As we have repeatedly said in the past, the quarterly Flow of Funds (or Z.1 [9]) statement is most interesting not for the already public household net worth and leverage data which serves to make pretty charts and largely irrelevant articles [10], but due to its insight into the stock and flow of both the traditional financial system but far more importantly - into shadow banking. And this is where things get hairy. Because while equities may have returned to 2008 valuations, the credit shortfall across combined US liabilities - traditional and shadow - still has a $3.6 trillion hole to plug to get to the level from March 2008 (see first chart). It is this hole that is giving equities, which have already surpassed 2008 levels, nightmares. Because while the Fed is pumping traditional commercial banks balance sheets via reserve expansion (read: fungible money that manifests itself most directly in $5 gas at the pump) resulting in a $2.3 trillion rise in traditional liabilities from Q3 2008 through Q4 2011, what it is not accounting for is the now 15 consecutive quarters of shadow banking system contraction, which peaked at $21 trillion in Q1 2008, and in Q4 2011 declined to $15.1 trillion... and dropping. It is this differential that will be the source of the needed "Outside" money, discussed yesterday [11], and that is only to get equity valuations to a fair level! But considering the Fed's propensity to print at any downtick, this is very much a given, much to the horror of Dick Fisher [12]. Any additional increase in stock prices will require not only the already priced in $3.6 trillion, but far more direct Outside money injections.
While we have explained the methodology [13]of approaching consolidated credit money in modern finance before (much more here [7]), here is a quick rerun. In the chart below, conventional wisdom only focuses on the red line, which represents traditional commercial bank liabilities (L.110, L.111, L.112 and L.113 from the Z.1 [14]), where Fed reserves and other monetary expansion mechanisms manifest themselves. As can be seen this line is rising rapidly, as is to be expected - in tune with the US deficit spending and Fed reserve growth. That both the US debt chart and the consolidated global balance sheet have now entered an exponential phase is a topic for another discussion.
What, however, is always forgotten is the blue line, which represents the liabilities in the shadow banking system - all the credit money that has been used by various unregulated institutions to perform the traditional transformations of maturity, credit and liquidity that define a "bank." And this line is for lack of a better word, collapsing. It is this collapse that the Fed has yet to tackle, and it is the offset of this collapse which the equity market has somehow already priced in!
[15]
Focusing exclusively on shadow banks, here are the 6 distinct components that make up this universe.
[16]
Why does the Fed never discuss the shadow banking "conundrum" in public? Simple. The chart below should explain it.
[17]
Finally the chart that puts it all into perspective: here is a close up of the consolidated Shadow + Traditional liability total. The delta from the prior peak is an all too real hole of $3.6 trillion (and possibly more when accounting for the factor contraction at the Prime Broker level, a topic discussed previously [18]when we spoke in length on the issue of rehypothecation). Yet it is this hole that the market is 100% certain that the Fed will plug. Because if it doesn't, watch out below.
[19]
And not only that, but since it is suddenly fashionable to sell US Treasurys, just who will step in to buy (not China) considering there is about $6 trillion in net new issuance over the next 4 years? Because if US GDP was at least rising faster than US debt one just may have made the case that there will be retained cash by various entities who can buy up US paper domestically. Alas, that is no longer feasible [20], and the only option is, you guessed it, for the buyer of last resort to step in - the @FederalReserve
[21]
In conclusion we wish to say - thank you Chairman for the firesale in physical precious metals. We, and certainly China, thank you from the bottom of our hearts.