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The M2 myth: money is not in scarce supply



With the CPI having fallen a bit in April, and the equity market behaving as if a double-dip recession is in the cards, fingers are pointing to the very slow growth in M2 and warning of deflation and other dire consequences. Pundits can be mistaken, of course, so it's always best to do some homework. As of today's release, M2 growth, on an annualized basis, is 0.6% for the past 3 months, 0.5% for the past six months, 1.5% for the past year, and 5.1% for the past two years. The reason for the slow growth in the past year is that growth in the prior year was exceptionally fast, as should be clear from the first chart above.

For the past 15 years, M2 growth has averaged about 6% per year. Over the past two years it has only grown 5% on average, but it is still above what looks to be its long-term trend. For purposes of comparison, I note that since 1995 nominal GDP growth has averaged about 5% per year, and real GDP growth has been about 2.5% per year. Inflation has averaged about 2.5% as well, and has been relatively stable around that level. All of these are fairly unremarkable numbers, and about as stable, on average, as you could hope to see.

From these facts I conclude that there is no basis for the widespread concerns about the economy being starved for money, about deleveraging leading to a Japanese-style slump, or about deflation. As I've maintained all along, the strong growth in M2 in late 2008 was driven by a surge in money demand (and a big drop in money velocity), while the slow growth in the past year has been a sort of pay-back, with money demand declining and money velocity picking up.

On a final note, I see that the 3-month annualized growth rate of M2 has increased from a low of -1.4% four weeks ago, to 0.6% today. This, in the context of the level of M2 approaching its long-term trend, seems perfectly reasonable. The behavior of M2 going forward will tell the tale of whether we have too much money, or not enough. It will also be important to watch M2 velocity, since it has a long way to go to "pay back" its decline over the past year or so. If M2 velocity keeps rising and M2 growth also picks up, even modestly—which would not surprise me at all—we would have the essential ingredients for some monetary inflation.

Financial indicators still point to recovery


This chart has the best track record of signalling recessions of any that I'm aware of. The blue line is the real Fed funds rate, and the red line shows the slope of the Treasury yield curve from 1 year through 10 years. Every recession for the past 50 years has been preceded by a rise in the real Fed funds rate and an inverted (negatively sloped) yield curve. When real short rates are high and the yield curve is inverted, its because the Fed is aggressively tightening monetary policy, and this eventually strangles the economy.

Conditions today are the exact opposite, and point to continued recovery. The Fed is easy, real short rates are negative, and the yield curve is almost as steep as it's ever been (even though it has flattened somewhat today). It would be astonishing if a recession were to develop given how accommodative financial conditions are today. (And I note that conditions in Europe are quite similar to conditions here in the U.S.)

Claims update


No sign of a recession here.

The Euro crisis reaches panic proportions


As panics go, the current one is a doozy, eclipsed in modern times only by the Lehman collapse and the Crash of '87. Is Europe teetering on the brink of collapse? I suppose anything can happen, but surely it can't be very likely.

I think the explanation for the current panic is that investors are simply very skittish and the market is not nearly as liquid as one would like to think. Hair-trigger stop losses can overwhelm the market when the going gets tough. The panic feeds on itself. Pundits predict another calamity in the making. European policymakers do stupid things like prohibiting naked short selling.


With panic selling of equities comes panic buying of Treasuries. German 2-yr Bund yields are down to less than 0.5% (US 2-yr yields are 0.7%). 10-yr Treasury yields are down 75 bps from their April highs. As this chart suggests (my interpretation), yields at this level only make sense if we are on the verge of another recession. Yet there are simply no signs of a recession that I can find. Central banks are still very easy, yield curves are still quite steep, corporate profits are strong, commodity prices are still quite high, swap spreads haven't widened significantly, and many areas of the global economy are experiencing V-shaped recoveries.



Sovereign yields are very low, implied volatility is very high, gold is very strong and the dollar is up sharply against other major currencies, but the classic precursors of a recession are nowhere to be found—all this makes sense only in the context of a panic. When the panic subsides, prices are very likely to rise again, as this last chart suggests:

Spread update: not much to worry about







Expanding on the theme of my prior post, here is a quick look at the current state of swap and credit spreads. As is the case with most "risk assets," we see a modest correction in credit markets. US swap spreads have moved up, but from very low levels to levels that are easily within the range of "normal." As the second chart shows, the rise in US swap spreads has pretty much followed the rise in euro swap spreads, suggesting some degree of contagion from Eurozone credit concerns; after all, if a large European bank should go belly up, it would surely be of concern to its US counterparties. But as my friend Mike Churchill reminds me, euro swap yields (as shown in the third chart), have been falling consistently throughout the developing Greek crisis. In other words, the rise in euro swap spreads has been driven mainly by a collapse in government yields, which is more a sign of investors seeking safety than it is of investors fleeing the market in general. Funding costs for most qualified borrowers have been declining all year, so the rise in swap spreads does not pose any threat to economic activity.

Meanwhile, 10-yr US swap spreads are trading at a mere 6 bps (vs. 28 bps in Europe), which is still quite low from an historical perspective. Consequently it would appear that the market is thinking that this is a near-term problem, not an enduring or structural problem.

