Consumer Crunch Update
July 1, 2006
This analysis brings our “Consumer Cash Flow,” “Real Estate and Money Supply,” and “The Interest Rate Conundrum” papers up-to-date. In simple terms, U.S. economic growth is completely dependent on consumer and government debt creation. We will track the consumer side effects and show them in the consumer accounts.
The latest 2005 economic statistics show that consumers depended on new debt for more than 90% of their cash flow during 2005. In 2006, we expect new debt to account for 95% of cash flow.
Our “Interest Rate Conundrum” paper was absolutely correct that long-term interest rates now control consumer spending instead of economic investment. In April, mortgage interest rates reached levels that should constrain household debt flows.
We also demonstrated in our March, 2006 update that consumer liquidity was falling sharply. After a brief respite at the end of March, consumer liquidity has resumed its downward trend. Liquidity has fallen to 3 weeks of funds on our preferred measure.
Finally, our “Real Estate and Money Supply” paper created a diagram showing that consumer money supply now flows backward. Historically, household incomes were sufficient to generate a cash surplus after consumption and debt service. Now, households have a large cash deficit.
The conclusion of our March, 2006 update has not changed: The key to the consumer’s future is now home resales. Since home resales peaked in the summer of 2005 and are in a downtrend, we expect a further slowing of home resales and a decline in M-2 growth consistent with our paper on “Money Supply and Real Estate.”
Our 6-step process assumes that new home construction will not slow until after home resales have entered a continuing and persistent decline. In April and May, we have seen the first evidence of new home construction weakness. This weakness could indicate that we have reached Step 5 of our economic process.
In our interpretation of this process and current monetary circumstances, the Federal Reserve MUST continue to raise short-term interest rates in order to prolong the opportunity for U.S. households to access long-term debt at high levels.
The Economic Process
In our paper, “Real Estate and Money Supply,” we outlined the economic trajectory that the U.S. economy is likely to follow. This section will describe that process and will be integrated with our updated economic analysis.
Current information indicates that we have progressed at least to Step 4 of that process. In our opinion, Step 4 is the most important piece of the process and the last point to influence the economic pain in Step 6. The process follows:
Step 1: The Federal Reserve raises interest rates and begins effecting the willingness and ability of consumers to access their back-up liquidity: home equity loans. This piece began in summer of 2004.
Step 2: Consumers allow M-1 growth to stagnate instead of accessing home equity loans to maintain liquidity. M-1 growth reached 0% in November, 2004. Since November, 2004, M-1 has barely changed.
Step 3: Liquidity becomes more dependent on mortgage refinancing. Consumers recognize that the best way to increase short-term liquidity is by controlling large purchases based upon their access to long-term financing. The sales fluctuations in the auto industry show this view to be correct.
Step 4: Existing home resales moderate as consumer liquidity remains under pressure. New home sales remain strong. Since home resales generate M-2 and new home sales deplete M-2, this step is the critical step. Home resales peaked in June through November, 2005 and have persistently been under pressure since November. The National Association of Realtors continues to trim its 2006 forecast.
Step 5: Existing home resales decline. This step should occur when long-term mortgage rates reach an unattractive level. It could cause M-2 growth to decline and exacerbate consumer liquidity considerations.
Consumption and economic activity slows with household debt generation. Household debt generation did not decline during the 1st quarter of 2006. That fact proves that we were not in Step 5 at that point. However, the continuing decline in mortgages for refinancing and home purchases may prove that the 2nd quarter of 2006 is the start of Step 5. Other information would be consistent with that interpretation.
Step 6: New home sales and remodeling decline. Household debt generation declines further. Household cash flow and incomes decline. Economic activity probably enters a recession.
Consumer Cash Flow
In our paper, “Consumer Cash Flow”, we developed a Sources and Uses of Cash Flow statement for U.S. households using the format for corporations. In that paper, we demonstrated that most new consumer cash flow now comes from new debt.
In 2005, over 90% of new consumer cash flow came from debt. In 2006, we expect debt to provide 95% of consumer cash flow. In the following table, we show the latest estimates of consumer cash flow for 2005 and our early guesstimates for 2006.
Statement of Household Cash Flow
($ Billions)
Preliminary Guesstimate
2005 2006
Net Cash provided by Operating Activities $193.4 $90.9
Net Cash used in Investing Activities $(1,405.5) $(1,317.0)
Cash Flows from Financing Activities
Repayments of Debt (501.4) (527.1)
Increases in Debt 1,710.2 1,770.4
Net Cash provided by Financing Activities $1,208.8 $1,243.3
Net Increase(Decrease) in Cash and Equivalents $(3.3) $20.2
Cash and Equivalents at beginning of period 1,372.1 1,368.8
Cash and Equivalents at end of period $1,368.8 $1,389.0
Cash Flow from Debt 1,710.2 1,770.4
Total Cash Flow(Debt + Operating Cash) 1,903.6 1,861.3
Percentage Cash Flow from Debt 90% 95%
Our guesstimates for 2006 are troubling. The consumer is increasingly dependent on high levels of debt flow. Without these high levels of debt flow, either consumption or non-savings investment activities must decline. The only alternative would be for consumers to deplete the money supply in an attempt to maintain both consumption and investment activities.
Consumer Cash Flow Model
We also developed a Consumer Cash Flow model that integrates with money supply statistics. We now expect that 2006 will be much worse than 2005. In March, we expected that $313.4 billion would be transferred from non-M-1 M-2 to support M-1 during 2006 as opposed to $303.6 billion during 2005. We now expect that about $460 billion will be transferred during 2006; or an increase of over $150 billion.
Consumer Liquidity
In this section, we will show the trend in consumer liquidity. This section utilizes our “Interest Rate Conundrum” and “Real Estate and Money Supply” papers as the basis of the analysis.
In 2005, consumer liquidity began to drop significantly. The drop in liquidity levels has continued during 2006. Money supply information shows that liquidity improved briefly at the end of March. However, tax payments during April eliminated the improvement and liquidity has resumed its downward trend.
The chart below shows a one-month forward measure based on current checkable deposits as a percentage of the annual level of consumer cash expenditures including consumer debt service. The level is adjusted for the expected monthly decline from net cash flow.
Mortgage Financing Environment
In this section, we will update our analysis of the mortgage finance environment.
The chart below shows the actual relationship between the Freddie Mac mortgage rates and the average interest rates on existing mortgages. This relationship shows that current mortgage rates are now above existing average mortgage rates.
The current mortgage environment indicates that consumer debt generation is likely to become more difficult rather than less difficult. This potential could cause large implications for consumer liquidity, consumption and investment levels.
Summary
This paper shows that consumer liquidity levels are under pressure and are declining to potentially inadequate levels. In our March, 2006 update, we stated, “If our economy enters Step 5 of the process outlined on page 2 of this paper, the possibility that consumers will ‘reduce consumption and investing to protect liquidity’ escalates.”
Based on the most recently available information, we are uncertain whether the economy has entered Step 5 of our proposed process. However, recent information removes our doubts that we have reached Step 4 of the process. In our opinion, we have clearly reached Step 4.
In our interpretation of this process, the Federal Reserve MUST continue to raise short-term interest rates in order to prolong the opportunity for U.S. households to access long-term debt at high levels. If the Federal Reserve does not raise short-term interest rates, we would expect long-term interest rates to increase and cause a significant slowdown in the accumulation of real-estate based debt. A debt slowdown would hasten a recession.
*If you want our complete analysis free of charge, please go to www.piscataquaresearch.com.
