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Commodity price update

The dollar is up almost 5% from its low of last month, but commodity prices are still rising across the board. These charts show the Journal of Commerce commodity price index (top chart), followed by the four sub-categories of the same index. All are indexed so that their price is equal to 100 at the time the 2001 recession ended. The bounce in the dollar has had virtually no impact on commodity prices in recent weeks, which in turn suggests that commodity prices of late are being driven primarily by strength in global demand. However, that does not necessarily imply that there is no monetary inflation going on in the commodity markets, since it's entirely possible that all currencies are experiencing a monetary debasement, and the dollar has merely enjoyed a three-week reprieve.

Regardless of what's causing the rise in commodity prices, it is likely some combination of a) a resurgence in global growth, and b) very accommodative monetary policies around the world. Whichever is dominant is anyone's guess, but it is not a stretch to say that strong commodity prices rule out both a renewed economic slump and the threat of deflation. Therefore, these charts add up to a bullish outlook on growth.

Unemployment claims update

The 4-week moving average of weekly claims for unemployment continues to move lower.

I contrast this to the headline I see on Bloomberg this morning: "The dollar rose to the highest level in three months against the euro while stocks and commodities slid as investors shunned risky assets on concern the global economic rebound will stall. Treasuries rallied." I don't see any sign of a global economic stall. Instead, I see markets that are still shell-shocked, still trading at levels that imply a great deal of concern for the future. Why else would someone believe that a stronger dollar—which is only a few percentage points above its all-time lows—is a reason to not buy U.S. assets with otherwise-attractive yields?

Credit default swap spreads are narrowing (6)

Yet another update on this important measure of the likelihood of corporate defaults. Credit spreads have fallen dramatically over the past year, resulting in spectacular performance for corporate bonds of all stripes. When spreads were soaring at the end of last year, it was because the market was bracing for an extended depression and an accompanying deflation. Things didn't turn out quite so bad, so now the market is braced for a run-of-the mill recession. There's still lots of room for improvement, especially now that the Fed once again has assurred us that they are not going to upset the economic applecart by raising rates anytime soon.

When cash yields zero, while other things, like investment grade bonds, junk bonds and emerging market debt carry yields that are still quite high relative to Treasury yields, then to hold cash and not more risky bonds only makes sense if you think the economic outlook is going to deteriorate materially. With credit spreads still at levels that in the past have been consistent with the onset of recession, the bond market is priced to a deteriorating economy. To lose money in corporate bonds, therefore, the economy has to really deteriorate. The Fed is doing its best to minimize that risk, and it is also making the odds of winning a corporate bond bet as high as possible, by keeping cash yields at zero. You should never fight the Fed.

On a related issue, I note that the spread between 2-year and 10-year Treasuries today is as high as it has ever been. A very steep yield curve, such as we have today, is the market's way of telling you that the Fed is expected to raise rates by leaps and bounds at some point in the future. (For example, 10-year Treasury yields imply that the Fed funds rate will average 3.5% over the next 10 years.) In other words, today's steep curve tells you that the market is braced for a significant Fed tightening. The only real uncertainty is when the Fed will start to raise rates. For the Fed to upset the market's applecart, they would have to either a) start raising rates very soon and very fast, or b) not raise rates for a very long time, and then by not very much. To the extent you think both of these alternatives are unlikely, then you should avoid holding cash.

Full disclosure: I am long a variety of funds that invest in corporate, high yield and emerging market debt, and I have zero cash holdings at the time of this writing.

Inflation is alive and well

These two charts show year over year changes in the consumer and producer price indices, the top chart showing total, or "headline" inflation, while the bottom chart shows just "core" inflation (excluding food and energy). Energy prices are a big part of the current headline numbers, as the difference between these two charts illustrates.

Looking at all prices, inflation has jumped rapidly from negative to back to where it was on average over the past decade or so (about 2%). But on the margin, the jump is even more impressive: in the past six months, consumer prices are up at a 4.2% annualized rate, and producer prices are up at a 8.3% annualized rate.

Looking at core prices, inflation is subdued, with the Core CPI rising at a 1.5% annualized rate in the past six months, and the Core PPI rising at a 0.7% rate.

If you're willing to ignore energy prices, then you could agree with the Fed that inflation is far from being a concern these days. If not, though, then you would be pounding the FOMC table today to reverse the quantitative easing ASAP.

