Survey of key market fundamentals

So far, the year 2025 has been pretty wild, not least because of Hurricane Trump. I'm not the only pundit that has been struggling to make sense of things. Seven weeks ago global markets were staring into the abyss, reeling from Trump's tariff onslaught. Some degree of calm has since been restored, and even Trump is licking his wounds. 

So it's time to take a step back and survey the landscape of market fundamentals as they appear in the 11 charts which follow. With the exception of the first, all are based on variables that are driven by the interaction of market forces, rather than forecasts or policy prescriptions. Think of them as market "tea leaves" that tell a story if you know how to interpret them. The story as I see it is reasonably healthy.

Chart #1

Chart #1 shows the level of bank reserves, which the Fed creates whenever it buys mortgage-backed and Treasury securities. Prior to the end of 2008, bank reserves were measured in tens of millions of dollars; today they are orders of magnitude higher, being measured in trillions of dollars. Prior to 2008, banks were required to hold reserves (which were non-interest-bearing) at the Fed in order to collateralize their deposits. The Fed controlled short-term interest rates and the money supply by keeping the amount of reserves relatively scarce, thus forcing banks to borrow reserves if they wanted to increase their lending. 

Today, in contrast, reserves are abundant and the Fed controls short-term interest rates by paying interest on reserves. Not only are reserves now abundant and interest-bearing, they are risk-free in the bargain, making them a very attractive asset. Flush with reserves, bank balance sheets are relatively strong and the banking system has plenty of rock-solid liquidity. Gone are the days when the Fed drained reserves from the system in order to force interest rates higher, while also restricting liquidity. Abundant reserves could well explain why the economy has avoided a recession even as the Fed has tightened monetary policy. 

Chart #2

Chart #2 shows the level of 5-yr Credit Default Swap spreads. This is arguably the best and most liquid measure of the market's confidence in the outlook for the economy and corporate profits (lower spreads being good, and higher spreads bad). When investors worry about the future, they demand higher spreads (the difference between the yield on corporate bonds vs. the yield on Treasuries) to compensate for uncertainty. Today, credit spreads are only modestly elevated, which means that the market is reasonably confident in the outlook for the economy and corporate profits. Spreads today are nowhere near the levels we might expect to see if the economy were teetering on the edge of recession. Chart #3 tells the same story, using an average of the spreads on all corporate bonds. 

Chart #3

Chart #4

Chart #4 shows a measure of how much financial risk is being held by the private sector: it's the ratio of total household liabilities divided by total household assets. Private sector leverage today is an order of magnitude less than it was at its peak in 2008. This makes the economy much more resilient and able to withstand unexpected stresses. Thank goodness we have a prudent private sector to help offset our profligate public sector.

Chart #5

Chart #5 compares the level of the S&P 500 with the implied volatility of equity options. The latter is a commonly referred to as the "fear" index. Note how spikes in the fear index tend to coincide with declines in the stock market. As Hurricane Trump recedes from the headlines, fears are declining and stocks are advancing.

Chart #6

Chart #6 compares the level of real short-term interest rates (blue line) with the slope of the Treasury yield curve (red line). Note the strong tendency for recessions to be preceded by high real interest rates and inverted yield curves, both of which are the direct result of Fed monetary policy tightening actions. Those conditions have prevailed for the past several years, and so it is little wonder that there have been many predictions of imminent recession. I think we have avoided a recession this time thanks to the Fed's abundant reserves policy, as well as to the private sector's lack of appetite for leverage.

Chart #7

Chart #7 compares the level of real and nominal 5-yr Treasury yields to the difference between the two, which is the market's implied expectation for the average annual inflation rate over the next 5 years. Inflation expectations are reasonably stable these days and within spitting distance of the Fed's target. But ideally, I would prefer to see the Fed target zero inflation. A rock-solid currency is the best platform for a strong economy.  

Chart #8

Chart #8 compares the real yield on 5-yr TIPS (red) to the ex-post real yield on risk-free overnight yields (blue). Real yields on TIPS are determined by expectations for Fed tightening. That the two are roughly identical suggests the market sees Fed policy as being relatively stable at current levels for the foreseeable future.  

