Tuesday, June 19, 2018

The US keeps on truckin'

Truck tonnage continues to post significant gains, according to the American Trucking Association's latest release. Tonnage is up 7.8% year over year, and it is up at an annualized rate of 7.8% year to date.

Chart #1

Chart #1 is an updated version of the one in my post last month, "Truck tonnage evidence of a Trump Bump." As it suggests, there is a strong correlation between truck tonnage—a good proxy for the physical size of the economy—and equity prices.

From the ATA's latest release, including some relevant facts:
“This continues to be one of the best, if not the best, truck freight markets we have ever seen,” said ATA Chief Economist Bob Costello. “May’s increases, both sequentially and year-over-year, not only exhibit a robust freight market, but what is likely to be a very strong GDP reading for the second quarter.

Trucking serves as a barometer of the U.S. economy, representing 70.6% of tonnage carried by all modes of domestic freight transportation, including manufactured and retail goods.

For all the reported angst over Trump's escalating trade war with China, the Vix/10yr ratio has barely budged (see Chart #2), which suggests the market does not expect much if any damage to occur as a result. My own assessment is that rising tariffs are acting as a headwind to growth, but that this will not prove terribly disruptive. Without this headwind, the economy would likely be on its way to sustained growth of 4% or more; with the headwind, we're more likely to see 3-4% growth. For Trump's purposes, I believe, higher tariffs are a temporary disruptive factor that is necessary to achieve a long-term reduction in overall tariff barriers and freer overall trade. It's a risky gambit, to be sure, which could backfire if China continues to counter Trump's tariffs with more of their own. But in the end, tariffs are so universally understood to be counter-productive that I find it hard to believe the escalation won't reverse sooner or later.

Chart #2

Meanwhile, the ongoing flattening of the yield curve (see Chart #3) is not a danger signal. It's more accurate to say that it reflects the market's judgement that, if anything, tariff wars will keep the Fed from hiking rates more than just a few times over the course of the next year, because the economy is not likely to "overheat." To date, no one is suggesting the economy will prove so weak that the Fed will need to lower rates: that's what would be necessary for the curve to invert. We'd also need to see much higher swap and credit spreads, which so far remain quite low, as I noted yesterday.

Chart #3

Monday, June 18, 2018

Key credit indicators still green

A typical boom-bust cycle starts with the Fed tightening monetary policy, usually in response to rising inflation and/or an economy that seems to be "overheating," or growing too rapidly. Prior to late 2008, when the Fed began its Quantitative Easing, tighter monetary policy worked by draining liquidity (i.e., by making bank reserves scarce and thus restricting banks' ability to create new loans), which in turn led to higher real borrowing costs and a general credit squeeze. Tight credit conditions and rising borrowing costs dealt a one-two punch to leveraged borrowers, and the bond market expressed this by pushing credit spreads higher as default risk rose.

We are now 2 ½ years into a Fed rate-hiking cycle: the Fed started raising short-term rates in late 2015 from a low of 0.25% to now 2.0%. Real yields have risen from -1.5% to now about zero—still very low from an historical perspective. Not surprisingly (since there has effectively been no tightening), there are still no signs of rising systemic risk or deteriorating credit conditions. Credit spreads remain low and liquidity remains abundant. Although the Fed has been draining bank reserves, they are still magnificently abundant, totaling about $1.9 trillion. 

Bottom line: the Fed "tightening" cycle looks very different today than in the past, mainly because bank reserves are still quite plentiful and real borrowing costs are still very low. 

Chart #1

Chart #2

Swap spreads, shown in Chart #1, have traditionally been excellent coincident and leading indicators of economic and financial market health. (See my primer on swap spreads for more background.) Currently, swap spreads are generally low and fully consistent with healthy financial and economic conditions. Low swap spreads are also indicative of plentiful liquidity conditions and healthy risk appetites. Eurozone swap spreads (see Chart #2) are a bit elevated, however, suggesting that conditions in Europe are not as healthy as in the U.S. Not surprisingly, we observe that the Eurozone stock market has been underperforming the U.S. by a widening margin for the past decade. But despite their being elevated, Eurozone swap spreads are not indicating a serious credit squeeze..

Chart #3

Chart #4

Chart #3 shows the spreads on investment grade and high yield (aka "junk") corporate bonds, and Chart #4 shows the difference between these two spreads. All three measures of corporate credit risk are low by historical standards, and they appear to have been improving in recent years.

