Is the Party Over on New Year's?
by Stephen Church
Our September, 2006 update showed that we had reached Step 5 of our economic process. Based on current information, we have advanced to Step 6. Our housing bubble analysis shows that Step 6 will be a multi-year process of diminishing real residential investment.
The Federal Reserve appears to be finishing 2006 on a 5-month monetary stimulation binge. Stocks and bonds are responding to the stimulation in a classic manner. Unlike 2001 through 2003, consumer liquidity is still declining in spite of the stimulation.
We expect the Federal Reserve will be even more aggressive in 2007 as they try to reliquify households. We expect falling consumer liquidity will force much lower corporate profits. 2007 should be an economically interesting year. Our suggestion: take your gains on long Treasuries!
This analysis brings our “Consumer Cash Flow”, “Real Estate and Money Supply”, and “The Interest Rate Conundrum” papers up-to-date. The growth of real-estate based debt is slowing and is causing lower consumer liquidity. The slowdown in household mortgage debt flow SHOULD lead to a recession – BUT the Federal Reserve is determined to prevent one.
The latest economic statistics show that consumers depended on new debt for 90% of their cash flow during 2006. Any decline in debt flow will constrain liquidity and should cause a decline in the growth of consumption and household investment.
We demonstrated in our March, 2006 update and confirmed in our June and September, 2006 updates that consumer liquidity was falling sharply. This report shows that consumers could be setting historic liquidity lows on all of our measures by January 1, 2007.
The consumer needs mortgage market access in order to maintain liquidity. In 2007, our research indicates that the consumers’ deteriorating financial condition should cause mortgage access to diminish. If home prices fall or 10-year Treasury interest rates rise, then mortgage access will diminish quickly. We expect that:
? Mortgage debt growth for residential investment in newly-built housing or for renovations will be constrained by the consumer’s ability to carry new housing related financial obligations.
? Mortgage debt growth for purchasing existing homes will diminish rapidly. New homes are still better values. The competitive value of new homes will virtually ensure lower prices for existing homes. Consumers could become “locked into” their homes.
? Mortgage debt growth for consumption purposes should diminish. Increasingly, mortgage refinancing will be used only to restructure debt and replenish cash resources.
In our 6-step economic process, residential investment slows after home resales slow. The reason: home resales provide consumer liquidity and help maintain the economy. Home resales are now persistently lower. New home starts are declining dramatically: 28% since late 2005.
This environment should cause falling M-2 growth. Constrained access to mortgage debt should prevent inadequate consumer liquidity levels from improving. Only very aggressive monetary stimulation since late August has maintained M-2 growth near 5%.
Finally, our “Real Estate and Money Supply” diagram shows that consumer money supply still flows backward. The pace at which debt service and consumption depletes money supply has accelerated in 2006 to about $30 billion per month. In order to immediately improve this measure from ($30) billion to $0, households would need to cut nominal spending by nearly 4%.
Conclusion
The conclusion from our “Money Supply and Real Estate” paper has not changed: slowing home resales could cause a decline in M-2 growth. Consumer liquidity continues to decline in a process consistent with our analyses. January 1, 2007 will be a historic date in this context.
The interaction of declining liquidity and mortgage access should cause a recession by cutting consumer spending growth. With profit levels so high, we might avoid a true recession if lower profits are the cushion between lower spending growth and economic growth. With or without recession, significantly lower profit levels should occur in 2007.
The Economic Process
In our paper, “Real Estate and Money Supply”, we outlined the economic trajectory that the U.S. economy is likely to follow. This section describes that process and is integrated with our updated economic analysis.
Current information indicates that we have progressed to Step 6 of our economic process. The process follows:
Step 1: The Federal Reserve raises interest rates and begins effecting the willingness and ability of consumers to access their back-up liquidity: home equity loans. This piece began in summer of 2004.
