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Baltic and trade update





Both these measures of shipping costs for bulk commodities have strengthened meaningfully over the past two months. U.S. goods exports are up at a 34% annualized rate in the five months ended September. Spot industrial commodity prices are up 33% from their lows of late last year. Clearly, the wheels of global commerce are spinning back up. Skeptics continue to claim that this huge and pervasive rebound in activity and pricing is being driven by mindless Chinese stockpiling of commodities. I think it must go far beyond that. Everything I see is consistent with a global recovery in confidence, in demand, and in production.

Accommodative monetary policy undoubtedly is playing a role here, but for now I view it more as facilitating the recovery in confidence that is necessary to get things going. At the end of last year, the world's investors and businesses were frozen by the terror of counterpary risk, and the demand for money was almost overwhelming. This demand desperately needed to be satisfied by the world's central banks, and they have complied. Now that things are back on track, however, they should start to reverse their massive liquidity injections. The longer they wait, then the greater the risk that the upturn in demand that we are seeing will get blown out proportion by speculation.

Federal budget update





October budget data released today show a modest improvement in federal government finances, thanks mainly to the fact that spending in October of this year was about $90 billion less than it was in October of last year, when the frenetic bailouts and TARP legislation were launched. Still, spending growth is likely to continue to outpace revenue growth, with the result that the federal debt will continue to rise in relation to the economy. As this next chart shows, there does not appear to be any solid relationship between debt outstanding and long-term Treasury yields. Indeed, the relationship appears for the most part to be counter intuitive, with bond yields moving inversely to the size of the debt. Within reasonable limits (which we are still within), there is no reason for large deficits to impact interest rates, mainly because the latter are driven by inflation. Inflation, in turn, is ultimately controlled by the Fed, whose purchases this past year of $1 trillion or so of Treasuries and MBS threatens to push inflation higher in coming years.


Mortgage market update





I decided to post these charts after seeing a headline to the effect that new applications for mortgages had fallen to a 9-year low. Could this have something to do with the phasing out of the tax credit for first-time buyers? The first chart here would say in answer to that: not much. New applications for mortgages have been steadily declining for the past four years, even though mortgage rates today are almost as low as they've ever been (which should be worth at least as much as the tax credit). I think it's just the tail end of the housing bubble deflating. Ten years ago, today's level of new applications would have been considered extremely healthy; it was when the market became frenzied in the early 2000's that things started spinning out of control.

Another side of the story is mortgage refinancings, shown in the second chart. With the exception of a few brief spikes in the past 10 years, refi activity has been gradually trending up as mortgage rates have trended down. This is exactly what one would expect to see.

This is a good time to put in a plug for fixed rate mortgages. Fixed rates, as shown in the next chart, are very close to all-time lows. Refinancing an existing mortgage or planning to get a new mortgage? Go with a fixed rate. If interest rates go up, you have locked in a very low rate from an historical perspective. If rates go down further, you simply refinance, and the cost to do so is generally quite low. Adjustable rates might be very tempting, but they are also very risky. It's not a question of if short-term rates rise, it's a question of how much they rise. If inflation starts to heat up, short-term rates (the basis for adjustable rate mortgage rates) could rise by much more than the market currently expects.


Unemployment claims update



No changes here, just slow but continued progress.

Commodity update



Commodity prices and gold prices continue to rise. This chart makes two important points: 1) in real terms, commodities are still quite cheap from an historical perspective, and 2) monetary policy plays a very important role in commodity prices. I've broken the past 40 years down into three separate monetary regimes: first, the easy money policies of the 1970s, followed by the tight monetary policy of Volcker and then Greenspan, and lastly, the easy money policies of Greenspan and then Bernanke. One might argue with my classifications, but in a gross sense I think they make sense. Tight money is bad for commodity prices, while easy money is good. It would appear that commodity prices today have plenty of upside potential.

P.S. Blogging has been light since I was hit with the flu yesterday.

Inflation expectations continue to rise



Here's an interesting chart that strongly suggests that 10-year Treasury yields will be trending higher. The blue line is the 5-year, 5-year forward breakeven inflation rate as calculated by Barclays and as reported by Bloomberg. It's a way of extracting future inflation expectations by looking at the relationship between nominal and real Treasury yields along the yield curve. The blue line shows a tendency to lead the red line, which is another way of saying that the T-bond market is a little slow to pick up on underlying inflation fundamentals. Inflation expectations, as embodied in the breakeven spreads of TIPS—as well as gold and commodity prices—are rising. Treasury yields are perhaps being suppressed by Fed purchases of Treasuries and MBS, but I don't feel comfortable making that argument. I think it's just a case of the bond market being slow to the party as usual.

The blue line is something to watch very closely (especially now that it is within 8 bps of a multi-year high) since the Fed has said many times that this is its preferred measure of the market's inflation expectations, and the FOMC recently cited inflation expectations as one of the key indicators they will be watching for signs of whether or not they should tighten monetary policy. If inflation expectations continue to rise, the chances of a tightening will increase significantly, even though it will take a long time for the other indicators the FOMC cited (resource utilization and actual inflation) to sound alarms. Resource allocation (aka economic slack) and actual inflation are notoriously lagging indicators.

Full disclosure: I remain long TBT and short a 30-yr. fixed-rate mortgage at the time of this writing.

Credit spread update



I've been chronicling the evolution of swap and credit spreads for over a year now because I think they are key, market-based indicators of financial and economic fundamentals. If I had to choose between knowing what the unemployment was or knowing what the option-adjusted spread on corporate bonds was (see chart above), I wouldn't hesitate to choose spreads. The unemployment rate is flawed because it is impossible for the government to measure accurately (they can't possibly survey a workforce of more than 150 million people, so the government is forced to rely on surveys and guesstimates), and because it is backward looking—people don't get fired or hired until well after the economic fundamentals deteriorate or improve.

