Sunday, March 29, 2015

Thinking about inflation while in Argentina

It was while living in Argentina in the late 1970s that I was first exposed to what it is like to live with high inflation. So it's fitting that I reflect on how inflation works, now that I'm here again and have some time on my hands.

During the four years that I spent in Argentina (1975-1979), I think the rate of inflation averaged about 7% a month, or about 125% per year. That's enough inflation to impact your everyday life, and in a big way. My first memory of when the reality of inflation impacted me was the day I collected my first paycheck. I began thinking "what should I do with this money?" It wasn't too long before I realized that keeping the money in my pocket or under the mattress made no sense, since the money was losing value constantly. So my wife and I set off for the nearest warehouse store to buy "stuff" that we could store in the closet. Canned foods and powdered milk for our 1-year old infant ranked high on our list. We scoured the store and found a bunch of stuff, but we couldn't find any milk. I thought that was curious, because it was very popular (Leche Nido, by Nestle). But just then I opened a door to an adjacent storage room and saw boxes of powdered milk stacked to the rafters. So I asked the girl at the cash register if someone could fetch us a couple of boxes. "I'm sorry, sir," she replied. "The milk is not for sale."

That's when it dawned on me that everyone was thinking like I was: nobody wanted money, everyone wanted stuff instead. For the next several years I would juggle money balances between pesos and dollars and "stuff." When I saw something for sale that I needed and the price looked reasonable, I would buy it immediately, because I learned that if you waited to look for it in another store, the price could go up. During one episode of very high inflation, grocery stores would post prices on chalkboards, and change them throughout the day. It was a daily struggle to survive, because salaries and wages always went up after the prices for "stuff" went up; incomes lagged prices. 

Years later I would study the situation in Argentina during the time we lived here, and understand what was happening. In a nutshell, since the government was unable to finance its deficit by selling bonds, it simply ordered the central bank to print up a bunch of new currency in order to pay its bills (that's the same thing that's been going on here in recent years, as I noted last week). New bills flooded the country like Monopoly money. Money became like a hot potato that nobody wanted to hold. Better to change my peso salary to dollars at the beginning of the month, and then convert back to pesos when I needed to buy something. Better to save money by buying stuff than to save money in the bank. Since very few people back then had bank accounts, newly-minted bills just kept accumulating in the economy and losing their value. A $1 million peso note issued in 1978 was initially worth several thousand dollars, but by the mid-1980s, that same note was worth only 20 cents and was withdrawn from circulation.

Bottom line, the supply of pesos was growing rapidly at the same time that the demand for pesos was falling. This resulted in a huge increase in money velocity; the ratio of money to nominal GDP fell sharply for years and years. A 50% increase in the money supply could support a 70 or 80% rise in prices. The government would periodically try to slow the rate of inflation by limiting money growth to a rate lower than the prevailing rate of inflation, but it never worked because the velocity of money just kept increasing. More and more people held their money balances in dollars instead of in pesos, and spent their pesos as fast as they could. The government was essentially financing its deficit via an inflation tax: as long as you were holding pesos in your hands, they were losing value and you were effectively paying money to the government. So everyone naturally tried to avoid holding pesos. It was a vicious circle, as rising inflation destroyed confidence and the demand for money, and that in turn fueled higher inflation.

Fortunately, the U.S. is extremely unlikely to experience an Argentine-style inflation, for several reasons. For one, the federal deficit is easily financed by selling bonds, so deficits do not result in an unwanted increase in cash. Two, you can't flood the U.S. economy with newly-minted bills, because nobody uses much currency these days. If I were to receive $5000 in cash for whatever reason, I would just take it to the bank. Unwanted cash money returned to banks would be turned over the the Fed, where it would disappear in exchange for bank reserves credited to banks' accounts at the Fed. Three, there is no real alternative for most Americans to holding dollars (bitcoin might be someday, but not for a long time). 

But this is not to say that the U.S. can't suffer from rising inflation. Inflation in Argentina was aggravated by a significant decline in the demand for money. But in the U.S., the dominant monetary development of the past seven years has been a significant increase in the demand for money. Argentines wanted to minimize their peso holdings, but U.S. consumers (and many consumers around the world as well) have been actively building up their holdings of dollars. The demand for dollar money has been very strong, so an increase in the dollar money supply has not been inflationary. Inflation has actually been quite low, thanks to very strong money demand. 

As the chart above shows, the ratio of M2 to nominal GDP has increased by about 30% since the Great Recession. It was a traumatic event for the entire world, and it triggered a huge and unprecedented increase in the demand for money. But note: money demand growth has slowed significantly in the past year or so.

