Friday, May 14, 2010

Reading the monetary tea leaves

M2 growth over the past 6-9 months has been extremely low. Lower than at almost any time in the past 50 years. Economy bears point to this as evidence that the economy is on thin ice, because the Fed hasn't done enough to counteract the deflationary pressures that are being created by all the "slack" in the economy. Economy bulls like me see things very differently. I note that M2 growth surged in late 2008, mainly because the public's demand for money (M2 being a better measure of money demand than of money supply, in my view) surged. That was when everyone wanted to hoard money, and as a consequence spending ground to a halt all over the world. That money is now being released, and it is showing up as increased spending (see the retail sales post earlier today). Money demand here in the U.S. is declining, and M2 velocity is rising, and that goes hand in hand with the return of confidence and the improving fundamentals of the U.S. economy.  So as I see it, the slowdown in M2 growth is a very good sign that the economy is coming back to life.

In Europe, however, it's a different story. The list of pundits and economists predicting the demise of the Euro is long and growing daily. I note that yesterday even Paul Volcker jumped on the "euro is dead" bandwagon. There is great fear and trembling in Europe over the possibility of Greek contagion spreading, bringing down the banks and ultimately the euro. I don't think that's likely, but in the meantime this fear is showing up as a much stronger dollar and a surge in dollar currency outstanding, as this second chart shows. Since January, when Greek default risk first started to rise, the euro has dropped about 15% against the dollar, and the growth of dollar currency outstanding (most of which is held overseas) has risen from zero to a 3-month annualized growth rate of 8%. A similar panic-driven demand for dollars occurred in late 2008, only then it was much more intense. (Interesting footnote: if it weren't for the recent surge in foreign demand for U.S. currency, M2 growth would be at an all-time low, currency being about 10% of M2.)

This latest Greek panic attack has spilled over to equity markets worldwide. As this third chart shows,the Vix index, a good proxy for the market's level of primal fear, has surged and equity prices have fallen. We saw a similar situation in January. So far it doesn't look like a big deal.

How are things likely to play out from here? I think the fundamentals in the U.S. are fairly strong at this point. So many things are improving in the U.S. economy and in Asia that the momentum to the upside is powerful. The U.S. economy is unlikely to be derailed by the problems in Greece, just as the problems in California are unlikely to make a huge difference to the rest of the economy—California has been struggling for quite some time now, and Greek has been unproductive for years, but both might get revitalized if fiscal policies can get back on track. The U.S. is growing despite numerous headwinds, and Greece is but a whisper in a gale. Furthermore, Europe is not going to collapse even if Greece restructures its debt. The world has survived big debt restructurings before (recall the Latin America debt defaults of the early 1980s) with growth hardly skipping a beat. I take the optimist's view that the world's intense focus on Greece's problems, which all stem from bloated government and strong unions, is very likely to drive meaningful political change (i.e., calls for smaller government) going forward; and that is a very good thing. In fact we're already seeing this here in the U.S., with Utah Senator Bennett's stunning defeat in the Republican primary.

Meanwhile, Europe is legitimately concerned about the problems in Greece, because a) citizens of the Eurozone are being forced by their governments to effectively bail out the lazy Greeks with new loans (think of all the money we wasted on TARP), and b) the ECB may bow to political pressure and monetize Greek debt, thus adding an inflation burden to the citizens of the Eurozone. Investors are exiting the euro in advance of its possible debasement, creating a self-fulfilling prophecy. None of this is a good portent for European growth, but then again, nobody ever expected Europe to grow like gangbusters.

In short, while the problems in Europe are real, I think this crisis will not have much impact on the U.S. economy, and that consequently the latest bout of the heebie-jeebies in the U.S. equity market will pass. Turning back to the monetary tea leaves, you might say that the M2 velocity story is much bigger and stronger than the dollar currency story.


John said...

Another good, set of economic facts along with practical interpretation. Everyone might not agree but with the economy still improving this correction will soon pass.

I have added a small position in the Spydr Technology ETF, XLK. I am continuing to look for good entry points in quality stocks on further weakness. If Scott is correct (I believe he is) investments in quality stocks near today's levels will look quite good by the end of the year.

S&P: 1129

John said...

I think it is interesting to note that in the graph of the dollar and the currency, the dollar has regained almost everything it had lost in the past year or so. I can remember a similar cacophony from those who were calling for the dollar's demise as a reserve currency, it was washed up, etc, etc. Well, how the worm can turn. Those calls are long gone.

I see something now that is similar with the euro. Selling the euro now is as crowded a trade as selling the dollar was back then.

As Scott says, Greece can still wind up restructuring their debt and handing a haircut to some banks but as long as the others can get their fiscal houses in order the Euro will be fine. It still could trend lower for awhile but that could help them not hurt.

Unknown said...

USD net longs are at 19 bn, very big (but record ever net USD shorts were 36 bn)(data as of May 4). So there is statistically a lot of space for further positioning.EUR is still ca 10% too expensive on trade weighted basis.

John said...


Some time ago I remember seeing a forcast by someone I respect that showed the Euro's potential decline being 1.15 or so. When I checked a chart of the euro/dollar cross I couldn't see a technical reason why 1.15 would be significant. Now Scott's chart in the blog post made just after this one shows the purchasing power parity of Euro/dollar at about 1.15. That is probably what the forcast I read was using. That also fits in with your estimate.

So maybe the Euro has a little more to fall, but I'm thinking not much more. The Eurozone needs an economic lift. Maybe a slightly weaker euro will help.

Benjamin Cole said...

Jeez, this chart looks to me like M2 is in a negative growth mode now. Negative!

How this will translate into inflation--along with declining unit labor costs and soft property rents--is a puzzle to me.

The Fed has room to go wide-open on the printing plants. I hope they do. Normally, I like balanced federal budgets, but in this situation, maybe the deficits are not so bad (if balanced by surpluses in good times).

Property deflation is a crippler, for lenders and investors. We seem to have hit bottom, but any weakness, and we could see another round of fear-selling and transactional freezes, bad for everybody.

Unknown said...


This guy was many times right (but not money back quarantee though, yet..)
The EM reserves distribution moves the currencies a lot, via bonds flows. Plse also check BNY free comments, they adding value.