Wednesday, April 14, 2021

Updated outlook and some interesting charts

It's fairly clear to all that the near-term outlook is rosy. Vaccinations are becoming ubiquitous, and although daily new cases have ticked up a bit here and there (with the notable exception of Michigan), the severity of cases and hospitalizations is declining; most of the old and most vulnerable folks have either left us or are by now largely immune, so most of the new infections are occurring amidst the young and healthy. In any event, "herd immunity" is likely only months away at the current pace of vaccinations. Jobs are growing at a healthy clip and business investment is surging—the economy has recovered most if not all of the ground lost over the past year. Optimism is on the rise, but animal spirits are somewhat restrained by still-pervasive risk aversion. None of this is likely to reverse in the next several months, so the economy will continue to benefit from a widespread, natural healing process.

Looking further into the future, however, there are dark clouds on the horizon. On the monetary front, the Fed has supplied more liquidity to the system than ever before—and by orders of magnitude—but the inflationary potential of this has been kept in check by a still-robust demand for liquidity and safety. By promising to remain super-accommodative for at least a year or so, the Fed runs the real risk of allowing inflation and inflation expectations to run wild. Who wants to hold all that cash, when cash returns are zero in nominal terms and -2% in real terms? Who doesn't want to borrow at near-zero or negative real interest rates, when just about all commodity, real estate, and equity prices are rising? Absent a blow to confidence, the demand for money is sure to decline, and that in turn could fuel a substantial rise in the general price level (aka inflation) as economic actors attempt to unload unwanted cash—unless the Fed reverses course in a timely manner. 

Perhaps the darkest of clouds is the Biden Administration's urge to expand government spending (on just about everything except a relative handful of actual infrastructure projects) while borrowing trillions in the process, reversing the de-regulation accomplishments and jacking up marginal tax rates on the rich. Common sense tells us that increased government spending, borrowing, regulatory and tax burdens, subsidies, and income redistribution cannot possibly strengthen the economy, and can only weaken it. Today we enjoy a long-awaited healing and reopening process, but by next year we could be slowly suffocating under the burden of Big Government.

It's hard to imagine a worse scenario than inflationary monetary policy coupled with anti-growth fiscal policies, but that's the risk that lies menacing on the horizon. 

I am surely not the only one to worry about such things. The bond market is so dominated by risk aversion that short-term Treasury yields are still extremely low, and risk-free real yields are frankly negative. Bond investors are willing to pay exorbitant prices for anything resembling security. The equity market is far less frothy, since valuations do not appear terribly out of line with interest rates and the global economy (see Chart #9 below). 

Chart #1

With yesterday's release of the March CPI stats, no one was surprised to see year-over-year inflation rise by over 2.6% (as compared to the weak price action of March '20). But as Chart #1 shows, most of the inflation "noise" comes from energy prices, which are by far the most volatile component of the CPI index. Subtracting energy prices, the CPI rose a little over 1.9% in the past year (red line).

Chart #2

Chart #2 shows the ex-energy CPI index plotted on a log scale y-axis. Here we see that the long-term trend of ex-energy prices has been a relatively steady 2% per year over the past two decades. We have been living in a 2% consumer price inflation world for many years, and nothing so far has changed. 

Chart #3

Chart #3 compares the price of gold to the price of 5-year TIPS (Treasury Inflation-Protected bonds), using the inverse of their real yield as a proxy for their prices. Both of these assets promise protection not only from inflation but also from geopolitical risk and general currency debasement. In short, they are classic safe-haven assets. That both are trading very near their all-time highs is a good sign that the world is still quite risk-averse. 

Chart #4

Chart #4 shows 10-yr Treasury yields, which have surged over 100 bps from last year's all-time lows. Yet yields today are only marginally higher than they were prior to the onset of the Covid crisis. Back in February of last year, a casual observer would have remarked that Treasury yields were exceptionally—and historically—very low. Yes, the outlook has brightened, but it still remains unusually dark. That investors are still eager to buy Treasuries at today's prices can only be interpreted to mean that the demand for Treasuries (arguably the safest place in the world to park long-term funds) is still very, very strong, which in turn strongly suggests that risk aversion is still very much alive and well. So strong that the nominal yield on Treasuries is fully expected to be less than the rate of inflation for the foreseeable future. 

Chart #5

Chart #5 shows the volume of passenger traffic in US airports. On a seven-day average basis, 1.4 million people took to the air as of yesterday. That's a huge improvement (about double) from just two months ago, but it is still more than one-third less than the rates we were seeing in 2019 and early 2020. There is still plenty of upside here.

Chart #6

As Chart #6 shows, equity prices have moved ever higher of late thanks in large part to a decline in the Vix "fear" index. Yet the level of the Vix today (17) is still substantially higher that the average (about 12) that is typical of periods of relative calm. Again we see that risk aversion is still alive and well, though obviously much less so than it was at this time last year. 