I'm willing to concede that energy is indeed volatile, and since energy prices are down this month relative to last month, that their impact in future inflation statistics is going to be minimal. But I continue to believe that the level of core inflation is "the dog that didn't bark," in the sense that it should be far lower than it is, if the Fed's theory of inflation is correct. The economy is still very weak, and there is an awful lot of "resource slack" out there. If resource slack is the thing the Fed is betting on to keep inflation subdued for the foreseeable future, then the Fed governors ought to be pretty nervous right now, because the Core CPI is only half a percent below the Fed's upper target of 2%. The bond market ought to be more nervous too, since breakeven inflation rates on TIPS maturing in 5 years or less is 1.5-2%.

I doubt the FOMC will acknowledge this reality in its statement today, but if they did I would feel a lot better about things.

Housing starts -- a U-sign

Not every sector of the economy is in a V-shaped recovery. Based on housing starts data so far this year, residential construction is in a U-shaped recovery. It sure looks like it's hit bottom, but the upturn is relatively anemic. I look for more improvement over the course of next year, but of the slow type, not dramatic.

The confusing connection between M2 and inflation

In a recent post on Carpe Diem, Mark Perry notes that year over year M2 growth is now at its lowest point since the beginning of 2005, and asks "Wouldn't M2 money growth have to be much higher to fuel the kind of inflation many are worried about?"

A standard monetarist answer to his question would be "yes." But in my experience the connection between M2 and inflation can be quite convoluted, to say the least. Let me explain this by first noting that the connection between M2 money growth (M2 being the most reliable, enduring and meaningful measure of "money" that I'm aware of) and inflation is not always what one would expect. Milton Friedman was one of the best economists of the past century, but his inflation forecasts over the past three decades, based on his observations of M2 growth, were often famously off the mark. Here are two charts which illustrate the difficulty of relating M2 growth to inflation.

In the first chart I show the 2-year annualized growth rate of M2, with an overlay of different colors which depict periods of rising and falling inflation. I use the 2-year growth rate of M2 to smooth out the monthly fluctations and focus on the trend, and also to recognize that there is a lag between money growth and inflation. If money growth is high for one year and then low the next, it's impact on inflation is not going to be as big as if it is high for two years. In the second chart I present the history of consumer price inflation on a rolling 12-month basis, in order to back up my choice of rising and falling inflation periods in the first chart.

There are quite a few conundrums that jump out of the first chart. First, M2 growth in the 1970s was about the same as it was in the early 1980s (about 9% a year on average), yet inflation rose sharply in the 70s and fell sharply in the first half of the 80s. Inflation then rose in the second half of the 80s, even though money growth slowed down throughout the period. The early 90s is a difficult period to deconstruct, due to the impact of FIRREA on the banking system, but it does appear that faster money growth through most of the 90-2003 period corresponded to falling inflation. Finally, we see relatively slow money growth from mid-2003 through mid-2008, yet inflation accelerated.

If a novice were to draw conclusions from this, he or she might say that slow money growth leads to rising inflation, and fast money growth leads to falling inflation. That would of course run directly counter to everything that Milton Friedman taught us, when he asserted time and again that "inflation is always and everywhere a monetary phenomenon."

The source of the problem/conundrum here is that while M2 is an excellent measure of liquid money that is available to be spent, it is a much better of money demand than it is of money supply. According to the monetary theory of inflation, inflation occurs when the supply of money exceeds the demand for it; in other words, when the Fed supplies more money to the economy than the economy wants. (The Fed supplies currency and bank reserves to the system, but that doesn't mean the Fed can control the amount of M2. In the past year the Fed has poured $1 trillion of reserves into the banking system, but the increase in M2 has been comparatively very small, because banks have tightened their lending standards, and many corporations and individuals have been deleveraging their balance sheets.) If the demand for money is rising, the Fed can accommodate this—by allowing money growth to rise—without faster money growth being inflationary. Conversely, if money demand is falling but the Fed fails to offset this by tightening policy (the situation we find ourselves in today), then money growth can slow and inflation can rise.

The key to figuring out whether Federal Reserve monetary policy is inflationary or not lies in determining whether the Fed is oversupplying money or not. But you can't tell this by looking at M2 growth. One of the key insights of supply-side economics is that free markets are excellent sources of real-time indicators that can be used to tell, for example, whether monetary policy is inflationary or not. It's rather simple: if there are too many dollars in the system, then we would expect to see some or preferably all of the following: a) the value of the dollar falling relative to other currencies, b) gold prices rising, c) commodity prices rising, d) the yield curve steep or steepening, e) credit spreads tightening (since easy money is great for debtors and should reduce default risk), f) inflation expectations as embodied in TIPS prices rising, and g) currency growth falling (currency becomes a hot potato when inflation rises, so the demand for currency should fall). All of these are symptomatic of a situation in which the supply of money exceeds the market's demand for money.

(The late Jude Wanniski was by far the most prolific supply-side writer, and he wrote extensively on this subject. A vast archive of his writings can be found here.)

