Wednesday, April 13, 2016

More encouraging developments

Ten days ago I wrote about a few encouraging developments amidst a sea of negativity. I'm happy to report that the list of encouraging developments is expanding. At root, the good news is the growing perception that China is not collapsing and oil prices are not going to zero. In fact, China seems to be on firmer footing these days, albeit with less rapid growth, and oil prices have rebounded over 50% from their recent lows. Meanwhile, the outlook for the U.S. service sector has improved, commodity prices continue to rally, credit spreads continue to narrow, and bank lending continues to surge. First quarter GDP growth may prove to be miserably slow (Bloomberg's consensus is for 0.6% growth), but that's old news by now and is trumped by a range of market-based prices that reflect improving economic fundamentals on the margin.

China's foreign exchange reserves (the red line in the chart above) are best thought of as a measure of net capital flows, given the central bank's exchange-rate policy.  Since the central bank relies on a managed peg regime, whenever more money comes into China than leaves, the central bank must buy any net inflows, which in turn increases forex reserves; by the same logic, net capital outflows show up as declining forex reserves because the central bank must sell reserves to keep the yuan from declining. 

The fact that reserves have been relatively stable for the past two months, while the yuan has actually risen a bit suggests that the central bank has been successfully managing the changing dynamics of the Chinese economy. The market had worried about a deluge of capital outflows and a weaker yuan and a weaker economy, but those fears appear to have been largely put to rest. In other words, the much-feared panic exit from China has not materialized, and markets seem to be finding a new equilibrium.

The stabilization of the yuan (it needn't fall further if there are no net capital outflows) has, unsurprisingly, coincided with the restoration of some confidence to the Chinese equity market, which has firmed up in recent months as shown in the chart above. Investors are still smarting from the equity market collapse in June of last year (which now looks increasingly like a speculative bubble that was doomed to burst), but prices today are still 50% above the levels that prevailed prior to the yuan's devaluation and prior to the loss of forex reserves. On the margin, the outlook for Chinese growth is improving (now 6-7% a good deal less than the 10% annual average over the past two decades, but still impressive), to judge from the stabilization of reserves and the yuan, and the rising stock market.

With the dollar no longer appreciating, commodity prices have found new support. Industrial metals prices, shown in the chart above, are up over 20% in the past 3-4 months. At the very least this dispels any notion of a global economic collapse or slump, and hints instead at improvement on the margin.

Most important is the fact that oil prices are up over 50% in since mid-February, as cutbacks in oil production have restored some balance to the oil market (see chart above). For example, the number of active drilling rigs in the U.S. has plunged by a staggering 78% in the past 18 months. Meanwhile, oil consumption has undoubtedly risen in response to very low prices.

5-yr Credit Default Swap spreads have narrowed meaningfully since mid-February, as investors infer that rising commodity prices reflect an improvement in global economic fundamentals. CDS spreads are now only modestly elevated relative to prior lows. 2-yr swap spreads remain very low, and continue to suggest that liquidity conditions are excellent and systemic risk is low. In short, markets are dealing successfully with, and overcoming, the oil price and China slowdown shocks.

Spreads on high-yield energy bonds soared to almost 2000 bps in mid-February, but have since dropped back to 1200 bps. The stench of panic is rapidly dissipating.

The March ISM service sector business activity index, shown in the chart above, rebounded strongly from its February low. This is the functional equivalent of a big sigh of relief, as a much-feared deterioration failed to materialize. February's very weak reading was likely influenced by the panic that had infected some areas of the market. Confidence, in other words, is returning.

Bank lending to small and medium-sized businesses, shown in the chart above, continues to surge, rising at a 16.6% annualized pace in the past three months and 10.3% in the past year.

Not surprisingly, as the market's fears have been allayed, equity prices have risen:

We're still not out of the proverbial woods yet, to be sure. The Vix index remains somewhat elevated (14), 10-yr Treasury yields are very low (1.76%), real yields on TIPS are very low (flat to negative), and the earnings yield on stocks is still unusually high, especially relative to the yield on Treasuries (5.3% vs. 1.75%). These market-based indicators all reflect the presence of caution and concern. If markets were confident and optimistic, Treasury yields would be higher (3-4%), the earnings yield on stocks would be lower (i.e., PE ratios would be higher), and the Vix index would be 10-12.