Chart #7

Chart #7 compares the market capitalization of Apple and Microsoft, the two leading tech giants. Both companies are worth over $2 trillion, an amount previously thought unimaginably high. If Apple were the only company to sport a two-trillion handle, we might be tempted to call it a bubble. But both companies have experienced similar gains over the years, and they were both well-positioned to profit from the new work-at-home reality which Covid fears sparked. 

Chart #8

Just for fun, Chart #8 compares the market caps of Walmart—the former world's retail giant—and Amazon, the new world-class retail giant. At $1.7 trillion, Amazon's market cap is more than four times larger than Walmart's and only a bit below that of Apple and Microsoft's. Arguably, both companies radically changed the retail world, only in very different ways and at different times.

Taken together, the market cap of these three giants adds up to about 14% of the current market cap of all US equities, according to Bloomberg. And to think they barely existed 30 years ago!  

Chart #9

Much has been made of late of the Buffett Indicator, which says that the market cap of US stocks exceeds US GDP by such a huge and unprecedented margin as to be a clear sign that the market is in a "bubble" that is set to burst. Chart #9 is my counter to that argument. I don't think it makes sense to compare the market cap of US corporate giants to just US GDP. After all, they have become huge players in the global marketplace, which is like saying their addressable market has expanded exponentially in recent decades. Globalization is a relatively new phenomenon, and it has meant that a US corporation can derive a huge portion of its profits from overseas markets which previously barely existed (e.g., China, India). Comparing after-tax corporate profits (a rough proxy for market cap) to global GDP shows no sign of an extreme. Profits have increased dramatically relative to US GDP (they averaged about 6% of GDP through 2000, but they have averaged almost 10% of GDP for the past decade), but not when measured against the surge in global GDP.

The long-term outlook is cloudy, but the near-term outlook is still favorable for investors. It's not an entirely comfortable situation, unfortunately. But the good news for now is that the risks out there are not going unnoticed, and that's a healthy sign. Will Congress really end up passing economy-crippling legislation?

UPDATE: This article by Gregory van Kipnis of AIER adds a lot of meat to my brief discussion regarding Chart #9. The author uses a rough estimate to make his point: "... half the growth in the Buffett Indicator comes from the increased importance of foreign earnings to US corporations, and another half of the growth comes from the increased amount of profits emanating from publicly traded companies."

Monday, April 5, 2021

Booming prices

The Fed continues to expand its balance sheet, the federal government continues to send out Covid relief checks, and the Fed continues to effectively monetize most if not all of this monetary "stimulus." Although this "stimulus" hasn't yet resulted in a significant rise in the general price level, we do see increasing—and potentially troubling—signs of booming prices in certain areas of the economy. I've been arguing for some time now that the Fed's profligate monetary expansion has not been inflationary because it has simply accommodated a similar, robust increase in the demand for money. But the demand for money of late is surely declining (while the supply is not) thanks to 1) rapidly spreading vaccinations and a significant increase in the US population's natural immunity, 2) increasing consumer confidence, 3) the ongoing relaxation of lockdowns and mask mandates, and 4) impressive signs of economic recovery.

In my view, we are already seeing early signs of what will eventually prove to be a meaningful increase in inflation, and this process is likely to play out over the next few years. Inflation seems sure to rise, but we do not yet know by how much.

Chart #1

As Chart #1 shows, the Fed has allowed the M2 money supply to increase at an unprecedented pace since February '20. M2 has surged by $4.2 trillion (27%) in the past 13 months, and has been rising at a roughly 15% annualized pace in recent months; that is far and above the 6.5% annualized rate of M2 growth in previous decades. The vast majority of the outsized increase in M2 can be found in bank savings and deposit accounts at the retail level. The public, in other words, has been hoarding money like never before, likely as a response to all the uncertainties raised by the Covid crisis. I calculate that M2 currently is about $2.3 trillion above its long-term growth trend. That's an extra 12% increase in the amount of money than would be held in "normal" times. If the public decides to reduce its cash holdings relative to income, this "extra" M2 could fuel a 12% increase in inflation over the next few years.

Chart #2

Chart #2 shows the Manheim Used Vehicle Value Index in both nominal and inflation-adjusted terms. Since February 2020, used cars have jumped 22% in price! In real terms, they are almost back to where they were during the boom times of the late 1990s. 

Chart #3

Used cars appear to be in very short supply (relative to demand), and new car sales these days are about as strong as they have ever been, as Chart #3 shows. No matter how you look at it, the demand for new and used cars is robust. Strong demand could be due at least in part to all those stimulus checks, coupled with very low borrowing costs and the public's pent-up demand to get out and about following a year of being shut in. 

Chart #4

Chart #5

Charts #4 and #5 show the prices paid component of the ISM manufacturing and service sector surveys. The vast majority of businesses are paying higher prices for stuff these days. That last time we saw such high levels—in the late 2000s—we also saw elevated levels of the CPI, which averaged 4% per year from mid-2005 to mid-2008. 

