The past year, 2018, is looking more and more likely to be the year of the peak in this last credit cycle. When I say credit cycle, I'm talking about overall credit.
Based on the senior loan officer survey, which is a quarterly survey sent to US domestic banks asking about loan demand and the degree of loan requirement standards, demand for loans is showing weakness. This weakness may well prompt the Federal Reserve to lower interest rates to help to incite more borrowing.
Lower loan demand may also foretell a slowing of the US economy and, quite possibly, a recession in the making.
It is aggregate credit that needs to grow year over year to provide the money for a growing economy.
At the end of 2018, we were up to a total debt of $72.098 trillion.
Below is a chart showing year over year % change in aggregate credit and the effective Fed Funds rate:
We always need to have credit growing if we are to have a growing economy with stable prices. In order for companies to increase sales and profits, the economy needs to introduce new money. This new money comes from new loans.
So, the Fed will set interest rates to either a higher rate to stifle loan growth due to either excessive inflation or speculation, or, when the economy slows and businesses or households are less willing to borrow, the Fed will lower rates to incite borrowing.
The red line in the chart above shows how the Fed lowers and raises interest rates relative to the rate of loan growth. Since the rate of credit growth peaked in 1986, both the rate of credit growth and the Fed Funds rate have been drifting lower and lower.
A Closer Look
The chart above goes back to 2000, and again, shows the rate of credit growth compared with the effective Fed Funds rate.
To be clear, this is net credit growth. Loans are getting paid down every year, and some loans are being defaulted on. So, credit growth is the total net credit growth.
In the 2000s, we had very high rates of credit growth, which is what helped fuel the housing bubble.
In the middle of the last great recession, the Fed lowered rates to 0% and kept them there for 7 years. This was to accommodate and incite borrowing. Aggregate net credit has grown at the slowest pace since this last recession.
In October 2015, the Fed began to raise rates and credit growth continued. With Trump getting elected President and pushing for pro-growth policies, credit continued to grow even as the Fed raised rates. Net credit growth appears to have peaked in the 2nd quarter of 2018 at 4.95%.
By the 3rd quarter, the rate of growth was down to 4.65%, and in the 4th quarter, the rate of credit growth was down to 4.33%. This decline in credit growth is probably why the Fed has paused in raising rates as high as we were expecting back in 2018. We were supposed to be at 2.90% this year, as was forecasted as early back as January of this year.
With the tax cuts in 2018, that was probably the best time to see strong demand for credit. That it peaked in the 2nd quarter of 2018 doesn't come as a surprise. I was predicting this late last year. I went as far as suggesting back in November of 2018 that inflation was heading lower and investors should look at the iShares 20+ Year Treasury Bond ETF (TLT) when it was trading at 115.14 a share. It's now over 129!
With all the stimulus and tax cuts behind us, the prospects for net credit growth gaining steam are looking slim to none.
I pay good attention to the senior loan officer survey that the Federal Reserve puts out quarterly. It gives us a heads-up on the state of loan demand and what we should expect as far as the rate of credit growth goes.
The chart above includes 3 sets of data. The first is the net percentage of banks reporting stronger demand for commercial and industrial loans from large and middle-market firms. This is the blue line, and it goes back to 1992.
The red line is the effective Fed Funds rate. This is good, because it shows us the relationship to how the Fed responds when demand for loans rises or falls. Lower loan demand is also something we'd see during a recession, so it's not surprising that the Fed cuts rates during recessions, at the time when loan demand is low.
Last is the green line, which only goes back to 2014. This is the net percentage of banks reporting stronger demand for commercial real estate loans with construction and land development purposes. As of the 2nd quarter of 2019, the net percentage of banks reporting strong demand for commercial and industrial loans was -17%. The percentage of banks reporting stronger demand for commercial real estate loans for construction purposes was even lower, at -27%.
In other words, out of 100 banks being asked if they are seeing stronger or weaker demand for commercial and industrial loans versus the previous quarter, 33 would have said stronger and 67 would have said weaker, making the net percentage -17%. For commercial real estate demand, out of every 100 banks surveyed, 23 would have said stronger demand, while 77 would have said weaker.
The very idea that we're seeing the declines in loan demand is quite telling for what the future holds for the economy and interest rates. Aggregate credit growth has already been slowing since the 2nd quarter of 2018. It is likely to have continued to slow into 2019, based on these senior loan officer surveys.
Another quarter of declining net percent of banks reporting slowing loan demand will probably prompt the Fed to lower interest rates to help incite borrowing demand.
The consequences of slower aggregate net credit growth will prove recessionary for the economy. Net credit growth is the lifeblood of the US economy. It pays for your raises at your job. It's the money that makes corporate sales and profits rise 10% from the year before. It pays for the projects and work that help keeps us employed.
Net aggregate credit growth also pays for the interest on bonds. The less net credit growth, the less interest is even available to be paid on long-term bonds.
The market is saying that credit growth is in trouble. The 10-year treasury yield has crashed since November, down almost a full percentage point.
I'm expecting the Fed to lower rates probably as soon as the summer.
A decline in net credit growth makes money more scarce, and when money is scarce, people start selling things. A stock market selloff could also be coming as concerns about net credit really start catching on.
Disclosure: I/we 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.