Near-term gloom, long-term boom

Sorry for my prolonged absence. I had some minor health issues that are now behind me, and more recently I've enjoyed a few weeks skiing at Deer Valley with my brother. What's really kept me off balance, though, is the blizzard of executive orders emanating from the Trump White House—most of them good, but some—particularly punitive tariffs—bad for growth. Trump can't change so many things without causing near-term problems, even if the long-term result is undeniably positive. So I struggle to understand how serious the negative fallout of cutbacks, firings, and tariffs will be over the near term, as compared to the hugely beneficial effects of sharply reduced tax and regulatory burdens over the long term and how both those factors will play out in the months ahead. For that matter, I doubt whether anyone has a clear view.

As we continue to try to parse the daily barrage of news, there are disturbing signs that the economy has entered a weak patch. The Atlanta Fed's GDP Now model is forecasting Q1/25 growth to be a very disappointing -2.8%, driven primarily by the assumption of an import surge driven by attempts by businesses to avoid future tariffs. The housing market is fragile and housing starts are weak because prices are high and interest rates are high, and the combination renders housing unaffordable for most. Loan delinquencies are still relatively low, but clearly rising. Business capital spending has stagnated for years, but shows some signs of life of late. Meanwhile, tariffs—which are equivalent to a tax hike, and as such will disrupt sectors of the economy to some degree—are increasingly taking center stage, enough so to keep the market and the economy off balance. Private sector jobs growth is modest, while public sector jobs growth will certainly weaken thanks to DOGE house cleaning. The dollar is quite strong, and that is keeping pressure on commodity prices. The Fed is reluctant to ease further because they feel Trump's tariffs could be inflationary, and they are unwilling to overlook the fact that the CPI is a little on the high side mainly because of the way shelter costs are measured.  

On the positive side—and this has been a big positive for a long time—liquidity conditions are healthy and credit spreads remain quite low. It's hard to overstate how important it is for financial markets to be free of the liquidity squeeze which has accompanied every Fed tightening episode prior to the current one. Banks are flush with over $3 trillion of reserves, instead of being forced to bid for scarce reserves. Credit markets are thus well-oiled and able to fulfill their role as a shock absorber for the physical economy; risk is able to be distributed from those who don't want it to those who do, and that is a big positive. Meanwhile, real interest rates on 5-yr TIPS have dropped by an impressive two-thirds of a point so far this year. This foreshadows a meaningful relaxation of monetary conditions which will help ease the pain in the housing and commodity markets—but not soon.

Stepping back from markets and the economy, I see a serious potential threat in the cryptocurrency space. Speculative fever is raging, turbo-charged by the belief that Trump will buy a mountain of bitcoin for a U.S. reserve stockpile—a move I consider foolish to the extreme. Some amazing statistics: there are over 10,000 different crypto currencies that now have a total market cap of $2.95 trillion, down some 20% from an all-time high of $3.72 trillion in mid-December. Bitcoin dominates, representing about 60% of the total.  No one has the slightest idea of the inherent or intrinsic value of crypto currencies, so their price is driven solely by speculative ebbs and flows. Did you hear about the guy who lost a hard-drive containing $775 million worth of bitcoin and has no hope of recovering it?

A series of charts follow that help illustrate some of the above points.

Chart #1

The M2 measure of the money supply is the most important financial variable that almost no one (including the Fed) pays any attention to. (I have been reporting on M2 ever since this blog started back in 2008.) By now everyone knows that the big inflation we suffered in 2021 and 2022 was caused by a $6 trillion explosion in the M2 money supply, which in turn was fueled by $6 trillion of federal stimulus checks that were effectively monetized. 

As Chart #1 shows, M2 today is only about $1.5 trillion above where it would have been if nothing extraordinary (like Covid) had happened. From 1995 through 2019 M2 grew by about 6% per year, and inflation was not a problem. M2 is now almost back on track, and inflation is no longer a problem. The Fed has tightened enough, and most of the excess money that was printed has been absorbed by the economy. This is very good news from a monetarist perspective; without excess money there can be no rise in inflation. 

Chart #2

Chart #2 tells the part of the monetary story that almost no one hears: the demand for money, expressed as the ratio of M2 to nominal GDP. When the money supply exploded in 2020 and early 2021, it wasn't inflationary because the demand for money also exploded—people let the checks sit in their bank accounts because of great uncertainty and the inability to do anything. But beginning in early 2021 the demand for money started to decline as economic life began to return to normal, and that meant the economy was suddenly holding a lot more money than desired. People began to spend that money in earnest, despite supply bottlenecks, and that quickly resulted in higher prices. Today the demand for money is almost back to where it was pre-Covid and it appears to be stabilizing, plus bottlenecks have disappeared.  