To top it all off, we have the great uncertainty surrounding this year's presidential elections and what the result holds for the direction of fiscal policy, since that holds the key to the future health of the U.S. economy. We've been muddling along with 2 - 2 ½% growth for the past seven years, thanks mainly to the economy's inherent dynamism which has managed to overcome rising tax and regulatory burdens. The economy has a lot of untapped potential if fiscal policies were to become more growth-friendly (e.g., tax reform, lower tax rates, reduced regulatory burdens). But a replay of the faux "stimulus" policies of 2009, coupled with higher taxes (as both Democratic candidates are advocating) could deliver more years of disappointingly slow growth—or even no growth.

To judge from the degree of caution and concern still priced into the market, I think the consensus of investors is that the fiscal policy headwinds are more likely to strengthen than weaken (i.e., bad news is priced in). But if the outlook for China and the global economy continues to improve, this could go a long way towards offsetting the negatives that might surface in November. Regardless, it's hard to develop strong convictions about where policy is headed next year given all the variables still in play (e.g., a Hillary indictment, Trump vs. Cruz, who controls the Congress). I'm inclined to believe that things will improve, if only because in the past 8 years we have tried so much of what doesn't work.


Benjamin Cole said...

Great review. I for one appreciate Scott Grannis' optimistic outlook, even if I disagree on this or that.

Will the US economy grind to a standstill under the entirely boring Hillary Clinton? Possibly. She made bore us into a stupor.

But we did pretty well under her husband, and the stock market quadrupled. There was a GOP Congress.

So in this particular instance I am even more optimistic than Scott Grannis!

Alain said...

Me too I appreciate Scott's positive and data driven outlook. Must be all of the calafia beach sun.

Hans said...

On a Macro level, this nation is not preparing for the unfunded
liability crisis within the next two decades or less.

Rather than building reserves and shrinking debt, we are merely
plodding along expanding debt and wrecking what little is left
of the governmental unit balance sheet.

There are too many social trends, which unfortunately are not
represented here by either words or charts.

I am quite sure, that the declining MC is fully assured by
rising commod prices and bank loans.

There appears to be no sense of urgency by the OP and many
of his co-harts. Just like our political class and their
minions the governmental units, as that all is needed is more time
for the ship to right itself.

This is all we get from seven years of the current Fedzero
policy? Oh, perhaps a few more years should do the trick, eh?

FRB is completely lost. They have no idea what what they are
doing, other than to subsidies debtors and spenders. They have
been in bed, legs spread, for the past two administrations. There
will be no further increases this year in Fed rates and likely
none next year.

The economy and as well the markets, are being driven by the
Central bank; not only here but worldwide. If corporations committed
such grievous acts, they would be charged by Justice for violating
the RICO act.

I suspect a year or two from now, the same redundant threads will be

Look at America's past 15 years GNP growth rate and you should truly
be alarmed. The past thirty years are almost as frightful, as the
plot line declines to the right.

These are disconcerting, systemic macro trends which can not be explained away
with micro charts of economic activity.

America, has the ability to overcome these shortfalls but not in the
current atmosphere. It will require immense changes which even many
of you hear would find appalling. It will require a pol with courage
and strength to only offer the populace, blood, sweat and tears.

You can not forever move the economic clock forward endless without
repercussions. Just consult with former economic powers - to examine
how the rot started and ended.

And this is the generation in which we are entrusting America's future,
one that thinks breakfast cereal takes too much time to make!

Just as past great nations, we are declining economically, militarily and
social and morally.

Thinking Hard said...

China entering their own gold benchmark (

Scott - Any significance here to the gold or FX markets in your opinion?

Hans - The Fed will have a significant confidence issue if core inflation is over target and we are at full employment without any further rate increases. Blaming the millenials for societal problems is a red herring. The millenials did not create the problems, but they will have to solve some of them. Millenials being defined as being born between 1982-2004. What does this period coincide with? Lower interest rates and higher debt levels. Please see (

Also remember the two areas of household credit that are actually above 2007 levels, student debt and motor vehicle debt. Lazy, entitled, self-centered...or rational with the understanding we are at the ZLB with NIRP being adopted in many parts of the world and QE expanding CB balance sheets by over $10T in 8 years? Millenials missed the asset price boom brought on by the above, so anger is present, and unfortunately so is a belief in far left political ideology seen in Bernie Sanders. So, how low can we go in interest rates, how high in debt levels, how high in CB balance sheet expansion, before...rates have to materially rise? The alternative would be a major shift in politics in the U.S. which may already be underway.