Chart #9

Chart #9 compares the strength of the dollar vis a vis other major currencies (blue) to the price of gold in constant dollars (red). (Note: a falling blue line represents a stronger dollar, and a rising blue line a weaker dollar.) Traditionally, gold has acted as a hedge against a declining dollar, as can be seen by the action from 1992 through 2015—a stronger dollar coincided with lower gold prices, and a weaker dollar coincided with rising gold prices. In recent years, however, this relationship has completely broken down, with gold reaching new highs even as the dollar has been relatively strong. I'm not sure what this means, but it certainly implies that gold is very expensive from a long-term viewpoint.

Chart #10

Chart #10 is constructed in a similar manner to Chart #9. It shows that until fairly recently, commodity prices (excluding oil, which is by far the most volatile of all commodity prices) have moved inversely to the strength of the dollar. I would venture to say that commodity prices look relatively expensive given the dollar's strength.

Chart #11

Chart #11 shows that real oil prices, like most commodity prices, show a strong tendency to move inversely to the strength of the dollar, even in recent years. The chart further suggests that oil is appropriately priced today given the strength of the dollar.

M2 charts look good

This blog is one of the few places you will find information about the all-important M2 measure of the US money supply. I've been covering this since I first began this blog in the summer of 2008. The reasons that few follow M2 are several: 1) the Fed apparently pays no attention to the money supply, 2) not many Wall Street analysts pay attention to M2, and 3) making sense of money supply is difficult in the absence of any concrete measures of money demand. I try to fill in those gaps.

These links will take you to a more in-depth discussion of this topic, but to simplify: Inflation happens when the supply of money exceeds the demand for it. M2 is arguably the best measure of money supply. Currency is arguably a proxy for money demand, as is the ratio of M2 to nominal GDP. The reason surging money supply in 2020 through early 2022 didn't create inflation is that money demand also surged. The reason that declining money supply over the past two years has not been deflationary is that money demand also declined. Today, money supply and money demand appear to be in balance, which explains why inflation has been relatively low and stable. 

Chart #1

Chart #1 shows the level of the M2 money supply. M2 grew at about a 6% pace from 1995 through 2019, a period characterized by relatively low and stable inflationm which further implies that money supply and demand were in balance. M2 then exploded from March 2020 through early 2022, but inflation started rising in early 2021; this implies that money demand started to collapse in early 2021. For the past year or so, M2 growth has picked up but inflation has slowed, which implies that money demand has begun to stabilize at a lower level (see Chart #2). 

Chart #2

Chart #3

Chart #3 shows currency in circulation (a lot of which is held overseas, by the way). I have argued that currency is a proxy for money demand because people only hold currency if they want to; unwanted currency can simply be deposited in a bank, whereupon it disappears from circulation and is returned to the Fed. Like M2, currency increased at about a 6% annual rate from 1995 through 2019. It then surged over the next year or so, even though we saw relatively low and stable inflation. The growth of currency then began to slow (and inflation to pick up) in early 2021, and has now returned to its long-term growth path, coinciding with relatively low and stable inflation.

In sum, money supply appears to be growing at a moderate but sub-normal rate, while money demand appears to be somewhat soft. That's not a recipe for rising inflation, and instead signals, in my view, that inflation will remain low and relatively stable for the foreseeable future. 

April CPI looking good

A quick update to my favorite CPI chart, following today's release of the April numbers:

The chart compares the year over year change in the CPI index with the same change in the CPI index ex-shelter. The ex-shelter version of the CPI has increased by 2.3% or less for the past 24 months (since May 2023), and it has averaged a mere 1.7% per year for almost two years. In the past year, overall inflation was 2.3%, and ex-shelter inflation was only 1.4%. Conclusion: only shelter costs (which I and many others believe have been overstated by faulty calculations) have kept the broader CPI from long ago meeting the Fed's objective, and their impact is continuing to fade away.

It's worth noting also that the April figures included the impact of some of Trump's tariffs, which resulted in higher prices for some imported goods. But this upward nudge to inflation was fully offset by a slower rise in prices for services. Which further illustrates how, when monetary policy is doing a good job, rising prices for some things are perforce offset by lower prices for others.