Fed fever is cooling off

I'd like to think that last week's post got the ball rolling, because the impulse for the 5.6% rally in the S&P 500 over the past three days looks to be declining expectations for Fed tightening. I thought it was inevitable: a super-strong dollar, collapsing housing and commodity prices, and a huge increase in real interest rates were all but shouting at the Fed to back off and give the economy some time to digest things.

The following charts highlight three major news items revealed today:

Chart #1

As I've been noting for well over a year, Chart #1 (growth of the M2 money supply) is the most important financial news that nobody (outside of a handful of economists) has been paying any attention to. As the chart shows, there was explosive growth (completely unprecedented!) in the money supply in 2020, driven almost entirely by the monetization of Covid stimulus payments in 2020-2021. This was the proximate cause of the inflation which has wracked the country for almost two years. Fortunately, with the cessation of Covid payments in mid-2021, M2 growth cooled dramatically: M2 has not increased meaningfully for the past 9 months, and it has in fact declined at a 2.2% annualized rate over the past 6 months, as we learned from this morning's release of the September numbers. This all but guarantees a future decline in measured inflation. 

If the Fed had been paying attention to the slowdown in M2, they would have toned down their tightening 4-5 months ago. And of course, if they had been paying attention to M2 18 months ago, they would have begun raising rates long before it became painfully obvious that we had an inflation problem. 

Chart #2

Chart #2 compares the value of the dollar (white line) with the level of real interest rates on 5-yr TIPS. Long-time readers will know that 5-yr real yields are the market's expectation for what the real Fed funds rate will average over the next 5 years, and as such they are the best measure to watch for how much the Fed is expected to tighten. These two variables have been joined at the hip for at least the past year: rising real rates have tracked the increase in the dollar's value on the forex markets. Declining real yields this month have closely tracked the decline in the dollar's value. A weaker dollar has nearly everyone breathing a sigh of relief. Maybe the Fed won't have to cause a recession after all ... as I argued in a post last August.

Chart #3

The other big piece of news this morning was the sharp decline in national home prices (Chart #3 shows the 12- and 6-month rates of growth of prices). It's important to note that the August number is actually an average of prices over the 3 months ending in August, which means that prices today are almost certainly much lower than the chart suggests. This decline in prices was virtually assured, given the doubling of 30-yr mortgage rates this year and the huge decline in new mortgage originations that I highlighted last week (Chart #3 of this post). The last thing the Fed needs to do is kill the housing market yet again (remember 2008?).

The next FOMC meeting is scheduled for November 2nd, and it's going to be very important. Not too long ago the market thought a 75 bps hike in the funds rate (to 4.25%) following that meeting was virtually assured. Now it's questionable, while a 50 bps hike is beginning to look like a (remote) possibility. 

China's dismal prospects

One-man rule can never compete with a free market, and that's very evident in the plunge in the value of Chinese companies. Xi Jinping, now fully in charge of China, may think he has reached the pinnacle of power, but the market is thinking he's doomed to defeat.

These two charts say it all:

Chart #1

Chart #1 compares the MSCI China Index (priced in Hong Kong dollars) to the S&P 500 index. By these measures, Chinese equities are cheaper now than they were in 1995, while US equities have increased by 176%. (The chart starts in 1995 because that is just after China massively devalued its currency and began opening its economy to the world.)

Chart #2

Chart #2 compares the Golden Dragon Index (Chinese companies that trade in the U.S.) to the S&P 500. The recent destruction in Chinese valuations shown in this chart is more evident: the Dragon Index today is down almost 80% from it's Feb. '21 high. 

One-man rule can never compete with a free market. 

Fed's Rx for the economy should be a tincture of time

As I've argued in recent posts, there's plenty of evidence to suggest the Fed has already tightened by enough to bring inflation down: the dollar is super-strong, real yields have risen sharply, the yield curve is inverted, commodity prices are plunging, and the housing market has run into a brick wall. Yet the Fed seems determined to tighten even more. I think they're driving by looking into the rear-view mirror. They're trying to burnish their reputation as an inflation fighter, after having fallen miserably behind the inflation curve in 2020 and 2021. And I think that the long-discredited Phillips Curve (which posits that unemployment must rise if inflation is to fall) still haunts the Fed governors' minds. It's all so unfortunate.

Fortunately, however, a recession is neither imminent nor inevitable. Industrial production and jobs are still growing at decent rates, 2-yr swap spreads are still in normal territory, and real interest rates are not prohibitively high. But the economy could fall into a recession if the Fed doesn't change course (aka "pivot") before too long. There's a precedent for this—in January 2019, when the Fed realized it had become too tight and reversed course—and I don't see why they can't do it again.

