Improvements in the euro area credit conditions should not be ignored

While there is almost no coverage of this topic in the financial media and the blogosphere, credit conditions in the Eurozone are showing marked improvements. This is an unpopular view these days, but ignoring the trend results in an incomplete view of the area's economy and markets. Here are the key indicators:

1. Credit supply/demand fundamentals are trending in the positive direction. Loan demand has improved dramatically and credit standards are looser than at any time since the Great Recession.

This shows indicators for corporate loans and residential mortgages (source: ECB)

2. Since the conclusion of ECB's stress tests in early 2014 (which had been a major source of uncertainty for banks in 2013), loan balances in the Eurozone are beginning to stabilize. Corporate loans are still declining (as maturing loans are not being fully replaced by new loans) but at a much slower rate. These improvements are of course dwarfed by credit expansion in the US where loan balances are growing at over 8% per year (see chart). Nevertheless, the painful deleveraging process in the euro area's banking system is coming to an end.

Source: ECB (adjusted for sales and securitization)

3. Lending rates in the Eurozone periphery are declining sharply. The so-called "monetary transmission" of zero ECB policy rate into rates paid by borrowers is still not great, but the process is starting to work.

Source: @sobata416 

4. Corporate capital markets flows in the EU have jumped recently and a number of Eurozone-based companies will benefit from this trend. Cash-rich euro area investors are shopping for yield and now there is some demand from the corporate sector.

Source:  @lcdnews 

5. Perhaps the best indicator of credit expansion and diminishing effects of bank deleveraging is the growth in the Eurozone's broad money supply. The improvements which followed the ECB's stress tests have been impressive.

Source: Investing.com

Why then do we need such an aggressive monetary response from the ECB? The answer has to do with rising deflationary risks in the euro area. While some have associated falling inflation with sharp declines in energy prices, the issue in the Eurozone is broader than energy (see "core" CPI). And deflation could easily extinguish this nascent improvement in credit.

Clearly the area faces significant headwinds such as the mess related to Greece. Rising probability of "Grexit" for example could dampen lending in other nations. The improvements to date however have been impressive and should not be ignored.

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Decomposing the velocity of money

We've received some questions about the ongoing declines in the velocity of money in spite of stronger US GDP growth in the past couple of quarters.

The velocity of money (as calculated by the Fed) is the ratio of quarterly nominal GDP to the quarterly average of money stock (M2 in this case). It's one of the measures used to assess how quickly money in circulation is used for purchasing goods and services.

The broad money stock growth in the US is currently quite close to its 30-year average of around 6% per year.

On the other hand, the nominal GDP gains in the US have been materially below historical averages. The ratio of Nominal GDP to M2 has therefore been declining.

However, with US inflation subdued, a relatively low nominal GDP increase has recently translated into decent real GDP results. Going forward, as long as inflation remains low, we could continue to see reasonable real GDP growth while the velocity of money remains depressed.

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US cash managers struggling with weak supply of high grade product

The amount of cash in circulation in the US is growing at over 10% per year, and with it the need for short term fixed income product outside of bank deposits.

At the same time, treasury bills outstanding hit a new multi-year low this month.

Recently issued floating rate treasury notes (see discussion) provide an alternative for bills, but the amount hitting the market is immaterial to make a dent at this stage. Money market funds also jumped into the Fed's RRP program (see discussion), but the supply of that experimental product is also limited for now.

Private repo, one of the most common places for parking short-term cash outside of bank deposits, has been somewhat problematic as well. The supply of treasury collateral, large portions of which remain trapped on Fed's balance sheet, has often been insufficient. The recent rise in treasury settlement fails (failure to deliver) is an indication of such shortage.

Source: Barclays Research

Investors looking to park cash outside of bank deposits can also buy bank commercial paper (CP), which is what most "prime" money markets have been doing. But banks do not like to rely on commercial paper for funding because many found themselves unable to roll it during the financial crisis. The volumes of bank CP therefore remain subdued (with rates declining as well).

Bank commercial paper outstanding

The only place where we can see substantial growth in short-term product volumes is corporate commercial paper.

