Going Nowhere In A Hurry?...To suggest that the theoretical end of QE2 has been and continues to be widely anticipated by investors is an incredible understatement. Opinions on financial market and well as real world economic outcomes diverge widely. The two QEs have been an unprecedented journey in the annals of Fed and US economic history. We'd like to take a very quick look at what we hope is relevant data from the recent Fed Flow of Funds report relating to what has been and has not been accomplished in the macro over what is close to the last two years. Clearly a key macro over the remainder of this year and into next is the need for the private sector to grab the economic growth and credit cycle acceleration baton from both the Fed and Federal Government as supposedly QE and Government stimulus wind down on a rate of change basis. Important bottom line issue being, the Federal Government and the Fed have been the key provocateurs of the continuance of the decades long US credit cycle expansion over the last three years as the private sector has spent meaningful time in the balance sheet repair shop. As the Fed and Government are slated to be a much lesser force in macro credit cycle expansion dead ahead, is the private sector now ready to again move the macro credit cycle ball continually down the field? Personally, we're not so sure. And this clearly has very meaningful implications for outcomes in a post stimulus world.

Two key characterizations of the current cycle are more than well known. First, the real hurt and balance sheet reconciliation in the cycle so far can be seen in the financial sector. We'll spare you a plethora of charts as you know financial sector credit outstanding has shrunk meaningfully, importantly driven by contraction in the asset backed markets. Secondly, we know growth in Federal Government debt has acted to more than offset financial sector credit contraction. So let's take the biggest hurt out of the equation that is the financial sector. Below is a quick look at total US non-financial sector leverage as a percentage of GDP, necessarily capturing Government, household, non-financial corporate and state and local balance sheets. Message being? Relative to GDP there has been no reconciliation at all in US non-financial sector leverage as a percentage of GDP over the entirety of the cycle to date. In the macro, total credit cycle contraction leading to deflation has been forestalled. As of the recent 4Q numbers, we're now back to all time highs seen in early 2009 when nominal GDP hit its lows for the current cycle. And let's face it, we can try to characterize this as the Government picking up the slack for US non-financial private sector credit growth as if the Government were some separate entity in and of itself, but the government is ultimately funded by households and corporations. So what we are looking at is "us" as a whole, exclusive of the financial sector.

Key macro issue looking directly ahead being since we've seen no deleveraging in the totality of the US non-financial sector as per the Fed's own numbers captured above, the actions of any one non-financial sector player in the future must necessarily be offset by another sector to keep the system "in balance", to keep deflationary deleveraging from occurring in the greater whole. Specific issue being, if Government stimulus (continued debt acceleration) and Fed money printing (essentially monetizing additional Government stimulus/debt) wind down in latter 2011 and into 2012, will US households, the non-financial corporate sector, or state and local governments again begin to lever up their balance sheets to keep what you see above from contracting?

So let's have a quick look at the specific components of the US non-financial sector. Below are historical reviews of US household, non-financial sector corporate and state and local debt as a percentage of GDP. Obviously we've left out a look at the Federal Government as debt acceleration in the past three years has been off the charts. You know that and there's no sense wasting time repeating or reviewing it. We told you last week that official (not including Fannie/Freddie/SSI/Medicare) US Government debt has doubled since the first quarter of 2006. That says it all. Have a look at these key players and the relationship of individual sector debt to GDP ratios over close to the last six decades.

It's clear that in the current cycle to date, really only the US household sector has seen balance sheet reconciliation relative to the benchmark of GDP. As we've explained and quantified in the past, the bulk of this household balance sheet reconciliation has occurred through default on mortgage debt. But what is important is that we're still very near all time highs in the relationship of non-financial corporate sector and state and local government debt relative to GDP. So again the question becomes, as we look at the totality of the US non-financial sector and assume Federal Government borrowing slows perhaps meaningfully on a rate of change basis, just who or whom picks up the slack to keep total non-financial sector debt to GDP from contracting? A contraction that implies credit deflation? We suggest this is a key macro as we are addressing the potential for systemic deleveraging. Systemic deleveraging in the current cycle that has so far been forestalled by unprecedented Federal Government borrowing.

NON-FINANCIAL CORPORATE SECTOR

We'll try to make this quick, but we'd like to dig just a bit deeper into each component of the non-financial sector you see above and ask the question, is this sector ready to lever up in deference to theoretical slowing in Government debt accumulation? Again, we're not going to go through Federal Government numbers as they are more than well known. Let's start with the non-financial corporate sector. Have a quick look at the next chart.