Bank savings deposits, shown in the chart above, have almost doubled in the past seven years—accounting for most of the increase in M2—despite the fact that interest rates on savings deposits are almost nil. Deposits have surged because the public wants to hold more money. Banks pay almost nothing for those deposits because the demand for them is intense. But note in the chart that deposits were growing at a 12% rate for almost 5 years, and the rate of increase has slowed to about 7% in the past year or two. The demand for increased money balances is less strong these days. The trauma of the Great Recession has faded, and confidence is returning.

The potential source of higher inflation in the U.S. can be found in the charts above. The huge increase in money demand since the Great Recession has resulted in the public accumulating huge stores of cash and cash equivalents relative to annual income. This money did not fuel inflation because the public wanted to hold it. But should there come a time when the demand for those cash balances starts to decline, that's when inflation pressures could start to build. 

Meanwhile, there is growing evidence that the demand for money is indeed beginning to decline on the margin.

Since the beginning of last year, bank lending has picked up noticeably. This not only reflects improved confidence (banks more willing to lend, businesses and consumers more willing to borrow), but also—importantly—a decline in the demand for money. This may be counter-intuitive, so think of it like this: When you are very confident about the future the last thing you would think to do would be to increase your money balances. You only increase your holdings of money when you become uncertain about the future. When you want to hold more money (e.g., cash, cash equivalents, money market funds, T-bills—things that don't change in value and are highly liquid) you don't want to have more loans; you want to pay down loans and generally deleverage. When your desire to hold money drops, then you want to borrow more and leverage up; (i.e., borrow more money).

As the chart above shows, bank lending to small and medium-sized businesses has been expanding at double-digit rates for the past year or so. C&I Loans are up at a 15.6% annualized rate in the past three months, and they are up at a 12-13% annualized rate since the beginning of last year. 

Increased demand for loans, and increased lending, are signs of increased confidence and a decline in the demand for money. That's very important, because the Fed has ensured, via its massive provision of bank reserves, that there is absolutely no shortage of money in the banking system; banks have a virtually unlimited ability to make loans and create money, if they choose to do so.

If the Fed doesn't take appropriate measures to bolster the demand for bank reserves (by increasing the interest rate it pays on reserves) and the demand for money in general (since there is so much of it out there right now), we could find ourselves in a world where the supply of money exceeds the demand for it, and that is what could fuel a rise in inflation.

I've said it before and I'll say it again: The return of confidence is the Fed's worst nightmare.

Friday, March 27, 2015

Corporate profits are still very impressive

With today's release of the latest Q4/14 GDP estimate, we learn that corporate profits—despite the damage suffered by energy-related companies from the plunge in oil prices in the second half of last year—were still quite impressive: $1.84 trillion after tax on an quarterly annualized basis, and about $1.83 trillion the year as a whole. That puts profits very close to all-time record highs, both in nominal terms and relative to GDP. Yet standard PE ratios are only modestly above their 55-yr historical average. This anomaly—record-setting profits vs. only slightly above average multiples—has persisted for years, and it calls into question the oft-repeated claims of those who argue that stocks are in "bubble territory."

To fully understand this argument, I recommend reading a series of many similar posts over the past 5-6 years. I'm using the same charts over and over, and making the same basic argument, which is that corporate profits have been extraordinarily strong for years, but the market has been (and is still) unwilling to assign an unusually high multiple to those profits. This tells me that equities could be fairly valued at current levels, and at the very least they do not appear to be "overvalued."

The chart above compares after-tax corporate profits as reported by S&P 500 companies using GAAP standards (blue line) to total after-tax corporate profits of all companies as measured by the folks at the BEA (red line). Note that the scale of each y-axis is similar (the top value is 100 times the bottom value), and note also the apparent divergence of the two lines beginning in the early 1990s. I explain here some reasons for this divergence (e.g., different tax regimes and different accounting standards have combined to understate corporate profits when calculated by GAAP methods). Regardless of the divergence, corporate profits by either measure are at or near record levels.

When compared to GDP, after-tax corporate profits are doing extraordinarily well from a long-term historical perspective—far above their long-term average. It's almost never been such a good time to own equities.

The chart above uses the NIPA measure of after-tax corporate profits as a proxy for earnings of the S&P 500, constructing a measure of price/earnings by dividing the S&P 500 index by NIPA profits and normalizing the series so it has the same long-term average as the commonly-used measure of PE ratios. If the NIPA measure profits is closer to the true underlying realities of corporate profits, then PE ratios today are simply average, and orders of magnitude less than they were at the height of the dot-com "bubble" of 2000.