Swap and credit spreads, on the other hand, are determined daily by many millions of people around the world who do their part to clear the supply and demand for credit in this massive global economy. No surveys, no guesses: there is real money at stake here, and the market in aggregate has access to information that government bureaucrats can't possibly obtain.

Swap spreads typically lead the way, and they returned to "normal" last summer, as I noted here. The big decline in swap spreads that occurred in November and December of last year was the first serious indicator that the economy was on track for an eventual recovery. Credit spreads take longer to react to changing fundamentals, but as the chart above shows, they too have narrowed significantly since peaking at previously-unimaginable levels last year.

When I look at credit spreads today, I see great optimism in the fact that they have narrowed so dramatically. But if I just look at the level of spreads today and compare that to the history of spreads prior to last year's economic collapse, I see great pessimism. Credit spreads today are at levels that would have been consistent with the onset of recession at any other time in the past. This forms the basis for my statement in an earlier post today that, whereas the market was braced for a massive depression earlier this year, it is now braced for a simple recession. I see no signs of unfounded optimism in this market, since there are still plenty of signs of deep fear, uncertainty, and pessimism: implied volatility, credit spreads, and consumer confidence are still well above normal levels, and Treasury yields are well below normal levels. The market, like the economy, is still recovering from a massive blow.

The fatal flaw in healthcare reform

In their urge to have everyone covered by health insurance, Democrats have made sure to include a provision in their healthcare reform bills that would prevent insurance companies from denying coverage to those with preexisting conditions. Wisely, they realized that smart consumers might take advantage of this feature and wait until they came down with a serious illness before signing up for an insurance policy, so they mandated that everyone must buy health insurance from day one. To enforce that mandate, they added penalties for those who refused to cooperate.

But as Martin Feldstein explains, the penalties won't be enough to keep rational consumers from deciding it is in their best interest to be uninsured.

Consider: 27 million people are covered by health insurance purchased directly, i.e. outside employer-based plans. The average cost of an insurance policy with family coverage in 2009 is $13,375. A married couple with a median family income of $75,000 who choose not to insure would be subject to a fine of 2.5 percent of that $75,000, or $1,875. So the family would save a net $11,500 by not insuring. If a serious illness occurs--a chronic condition or a condition that requires surgery--they could then buy insurance. Since fewer than one family in four has annual health-care costs that exceed $10,000, the decision to drop coverage looks like a good bet. For a lower-income family, the fine is smaller, and the incentive to be uninsured is even greater.

And as Mark Perry notes, "What would make this choice to drop insurance and pay the penalty even more rational is the convenient, low-cost availability of basic health care from 1,200 retail clinics around the country, or through pre-paid plans like the No Insurance Club, or concierge medicine."

Ok, Congress, bring on your healthcare reform, if you dare! I'm looking forward to saving lots of money by dropping my own plan since I'm pretty healthy these days.

Fear subsides, prices rise (14)





I've posted these charts numerous times this year because the enduring relationship between equities, the value of the dollar, and implied volatility has been so fascinating.

The first chart isn't so hard to understand: it basically says that equities do better as fear and uncertainty decline. That makes perfect sense—how could any asset market prosper if the future became less certain and more variable? In the past several months there have been several equity selloffs, each one accompanied by a spike in the Vix index, which is a proxy for the market's fears, doubt, and uncertainty. Since these selloffs have been driven by "panic," rather than by any change in the fundamentals, they have proved to be only temporary. I pointed this out most recently in this post.

The second chart is more difficult to understand. In fact, it's counter intuitive, since it suggests that a falling dollar is good for the stock market. For a supply-sider, that goes against all common sense. Supply-siders would normally view a strong currency as a necessary condition for a strong economy, since it reflects confidence, a willingness to invest, and a low-inflation outlook. So how can 8 months of a falling dollar (the dollar is down 15% against other major currencies and down 19% against gold) coincide with a 60% rise in the stock market?

The answer that ties everything together is that the big changes in the dollar's value since early last year have been a reflection of big changes in money velocity. The economic collapse of last year was largely driven by a huge and relatively sudden collapse in money velocity. Consumers and businesses alike were panic-stricken by fears of a collapse of the global banking system, so everyone stopped spending money and tried desperately to increase their holdings of money, by selling other assets and by paying down debt. Then we had the big collapse in the equity market that hit bottom in early March, and that collapse was driven by fears of a looming fiscal train wreck in the U.S. Once again fear drove investors to stock up on cash. The dollar ended up being the chief beneficiary of the world's desperate desire for safety and liquidity.

What we have seen since March is therefore the gradual return of confidence and the unwinding of flight-to-safety trades. Dollar cash is no longer so desperately desired, and we see evidence of this in a huge decline in the growth rate of dollar currency and M2 since March. This next chart documents the big slowdown in money growth which began at the same time as the equity market started to turn up last March. Note also the huge increase in M2 growth which started in Sept. '08, around the time of the Lehman bankruptcy.



Equities have turned up because the economy has been recovering from shell-shock. Cash is being spent again, and the economy is gradually recovering the ground that it lost last year. In economic terms, we are enjoying a rising velocity of money; in a sense, money that had been "stuffed under mattresses" is now being spent, and that is powering a rise in economic activity. Contrary to what many pundits are suggesting, I think equities are far from signaling a bubble—they are rising because the market is experiencing the equivalent of a big sigh of relief. In early March, markets were braced for a super-double depression and deflation. Now that it is clear that we are not going to fall into an economic black hole, risky asset prices are slowly returning to levels that, in my estimation, reflect the expectation of a run-of-the-mill recession.