With the FOMC meeting currently in full swing, speculation is rampant what will be announced tomorrow at 2:15 pm, with the market exhibiting its now traditional schizophrenic mood swings of either pricing in QE 6.66, or, alternatively, the apocalypse, with furious speed. And while many are convinced that at least the “Twist” is already guaranteed, as is an IOER cut, per Goldman’s “predictions” and possibly something bigger, as per David Rosenberg who thinks that an effective announcement would have to truly shock the market to the upside, the truth is that the Chairman’s hands are very much tied. Because, all rhetoric and political posturing aside, at the very bottom it is and has always been a money problem. Specifically, one of “credit money.” Which brings us to the topic of this post. When the Fed released its quarterly Z.1 statement last week, the headlines predictably, as they always do, focused primarily on the fluctuations in household net worth (which is nothing but a proxy for the stock market now that housing is a constant drag to net worth) and to a lesser extent, household credit. Yet the one item that is always ignored, is what is by and far the most important data in the Z.1, and what the Fed apparatchiks spend days poring over, namely the update on the liabilities held in the all important shadow banking system. And with the data confirming that the shadow banking system declined by $278 billion in Q2, the most since Q2 2010, it is pretty clear that Bernanke’s choice has already been made for him. Because with D.C. in total fiscal stimulus hiatus, in order to offset the continuing collapse in credit at the financial level, the Fed will have no choice but to proceed with not only curve flattening (to the detriment of America’s TBTF banks whose stock prices certainly reflect what a complete Twist-induced flattening of the 2s10s implies) but offsetting the ongoing implosion in the all too critical, yet increasingly smaller, shadow banking system. And without credit growth, at either the commercial bank, the shadow bank or the sovereign level, one can kiss GDP growth, and hence employment, and Obama’s second term goodbye.
As the two charts below demonstrate, the economy’s ongoing inability to create any growth in the shadow banking system, primarily as a result of the complete shut down of the securitization machine, has been and continues to be, the biggest threat to the Fed. Specifically, after hitting an all time high of $20.9 trillion in March of 2008, this all too critical source of “credit money” has collapsed by a whopping 25%: since the peak $5.5 trillion of credit, and not just any credit, but shadow, and thus non-regulated credit, has evaporated! And as Q2 demonstrated, after almost bottoming in Q1 following a decline of just $57 billion, or the smallest Q/Q decline since Q2 2008, the drop has picked up again, with a one year high $278 billion plunge in Q2.
Among the liability components of the Shadow Banking system’s credit money abstractions, we look at:
- Money Market Mutual Funds: at $2.6 trillion, a decline of $41.6 billion Q/Q
- GSE and Agency Paper: at $6.5 trillion, a decline of $73.8 billion Q/Q
- ABS Issuers At $2.2 trillion, a decline of $80.4 billion Q/Q
- Repos at $1.2 trillion, a decline of $49 billion Q/Q
- Open Market Paper at $1.1 trillion, a decline of $50 billion Q/Q
- and these declines were offset by a tiny increase of $17 billion to $726 billion at Funding Corporations
Altogether, added across this amounts to a massive $278 billion in the second quarter, and explains why GDP, when the manipulation from the Census Bureau is eliminated would have probably declined. What is worse is that should this decline continue without an offset, there will be no economic growth guaranteed.
So where can said offset come from? Well, just as there is a shadow banking system, so there is a traditional commercial bank system with listed liabilities. To be sure, for the duration of collapse in the shadow banking system, this has been the only offset, although granted one that is not nearly doing a good enough job. Specifically, total liabilities of Commercial Banks in Q2 were $13.4 trillion, an increase of $238 billion in the quarter. Alas, this is nowhere near enough to offset the decline in Shadow Banking, having grown by “only” $2.6 trillion since Q2 2008, even as shadow liabilities declined by double this amount. Yet there was a brief saving grace came in Q1 when the spike in Traditional liabilities more than offset the drop in Shadow, as the cumulative total rose by $337 billion, the most since 2008. Too bad, however, that adding across these two categories (second chart below), we once again witnessed a decline in Q2, amounting to $40.1 billion. This explains not only why QE2 could only do so much, but why GDP growth has rolled over and is now almost certainly negative.
What is most important to keep in mind, is that Traditional Commercial Bank assets only grow courtesy of QE. And with Shadow banking continuing to implode, Commercial Banks have to pick up the slack or else… Which in turn means Bernanke has to keep pumping reserves. Whether banks use these to lend out, or to buy shares of Netflix is irrelevant: remember – America, and the entire developed world, is a credit driven system. Take away credit growth and it is game over.
Which explains why tomorrow’s decision is a formality: Bernanke has no choice but to continue offsetting the relentless contraction in shadow liabilities, which as of Q2 collapsed at an annualized rate of over $1 trillion. Incidentally this, +$1, is the very minimum that Bernanke
will have to bring into reserve circulation to offset the relentless deleveraging of the once biggest contributor to American growth, which ironically is now the biggest adverse factor.
That reversion to the mean sure can be a bitch.