June 14, 2013
2013 Midyear Update – Another False Dawn?
We’ve seen this movie before since midyear 2009, haven’t we? The pace of economic activity begins to quicken and it looks as though a full-throated cyclical expansion might finally be at hand, only to have the economy slip back into the doldrums. Nominal private domestic spending on currently-produced goods and services grew in the first quarter at an annualized rate of 5.5% compared to 3.4% in the previous quarter. Consumer spending accelerated, housing sales picked up and business spending on equipment and software continued to grow at a healthy pace. Households appear to think that this is the real deal. Will they be disappointed? I don’t think so.
Why don’t I think this is just another false dawn? After all, federal fiscal policy has gotten “tighter”, what with tax rates having risen at the beginning of the year – an increase in the marginal income tax rate on upper-income households and an increase in the payroll tax rate on working stiffs -- and federal spending now declining outright as a result sequestration and other budgetary restraints (see Chart 1).
The reason I think “this time is different” (the most dangerous four words associated with economic prognostication) is because of the recent and expected behavior of “thin-air” credit. As you recall, thin-air credit is credit created by the Federal Reserve and/or the depository institution system (commercial banks, S&Ls and credit unions). This credit is unique inasmuch as it is created figuratively out of thin air. Credit created figuratively out of thin air enables the borrower to increase his/her current spending but does not require the lender or any other entity to cut back on its current spending. Hence, a net increase in thin-air credit, in all likelihood, will result in a net increase in nominal spending in the economy on goods, services and assets, both physical and financial. We cannot categorically say that credit granted by other sources will have the same positive impact on nominal spending because this credit is not created out of thin air. Thus, we cannot categorically say that the grantor of this credit will not curtail his/her current spending in order to fund the credit. Alright, now that you are up to speed on the uniqueness of thin-air credit, let’s talk about its behavior in recent years, as illustrated in Chart 2.
The Fed’s third round of quantitative easing (QE) commenced at the end of third quarter of 2012. Although depository institution credit has been growing consistently since Q2:2011, this growth has been relatively slow compared with its approximately 7-1/4% median annualized growth from 1953 to today. But when we look at the sum of Fed and depository institution credit growth of late, we see a different story. In Q1:2013, the sum of Fed and depository institution credit grew at an annualized rate of 13.8% vs. Q4:2012. To put that into perspective, the median annualized growth in this credit sum from 1953 through today has been 7.0%. Of course, the Fed’s $85 billion per month securities purchase program has been an important contributor to the recent outsized growth in the sum of Fed and depository institution credit.
As Chart 2 shows, this is not the first time in recent years that there has been a spike in the growth of the sum of Fed and depository institution credit. Will this recent surge in thin-air credit growth peter out as it has earlier in the current economic recovery/expansion? Not likely, for two reasons. Firstly, although the Fed may very well “taper” the monthly amount of its securities purchases sometime in the second half of 2013, it is unlikely to go “cold turkey” and completely cease all purchases. Secondly, depository institutions are likely to step up their creation of thin-air credit, although there was not much evidence of this in May. Why? Depository institutions, in general, are now very well capitalized, which will enable them to take on more earning assets. With house prices on the rise, more and more “underwater” mortgages on the books of depository institutions are rising toward the “surface”. This implies a reduced amount of future loan losses, thus a larger capital cushion.
Evidence of a greater ability/willingness of depository institutions to step up their net acquisitions of earning assets, specifically, loans, can be found in the Federal Reserve’s quarterly survey of bank senior loan officers with regard to their lending terms. Each quarter the Fed asks senior loan officers whether their institutions have tightened terms, eased terms or left terms unchanged on various types of loans. The data in Chart 3 pertain to lending terms on small business loans and prime home mortgages. A datum point in positive territory indicates that the percentage of respondents stating that lending terms had been tightened in the past quarter exceeded the percentage stating that lending terms had been eased. A datum point in negative territory indicates that the percentage of respondents stating that lending terms had been eased in the past quarter exceeded the percentage stating that lending terms had been tightened. So, data points above zero suggest banks, on net, are tightening their lending terms. Conversely, data points below zero suggest banks, on net, are easing their lending terms. (Be aware that a datum point can drift toward zero if respondents who last quarter tightened their lending terms and subsequently do not tighten further, but maintain the same degree of restrictiveness as the prior quarter.)
Where was I? Oh yes, Chart 3. There was a sharp increase in the percentage, on net, of banks tightening their lending terms on small business loans and prime mortgages starting in 2008. Although the net percentage of respondents stating that lending terms on both types of loans declined significantly in the second half of 2010, as mentioned above, this does not necessarily that there was a lot of easing of lending terms going on. Rather, it was more likely that many respondents were stating that their institutions were maintaining previously tightened lending terms. When we come to the latest data, the data for Q2:2013, it appears that there has been a significant percentage of respondents stating that their institutions had eased their lending terms, especially on small business loans. Thus, it is likely that as the Fed tapers its provision of thin-air credit, commercial banks will be stepping up their provision.
In conclusion, I expect that the pace of nominal domestic demand will surprise on the upside over the second half of 2013. The principal reason for my bullish economic outlook is my expectation that growth in thin-air credit over the course of 2013 will be strong compared to what it was in the prior four years. On a Q4/Q4 basis, the sum of Fed and depository institution credit is likely to grow in the neighborhood of 7% to 8% for 2013. This would compare with changes of -4.2%, +2.8%, +5.2% and +2.8% for 2009, 2010, 2011 and 2012, respectively. The investment implications of this are that risk assets, such as equities, junk bonds, real estate and commodities should outperform relatively “safe” assets such as Treasury securities and investment grade corporate bonds.
While on the subject of bonds, it should be pointed out that although the Fed has increased significantly its holdings of Treasury coupon securities in recent years, as shown in Chart 4, relative to the amount of Treasury coupon securities outstanding, the Fed’s holdings, while elevated, are well below its relative peak holdings back in the early 1970s. Moreover, the very low correlation coefficient of 0.05 out of a maximum possible 1.00 between the Fed’s relative holdings of coupon Treasury securities and the yield on the 10-year Treasury security suggests that this yield marches to a different drummer than Fed quantitative easing. To borrow a 1992 Clinton presidential campaign slogan, “it’s the economy, stupid” when it comes to the behavior of Treasury bond yields.
The investment environment in 2014 is likely to be more challenging. I expect that during the course of 2014 the Fed will not only have ceased its QE, but also will be allowing its policy interest rates to rise. If so, then both stocks and bonds will have the wind in their face.
Paul L. Kasriel
President and Senior Research Assistant
Sturgeon Bay, WI