This last chart is the standard measure of PE ratios, for context. According to this, PE ratios are only modestly higher than their long-term average (18.3 today vs. an average of about 16). But think once again what this means: despite the fact that corporate profits have reached exceptionally high levels for several years running, PE ratios are only average or slightly above average. This is not at all what you would expect to see if the market were overly enthusiastic about the future. No, this is a market that is still very skeptical of the ability of corporate profits to sustain current levels, much less continue to grow. In fact it could be symptomatic of a market that is actually priced to a decline in profits from current levels. The market is setting the bar relatively low.

Equities are no longer a steal, but neither are they even close to being egregiously overvalued. I've argued for more than a year that profits growth would be likely to slow, and that further progress for the stock market would be driven mainly by an expansion of multiples, and that is a pretty good description of what the reality has been. I look for more of the same: slower profits growth, maybe even flat-lining, but higher multiples. Today's PE ratio translates into an earnings yield of about 5.5%, and that is still very generous given the prevailing level of Treasury yields. As the chart below demonstrates, equity risk premiums are still unusually high (currently 3.5%) when viewed from an historical perspective. This is still a market ruled more by caution than by enthusiasm.

Wednesday, March 25, 2015

When $100 gets you a sandwich and a Coke

The amount of currency in circulation in Argentina is just over $300 billion pesos, and it is comprised almost entirely of six different denominations of bills, as show above (coins are essentially worthless and hardly ever seen). According to the Argentine Central Bank, about two-thirds of all the currency in circulation is of the $100 peso variety, with the other third spread between the five smaller denominations. If my experience here is any guide, it is rare to see a $2 bill, and the occasional $5 bill is, in practice, the smallest denomination that most people are able or likely to use. Ironically, the smallest denominations are the hardest to come by, and when you do see them they are so frayed and flimsy that many of them are held together by scotch tape.

To put this in perspective, $100 pesos today is worth about $8 dollars (US) on the black market, and about $11 dollars at the "official" rate. Imagine how it would be if consumers in the U.S. were limited to buying things in increments of 40 cents ($5 pesos), and if the largest bill available were worth less than $10. My friend (the one whose daughter got married yesterday) today told me that in order to pay for the wedding and all the people involved, he had to disburse an amount of bills (most things are still paid for in cash here) that would fill almost two shoeboxes. It's become almost comical, and reminiscent of the stories of hyperinflation we have all heard when people had to use wheelbarrows to carry enough currency to pay for daily expenses.

Why are things so crazy? For one, it's the inevitable result of a classical monetary inflation. But it's also because the government doesn't want to officially recognize that inflation has been running at 25-30% for the past six years—printing larger denomination bills would be equivalent to legitimizing all that inflation. That's silly, of course, since you can't cover up an inflation that is fundamentally driven by an almost 30% annual increase in pesos in circulation (see chart above) over the past six years by printing tons of small-denomination bills. Prices are going up at a significant pace, and it doesn't matter what denomination the bills have.

In an attempt to remedy this idiocy, an opposition politician recently proposed a law that would create bills of $500 and $1000 pesos. The government will certainly oppose this measure, but eventually it will pass in some form or other because otherwise the average citizen will need a huge wad of currency in his or her pocket just to make it through the day. Meanwhile, a $100 peso note will buy you a sandwich and maybe a Coke.

For us Americans it's not so bad, since $100 pesos will also get you a decent bottle of wine in most restaurants, or even a decent steak. And despite the inflation, Argentines are wonderfully nice people and the food is terrific.

The Reluctant Recovery continues

Back in October, 2012, I gave a presentation to the Economic Club of Sheboygan titled "The Reluctant Recovery." Almost 2 ½ years later I can reread my comments and conclusions about the presentation and not find much to fault or change. This says it all, and it is a mantra I have repeated continously ever since: "although this is the weakest recovery in generations, with a few exceptions the economy has undergone some significant adjustments and is continuing to expand, although growth is likely to continue to be rather slow and disappointing until and unless we get significant improvement in fiscal and monetary policy." Further, "the recovery has been a reluctant one, because the market has from the very beginning been reluctant to embrace the notion that the recovery was real and durable, much less robust. There are plenty of good reasons for the market to be concerned, of course: unprecedented changes in monetary policy, misguided fiscal stimulus, the deep-seated problems in the Eurozone, the housing disaster, and the huge federal deficit, among others. The fundamentals have improved, but market sentiment remains pessimistic. This creates an interesting environment for investors, since it means that the bar for economic performance has been set very low: the economy only needs to avoid a recession for markets to react positively."