Step 2: Consumers allow M-1 growth to stagnate instead of accessing home equity loans to maintain liquidity. M-1 growth reached 0% in November, 2004. Since November, 2004, M-1 is nearly unchanged.
Step 3: Liquidity becomes more dependent on mortgage refinancing. Consumers recognize that the best way to increase short-term liquidity is by controlling large purchases based upon their access to long-term financing. The sales fluctuations in the auto industry have shown this view to be correct.
Step 4: Existing home resales moderate as consumer liquidity remains under pressure. New home sales remain strong. Since home resales generate M-2 and new home sales deplete M-2, this step is the critical step. Home resales peaked in June through November, 2005.
Step 5: Existing home resales decline. Home resales are now clearly declining. October information shows home resales down 11.5% from 2005. Median home resale prices are now down 3.5% from 2005.
M-2 mortgage-related accounts have been near 0% growth on a year-over-year basis since the end of September. M-2, itself, has declined to under 5% growth on a year-over-year basis.
Step 6: New home sales and remodeling decline. This step is now happening. New permits and home starts have declined 28%. New homes under construction have declined 6%. New homes completed have only declined 1%. New home sale prices have been flat during most of 2006. Builders are in a race to complete and clear existing inventories as new home sales fell 25% nationally during October.
We have progressed to Step 6 of this consumer cash flow driven process. Now, we will learn whether a Step 6 slowdown leads to a recession or not.
In our paper, “Recipe for a Depression”, we estimated the National Income and Product Accounts for the 1920s. We showed that residential construction declined significantly from 1928 to 1929. Non-residential construction lagged approximately a year behind falling residential construction.
It is possible that a similar economic process is already at work in 2006. If we had to benchmark the process, we would compare our current status to approximately June, 1929. We have three data points that seem comparable: falling residential investment, peaking non-residential investment, and rising auto inventories.
Our current economic guesstimates show that the fourth quarter of 2006 will be low but positive. Based on the aggressive inversion of the yield curve during the 4th quarter, new mortgage debt generation should be sufficient to maintain consumer spending into December.
In the best case for 2007, we barely avoid the recession that we are now approaching. In the worst case, the Federal Reserve fails to maintain debt flow to the consumer and 75% of the economy achieves a net negative growth rate. We could get inflation, recession, or both.
In our paper, “Consumer Cash Flow”, we developed a Sources and Uses of Cash Flow statement for U.S. households using the format for corporations. That paper demonstrated that, historically, 50% of consumer cash flow came from “Operating Activities.”
In 2005, 88% of new consumer cash flow came from debt. In 2006, we expect debt to provide 90% of consumer cash flow. In the table below, we also show our guesstimate for 2007. Our guesstimate for 2007 assumes that the U.S. avoids recession and that the Federal Reserve maintains control of credit markets.
Frankly, we do not have a clue how high debt flow will be in 2007. Our analyses show the opportunity for drastically lower increases in debt. That outcome would dramatically lower money supply growth and the monetary value of purchases of existing homes and investments
We also have a Consumer Cash Flow model that integrates with money supply statistics. In September, we expected that $256.2 billion would be transferred from non-M-1 M-2 to support M-1 during 2006. We now expect about $343.7 billion will be transferred during 2006.
The increase reflects recalibrated governmental statistics and another change to the Federal Reserve’s debt service and financial obligation ratios. The latest change in Federal Reserve financial obligations ratios increased expected principal repayments.
The increase since September in our estimate of the 2006 transfer from Non-M-1 M-2 needed to support M-1 is attributable to the following changes in rounded numbers:
? $5 billion increase from a higher estimated M-1;
? $45 billion increase in principal repayments; and
? Assorted income and consumption adjustments netting about a $35 billion increase.
Household finances are worse in 2006 than they were in 2005. Households continue to show a willingness to absorb lower liquidity in spite of their deteriorating cash flow.
The consumer cash flow model shows that M-1 remains under pressure. It needs about $350 billion of financing from non-M-1 M-2 during 2006 just to maintain transactional balances. During 2006, new debt will finance 100% of consumer investing activities including growth in the money supply and about 65% of consumer payments on the principal of outstanding debt.