Corporate commercial paper outstanding

Highly rated investment grade corporations can borrow money for a month at as little as 5-7 basis points (annualized). With the CP market often cheaper than bank revolvers, a number of companies are using it to finance working capital.

Source: FRB

However, given the limited number of firms with ratings high enough to satisfy money market funds' requirements, the increased corporate CP volumes are insufficient to meet the rising cash management needs in the US.


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From our sponsor:

The ECB betting on "creditless" recovery

The story from the Eurozone is beginning to sounds like a broken record. The area's monetary conditions continue to tighten as the Eurosystem's balance sheet shrinks.

Eurosystem total balance sheet (source: ECB)

The decline is driven by banks' deleveraging, as the LTRO balances decline.

LTRO balances (source: ECB)

As a result of bank deleveraging, loans to area's households are now growing at merely 0.4% per year,

Loan growth to households (YoY; source: ECB)

... while loans to Eurozone's businesses are falling at over 3% per year.

Loan growth to companies (YoY; source: ECB)

This has resulted in the overall decline in private loans of 2.2% from a year ago, which was worse than economists had expected. With credit contraction continuing, it is not a surprise that the broad money supply growth has stalled at just over 1% a year.

M3 broad money supply growth (YoY; source: ECB)

According to some however, these trends do not matter much because the Eurozone is simply undergoing a "creditless" recovery. We are supposedly paying too much attention to credit growth. The ECB will simply stay on the sidelines and watch the area's economy blossom.

WSJ: - But if the banking system is in poor shape, why are policy makers increasingly optimistic about the recovery?

Part of the answer is that too much focus is being placed on credit growth.

One in five recoveries is "creditless" according to a 2011 International Monetary Fund working paper. Credit growth remained very subdued for several years during the recovery from Sweden's financial crisis in the early 1990s, according to J.P. Morgan research. U.K. bank lending is only now starting to pick up, more than a year after a strong recovery began.

The early stages of a recovery are funded from income and savings rather than new debt. Indeed, continued deleveraging is inevitable as loans issued during the boom are repaid.

More importantly, there is encouraging evidence that the ECB's ongoing "comprehensive assessment" of bank balance sheets is having a cathartic effect.

Of course Japan too had a "creditless" recovery - until it didn't. But let's not make such silly comparisons.

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From our sponsor:

Growth in loans at US banks continues to weaken

Loan growth in the US continues to slow. Credit expansion is certainly not nearly as bad as what has transpired in the Eurozone (discussed here), but the slowing trend is unmistakable. The current rate of loan growth is now significantly below the nominal GDP expansion.

Source: FRB (adjusted for the FASB 140 accounting change)

One exception may be the corporate sector, where loan growth has been robust (see story). But as percentage of banks' total balance sheets, business loans are not growing. In fact much of the corporate debt growth is actually coming from outside the banking system (see post on shadow banking).

Many expect that bank balance sheets will remain constrained by the new regulatory framework (Basel II, etc.), with loan growth continuing to stay weak. As a result, the increases in US broad money supply (M2) have slowed as well.

This is one of the reasons inflation in the US has been subdued in spite of massive injections of liquidity by the Fed.

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From our sponsor:

US broad money supply growth slows

The US broad money supply expansion has slowed materially in the last few months, with the year-over-year growth now at the lowest level since mid 2011. Except for certain components of M2 such as money market funds, the broad money supply is an indicator of the nation's overall credit expansion. This may, at least in part, explain the relatively low inflation the US has experienced in recent months (see post).

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From our sponsor:

Other central banks impacting US money supply

Guest post by Lee Adler (The Wall Street Examiner)


When the Fed prints reserves by buying MBS and Treasuries with money that did not exist previously, this increases bank deposits (liabilities) and cash assets pretty much dollar for dollar. I have run charts showing this relationship, but something went wrong beginning in January.

That something was the breakdown in Treasuries holdings, as Eurozone banks began to unwind the LTRO trade at the first opportunity in January.

The Fed is not the only actor in this game. All the major central banks conduct operations with the Fed’s 21 Primary Dealers. US money supply data represents not just the US but is a pretty big slice of the whole world and reflects other central bank policies and the flows of capital between nations and banking systems.

