BNP Paribas analyst Julia Coronado highlighted an overlooked and significant aspect of the Fed’s latest flow of funds report, that of private sector deleveraging.
As she put it in a note released on Friday (emphasis FT Alphaville’s):
Private sector deleveraging accelerated fairly dramatically in Q2, even as financial market conditions were showing material improvement. Private sector credit contracted by $2.32 trn at an annul rate after shrinking $1.84trn in Q1. This is an unprecedented event in the postwar period and highlights the fragility of the recent recovery. It is therefore not surprising that markets ignored a spate of good economic data with falling jobless claims, rising housing starts, and an upside surprise on the Philly Fed manufacturing index. Stocks were down modestly and bond markets continue to be well supported.
This is important because, according to Ms Coronado, “it is difficult to see how lasting growth or inflation could take hold in an economy where the private sector continues to deleverage.” Accordingly:
A number of FOMC members have continued to stress tight credit market conditions and deleveraging as reasons to not be overconfident in the economic outlook. We agree, and think the focus on the Fed’s expanded balance sheet and talk about possible early exits from the credit easing policies is misplaced.
The deleveraging therefore has important implications for Fed policy and the outlook for the US housing market, Ms Coronado said:
Indeed the vital role of policy and potential need for further credit easing from the Fed is clear from looking at residential mortgage credit. The only sector providing credit is the Agency MBS market, all other banking and private securitization markets are still contracting sharply (see chart below). Moreover the Fed has purchased more than the total net issuance over H1 2009. To the degree the housing market has stabilized, it is the direct result of the vast stimulus being provided by policy. While the corporate bond market has shown robust improvement, most other segments of the credit market are very fragile and the banking sector is contracting; the commercial banking sector shrank by $631bn in Q2, and savings institutions contracted by $560bn. It is hard to imagine the Fed pulling the plug on the market realizing the greatest benefits from its efforts, particularly when fundamental questions about the structure of the GSEs and the future federal role in mortgage finance are unresolved.
Reasons to be cheerful? Not here:
the Flow of Funds report highlights some of the deep structural issues the financial system and economy still have to work through before a more lasting and buoyant period of economic expansion can take hold.
Related links:
Don’t worry about deleveraging – FT Alphaville
The anemic equity rally – FT Alphaville
Just who is buying this rally? – FT Alphaville