Sunday, December 31, 2023

Recommended reading: "Poor Charlie's Almanack"

I learned many things from my time at Western Asset Management, many of them from fellow colleagues such as Ken Leech. Ken further endeared himself by one day inviting Charlie Munger to address the professional staff. What a delight that was! As icing on Munger's talk, we received a copy of the first edition of Poor Charlie's Almanack, which I subsequently read and reread. It's full of wit, wisdom, and investment savvy. If somehow you've never heard of Charlie Munger the legendary investor, don't stay ignorant for longer than it takes to click on the link below.

A second edition has just been published by Stripe Press, only weeks after Charlie's passing at the ripe old age of 99. Not content with just publishing a marvelous book, the good folks at Stripe have also made it available online in a delightfully inspired format. I know of no greater and free gift to the world than this: Poor Charlie's Almanack

Best wishes to all for the coming New Year!

Wednesday, December 27, 2023

Monetary policy and economic overview at year end

The Fed has conquered inflation. It's time to start easing. The economy looks OK, no looming recession. 

Chart #1

Chart #1 is arguably the most important chart that the market and the Fed have almost completely ignored for decades. Sure, everyone talks about the money supply (the best measure of which is M2), but no one talks about money demand. And as all students of economics should have learned, prices are set at the margin by the intersection of supply and demand. As Milton Friedman taught us, inflation happens when the supply of money exceeds the demand for it; so when there is an excess of money supply relative to demand, then prices rise and the value of the dollar declines. But without knowing money demand, which is half of the equation of inflation, we are in the dark when it comes to understanding inflation. To be fair to those who have ignored money demand, there is no direct measure of money demand. But we can infer what is happening with money demand if we just observe inflation: rising inflation must mean that money demand is falling relative to money supply. 

And as subsequent charts show, there are other ways of understanding what is happening with money demand.

Chart #2

Chart #2 shows the amount of dollar currency in circulation (currency represents about 10% of M2). From 1995 through early 2020, money in circulation grew by a relatively constant 6.6% rate per year. This in fact is an excellent measure of money demand, because no one holds onto currency if they don't want it, because there is an opportunity cost to doing so. If you handed me a suitcase full of $100 bills I would rush to the bank to deposit the money in order to earn interest. And then I would probably use some of the money to buy some stuff and invest in the stock market and/or real estate. In short, I have no need to hold tons of cash. But in the wake of the Covid crisis the demand for dollar currency soared; everyone wanted to hold more cash because of all the uncertainty that prevailed at the time. Currency grew by a record 16.4% in the 12 months ended Feb. '21. More recently, however, the demand for cash money has fallen rather significantly. Currency has increased at a mere 0.9% annualized rate in the 6 months ended Nov. '23. Currency now is within spitting distance of its long-term growth trend. The surge in the demand for currency has almost completely reversed from its early-covid levels.

Rising money demand in 2020-21 kept the surge in M2 money from causing inflation. Falling money demand since 2021 has kept the decline in M2 money from causing deflation.

Chart #3

Chart #3 shows the level of M2. Here the story is similar to that of currency, only much more dramatic: M2 surged in the wake of Covid, rising by some $6 trillion (almost 40%) to a peak in late 2021. (As I have explained before, this surge in M2 was almost exactly equal to the increase in the federal deficit that was caused by $6 trillion of Covid-related "stimulus" payments.) Since its peak, the "excess" of M2 at its peak has fallen by 58%, and M2 now looks on track to return to its long-term trend line in a year or so. 

Chart #4

Chart #4 shows the level of retail money market funds, which now comprise about 8% of M2. Even as M2 started to decline early last year, retail money market funds began to surge, fueled by the sharp rise in short-term interest rates that resulted from Fed tightening. Virtually all of this increase was in fact money that moved out of traditional bank savings and deposit accounts as individuals were attracted to the much higher yields on money market funds, so this increase was not a sign of increased money demand. Instead, it is an excellent example of how rising interest rates can increase the public's demand for certain forms of money. 

