Bond Market Strength Forged in the Fires of Adversity
By Vince Foster Mar 04, 2013 9:40 am
Contrary to the consensus belief, we may actually be in the early innings of the capacity liquidation adjustment process.
Total Bank Credit NGDP Vs. Marshallian K
Click to enlarge
Marshallian K, named for economist Alfred Marshall, is a measure of excess liquidity in the economy by plotting M2 vs.Nominal GDP (essentially the inverse of velocity). When Marshallian K falls, money demand exceeds supply; when it rises, money supply exceeds demand.
Throughout the '70s, '80s and '90s, when the total credit in the banking sector was within the 45% historical average, Marshallian K generally was in a downward trajectory. You can see that in the late '90s as banking credit began to rise relative to NGDP, so too did Marshallian K, suggesting this credit supply was exceeding demand. I overlaid the yield curve (5s/10s) because the slope of the curve is a manifestation of the inflation discount; this is a product of excess liquidity in the system clearly showing a widening trend (higher inflation discount), acting as a coincident indicator as excess liquidity expanded.
In my interpretation, part of the structural trap that must be remedied is in the banking system because there is simply too much credit capacity to meet credit demand. This credit capacity must be liquidated before the economy can experience sustainable organic growth, and that process will not be pleasant.
In my opinion, the financial crisis was the market's solution to the necessary adjustment of liquidating credit capacity in the banking system, but the Federal Reserve and US government stepped in to prevent it from happening all at once. They have been successful in stemming the severity of the capacity liquidation, but the adjustment must still occur in order to return the supply and demand for credit to equilibrium.
Since the financial crisis, total credit as a ratio of NGDP has eased somewhat but still remains near recent peaks. This is not because banks are creating credit by expanding lending, but rather the increase has come in the form of increased securities holdings. As total loan credit has fallen as a ratio to NGDP from 50% to 45%, total securities credit has continued to rise, pushing total credit at the end of 2012 to just under $10 trillion equal to 63% of NGDP.
Perhaps the bond market is trying to force the credit adjustment through the back door. Banks have no loan demand and continue to purchase securities with meager returns. Eventually bond yields will fall to a level where they are no longer economical to hold. Once we reach that level (and we aren't far) if the banking system has no credit demand they will be forced to kick out the deposits and shrink the balance sheet. It seems this is the inevitable end game. The banking system must contract until the supply of credit meets the demand.
For total credit to return to its historical mean of 45% of NGDP, it would require a substantial contraction in the US banking system which would put considerable pressure on economic activity. Based on the current $15.8 trillion level of NGDP, you would be looking at total bank credit at $7.11 trillion vs. today's level of $9.98 trillion, representing a contraction in credit of $2.87 trillion equal to 18% of NGDP. It's safe to say that for an economy based on fractional reserve banking, that kind of credit contraction will have a significant impact on economic growth.
With NGDP already growing at a tepid 3.5% annual rate, even if you spread the credit contraction over a decade you would still potentially be looking at nominal growth below 2.0%. This would ironically bring the 10-year yield NGDP spread I discussed last week back in-line with the historical mean. Now all of the sudden the 2.0% 10-year doesn't look so rich. With the US bond futures contract holding the critical 143-00 level in the fires of adversity, maybe the bond market strength is trying to tell us something. Contrary to the consensus belief, we may actually be in the early innings of the capacity liquidation adjustment process. As scary as this may sound, it's conceivable that the big bubble hasn't even imploded yet.
No positions in stocks mentioned.