Chart #6

Chart #7

Housing has also been the beneficiary of unusually strong demand, as Chart #6 shows. In real terms the average home price in the US is now just about as high as it was at the peak of the 2006-2007 housing boom. Prices rose by about 11% last year and continue to move higher (it's not uncommon to see Zillow and Redfin reporting asking price increases these days, at least in local neighborhoods I follow). I expect to see this continue, fueled by exceptionally low mortgage rates and lots of cash in people's pockets. Plus, the Fed has vowed to not interfere with any of this until late next year. 

As Chart #7 shows, it takes about 18 months for big moves in housing prices (blue line) to show up in the housing component of the CPI (red line). As Milton Friedman taught us, the lag between monetary policy and inflation can be long and variable.

Chart #8

The elephant in the rising-price room is the US equity market. The S&P 500 is up over 20% since it's pre-Covid high in February '20. According to Bloomberg, the market value of all US equities has increased over that same period by about $10 trillion.

Chart #9

Non-energy commodity prices (red line, Chart #9) are up over 20% from their January '20 highs. A good portion of that rise can be attributed to a weakened dollar (blue line), but a weaker dollar is symptomatic of easy money and a precursor to inflation (as we saw in the 1970s). Note also that the dollar weakened in the 2005-2008 period and commodity prices also rose—and inflation increased meaningfully, as noted above.

Chart #10

The price of copper has jumped over 40% since the highs of January '20. This undoubtedly reflects booming construction activity around the world, but also can be attributed in part to easy money conditions in the US. 

Chart #11

Finally, as Chart #11 shows, one driver of higher prices is simply a decline in the market's level of uncertainty, as reflected in the declining Vix "fear" index. The uncertainty that prevailed throughout most of 2020 undoubtedly contributed to the public's hoarding of cash, and now this dynamic is unwinding. 

Unless and until the Fed reverses its Quantitative Easing efforts and/or raises short-term interest rates, declining fear, rising confidence, and strong economic growth are likely to fuel a palpable rise in inflation for the foreseeable future. 

Unfortunately, that in turn will give way—as has always been the case after periods of rising inflation—to tighter money, higher interest rates, and eventually (2023?) to sharply weaker economic growth.

Tuesday, March 23, 2021

The problem with unwanted money

The demand for money—as measured by the ratio of M2 to nominal GDP—currently stands very near to an all-time, eye-popping high (see Chart #1). The turmoil and fears which characterized the Covid-19 era caused the public to seek out and hold trillions of dollars of extra cash, and the Fed correctly obliged this demand for money and money equivalents by greatly expanding its balance sheet— transmogrifying notes and bonds into T-bill equivalents (aka bank reserves). (I've explained this all in detail over the course of many previous posts.) Conveniently, increased savings on the part of a terrified and sheltering public provided most—if not all—of the money that Treasury borrowed to fund Covid relief spending. 

Chart #1

Chart #2

But as Chart #1 suggests, the surge in money demand has passed. Confidence is returning and the economy is regaining lost ground. It stands to reason that the demand for money should begin to decline, and it has already declined, as we see in Chart #2, driven mainly by a sharp rise in nominal GDP. This is quite likely to continue; the main question going forward is how much of the increase in nominal GDP will be real and how much will be inflation. 

Chart #3

Chart #3 shows the daily volume of airline passengers (white) screened by TSA, with the magenta line being the 7-day moving average. Notice the sharp increase in air traffic in the past two months. Compared to the levels which prevailed 2 years ago at this time of year, air traffic is now down only 40%, whereas at the lows of last April, air traffic had plunged by an astounding 96%. With the rapid pace of vaccinations and increasing signs of optimism, there is every reason to expect air traffic to grow rapidly in coming months and the economy to grow as well.

The resurgent demand for air travel almost certainly is driven in large part by increased confidence. And with increased confidence, the rationale for the public continuing to hold a huge portion of their annual incomes in cash (i.e., the public's demand for money) surely is fading. But since the Fed has taken no steps to reverse its note and bond purchases, the M2 measure of money supply can't simply evaporate. And with the recently passed Covid relief bill, deficit-funding spending is going to ratchet up once again, which could add yet more money to the financial markets, especially since the Fed plans to continue to its purchases of notes and bonds. 

Unwanted money can't disappear, but it can fuel an expanding economy and it can bid up the prices of other assets.

Chart #4

Chart #4 provides some clues as to how this works. The bars represent the current yield on a variety of investments. The green line is the market's expected average annual increase in the CPI over the foreseeable future (about 2.3%); think of that as the average increase in the prices of all goods and services over the next 5-10 years. Owning cash, short-term Treasuries or mortgage backed securities is very likely to give you a loss in terms of purchasing power. On the other hand, yields on real estate trusts, high-yield debt, emerging market debt and the S&P 500 promise to deliver a purchasing power gain. Unwanted money (much of which is held in very short-term investments such as T-bills, bank deposits and 2-yr Treasury notes) will naturally want to seek out the much more attractive returns on just about all other assets. And as prices for other assets rise, their yields will decline. 

This is another way of saying that a tsunami of unwanted cash likely is going to lift the prices of just about everything, and that is another way of saying we are going to see more inflation in the years to come, UNLESS the Fed reverses course. Which they have promised not to do for at least another year and a half. 