Chart #1

Chart #1 shows two measures of the inflation-adjusted and trade-weighted value of the dollar. By any measure the dollar is very strong. This is fully consistent with US monetary policy being tight and much tighter than that of any other major economy. Demand for dollars is strong, and there is no shortage of reasons for why that is so: geopolitical turmoil in Europe and East Asia would surely suffice. From an economics point of view, it would be highly unusual for a very strong currency to also be experiencing inflation (otherwise known as a loss of purchasing power). Prices all over the world, when translated into dollars, are falling.

Chart #2

Chart #2 compares the inflation-adjusted value of gold (red line) to the inverted value of the dollar (blue line). Big moves in the dollar's value almost always accompany inverse moves in commodity and gold prices. What's striking about today is that gold and commodity prices have not fallen further given the strength of the dollar. Long-time readers will note that this chart, which has appeared many times in recent years, has correctly predicted falling gold prices.

Chart #3

Chart #3 compares the nationwide average rate for 30-yr mortgages (orange line) to an index of new mortgage originations (mortgages taken on to finance the purchase of a new home). Mortgage rates have doubled this year, and new mortgage originations have fallen by half. That's a huge development! In other words, soaring mortgage rates combined with very high prices have dealt a heavy blow to the housing market. This is a perfect example of how higher interest rates can change incentives and also slow the economy. People today are much less willing to borrow (which implies higher money demand) and much less willing to buy (which also implies a demand for cash rather than goods. The sharply increased demand for money is acting directly to neutralize much of the extra M2 money supply that was created a few years ago. And that, in turn, means declining inflation pressures. (Recall that M2 has been flat for the past 9 months or so.)

Chart #4

Chart #4 compares housing starts (blue line) with an index of homebuilders' sentiment. Sentiment has plunged in recent months as homebuilders have seen a sudden slowdown in home purchases. In the past, sentiment has often been a very good predictor of housing starts. We could be on the verge of seeing a big slowdown in residential construction, and that would be a surefire contributor to a recession. Chairman Powell, please take note!

Chart #5

The top portion of Chart #5 compares the average rate on 30-yr mortgages (white line) with the yield on 10-yr Treasuries (orange line). The bottom portion shows the difference between the two, which looks to average about 150 bps in normal times. The spread today, in contrast, is over 300 bps; no wonder the housing market is in trouble. As the bottom chart also suggests, such peaks in spreads is typically short-lived, since they most likely reflect panicked selling and hedging by institutional players. Something is likely to change before too long, and it's likely that mortgage rates and spreads to Treasuries will decline.

Chart #6

Chart #6 compares the value of the dollar (orange line) with the real yield on 5-yr TIPS. As I've noted before, 5-yr real yields on TIPS are equivalent to the market's expectation for what the real Fed funds is going to average over the next 5 years. Real yields have soared by almost 400 bps in just over a year, which is not only unprecedented but also indicative of an extreme tightening of monetary policy. It's sort of like giving a horse tranquilizer to a mildly psychotic patient. Please, Chairman Powell, enough is enough!

Chart #7

Chart #7 compares an index of U.S. industrial production with a similar one in the Eurozone. Without a big decline in industrial production it is very unlikely that the U.S. economy is experiencing a recession. And so far, industrial production continues to grow. The Eurozone economy has been battered by the Ukraine conflict and soaring energy prices, yet industrial production has yet to decline. Both economies have an urge to recover what was lost to the Covid shutdowns.

Chart #8

Chart #8 shows the level of private sector non-farm employment, which continues to grow at a healthy pace. Recessions are famous for throwing people out of work, but we have yet to see any sign of that in the U.S. economy. 

Chart #9

Chart #9 shows the level of 2-yr swap spreads, my favorite indicator and predictor of the health of the U.S. economy and financial markets. Swap spreads are still within a "normal" range, which implies that liquidity is still abundant and the corporate profits and the economy are likely to remain reasonably healthy. As the chart suggests, swap spreads would have to rise appreciably before one might expect to see a recession on the horizon. Note also that swap spreads have tended to decline in advance of recoveries. 

Chart #10

Chart #10 is my favorite recession "dashboard," since it tracks two key indicators of monetary tightness and how they interact to produce recessions. Every recession here was preceded by an inversion of the yield curve (red line) and a significant rise in real short-term interest rates (blue line). As I noted in Chart #6, the market expects the Fed to raise short-term real interest rates (a key measure of Fed tightness) to at least 2% in coming years, but that has yet to happen, and so far the yield curve is only mildly inverted. To be fair, I'd score this chart as tentatively predicting a recession within the next year or so. 

Summing things up, there is little doubt that the Fed has already tightened monetary conditions to a significant degree. Sensitive prices (e.g., the dollar, commodity prices, gold) have turned down meaningfully, which alone would be a decent indicator of lower inflation to come. It would be a real shame if the Fed were to continue on its present tightening course in the belief that only by crippling the economy (e.g., higher unemployment, falling industrial production, and a collapsing housing market) can they hope to get inflation back under control. 