Certainly a truism of the current cycle is that corporate balance sheets are in darn good shape. That's very true. But it's also true that non-financial corporations in aggregate have not delevered their balance sheets relative to the GDP benchmark. We've covered this a number of times so we'll make it fast. The non-financial sector has been treated to once in a career financing opportunities in very good part related to global central banker monetary policies of holding down nominal rates. The chart above shows us as much as the top clip looks at nominal Moody's Aaa corporate financing costs looking back six decades. The fact is that Moody's Aaa yields hit a half century nominal low not amidst the Treasury interest rate implosion of late 2008 and early 2009, but literally in August of 2010. And the chart below show us exactly how US non-financial corporations responded to this set of circumstances - they borrowed.

They increased borrowing at a nominal dollar rate greater than anything seen since early 2008 in the final two quarters of last year. Now that Moody's Aaa yields literally at the end of last week were close to 90 basis points above what was seen last August, it will be interesting to see just how non-financial sector corporations act in 1Q of this year. Although it will be another three months or so until we get the "official" Fed Flow of Funds numbers, we do have a current period anecdote that deserves mention.

You'll remember that in the credit market implosion of late 2007/early 2008, the commercial paper markets were a highlight financial sector casualty. You'll remember that the Fed (through recent disclosures, of course) made funds available to the Home Depot's and Harley Davidson's of the world. Why? Because they were essentially cut off from the commercial paper markets. But as you'll see in the chart below, the numbers being courtesy of the Fed, we've seen a resurgence in non-financial corporate sector commercial paper issuance just this year. What does this tell us? Non-financial sector corporations are once again financing "short" as longer dated Moody's Aaa yields have risen meaningfully since late summer. It certainly looks like changed behavior relative to nominal corporate interest rate lows of last summer. Corporations are responding to change in the very short term.

Hopefully in a bit of quick summation, non-financial sector corporate debt relative to GDP stands at a current level simply not far from all time highs. Will corporations be willing to take this ratio ever higher immediately ahead in support of total US non-financial sector credit expansion? Corporations will respond and borrow in an anomalistically low nominal interest rate environment, as seems clear by the numbers reviewed above, but for now that occurred last summer and there's no guarantee we'll see half century Moody's Aaa yield lows again. Moreover, as Moody's yield levels rose from record lows, non-financial corporations simply moved back to financing in the short term commercial paper markets. It sure seems that for corporations, it's all about the very granular short term cost of capital. Given this overall set of circumstances, again, can the US non-financial corporate sector be a key credit cycle provocateur able to pick up the slack that will be created ahead if government borrowing slows? Yes or no?

Before moving ahead, one last key point. Remember, a keynote issue of the whole QE exercise is to engender macro credit acceleration. But we already know the banks have simply let excess reserves mushroom, eschewing lending as an alternative use of funds up until now. We've said it a million times that the banks are key in terms of the character of the US credit cycle to come. Here's the deal. You saw above that in response to generational lows in Moody's Aaa yields last summer, corporations ramped up their borrowing by a little over a few hundred billion in 3Q and 4Q of 2010. But if we look at US bank loans and leases outstanding over the 2010 3Q and 4Q periods, we see outstandings actually fell! This tells us directly that non-financial sector corporations bypassed the traditional banking system completely with their increase in leverage late last year. Moreover, the uptick in non-financial sector commercial paper we see so far in 2011 is likewise being done outside of the traditional banking system. In other words, no credit multiplier is coming into play here. No fractional reserve banking system expansion is getting into the equation. Again, can we really expect the non-financial corporate sector to pick up any of the slack from a Federal Government that will need to decrease rate of change in leverage ahead?

STATE AND LOCAL GOVERNMENTS

We will not spend any serious time here as you know full well what is occurring at state and local government levels. Does the following combo chart tell the story? There is simply no way state and local governments are about to embark on some type of balance sheet leverage acceleration any time soon in support us US systemic non-financial sector credit acceleration. No way. The pension issues that loom large in the decade ahead tell us the road of reconciliation will be long and hard for state and local governments. By the way, all of the numbers below are current through YE 2010.

US HOUSEHOLDS

And so this leaves US households as a final potential macro US non-financial sector credit cycle provocateur, assuming the Federal Government and Fed reduce forward largesse on a rate of change basis. The facts are that from the prior peak in 2007, nominal dollar US household sector debt has declined by approximately $450 billion, non-financial sector corporate debt has risen to an all time high, and state and local government debt has likewise clocked in at a new nominal dollar record high as of 4Q 2010. The table below very quickly summarizes in nominal dollar terms the influence of each component of the US non-financial sector on total non-financial sector credit market debt outstanding (the macro US credit cycle).