Chart #3

Chart #3 shows the trade-weighted and inflation-adjusted value of the dollar vis a vis two baskets of other currencies. By either measure, the dollar today is quite strong from an historical perspective. A strong dollar is a good thing: 1) it confirms the absence of excess money, 2) it reflects confidence in the Fed and the economy, and 3) it keeps prices of imports relatively low. From a macro perspective, a strong currency is the very antithesis of inflation. 

Chart #4

Chart #4 shows one reason the dollar is strong: real yields (the yields that really count) are relatively high. Real yields in turn are a good barometer of how tight monetary policy is. High real yields reflect tight money and they make owning the dollar attractive because they enhance the real return on holding dollars.

Chart #5

Chart #5 shows that commodity prices tend to move inversely to the value of the dollar (note that a rising blue line represents a falling dollar and that tends to correspond to rising commodity prices). In recent years that relationship has weakened, but it still looks to me like a strong dollar is exerting downward pressure on commodity prices. 

Chart #6

Chart #6 shows the real (inflation-adjusted) price of gold from 1947 (when it was about $35/oz.) through today. I've used the Consumer Price Index to calculate how much in today's dollars it would have cost to buy gold at different times in the past. Note the enormous volatility of real gold prices. From a high of over $2,500/oz in late 1980, real prices subsequently fell to a low of $470 in early 2001—a decline of over 80%. Today, real gold prices are at all-time highs.

A century ago, an ounce of gold cost a little less than $21. Since then, the gold price has risen by 13,800%, to $2,925/oz. as I write this. Over that same hundred years, the Consumer Price Index has increased by 1,755%, which means the real price of gold has increased by 670%, or about 2% per year. Yes, gold tends to hold its value over time, but sometimes it takes a lifetime for that to be true. 

Chart #7

Chart #7 compares the dollar to real gold prices. Here we see that from 1997 through late 2022 gold has shown a strong tendency to rise as real yields fall and to fall as real yields rise (note that real yields are plotted on an inverse scale), and vice versa. That makes sense because high real yields are a compelling alternative to owning gold, because TIPS not only preserve purchasing power but they also offer positive income, whereas gold only sometimes preserves its purchasing power and pays no income. But in the past several years the opposite has happened: gold has risen as real yields have risen! 

That gold, bitcoin and the dollar today are all historically strong, at a time when real yields are relatively high and the dollar is strong, demands a closer look. In theory, gold should rise in dollar terms as the value of the dollar falls, and gold should fall in dollar terms as the dollar rises. Meanwhile, the dollar tends to rise as real yields rise. 

Chart #8

Turning to the economy, Chart #8 shows two measures of the growth rate of private sector jobs. Jobs growth has weakened significantly in recent years, and is now only slightly more than 1% per year. 

Chart #9

Chart #9 compares the year over year change in the CPI to the CPI ex-shelter costs. If one agrees that shelter costs as per the government's calculation are overstated, then the CPI has been at or below the Fed's target of 2% since mid-2023.

Chart #10

Chart #10 shows the nominal and inflation-adjusted value of national home prices since 1987. Real home prices are at all-time highs by a clear margin, but they haven't increased for the past several years. 

Chart #11

Chart #11 compares 30-yr fixed mortgage rates to an index of new mortgage applications, which are a proxy for home sales. Home sales and new mortgage applications have been severely depressed for several years now, most likely because of very high mortgage rates.

Chart #12

Chart #12 combines the price of homes with the level of interest rates and average incomes to calculate how affordable homes are. Housing affordability has almost never been so low, and that explains the dearth of home sales, housing construction, and new mortgage applications (see Chart #13 below). 

Chart #13

Chart #13 compares an index of builder sentiment to the level of housing starts. Builder sentiment has been depressed for several years now, likely because of how unaffordable homes are. Until this improves, the level of housing starts is likely to remain depressed as well. That in turn will only aggravate the picture, since a dearth of new homes will tend to put upward pressure on housing prices. The solution to this must come in the form of lower interest rates and/or rising incomes and/or lower home prices.

A final thought: a reasoned calculation of the amount of federal, state, and local government fraud approaches the staggering sum of $1 trillion per year. Meanwhile, I can't pretend to know how the blizzard of activity in Washington is going to affect the economy over the next 3-6 months. We could easily see a mild recession, but would that justify a bearish investment stance? 

