Thursday, December 2, 2010

Key market-based indicators point to more growth and higher inflation

Relying on government statistics to track the fundamentals of the economy is a lot like driving by looking in the rear view mirror—and a foggy one at that. The data comes with an unavoidable and sometimes significant delay, it is often manipulated and estimated, and many series are subject to substantial revision long after the fact. That's why it can be more rewarding to watch market-based indicators (i.e., prices), since they reflect real-time information, and they incorporate the collective knowledge and decisions of hundreds of millions of economic actors with access to every conceivable piece of information.

What follows is a quick review of the status and significance of a variety of market-based indicators that I think are important, in no particular order.

Virtually all commodity prices are rising, and have been rising since early last year. Several broad-based indices of non-energy commodity prices are now at or close to all-time highs. This is good evidence that global economies are growing—demand is outstripping supply— and it likely also reflects the fact that most central banks are being very generous with the supply of money: money is cheap just about everywhere. Cheap money makes it easy to engage in commodity speculation, and it also makes investments in tangible goods more attractive, since they provide a hedge against easy money turning into an unexpectedly large rise in inflation.

The first of the charts above is an index of non-energy, industrial spot commodity prices. Only half of its components have related futures contracts, so it is insulated to a degree from commodity price speculation. The second and third charts show industrial metals prices, and their strength makes a good case for global construction and manufacturing activity being strong. The fourth chart shows the relatively obscure prices of textiles, which have been unusually strong of late. With so much evidence of rising prices, it's very hard to escape the conclusion that the global economy is growing and inflation pressures are rising.

Gold is only a few dollars shy of its all-time high, and has been in a rising trend for almost 10 years. It cannot be a coincidence that gold began rising only a few weeks after the Fed surprised the world in early 2001 by cutting the funds rate in response to a weakening economy—and then ended up slashing the funds rate from 6.5% to a mere 1.0% by the end of 2003, where it stayed for an entire year. Easy money got the gold rally going, and easy money has sustained the rally ever since. Gold is telling us that the dollar is likely to suffer a significant loss of purchasing power in the future due to overly-easy monetary policy.

The dollar began declining about a year after gold started rising, and gold has been a good leading indicator of the declining purchasing power of the dollar against other currencies ever since. It is not unreasonable to think that the dollar's huge loss of purchasing power against gold, commodities, and other currencies will eventually be reflected in rising prices of the goods and services that make up the consumer price index. Today the dollar is about 13% above its all-time low in nominal terms, relative to a basket of major currencies. On an inflation-adjusted basis and relative to a large basket of trade-weighted currencies, the dollar is at or very near its all-time low. The dollar is weak no matter how you measure it relative to other currencies, and it's recent upward blip was mostly due to concerns about the euro. This weakness suggests a variety of observations: the Fed is effectively easier than most other central banks; there is an abundance of dollars in the world relative to the world's demand for dollars; confidence in the future of the U.S. economy is low; and many other economies have better prospects than we do.

The implied volatility of an option contract is a good measure of how much the market values the risk-reducing properties of owning options. This in turn makes implied volatility a good measure of the market's risk aversion: high implied volatility implies a lot of risk aversion, while low implied volatility suggests the market is very happy to take on risk. Similarly, implied option volatility can be used as a gauge of systemic risk, since it is reasonable to assume that people are willing to pay a lot for options at a time when systemic risk is high or people perceive it to be high. As the above chart shows, the implied volatility of equity index options and Treasury note and bond options today is relatively low, after soaring to unprecedented heights at the peak of the Lehman crisis in late 2008—a time when many believed that global financial markets were on the verge of a meltdown. The big decline in implied volatility is good indicator that markets have become much less risk-averse, and that systemic risk has declined significantly. We're still not back to normal levels, however, which suggests lingering concerns on the part of investors, and that in turn suggests that the equity valuations are not unreasonable high (euphoric price rises often occur when implied volatility is very low and risk aversion is almost nonexistent).

