Monday, October 29, 2018

Still just a panic attack?

A few weeks ago I opined that the sudden equity selloff was just another panic attack, and unlikely the start of a major rout or a harbinger of another recession. It's now turned into an official correction, with the S&P 500 down 10% from last month's peak. Has anything changed to make the prognosis worse? Lots of things have changed, mainly equity valuations (which have improved significantly), but the underlying fundamentals are still healthy and therefore at odds with the market's apparent level of distress.

Nine months ago (January 26th) the market was enthusiastic: the PE ratio of the S&P 500 (using Bloomberg's measure which counts only profits from ongoing operations) was just over 23. Today, despite the fact that profits have since risen almost 16%, that same PE ratio has fallen over 20% and now stands at 18.5. That's quite remarkable, considering the market currently expects profits to grow by another 25% over the next 12 months, which would imply a forward PE ratio of a mere 14.7, significantly below the market's long-term average of just under 17 (see charts below). In short, the market has gone from enthusiastic to very worried in a relatively short time frame. To judge from these metrics, while a recession seems very unlikely in the next year, beyond that the market appears to have lost all confidence.

The causes of this dramatic turn of events are many, and I'm now going to sum them up as "global angst:" a weakening Chinese economy, budding tariff wars, concerns about Fed tightening, a fragile Eurozone, weakening emerging market economies, rising oil prices, and all coupled with the fact that we are entering the 10th year of an economic expansion (which by itself makes investors quite nervous—how much longer can the good times last?). None of these factors have appeared out of the blue however; they've all been headwinds for awhile, but it seems they have rather suddenly combined into something like a perfect storm.

Equity valuations have plunged, but it's hard to find any evidence of a sudden or imminent economic downturn. In fact, financial market and economic fundamentals remain solid: swap spreads are low (which implies low systemic risk and abundant liquidity), credit spreads are up only slightly from relatively low levels, the yield curve is still positively sloped and real yields are still relatively low (which together imply that the Fed is far from being tight), the dollar is reasonably strong, and inflation expectations are reasonably anchored. The Powell Fed has given no hint of being willing to ignore the market's sudden distress in pursuit of an aggressive tightening agenda, and I seriously doubt they would do so anytime soon.

So it seems this is still in the nature of a panic attack, and as such it should pass. But of course there are events that can pop up that are unpredictable, and investors must always shoulder the burden of the unforeseen. If you can't take that heat, you shouldn't be in the market.

Here are some updated charts which flesh out the story:

Chart #1

Chart #1 illustrates how all of the market selloffs in recent years have been accompanied by a sharp rise in "worries." For "worries" I use the Vix index divided by the 10-yr Treasury yield. The Vix index rises as fear rises, while the 10-yr Treasury yield tends to rise as confidence in the economy rises. We've seen much more serious levels of worry in recent years than we see now.

Chart #2

Chart #2 shows that swap spreads, which are a key coincident and leading indicator of financial market and economic health, remain relatively low. At 20 bps, US swap spreads are fully consistent with healthy and liquid financial markets. At the same time they tell us that systemic risk is low. Liquid financial markets are a sine qua non for a healthy economy. No problem here.

Chart #3

Chart #3 shows the level of real and nominal 5-yr Treasury yields and the difference between the two, which is the market's expected annual inflation rate over the next 5 years. Inflation expectations today are very close to the Fed's 2% target. No problem here.

Chart #4

Chart #4 compares the level of 5-yr real TIPS yields with the real Fed funds rate. This tells us that the real yield curve is positively sloped, and the market is not concerned that the Fed has tightened too much. The time to worry is when the blue line exceeds the red line, as that would be an indication that monetary policy was too tight and the Fed would likely be force to cut rates in the future. That's not the case today. At worst, the bond market is telling us that perhaps the Fed will need to move rates up more cautiously in the future. That's not a problem.

Chart #5

Chart #5 shows 5-yr Credit Default Swap Spreads. These are highly liquid and generic indicators of the market's confidence in the outlook for corporate profits. These spreads have increased only modestly despite the sharp equity selloff, which further suggests the market is still confident in the outlook for corporate profits and the health of the economy. No obvious problem here.

Chart #6

Chart #6 shows Bloomberg's measure of the S&P 500's PE ratio, which uses profits from continuing operations. Since January of this year PE ratios have plunged rom 23.3 to now 18.5 (-20%). This reflects a rather sudden loss of confidence in the long-term outlook, especially considering that profits continue to rise. Curiously, the bond market appear to be much more confident about the future than the stock market, given the low level of swap and credit spreads. This further suggests the equity market may just be in the throes of a panic attack.

Chart #7

Chart #7 compares two measures of corporate profits: after-tax corporate profits as calculated in the National Income and Product Accounts (red line), and after-tax earnings per share based on a 12-month trailing average of reported quarterly earnings. Both are at all-time highs and rising. No problems here.

