Near-term gloom, long-term boom

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

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

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

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

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

Chart #1

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

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

Chart #2

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

Chart #3

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

Chart #4

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

Chart #5

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

Chart #6

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

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

Chart #7

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

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

Chart #8

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

Chart #9

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

Chart #10

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

Chart #11

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

Chart #12

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

Chart #13

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

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

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

Happy Hunting, Elon!