Chart #5

Chart #5 shows us the bond market's way of expressing the view that inflation is likely to average about 2.3% per year for the foreseeable future. The difference between real and nominal Treasury yields gives you the market's expected rate of inflation. Note that most of the increase in inflation expectations of late has come from a rise in nominal Treasury yields. Real yields are still very low.

Chart #6

Chart #6 shows how 2-yr real yields on TIPS have a strong tendency to track the growth rate of real GDP over time. That real yields are currently so low means that the market either does not have a lot of confidence in future growth prospects, and/or the market is still very risk averse (meaning that people are willing to pay extremely high prices for the relative safety of TIPS). Going forward, we are likely to see real yields rise as long as the economy demonstrates that it has the ability to grow by at least 1-2% per year for the next several years. 

Chart #7

Chart #7 gives us a long-term view of the evolution of the Treasury yield curve (using 2- and 10-yr yields as the classic reference points for short and long-term interest rates). Bear in mind that short-term rates are heavily influenced by both the Fed's monetary policy target and the market's demand for safe assets. The yield curve has steepened noticeably since last summer, mainly due to rising long-term yields, which in turn have been driven by expectations that the economy will improve enough to allow the Fed to raise short-term rates in the future. This is a healthy development, since very low yields are a sign of a very weak and risk averse economy. There's no reason yet to worry that higher yields will derail the ongoing equity market rally. 

Tuesday, March 16, 2021

The Covid winter is over

Here are just a few important and very encouraging charts—part of a larger picture in which the US  economy is definitely emerging from its long Covid winter.

Chart #1
Chart #1 shows a critical and timely measure of US air travel, which includes data as of yesterday. The green line is the 7-day moving average, which is the one to watch since there are definite trends in travel on the various days of the week. Here we see that passenger traffic has increased 78% (!!) since January 27th of this year. It's still down over 40% compared to the levels which prevailed before the onset of lockdowns, but the recovery is proceeding rapidly. Looking ahead, we still have a lot of good news to look forward to as confidence is on the rise and vaccinations proceed apace. And by the way, the US stands out as leader of the vaccination pack among developed nations, with the notable exception of Israel, which has vaccinated over half of its population.

Chart #2

My state has been one of the hardest hit (mostly due to extreme lockdown measures ordered by our politicians). As Chart #2 shows, big lockdowns didn't flatten the curve at all last year, since they were firmly in place last November, when daily new cases began to surge. Vaccines have helped, but they can't really account for the bulk of the decline year to date, since it was underway well before significant numbers were vaccinated. That means natural immunity (acquired from exposure to the illness or natural exposure to similar viruses over the years must be a very important factor contributing to the rapid demise of this pathogen. Either way, the severity of Covid cases and the growth of new daily cases has improved dramatically. In Los Angeles County (10,000,000) population, there were only a handful of Covid-related deaths in the most recent reported week, and daily new cases have dropped almost 90% since late January. Overall, statewide daily new cases have plunged 92% since late January.

Governor Newsom: please open the California economy NOW!

Chart #3

Chart #3 is one of my perennial favorites, since it shows the Fed has been responsible for almost every recession in the past 60+ years (the notable exception being the brief Covid crackdown recession that started a year ago). Recessions (gray bars) have occurred after every major spike in the real Fed funds rate (blue line) and every major flattening or inversion of the yield curve (red line). The purpose of Fed tightening has always been to increase real interest rates (and effective borrowing costs) in order to break the back of rising inflation. (Higher real interest rates work to increase the demand for money thus reducing the amount of excess money in the system at the same time the Fed is withdrawing reserves and shrinking the supply of money.) A significant tightening of monetary policy also causes the yield curve to flatten and to eventually invert (when long-term rates fall below the level of short-term rates). An inverted yield curve almost always means that monetary policy is so tight the economy begins to suffer and the market realizes that the Fed will soon have to reverse course.

As should also be apparent, we are nowhere near either of those conditions at present. Real interest rates are exceptionally low, and the Fed has promised to keep them there for a looonnnggg time. (I have serious doubts they will actually do that however). The yield curve has steepened a bit, which is a sign that the bond market realizes that the economy is improving and the Fed will eventually have to raise short-term rates at some time in the future. But it is not very steep from an historical perspective. 

Other indicators that have traditionally signaled that monetary policy is so tight that it is threatening economic growth prospects—such as 2-yr swap spreads and Credit Default Swap spreads—are firmly at the low end of their historical ranges. That means that liquidity is abundant and the outlook for corporate profits is positive. In short, there are no warning signs of economic trouble ahead to be found in the market. 

I would ordinarily be ecstatic about the prospects for the economy, were it not for a growing number of disturbing developments such as huge increases in government spending, promises of huge increases in a broad range of taxes, growing federal control over the economy, continued lockdowns and mask mandates, and expanded welfare measures (e.g., higher minimum wages and increased healthcare subsidies). Most troubling is the prospect of a significant increase in inflation, since that inevitably erodes standards of living, raises barriers to savings and investment, and works to transfer the burden of a mountain of government debt to the private sector in devious and pernicious ways.