Chart #8

Chart #8 shows the Fed's preferred measures of inflation, based on a broad measure of personal consumption. Both total and core inflation are very close to the Fed's 2% target. No problem here.

Chart #9

Chart #9 compares the real Fed funds rate (a good measure of how loose or tight monetary policy is) with the slope of the Treasury yield curve. Recessions have always been preceded by a substantial tightening of monetary policy and a flattening or inversion of the yield curve. We're a long way from those two conditions today.

Chart #10

China has taken a beating in recent years, and especially this year, which has seen the steepest-ever drop in the value of the yuan. This has occurred in tandem with a decline in the Chinese central bank's holdings of foreign exchange reserves, and both are symptomatic of capital flight. Capital is leaving China because investors are worried about the future of the Chinese economy. In a relative sense that's good for us, but if China were to fall off a cliff, well, that would not be good. China is the biggest concern in the world right now, but their leadership could fix that problem by simply acquiescing to Trump's (and the WTO's) demands: respect intellectual property rights, and reduce or eliminate tariffs and subsidies. In short, China's outlook would improve dramatically if they simply adopted sensible policies. How hard is that?

Chart #11

Chart #11 compares the Chinese and US stock markets. Note that both y-axes have the same ratio between top and bottom values (15x), and both use a semi-log scale. China's stock market has truly plunged since January of this year, suffering a punishing loss of almost one-third of its value. Worse still, China's stock market today is trading at close to the same level as it was over 20 years ago, whereas the US market has risen 460% over the same period. Big problem for China. Free market-style reforms could do wonders for China's wealth. What's good for China would be very good for the rest of the world.

What stands out in all of this is that equity market fears are not supported by any deterioration in the economic and financial fundamentals, at least in the U.S. economy. That could always change for the worse, but for now it's still in the realm of speculation. 

Thursday, October 18, 2018

Hope for Argentina

Four months ago I proposed "A simple fix for Argentina's peso." Late last month, after some much-needed changes in leadership, the central bank announced an agreement with the IMF in which they proposed to do exactly as I recommended: sharply curtail future money printing. In fact, the central bank vowed to deliver zero growth in the money supply over the next year. Wow. Milton Friedman would be jumping for joy.

I'm happy to report that the central bank appears to be honoring its pledge. Over the past four weeks, year over year growth in Argentina's M2 money supply has plunged from 32% to 19%, which corresponds to a 10% outright decline in M2 over a 3-week period. Not surprisingly, this impressive resolve has translated into an almost 13% gain in the peso's value vis a vis the dollar. (Boosting short-term interest rates to 73% certainly helped in this regard, by stimulating demand for pesos.)

In dollar terms, the value of the Argentine stock market has plunged 57% since its January '18 high, but it has been relatively stable for the past two months. The economy is in recession, and discontent with the Macri administration is rampant. There's no assurance things will hold together for another 11 months. How will the government borrow what is needed to fund its deficit (3-4% of GDP) if it can't ask the central bank for free money? Only time will tell. But if the central bank can maintain its resolve for a few more months, a surge of confidence could produce a wave of foreign capital inflows more than sufficient to do the job. There is hope.

Chart #1

Chart #1 shows the level of Argentina's foreign exchange reserves. They surged by almost $30 billion following the late-2015 election of President Mauricio Macri, and were further boosted by about $8 billion thanks to the successful sale of bonds earlier this year. But beginning last April, the central proceded to squander some $30 billion (including monies received as the result of an IMF loan), in a futile attempt to "defend" the peso against massive capital outflows that were sparked by a terribly foolish tax on foreign capital (see the post linked above for more detail). In reality, the central bank simply accommodated capital flight, since the supply of pesos continued to surge. (In technical terms this is called "sterilized intervention.") Very foolish.

Chart #2 

Chart #2 shows the level of Argentina's M2 money supply, which grew at a roughly 30% annual pace from early 2010 until recently. In relative terms, Argentina's money supply expanded by about 25% more every year than did our M2.

Chart #3

In theory, much more rapid growth in Argentina's money supply should have resulted in a roughly 20% annual decline in the value of the peso. Chart #3 illustrates this (green line). Note that in recent months the peso fell by much more than would be suggested by its rate of monetary expansion: this is a measure of the panic selling that typically precedes periods of consolidation. With the peso at extremely cheap levels, the market was ripe for a positive shock, which the central bank fortunately was able to deliver in the form of a "no more money printing" pledge.

Chart #4

Chart #4 shows the dollar value of Argentina's Merval (stock market), which has plunged by 57% since early this year. All the gains that accompanied the election of Macri and the subsequent massive capital inflows have been reversed. If Macri and his new central bank leadership team can stay the course, the upside potential of this struggling emerging market economy is HUGE.