Spreads on 5-yr credit default swaps are a very liquid and reliable measure of the average risk of corporate defaults. While default risk was perceived to be a bit lower earlier this year—when it appeared that the economy was displaying surprising strength—the level of spreads today is far lower than it was the height of market panic in late 2008 and early 2009. It's still higher, though, than the levels that might be considered "normal." This confirms the message of implied volatility: corporate bond prices and equity prices still have a substantial risk premium built in, and there is still room for more price gains if economic conditions continue to improve.

Swap spreads are also an excellent indicator of risk aversion and systemic risk (or health, as the case may be). After surging to all-time highs during the height of the late-2008 banking crisis, U.S. swap spreads have led the way down (thus accurately forecasting improving conditions) ever since. There was a brief flare-up of concern last May over Euro (Greece) debt contagion, but those concerns have since passed. Swap spreads in the U.S. are now firmly in a range that would be consistent with normal systemic risk. European swap spreads are still somewhat elevated, however, which means that there is still a good deal of uncertainty surrounding the sovereign debt endgame. But to judge from rising commodity prices and rising equity prices around the globe, the world is not very concerned that the EU debt problem is an end-of-the-world-as-we-know-it type of problem. John Cochrane has a good op-ed in today's WSJ that explains why the Euro contagion is not a serious risk.

This chart shows the market capitalization of all global equity markets (in dollars). The message of this indicator is clear: the global economy suffered a devastating blow in 2008, but has since recovered a substantial portion of the ground lost. The best explanation for the huge swings in equity values in recent years is this: the reality of today's economy is an order of magnitude better than it was expected to be just two years ago, when there was almost universal agreement that we were headed for a global financial collapse and a deep depression. It is shocks such as this—when the facts turn out to be far different than expected—that drive huge changes in asset prices. It is not unreasonable to think—especially when one reads the countless analysts who continue to doubt that we will see an ongoing recovery, plus all those who worry that European debt contagion will precipitate another global banking crisis—that the future could prove to be better than many people expect, and that equity prices therefore can continue to rise.

The chart above is based on the 13th Fed funds futures contract, which is a good proxy for the market's expectation of where the funds rate will be in one year's time. Note how the expected funds rate one year forward fell to a low of 0.2% last month; this is consistent with the market fully embracing the Fed's plan to proceed with QE2 and keep the funds rate extremely low for a very long time (at least a year). Since then, the doubts about and the criticism of QE2 have been on the rise, and the news on the economy has been better than expected, and that is confirmed by the 17 bps rise in the one-year-forward expected funds rate. In short, the market is expecting the Fed to scale back the scope of QE2 and to begin reversing it sooner than was recently expected, because the need for and the justification of QE are less obvious now. These expectations are also apparent in the 60 bps rise in 10-yr Treasury yields since mid-October.

UPDATE: Below is a chart which combines implied volatility and equity prices, and shows how the decline in risk and risk aversion has coincided (and even tended to precede) the rise in equity prices. As confidence in the future improves, risk-taking is likely to rise too, and that should result in more investment, more growth, and higher equity prices.


Benjamin Cole said...

Scott Grannis is a Hercules among economists for his heavy and insightful blogging.

Glad to see positive news; may it continue and in force!

Not sure the commodities mean anything anymore. The dollar-gold link is especially mysterious. Copper markets evidently cornered by a single buyer. Oil gamed on the NYMEX, and by OPEC.

A weak, or better-described, "trade-enhancing" dollar? I say bring it on, the dollar cannot get too low for me. Exports will go up, foreign capital will seek acquisitions here. Tourists will come to America, spend money. All good.


If Liberace were alive, maybe he could beat up Mike Tyson, and maybe we will see inflation again. Just don't count on it.

John said...


I agree with Benj. This is very nice work (as usual I might add). I, for one, am grateful for the effort you put into this. I find it very useful.

As I would say in my youth, the market is within "spittin' distance" from it's highs for the year with the bulk of the month of December still left. I am not a short term trader so I don't know if it will take out those highs or not but the momentum is up. We'll see.