The chart above perfectly summarizes the problem that has persisted for the past 6 years: disappointingly slow growth. The economy is 10% or more below where it could have been if this had been a "normal" recovery. We are missing out on almost $2 trillion per year in annual income, and that's not insignificant.

Although the same themes of "reluctant recovery" apply today, valuations have improved and so stocks are not as cheap as they used to be. This has led to repeated bouts of angst that the market has struggled to overcome: "climbing walls of worry" has been a theme since last October.

This morning's Capital Goods Orders was weaker than expected, but it fits within the theme of "reluctant recovery." One reason the recovery has been disappointingly slow is that businesses have been reluctant to invest, even as corporate profits have reached record levels. Investment might be a lot stronger if we cut or—better yet—eliminated the corporate tax rate. That it is manifestly too high can be seen in the roughly $2 trillion in corporate profits that have not been repatriated.

A few days ago the Fed released its estimates of household financial burdens as of the end of last year. Households have undergone some significant deleveraging since prior to the Great Recession, but on the margin not much has changed for the past few years. I think this is a sign that caution still reigns; people are reluctant to go on a borrowing binge, preferring instead to accumulate savings and keep their powder dry. It's a time of prudence. Nobody is taking outsized risks these days. "Once burned, twice shy" is still an apt description of the mood of risk-takers.

But all of this is not a reason to be pessimistic. On the contrary, it's a reason to remain optimistic. There is still a tremendous amount of untapped potential out there, if only policies could move in a more favorable direction. Policies need to be designed so that they increase the after-tax rewards to working and investing and taking risk. It's that simple: we need to cut marginal tax rates on income and investment. Moreover, we need to continue the favorable trend in fiscal policy that has prevailed for most of the past six years: federal spending needs to grow at a rate slower than nominal GDP, so that the burden of spending (which as Milton Friedman taught us is really the burden of taxation, since all spending must eventually be repaid by taxation) continues to fall. One other important reason for why this has been a reluctant recovery is that government tax and regulatory burdens have been exceedingly high. Things are improving on the margin, as federal spending declines as a share of GDP, but we've got to slash the size of the Federal Register. Starting and running a business is simply too difficult these days. I should know, since I would face a marginal tax rate of 65% or so if I decided to charge money for viewing this website. Readers will be happy to know that I prefer to work for free rather than give the government two-thirds of the fruits of my labor.

Thursday, March 19, 2015

Off to Argentina

We're leaving shortly for Argentina to attend the wedding next week of our best friends' daughter. It should be a blast, as most weddings are in Tucuman. Blogging will be light for the next several days, but I should have some time later to get back in touch with the markets. With an important presidential election looming later this year, I'll be interested to see what's happening on the political scene.

Wednesday, March 18, 2015

How to know if Fed policy is a threat to growth

There's a way to judge whether monetary policy is likely to pose a threat to economic growth, and I lay it out in this post. It involves looking at the real Federal funds rate (using the Interest on Reserves that the Fed pays as a proxy), the real yield on 5-yr TIPS, and the slope of the nominal and real yield curves. If overnight real yields are high (>3%), if they exceed the real yield on 5-yr TIPs, and if the nominal and real yield curves are flat or negatively sloped, then monetary policy poses a clear and present danger to the economy. By these standards, monetary policy currently poses little or no risk to the economy. The risk of recession is consequently very low for the foreseeable future. Today's market action suggests that the market has been excessively concerned about the threat of monetary policy. That reinforces my long-held belief that the market still has a healthy amount of risk aversion, and is therefore not over priced.

When judging the impact of monetary policy on the economy, it's important to remember that the level of nominal short-term interest rates is far less important than the level of real short-term interest rates. For example, 10% nominal interest rates are far less burdensome in a world of 10% inflation than in a world of 1% inflation. The FOMC in the past has stated clearly that although its main monetary tool/target is the overnight Fed funds rate, what it is really targeting is the real overnight Fed funds rate. When they want to slow the economy and/or bring inflation down, the FOMC raises real short-term rates; when they want to "stimulate" the economy the FOMC seeks to lower real short-term interest rates. 

As the chart above shows, the real Fed funds rate has been negative for the past seven years, and is currently about -1%: the difference between the 1.3% year over year rise in the PCE Core deflator, the Fed's preferred measure of inflation, and the interest rate paid on reserves of 0.25%. 