Wednesday, October 10, 2018

Just another panic attack

The S&P 500 has lost about 5% since last month's record high, but it's still up about 4% year to date. It's painful, but still short of a typical correction (-10%). The culprit? News reports cite the 80 bps rise in 10-yr bond yields this year, Fed tightening, rising tariffs, and the flatter yield curve. 

I don't buy most of that. Bond yields are still unusually low, and the driver of higher yields is rising real yields, which reflect a stronger economy; why should a stronger economy be bad for stocks? The Fed hasn't even begun to tighten, since the real Fed funds rate is only slightly above zero; short-term borrowing costs are almost free. The yield curve has flattened, but it is still positively sloped; the all-important real yield curve is still nicely positive—no implied threat there. Rising tariffs are a genuine problem, to be sure, but that's still in the nature of a headwind rather than impending doom. Tariffs can be dismantled as fast as they are applied, and Trump has made good—if hardly perfect—progress bringing down tariffs with Canada, Mexico, and the Eurozone. China is the main problem, and it boils down to a big game of tariff chicken. It's in no one's interest to escalate this conflict to outright tariff wars. I remain confident that the future of global trade will be "freer and fairer." The truth about tariffs is that a) they mainly hurt the country that applies them, and b) lower tariffs are always better for all concerned. I'm not ready to bet that Trump and China will refuse to come to an agreement that would be mutually beneficial.

Right now, my best guess is that this is just another panic attack, of which we've had quite a few in recent years. They've all been resolved eventually, as the stock market manages to climb successive walls of worry. This is healthy. It wouldn't be surprising to see prices decline further, but it would be surprising if this proved to be the beginning of a major rout or recession.

Here are some up-to-date charts that focus on key indicators:

Chart #1

The Vix index is the classic measure of investor's fears; the higher it is the more it costs to buy the protection of options. I like to divide it by the 10-yr Treasury yield, since that is a proxy for the market's growth expectations; the higher the yield, the stronger the economy, and vice versa. The ratio of the two is thus a measure of how fearful and doubtful the market is about the future. It jumped today, but as Chart #1 shows, it is a minor blip from an historical perspective. Note how jumps in the Vix/10-yr ratio always coincide with big drops in equity prices.

Chart #2

Chart #2 shows 2-yr swap spreads in the US and Eurozone. Swap spreads are an absolutely key measure of market liquidity and systemic risk (the lower the better). Swap spreads also have proven to be excellent leading and coincident indicators of financial market and economic health. Conditions in the Eurozone aren't quite as good as they are here, but conditions in the US are about as good as they get. There is plenty of liquidity, which is essential to ensure orderly markets. With plentiful liquidity, the market can price in and deal with all sorts of problems. Problems arise when liquidity is scarce and markets are thus unable to perform one of their key functions, which is to distribute risk from those who don't want it to those who do. This chart is also prima facie evidence that the Fed is NOT tightening monetary policy.

Chart #3

Chart #3 compares the prices of gold and 5-yr TIPS (using the inverse of their real yield as a proxy for their price). It's remarkable that the prices of these two distinct assets should tend to move together. Both have been in a gentle downtrend for the past several years. I've interpreted that to mean that market is gradually losing the risk aversion that peaked about six years ago. Confidence is replacing risk aversion, and with rising confidence comes less demand for the safety of gold and TIPS. This is healthy.

Chart #4

Chart #4 shows a popular measure of the dollar's value against other major currencies. By this measure, the dollar has been roughly flat for almost four years. Problems usually arise when the dollar experiences big moves up or down, since that can and often does reflect big changes in monetary policy (tight money tends to strengthen the dollar, and vice versa). This is a good indicator that US monetary policy is not causing significant problems for the rest of the world.

Chart #5

Chart #5 shows the real and nominal yield on 5-yr Treasuries (blue and red lines) and the difference between the two (green line), which is the market's average expected rate of inflation over the next 5 years. Note that inflation expectations have been relatively stable around 2% for quite some time, and especially over the past several months. This means that nominal and real yields are rising and falling by about the same amount, which further means that what is driving the ups and downs in interest rates is changes in real yields. As I've noted many times before, real yields have a strong tendency to follow the real growth trend of the economy. Real and nominal yields are up because the bond market is becoming more optimistic about the health of the economy. Nothing at all wrong with that!

Chart #6

Chart #6 compares the real yield on 5-yr TIPS (inflation-protected securities) with the real Fed funds rate, which I calculate by subtracting the year over year change in the core PCE deflator from the nominal Fed funds rate. The real funds rate is the best measure of how "tight" or "easy" monetary policy is. What this chart shows us is that over the past few years the Fed has moved from being very accommodative to now roughly neutral. This is not threatening, especially considering the improving health of the economy. In truth, what would be very worrisome would be if the Fed had NOT raised rates, since that would have given us a weaker dollar and rising inflation. 

