While investors happily chase stock prices higher to see who can overpay the most for a share of stock, the contraction in corporate debt over the past two weeks is signaling a major problem. In a debt-based economy, economic growth is tied to the expansion of debt, so a contraction in debt implies an economic contraction is coming or has already started. The recent corporate debt defaults are an ominous sign for the economy since corporate debt is the second-largest amount of debt in the economy behind residential real estate.
Corporate debt levels are tracked in the Commercial and Industrial Loans subcomponent of the weekly Assets and Liabilities of Commercial Banks report released by the Federal Reserve and are a barometer of the health of the economy. When the economy is growing, corporations tend to borrow an increasing amount of money and when the economy is stagnating, corporations tend to borrow less money. When the economy sick, corporate debt is soon to start defaulting.
Declines in commercial lending growth are prevalent ahead of recessions, as slowdowns in lending growth have led the last several recessions. Corporations borrow to expand production and operations, along with financing new orders, which is why the rate of expansion or contraction in commercial loans is a strong indicator of the health of the economy. Corporations borrow large amounts of money compared to individual consumers, so a decrease in lending growth has a significant impact on the broad economy and employment.
In the past two weeks, commercial lending has started to make large contractions, which usually signals debts are starting to default. Commercial lending is a little over $2 trillion in size, so when it starts to contract at a rate of over $500 billion per year, it is a serious indicator of a growing problem in the corporate debt market. Commercial lending contracted by $10 billion two weeks ago, and $12 billion last week, indicating loans are starting to default.
It is unusual for lending growth to contract ahead of a recession, as lending growth did not start to contract at this rate until two months before the stock market bottomed in 2002 and in the same month the stock market bottomed in 2009. In both prior occurrences, the Federal Reserve had lowered interest rates and was providing a substantial amount of liquidity in hopes banks would work with corporate borrowers to stop the collapse in lending growth. While the Fed has lowered interest rates and is providing overnight and short-term dollar loans, it has not prevented the two large back-to-back contractions nor is it enough to stop further contractions.
An occasional one-week contraction in commercial lending during an economic expansion is not unheard of. Usually, the issue is resolved in the following week as the defaulted loans reappear in the data. Whenever possible, banks will work with borrowers to bring a loan out of default since banks want their money back. Large back-to-back weekly contractions are only seen towards the official end of a recession and are an indication of corporate bankruptcies or failures.
The problem with defaulted loans in a debt-based economy is money is removed from the monetary system when the principal value of a loan is repaid or when a loan is defaulted on. Once defaults start, it begins a chain reaction that usually leads to further defaults and a deep contraction in commercial lending. As the amount of commercial loans falls, money is destroyed, which leads to a contraction in the broad economy as evident in the prior recessions.
The only solution to contracting lending growth is for interest rates to fall far enough to entice consumers and corporations with healthy balance sheets to spend money into the broad economy by borrowing more money. As commercial lending continues to contract, it will put pressure on the Federal Reserve to lower the Federal Funds Rate to zero percent and increase the size of its balance sheet. After all, it was the Federal Reserve who tightened monetary policy which led to the largest dollar shortage in history that will inevitably end with the Fed easing to stop the avalanche of loan defaults to come.
Defaults are how the monetary system attempts to adjust to the reduction in dollars in the global economy due to the Federal Reserve destroying dollars when they overtightened monetary policy. The monetary system first started to adjust itself in order to prevent asset prices from falling by trying to force interest rates down. To spur lending growth, the monetary system began to force interest rates down beginning in October 2018, but speculators had different plans.
When Treasury yields fell back to their 2016 lows last year, speculators and other investors thought interest rates were too low. Little did they realize at the time, interest rates were still too high, but it did not prevent speculators from taking out the second-largest speculative bet in the Treasury Bond futures market that interest rates would rise. While speculators did force interest rates up a bit, all it did was cause commercial lending growth to continue its decline.
With speculators and other investors preventing interest rates from further falling, the monetary system began to break when the dollar shortage problem became so bad the Fed had to intervene with overnight and short-term dollar loans along with outright Treasury Bill purchases. Since starting both programs, the Fed has purchased approximately $210 billion worth of Treasury Bills and lent out $210 billion in dollar loans in the past four-and-a-half months.
Dollar loans and outright asset purchases are just a bandage on the overall problem. By design, there are too few dollars in the global financial system to meet all of the dollar-denominated debt obligations and even fewer since the Fed overtightened monetary policy. It is inevitable some corporations and consumers will find themselves with too few dollars to meet their financial obligations. Dollar loans merely grant those in need of dollars more time to acquire the necessary dollars to pay their debts since dollar loans do not help create more dollars. Dollars are only created when a new loan is originated.
When interest rates were prevented from falling far enough to reignite lending demand and the temporary dollar loans did not work, the monetary system entered the liquidation phase. The liquidation phase is where the monetary system will force asset prices down to a level where asset prices can be supported by the number of dollars in the global economy. Debt defaults are the fastest way for the monetary system to shrink asset prices.
Dollar liquidity shortages are similar to musical chairs. During dollar shortages, there are even fewer dollars chasing debt payments than normal. When the music stops on the day a debt payment is due, an increasing number of borrowers may not have enough dollars to meet their obligations. The more debt in the economy relative to the number of dollars, the greater the number of debt defaults to come.
The bottom line is, our monetary system is rather resilient to external shocks, such as the Fed tightening monetary policy, and it will take the necessary steps to heal itself from dollar shortages. When our monetary system is prevented from healing itself, the debt defaults will eventually begin. The debt defaults will only get larger until something serious breaks to force the Fed into lowering interest rates and a massive easing cycle. The recent corporate debt defaults are just the beginning, but if history is a guide, those who own U.S. Treasury bonds are near a huge payday.
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