So the Fed's primary policy tool is the real Fed funds rate, and that determines the risk-free yield for the front end of the real yield curve. The market's assessment of the future path of the real Fed funds rate is what determines real yields across the maturity spectrum; that in turn is a function of Fed guidance and the market's view of the future strength of the economy and the direction of inflation. If the market expects the Fed to raise real short-term yields over time, the real yield curve will be upward sloping; if the market comes to believe that the Fed will begin to reduce short-term real yields, then the yield curve flattens and eventually inverts. Fortunately, the real yield on TIPS (which are default free and inflation-protected) is a handy, liquid, and market-based indicator of the expected future path of the real Fed funds rate. In my opinion, TIPS are one of the most under-appreciated of all economic and financial indicators.

As the chart above shows, it is the combination of the level of the real Fed funds rate and the market's perception of the future direction of real yields that can tell us volumes about the health of the economy. Every recession in the past 55 years has been preceded by a significant increase in the real Fed funds rate (blue line) and a flattening or inversion of the yield curve (red line). When the market begins to sense that the Fed will eventually need to reduce real short-term rates (i.e., when the yield curve flattens and/or inverts), that is the time when monetary policy has finally begun to weaken the economy, and that in turn will force the Fed to respond with a reduction in real interest rates. Today, the real overnight rate is very low and both the nominal and real yield curves are positively sloped, so the risk of recession or even an economic slowdown is minimal, according to this model.

The chart above compares the real Fed funds rate to the real yield on 5-yr TIPS. When the real yield on 5-yr TIPS is higher than the real overnight yield, as it is today, the real yield curve is by definition positively sloped, which means the market expects that the Fed will be raising rates for the foreseeable future. It's when the real yield curve becomes inverted (when short-term real yields equal or exceed 5-yr real yields) that monetary policy becomes a threat to the health of the economy, because a flat or negatively-sloped real yield curve tells us that the market senses that the Fed can no longer raise rates and will soon have to lower them in response to a weakening economy. That (an inverted real yield curve) happened prior to both of the last two recessions, and at a time when real yields in general were much higher than they are today. Once again, the conclusion is that monetary policy today is not even remotely a threat to growth, nor is there a significant likelihood of an economic slowdown or recession.

Using the past as a guide to the future, we ought to start worrying about Fed policy only when the real Fed funds rate rises significantly and starts to approach or exceed the real yield on 5-yr TIPS. Today, that means the Fed could raise the interest rate it pays on reserves by 50 or 75 bps without threatening the health of the economy. The Eurodollar futures market says the Fed won't raise its target rate by that much until about a year from now. If by that time the economy has gathered a bit more steam and/or real TIPS yields have increased, then even a 0.75% or 1% Fed funds rate a year from now (which would equate to a real Fed funds rate of -0.5% or -0.3%) shouldn't be a problem at all. Monetary policy would still be "easy."

For investors, this strongly suggests that cash and cash equivalents are an inferior asset class. Yields on almost all other asset classes are substantially higher, and likely to remain so for the foreseeable future because of the low risk of an economic slowdown or recession.

Tuesday, March 17, 2015

U.S. wealth hits a new high

The citizens of the U.S. have never been richer. According to the Fed, household net worth in nominal, and real per capita terms hit a new all-time high last year. We could be a lot wealthier if we had had better fiscal policy (e.g., lower tax and regulatory burdens and less income redistribution), but at least things are improving. Progress is slow, but it is still progress.

Gains in net worth have been driven primarily by gains in financial assets (equities, bonds, and savings), and also by real estate, which has recovered to levels last seen some seven years ago. In contrast, household debt today is about the same as it was over 7 years ago. The wealth of U.S. households now stands at almost $83 trillion, up $4 trillion in just the past year.

By cutting back on debt while financial assets and real estate prices appreciated, households have achieved a significant reduction in leverage, as shown in the chart above.

In constant dollar terms, household net worth is now at a new all-time high, having finally surpassed the previous pre-recession (and bubble-like) high.

In constant dollar terms, per capita net worth is also at a new all-time high of $260K. 

This is all unquestionably good news, yet it stands in sharp contrast to the prevailing mood of the market—at least as I see it—which still exhibits a good deal of caution. Households have amassed almost $8 trillion in bank savings deposits, despite their miserably low yield. Nominal yields on high quality bonds are near record lows, and real yields on 5-yr TIPS are zero. The demand for safe, risk-free assets has never been stronger.