The mismatch in magnitude clear in the numbers simply amplifies the question central to this discussion. Just who or whom in the non-financial sector could pick up the slack in a potential slowing of Government borrowing in order to keep macro US non-financial sector debt to GDP from contracting? A contraction that would represent credit deflation. Our conclusions above are that despite some increase in nominal dollar debt since early 2009, US non-financial sector corporations will only be willing to leverage up when it's in their best short term financing interests. Unless we return at least to nominal Moody's Aaa yield levels seen last summer 90 basis points lower than levels seen last month, we cannot expect the non-financial corporate sector to be a meaningful driver of total non-financial sector credit expansion ahead. Conditions at State and Local governments speak for themselves. Not a chance that these folks even help to drive total macro credit cycle acceleration. And so what are we to expect of households? Can they be the leaders of the band and pick up any diminution in the rate of change of Government borrowing ahead?

Let's start with some good news from the household front. According to the merry pranksters at the Fed, the financial obligations ratio (FOR) for both homeowners and renters fell to new lows as per the latest numbers for the current cycle as of 4Q 2010. Please remember, the FOR accounts for mortgage and consumer debt payments relative to disposable income, as well as auto and rent payments, and homeowners insurance and property tax costs. As you can see in the top clip of the chart, we're now back to the ratio average of the last three decades. For renters, the numbers look even better set against historical perspective.

The historical retrospective above tells us households have "freed up" disposable income by lowering their interest costs since the peak in 2007. This lowering has been accomplished by both default and refinancing. Does this imply households now have the capacity to again leverage up from here in support of total non-financial sector credit acceleration, or stability in ratios at worst? It does imply such, but as always the question comes down to capacity to lever up versus desire. Hopefully the following chart is a "comment" on desire.

Again, we're looking at the FOR this time on top of the macro household debt to GDP ratio since 1980. There indeed have been prior periods where we have seen the FOR contract. The 1990 to 1993 experience was meaningful. The red bars in the chart represent those periods where we've seen FOR contraction. As is clear, in prior periods of FOR contraction, the macro household debt to GDP ratio has either been stable or continued to accelerate. In other words, when household interest "financial" costs declined in prior cycles clearly due to refinancing opportunities, household kept right on levering up. But the current cycle up to the present has been completely different in character. After hitting a record high in 2007, we've seen the FOR drop by a record amount for this data series, yet in the current cycle household debt to GDP has likewise contracted. Again, a big reason for this so far has been mortgage debt defaults.

But the macro message appears loud and clear. Despite lowered costs of financing, household debt continues to contract both in nominal dollar terms and as a percentage of GDP. Certainly, although we have not marked it in the chart, we remain far from the long term average household debt to GDP ratio for the period shown that is 67%. This number is about where we stood in 2000. We expect to see that number again, but it's going to take time.

Bottom line being that as long as US residential real estate remains depressed, we cannot expect households to accelerate debt expansion, especially given that real estate was the key piece of collateral in the greater equation. The chart above is showing us exactly this. Moreover, the Fed in prior cycles has gotten around the macro "economic problem" via credit/liquidity/money printing expansion. It's doing the same in the current cycle, but from the standpoint of households, the Fed can do nothing to stimulate growth in personal income. You remember, personal income necessary to shoulder any burden of servicing an increase in leverage.

We'll stop right here. You are fully aware that Bill Gross is now asking a relatively important question. Just who or whom will be the buyers of US Treasury debt once the Fed ends QE2? We're simply trying to ask an adjunct question we believe likewise worthy of contemplation. Who or whom will pick up the credit cycle acceleration slack if the US Government slows its borrowing in any meaningful manner ahead? US non-financial sector debt relative to GDP remains at an all time high. Any contraction in this key relationship will imply credit cycle contraction/deflation. The analysis above suggests to us that state and local governments as well as US households are in no position to or have no desire to leverage up in any meaningful manner, especially set against what we've seen in the magnitude of Government debt growth even over the last few years alone. Non-financial sector corporations will necessarily act in their own bests interests and really cannot be induced to borrow. How does the Government stop levering up and not induce a contraction in macro non-financial sector debt to GDP that really defines current the macro credit cycle of the moment? Up to this point in the current cycle as per the message of historical non-financial sector debt to GDP, the Government has done a masterful job of maintaining macro credit cycle stability. Could all of this change dead ahead? You better believe it could. In like manner, the Fed and Federal Government may quickly come to find out the ramifications of a potential decline in non-financial sector debt to GDP in the latter half of this year. QE3, more government borrowing to come? What would all of this mean for the already sick US dollar, precious metals, commodity prices, etc? This is all part of the greater equation. We suggest to you that this set of dynamics will be critical over the remainder of this year and into next. Bernanke's worst nightmare must be the potential for contraction in macro US non-financial sector debt relative to GDP. Ben, how ya sleepin' lately?