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.)