Important charts to watch

We're in the midst of what is so far a moderate selloff in the equity market. And as usual, in such circumstances (at least in the past decade or so) there is no shortage of bad news. China is ramping up its military threat to Taiwan, Congress is struggling to pass damaging tax hikes and massive and wasteful social spending, equities have soared by almost 550% since their March '09 bottom, 10-yr Treasury yields have jumped by 30 bps in the past two months, the Fed is about to start tapering it bond purchases, Biden's popularity is plunging, and our southern border is being overrun. In the background is the growing sense that we don't know if anyone, even Biden, is in charge. That in turn contributes to a global policy vacuum which our rivals and enemies are unlikely to ignore. 

That's an uncomfortably long list of things to worry about—no wonder the stock market is uneasy. Indeed, it's a wonder it has done so well of late.

I won't pretend to be able to predict whether now is a good time to buy or not. But I can offer some charts and thoughts which are reassuring in the sense that they offset at least some of the bad news, and also because they are not being talked about much these days (the things the market is overlooking can often be very important). Meanwhile, I'm pretty sure that inflation is going to be a lot higher for longer than the Fed currently predicts, and the eventual realization that we have an inflation problem (sometime next year?) will pose a threat to the economy because it eventually will lead to some serious Fed tightening. That just so happens to be the scenario that has preceded every recession in my lifetime save the last one (which was entirely the fault of Covid and politicians' overreactions to it). 

Chart #1

Chart #1 shows the level of M2 less currency in circulation. It's the total of all the retail bank savings deposits and checking accounts, plus a small amount of retail money market funds. This is money that the public has socked away, and it is money that is easily spendable. What we see here is a shocking and totally unprecedented increase in the money supply immediately following the Covid lockdowns. The amount of spendable money in the economy is almost $4 trillion higher than it would have been had the money supply grown at its long-term rate of about 6% a year. Notably, the Fed's three waves of Quantitative Easing in the 2009-2018 period hardly register on this chart. It's remarkable indeed that this explosion of money (a REAL BIG quantitative easing!) is hardly mentioned in the press these days.

It's hard to see the economy stumbling when liquidity is super-abundant and borrowing costs are incredibly low. It will take a looonnng time for those conditions to reverse.

Chart #2

I didn't just make up the 6% growth rate shown in Chart #1. Chart #2 shows the same 6% growth rate trend going all the way back to 1995. For the past year, M2 has grown by about 12%, and the annualized growth rate of M2 over the past three months has been about 12% as well. Money continues to grow about twice as fast as it ever has before! It's hard to imagine, given this explosion of money, that the inflation we've seen so far this year is going to prove transitory. This is a big deal that is not getting much news. For more color on how inflationary psychology works, see my post from last June on my experiences with inflation in Argentina.

Chart #3

Chart #3 is one of my all-time favorites, since it makes clear that every recession in modern times (except for the last one) has been preceded by a prolonged period of Fed tightening. The blue line is the real Fed funds rate (the Fed's policy target minus the year over year change in the Core PCE deflator). Note that it rises to at least 3-4% just prior to every recession but the last one. This is the best measure of how "tight" Fed policy is, because high real interest rates equate to very expensive borrowing costs; the Fed raises this rate in order to discourage banks from lending and to discourage the public from borrowing—this results in a shortage of liquidity and that in turn puts downward pressure on inflation. The red line is the slope of the Treasury yield curve from 1 year to 10 years. Note that it falls to zero or less just prior to every recession. A flat to negatively-sloped yield curve is the bond market's way of saying that Fed policy is so tight that it threatens the economy; that will eventually force the Fed to ease in the future—thus making long term interest rates lower than short-term rates.

In the meantime, even if the Fed finishes its tapering and starts raising its target funds rate well before anyone currently expects them to, they will still have to counteract the super-abundance of bank reserves. In the past, Fed tightening meant a shortage of bank reserves and a general lack of liquidity–conditions that proved lethal to over-extended borrowers. It would take extraordinary measures and a lot of time for those conditions to return in the future. So the threat to the economy of Fed tightening today is not nearly as imminent as one might think based on past experience. 

Chart #4

Chart #4 compares the price of gold (blue) to the 3-yr forward yield on eurodollar futures contracts. This latter is a good proxy for what the market expects the Fed's target overnight rate to be 3 years in the future. There is a strong inverse correlation between the two (I've plotted the eurodollar yield in inverted fashion). When the Fed is expected to ease in the future, gold prices tend to rise. Today, the market is pricing in future Fed tightening, and gold is declining. Gold today is not reacting to rising inflation; on the contrary, it is reacting to the expectation that the Fed will eventually have to tighten policy in order to rein in inflation. Flat to falling gold prices today suggest the gold market is pricing in a future of Fed tightening and an eventual return to lower inflation. 

Chart #5

Chart #5 shows the inflation-adjusted price of crude oil futures contracts. This price has averaged about $55/barrel for the past 47 years. Today, crude is trading just under $70/barrel. The big jump in crude prices in the early 1970s was triggered by Nixon's decision to take the dollar off the gold standard. Both gold and crude prices (and nearly all other prices) rose following this effective devaluation of the dollar. 

Chart #6

Chart #6 shows the ratio of gold prices to oil prices. This ratio has averaged about 20 (i.e., one ounce of gold tends to be worth 20 barrels of oil. Today the ratio is in the mid-20s, which suggests that oil is somewhat cheap relative to gold. In any event, gold and oil prices seem to be in rough equilibrium these days, and neither one is out of line with historical experience.

Chart #7

Chart #7 shows the level of capital goods orders in both nominal and real terms. Capital goods orders are a good proxy for corporate America's confidence in the future: more orders mean greater productivity for workers in the future. Business investment hasn't been this strong for many years (but it was even stronger in the late 1990s). Strong business investment today suggests a stronger economy in the years ahead. This is a very optimistic sign, and good evidence that we are not facing a future of stagnant economic growth. We may have a lot of inflation, but the economy is still likely to grow. High inflation is eventually destructive of an economy's growth potential, but that might take years to play out. In short: in may be premature to worry about "stagflation."

Chart #8

Chart #8 is very important, since it shows how inflation expectations are built into bond prices. The green line is the difference between the yield on nominal and real 5-yr Treasury notes, and thus it is the market's explicit expectation of what consumer price inflation will average over the next 5 years (currently 2.7%). That's near the high end of historical experience, which tells us that the bond market is only just beginning to believe that the Fed is wrong to predict that the current spurt of inflation will prove transitory. It also tells us that if future inflation expectations rise to the 4-5% level that exists currently, the bond market will have an awful lot of painful adjustment to endure (e.g., nominal yields will have to rise significantly and/or real yields will have to hold steady or fall). 

Chart #9

Chart #9 compares the level of housing starts (blue) with an index of home builders' sentiment. Sentiment tends to lead starts, not surprisingly, so the current level of sentiment points to continued strength in the housing market. One reason home prices have been so strong of late is that the nation has acquired a meaningful housing deficit after the collapse of new home building which began in 2006. It could take years to make up for this. The major risk facing the housing market today is rising mortgage rates, which are currently still incredibly low (~3% for 30-yr fixed rate mortgages). Borrowers may well be intimidated by soaring home prices, but the prospect of borrowing cheap money in a rising inflation environment is very appealing. What we are seeing today (rising housing prices and cheap borrowing costs coupled with rising inflation) is a virtual replay of what happened in the 1970s. Recall that mortgage rates eventually topped out at double-digit levels in the early 1980s. 

And by the way, it took the Fed quite a few years to break the back of double-digit inflation back in the early 1980s.