Treasuries were liquidated to pay down the LTRO. At the same time we saw the echo of that in US commercial bank repo lending and other securities lending to nonbanks, extinguishing the offsetting deposits.

The forced March liquidation of leveraged holdings by big Chinese shadow institutions also showed up here. The BoE has also been running tighter policy.

So the Fed and BoJ are fighting an uphill battle to keep money supply inflating. US money supply would still be increasing dollar for dollar with the Fed’s purchases, but their friends, the other central banks, are no longer cooperating.

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From our sponsor:

Chart that seems to violate key principles of money creation

The chart below shows a clear divergence in trends of the total loans and leases on US banks' balance sheets and the broad money supply measure (M2). Loan balance growth is slowing, while the money supply keeps growing at a steady rate of around 7%.

Source: FRB (H.8)

This is enough to give some economists nightmares. That's because they may view this divergence as a violation of principles they hold dear. Many still believe that bank loan balances and M2 money supply have to be tightly linked because the creation of deposits (the money supply) is entirely tied to lending. And this chart shatters that belief.

But in spite of the divergence in the chart above, the "loans create deposits" axiom still stands - deposits are still created through bank credit. What's at play here is shadow banking. Two key developments explain much of this divergence without violating these principles.

1. Loans on banks' balance sheets do not represent the entirety of credit creation. Loans originated by banks increase deposits, but banks often sell some loans into the shadow banking system, such as Fannie and Freddie. A material portion of these mortgages then ends up back on banks' balance sheets in the form of Agency MBS. These securities are exempt from the Volcker Rule, allowing banks to hold substantial amounts. That process reduces total loan balances without reducing deposits, thus contributing to the divergence in the chart above.

2. As discussed before, M2 includes another form of shadow banking - retail money market funds. These funds have seen their AUM rise recently due to increased risk aversion, particularly in fixed income (see last chart in this post). That development has added to M2 growth without increasing loans on banks' balance sheets.

So our friends in the economics profession should be able to sleep well at night. The divergence between the trajectories of M2 money supply and bank loan balances has explanations that do not violate key principles of money creation.

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From our sponsor:

Fed's action won't influence deposit growth

A quote from an elevator mechanic in NYC: "You need to push the 'up' button to make the elevator come up. But pushing the button many times is not going to make the elevator move any faster."



We continue to receive emails pointing to what some have called "a broken monetary transmission" in the US. On the surface the argument looks compelling. The Fed's securities purchase program is expanding the monetary base - the amount of dollars in the system. In theory some of those extra dollars should encourage the banking system to extend more credit than it normally would, ultimately growing the broad money supply (M2 for example). But that's not how things turned out.

Unit = $ Billion

The argument goes that the banking system is broken and is unable to grow credit - which is being manifested as tepid growth in the broad money stock. Is that what's really going on here?

A closer look reveals that the slow growth in M2 is driven primarily by the leveling off in the amount of deposits in the US banking system (in the chart below the monthly fluctuations reflect the payroll cycle). Note that the spike at the end of last year is the "income harvesting" prior to higher tax expectations (see post).

Deposits in the US banking system (NSA, source: FRB)

But is this leveling off in deposits that unusual? How does it compare to changes in total deposit balances across US banks over longer periods? It turns out that the growth of deposits in the United States has actually been fairly steady - roughly 6.8% per year over the long run. The chart below shows a fit to 40 years of weekly deposit data.

While deposit growth fluctuated over time, it has maintained a steady growth trajectory. Recessions, market booms, Fed's policy, reserve requirements, etc. have had a relatively minor impact on deposit expansion in the long run. And based on this fit, we are currently right about where we should be in terms of the overall deposit levels.

The assumption that the banking system can generate unlimited amounts of broad money simply because the banks have been injected with record levels of reserves is wrong. Banks' capacity to grow credit has always been limited, and it's no different this time. The "monetary transmission" is not broken - it is simply constrained.

The recent fluctuations are due to flows into stocks, mutual funds, short-term income funds (see post), etc. Deposits in the system will continue to grow at roughly 6.8% a year as they have done for the past 40 years, possibly longer.  Therefore the broad money supply - a great deal of which are deposits - will never keep up with recent unprecedented growth in the monetary base (which is up 18% YoY). The elevator "isn't going to move any faster".