Chart #7

Chart #7 shows the evolution of the slope of the Treasury yield curve between 2 (orange) and 10 (white) years. Nominal yields are on the top portion of the chart, while the difference between the two (the slope of the curve) is shown on the bottom portion. Note that the curve has been steepening for the past two months. This is prima facie evidence that the Fed is NOT too tight. Instead, it tells us that the market is expecting the Fed to continue raising short term rates modestly. If the Fed were too tight, the curve would be inverted, and that would mean the market was expecting the Fed to have to cut rates. There's nothing scary about the current shape or slope of the yield curve.

Chart #8

Chart #8 shows Credit Default Swap Spreads for investment grade and high-yield corporate debt. These are highly liquid and reliable indicators of how concerned the market is about future corporate profits (the lower the better). While spreads have increased a bit of late, this is a mere blip from an historical perspective. Credit spreads are still relatively low, which is another sign that the market is not very worried about the health of the economy.

We likely will learn more about what sparked the current panic attack in the fullness of time. But for now, it looks to me like it's just another one of those unpredictable—and disconcerting—reversals that occur from time to time. Market are like that. Things should get back on track eventually, because there is no sign as of now of any serious deterioration in the market or economic fundamentals. 

Wednesday, October 3, 2018

Interest rates are rising because the economy is strengthening

I have been predicting higher interest rates, a stronger economy, and healthy returns in equities for a long time. For years I've gone against conventional wisdom, which typically worries that rising interest rates will choke off growth. Conventional wisdom, however, ignores an important detail: whether rising rates are the result of aggressive Fed tightening or not makes a big difference.

Today's rising rates are not being driven by the Fed, since monetary policy is still relatively neutral. To date the Fed has been following the market, moving rates higher in baby steps. The real Fed funds rate is only marginally above zero, and neither the real nor the nominal yield curve is inverted. Liquidity is still abundant, to judge by the very low level of 2-yr swap spreads. Credit risk is relatively low, to judge by credit spreads. Financial conditions are optimal. Furthermore, regulatory burdens have declined significantly, as have tax burdens. What's not to like?

The higher rates we are seeing of late are being driven not by higher inflation expectations, but by higher real yields. This is healthy. A stronger economy goes hand in hand with higher real interest rates.  A stronger economy is being built on a foundation of rising confidence and increased after-tax rewards to work and risk-taking. As I mentioned in a recent post, rising confidence is reducing the demand for money and safety, and that goes hand in hand with falling prices on safe TIPS and Treasuries and, ipso facto, higher yields.

Today's September ISM surveys of the manufacturing and service sectors were undeniably strong. These surveys reflect fairly recent activity, and the results corroborate the solid numbers we have seen in regards to small business optimism, hiring plans, and jobs growth.

Chart #1

Chart #1 shows that the ISM survey of the manufacturing sector has done a pretty good job of tracking growth in the overall economy. Current survey levels are consistent with GDP growth of at least 4-5% in the current quarter. If this sort of growth persists for a few more quarters, the US economy will have left behind the "new normal" rate of growth of 2 - 2.5% that prevailed for the first 8 years of the current business cycle expansion. A return to more normal 3% growth trend (and quite possibly higher) seems almost assured at this point.

Importantly, we are now on the cusp of having hard evidence that the Keynesian "stimulus" policies championed by Obama are inferior to the supply-side stimulus policies championed by Trump. Thanks to lower tax rates and reduced regulatory burdens, the private sector is blossoming, investing, and working harder.

Chart #2

Chart #2 shows the ISM survey of service sector business activity. It's been volatile of late, but the September released was a blockbuster. It's safe to say that business activity in the service sector (by far the largest sector of the economy, generating about 70% of total jobs) is picking up meaningfully.

Chart #3

Chart #3 shows that the hiring plans for businesses in the service sector are robust—September's number was the strongest on record.

Chart #4

Chart #4 compares the service sectors in the U.S. and the Eurozone. The Eurozone continues to lag conditions here, especially over the past year. That is likely the result of our tax cuts, strong corporate profits, a pickup in business investment, and sharply reduced regulatory burdens. In short, Trumponomics appears to be working, and in a big way. The Eurozone still suffers from "eurosclerosis."

Chart #5

Chart #5 shows how real yields on 5-yr TIPS (Treasury Inflation-Protected Securities) tend to track the growth trend of real GDP. If GDP growth reaches 4% or so on a sustained basis, this chart suggests that real yields could rise significantly from current levels. Nominal yields would not be far behind: a 2.5% real yield on 5-yr TIPS would be consistent, in a 2% inflation world, with 10-yr Treasury yields of 4-5%.  

