Does The Increase In The Yotai Gap Again Presage A Stock Market Sell-Off?

Includes: IWM, SPY
by: DoctoRx

Is the SPDR S&P 500 ETF (NYSEARCA:SPY) going to reprise its Summer 2011 drop, following Bloomberg's recent report of an increasing yotai gap in the U.S. banking system?

What, you ask, is a yotai gap, and what does it have to do with financial markets?

To explain, let's go back to June 26, 2011, when I posted "Yotai Gap to Provide Fuel to the Treasury Bond Bull?" Some excerpts follow. First, a quote from the source article at on which I relied (emphasis added):

Japan's biggest bond investors see increasing parallels between the nation's government debt market and Treasuries, indicating that historically low yields in the U.S. have room to fall.

Just as in Japan, deposits at U.S. banks exceed loans, reaching a record $1.45 trillion last month, Federal Reserve data show. As recently as 2008, there were more loans than deposits. The gap is also at an all-time high in Japan, where banks use the money to buy bonds, helping keep yields the lowest in the world even though the country has more debt outstanding than America and a lower credit rating . . .

Loans dropped and savings rose in Japan, too. Lending has declined 27 percent from the peak in March 1996, while bank holdings of government debt surged more than fivefold to a record 158.8 trillion yen ($1.98 trillion) in April, according to the Bank of Japan. The difference in deposits and loans, known domestically as the yotai gap, is 165 trillion yen, or more than Spain's annual economic output.

I commented in my June 2011 post thusly:

In other words, if economic activity is decelerating in a world in which "excess" capital is created by the banking system (led by the conductor of the symphony, aka the central bank), then all this capital (which, again, has been created in greater quantity than the available goods and services that can be provided) has to bid some asset(s) up in price and can bid up Treasuries simply because they appear, for the moment, "less bad" than alternatives. Better to lose a bit (one hopes it's only a bit) to price inflation in a Treasury than lose a quick 20-50% to a stock market crash.

And indeed, within 6 weeks, the Russell 2000 fell 25% and prices of Treasuries indeed soared. Economic activity downshifted, wrong-footing almost every mainstream economist.

To sum up, the failure of "Recovery Summer" in 2010 to meet expectations necessitated QE 2. By June 2011, it had become clear to me that the economy still had not healed. The massive weakness of the economy in 2008-9 traditionally would have been followed by an economic explosion. But despite all the commodity speculation that accompanied QE 2, the real economy still stank. The Bloomberg data on the yotai gap was, for me, the "tell" that I was more on target than the mainstream economists, almost all of whom were still expecting a "normal" recovery. Sometimes the blogosphere gets it right; that was one of those times.

This may be the case again, based on the latest data.

Going back to the recent Bloomberg article linked to in the lede:

JPMorgan Leads U.S. Banks Lending Least Deposits in 5 Years

The average loan-to-deposit ratio for the top eight commercial banks fell to 84 percent in the fourth quarter from 87 percent a year earlier and 101 percent in 2007, according to data compiled by Credit Suisse Group AG. Lending as a proportion of deposits dropped at five of the banks and was unchanged at two, the data show...

For small businesses, the economy isn't improving enough to justify the risk, said William Dunkelberg, chief economist for the Washington-based National Federation of Independent Business. Those that do want to borrow aren't always credit- worthy, said Bob Seiwert, vice president at the American Bankers Association, a trade group based in Washington.

"Bankers out there are drowning in liquidity -- we're dying to make loans," Seiwert said. The challenge is to find qualified borrowers, "and in this economy, there just aren't that many," he said.

The share of small firms turned down by lenders in the fourth quarter rose to 22 percent at the end of 2012 from 10 percent in the same period in 2011, according to Minneapolis- based Barlow Research Associates Inc. Among midsized firms, 9 percent were denied credit, triple the level in 2011.

The biggest U.S. banks including JPMorgan Chase & Co. and Citigroup Inc. are lending the smallest portion of their deposits in five years as cash floods in from savers and a slow economy damps demand from borrowers.