All the things that worry me share a common denominator: they serve to reduce the incentives to work and invest. In short, they are anti-supply side. As a supply-sider, I firmly believe that the only way to truly stimulate an economy is to increase the incentives to work and invest by reducing tax burdens, keeping the value of the currency stable, and minimizing the amount of government intrusion in the economy.

Thursday, March 11, 2021

This is a very wealthy country

Today the Fed released its estimates of household net worth as of the end of December 2020. Net worth has reached a new record high in nominal, real, and per capita terms. Covid has been a disaster, to be sure, but the US economy is healthy and poised to continue to prosper, albeit at a much slower rate than we have seen in the past. Here are some charts that tell the story, which is for the most part very impressive.

Chart #1

As Chart #1 shows, the private sector of the US economy currently has a net worth (total assets minus liabilities) of more than $130 trillion. That's up $12 trillion from a year ago, for a growth rate of 10%. Financial assets have done the best, but noteworthy is the relatively small increased in household liabilities since just before the Great Recession: liabilities have gone from $14.5 trillion at the end of 2007 to only $17.1 trillion as of a few months ago, for a growth rate of only 1.3% per year. Real estate holdings, meanwhile, have gone from $25.8 trillion (that was just after the peak of the housing boom) to $35.8 trillion at the end of 2020, for a growth rate of only 2.6% per year. 

Chart #2

Chart #2 adjusts the net worth figures for inflation, and uses a semi-log scale for the y-axis to show that over the long haul, real net worth in the US has increased by an annualized rate of about 3.6% per year. Recent experience is not at all out of line with what we've seen in the past.

Chart #3

Chart #3 further adjusts the net worth figures, subtracting inflation and dividing by the size of the US population. Here again we see a fairly steady rate of growth over the years, but it does look like the current number is on the strong side of what we might have expected. Regardless, the average person in the US enjoys a net worth of about $390,000. Yes, of course that number is inflated due to the estimated 2,100 billionaires we have amongst us, whose total net worth is estimated to be about $8 trillion. (I'm sure it's even more today given stock market gains year to date.) But if we subtract that from the $131 trillion of total net worth and divide by population, we still get a pretty healthy value for the average person: $333,000.

I don't know what the median value of per capita wealth is, but it's important to remember that our collective net worth is based on the wealth-generating value of all the assets we collectively own. Everyone benefits from all the roads, infrastructure, phones, computers, cars, machinery, etc., even if not everyone owns things. Office workers don't own their office building, but without it and without all the US infrastructure that has been built up over the years, they would most be earning far less. Our massive net worth as a country translates directly into the highest living standards we have ever enjoyed.

Chart #4

Sadly, total federal debt held by the public is now roughly equal to our annual GDP (roughly $22 trillion). This is the highest level of debt by far since just after WW II. But relative to our net worth as a country, it is only slightly higher than it has been for most of the past decade. This is not a picture of impending disaster, but I sure wish we weren't going to be borrowing another $4-5 trillion this year.

Chart #5

And despite its enormous size and ongoing (and staggering) growth, Chart #5 shows that the burden of all that debt (i.e., total interest payments on the debt relative to GDP, a proxy for our annual income) is about as low as it has been for many decades, thanks to today's extremely low interest rates. Our national debt is not about to kill us. But since the driver of all the new debt is mostly profligate spending (e.g., huge transfer payments, subsidies, and generally wasteful spending) which does little or nothing to make our economy bigger or healthier. We've been consuming a lot of our seed corn, instead of saving and investing for the future, and this can't go on forever without serious and unpleasant consequences. 

Running up debt the way we are will only serve to weaken our economy over the long run, making future gains in net worth far less than we have enjoyed to date. This will mean a much slower rise in living standards for our children and grandchildren than we have been enjoying.

Chart #6

Our federal government is spending money like a drunken sailor, but the private sector, fortunately, has been very prudent. Chart #6 shows private sector leverage: total household liabilities as a percent of total assets. Leverage today is as low as it has been since 1976, and it has declined by a huge 40% since the peak in early 2009. 

Chart #7

Chart #7 compares the performance of the US stock market to that of the Eurozone. The US is kicking a**. Note that both y-axes are semi-log and use the same ratio from top to bottom. The S&P 500 has gone up by more than double the increase in the Euro Stoxx index since early 2009. This is huge, and quite remarkable. 

Wednesday, March 10, 2021

More signs that inflation is set to increase

For many years I have been unconcerned about the Fed's conduct of monetary policy. To be fair, neither has the market (inflation expectations priced into Treasury notes have been subdued), and neither have legions of economists who have noted that the inflationary impetus of the Fed's expansive monetary policy has been kept in check by the decidedly and protracted sub-par rate of economic growth (~2% per year) over the past decade or so.

Nevertheless, my reasons for being unconcerned are distinctly different from the prevailing view. I think inflation has been held in check by the public's apparently voracious demand for money and money equivalents. The Fed has not so much flooded the market with liquidity as it has supplied money—sometimes reluctantly—in order to satisfy the public's desire for money. As Milton Friedman taught us, when the supply of money is matched by the demand for money, no inflation results.

