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Summary Takeaways: 

  • It has been a combination of Credit Standards and Consumer & Business loan demand that have dampened credit creation over the last 5 years. 
  • Bank Credit policy is reactive and credit availability pro-cyclical as banks will ease credit standards on a lag as demand rises.  Demand is rising, credit standards continue to ease and accelerating labor market trends should support further improvement.
  • The 1Q13 Senior Loan Officer survey suggests loan growth should begin to accelerate as Commercial & Industrial loan demand picked up sharply, prime residential loan standards continued to ease, and auto & other consumer loan demand accelerated sequentially.
  • The confluence of a wealth effect (equity and/or housing), sustained improvement in labor market trends, and accelerating credit creation should continue to support domestic #GrowthStabilization

The chart below shows the velocity of money versus the monetary base and bank excess reserves held at the fed.  Policy makers hate that chart as it’s a singularly expressive reminder of a five year exercise in monetary policy string pushing in the face of credit tightening and private sector deleveraging.   

Domestic Credit: The Policy Transmission Channel Is Beginning to Open  - M1  Monetary Base    Excess reserves

Post-Crisis Economic & Policy Redux:

To briefly review the economic dynamics underpinning the above chart:  The Fed, through policy initiatives and open market operations, can effectively control the base money supply (ie. Fed prints money --> buys bonds from the banks --> bank reserves increase).  What it can’t control is consumer demand for credit or banks willingness to lend.   

So, while the Fed can print as much money as it wants in hopes of moderating both an acute shock and a protracted deleveraging, if that money simply sits at the Fed as excess bank reserves, it can’t work to drive credit creation, money turnover (M1 Velocity) or end demand growth.  In effect, the Central Banks’ normal monetary policy transmission channel becomes ineffectual and the Fed is largely impotent to counter this dynamic, regardless of the magnitude of easing initiatives – thus, policy string pushing.    

The prevailing dynamic characterizing the post-recession period can, perhaps, be most simply understood in the context of the GDP componentry:

GDP = Consumption (C) + Investment (I) + Government (G) + Net Exports (E)

Consumption (C) remains depressed for a protracted period due to employment loss and a secular private sector deleveraging, Investment (I) fails to accelerate because businesses don’t want to ramp spending in the face of slowing/stagnated topline growth, the government (G) faces structural debt/deficit issues and has largely exhausted its stimulus bullets, and Exports (E) can’t get traction because  1. We’re no longer an export economy and 2. because Bernanke’s explicit attempts at currency debauchery have been repeatedly trumped by the safe haven and relative value plays driven by the EU, Arab Spring, and other global economic and geopolitical crises.

With the typical, and most efficient policy transmission channel blocked at two junctures, the implicit, singular policy objectives became to continue to support housing while daring investors, via financial repression and negative real interest rates, to chase risk assets in hopes of re-flating financial assets and inducing the some measure of wealth effect.  More or less, this remains the current policy playbook.  

If the Fed’s policy initiatives are ultimately successful in jumpstarting consumption and business investment, the trajectory of bank excess reserves should begin to reverse and M1 velocity inflect upwards as aggregate demand and economic activity accelerate.   The Fed’s Senior Loan Officer Survey is one measure offering some insight into the directional trend in investment and consumption.  

 

TRENDS IN CREDIT DEMAND & AVAILABILITY:

Anecdotally, the explanations offered for the lack of demand via loan and credit growth in the post-crisis epoch tend to take a binary, mutually exclusive view on credit availability and consumer demand.  Many argue that credit growth is  bottlenecked exclusively by tighter credit standards and banks unwillingness to lend in the face of existing/rising private sector demand, while others argue the reverse. 

In reality, understanding the prevailing trends in Commercial/Industrial, Real Estate, and Consumer Loan activity requires taking a composite view of Bank Credit Standards and Consumer & Commercial Loan Demand.  It’s a combination of and interplay between the two that have defined the trajectory of loan growth over the last five years, and both are currently trending favorably. 

Generally, Bank Credit policy is reactive and credit availability pro-cyclical as banks will ease credit standards on a lag as demand rises.  The combination of Improving economic/labor market trends and easing credit standards feedback on one another and benefit credit growth from both ends during an upswing.   Higher employment helps drive organic credit demand while easing credit standards expands the pool of available borrowers.  Similarly, improving economic and consumption trends drive both a decrease in corporate credit risk and marginal demand for C&I and commercial real estate loans. 

In the context of our view of housing as a Giffen good, the pro-cyclical nature of credit sets up a positive feedback cycle whereby rising demand drives home prices higher which, in turn, drives easing credit standards for residential real estate and a further increase in demand in a virtuous cycle. 

Measures of Credit Availability and Demand from the Fed’s Senior Loan Officer survey can provide some insight into trends in consumer and business consumption expenditures.  The latest 1Q13 data suggests loan growth should begin to accelerate as Commercial & Industrial loan demand picked up sharply, prime residential loan standards continued to ease, and auto & other consumer loan demand accelerated sequentially. 

While trends have been showing positive improvement over the last 4 quarters or so, an acceleration in employment alongside a sustained (& accelerating) housing recovery and some fiscal policy clarity on the other side of the Fiscal Cliff/debt Ceiling/Budget/HealthLaw issues, would serve to further increase consumer and business loan demand and support ongoing credit standard easing.   The confluence of a wealth effect (equity and/or housing), sustained improvement in labor market trends, and accelerating credit creation is a factor cocktail capable of perpetuating virtuous economic reflexivity.   

The trends are certainly encouraging, but we’d like to see a deceleration in the decline of M1 velocity in print and current credit trends confirm a bit further.  We’ll get our next update to the Senior Loan officer survey in April.  

Domestic Credit: The Policy Transmission Channel Is Beginning to Open  - Senior Loan Officer Survey Credit Standards

Domestic Credit: The Policy Transmission Channel Is Beginning to Open  - Senior Loan Officer Survey Demand

Christian B. Drake

Senior Analyst