Since we have been seeing most or all of these rising inflation symptoms for the past year or so, that's why most supply-siders have been predicting rising inflation even though M2 growth has slowed down rather remarkably (M2 growth is essentially zero over the past six months).

Caveat: this is a highly contentious issue about which reasonable men can and do disagree.

Why a stronger dollar is not a problem (2)

It's amazing to me that the market seems awfully concerned about the recent rise in the dollar's value. This chart shows what is arguably the best measure of the dollar's value against a large basket of currencies, since it is both trade-weighted and inflation-adjusted. At the end of November the dollar was trading (for the fourth time in history) at its lowest level ever. Today it is up about 3% from that low. How can this possibly be construed as a bad thing?

Those who worry about a stronger dollar are making several mistakes, and here are a few:

1) An ever-weaker currency does not lead to a stronger economy by way of boosting exports. Big downward moves in a currency can eventually lead to rising exports (the J-curve effect), but a depreciating currency also makes imports more expensive. Spending more on imports can offset whatever benefits there may be from rising exports.

2) An ever-weaker currency inevitably leads to rising inflation. The basic definition of inflation is a decline in the value of a nation's unit of account. Rising inflation throughout the economy can more than offset whatever gains there may be in the export sector.

3) An ever-weaker currency discourages investment, and without investment it is very difficult for living standards to rise. Who wants to invest in a country whose currency is falling? A depreciating currency can wipe out investment gains.

4) A weaker currency not only discourages investment, it encourages price speculation. A weaker dollar has helped boost commodity prices, and that in turn attracts commodity speculation. Speculative activities do not necessarily create a more productive economy, and many times they simply result in a transfer of wealth. Speculators play a very important role in keeping markets liquid and efficient, but when everyone starts speculating on price increases, you know that fewer people are paying attention to the investment that is essential to boosting the productivity of labor. The good thing about a strong and stable currency is that it reduces the rewards to price speculation, and that in turn forces the market to direct its resources to productive investments.

5) The dollar's rise from all-time lows is at least partially due to the expectation that the Fed will begin raising interest rates sooner than previously expected. Higher interest rates, coming off a base of zero, can hardly be considered a threat to economic activity. On the contrary, higher interest rates directly benefit the majority of U.S. households, since the household sector has significantly more floating-rate assets (e.g., bank CDs and money market funds) than floating-rate debt (e.g., adjustable rate mortgages, now at risk of extinction). Interest rates would have to be hugely higher for a long time—and the yield curve inverted—before they posed a serious risk to economic growth.

Inflation expectations -- another V-sign

This chart shows the breakeven inflation rate for 10-year TIPS (aka the market's 10-year expected inflation rate). It's simply the difference between the nominal yield on 10-year Treasuries and the real yield on 10-year TIPS. As should be obvious, after collapsing last year, inflation expectations have rocketed higher this year for a rather spectacular comeback. Inflation expectations haven't completely returned to the levels they were registering several years ago, but at this rate it won't take much longer to get there.

In one sense, however, inflation expectations are already breaking out to new highs, as shown in this next chart. It's the market's 5-year inflation expectation 5 years forward, as calculated by Barclays. It's now as high as it has ever been, with the brief and tiny exception of Mar. '08, and it looks like it's headed higher. In the annals of inflation, this past year—in which inflation expectations collapsed to zero only to fully rebound 12 months later—will undoubtedly go down as one of the great deflation head-fakes in financial history.

I can't resist referring back to my posts of late last year, in particular this one, in which I argued that "TIPS are a steal" because the market was projecting zero inflation but the Fed was hell-bent on reflating. If I were running the Fed, my message to fellow governors would be "OK, guys, job done: inflation expectations are back on track, now we need to get interest rates back on track."

Industrial Production -- another V-sign

Industrial production has surged at a 9.3% annualized rate since the recession ended late last June. Consumers are getting back their spending mojo, and factories are gearing back up after having shut down in a panic. This is just the standard stuff of any recovery. Factories still have tons of idle capacity, but that just means that revving up production is relatively cheap and painless—no need to go out and build new plants, just turn the machinery on.

Why a stronger dollar is not a problem

Today marked a milestone of sorts: the S&P 500 hit a new closing high for the year, even as the dollar traded about 3% above its November lows. For almost all of the past year or so, there has been a strong inverse correlation between moves in the dollar and equities. Now we see that relationship possibly beginning to break down. If this continues, it could have some very significant consequences, although there is some fundamental disagreement about what those consequences might be.