In any event, the Fed has not "printed" money with abandon, since it has simply transmogrified notes and bonds into T-bill equivalents by buying them and paying for them with bank reserves, which are not money in the traditional sense, since they can only be held by banks. Banks have apparently been quite happy to hold on to the more than $3 trillion of bank reserves that the Fed has issued this past year, because those reserves are an attractive asset (default free) and they pay a floating rate of interest (the Fed funds rate). Simply put, the Fed has taken in notes and bonds (which are in abundant supply, thanks to trillion-dollar deficits) and exchanged them for T-bill equivalents, which have been in short supply. Nothing at all wrong with that.

Banks used their strong cash inflows during the onset of the Covid crisis—in the form of increased bank savings deposits and checking accounts—to purchase the notes and bonds which they then sold to the Fed.

More recently, I've become concerned that the return of confidence and a rebounding economy would result in a decline in the public's demand for all that money, and that the Fed would be slow to react with offsetting measures: a) higher short-term interest rates, which would work to boost the demand for money, and/or b) a reversal of its quantitative easing (which would withdraw unwanted bank reserves from the financial system). Per Friedman, that is the classic recipe for a rising price level (i.e., create a surplus of money relative to the demand for it). So far, the Fed seems determined to do just that—to ignore (and even welcome!) signs of declining money demand and rising inflation. Moreover, they fully intend to keep purchasing more notes and bonds in the months ahead. It's getting increasingly likely that the supply of bank reserves will exceed banks' desire to hold them as assets. Going forward, banks could well begin to expand their lending (abundant reserves make this possible), which is a sure-fire way to increase the amount of money in the economy. A future tsunami of money would almost certainly "float" higher prices for just about everything.

To once again be fair, the market is also beginning to get concerned about rising inflation: inflation expectations over the next 5 years have risen from 0.5% last summer to now over 2.5% per year (see Chart #1 below). What I'm saying is that there could be a lot more of this in the future.

Today Congress sent a $1.9 trillion spending bill to President Biden's desk, and he will almost certainly sign it in short order. In deja vu fashion, it passed very narrowly without a single Republican vote—just like Obamacare. In my view, it will do just about everything wrong. Far from "stimulating" the economy, it will instead greatly expand the welfare state and greatly increase the power of the federal government. Worse still, it will artificially inflate demand for just about everything but larger checking and savings deposits. Taking money from the economy (by selling notes and bonds) can't possibly stimulate the economy, just as taking a bucket of water from one end of a swimming pool and dumping it in the other end won't raise the water level. A lot of the money dished out by the bill is going to end up being used by people paying higher prices for all sorts of things. We see the beginnings of this already in, for example, the market for used cars (see Chart #4 below).

The economy doesn't need more demand, it needs more people working and more businesses reopening. Paying more to those who are still unemployed (plus exempting those higher unemployment benefits from taxation, as the bill does) won't encourage them to return to work. On the contrary, it will unnecessarily prolong the return to full employment. Many workers will surely discover that they can earn more (after-tax) than they could by going back to work. See my friend Steve Moore's estimates of just how pernicious this could be. And do subscribe to his daily newsletter, which has gobs of depressing facts and statistics.

The economy undoubtedly will get a boost in the months to come, but mainly because the Covid crisis is in rapid retreat. Daily new cases in the US are down almost 80% since the peak of mid-January. In California, they are down an astonishing 90% over the same period. We are rapidly approaching herd immunity, with estimates that upwards of 50-60% of the population has by now acquired immunity, either through infection, innate immunity (T-cells), or vaccination.

As is to be expected, by the time politicians rush in to supply aid to an ailing economy it is no longer needed. Moreover, it is counter-productive. Politicians almost always screw things up. That's why I'm a libertarian: we need less government, not more, to solve our problems.

Chart #1

Chart #1 shows the level of 5-yr nominal (red) and real (blue) Treasury yields, along with the difference between the two (green) which is what the bond market expects annual CPI inflation to average over the next 5 years. This latter has jumped from 0.5% last summer to now over 2.5%. Note that virtually all of the rise in inflation expectations is due to the rise in nominal yields. Real yields are very low, and they have barely budged; that's a sign that the rise in rates is not due to increased growth expectations—it's mostly due to increased inflation expectations.

Chart #2

Chart #2 shows how gasoline prices have surged in recent months. People are driving more, economic activity is on the rise, and oil prices have risen as demand challenges supply. 

Chart #3

But as Chart #3 suggests, while higher oil and gasoline prices will certainly contribute to rising inflation, there are other, more powerful forces also at work. Rising inflation expectations far exceed the contribution to inflation resulting from higher oil prices. 

Chart #4

As Chart #4 shows, used car prices have exploded since last summer. Extra cash seems to be burning holes in many consumers' pockets, and that could be fueling the rise in prices.