Regardless, things are getting better, albeit slowly. But frustration over the lack of even more progress (e.g., the economy should be growing at 4-5% per year instead of only 2.5-3%) is not a reason to be pessimistic. Especially when the price of safety (i.e., the yield on cash and high quality, short-term debt instruments) is so high. If anything, this tells me that there is a lot of under-appreciated upside potential in the market and the economy, if we could only improve the outlook for fiscal policy.

Poor Brazil

Investing in Brazil is like making a leveraged bet on a weaker dollar and higher commodity prices. It's produced massive losses for the past four years.

In dollar terms, the Brazilian stock market has collapsed—down by some 65% since mid-2011. Values are approaching the lows that occurred at the height of the 2008 financial crisis.

A big factor in the decline of the stock market is the collapse of the Brazilian real, which has lost about half its value since mid-2011.

The weakness in the Brazilian currency tracks the weakness in gold and commodity prices, both of which have been falling since 2011.

Likewise, the decline in commodity prices has tracked the strength of the dollar.

I'm not yet ready to try catching this falling knife, but Brazil is getting cheap and potentially very attractive—though it's not for the faint of heart. 

Housing market still healthy

February housing starts were much weaker than expected (897K vs. 1040K), but the weakness is quite likely to prove temporary.

The drop in starts last month was probably weather-related. Builders' sentiment suggests that conditions are probably slowly improving.

The chart above shows February building permits, which are still trending higher. This corroborates the slowly improving trend in builders' sentiment. Permits lead starts, so we'll likely see starts picking up in the months to come. There is plenty of upside potential in the housing market.

Monday, March 16, 2015

Trader/admin/analyst opportunity

A long-time supply-side friend needs help running his growing equity research business that specializes in small cap overseas opportunities that are decidedly not mainstream. Here’s how he describes the position:

Independent equity research shop in Arlington VA looking for a trader/admin/analyst. Tricky spot to fill. Basically we run a lot of positions (some in thin foreign names) in several accounts and need someone to keep on top of them. There is room to do analysis as well. Experience in dealing with brokers, running foreign small caps, technical analysis a plus. Could be part-time. The hours could be strange, with a lot of Asia trading (punctuated by periods of no trading at all). Can live anywhere but being closer to Arlington makes it much easier. Salary somewhere in five figures depending on the person, hours, role, etc. The ideal would be to find someone who adds value to the portfolio management process while also being easy to work with, mild mannered, etc. The job is best conceptualized as an admin/support role with plenty of room to grow. An appreciation for Scott’s style of economics is certainly helpful. If interested, contact

Friday, March 13, 2015

Time for a European vacation

Today the Euro hit a 12-year low against the dollar. According to my calculation of the PPP value of the Euro, it is roughly 10% "undervalued" vis a vis the dollar. That means that Americans traveling to Europe should find that, on average, goods and services on the Continent are about 10% cheaper than they would be here. It's time to schedule that European vacation!

Note that the chart shows that the Euro has been much weaker in the past, at times, than it is today. So there is nothing terribly unusual going on. I think the dollar's strength is a function of the fact that the U.S. economy seems more dynamic than the Eurozone economy. That naturally tips the balance of monetary policy towards higher rates in the U.S. than in the Eurozone.

And as the chart above suggests, the interest rate differential does appear to be contributing to the Euro's weakness.

Sunday, March 8, 2015

The Fed's Balance Sheet simplified

In hopes of clarifying what the Fed has done—how it has expanded its balance sheet, and what that means—I offer the following chart:

The blue bars represent the Fed's balance sheet in January 2007, well before the financial crisis of 2008 erupted and Quantitative Easing began. The red bars represent the Fed's latest statement of its balance sheet, which can be found here. I've simplified things considerably (e.g., I've not included reverse repo agreements and other miscellaneous liabilities), but the story remains the same.

The left portion of the chart represents the Fed's liabilities, while the right side represents the Fed's assets. At the end of the day, the Fed's purchases of notes and bonds were offset by an increase in the Fed's liabilities, most of which are bank reserves (and the majority of those are considered to be excess reserves) and the rest currency in circulation. The Fed effectively transmogrified most of the notes and bonds it purchased into reserves (which are functionally equivalent to T-bills, since they are default free, short-term in nature, and pay a floating interest rate). The banking system has been happy to hold those reserves; rather than lending out the flood of savings deposits (almost $4 trillion since late 2008), banks have preferred to lend the money to the Fed in exchange for reserves.