Chart #5

Chart #5 shows the level of bank reserves supplied by the Fed to the banking system. Bank reserves are not cash that can be spent anywhere, and they are only held by banks—in effect, they represent loans that banks grant to the Fed in exchange for reserves. Prior to late 2008, reserves paid no interest and so banks held only the minimum amount of reserves necessary to collateralize their deposits. Since 2008, bank reserves have effectively become T-bill equivalents for the banking system. As the chart shows, reserves have rarely been more abundant. Banks' balance sheets are thus loaded with high-quality, liquid, interest-paying debt. That in turn means that banks are effectively awash in liquidity. As I've argued before, abundant liquidity has made the current Fed tightening episode unique. In previous tightening episodes, the Fed actively restricted the supply of (non-interest paying) reserves in order to push interest rates higher, and that in turn aggravated credit conditions and helped tip the economy into recession. Not so today, thank goodness!

John Cochrane elaborates on this subject in his op-ed in today's WSJ.

Chart #6

Chart #6 shows the so-called "junk spread," which is the difference between the credit spread on high-yield vs investment grade corporate bonds. Both nominal spreads and the difference between credit spreads are near all-time lows, which is unprecedented at a time when the Fed is no longer tightening and is instead poised to start lowering interest rates. this directly contradicts other "classic" recession predictors, such as the following chart. Monetary conditions are VERY different this time.

Chart #7

Chart #7 shows why many still worry about a looming recession. Note how every recession since 1960 was preceded by sharply rising real interest rates (blue line) and an inversion of the yield curve (red line). Today we see rising real interest rates and a definite inversion of the yield. So does that mean a coming recession? Not necessarily.

As the discussion above highlights, not all Fed tightening episodes are the same. I've embellished on this many times in the past, noting that it's not enough to have high real interest rates and an inverted curve to produce a recession: you also need to see high and rising credit spreads and a shortage of liquidity.

Chart #8

As Chart #8 shows, inflation as measured by the Personal Consumption Expenditure Deflators (a better measure of inflation than the CPI) has, over the past six months, fallen to 2% or less on an annualized basis. The Fed has succeeded in reaching its goal. Bravo!

Chart #9

Chart #9 shows the three major components of the PCE deflator. Non-durable goods price inflation has been almost zero since mid-2022, while durable goods have experienced deflation over the same period. Only service sector prices (which are dominated by housing costs; see my previous post for an explanation) are rising these days, but the rise is exaggerated by flawed calculations. 

Chart #10

Chart #10 shows the level of Commercial & Industrial Loans by US banks. Loan growth has been almost non-existent in the past year (thanks no doubt to high interest rates choking off demand for credit), and many analysts worry that this poses a threat to economic growth.

Chart #11

However, as Chart #11 shows, delinquency rates are near historic lows. Deliquency rates tend to rise as the economy nears recessionary conditions, but this is manifestly not the case today. Corporations are not struggling to pay outsized debts, and are thus much less at risk of having to tighten their belts. Mortgage delinquency rates are now below their pre-Covid lows. Private sector indebtedness is not a problem today. Public sector indebtedness, however, is another story, which I hope to address soon. 

Chart #12

As Chart #12 shows, real yields tend to track real growth trends. With the economy likely growing by a little more than 2% per year (tepid by historical standards), real yields should be much lower than they are today. That will correct itself as the Fed eases.

The big question today: when will the  Fed start lowering interest rates? Today the bond market is betting it will happen at the March 20 FOMC meeting. In my experience, however, when the market becomes highly confident of something that is going to happen in 3 months' time, the event usually happens sooner. Sometimes the future cannot wait very long to happen. I'd put some bets on an ease at the January 31st FOMC meeting. 

Tuesday, December 12, 2023

CPI less shelter is only 1.4%

Shelter costs comprise about one-third of the CPI, and shelter costs are driven primarily by housing prices 18 months before. Which is to say that the way BLS goes about calculating the CPI is bogus. If we take out this bogus component of the CPI we are left with the fact that the CPI rose a mere 1.4% in the 12 months ended November '23. Long story short: the Fed has successfully stomped out the inflation fires that started back in early 2021. The inflation that is still grabbing headlines today is an artifact of the crazy way that the government has decided to measure shelter costs.

Of course, shelter costs are not the source of inflation—they are the result of inflation. Since June 2022, readers of this blog have known inflation was going to decline. That was when I confirmed the impressive decline in the M2 money supply. As I explained at the time, huge growth in M2 from 2020 to 2021, fueled by the monetization of Covid-related deficit spending, was the proximate cause of our national inflation nightmare. M2 continues to decline, and interest rates continue to be high (both of which mean monetary policy is tight), so shelter costs and the broader CPI will likely continue to decline as well.