I remain an inveterate rational optimist: there are so many things that could be fixed for the better in this country!

Happy Hunting, Elon!

Tariff fears trump modest jobs growth

Today's December private sector jobs report beat expectations (223K vs. 140K) and that supposedly triggered a sharp, negative response from the bond market. Interest rates are now priced to only one more cut in the Federal funds rate for the rest of this year. As a result, in the past few months short-term interest rates have jumped by almost one percentage point, 10-yr Treasury yields have jumped by more than one percentage point, and 30-yr mortgage rates have risen to almost 7%. 

But the perceived health of the jobs market wasn't the only thing that rattled the bond market today. Another contributing factor was the Fed's fear (shared by the market) that Trump's threatened tariffs would boost inflation, as revealed in the minutes of the last FOMC meeting. From mid-August, when Trump's probability of winning the election bottomed, 5-yr average inflation expectations have jumped from 1.87% to 2.54%. In any event, it remains the case that inflation is not caused by a stronger jobs market or stronger economic growth: growth has soundly beat expectations in recent years even as inflation has declined significantly.

 

Whatever the cause, higher rates and higher inflation expectations effectively put the kibosh on hopes for lower mortgage rates, and thus will likely worsen the prolonged period of historically weak home sales, housing starts, and new mortgage applications which began over two years ago. Sadly, it will add insult to the injury of many thousands of displaced Los Angeles area residents seeking to rebuild or replace homes lost to multiple fires.

As I see it, the rationale for today's sharply higher rates and slumping stock market has weak underpinnings: the mistaken belief that tariffs will boost inflation and thus require tighter-than-expected Fed monetary policy. 

Chart #1

Chart #1 shows the monthly change in private sector payrolls over the past 3 years. Note how volatile this statistic is on a month-to-month basis; that anyone—especially the Fed—would use just one month's number as a basis for important long-term policy decisions strains credulity. But that's what happens every now then, with today being a prime example. 

Chart #2

Chart #2 uses a more realistic approach to interpreting the state of the jobs market, by focusing on percentage changes in jobs over 6- and 12-month periods. By either measure there has been a dramatic slowdown in jobs growth in recent years. At best, jobs currently might be growing at a 1.3% annual rate, which is marginally lower than the 1.4% annualized rate that has prevailed over the past 30 years (a period that includes three recessions). Current jobs growth is moderate at best.

Chart #3

Chart #10 shows the level of 10-yr Treasury yields, which is the benchmark for all long-term interest rates (including fixed-rate mortgages). Simply put, interest rates have exploded higher in recent years. Only abundant liquidity has kept this from tanking the markets and the economy. (For a longer explanation, see this post from last November.)

Chart #4

Chart #4 compares the level of fixed rate mortgages to an index of new mortgage applications (as opposed to mortgage refinancings). The plunge in new applications reflects a similar plunge in new home sales and housing starts. In effect, sharply higher rates have crushed the housing market. 

Chart #5

Chart #5 compares the level of real yields on 5-yr TIPS to an index of the dollar's strength vis a vis other major currencies. Rising real yields are an excellent measure of how tight monetary policy is. Not surprisingly, tight money and high real yields have significantly boosted the dollar's appeal. A strong dollar positively impacts our purchasing power while also keeping imported goods prices low; indeed, a strong dollar is an excellent defense against inflation, especially when accompanied by tight monetary policy. 

Chart #6

As I mentioned in my last post, a strong dollar puts downward pressure on commodity prices. Indeed, industrial commodity prices have declined in both real and nominal terms over the past two years, as shown in Chart #6, thanks to a strong dollar.

Monetary policy is tight and has become tighter of late, as the market and the Fed worry about the presumably inflationary impact of Trump's tariffs that have yet to be imposed. It makes much more sense to believe that Trump's promises to significantly lower tax and regulatory burdens will deliver stronger growth with low inflation.

Monetary policy trumps tariffs

There's no need to worry about Trump's threatened tariffs causing another bout of inflation. Inflation is a monetary phenomenon that can only be caused by excess money, not artificially jacked-up prices. A sound monetary policy deals with rising prices for some things by forcing the prices of other things to decline. It's like living on a fixed budget—if you have to pay more for something that means you have to pay less for others. 

This post reviews the monetary variables that matter most, and concludes that monetary policy is consistent with inflation remaining low and relatively stable; i.e., monetary policy today is sound. Indeed, we are more likely to see lower inflation than higher inflation this year.