Scott Grannis said...

Re California sun: Being on the beach on the West coast has many advantages, not least being insulated from the groupthink of Wall Street.

Hans said...

Thinking Hard, I was suggesting that the GenMe group will
be tomorrows leaders, whom's minds have been economically
polluted, despite their high priced diploma.

The FRB, needs to get out of the way and let the market place
decide the level of growth, interest rates, inflation, deflation
and not a group of intellectuals with their planning board and
computer models.

BUT WAIT! I now expect very, very strong growth going forward.

Johnny Bee Dawg said...

Our Junior Senator from Canada, Ted Cruz, was on CNBC live this morning. He ranted that the Fed has been "printing money" and "artificially propping up the stock market for rich people". Ted said its all a bubble that's getting ready for an enormous crash. Nobody running for President has a clue how the Fed works.

Scott Grannis said...

JBD: Indeed, economic ignorance is a major problem, especially when it comes to the Fed. Donald Trump is one of the worst offenders, but most politicians seem to = find it easy to seize on mistaken notions of how things work in order to buy votes.

Johnny Bee Dawg said...

I agree Trump has no clue on much of it. But he aint alone.
Only consolation for me is that I think there is very little that they can actually DO about most of the stuff they rant about.

Scott Grannis said...

I would tend to agree, but then you have California. No sooner had the Gov and the legislature passed the $!5 minimum wage, they began handing out exemptions to labor unions. The min wage and the bullet train are mistakes of epic proportions, not to mention the mismanagement of our water resources. La La Land

Hans said...

For those whom opine the reducing of Defense of America
please read this link.

Hans said...

"Nobody running for President has a clue how the Fed works."

Well, some of them may wonder how the FRB can purchase hundreds
of billion in MBS, bonds and notes by simply extending unusable

Go to the FRB's website, they are less than transparent.

And here some opinion about the real intent of QE and Twist.

"A large portion of these QE purchases, however, removed some of the riskiest assets—Fannie’s and Freddie’s debt and MBS—from commercial banks’ balance sheets. This fact has led some to argue that the Fed designed the QE programs as a way to bail out banks, not merely as a new form of expansionary monetary policy.[10] Regardless of the true intent, the QE programs have been so controversial because they effectively exchanged cash—created out of thin air—for bank assets that had dramatically declined in value. From the perspective of banks, the QEs could be judged a success because the purchases strengthened their financial position.

Controversy arises because those assets—including the MBS frequently referred to as “toxic” assets—have not simply disappeared. As seen on Chart 1, these assets are now on the Federal Reserve’s balance sheet. Put differently, the Fed now holds trillions of dollars in debt of two insolvent companies as well as the same securities that led to the 2008 financial crisis.

The solvency of any commercial bank holding these assets would be in doubt, and most of these purchases came after the Fed allocated credit directly to struggling financial firms.[11] Combined, these policies cast doubt on the financial health of the Fed as well as on the validity of the Fed’s function as lender of last resort. Consequently, many people have started asking what Federal Reserve insolvency would look like. The answer to this question is complicated, though, because a central bank is quite different from a commercial bank."

If these assets go bad, how would the FRB balance it's sheet?

They have little options other than the proverbial "print money."

Yes, Mr Bee, the FRB has already freely admitted to manipulating the stock and bond

And why are they afraid of a Public Audit? It is certainly not in the name
of transparency.

If Cruz is elected, I foresee a rapid succession of rate increase the following
year. (two or more)

The Chairwomen stopped the rate increases because Wall & Board where on
a very serious decline.

It is the only achievement of Barrocko and the FRB; everything else is a house
of cards.

Hans said...

Upon signing the min/max wage bill, Gov Brown stated "I know this is
economically wrong, but right morally, socially and politically."

Let optimism reign, as the Socshevikes are destroying 1/7 of the
US economy.

I believe the long term plan is to sell California back to Old Mexico.

Hans said...

If the pols know nothing about the "fed"
then what does the "fed" know about policy
and economic matters?