Chart #6

Chart #6 compares the real and nominal yields on 5-yr Treasuries (blue and red lines), and the difference between the two (green line), which is the market's implied inflation expectation over the next 5 years. Inflation expectations remain anchored around 2%, which is exactly what the Fed is targeting. I worry that the Fed might be slow to raise rates in line with stronger growth expectations (which would allow inflation to pick up), but so far they seem to be doing a good job.

Chart #7

Chart #7 shows the overnight real Fed funds rate (blue) and the real yield on 5-yr TIPS. You can think of these two lines as a measure of the slope of the real yield curve from one day out to 5 years. The time to worry is when the real yield curve becomes inverted (as it did prior to the last two recessions). For now the curve is positively-sloped, and that is normal. The real Fed funds rate is an important variable to track since it is the Fed's true target, and it best reflects how tight or loose monetary policy really is. Real yields are only just beginning to rise from zero. That is consistent with the Fed's stated desire to be relatively "neutral."

Chart #8

Chart #8 compares the slope of the Treasury curve (from 1 to 10 years, shown in red) to the real Fed funds rate (blue). Recessions have always been preceded by a flat or inverted yield curve and very high real short-term yields. We're a long way from there still.

Chart #9

Chart #9 shows Bloomberg's Financial Conditions Index. By this measure financial conditions are pretty much optimal. I note that 2-yr swap spreads are only 16 bps, which means that the market's appetite for risk is strong. 5-yr Credit Default Swap Spreads are around 60 bps, which is about what you would expect in a normal, healthy economy with a supportive financial backdrop.

For the time being, higher interest rates are something to cheer, not fear. (Unless of course you are a bond investor, in which case you need to minimize your duration risk.)

Thursday, September 27, 2018

More impressive financial milestones

The Fed last week released its Q2/18 estimates for Household Net Worth and related measures of prosperity. Of note, households' leverage (liabilities as a % of total assets) fell to a 33-yr low, and households' net worth hit hit a new all-time high in nominal, real, and per capita terms. Total household net worth is now almost $107 trillion, up over 50% from pre-2008 highs, whereas liabilities are up only 7% from their Great Recession highs. Housing values have increased by about 15% since their 2006 bubble highs, but are still about 6% lower in real terms. Households have been busy deleveraging, saving, and investing, and the housing market is back on its feet and healthy. Major trends are all virtuous and consistent with past experience.

Chart #1

As Chart #1 shows, private sector (households and non-profit organizations) leverage (liabilities as a percent of total assets) has now fallen 36% from its early 2009 high, and has returned to levels last seen in early 1985, when the economy was in full bloom. Our federal government, in contrast and very unfortunately, has borrowed with abandon, raising the burden of federal debt (federal debt owed to the public, as a percent of GDP) from 37% to 83% over the same 33-year period. If our government were run with the same discipline as households have displayed, that might be termed nirvana. We're as well off as we are today despite the ministrations of our government.

Chart #2

Chart #2 summarizes the evolution of aggregate household balance sheets. Note the very modest increase in liabilities over the past decade, the gradual recovery of the real estate market, and the strong gains in financial assets, driven by increased savings and rising equity prices.

Chart #3

Chart #3 shows the long-term trend of real net worth, which has risen on average by about 3.5% per year over the past 66 years. Note that recent levels of real net worth do not appear to have diverged appreciably from this long-term trend. That wasn't the case in 2000 or 2007 however, when stocks were in what we now know was a valuation "bubble."

Chart #4

Chart #4 shows real net worth per capita. The average person in the U.S. today is worth about $327K, and that figure has been increasing by about 2.2% per year, adjusted for inflation, for the past 67 years. (Note: the difference in the trends of Chart #3 and #4, 1.3%, is the average rate of population growth over this period.)

To be sure, there are lots of mega-billionaires these days who are skewing the statistics upward, but that doesn't imply that the average person's living standards have declined. Virtually all of the wealth of the mega-rich is held in the form of equity or real property investment, and all of that is available to everyone on a daily basis. A person making an average income in the U.S. enjoys all the advantages that our nation's net worth has created. Regardless of who owns the country's wealth, everyone benefits from the infrastructure, the equipment, the computers, the offices, the homes, the factories, the research facilities, the workers, the teachers, the families, the software, and the brains that sit in homes and offices all over the country and arrange the affairs of the nation so as to produce over $20 trillion of income per year. Would the average wage-earner (or, for that matter, the average billionaire) in the U.S. enjoy the same quality of life if he or she earned the same amount while living in a poor country? I seriously doubt it.

