Commentary

US deleveraging ending, outlook upbeat, tapering coming

By Edward Harrison

Today’s commentary

The latest flow of funds data from the US Federal Reserve show that the great American household deleveraging may be over. This should add a credit accelerator to the US economy which maintains growth. Meanwhile analysts are increasingly optimistic about US and global economic fortunes. Data points and analysis follow.

As I delve into this topic, I want to be upfront that I share the optimism about the cyclical upswing in the US and global economy which I will describe. I see the risks as mostly to the upside, in the form of asset bubbles. Nevertheless, I do want to add a word of caution here because I believe that the secular forces of private debt are looming in the background. So we will need to see wage growth during this cyclical upturn for the incipient releveraging not to have negative effects on a secular basis.

Last night I wrote a series of tweets to this effect on another one of my twitter rampages . I wrote:

So while I believe we are seeing growth and am optimistic that this growth will last, I am worried that the growth we have seen thus far has not ‘trickled down’ into median wage growth, making this recovery unsustainable on a secular basis. And I use the term ‘trickle down’ very deliberately because I believe a recovery fuelled by monetary policy is inherently trickle down economics to the degree it depends exclusively on credit and private portfolio preferences to support growth without wage gains.

That is the background here. Keep that in mind as I parse the data.

First, let’s look at the US. The latest bullish data point came from the Fed and its Flow of Funds report. Robin Harding at the FT writes under the likely accurate headline, “Jump in mortgage borrowing a good for US consumption”

After reducing debt for 21 consecutive quarters, US households increased their net mortgage liabilities at an annualised rate of 0.9 per cent in the third quarter of 2013, according to new data from the US Federal Reserve.

The rise in mortgage borrowing is a sign that US households are making progress in their painful develeraging after the financial crisis, and may be better able to increase their consumption, supporting economic growth next year.

The pick-up in mortgage debt is likely to reflect the improvement in the housing market and the big decline in foreclosures. The drop in outstanding mortgages has mainly been driven by banks writing off debt when they foreclose rather than consumer repayments.

Total mortgage debt of $9.4tn is now 12 per cent below its peak in the first quarter of 2008. Although outstanding mortgage debt rose, it continues to fall as a share of gross domestic product. It is now down to 55.6 per cent of GDP compared with a peak of 73.6 per cent.

The figures from the quarterly Fed’s flow of funds data show the slow recovery in consumer and business demand for credit and a sudden halt in government borrowing.

Total household credit grew at an annualised pace of 3 per cent, a little slower than the growth of nominal GDP, while credit in the business sector expanded at a pace of 7.5 per cent.

But whereas outstanding government debt grew by more than 10 per cent in every year from 2008 to 2012, in the most recent quarter it expanded at an annualised pace of just 1.5 per cent, reflecting the sharp narrowing of the budget deficit caused by spending cuts and tax rises this year.

This is as good and even-handed a summary of the data as you will get. In terms of cause and effect, lower mortgage borrowing costs and rising house prices have at once decreased mortgage interest payments, stabilized household balance sheets and reduced the number of borrowers who are underwater. This will allow more Americans to refinance their mortgage at lower rates, increase disposable income, and free Americans to move house in search of employment. All of this will most assuredly increase US consumption.

Moreover, as I have documented in the past, the employment data are supportive of recovery. Jobless claims are at cycle lows, nearing levels at 320,000 per week that I believe represent about the lowest we are likely to see. And the payroll figures are now showing a net add of 200,000 jobs per month, with the unemployment rate dropping to 7.0%. These numbers too are supportive of increased consumption by U.S. households.

The data put the Fed in somewhat of a bind, however. The Fed wants to remain accommodative because the jobs numbers belie an underlying weakness in wage growth and labor participation rates. Yet, the 7.0% unemployment figure is dangerously close to the Fed’s 6.5% bogey that will flip the Fed from an accommodative to tightening bias according to the Fed’s forward guidance. And the Fed hasn’t even started to reduce its large scale asset purchases. How does the Fed change its forward guidance while remaining accommodative without undermining the credibility of that guidance in the face of the 6.5% unemployment rate threshold? It will be difficult.

I agree with Tim Duy that the Fed desperately wants to taper, likely because it fears that evidence is building that investors are ‘reaching for yield’ as a direct result of Fed policy. James Bullard, the St. Louis Fed President wants the Fed to add a deflationary threshold and has already indicated that the Fed could taper asset purchases as soon as next week. According to news reports however, there is little support within the Fed for the deflationary floor Bullard wants (and that I support). Moreover, the Fed does not want to simply change its 6.5% threshold.

Meanwhile, the voices within the Fed supporting tapering increase. Kansas City Fed President Elizabeth George, Dallas Fed President Dick Fisher, and Philadelphia Fed President Charles Plosser have always been against QE3. But now we see Atlanta Fed President Dennis Lockhart, St. Louis Fed President Jim Bullard, Richmond Fed President Jeffrey Lacker all saying that tapering needs to happen now. The Fed Presidents then are lining up against QE3 and that means a taper is likely to happen sooner than later. The market is still betting on a March taper but the number of people saying December or January has increased.

I think Bullard’s call for a small taper as signal is the likely option and I believe we will see it next week and if not, then in January. Moreover this is necessary given that the 6.5% threshold is fast approaching. One or two monster jobs reports and it will be right on top of us. So the Fed wants to get the tapering out of the way before that happens. And the reason is that the Fed wants to signal further accommodation despite the 6.5% threshold and it cannot do that if it tapers and the 6.5% unemployment threshold is reached. Those are both tightening signals. Instead the Fed will taper and switch its eggs all into the forward guidance basket by either pushing the 6.5% unemployment threshold down or inventing some other threshold or trigger to blunt the importance of the present threshold. Moreover, lest we forget the Fed already has given guidance that it will taper asset purchases when the unemployment rate hits 7.0%, where it is now. This speaks to tapering now.

Does it really matter when the Fed tapers at this point? Probably not as much as it used to matter. People are really bullish and that’s going to drive expectations more than anything. The Treasury yield forecast for end of year 2014 is now at a record high 3.41%. Meanwhile inflation expectations remain muted. This yield curve steepening will be bullish for bank earnings and may induce a further uptick in credit growth.

The only missing piece is wage growth. For example, I saw a piece today at the Huffington Post which did the math on wages at McDonald’s. It would take a typical McDonald’s employee almost 4 months at overtime pay rates to earn what the McDonald’s CEO earns in just one hour. That is astonishing. And it is emblematic of the increasing disparities in the US that represent the Achilles heel for this cyclical recovery. If this cycle continues on the back of a household credit accelerator without concomitant wage growth, we will see serious deleveraging in the next downturn and an awful shake out in shares. Stay tuned.

The next report will be on global growth.

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Edward Harrison 7783 posts 575 comments

Edward Harrison is a senior Editor at Bloomberg. He is also the founder of Credit Writedowns newsletter, a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.

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