Chart #5

Chart #5 compares the yield on 10-yr Treasuries (red) with the ratio of copper to gold prices (blue). Both of these variables tend to rise and fall as economic growth prospects improve and deteriorate. This market-based indicator is telling us that there is a lot of construction activity (copper demand) going on around the world, and the bond market is sensing that the prospects for an increase in nominal activity have improved from last summer's abysmally low levels. 

Chart #6

Chart #6 is a long-time favorite of mine, if only because it shows how tightly correlated the prices of these two assets (gold and TIPS) have been for the past 15 years. (I use the inverse of the real yield on TIPS as a proxy for their price.) It also suggests that gold prices tend to move in advance of TIPS prices. Right now that is telling us that TIPS prices are likely to decline (as real yields rise) in the future, but not by a whole lot. I would fully expect a big rise in real yields to happen at some point in the foreseeable future, either as a result of a stronger economy and/or a Fed tightening (which in turn would likely be a response to an unpleasant and/or unwanted increase in inflation). It's also interesting that gold prices have declined so much in the past year at the same time inflation expectations have risen. Gold is an imperfect inflation hedge, to say the least. Gold these days is likely being challenged by stronger growth expectations and the prospect of a tighter Fed in the future.

As I've said in earlier posts, although there is no shortage of reasons to be concerned about the future—number one being a significant rise in inflation followed by a Fed tightening response—I don't think things will collapse for at least the next 3-6 months. Indeed, there is every reason the economic landscape should brighten in the months ahead as the Covid crisis fades into history. It's unfortunate that the government seems hell-bent on doing the opposite of what is needed, but despite all the damage that may be done by the stimulus bill, a rebounding US and global economy—and higher prices—should provide significant support to the equity market. 

And besides, what alternative is there, if cash yields zero? The expected return on cash is virtually guaranteed to be negative, as inflation rises and the purchasing power of cash declines. And don't forget that equities give you exposure to a rising price level, just as real estate does. As I've said repeatedly, what the Fed is telling you to do its "borrow and buy." The Fed wants you to shun cash, and the Fed almost always gets what it wants eventually.

The profoundly disturbing side of the Covid crisis

My long-term rational optimism was seriously challenged this morning after reading two essays. The issue that will likely haunt us and our economy for years to come is the inordinate expansion and intrusion of government into our daily lives and into the conduct of our private business affairs. Once politicians discover they have powers that were heretofore virtually unthinkable, they are very unlikely to relinquish those powers unless and until the population mounts a vociferous resistance—which so far is barely audible.

Scott Atlas: The Last Word


I have been shocked at the enormous power of the government, to unilaterally decree, to simply close businesses and schools by edict, restrict personal movement, mandate behavior, and eliminate our most basic freedoms, without any end and little accountability.

I remain surprised at the acceptance by the American people of draconian rules, restrictions, and unprecedented mandates, even those that are arbitrary, destructive, and wholly unscientific.

The United States is on the precipice of losing its cherished freedoms, with censorship and cancellation of all those who bring views forward that differ from the “accepted mainstream."

"Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one." - Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds


Masks Are Just Part of the Socialists' Uniform – J.B. Shurk

The Centers for Disease Control released another study showing no statistically significant decrease in "daily case" or "death growth" rates from COVID-19 in areas with mask mandates. This comes after a similar CDC study in October indicated that mask mandates do not appear to have slowed or stopped the spread of the coronavirus at all. Still, the CDC continues to recommend that all Americans wear masks, except in certain private settings when individuals are fully vaccinated, unless the goalpost-shifting Dr. Fauci gets his way.

Mask mandates are also an illustration of the sharp philosophical divide straining Americans into two camps guided by conflicting worldviews. In the one are true democrats who believe that all legitimate government power is derived from individual consent, and in the other are true socialists who sanctify the exercise of government power in pursuit of collectivist goals at the expense of individual liberty.

Alexis de Tocqueville contrasted these worldviews aptly: "Democracy extends the sphere of individual freedom; socialism restricts it. Democracy attaches all possible value to each man; socialism makes each man a mere agent, a mere number. Democracy and socialism have nothing in common but one word: equality. But notice the difference: while democracy seeks equality in liberty, socialism seeks equality in restraint and servitude."

... mask mandates have become nothing more than dress code loyalty oaths to the same state and local governments that have claimed for themselves the extraconstitutional powers to restrict free speech, religious liberty, personal commerce, and voluntary movement beyond the home in the name of a virus. They represent Americans' symbolic acquiescence to government's mass lockdowns and economic shutdowns and their tacit acceptance that government's unconstitutional power grabs are somehow legitimate.

Finally: “Masks have been transformed from tools that are moderately useful in the right circumstances to magical totems. The sort of thing that a . . . neanderthal might employ against disease.” - Glenn Reynolds

Friday, March 5, 2021

It's time to end the Covid mandates and lockdowns everywhere

Just look at the charts and facts on this page (screen shot below) and you will see that that lockdowns and mask mandates don't change the course of the Covid pandemic and in fact just make things worse. 

Reminder of what I said last April: "The shutdown of the US economy will prove to be the most expensive self-inflicted injury in the history of mankind.™" What a disaster it has been, and all for nothing. Indeed, we have more problems now, thanks to the lockdowns, than we would have had without them. 