And of the two, which are by far worse?

Thanks to the brilliant FRB, there are ten of thousand ghoul
companies which continue to operate sucking up precious capital
at the expense of more efficient and profitable firms.

How accountable is the FRB? Apparently, like so many other .gov
above reproach or any consequences.

Long live the Reserve! BTW, are they are required to file a 990?

Scott Grannis said...

The Fed holds about $30 billion of Agency (Freddie and Fannie) debt, about $1.75 trillion of MBS (mortgage-backed securities) and $2.44 trillion of Treasury notes and bonds. No one currently doubts the solvency of the Fed. It is highly unlikely that the MBS the Fed holds are at risk of default.

Benjamin Cole said...

Scott-- the biggest impediment to business development in California is property zoning. What the state actually needs to go to free markets in property development. No zoning.

Can you imagine the development boom that would happen on coastal Orange County if builders were allowed to serve the market?

You would have a forest of 50-story condo towers and jobs for everyone.

Hans said...

The Shanghai Conspiracy or simply a Gee 20 meeting? You make the call.

Ben Jamin, it is the reason of one of America's largest home
builder left the San Francisco market. A build broad there read,
homes starting at $1,000,000! The two class structure is already
dominate and continues to grow.

Mr Grannis, how do toxic mortgagees return back to desired
notes? If the FRB has this magic touch, perhaps Broke-a Rico
could sell them all of their deficient debt.

Then there are hundreds of billion in commercial bonds rated
junk - just waiting for the next recession with the default
judgement coming. Since most of these are not from the financial
industry, there will no gleeful rescue from America's number one financial

You know, FRS, known to many as Forced Reduced Sale. Wall and Broad and as
well the entire banking system known, that the FRB is there at their beck-
oning, strings attached of course.

Benjamin Cole said...


Property zoning has become a disgrace. Property owners know that by downzoning they increase scarcity and the value of their properties.

Same old story: everyone loves free enterprise and free markets - - - for somebody else.

Johnny Bee Dawg said...

I don't think unions would even exist anymore without government support. The GM bailout paid about a third of those tax dollars directly into corrupt Union coffers, even as their membership plummeted, and their funds were "mismanaged" (stolen). Lots of states still allow forced withdrawals from paychecks, against the will of employees. Scalia's untimely death allowed the most recent case to uphold this practice. Darn the luck. Many companies are forced into destructive union contracts by government...and many contract rates are tied to the Federal Minimum wage. Just like with ObamaCare, if you have enough influence with the politicians you can be exempt from the most onerous rules. That keeps the political contributions and the quarter-million dollar speaking fees flowing! (Who'd a thunk it....risk aversion!) Labor unions are little more than a money laundering scheme for Democrat political contributions.

I like the idea of states competing and experimenting with policy. It helps capital and labor find its own level, like water flowing. California offers the highest payouts and grocery allowances in the nation for welfare recipients...especially if they have a few babies. Low skilled after-tax paychecks there can't compete with sitting at home producing Democrat voters. I personally know a young slacker woman who moved to California for that very reason. Open border welfare state, doncha know. 3 kids there will give her far more benefits than she could ever earn in a job. Meanwhile, businesses are moving out if they can. And USDA has been running radio ads in Mexico since the Bush administration advertising that illegals can have babies here and get them US food stamps without jeopardizing deportation. Come on in!! ALL of you! There's free school and healthcare for your anchor babies, too!

Cheap labor for the corporations, while the taxpayer suckers pick up the tab for their living expenses. Pretty sweet deal for big political contributors of both Parties. No wonder that wall that was voted into Law never got built.

I'm ready to give Trump a try for a bit. Bust up some power structures. Let the pendulum have a chance to swing. The regular political mechanisms have stopped protecting We The People. Too many snakes. No wonder they have paid protestors disrupting his rallies for TV cameras. He's a real existential threat to these power structures, and political cash flows. Jefferson said we need a little revolution every few years to preserve Liberty. I'm ready.

Hans said...

Ben Jamin, it is the Socshevik model which despite it's
claims bring about scarcity rather than bounty.

It is there for all whom wish to seek the truth rather
than an ideology.

No one more facilitates the process of turning lead
into gold than governmental units.

The beauty of the event you describes, is the fact that
this allows them to create or expand programs to address the problems
that they themselves created.