Tuesday, September 25, 2018

An emerging and important secular trend

I've mentioned the demand for money countless times in the 10-yr history of this blog, because it's a very important macro variable. The Fed controls the supply of money, but the demand for money is a function of a variety of factors, some of which are beyond the Fed's ability to control. The secret to any central bank's ability to deliver low and stable inflation is to keep the supply and demand for money in balance. For, as Milton Friedman taught us, inflation is always and everywhere a monetary phenomenon, and inflation results from an excess of money relative to the demand for it. It's that simple. Unfortunately, you don't see many people, including the Fed, talk about this. That's one of the things this blog brings to the table.

For the first 9 of the 10 years I've been following it, the demand for money (which I define as the M2 money supply divided by nominal GDP) was in a secular uptrend: M2 growth exceeded nominal GDP growth. During this same period, inflation remained low and relatively stable. I interpreted this to mean that the world was in effect "hoarding" money, and that hoarding, in turn, was being driven by risk aversion and a general preference for caution and safety, leftovers from the monstrous shock to confidence that the Great Recession produced. Moreover, I thought the Fed was correctly responding to this money hoarding by rapidly and dramatically expanding the supply of bank reserves. You won't hear this same story from many others either.

Towards the end of the Great Recession, the Fed adopted a radically new monetary policy which they dubbed Quantitative Easing (QE). Most people erroneously believed, and still believe, that the objective of QE was to stimulate the economy by printing money and otherwise making money cheap (i.e., by keeping interest rates low). I have argued in numerous posts that this was most definitely NOT the case. The purpose of QE was to accommodate the market's seemingly-insatiable demand for risk-free, liquid assets.

Think of it this way: in the wake of the near-collapse of the global financial system, the world was desperate to acquire more T-bills, the gold standard for cash/money/safety. The demand for T-bills was so extreme that there were not enough in supply. Without enough safe liquidity to satisfy the demand for such, the financial system was in serious danger of imploding. The Fed solved this problem by buying trillions of dollars of notes and bonds and paying for them with bank reserves, which they also announced would for the first time ever begin to pay a risk-free rate of interest. Bank reserves, crucially, are not "money" that can be spent like dollars can. The banking system was happy to use strong inflows of savings deposits to invest in and hold all these new bank reserves, which had suddenly become a valuable asset, being risk-free and interest-bearing (just like T-bills). Banks were risk-averse too. In the end there was no "money-printing."

QE essentially amounted to the Fed transmogrifying notes and bonds into T-bill substitutes. And it worked. Now that the crisis of confidence has finally passed, the Fed can safely reverse the QE process, because the demand for money is declining. There is nothing mysterious or sinister about this. In fact, if the Fed does NOT reverse QE, they would run the serious risk of allowing there to be too much money relative to the demand for it, and that would lead to a destabilization/devaluation of the dollar and an unwanted rise in inflation. Especially today, when all the evidence points to rising confidence, more optimism, and more risk-taking appetite. The demand for money is declining, and that fully justifies higher interest rates and a reduction in the Fed's balance sheet. Expect interest rates to continue to rise across the yield curve.

Beginning about one year ago, the demand for money appears to have peaked, and it has since fallen by 1.9%. I take this as evidence that risk aversion and caution are giving way to risk-seeking. If I'm right, and this trend continues, this has profound implications for future economic growth and the conduct of monetary policy.

What this means in practice is that measures of "money," the classic being the M2 money supply, are likely to grow at a slower pace than nominal GDP for the foreseeable future. One dollar of money supply will be associated with an increase in total nominal output (and national income) of greater than one dollar. Put another way, a given amount of money will support a larger economy, as the velocity of money (the inverse of money demand) increases. The only way that people can reduce their holdings of money relative to other things is to spend it on something else, or invest it, such that the volume of transactions (akin to GDP) grows. Interest rates will continue to rise, and the economy will continue to grow, and inflation may rise as well, depending on how the Fed manages monetary policy. Many people will mistakenly worry that higher interest rates will kill the economy; they will be wrong, because higher interest rates will be a by-product of a stronger economy, more confidence, and more investment.

As always, here are charts that provide the evidence for my story:

Chart #1


The M2 measure of money supply is generally considered to be the best measure of "money." As Chart #1 shows, M2 consists of currency, checking accounts, bank savings deposits, and retail money market funds. The largest component by far is bank savings deposits, which grew from $4 trillion at the end of 2008 to now $9.2 trillion. This is significant, because until recently bank savings deposits paid almost nothing in the way of interest. Yet people were happy to hold them because they offered safety and liquidity. The demand for this type of money was very strong, and that is evidence of the world's strong desire for safety in the wake of the Great Recession.

Chart #2


As Chart #2 shows, the growth rate of M2 has slowed significantly in the past year or so.

