarantee cash pools’ principal safety and redeemability on demand and at par and in unlimited amounts and in all states of the world.
The diagnosis that deposit-funded banks were the ultimate guarantors of institutional cash pools’ principal balances is an important one given that the volume of uninsured institutional cash pools at $3.5 trillion is not far behind the volume of households’ insured cash balances at $6 trillion (both as of the first quarter of 2011).
At just over 5%, uninsured institutional cash pools were a negligible fraction of insured deposits as recently as two decades ago, but account for over 55% of insured deposits today. In light of these developments, it is legitimate to ask whether the secular rise of institutional cash pools relative to the volume of insured deposits in the US financial system is making banks increasingly less able to backstop them.
The banking system is both too big and not big enough. It’s too big in the sense that the capacity to make loans far outweighs the demand for credit, but by the same token, it's not big enough to accommodate the demand for liquid savings. If liquid deposits continue to dominate household net worth then this problem is only going to get worse.
Friday the bond market got word that the US Treasury requested that holders of over $2 billion in Treasury securities contact the Federal Reserve of New York by March 21 to address their large positions in an effort to probe the recent 10-year repo squeeze that saw nearly $80 billion in fails last Monday. Buried in Saturday’s Wall Street Journal:
Regulators tuned into the irregular activity in the Treasury market when they saw some $80 billion worth of loans bust up last Monday in the more than $3 trillion repo market, where financial institutions take out short-term loans to fund themselves using Treasuries as collateral.
Market participants said the recent anomalies in the trading of 10-year Treasury notes stemmed largely from a recent increase in bets that Treasury prices would fall and yields would rise....
Back in 2009 we saw a similar repo squeeze when the 10-year yield went from 3.75% to 2.125% and back to 3.80%. However back then it wasn’t speculative positions that were short, it was hedging. MBS holders who are naturally short volatility saw volatility spike and thus the need to hedge their negative convexity risk. This could be the case today. The 10-year shorts could either be due to outright MBS extension hedging or by the swap desks which sell the hedge to the MBS holders. Either way considering we only had a 50bps move in rates tells you something about the sensitivity of price and duration with these low negatively convex coupons vs. what it was like in 2009 200bps higher.
Let’s examine a scenario that may have led to the repo squeeze. Since the financial crisis total bank credit and bank deposits have continued to expand to all-time highs at $9.97 and $9.23 trillion respectively. Yet in an environment with no loan demand securities have supplemented the growth in total credit. One of the largest allocations in a bank’s securities portfolio are MBS representing roughly 50% of the $2.7 trillion currently sitting on bank balance sheets. In September when the Fed launched QE III targeting MBS in amounts that some estimate could absorb the total supply of new production, spreads on MBS collapsed 100bps in a short period of time.
MBS 30-Year CC Vs. 10-Year
Levered investors such as hedge funds and REITs (and some large banks) were forced to hedge prepayment risk by buying duration. This was all happening against the backdrop of a radical regime change in Japan that was intent on increasing inflationary monetary policy which saw a precipitous drop in the USDJPY. This reversed the rally and put upward pressure on long-term interest rates, which pushed MBS spreads wider, driving hedgers to reverse longs to go short in order to hedge extension risk. As a consequence of the rapid reversal in yields there was tremendous short position built up in a short period of time, which is leading to a squeeze in the repo market.
The consumption bubble led to $2.5 trillion in liquidity on corporate balance sheets. This liquidity now represents institutional cash pools looking for liquid assets. At the same time following back-to-back investment and consumption bubble collapses right in front of baby boomer retirement we are seeing a shift in household investing behavior back towards liquid deposit savings at a level that now exceeds $9 trillion. This double whammy is now stressing the system’s capacity to meet this demand for short term safe liquid investments.
With this week’s FOMC meeting the headlines will focus on the QE exit strategy and what that means for higher interest rates. However with deposit yields already at zero and the cycle of savings just underway there is also risk if interest rates fall. As the reflexive process evolves, the lower they go the more you need to save, and the more you need to save, the lower interest rates will fall. This will provide banks with more funds to invest and lend which will force more capital into an already saturated system, which will only generate more stress.
Liquid savings demand continues to represent a rising share of household net worth at a time when the banking system’s capacity to accommodate this demand is getting maxed out. This is the evolution in household behavior following investment and consumption cycles, but it’s not clear how the imbalance gets reconciled. What is clear is that the slightest uptick in volatility can make a seemingly very liquid banking system suddenly very illiquid.