My recommendation would be for Dr. Powell to give the economy a "tincture of time," not higher interest rates.

Charts you probably haven't seen

Headline news can often be misleading.

The current drumbeat of news goes like this: the US economy is probably in recession, inflation and interest rates are soaring, our national debt is out of control, and the Fed needs to get tighter. Things are a mess.

The reality is very different: Financial markets are highly liquid and far from breaking down. The economy is growing, albeit slowly. Inflation pressures peaked months ago. Our national debt is still manageable. The Fed will likely adopt a less aggressive policy stance soon. 

The charts tell the story:

Chart #1

Chart #1 shows the level of 2-yr swap spreads. I pay a lot of attention to these spreads, because they are excellent coincident and leading indicators of the health of the economy and the financial markets. They are a bit esoteric for those unfamiliar with the inner workings of the bond market, which is probably why you haven't heard much about them (unless you've been a long-time follower of this blog). Here is a short primer on swap spreads if you want more information.

2-yr swap spreads currently stand at 31 bps, which is just below their long-term average of 33 bps. As the chart shows, spreads tend to rise in advance of recessions, and they tend to fall in advance of recoveries. Levels above 40-50 bps reflect an economy that is in trouble; current spreads say conditions are close to normal. 

Chart #2

The current level of spreads also reflects the fact that that liquidity is abundant, and that's extremely important. Up until recently, the Fed tightened monetary policy by shrinking the supply of bank reserves (before 2009, banks always held just enough reserves to collateralize their deposits, because reserves did not pay interest). This forced banks to bid up the price of reserves, since they needed more reserves to support a growing deposit base. Higher borrowing costs and a general shortage of liquidity put marginal borrowers and overstretched firms and individuals in a bind, and that in turn led to higher credit spreads, rising bankruptcies and eventually a recession. But since 2009, Fed tightening is very different: instead of shrinking the supply of reserves, the Fed simply raises the rate it pays on reserves, which have been and continue to be abundant, as Chart #2 shows.

Abundant liquidity is essential to a healthy financial market. And we have it in spades.

Chart #3

Chart #3 shows the level of BBB-rated corporate debt (the majority of corporate bonds are rated BBB). Although spreads here are a bit elevated, they are still well below levels that coincided with economic distress.

Chart #4

Chart #4 shows the real yield on 5-yr TIPS (red line), which is the market's expectation for what the real Federal funds rate will average over the next 5 years, and the current inflation-adjusted level of the Federal funds rate (blue line). This tells us that the market is expecting the Fed to tighten significantly in coming years (a high real funds rate is the very definition of tight money). Note also that real rates have not been as high as they are today for a very long time. High real rates mean monetary policy is tight, but they can also be a sign that the economy is very strong (as they were in the late 90s). Since a strong economy is going to be tough to come by these days, high real rates confirm that money is very tight. Very tight, and most likely tight enough to bring money supply back into line with money demand. We know that, since we can observe many sensitive prices declining (as my recent posts have highlighted)> 

Chart #5

Chart #6

Chart #7

Charts #5-7 show different measures of Producer Price Inflation (inflation at the wholesale level). Chart #5 compares the headline, year over year change of the PPI to the core (ex food and energy) change. Inflation by either measure has most likely peaked. Charts #6 and #7 compare the year over year change in the PPI to the 6-mo. annualized change. Here it becomes quite obvious that the peak of PPI inflation was several months ago. 

Chart #8

Chart #8 is the key to understanding the current state of the housing market. The top half of the chart compares the national average rate on 30-yr fixed rate mortgages to the yield on 10-yr Treasuries. The two are joined at the hip most of the time, and that's how it should be. The bottom half of the chart shows the difference between the two, which is now at a record high. 

In other words: mortgage rates today are extremely high relative to yields in the Treasury market, and this situation is very unlikely to last much longer. Prior peaks of this sort were short-lived. Super-high mortgage rates act as a brake on housing prices, since they boost the cost of home ownership. Homes today are very expensive relative to everything else, and there is mounting evidence that home prices have peaked and are now declining. Not surprising. Mortgage rates and housing prices should become more affordable before too long.

Chart #9

I'm sure you heard about the fact that Federal debt has now surpassed the staggering sum of $31 trillion dollars. Actually, that's not true. Federal debt held by the public (which is the correct measure) is only $24.3 trillion. The larger figure includes $7 trillion that the government owes itself, which is nonsensical. But isn't it huge relative to the economy? Well, yes, as Chart #9 shows. It is just under 100% of GDP, and that's big, but it's not unprecedented, and it hasn't increased in recent years.