Failures begets failures, an endless cycle until all the
assets have been destroyed. When the host is no longer hosting,
simply take fight and find a new vic.

What you describe, Ben Jamin, is not free enterprise but rather
crony corporationalism.(please right click & add to your dictionary)

As I have stated before, my belief in the circle of inclusion which
applies to all economic activities. This model expands and contracts
based on free market principals - of which few exist. This
component does have subsets depending on markets, of which redistribution
activities (governmental units) would represent it's base.(non-productive)

Much to my surprise, Massachusetts through the use of public referendum
has restored some it's economic competitiveness by banning statewide rent control
and reducing business taxes by nearly one half.

The Empire state on the other hand, despite a multi-media blitz (millions of dollars)
offering large and extended tax breaks to newly incorporated business, still
ranks in the top five for taxation.

The state of New York should re-brand itself as the Medicaid state, as one out
of four inhabitant are enrollees.

Johnny Bee Dawg said...


IMO, the Fed exists to protect the banking system. That's why it was really created. No one should be surprised when they act on behalf of banks. That's what they are here for, ultimately. I don't consider actions they do on behalf of banking as controversial or surprising. They should be expected. They are a private banking cartel with private shareholders, (paying them a 6% dividend), but intertwined inextricably with the government. So our banking system is, for the last 100 years, not really private, but not really public, either. (Only halfway to the Communist Manifesto's dictum of credit being controlled by the government!!)

The Fed is not the government, and doesn't "print money". They monitor economic conditions and make certain conditions for lending easier or harder. The lending done out there in the so-called Private Marketplace is then what "prints" the money. Money isn't "created out of thin air" until a loan is actually made in the private sector. The Fed can't make anybody go out and borrow, nor can they make anybody lend. Yet! (Although, I guess if government has now been empowered to force every person to buy a health insurance policy, it's not a stretch to think that it could one day force every person to take out a loan...for the public good, of course! I'm only half-joking.)

The government itself obviously caused too many of those loans to be made with numerous regulations, laws and threats to bank market shares. But those loans didn't cause the 2008 meltdown, IMO. After all, we've dealt with that before. The actual meltdown was caused by the abrupt change in mark-to-market accounting rules that changed how those loans must be treated by every financial institution that owned, bought or sold them. The rule change itself in Nov 2007 (the first of its kind since 1938) made them impossible to hold while maintaining required liquidity ratios, and caused a death spiral of forced selling that was never going to end until it was all wiped away. The crisis ended once the rule was essentially changed back in March 2009. Financial crisis over.

The real controversy is not how the Fed responded....but why the change was made, who was behind it, and why.

marcusbalbus said...

i demand more QE

William McKibbin said...

Industrial production declines over past seven months indicate that US economy is in recession -- chart at:

Hans said...

JBD, a very informative post. The one and only legitimate purpose
of the FRB should be to provide liquidity for the financial sector.

If the FRB is not printing money, which BTW the Bank of England did
in their QEs, many of us dolts wonder how it can acquire trillions of
assets, many of them toxic and compensate the exchangee.

If these institutions ever had to use all of their reserves, the FRB
would be in a pickle. This is the only agency which can purchase assets
with a electronic promise to pay.

This select group of people, wheeled too much power, to an industry which
health and welfare falls onto the taxpayer.

Furthermore, their policy since 2000 has been a disaster, reflected in the
growth rate, and few have even bother to call them accountable.

Johnny Bee Dawg said...

I blame bad government policies for the low growth rates and massive risk aversion more than the accommodative Fed.

Hans said...

JBD, no one should be foolish
not to finger the FRB for misallocation of capital and investments. I for one
would shoutout, that the FRB has over stayed it's welcome and it's mission
statement. With the exception of a few, CONgress is paralyzed and inept accepting
the status que and hoping for the best. (time for the Free Ranging Congressperson Act

The only investors whom are risk averse are those in cash. Investors today, whom
seek a "nominal" return are at a historcal, systemic ricks of large drawdowns. This is
solely due to FedZero and nothing else.

The governmental unit and it's proxy the FRB, with zero interest rates and
deficit spending, are impacting today's and future economic growth in a
vain effort to avoid a recession.