Note: The increase in currency since 2007 was not "printing money" in the way that Argentina has freely printed money. In the U.S., unlike in Argentina, currency in circulation represents cash that the public wants to hold. In Argentina, the central bank prints up lots of currency which it then "lends" to the government in order to pay bills and benefits. Newly printed cash floods the economy—nobody wants to hold all that extra cash—and pushes up prices in the classic inflation definition of "too much money chasing too few goods."

Also of note is that the majority of U.S. currency in circulation is held outside the U.S. by people who actually want to hold it. If the world did not want all that currency, it would be returned to the banking system in exchange for short-term deposits.

Friday, March 6, 2015

No reason to worry about jobs growth

Blogging has been light this week and will be light next week, since I am in the midst of our annual Guys ski trip—this week in Park City and next week in Big Sky, Montana. I am still following things, nevertheless, and was somewhat amused to see today be one of those "good news is bad news" days. 

February jobs growth was stronger than expected, confirming that labor market conditions have improved. But not by much. The economic outlook has not improved dramatically, it's simply gotten a bit better. Whether the Fed tightens one month earlier than expected as a result of this number is almost a trivial matter. Short-term rates are not going to be problematic for the economy for a long time, no matter what. I see no reason the economy couldn't continue to (very slowly) improve even as the Fed raises short-term rates a couple of hundred basis points over the next two years or so (that's a forecast drawn directly from the bond market's current expectations). 

The chart above documents the improvement in the labor market over the past year. The 6-mo. annualized growth rate of private sector jobs (the ones that really count) has inched up from 2.1% early last year to 2.9% as of last month. That's hardly enough of an improvement to transform the economy within the foreseeable future, since the number of jobs is still roughly 10 million less today than it could be if this had been a normal recovery. Even with 4% jobs growth it would take many years for the economy to get back to a level at which the Fed might begin to worry about the economy "overheating." For things to get dramatically better we'd need to see some big changes coming out of Washington: reduced tax and regulatory burdens, to name just a few. Sadly, that doesn't seem to be right around the corner.

Arguably, the more important developments in the economy are being overshadowed by the modest improvement in the jobs market: monetary developments.

Banks are lending, and at a fairly rapid pace. C&I Loans, as shown in the chart above, are growing at a 12% annual pace. This is an important indicator of rising confidence: banks are more willing to lend, and businesses are more willing to borrow. Banks have huge supply of "excess" bank reserves on hand, enough to support a terrifying increase in lending and money supply growth if they chose to do so. Hiking short-term interest rate by a few notches is not going to change that equation.

The relatively fast growth of lending is a sign of rising confidence and a sign of declining demand for money. When you want to borrow more, you want less exposure to money; you want to be short money. When you want to borrow less, you want more exposure to money, etc. The whole point of the Fed hiking the interest rate it pays on reserves is to keep the banks from increasing lending too much; to keep them satisfied with holding bank reserves, which are effectively T-bill substitutes and the quintessential "money" asset—risk-free, default-free, and with a floating interest rate.

The thing to worry about today is not whether the labor market is growing a bit faster, but whether the Fed is failing to raise rates by enough to keep the growth of bank lending within acceptable limits. Too much lending would result in a large increase in the money supply and it could eventually debase the dollar, resulting in rising inflation (too many dollars chasing too few goods and services). 

As the chart above shows, the growth of the M2 measure of money supply has averaged about 6.5% per year over the past 8 years. Since 1995, M2 has grown about 6.2% per year, so it would appear that nothing unusual is going on. But over the past several months, the 3-mo. annualized growth of M2 has climbed to 10%. Money supply growth is really picking up, most likely because of the increase in bank lending. Total bank credit is up 8.3% in the past year, which is the fastest pace of growth since prior to the Great Recession.

So far, there are no alarm bells ringing. Despite the more-rapid pace of bank lending and the more-rapid pace of M2 growth, the dollar is doing very well. Demand for dollars is outpacing the supply of dollars, so the Fed is not yet "behind the curve." 

Add it all up: the labor market is gradually improving, confidence is gradually building, and the Fed has managed to keep the supply and demand for money in balance. What's not to like? 

Monday, March 2, 2015

10 charts to watch

The news and the economic fundamentals haven't changed much in recent months, but on the margin there has been some modest improvement. The following charts highlight some of the more interesting developments that bear watching.

Rising profits have been the source of most of the gains in equity prices in recent years. Since the post-recession low in PE ratios (13.9 in August 2010), ratios have increased by 35% to almost 19 today. Over the same period, earnings have increased almost 50%. However, profits growth has declined in the past year, with S&P 500 trailing earnings up only 4.4% in the past 12 months, thanks in part to falling oil prices. Fortunately, that's not exactly a bad thing for everyone. PE ratios are above average, but not by a significant amount.