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From our sponsor:

Rotation out of money market funds - where is the cash going?

Investors are fleeing dollar-based money market funds. After the spike in cash holdings from taxable income "harvesting" at the end of 2012 (see discussion), the assets in money funds have declined sharply.

Source: ICI

What's causing this decline? The common explanation has been a major rotation into equities. That certainly explains some of it, but there is more to the story. Some institutional investors are becoming uneasy about the impending money market funds regulation. Not only are investors paid a near zero rate on their money market holdings, they also may be subject to some NAV fluctuations in the near future. Furthermore, the NAV fluctuations may only be applied to funds holding commercial paper and not to those holding just treasury bills or treasury repo.

Reuters: - Two-tier money market fund reform is as clear as mud. The U.S. Securities and Exchange Commission is trying again to regulate these mutual funds, which compete with bank deposit accounts. But the rules could favor funds that invest in government debt over those buying corporate debt.

The SEC isn't talking specifics, but Larry Fink, chief executive officer of BlackRock, is. He told analysts this week that some funds may have to adopt a floating net asset value (NAV) - a standard in the mutual fund industry but anathema to those running these accounts that invest in short-term debt. That's because investors, who view money market funds as higher-yielding savings accounts, could actually lose money if NAV is no longer pegged to $1 per share. But the scheme is the best option floated by regulators who want to stop 2008-like runs from happening again. It's simple and puts risk back where it belongs: on investors.

But, according to Fink, it seems a floating NAV may not be applied to funds that invest in government debt like U.S. Treasuries. In a letter to regulators last December, BlackRock argued these funds, which represent 45 percent of the $2.5 trillion market, should be exempt. After all, they weren't part of the panic in 2008, which forced the government to bail out the industry with a blanket guarantee.
...
It's not clear why there need to be two sets of rules for money market funds, other than the need to get a deal done. The effort to reform money market funds has been a long slog. And the SEC has already failed once to overhaul the industry. Compromise may be necessary, but it shouldn't come at the expense of sensible regulation.

The whole attraction of money market funds has been the stability of principal. But with this type of regulatory risk, investors may be better off moving cash into short-term bond funds or ETFs. If one is going to be subject to volatility, why not hold money in something like the PIMCO Enhanced Short Maturity Strategy ETF (MINT), yielding 75bp. That's in contrast to PIMCO's Institutional Money Market Fund (PMIXX) which pays precisely zero, while its NAV may drop below par.

Not surprisingly, that's precisely what investors have been doing. In March short-term bond mutual funds and ETFs have clocked the largest inflow since 2009.

Source: JPMorgan

One unintended consequence of this shift to bond funds will be perturbations in some measures of money supply. Money market funds traditionally have been included in certain broad measures of money stock (such as MZM) while bond funds have not. The definition of "cash equivalents" have now been blurred further. Just watch certain high-profile economists in the next few months mistakenly interpreting this "rotation" as a slowdown in the growth of US money supply.

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From our sponsor:

Why has the US broad money supply flat-lined in 2013?

The US money indicators have been showing something odd in the last few months. While the monetary base (M0) has been rising sharply due to increasing bank reserves (the liability side of the Fed's balance sheet), the broader money supply has stalled.

Both M2 and MZM measures of money stock have been relatively flat this year.

Some attribute this to limited bank lending driving the so-called velocity of money lower, "trapping" liquidity from entering the broader economy. That would explain the growing monetary base and stagnant M2 and MZM.

But stalled credit growth can not be the explanation - simply because bank lending in the US continues to increase at a fairly constant pace since mid 2011.

Loans and leases for all commercial banks chartered in the US (source: FRB)

The answer has to do with cash balances, particularly in money market funds. The amount of cash in dollar money market funds has declined sharply since the beginning of the year. The retail accounts show a particularly large relative drop.

Source: ICI

In preparation for higher federal taxes, both individuals and institutions took capital gains, received special dividends, and pushed incomes into 2012 where possible (see discussion). And these accounts have been deploying this cash from the beginning of the year - with a big chunk of it apparently going to equities. That should explain part of the equities rally we've had this year.