The two in concert, are damaging the health and welfare of the American
economy with little opposition from either the taxpayers nor non-taxpayers.
All four parties, including the pols are praying that the ship will right
itself and that the economy returns to it norm.

It shall not happen - short of historcal changes. With the decline of social
and moral values, few will care about debt, inverted interest rates, king dollar,
and governmental unit spending.

As long as the cause and effect serves their own special needs, principals and
right and wong are not germane; for too many of us live for today and care little
about the past and future.

The liabilities keep growing and growing and one day the repercussions will be
felt by all.

Maybe it will be the generation of blood, sweat and tears, which will save
this republic from itself.

Mr Dog, you are a wise man for your age; unfortunately there are not enough of
you. The Gen AARP, those with a clear, mature conscience, would underscore the
devolution of the American fabric.

Benjamin Cole said...

So the Doha Dud results in lower oil prices...and thst is bad.


Johnny Bee Dawg said...
This comment has been removed by the author.
Johnny Bee Dawg said...

S&P 500 total return (including dividends) made an all time high today.

But Janet has the Gold Miners Index up another 5.75% today. Up 71% year to date.

Poor little Russell 2000 index is still down 12%. Not all stocks like the Fed as much as energy, gold and Caterpillar and 3M.

Scott Grannis said...

JBD: don't forget emerging markets. Brazil stocks up 24% year to date (in dollar terms). Peru stocks +54%. This is looking like a reflation trade (i.e., Fed is going to be too easy for too long) at least in part.

Benjamin Cole said...

Scott--I dunno. Explain the reflation trade to the 10-year Treasuries...beyond that, there are other central banks in the world.

Johnny Bee Dawg said...

I agree theres a reflation trade. Or at least an EM rescue trade.
CAT has missed all their numbers, but is the best performer in the Dow ytd, up 16%. Heck, lowly FCX is up 62%. Miners are screaming.
Market worries inflation coming.

Then there's a group that's not necessarily screaming inflation, but is not looking for a boost from Janet, yet:
Goldman, BofA, Wells, Citi are all still down over 10% each, YTD, despite recent bounces.

Then another group that sees low rates forever, but with seemingly NO inflation fears:
Dow Utility index up 15% ytd, excluding dividend.
Long treasury up 10% ytd, total return.
Zeros up nearly 15% Ytd.

Interesting to see long treasuries working so huge during a reflation trade.
It's like markets see inflation, but don't think the Fed has any intention of raising rates to deal with it.
Are markets voting that the Fed is inept?

Scott Grannis said...

I've always thought that a true reflation trade would be driven by monetary policy that is too easy. One sign of easy money is low or negative real interest rates, which we have today. Another sign would be a weak dollar, but it's not very weak--still trading around its long-term average. Another sign would be rising gold prices, which we have today, though gold is still quite a bit below its high of a few years ago. Interest rates tend to lag changes in inflation: falling more slowly than falling inflation, and rising more slowly than rising inflation. Calling a reflation is no slam dunk yet. Bonds are still priced to very low expected inflation extending for many years in the future. The bond market can be wrong, but it's risky to bet against it.

honestcreditguy said...

Easy money equals poor risk modeling

Tiered credit scenarios are so out of whack to risk that you could drive trucks thru it....

Auto production is rolling over and that has carried the manufacturing market for 5 years...

Inventory is higher than 2009....Fed and G20 induced hopium and dollar down is just another of the latest games in play by the evil Central bankers....

Hans said...
This comment has been removed by the author.
Hans said...

Well put, Credit Guy!

Hear are a series of charts, from FRED the FED, which should
not be ignored. Please be advised, these charts come from a
governmental unit and should be observed with extreme caution.

Another note, the CDW market has shrunk from a peak of 58 trillion
by 2/3. Apparently, investors are choosing the option markets instead.

Benjamin Cole said...

Scott: Milton Friedman said low interest rates are a sign that money has been tight and is expected to remain tight.

A central bank doesn't get to sub 2% 10-year Treasury yields by throwing money around.

We have been hearing now for 8 years that the Fed is wide-open crazy hyper-accommodative Grand Canyon-wide easy.

After this orgy of monetary licentiousness, we see 10-year treasury yields at ...1.72%.

You know... does the "Fed is easy" story hold water?

marcusbalbus said...

i won't rest until we get more QE

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