Chart #10

What about the burden of all that debt? It must be huge, given the amount of debt outstanding and the recent rise in interest rates. Well, not exactly, as Chart #10 shows. The interest cost of our federal debt is less than 3% of GDP, and that's relatively low by historical standards. It's going to rise, to be sure, since the federal government is still running big deficits. But rising interest rates only affect debt that is issued currently, not the great bulk of the debt that was issued at lower interest rates, so interest costs are going to rise slowly. And don't forget that nominal GDP currently is rising by leaps and bounds: third quarter real GDP is likely to be at least 2% and on top of that we will likely see at least 5-6% inflation. At an annual rate, nominal GDP is increasing by at least $2.5 trillion per year, while the deficit is increasing by about half that. So we're not spiraling out of control. 

But of course we would be far better off if we weren't spending so much. The deficit today is not due to tax revenues, which are exploding higher, but out of control government spending, which acts to slow the economy because most of that spending is wasteful.

Inflation visualized

Before leaving for Argentina a few weeks ago, I arranged with Western Union to pick up $2000 worth of Argentine pesos at the "blue" rate of 300 pesos to the dollar.

I knew in advance that I was getting a great exchange rate and that things would be very cheap in Argentina, and I wasn't wrong. What I didn't know was that the largest bill in circulation is a 1000 peso note. Which meant that my $2000 would become 600,000 pesos, in the form of 600 1000-peso notes. It took the cashier at a local Western Union kiosk about 10 minutes to organize and count the bills. The photo says it all: 6 bundles of 100 notes, each bundle worth $333.33; each note worth $3.33. I needed a bag to carry all that money back to our hotel.

It took one of these bundles of peso cash to pay for a dinner for 24 family members at a great restaurant in Tucumán called Di Vino. We tried a dozen different wines, and everyone was served empanadas, salad and a traditional Argentine BBQ (parrillada). The final cost with a tip thrown in (most Argentines tip very little or nothing at restaurants), was 92,000 pesos, or about $12.80 per person. Our huge suite at a local hotel was $75 a night. A 20 minute taxi ride cost less than $5. We took some friends to an estancia in Tafi del Valle; the bill for 3 rooms for 2 nights (including breakfast) was 126,000 pesos ($420).

You can find good wine for 2000 pesos, empanadas for 250 pesos, steaks for 1,700 pesos. Expensive wines run about 8,000 pesos (the cheapest wine in a trendy US restaurant these days starts at $40). Yesterday we had lunch at Fervor, one of my favorite restaurants in Buenos Aires. There were four of us and we ordered one Parrillada de Pescado y Mariscos—a huge selection of grilled fish, shrimp, squid, and calamari. We couldn't finish it all and it only cost 10,000 pesos ($33). We enjoyed two bottles of my favorite Argentine white wine, MariFlor Sauvignon Blanc, for 8,000 each.

A brief history of the peso: Today, a dollar gets you 300 pesos; a year ago a dollar was worth 200 pesos; two years ago 150; three years ago 70; four years ago 37; and ten years ago about 5. Why has the peso lost so much of its purchasing power? The answer is simple: the government pays most of its bills with the printing press. The M2 money supply has grown from 400 billion pesos 10 years ago to now over 10 trillion pesos. That works out to an annualized growth rate of about 40% per year. M2 has increased about 70% in the past year alone. Not surprisingly, Argentine inflation this year will exceed 100%.

Argentina has actually been suffering from bad monetary policy forever. When I lived there in 1975-79, inflation averaged about 125% per year. If Argentina had not changed its currency by lopping off zeros and renaming it 5 times since 1916 (when a dollar was worth 2 of the original pesos), the exchange rate today would be 3,000,000,000,000,000 pesos per dollar.

As Milton Friedman taught us, inflation is a monetary phenomenon which occurs when the supply of money exceeds the demand for it. Argentina has proved that countless times over the past century. It's no mystery, but nearly everyone—especially the Fed—completely ignores the fact that our inflation problem today started with a huge expansion of our money supply in 2020 and 2021. Most people seem to think that the inflation is up because the economy is "running hot," and that to get inflation down the Fed needs to cause a recession. Not so: the Fed simply needs to slow the growth of the money supply and boost interest rates by enough to restore a balance between money supply and demand. As I explained in my last post, it looks like they have done enough already. 

You can read more about this in my posts over the past two years. This is a good place to start. Also see this. Last June I stopped worrying so much about inflation, and this explains why.

UPDATE (10/12/22): Below is a chart of Argentina's dual exchange rates. The current "market rate" is also known as the "Blue" rate. Note that over the course of almost 17 years, the peso has dropped from 3 to the dollar to now over 300, for a loss of 99%. Cry for Argentina.