Our initial expectations for 2007 are similar to 2006. However, we are much less certain about 2007 now than we were about 2006 a year ago. We are unsure how lower cash flow will be allocated between reduced consumption and investment.
In some ways, our analysis is frightening. We can find no good outcomes for the U.S. consumer. It looks like 2007 will be the year that U.S. consumers finally realize that they are unable to maintain their current level of consumption and are forced to do something about it.
We analyze consumer liquidity needs in the context of the dollar level of economic activity shown in our consumer cash flow model. We tie those needs to the available money balances shown in the Federal Reserve money supply accounts.
Consumer liquidity has dropped significantly during 2006. In the 4th quarter, the decline slowed briefly. The chart below shows a one-month forward measure based on current checkable deposits as a percentage of the annual level of consumer cash expenditures including consumer debt service. The level is adjusted for the expected monthly decline from net cash flow.
As our research shows, the level of short-term consumer liquidity is now increasingly dependent on mortgage market refinancing conditions. We are experiencing a monthly cash flow pattern that implies consumer debt service levels have become too high.
The funding process in the mortgage market illustrates the dependence on long-term financing for short-term liquidity. At the end of each month, liquidity improves. Early in each month, the decline re-accelerates. It shows short-term reliquification drained by the next month’s payments.
We maintain three primary liquidity measures. Though none of them are perfect, they show a consistent story of depleting consumer liquidity. Our first measure, demand deposit levels, has reached a point where it cannot go much lower. Demand deposits averaged about 9.5 days of funds over the latest 13-week rolling period.
Since many people live paycheck-to-paycheck, this means that demand deposit levels are not sufficient to cover the loss of ONE paycheck. When entering the last recession in 2001, demand deposit levels equaled about 15 days of funds and would cover at least one paycheck.
Our preferred liquidity measure is shown above. It includes all checkable deposits included in M-1. This measure has declined to under 20 days of funds in December 2006. At the start of the last recession, we had nearly 1 week more of funds at about 26 days.
In 2006 alone, our preferred measure dropped by nearly 3 days. It shows that consumer liquidity concerns are accelerating even during a purportedly strong economy and a decent mortgage refinance environment.
Our most interesting liquidity measure is broader and includes savings deposits at thrift institutions. This measure shows how the mortgage refinance process reliquified consumers during the last few years as the Federal Reserve drove the refinancing process with massive interest rate cuts during 2001 and then maintained increasingly low rates into 2004.
This measure of liquidity established a historical bottom the week of March 12, 2001 and then recovered dramatically during the refinancing boom. We find it interesting that this measure bottomed in 2001 coincidentally with the start of the 2001 recession.
We expect that this measure will decline below the March 2001 historical low by New Year’s Day. In 2007, we should discover how creative the Federal Reserve can become as they will search for new ways to arrest the consumer liquidity decline.
It may be instructive to review the process by which the Federal Reserve restarted the mortgage market in 2001 and reliquified the consumer.
In late November, 2000, the Federal Reserve pushed 3-mos. Treasury Bill rates down dramatically as it lowered them nearly 0.75% in 4 weeks. Into January, it lowered them another 0.5% and followed with another 1% decrease during February and March. The total decrease was about 2.25% over 4 months.
The result of the Federal Reserve’s aggressive monetary expansion was predictable. The lower 3-mos T-bill rates forced mortgage rates down. As new mortgage rates went down, average outstanding mortgage rates went above new mortgage rates.
The important point is that it took over 3 months of incredibly aggressive monetary strategy for the Federal Reserve to slow and reverse the decline in consumer liquidity. The 2001 strategy was implemented at interest rate levels substantially higher than current interest rate levels.