Chart #1

As Chart #1 shows, the Owner's Equivalent Rent component of the CPI (red line) is primarily driven by changes in housing prices (blue line) with a lag of about 18 months. If this correlation continues (as is quite likely), then the contribution of OER to the CPI will be declining for another 12 months or so. 

Chart #2

Chart #2 compares the year over year change in the CPI with a version of the CPI less shelter. Amazing fact: the 6-mo. annualized rate of change of the CPI less shelter has been 2% or less for 11 of the past 12 months! 

Chart #3

Chart #3 compares the value of the dollar (inverted, blue line) to the level of non-energy commodity prices. Normally, there is a strong inverse correlation between the value of the dollar and commodity prices. The strengthening of the dollar in recent years (shown here as a declining blue line) has exerted a strong deflationary influence on commodity prices, just as has happened during prior episodes of a stronger dollar (e.g., from 2011 through 2015). In inflation-adjusted terms, commodity prices have fallen by about 25% since March '22, which was just a few months before the CPI peaked in June '22. This lends further weight to the idea that inflation is continuing to decline. (Commodity prices usually react early to changes in monetary policy.)

If these trends continue to play out, don't be surprised when you see negative consumer price inflation within the next 6 months. And don't be surprised if the Fed figures this out and lowers interest rates well before, and by more, than the market currently expects.

Tuesday, December 5, 2023

Some big picture charts

While the world waits anxiously to see if the jobs report this Friday shows that too many people are working—because the Fed (erroneously) believes that might be inflationary and thus a reason to raise interest rates still further—I offer six charts that look at the U.S. economy from a big picture perspective. I don't find anything sinister or strange in these charts. Instead, I see an economy that is growing moderately (perhaps only modestly). I see a healthy labor market, an equity market that is rising at a normal pace, bond yields that have most likely risen by enough to cool inflation, credit spreads that are unremarkable (which is good), and a dollar that has been fortified by Fed tightening. 

Chart #1

Chart #1 compares the number of job openings to the number of people looking for jobs. Rarely have openings exceeded the number of job seekers by as much as they have in recent years. What's wrong with that? 

Chart #2

Chart #2 shows an index of service sector business activity. Conditions are still improving (almost 55% of businesses surveyed report improving activity). Things have been better, to be sure, but they would have to deteriorate materially to make me worry about a recession. In any event, this survey suggests that it's reasonable to expect the economy to continue to grow by, say, 2% per year. No boom, no bust.

Chart #3

Chart #3 shows the S&P 500 index from 1950 through today. As any student of long-term stock market returns knows, equity prices tend to rise by about 8% per year on average (sometimes more, sometimes less). Add about 1.5% for dividend yields, and you get a long-term total return for equities of about 9.5% per year. Today's market looks pretty normal by those standards. 

Chart #4

Chart #5

Chart #4 shows the yield on 10-yr Treasuries going all the way back to 1925. It's been a wild ride, to be sure, especially for the past few years, as yields rose by more and faster than at any time in history. Yields hit a low of about 0.5% in the midst of the Covid shutdowns in 2020, and have since risen to a high of 5%; today they closed at just over 4%. 

Chart #5 compares these same yields to year over year consumer price inflation from 1960 through today. If—as seems likely—the Fed succeeds in bringing inflation down to 2% or so and holding it there, there's no reason 10-yr yields can't trade in a range of 3.5% - 4%. We're pretty close to that already.

Chart #6

Chart #6 shows two very liquid measures of credit spreads (Credit Default Spreads). Credit spreads are notorious for moving up in advance of recessions and moving down as the economy recovers. That's because credit spreads are driven primarily by the market's outlook for corporate profits, which in turn is a function of the health of the economy. Right now credit spreads are only modestly elevated, which is consistent with a forecast of about 2% real economic growth.

Chart #7

Chart #7 compares the value of the dollar (white line) to the real yield on 5-yr TIPS (orange line). The two have a strong tendency to move together over time. Fed monetary policy is captured in the level of real yields (higher yields mean tighter policy). So a tight Fed means higher real yields, which in turn make the dollar more attractive. The dollar looks somewhat weak of late, and that probably means the market is expecting the Fed to ease policy over the next year or so. And in fact the bond market fully expects the Fed funds rate to be cut 5 times (125 bps) by the end of next year, with the first cut coming in the second quarter of next year. I wouldn't surprised to see the Fed cut rates at the March FOMC meeting, if not sooner. Real yields on 5-yr TIPS will probably be trading around 1% by the end of next year.