Chart #5

Chart #5 shows Credit Default Swap spreads for 5-yr investment grade and high-yield corporate bonds. Credit Default Swaps are highly liquid contracts used by institutional investors to hedge generic credit risk. Here too we see that spreads are quite low.

Chart #6

Chart #7

Chart #6 compares the yield on 5-yr A1-rated industrial bonds to the yield on 5-yr Treasury yields. Both have been rising since the Fed started raising rates. Chart #7 compares the spread on 5-yr A1 Industrials to 5-yr swap spreads. Both are relatively low despite the substantial increase in yields. Note how spreads rose in advance of prior recessions, at a time that the Fed was pushing yields higher. This is further confirmation that the Fed has not been tightening. If anything, these two charts suggest we are still in the middle of what could prove to be a very long business cycle expansion.

Chart #8

Chart #8 shows the delinquency rate on all bank loans and leases, as of March, 2018. Here we see still more confirmation that rising yields have not negatively impacted businesses. Delinquency rates have been falling for almost a decade, and continue to do so.

Chart #9

Chart #9 shows the ratio of C&I Loans (Commercial and Industrial Loans, a good proxy for bank loans to small and medium-sized businesses) to nominal GDP. Here we see little if any sign of excess, and little if any indication that businesses are being unusually starved for credit.

Taken together, these key market-based indicators of credit conditions are still flashing "green." There is no sign of rising systemic or credit risk, liquidity conditions are still plentiful, and thus the outlook for the economy is healthy.

Friday, June 15, 2018

A simple fix for Argentina's peso

Since April 25th, the day the country imposed a foolish 5% tax on non-residents' holdings of Central Bank debt, Argentina's peso has lost almost 30% of its value, falling from 20 to 28. In the past year, the peso has lost almost half its value. The tax was merely the catalyst for the peso's abrupt decline, however. The real source of its persistent weakness since 2010—when the peso was trading at a relatively stable 3.8 to the dollar—is a 30% annual increase in the supply of pesos. Until Argentina's central bank stops massively printing money, the peso will continue to decline.

Why so much money printing? Because it's an easy, sneaky way of financing the government's deficit. The Central Bank effectively allows the government to spend Monopoly money in exchange for a meaningless IOU. Whoever holds pesos suffers a loss of purchasing power on an almost daily basis. That loss of purchasing power is otherwise known as an "inflation tax." The government funds its deficit by effectively robbing holders of its currency. That hits the little guy hard, and destroys confidence in the country in the process. It's hard to make significant investments in a country with a constantly depreciating currency.

Rather than own up to its shenanigans, the central bank first tried to "defend" the peso by selling one-fifth of its foreign reserves. Then the government sought $50 billion of "help" from the IMF, which it is in turn selling to further try to defend the peso. None of this has worked, of course, because it hasn't addressed the underlying problem, which is that there are way too many pesos being created. Selling a large part of your monetary base without a corresponding decline in the money supply (there has been no decline at all in Argentina's money supply for months) only facilitates capital flight. Technically speaking, Argentina's central bank has been engaging in sterilized intervention in the currency market.

In the face of a big decline in the world's demand for pesos, the only way to support the peso's value is to make a big reduction in the supply of pesos. Until that happens the peso will continue to decline over time. Sure, at some point if the peso declines enough, it will prove an attractive bet and some foreign capital will return and the peso will stabilize for a time. But it will just be a temporary respite.

Chart #1

Chart #1 is my attempt to illustrate the fundamental problem of the Argentine peso. To begin with, the supply of pesos has been increasing by about 30% per year since 2010, while the supply of US dollars has been increasing by about 6% per year. So the supply of pesos relative to the supply of dollars has been increasing by about 24% per year. That implies that the value of the peso relative to the dollar should be declining by about 19% per year, and that is shown in the green line. (Equity investors can understand this if they consider that a two-for-one stock split—a 100% increase in the number of shares—implies a 50% reduction in the price of a stock.)

Today the government announced that Luis Caputo, a man with extensive Wall Street experience, will be the new head of the BCRA. Let's hope he understands the peso's fundamental problem and promises to sharply curtail future money printing. If he does, confidence would be immediately restored and the peso could stabilize and even firm a bit. If he doesn't, then Argentina will eventually squander the IMF's $50 billion and the country will continue to suffer.