Benj, you may not think commodity prices are 'real' if speculation is involved but I would submit that if some pretty good fundamentals were not in place those bets would just as easily go the other way. A lot of people with very deep pockets see a global expansion coming and they aren't worried about Portugal.

Benjamin Cole said...

As usual, I enjoy yur viewpoints.

Commodities are going up, but I think it is on strong global demand, and has little to do with US monetary policy or perceived inflationary risks.

Gold was higher than this back in the 1980s (adjusted for inflation) but we had bad inflation back then. Now gold is up on Chindia jewelry demand. Measured in dollars, gold may go higher. Who cares, certainly not me.

Let's watch what really counts: job growth, real estate values, the Dow, the CPI or other major indicator of inflation.

I keep thinking we are setting up for a secular bull market, globally. Maybe next year.

But don't worry about inflation. Inflation is right there with Sandy Koufax's ERAs. For the next long while....

John said...


And I yours, sir.

I suspect that because of the excesses in real estate over the past few years that sector will lag the overall recovery...but the price behavior virtually everywhere else will at some point work its way around to it too. I think its 'when' not 'if'. Just my cheap opinion.

Incidently Goldman Sachs (I'm not a fan of theirs but I respect their work) is out with a report today forcasting a 23% increase in the S&P 500 in 2011, to ~1450, and S&P EPS of $94. That's about a 15 1/2 X multiple. With no competition fron MM funds that's not a stretch IMO.

Their opinion, not mine....but I think the direction is right.

Benjamin Cole said...


If interest rates stay low (and I think they will(, and if we get several years of earnings expansion, and then some multiples start to see some big numbers on the S&P or Dow.

I say the Dow can double in five years, with some lucky but not bue-ky breaks....

Property should come along too.

To accomplish this growth in the economy and assetvalues, I think we need accommodation from the Fed. The economy needs a lot of money, just like oxygen, to grow hardily for several years.

Right now, some sectors are beating up on Bernanke. A rally on Wall Street and they will go home and count their money.

I am generally optimistic....but Holy Toledo, SoCal property looks ugly right now....

John said...


I don't think Bernanke is a flake. The decision's been made. They'll do QE2 regardless of the criticism. The only thing that MIGHT change their minds is booming..and I do mean BOOMING economic numbers especially re employment. Possible, but not likely. QE2 is baked in the cake for better or worse. Maybe I'm wrong but that's how I'm playing it. As I've said before, whether its right or wrong is for those in Scott's paygrade to figure out. I'm a lemming that swims with what I see. This Fed is about as accomodative as anyone can reasonably expect. They'll get what they want. There will be consequences, but that's for another day...or year.

septizoniom said...

these posts are among your best. the cheerleading ones are tiresome

John said...


Then don't read 'em dude.

Parag said...

GDP growth has improved in the emerging economies with a surge of capital inflows from the advanced economies. Real GDP growth is expected to average over 7 percent for the main emerging economies—China, India, Brazil and Russia.
Global economic update

septizoniom said...

john: you a an arrant knight gallant. let mr. grannis speak for himself.

Richard O'Neill said...

I keep wondering when the ineluctable harbingers of serious inflation will emerge, and for that matter, when deflation is clear in the rear view mirror. Yet: Is there another foreclosure cycle ahead? Is European growth gonna tank ? Will the depreciating dollar curtail demand in the US and suppress inflation?

What I don't know is a lot, and growing...

Scott Grannis said...

Richard: I think deflation risk is history by now. The market's inflation expectations have moved impressively higher since August, with the 5-yr, 5-yr forward inflation expectation built into Treasury prices having risen from 2% to now 3%. Add to that rising gold and commodity prices, rising equity prices, and a weak dollar, and it's hard to escape the conclusion that the market has all but abandoned its deflation fears.

The harbingers of inflation are already here, but of course nothing is signaling serious inflation--yet.

A weaker dollar may weaken U.S. demand for imported goods, but at the same time it increases foreigner's demand for our exports. I think that on balance a weaker dollar only adds to inflation pressures, while it also slows the growth of foreign investment flows, so in the end you get a weaker economy and higher inflation.