We believe that the Federal Reserve started an aggressive monetary expansion in July, 2006 by forcing long interest rates down. Chairman Greenspan warned us that an inverted yield curve might not have the same meaning this time as it had in the past. This time it meant aggressive monetary strategy and it has failed to halt the decline of our consumer liquidity measures.
Since the Federal Reserve has failed to reliquify consumers during 2006, we would not be surprised by an extraordinarily aggressive Federal Reserve in 2007. Very few economists, including Piscataqua Research, foresee the Federal Reserve lowering interest rates to the 3% level. IF they follow the 2001 model for reliquifying the consumer, the Federal Reserve may need to go below 2% on the Federal Funds rate.
Until the last 3 weeks, new mortgage rates remained close to existing rates in spite of the Federal Reserve’s aggressive monetary expansion. Even though 30-year mortgage rates have fallen as much as the reduction that occurred from December, 2000 to March, 2001, the relationship between new and existing rates has prevented a significant increase in refinancing levels.
The evidence of the last three weeks indicates that consumers are responding to the extra rate reduction on the home purchase side but not on the refinancing side. The Federal Reserve may need to push 10-year Treasury rates as low as 4% to 4.25% in order to reliquify households.
Summary
This update shows that consumer liquidity levels are declining to potentially inadequate levels. It also documents the level of Federal Reserve aggressiveness needed in 2001 to halt a comparable decline in consumer liquidity.
In our March, 2006 update, we stated, “If our economy enters Step 5 of the process outlined on page 2 of this paper, the possibility that consumers will ‘reduce consumption and investing to protect liquidity’ escalates.”
Based on the most recent information, the economy has entered Step 6. Consumption and investing are being limited to protect liquidity. Reduced auto consumption, declining demand for homes, and difficult consumer retail comparisons are the effects that we expect in Step 6.
As we stated in our June update, “Every portion of our analysis continues to slip toward a significant slowdown in real estate-based debt creation.” The 3rd Quarter Flow of Funds report confirms that a slow-down in real estate-based debt creation started during the second quarter.
We believe that the Federal Reserve began a monetary expansion in July and became aggressive in August because of the falling consumer liquidity levels. It was imperative for the Federal Reserve to restart mortgage debt flow. They responded by purposefully inverting the yield curve.
In our September update, we stated: “In order to re-invigorate the mortgage market, our calculations show that 10-year Treasuries need to achieve a 4.4% to 4.5% interest rate level.” The Federal Reserve was finally able to invert the yield curve sufficiently on November 30.
The inverted yield curve propelled stock and bond markets higher. However, it did little for households. Our consumer liquidity measures continue to decline. The charts on pages 5 and 6 document the decline. Around January 1, all of our liquidity measures should achieve new lows and show that the Federal Reserve is failing to reliquify the consumer.
We expect that 2006’s expansionary monetary strategy will bring higher 2007 inflation rates of every type except for core consumer price inflation. We expect core inflation to remain low as corporate profit levels fall dramatically to protect business (i.e., consumption) levels.
How can we have falling M-2 growth and rising inflation? Our back-of-the-envelope calculations show M-3 rising at over 10%. Even though little of the money is getting through to consumers, the stock of money is growing at an extraordinary rate. Our analysis is consistent with Federal Reserve statements about inflation.
At this time, inflation rates are uncertain due to the dramatic short-term effects of oil price swings and, until recently, unusually stable currency rates. Though early indications are that the Federal Reserve may be losing in its goal of maintaining inflation levels, the recent currency declines and rising metal and energy prices may indicate that the Federal Reserve is actually succeeding.
If the current expansionary monetary strategy succeeds in maintaining or increasing inflation, then we may avoid a severe recession and a decline in nominal consumption. However, we do not expect it to be clear whether the Federal Reserve has succeeded until inflation accelerates.
Ed. Note: Stephen J. Church founded Piscataqua Research, Inc. in 1992. Steve has provided investment consulting service to wealthy investors and large pension funds since 1986. We provide investment supervisory, investment management or investment consulting services to clients with sizable assets.
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