Corporate credit spreads have also moved up, as shown in the fourth and fifth charts, but so far the correction doesn't appear to be significant or particularly disturbing. If we assume that swap spreads continue to be leading indicators for spreads in general (as I have been arguing since October '08), and given that swap yields are still declining, then there is little reason for alarm. The market is certainly uneasy, but that seems more likely due to a case of nerves rather than to anything concrete.

Is the commodity selloff significant?






A friend asked me yesterday if I saw any signs of concern in the commodity markets. Could the broad-based decline in commodity prices in the past month be signaling an economic slump? Could the worries over Greek debt and the future of the euro be spilling over into another round of consumer and corporate retrenchment around the world?

So I pulled together these charts of various commodity prices and indices and updated them with the latest figures. I think the message of every one is basically the same: yes, there's been a bit of a selloff, but it doesn't look particularly large from an historical perspective, and prices remain relatively elevated. In the case of gold (last chart), the recent decline is almost undetectable, and gold is the commodity most likely to be driven by speculative (and forward-looking) activity. The CRB spot commodity index is probably the one least influenced by speculative activity (since only a few of its components have futures markets attached to them), but it too has suffered only a minor correction of late.

Meanwhile, the dollar has experienced a pretty significant rally in the past month, coincident with the modest selloff in commodities. This is not unusual at all, since the value of the dollar and commodity prices have been inversely correlated for a long time.



Faced with the uncertainty of Greece and the euro, investors have retreated to the safety of the dollar and gold. Commodities have experienced a modest correction as the dollar has climbed, because commodity prices almost always respond that way to changes in the value of the dollar. If there's anything that stands out here, it is that the correction in commodity prices looks quite tame relative to the change in the dollar. And that, when combined with the very strong performance of gold, suggests that global liquidity is still in abundant supply.


Equity investors have been spooked as well. But note the big jump in the Vix Index, actually the biggest since those awful days of late 2008 when it seemed that the whole international banking system was on the verge of collapse. The biggest thing impacting the markets right now is that old familiar nemesis: fear, uncertainty and doubt. The rise in FUD is much bigger than any physical or financial sign of economic deterioration.

Bottom line: the most likely explanation for what is going on is this: the market is climbing one more in a series of "walls of worry." Today's concerns will eventually pass, to be replaced by a renewed focus on the many signs of renewed global growth.

The political tsunami is underway

Message to big-spending incumbents:

Rep. Joe Sestak defeated five-term incumbent Sen. Arlen Specter in Pennsylvania’s Democratic primary election. Mr. Specter is the third incumbent in as many weeks to lose his re-election bid in an intra-party contest.

With 65% of precincts reporting, the Associated Press called the race for the two-term Mr. Sestak, 53% - 47%.

Mr. Sestak defied the party establishment, including President Obama, in mounting a primary challenge to Mr. Specter, who switched parties last year in part to improve his re-election prospects.

Rep. Sestak faces Republican Pat Toomey in the fall election.

http://online.wsj.com/article/SB10001424052748703957904575252061587373610.html?mod=djemalertNEWS

This is huge. The people are very upset, and they are taking their revenge. At this point it seems difficult to underestimate the positive changes, from the perspective of a supply-sider or non-Keynesian, that will occur with the November elections. Very bullish.

One more attempt to repeal the law of gravity

In a few hours, Germany will introduce a "temporary ban on naked short-selling and naked credit-default swaps of euro-area government bonds." Presumably, this move is meant to calm markets by protecting them from the predations of greedy speculators. Predictably, however, it only makes matters worse. In the wake of the news announcement, the euro dropped, gold rose, government bond yields fell, implied volatility of equity options rose, and equities fell—all classic signs of a market suddenly more concerned about downside risks to the economy and financial markets. And it stands to reason, because announcing you're going to limit the market's ability to express downside risks tomorrow, only increases the market's desire to protect against downside risks today.

The only good news is that Germany's attempt to repeal the law of gravity (by supposedly limiting negative speculation), can be easily reversed. That's likely not the case with Venezuela's decision today to attempt to put a band around its sinking currency. Venezuela has already made two fatal mistakes, first by printing money (and thus fundamentally debasing its currency), and second by devaluing the currency but establishing a dual exchange rate for imports and exports (thus encouraging all sorts of shenanigans, like the over-invoicing of imports, that effectively funnel capital out of the country). You either respect your currency or you don't; the more you try to prevent it from falling by diktat or by exchange controls, the more you undermine confidence in the currency.

Banning naked short selling may make it harder for speculators to speculate on a Greek default, but it does nothing to change the fundamentals behind Greek debt. It does, however, interfere with markets by making them less efficient, and it heightens investors' concerns: do the regulators know something we don't? Thus Germany is taking steps that could needlessly prolong the crisis. That's unfortunate, but it's not the end of the world. The fundamentals of global growth are firmly in place and likely to carry the day once the dust settles.