Chart #3

As Chart #3 shows, the main reason for the big slowdown in M2 growth is a big slowdown in its main component, savings deposits. This, despite the fact that banks have been increasing—albeit slowly—the interest rate they pay on deposits. Conclusion: the demand for safety has declined meaningfully in the past year or so.

Chart #4


As Chart #4 shows, the growth rate of nominal GDP (shown in the blue bars) has picked up quite a bit in the past few years, even as the growth of money has declined.

Chart #5

Chart #5 is the main exhibit. This shows the ratio of M2 to nominal GDP. To understand this chart, think of M2 as a proxy for the amount of cash (or equivalents) that the average person, company, or investor wants to hold at any given time. Think of GDP as a proxy for the average person's annual income. The ratio of the two is therefore a proxy for the percentage of the average person's or corporation's annual income that is desired to be held in safe and relatively liquid form (i.e., cash or cash equivalents). In times of uncertainty, it stands to reason that most people would want to hold more of their assets in cash, and in times of optimism they would want to hold less.

I believe that, beginning one year or so ago, the dominant narrative switched from one in which people were willing to pay up for safety and liquidity (by accumulating cash) to now one in which the average person (or company, or investment manager) wants to reduce their holdings of "money" in favor of increasing their holdings of risky assets or just spending it. (Note: I have estimated the ratio for the current quarter by assuming a 6.5% annualized rate of growth for GDP and a 3.5% annualized rate of growth for M2, both in line with recent experience and other estimates.)

The demand for money was extremely strong beginning with the Great Recession (2007), and it reached an all-time high a year or so ago. If it reverts to the levels which prevailed from 1959 through 1990, there is the potential for declining money demand (and increased risk-seeking) to generate potentially an extra $4 trillion of nominal GDP as people direct a greater portion of their income to expenditures and/or investments.

Chart #6

As Chart #6 shows, consumer confidence has surged since November 2016. With increased optimism naturally comes a reduced desire to accumulate cash, and an increased desire to spend money and/or invest it. There is every reason to believe that the demand for money will continue to decline.

This all has very important implications for the Fed, because the Fed will need to take actions to offset the decline in the demand for money, or else it will risk igniting an unwanted increase in inflation. The Fed will need to raise short-term interest rates, and probably by more than the market currently expects (higher short-term rates have the effect of making savings deposits more attractive). The Fed will also need to continue to reduce the size of its balance sheet in order to reduce the supply of bank reserves as banks' demand for those reserves declines. This may cause the market consternation, but it will be exactly what is needed to ensure continued low and stable inflation and in turn a strong economy.

Wednesday, September 12, 2018

Can optimism make America great again?

It sure can't hurt. Thanks to sharply reduced tax and regulatory burdens, small business owners are more optimistic about the future than ever before. If we can make it through the current tariff wars, the US economy could experience surprisingly strong growth in the years to come.

Chart #1

Chart #1 shows how dramatically small business optimism rose in the wake of Trump's election. The index shown stood at 94.9 as of September '16. It now stands at a record-high level of 108.8. Trump gets pretty much all the credit for this, in my book.

Chart #2

Small businesses account for the great majority of jobs in the US. An index of the hiring plans of small business owners, shown in Chart #2, stood at 10 just before the November '16 elections. That has subsequently soared to a record-high 26 as of last month. New job creation is almost sure to increase as a result.

Chart #3

Not surprisingly, job openings already have increased by over 24% since October '16. I see no reason why this can't continue.

Chart #4

Since job openings now clearly exceed the number of people looking for a job (Chart #4), it is reasonable to think that companies that want and need more workers will inevitably have to entice more workers (that are currently on the sidelines, and which could conceivably total 8-9 million) to enter the workforce via better wages/salaries. What's not to like? All those new companies and expanding companies need more workers because they have, thanks to Trump, become more efficient and more productive. That alone justifies higher wages and salaries.

If Trump can turn his tariff wars (which I and others have argued are essentially negotiating tactics in the pursuit of more and freer trade) into tariff truces, then the future could hold very surprising and promising growth prospects. As I've said before, it makes little sense to bet against what could prove to be a win-win for all parties (i.e., if the threat of higher tariffs results in concessions that lead to lower tariffs, then all parties to international trade can win).


Monday, September 10, 2018

Key indicators are still healthy

This post recaps the market-based indictors that I think are very important to follow. On balance things look quite favorable. As always, all charts contain the most recent data available as of today (with a few exceptions, as noted, where I have estimated the latest datapoint).

Chart #1

I like to begin with 2-yr swap spreads (Chart #1), since they have proven to be excellent leading and coincident indicators of the health of financial markets and of generic or systemic risk (the lower the better, with 15-35 bps being a "normal" range). A more lengthy discussion of swap spreads can be found here. Currently, swap spreads are almost exactly where one would expect them to be if markets were healthy and the economy were growing comfortably. The current level of swap spreads also tells me that liquidity is abundant; i.e., the Fed has not squeezed credit conditions nor tightened enough to disturb the underlying fundamentals.

