Research & Commentary

Fed Concerned About Debt Deflation

In Chapter 9 of Conquer the Crash, Robert Prechter identifies the primary precondition of deflation as “a major societal buildup in the extension of credit (and its flip side, the assumption of debt).” He cites a 1957 letter from the founder of the Bank Credit Analyst and Elliott wave expert, Hamilton Bolton, who, on studying a history of major depressions in the United States from 1830 found that:

“All were set off by a deflation of excess credit. This was the one factor in common.”

Keeping a wary eye on credit conditions is therefore prudent, and this is what the Federal Reserve seeks to do through its semi-annual Monetary Policy Report, the latest one released on July 7. In that report, the Fed put some emphasis on the level of corporate debt, stating specifically,

“Debt owed by non-financial corporations remains elevated”

Although they added that non-financial corporate debt has been flat or falling in the last two years, the Fed should be worried about high levels of such debt because, in the past, it has been a precursor to economic slumps.

The black line in our chart below shows the level of US total credit to non-financial corporations as a percentage of gross domestic product (GDP) to the end of 2016. We can see that it peaked in the late 1980s, early, 2000s and 2008. The latest data point shows an all-time high of 72.3%. The red line is the debt default rate of corporations rated B by the ratings agency S&P, the rate of low-quality borrowers who fail to remain current on their loans. We can see that a relationship exists between the two series, especially since the early 1990s.

In general, as social mood waxes positive, people become less worried about who they are lending their money to, non-financial corporate debt balloons, and less creditworthy corporate borrowers find it much easier to raise capital. But as our chart shows, the accompaniment is an uptick in the rate of borrowers who end up defaulting on their obligations.

The Fed is correct in stating that, as a percentage of GDP, the level of non-financial corporate debt has stabilized so far this year, but the previous peaks coincided with the Savings & Loans Crisis of the late 1980s, the Technology, Media and Telecom (TMT) bubble of the late 1990s and the Great Financial Crisis of 2008. No wonder the Fed is worried about this metric now.

We anticipate that many more borrowers will welch on their obligations as debt starts to deflate.


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