The end of deleveraging: update

In a post three months ago, "The end of deleveraging," I noted signs that households' risk pendulum had stopped swinging in the direction of risk-aversion, and that the public was beginning to embrace risk rather than shun it. That had important implications for monetary policy, since the underlying rationale for QE, which in essence amounts to the "transmogrification" of bonds into T-bill substitutes, was to satisfy the world's seemingly unlimited demand for safe, short-term assets. If risk-aversion is on the decline and risk-taking is on the rise, there is no need for the Fed to continue QE. I think this explains why the Fed has been able to taper QE without there being any adverse effects on the economy or the markets. We don't need QE any longer, and the Fed is acting appropriately. 

The Fed has recently released pertinent data from the first quarter of this year which reinforces this view. What follows are some updated charts and commentary.

As the chart above shows, households' financial obligations (i.e., debt payments as a % of disposable income) reached a high in 2008, but have since declined significantly. Importantly, financial burdens are essentially unchanged in the past year. This means households have rebuilt their balance sheets and restructured their finances to the point where they no longer need to tighten their financial belts. Financial burdens today are as low as they have been at any time in the past three decades, and they are unlikely to decline meaningfully going forward. This is a very healthy development and it justifies the Fed's ongoing tapering of QE.

As the chart above shows, households' overall leverage (liabilities as a % of total assets) has declined significantly—by almost 30%—since hitting an all-time high in early 2009. Leverage is now back to levels that prevailed through much of the 1990s. All of the excessive speculation that helped fuel the housing boom in the 2000s has been reversed. This is also a very healthy development that is ongoing: household liabilities are no longer declining, but the value of households' financial and real estate assets are rising. This is healthy deleveraging, not risk-averse deleveraging.

As the chart above shows, as of Q1/14 the delinquency rates on consumer loans had fallen to its lowest level in decades. Consumers haven't been so careful with their finances for a very long time.

Gold prices, shown in the first of two charts above, have been relatively unchanged for the past year, even as tensions in the Mideast have risen. As the second chart shows, real yields on 5-yr TIPS have also been relatively unchanged for the past year. Both of these developments reflect a decline in risk aversion.

Capital goods orders—a proxy for business investment—were relatively flat for most of the past year, but in recent months (the most recent data, released today, cover May) have begun to rise. This is a good sign that corporations are shedding some of their risk aversion and are beginning to be more optimistic about the future.

PE ratios have been rising for several years, and are now above their long-term average, a good sign that risk-taking is beginning to come back into fashion. This is likely to continue, given all the other signs of the risk-pendulum swinging in a favorable direction, which means that there is still plenty of room on the upside for the stock market.

I should note that all of these changes are moving at a somewhat glacial pace—nothing dramatic is happening on the margin. It's all part of a slow but relatively steady improvement in the economy that is likely to persist until Congress adopts more growth-friendly policies.