Note that swap spreads have increased meaningfully in advance of past recessions and have declined in advance of recoveries. At current levels, swaps are consistent with healthy financial markets and an improving economy.

Chart #2

Chart #2 shows the same 2-yr swap spreads over a shorter period, and it adds Eurozone swap spreads for comparison. I note that conditions in the Eurozone have not been as healthy as in the US for some time now, but conditions do appear to be improving on the margin of late. Not surprisingly, Eurozone stocks have underperformed significantly over the past decade. All eyes are thus on the US as the world's growth engine.

 Chart #3

Bloomberg publishes an index of financial conditions which incorporates a wide variety of market based indicators, shown in Chart #3. In contrast to the swap spreads chart, higher values of this index are good. Here again we see that financial conditions are healthy and have rarely been better.

Chart #4

Chart #4 shows 5-yr CDS spreads (credit default spreads). These instruments are widely utilized by institutional investors, and are considered to be a highly liquid proxy for generic credit risk. Today, CDS spreads are rather low, which is good, though they have at times been lower. As with swap spreads, these spreads tend to rise in advance of economic trouble. So far they show not sign of any threats.

Chart #5

Chart #5 shows average credit spreads for investment grade and high yield corporate bonds. They tell the same story as CDS spreads: conditions today are healthy. The bond market is not concerned about credit risk, nor is it concerned about downside risks to the economy.

Chart #6

Chart #6 is a classic, since it shows how Fed tightening has preceded every recession in the past half century. Monetary tightening shows up in different ways: 1) in the level of real short-term interest rates, over which the Fed has direct control, and 2) in the slope of the yield curve. When real short rates rise significantly and the yield curve becomes flat or inverts, a recession eventually follows. Today many worry that the yield curve is almost flat, but it's important to view this in the light of very low real short-term rates. This combination tells me that the Fed has not yet begun to tighten monetary policy. The current slope of the yield curve tells us that the market expects the Fed to raise rates gradually, and not excessively. To date, the various hikes in the Fed's target rate have served mainly to offset a gradual rise in inflation over the past year or so. At its current pace, the Fed is likely years away from becoming "tight."

Chart #7

Chart #7 compares the nominal yield on 5-yr Treasuries to the real yield on 5-yr TIPS (inflation-indexed bonds). The difference between the two is the market's expected average rate of consumer price inflation over the next 5 years. Inflation expectations are relatively stable, and at 2%, they are almost exactly what the Fed is targeting. From this we can assume the Fed is doing a reasonably good job of balancing the supply and demand for money. This should be comforting and reassuring to a market that continually frets that something might be on the verge of going wrong.

Chart #8

Chart #8 compares the real yield on 5-yr TIPS to the inflation-adjusted (real) yield on the overnight Fed funds rate. The latter is the same series shown in the blue line of Chart #6 above. The comparison of the two here is important, since the red line is effectively the market's best guess as to what the blue line will average over the next 5 years. This is thus another way of judging the slope of the yield curve. A true yield curve inversion would almost certainly find the blue line exceeding the red line, as it did prior to the past two recessions, since this implies that the market expects the Fed to ease monetary policy in the future, presumably because of deteriorating economic health. According to Chart #8, the front end of the real yield curve is steepening, not flattening, and that is good.

The market is mistakenly focusing too much attention on the nominal yield curve. The real yield curve is more important, and its current message is definitely positive.

Chart #9

Real yields are driven in large part by the Fed's actions, especially in the very front end of the yield curve. However, 5-yr real yields are also driven by the market's perception of the health of the economy. Chart #9 shows how the level of real yields tends to follow the economy's trend growth rate. Currently, real yields are rising slowly, in line with the gradual strengthening of economic growth. There is no sign here of excessive optimism. If anything, both the market and the Fed are behaving in a cautiously optimistic manner.

On balance, all of these indicators are in healthy territory. Consequently, it is reasonable to assume that the economy is going to be growing for the foreseeable future. Systemic risks are low, inflation expectations are low and stable, and liquidity is abundant. The Fed has been doing a good job, and there is no sign they are going to upset any applecart. There's not much more you could ask for at this point.

We don't live in a risk-free world, however. For now, what risks there are, are concentrated in the trade-related sectors, thanks to the tariff wars that Trump seems to relish. Trade risks are undoubtedly acting as a headwind to growth, without which the market might be getting quite enthusiastic about the future.

UPDATE (9/11/18): Chart #10, below, shows just how dramatically US stocks have outperformed their European counterparts. An investment in the S&P 500 has returned 22% more than a similar investment in the Euro Stoxx 600 since just before Trump's election.

Chart #10