In fact a closer look at the broad money supply trend shows that the growth has been fairly linear except for the late 2012 jump which has dissipated this year. That's why the broad money supply looks flat from the beginning of the year. Here is another example of "unintended consequences" of government policy and policy uncertainty.

Now that the excess liquidity has essentially been used up, what does it say about the stock market rally going forward?

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From our sponsor:

Low money multiplier does not justify ultra easy monetary policy

An number of readers responded to the post (here) on growth in US monetary base with "so what?" After all the so-called "money multiplier" has been at historical lows - meaning that the Fed's monetary expansion has not made its way into the broader economy. The argument is that all this new liquidity is "trapped" in bank reserves, as lending remains tepid.

According to this traditional school of thought, you need sharp growth in the broader money supply to generate inflation - a major threat to the economy. But there is a problem with this argument.

Greenspan's Fed also believed that as long as the money multiplier was at historical lows, loose monetary policy is justified. And in 2002-2005 the money multiplier was indeed at historical lows. This is what the trend looked like to economists before the crisis.

Inflation of course was not a major issue at the time - at least not by historical standards. And the Fed continued with loose monetary policy, as fed funds target rate hit 1% during 2003-2004. The fed began to raise rates in the second half of the decade, but by that time it was too late. Rate increases ultimately served to burst the housing bubble in 2006.

What many economists failed to realize - and many continue to do so today - was that the risk of excessive liquidity is not necessarily the overall price inflation. With US wages stagnant, those looking for a 70s-style inflation will not find it. Instead liquidity manifests itself in asset bubbles, which is exactly what was happening in the housing market at the time when the money multiplier was at the lowest levels in recent history (chart above). Plus in a global economy, inflation (including wage inflation) was simply exported to emerging markets nations.

Economists and market participants however find ways of rationalizing asset bubbles - just as they did with the housing market in the US and China's double digit growth (among other bubbles) during the first half of last decade. That's why using the traditional money multiplier as a rationale for an ultra loose monetary policy is not prudent.

As an example of where this excess liquidity may be ending up today, consider the fact that the average US corporate junk bond yield ended up at an all-time low of 5.93 last week (chart below). Of course market participants have dozens of ways of rationalizing this trend - just as they did with other markets many times before.

Therefore before dismissing the expansion in the US monetary base as inconsequential, consider the fact that in spite of low money multiplier, excess liquidity will find ways to distort markets right under our noses. And you don't need to generate headline inflation in order for these distortions to damage the economy when the correction finally takes place.

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From our sponsor:

Weakness the Eurozone credit growth persists; stark contrast with the US

Tight credit conditions continue to persist in the Eurozone, inhibiting growth and dampening plans for fiscal consolidation.

AP via Yahoo: - Another drop in lending to companies in the 17-country eurozone showed the economic downturn is deepening, as a brighter mood on financial markets fails to catch on with businesses.

The European Central Bank said Thursday that loans to non-bank businesses shrank 1.4 percent year on year in September, double the 0.7 percent contraction reported the month before.

In fact loan growth to households trajectory shows an ongoing decline, while ...

Eurozone banks: loans to households  (YoY; source: ECB)

... loan growth to companies is declining sharply as well.

Eurozone banks: loans to non-financial corporations (YoY; source: ECB)

The stagnation in lending is in part due to banks deleveraging in order to improve capital ratios for Basel III. But a big part of the issue is simply lack of demand from borrowers.

AP via Yahoo: - The numbers show the economy is struggling despite efforts by the central bank to stimulate credit and calm financial markets fearful that the eurozone might break up. The ECB has cut its main interest rate to a record low 0.75 percent and made €1 trillion ($1.3 trillion) in cheap loans to banks that don't have to be paid back for three years.

Even so, that easy money is not making it from banks to businesses and consumers, largely because demand for credit remains weak. Businesses see no reason to borrow to invest in expanding production. Meanwhile, banks in some countries have less to lend because they are struggling to recover from losses on real estate loans that didn't get paid back and on government bonds that have fallen in value due to fears about those governments' finances.

Liquidity is trapped in the Eurozone core where businesses are borrowing less, while periphery banks have limited liquidity even if there was demand. Either way, liquidity provided by the ECB is not making it into the private sector, as the growth in money supply diverges materially from growth in lending to the private sector.