The good news, however, is very encouraging, as the last chart on this page shows. The US population is rapidly nearing the point at which it achieves herd immunity. It's no wonder, then, that the number of daily new cases (7-day moving average) in the US is down 75% since the peak of January 11, '21. In California, daily new cases are now down 90% from their peak. 

Wednesday, February 24, 2021

Reflation update: it continues!

The reflation theme is alive, well, and prospering. Today, Fed Chairman Powell himself told the world that.

He sees a long road to recovery, he's not concerned about rising prices, and he plans to keep short-term rates low for a long time.

And it's not just stocks that are benefiting. Here is a modest collection of charts that I'm currently tracking with interest:

Chart #1

As Chart #1 shows, copper prices are exploding to the upside even as gold prices hold relatively steady. The world is rebuilding and speculators are jumping on the commodity price bandwagon. The dollar is somewhat weak, but I think the chart tells us that a weaker dollar is not telling the whole story. Today the dollar is only slightly weaker than its average over the period of this chart, but copper prices (adjusted for inflation) are much higher than their average. Gold, by the way, is not looking good even though the world is reflating. That can only suggest that gold hit an all-time high several years ago in anticipation of what we are seeing today.

Chart #2

Chart #2 compares 10-yr Treasury yields (red line) to the ratio of copper to gold prices (a good proxy for global growth expectations). This reaffirms the view that we're in a reflation. Not only are inflation expectations rising, but industrial commodity prices are too, as is construction activity in general. 10-yr Treasury yields are up because the world is feeling a little less concerned about the economy remaining weak forever. More inflation and more growth mean higher yields, it's that simple. And yields have plenty of room on the upside (i.e., bonds are a terrible investment these days).

Chart #3

Chart #3 updates a chart I haven't featured for a long time. Given all the weakness in the economy in the past year, I was surprised to see that commercial real estate prices last December reached a new all-time high. Malls may be empty and downtown businesses and restaurants may be abandoned, but no one is giving up on the idea that we'll get back to normal before too long. Easy money, low borrowing costs, and the fact that life is not going to go dormant anytime soon all add up to the expectation that the physical side of the economy is going to be picking up for the foreseeable future. SPG (Simon Property Group) has more than doubled since early November. 

Chart #4

Chart #4 is a perennial classic that shows how equities are performing relative to gold prices. Typically, equities underperform in times of hardship and outperform in times of plenty. This ratio has a ways to go before it returns to the 5-handle highs last seen in 2000. 

Chart #5

Chart #5 is also a long-time favorite that I haven't featured in awhile. As I see it, the equity market tends to lead truck tonnage (a proxy for the health of the physical economy). Equities are effectively pricing in a full recovery and the eventual attainment of new all-time highs for GDP. This may worry the bears, however, but I would argue that the economy won't be at serious risk of a downturn until the Fed tightens by a ton, the yield curve flattens, and real yields rise significantly. And we're a long ways from those things happening.

This is not to say, however, that I see real GDP growth averaging more than 2% per year in the years to come. Things are definitely improving right now, but I think one's enthusiasm should not go unchecked. The policies favored by the Biden administration are not going to optimize economic health or maximize economic growth. And a multi-trillion dollar "stimulus" plan is going to do just the opposite of stimulating the economy. I'm hoping that clearer head prevail in Congress. Beware economic "stimulus" plans: they never work and they usually just make things worse. The government simply cannot spend money more efficiently than letting people spend their own money.

Chart #6

Chart #6 shows the makeup of inflation expectations that are priced into the bond market. Inflation is expected to average almost 2.5% per year for the next 5 years. We've seen something like this before, but nothing much worse than that. (I think we'll end up seeing worse.) Note especially the extremely low level of real yields (blue line). This can mean two things: 1) the market expects economic growth to be sluggish for the foreseeable future and that means low real yields in general, and/or 2) since TIPS are the safest and surest way to protect against inflation (TIPS pay a coupon equal to their real yield plus the rate of CPI inflation), and since the Fed is pledging to keep short-term rates very low for a long time, the Fed is effectively putting an artificially low cap on the level of all real yields, which forces investors to pay artificially high prices—and receive artificially low real yields in exchange—for inflation hedges. I'm inclined to think that both forces are working at present.

Chart #7

Chart #7 has been featured regularly for a long time. The market's level of fear (red line) is elevated but not excessively so, which allows equity prices to drift irregularly higher, hitting air pockets of panic along the way. Over the 3+ year period shown in the chart, an investment in the S&P 500 has produced an annualized total return of about 15% per year (including reinvested dividends). Not bad, considering all the air pockets and potholes along the way! 

Of course that also suggests that one should keep their hopes for the future from running wild. Stocks can't go up like this forever. 

UPDATE: (Feb 25th) As Chart #8 shows, capital goods orders (the precursor of future productivity gains and thus an excellent leading indicator of economic growth) have surged in recent months, far exceeding expectations and breaking out of a prolonged slump. This is perhaps the most optimistic chart in my basket.

Chart #8