To sort through the consequences of a new relationship between the dollar and equities, consider first that the "carry trade" is a popular theory for explaining the inverse correlation between the dollar and equities and other risk assets to date. According to this theory, a weaker dollar is a sign of people borrowing dollars and investing the proceeds in equities and other risky assets such as commodities, oil, gold, and other currencies. By keeping short-term interest rates close to zero, the Fed has provided tremendous encouragement to this trade, and this in turn is supposed to facilitate an economic recovery by pumping money into the system, reducing credit spreads, and boosting U.S. exports. However, it brings with it some very unpleasant inflation consequences, and it also means that the recovery is fragile, since it is built on a foundation of speculative activity rather than investment. Those who believe in this theory worry that a stronger dollar and/or a tighter Fed will shut down the carry trade, and thus expose the economy to a painful economic relapse.

I've explained the inverse correlation between the dollar and equities quite differently, keying on the demand for money. I've documented in a series of posts how changes in the value of the dollar since early 2008 have corresponded to changes in the demand for money (which is of course the flip side of money velocity). The dollar rose last year as money demand soared; this was reflected in a surge in the amount of dollar currency outstanding, a surge in the M1 and M2 measures of money supply; and a severe contraction in nominal GDP. Just the opposite has occurred since last March: money demand has declined, the dollar has weakened, the growth of dollar currency, M1 and M2 has dropped to near zero, and nominal GDP has picked up. In short, money that last year was hoarded was returned to circulation this year, thus boosting the level of economic activity. Declining money demand this year was thus symptomatic of a return of confidence and a portent of improving economic conditions in general; rising prices of equities and other risk assets were all simply the natural result of an improving economy.

It is also the case that there has never been a stable or enduring correlation between equities and the dollar. So if the correlation going forward becomes positive instead of negative there is no reason in principle to be concerned.

In the current situation, however, I think that a positive correlation between equities and the dollar would be a good indication that the economy was improving on its own merits, without help from money demand or the Fed. Since markets have been deeply distrustful of the economic improvement to date, and just as convinced that the Fed will have to keep interest rates at zero for a very long time, any signs that the economy is experiencing genuine growth directly contradicts the market's fundamental assumptions. We have seen hints of this already, in the form of declining unemployment claims and sharply reduced job losses, plus broad-based strength in commodity prices, and of course all the V-signs that I've been posting about for months. A stronger than expected economy would inevitably lead the market to demand more equity exposure, at the same time it would lead the Fed to tighten sooner than expected. Rising interest rates need not pose any great risk to the economy in my view; indeed, rising interest rates would be a very welcome indicator of economic health and vitality.

And of course, as a supply-sider I am a firm believer in the concept that a strong currency is always better than a weak currency. And since the dollar currently trades at historically low levels relative to most other major currencies, a stronger dollar would be doubly beneficial, since it would mark a badly-needed return of confidence (which would bring with it increased investment), as well as a lessening of inflationary pressures.

100 years of inflation

This chart puts the past 100 years of inflation into a context you've unlikely seen before. The message of this chart is that the "best" days of inflation are in the past. By best, I mean the times when inflation was low and relatively stable. The best decade, as shown in this chart, was the 1990s, with the second-best being the 1960s. The current decade is only the fourth-best.

(Note: the red bars mark the range between the highest and lowest level of year-over-inflation in each decade, as measured by the CPI. The yellow line represents the average level of year-over-year inflation in each decade. The blue bars represent the average plus or minus one standard deviation. Smaller red and blue bars correspond to less-volatile inflation conditions.)

The volatility of inflation has picked up in the past decade, even though the average level of inflation has been relatively low (2.6%). This volatility was driven apparently by extremely volatile energy prices, but energy price volatility arguably was driven by erratic monetary policy. The Fed can (and usually does) blame unwanted or volatile inflation on external factors beyond their control, but ultimately the Fed bears the responsibility for the level and variability of inflation.

CMBS update -- very bullish

Here's a graph of the price of a AAA-rated commercial mortgage-backed security index that is published by the folks at markit. Earlier this year, prices fell as low as 56, whereas today they are over 82 and rising. That's an impressive gain, and it comes despite the ever-increasing drumbeat of concern for commercial real estate. What this means is that the market was way too pessimistic earlier this year about the prospects for commercial real estate loan defaults. Even though defaults are likely to rise next year, they are now projected to rise by less than previously expected. This ties into a reply I made on a recent post comment, to the effect that rising default rates are not likely to be bearish for the market or for the economy, since the market has already discounted those losses. Enormous losses have been booked already in our forward-looking markets; what remains to be seen is whether the actual losses are more or less than what has been anticipated. Moral of the story: don't look at the level or even the projected level of CRE defaults, look at the behavior of the prices of securities that will be affected by those defaults. On that score things are getting better even though defaults are rising.