Source: GS

Note that this weakness in credit growth in the Eurozone is in stark contrast with the US, where banks continue to lend at a steady pace. This trend started in early 2011 (driven mostly by corporate lending) and seems to be ongoing.

Loans and leases on balance sheets of US-chartered banks (source FRB; click to expand)

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With credit conditions and growth deteriorating, UK authorities consider nationalizing RBS

The Bank of England has been quite aggressive in implementing an accommodative policy to stimulate the UK economy. Real 10-year yield is comfortably in the negative territory while the central bank's balance sheet continues to expand (heading for GBP375bil).

The UK Treasury has also been creative in trying to improve credit conditions in the country

Bloomberg/BW: - The 80 billion pound ($125 billion) Funding for Lending Scheme with the Bank of England opens today and allows banks to borrow at cheaper rates for as long as four years. An existing plan based on the same principle that’s limited to small companies will be superseded by today’s program.

Unfortunately the central bank policy and Treasury programs are not making their way into the broader economy. The broad measure of money supply is declining at a record rate.

UK Money Supply M4 YoY SA  (source: Bloomberg)

This is translating into housing prices moving lower and shrinking manufacturing activity.

Source: Markit

In desperation to expand the supply of credit, the UK government is considering some unorthodox and possibly unwise solutions. One of those is nationalizing RBS (a money losing bank that is majority owned by the UK government)  in order to force the bank to lend more. Some apparently want the UK government to be in the banking business.

FT: - Senior government figures are discussing the possibility of buying out private investors in Royal Bank of Scotland and fully nationalising it amid mounting frustration at banks’ failure to lend to British businesses.
...
Some at the top of government believe the Treasury’s various schemes to free up credit, the latest of which was launched on Wednesday, have not worked, and forcing RBS to lend more is the only way to push the banks into action.

This would mean directing the bank to increase its lending to companies, which would be open to legal challenge by the remaining shareholders. The only way to get round this, say some ministers, is to buy out those shareholders.

The UK government doesn't need to look far however to see the futility of managing a government operated lender. Providing credit to borrowers who shouldn't have access to credit at below market levels is not a way to improve credit conditions. The GSEs in the US (such as Fannie Mae and Freddie Mac) that will end up costing US taxpayers close to half a trillion dollars should be a good reminder. That's why the UK Treasury is against the idea.

FT: - The Treasury remains hostile to the idea of full nationalisation. The department said: “We are committed to repairing and returning RBS to full health so that it is able to support the UK economy in the future, and the current strategy is working to achieve that. The government’s policy has always been to return RBS to the private sector, but only when it delivers value for money for the taxpayer.”

Of course it will be a while before RBS is returned to profitability. In the mean time the UK government should be looking for other alternatives to stimulate the economy. Perhaps programs involving infrastructure investment, the stabilization of GBP vs the euro (the GBP has rallied 11% against the euro in the last year making the UK less competitive), tax cuts, work programs, etc. - all are more promising than nationalizing a failed bank.

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Fisher rejects the need for QE3

In a recent speech in Dallas, the Dallas Fed President Fisher (non-voter) made some comments on the Fed’s monetary policy. He said that he is "personally perplexed" by the markets’ "continued preoccupation" with "so-called QE3." Unless the "patient" (the US economy) goes into "postoperative decline," he sees no reason for additional monetary easing.

Fisher’s view is that large asset purchase programs "injected money into the system," but that "most of that money has accumulated on the sidelines" in the form of excess reserves with the Fed.

US banks excess reserves

The negative view of QE3 is in agreement with other more hawkish FOMC members who don’t believe such a program's benefits justify the potential risks. The chart below is a good example of how relatively ineffective QE has been in increasing the broad money supply. M3 was already recovering when QE2 began, and it's unclear just how much of an impact asset purchases had on broader liquidity.

Source: Capital Economics (* M3 is their calculation, not the Fed)

Fisher also referred to the FOMC forecast for exceptionally low rates through 2014 as "not to be used externally, but also harmful if swallowed" (a quote from the 1966 FOMC forecast).

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