M2 growth has normalized, and now is running at the same annual growth rate which prevailed from 1995 thru 2019 (~6% per year)—a time during which CPI inflation averaged 2.5% per year and PCE Core inflation averaged 2.0% per year (PCE Core is the inflation rate the Fed prefers to target). After surging in the wake of Covid stimulus spending and declining as the Fed raised interest rates, demand for money today is only modestly higher than it was in the pre-Covid period, Moreover, money demand appears to once again be stable. Meanwhile, the dollar remains very strong, credit spreads are low, real yields are high, the yield curve is steepening, lending is increasing at a modest pace, and liquidity conditions remain healthy. All consistent with relatively low and stable inflation.

The bad thing about Trump's threatened tariffs is that they could disrupt trade and slow global economies (including ours). If—as many of Trump's supporters suspect—tariffs are a bargaining chip and will prove only temporary at best, then markets may suffer a case of the jitters which should resolve over time. 

Chart #1

Chart #1 shows the level of the M2 money supply, which is widely considered to be the best measure of the amount of spendable money in the economy. The US money supply increased at a roughly 6% annual pace from 1995 through the end of 2019. It then surged in unprecedented fashion as the government sent "stimulus" checks totaling some $6 trillion to households and businesses in an effort to counteract the contractionary impact of Covid -related shutdowns. As stimulus checks ceased in late 2021 and Fed interest rate hikes began to bite, M2 growth not only slowed by turned negative. M2 today stands at the level it first attained 3 years ago, and it is growing at about the same rate as pre-Covid.

Chart #2

Chart #2 shows the level of US currency in circulation, which makes up just over 10% of M2. Currency is the one monetary measure whose demand always equals its supply. Why? Because anyone who finds him or herself with more currency than desired can simply deposit it in a bank account, whereupon it is subsequently extinguished by the Fed. 

What this chart tells us is that the demand for currency rose sharply as M2 surged, but then it declined, and now has returned to a level that is consistent with past experience. Today there is about the same amount of currency outstanding as there would have been if Covid had never happened.

 

Chart #3

Chart #3 is another measure of the demand for money: M2 divided by nominal GDP. By this measure, the demand for money has almost returned to where it was prior to the Covid era. This chart implies that the average person and average business holds about the same amount of spendable cash relative to income (nominal GDP is equivalent to national income) as they did prior to Covid. 

The Great National Money-Printing Nightmare is over, and we sincerely hope it never returns.

Chart #4

Chart #4 shows the 6-mo. annualized rate of growth of the PCE and PCE Core measures of inflation, both of which are within spitting distance of the Fed's 2% target. The Big Inflation of the 2020s is over.

Chart #5

Chart #5 shows the level of the 3 major components of the PCE deflator. Non-durable goods prices are unchanged since mid-2022. Durable goods prices are unchanged since the end of 2021, and have resumed their decline. Only service sector prices are increasing, and those are largely driven by faulty calculations of housing inflation. 

Chart #6

I've been showing Chart #6 ever since I can remember. That's because it shows that every recession in my lifetime has been preceded by a high level of real interest rates (blue line) and an inverted yield curve (red line). It was assumed to be an infallible indicator of a coming recession, but it didn't work over the past several years since the economy has continued to grow. The key difference this time is that the Fed has not caused a liquidity shortage like they did it past tightening episodes. 

real rates push dollar up, comms down wtip5

higher interest rates have done the trick

Chart #7

Chart #7 compares the level of real yields on 5-yr TIPS (not to be confused with the real yields in Chart #6, which are overnight, ex-post real yields) with an index of the dollar's strength against other major currencies. Over the time period shown, changes in real yields have reliably matched changes in the dollar's strength. In order to tighten monetary policy, the Fed must take actions that strengthen the demand for dollars, and the best way to do that is to increase the real yields on investments denominated in dollars. 

Chart #8

Chart #8 compares the strength of the dollar (blue line, same index as the one in Chart #7) with an index of non-energy commodity prices. (I exclude energy prices because they are orders of magnitude more volatile than other commodity prices.) Here we see a strong inverse correlation between the two, except over the past 4-5 years. Given the strength of the dollar, we would have expected to see much lower commodity prices. In my view, the current strength of the dollar is exercising a gravitational pull on commodity prices; over time this is likely to result in cheaper commodity prices.

Chart #9

Chart #9 shows the two most liquid indicators of corporate credit spreads. Spreads have rarely been lower than they are today, which is a strong vote of confidence in the health of the economy and the strength of corporate profits. No sign of an impending recession here. Instead, there is plenty of evidence that financial liquidity conditions are healthy and thus a recession is unlikely.