Sept 9. Lehman’s Shadows

The two year note closed at a new high this week of 2.703%.  The last time it was this high was just over ten years ago in July 2008 (in June 2007 the yield was 5.08%).

We’re rapidly approaching the 10-year Anniversary of the 2008 financial crisis. Exactly one decade ago to the day (September 7, 2008), Fannie Mae and Freddie Mac were placed into government receivership. And for at least a decade, there has been nothing more than talk of reforming the government-sponsored-enterprises. Credit Bubble Bulletin, Doug Noland

Global debt as a % of the world’s GDP was 286% when we were watching pictures of Lehman employees carrying out their boxes.  Today it’s 318%.  David Ader

Lehman Brothers filed for Chapter 11 bankruptcy on September 15, 2008.  And of course, this week is the 17th anniversary of the 9/11 attack.

In late 2008 the gold/silver ratio exploded from around 53 to 84 as the financial crisis cascaded.  By late 2010 it was falling back hard, and in 2011 reached a bottom in the low 30’s.  On Friday the gold/silver ratio closed at 84.4, equaling the peak set during the crisis.

By most measures, the US economy is doing quite well.  Friday’s employment report is another piece of evidence that the labor market is robust, with yoy wage gains accelerating to 2.9%. Manufacturing ISM was the strongest since 2004 and Service ISM was solid as well.  At least five Fed officials last week said that continued gradual rate hikes continue to be warranted.  Tim Duy sums it up this way: “Bottom line: Fed still hasn’t found a reason to pause.  The US data isn’t really giving one.  And don’t expect emerging market turmoil to factor much into the Fed’s decisions – until the problem threatens to wash up on US shores, it will fall into the general category of ‘risks we talk about but don’t act on.’”  Why would a stress measure like gold/silver be all the way back at crisis level highs if the future is so bright?

We all know that the Great Financial Crisis was brought on by extreme mortgage debt encouraged by lax lending standards and supported by exotic sliced and diced financing vehicles with inflated ratings that were pedaled to the global investment community. The Fed’s tightening cycle from 2004 to 2006 eventually caught up to slimly capitalized adjustable rate mortgages

So let’s look at outstanding debt levels from the Fed’s Z.1 report.  At the end of 2008, Household mortgage debt was $10.608 trillion.  As of Q1 2018, it’s $10.144 T.  It has DECLINED!!  As a result, homeowner’s equity as a percentage of household real estate is back to pre-crisis levels of 60% as low rates have helped to expand home values. That’s good.  Consumer credit in 2008 was $2.644T vs $3.873T now, an increase of $1.524T.  Nearly $1T of that increase is in student debt.  So, aside from student debt, the Household sector is in good shape, corroborated by the HH Financial Obligation Ratio (link at bottom) which has been stable for the last several years, now at 15.75%.  In Q4 2007 it peaked at 18.14%.

Corporate debt has expanded from $6.57T in 2008 to a record $9.057T now, a pretty big increase considering that capex has been weak; obviously share buybacks have been part of the reason for growth.   The change in state and local government debt has been tame, moving from $2.978T to $3.065T, an increase of only 3% in ten years!  However, FEDERAL Govt debt has exploded from $7.377T to $17.085T.  Federal gov’t current tax receipts have gone from a peak level in 2007 of $1.6T annually to just over $2.0T annually in 2017.  It doesn’t take a genius to see that private debts have been shuffled to the balance sheet of the federal gov’t, and that tax receipts are becoming a smaller percentage of the outstanding debt.  In a way, the HH sector has been the most financially savvy and conservative since the crisis.  It’s no secret that investment grade corporate debt is now bunching up at the lower tiers just above junk.  When analysts talk about an economic “sugar high” that has been juiced by the government, even a simple review of the data above makes the case.  Can growth dig us out?  That is, of course, the hope.

But the above domestic debt review also makes several things pretty clear.  First, the next crisis, if and when it comes, isn’t going to be a result of the HH sector.  Second, it’s obvious that the Fed and the administration are on a collision course if the Fed keeps hiking.  Third, if the markets become less hospitable to US debt, then Houston, we have a problem.

The Fed’s goal of 2% inflation to support normalization efforts runs squarely into the Federal budget, which is anything but normal.  So, as data like Friday’s annualized wage growth of 2.9% is released (which bolsters the Fed’s case for continued gradual rate hikes) the curve is under flattening pressure.  In Eurodollars, the red pack to green pack (2nd year forward to 3rd year forward) has traded a couple of basis points on either side of zero since June.  When the September’18 contract expires next week, the red pack will begin with the December’19 contract and the green pack will start with December’20.  That ‘new’ pack spread settled -2.5 bps on Friday.  The point is that the Eurodollar curve currently forecasts a slowdown next year, buying into the ‘sugar-high’ scenario.

In the old days it wasn’t uncommon to hear terms like “crowding out” which referred to voracious Federal Gov’t borrowing needs pushing private sector borrowers to the back of the line.  Recently, it seems as if federal debt offerings are effortlessly absorbed regardless of size.  This week brings auctions of 3’s 10’s and 30’s, that are raising $49 billion in new cash.  The strength of the US dollar, which tends to depress commodities, is perhaps seen as deflationary, supporting a bid for long dated treasuries.  But at some point sheer supply may become an issue.  Last week the NY Fed chief Williams said that long yields were depressed, in part, because of the Fed’s buying.  That dynamic could also work in reverse.

In the years leading up to the GFC, lending standards and regulations were relaxed; there was simply too much debt without enough equity cushion.  For emerging market economies that have borrowed in dollars, the ‘equity cushion’ is in the form of domestic currency vs the USD.  That cushion is evaporating.  Is the gold/silver ratio telegraphing the problem?  The chart below seems to reflect growing concern.  In the early days of the GFC, subprime concerns were shrugged off.  The same is occurring now with emerging markets.

Chart of Gold/silver ratio in white, vs JPM EMFX index.

 

Posted on September 9, 2018 at 7:00 am by alexmanzara · Permalink
In: Eurodollar Options

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