I remain fascinated by the chart above, which I've been following for the past few years. It shows a decent correlation between the earnings yield on equities and the price of 5-yr TIPS (using the inverse of their real yield as a proxy for their price). When earnings yields are high and real yields are very low, that is a sign of a market that is very risk-averse: investors don't trust earnings, and are willing to pay very high prices for the safety of TIPS. Risk aversion has been declining for the past few years, however, as confidence slowly improves. This is a significant trend that is likely to continue. Expect higher PEs and higher real yields over time. 

Equity risk premiums (defined here as the difference between the earnings yield on stocks and the yield on 10-yr Treasuries) have come down sharply from their October 2009 highs, but remain relatively high by historical standards. The earnings yield on stocks today is still substantially higher than the yield on safe Treasuries. That's another sign of risk aversion: in a strong, growing economy like we had in the 1980s, investors are typically willing to give up yield (i.e., accept a lower earnings yield on risky stocks than the yield on safe Treasuries) in order to benefit from a rising equity market. Today, investors still demand a higher yield on risky equities because they are still somewhat risk averse. Today's relatively high equity risk premium is reminiscent of the high equity risk premiums that prevailed in the late 1970s, when investors were reeling from the shock of double-digit inflation, a weak dollar, and soaring Treasury yields. Today's investors are still reeling from the shock of the Great Recession.

Earnings yields on stocks are still higher than the yield on BAA corporate bonds. This is relatively rare, since corporate bonds are higher in the capital structure. In a "normal" world, equities should have lower yields than corporate bonds, since equity investors are willing to give up yield in order to benefit from the expected growth of earnings. Bond investors, on the other hand, are willing to give up price appreciation in exchange for a higher and safer yield. Today, however, investors are unwilling to pay up for equities, in a sign that risk aversion that still prevails. I wouldn't be surprised to see equity yields continue to decline (i.e., rising PE ratios) even as bond yields flatten or begin to rise.

Equity prices continue their slow upward march, climbing a major wall of worry that is fading away (e.g., Greek defaults, collapsing oil prices, Ukraine tensions, Fed tightening).

The February ISM manufacturing index was about as expected. Although it's off quite a bit from its recent highs, it is still consistent with overall economic growth of 2-3%. The economy has been doing a bit better over the past year, but it's nothing to get excited about. The outlook for growth remains moderate; not great, but not bad either, with some modest improvement on the margin. Significant improvement will come when and if fiscal policy becomes more growth-friendly (e.g., lower and flatter tax rates, especially for corporations, and reduced regulatory burdens).

One of the more encouraging developments in the past year is the pickup in C&I Loans. This reflects increased confidence on the part of banks and businesses—banks are more willing to lend, and businesses are more willing to borrow. Bank lending to small and medium-sized businesses is growing at a solid 12% annual rate these days. The increased confidence this reflects lends solid support to a forecast of continued economic growth.

Money supply growth has averaged just over 6% per year for the past 20 years. No sign here of the Fed "printing money" in any unusual way. However, nominal GDP growth has averaged 4.4% over this same period. When money growth exceeds nominal GDP growth, we can infer that the world's demand for "money" has increased; people want to increase their money balances relative to their incomes, usually out of a desire to reduce risk.

Demand for money (i.e., the ratio of M2 to nominal GDP) has risen strongly over the past 20 or so years, especially since the Great Recession. But the rate of increase in money demand is slowing, as risk aversion declines. Rising money demand was the major impetus for the Fed's Quantitative Easing, whose major purpose was to "transmogrify" notes and bonds into T-bill equivalents (bank reserves). The world wanted a lot more safe assets, and QE generated over $3 trillion of safe assets to meet that demand. As risk aversion declines, QE is no longer necessary.

The important thing to watch for is a decline in money demand. It's been a long time coming, but sooner or later we are likely to see nominal GDP growth exceed M2 growth. That time will most likely coincide with rising confidence, a stronger economy, and a tendency for rising inflation. This will test the Fed's ability to keep the supply and demand for money in balance by increasing short-term interest rates.

The main source of M2 growth since the Great Recession has been bank savings deposits. Note the slowing in the growth rate of savings deposits that began about two years ago. Savings deposits were growing about 12% per year, but have only grown at about 6% over the past year. This growth slowdown is likely to continue, as households become less interested in accumulating savings deposits that pay almost nothing in a world in world in which stocks rise 1% a month, earnings remain at record levels, and inflation is at least 1-1.5% a year and rising.