Bloomberg is reporting that the yotai gap is at a record, though they ignore the term. This might imply that the slow-growth U.S. economy might have slowed further. Here are some thoughts on why.

Note please that I am not a banking specialist.

Let's start with this one: How could small firms be so very much worse off in 2013 than in 2011? Hasn't there been "recovery" since then? Certainly bank examiners were at their harshest in 2009 and 2010. The FDIC and the Fed have been living in the banks for several years already. By 2012-3, why aren't things visibly more "growthy" yet?

My main thought is that the "money illusion" trick has never fooled banks or their usual borrowers; but it may have been fooling the markets into lifting stock prices too far, too fast:

The Federal government's "Keynesian" policies "supported" by Federal Reserve bond-buying has put a lot of new money into the system. Even the deficit spending that has gone to people who spend and not save it all eventually has ended up in a bank account. It may be a grocery store's account, a doctor's or hospital's account, etc. But in order for a self-sustaining economic expansion to occur, as in the 1990s, that money should be re-lent. That so much of it is just sitting there, unlent, in such large proportions suggests that the deficit spending is pushing on a string. It resembles Japan's continuing period of economic stagnation. Entrepreneurs or established businesses are looking around and finding enough of most things that even at "low" borrowing costs, they are looking at the possible loss of their principal if they expand, not to mention all the time and effort to create "growth".

Stimulative (inflationary) policies can go on a long time, but they reach an intermediate-term limit when interest rates move up, as they have done for months now. That's a signal that monetary inflation has gone too far, too fast. This is when stock market selloffs often begin. The potential for crashes occurs because investors may have a Wile E. Coyote moment. They may look around and find that the growth paradigm they have bought into is not "growthy" at all, just the product of very stimulative (inflationary) fiscal and monetary policies. So they sometimes sell at the same time as they suddenly worry about the "Japanese" paradigm in which stock prices go sideways to down for decades. Out with the growth paradigm, in with the stagnation paradigm -- that's one way that discontinuous market events occur even if nothing horrible is really happening in the economy.

Let me put it one more way. In 1981, Volckerism made monetary policy strict. Congress refused to let the Reagan tax cuts take effect until 1982. So, in a recession, the net effect of governmental policy was restrictive. The country survived! What came next?

An amazing amount of potential energy was unleashed when the next year Volcker eased and the tax cuts took effect. The boom of the '80s was underway.

In contrast, current fiscal and monetary policy would appear to only have the potential to go in the opposite direction now from ease toward neutrality and even restraint. This could be the opposite of 1981.

As per this last Bloomberg report, the banks and their borrowers are looking at the economy as they find it. The numbers do not lie (though the report does not capture every bank, to be sure). It's not the Great Depression, but the continuing growth of the yotai gap -- more deposits going into banks than come out as loans-- can only be a negative sign for the current state of the economy. Yet trailing P/Es on the market have risen a lot in the past year-and-a-half.

There are of course many influences on stocks. This article is not making a prediction. But I am presenting a macro bit of data that few people think of. In the Summer of 2011, with the Federal government merely facing a demand for budgetary restraint, the growing yotai gap plus the fiscal issues (plus the U.S. credit downgrade) were associated with a sudden bear move in stocks. The can that was kicked down the road that summer and fall helped a lot to create the long, strong bull move we are seeing now. And now we are seeing the authorities deal with this same can now. Yet the banking system still has not generated growth.

This is an objective negative for the stock indices such as the SPY. It could be an even worse indicator for more domestically-oriented indices such as the Russell 2000, for which the main ETF is the iShares Russell 2000 ETF (NYSEARCA:IWM).

The increasing yotai gap suggests that the decades of stimulative Federal Reserve policy and miserable lending decisions by both banks and non-bank banks such as Countrywide have led to massive mismatches between investments in houses and commercial real estate and the real need for them. I for one would expect that one of the "tells" that the excess has really been worked off will be when the yotai gap starts shrinking as banks and their customers see profit-making opportunities and borrowing and lending accelerates upward, as the free market once again works its magic.

I don't think that time has yet been shown to be now, and thus I'm staying cautious on macroeconomically-sensitive investments.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Not investment advice.