Greek Myths

John Cochrane has a superb op-ed in today's WSJ: "Greek Myths and the Euro Tragedy." Superb because he argues clearly and concisely that conventional wisdom on the subject of a possible Greek default, and how that might be really bad for the euro, is completely wrong.

"We're told a Greek default would imperil the euro. The opposite is true." A Greek default would only harm the euro if the ECB failed to act responsibly.

"A currency union is strongest without fiscal union." Giving investors the impression that other countries and the ECB itself stand ready to bail out profligate governments only creates moral hazard. Allowing Greece to default or restructure its debt would show the world that the ECB means business.

"... the euro's founders ... set debt and deficit limits. The problem is not that these limits were too loose. The problem is having them at all." The market is the best enforcer of limits on debt, not politicians. Those who borrow too much soon find that the cost of borrowing becomes prohibitive, and they then have no choice but to either reduce their spending or restructure their debt.

"We're told that a Greek default will threaten the financial system. But how? Greece has no millions of complex swap contracts, no obscure derivatives, no inter-twined counterparties. This isn't new finance, it's plain-vanilla sovereign debt." Those who read "Panic," the book I reviewed last week, will understand that this is a crucial point. The financial panic of '08 and early '09 was in large part driven by the market's lack of understanding of the risks inherent in complex derivative securities. In the case of Greek bonds, the risks are simple and straightforward.

"Letting someone lose money on sovereign debt is the acid test for the euro. If not now, when? It won't happen in good times, nor to a smaller country."

"The only way to solve the underlying euro-zone fiscal mess (and our own) is to slash government spending and to focus on growth. ... growth does not come from spending. Greece's spending over 50% of GDP did not result in robust growth and full coffers. At least the looming worldwide sovereign debt crisis is heaving 'fiscal stimulus' on the ash heap of bad ideas." This point is also crucial, as I have tried to point out before. Deficit-financed spending can never stimulate an economy, so slashing spending in order to reduce financing needs is not likely to kill an economy. It is likely, however, to improve investor confidence and economic efficiency, and those in turn become key ingredients for badly-needed future growth.

What this all means is that the market is likely overestimating the risks to Europe and the euro. The problem is not nearly as bad or intractable as the market seems to think.

Inflation is still alive and well


The Producer Price Index of finished goods in April fell 0.1%, but only after rising at a 7.3% annualized rate in the past six months, and 5.4% in the past year. Excluding food and energy prices, the core PPI has been rising at a fairly steady 1% annual pace since early last year. So food and energy prices have been the major sources of inflation for the past year, but that doesn't mean inflation is dead.

If monetary policy were being run with the objective of keeping overall prices steady, then a significant rise in the price of one good or service would necessarily result in a significant decline in the prices of some other goods or services. With the above chart we see instead that big increases in food and energy prices did not prevent all other prices from rising. To the contrary: I note that prices of intermediate goods ex-food and energy have risen at an 8% annualized pace over the past six months, and 5.6% over the past year, while crude goods prices ex-food and energy are up at a whopping 48% annualized pace in the past six months, and 50% in the past year. Consequently we can conclude that the Fed is not pursuing a policy designed to deliver price stability.

The fact that inflation is still alive and well despite the huge amount of economic slack that has prevailed for the past 18 months also casts even more doubt than already existed on the still-popular Phillips Curve theory of inflation. Surely, if inflation had anything to do with the unemployment rate (the Phillips Curve posits an inverse relationship between the unemployment rate and the rate of inflation), then we should have seen plenty of evidence of deflation by now. To be sure, there are sectors of the economy that are experiencing price declines, but as the PPI numbers show, the overwhelming majority of prices are rising.

I've been arguing for quite some time that inflation is alive and well, and I think this is a significant issue. That's because the market continues to be very concerned about the risk of deflation; I see this in the relatively low 1.25% breakeven spreads on 2-year TIPS; I see it in the relatively low level of Treasury yields in general (2-yr Treasuries at 0.8%, 5-yr at 2.2%, 10-yr at 3.4%); and in the Fed's continued concern over deflation risk (why else would they insist on keeping short-term rates at close to zero?). If the market and the Fed were to lose their preoccupation with deflation risk, then the outlook for the economy and for corporate profits would brighten considerably, and default risk would decline. This would be undeniably good news for stocks and corporate bonds, and very bad news, of course, for Treasury notes and bonds, and for mortgage-backed securities. Furthermore, I suspect that if the Fed acknowledged that deflation risk were dead, the gold market would get a big case of the willies, because that would mean that super-accommodative monetary policy—the lifeblood of quadruple-digit gold prices—was on its way out. By the same logic, this would be a boon for the dollar, which remains historically weak.

Housing market recovery underway


It is now abundantly clear that the U.S. housing market is recovering. From the all-time lows registered in April of last year, starts have now risen 40%. To be sure, the level of activity is still dismally low, but that a recovery is underway is virtually certain. The Bloomberg index of home builders' stocks has been saying the same thing for some time now, with the average stock up 125% from last year's low. Recovery skeptics have been telling me for many months that a true recovery can't happen without a recovery in housing; if they are right, then this is pretty good news indeed. Regardless, I view this as just one more of many signs that the economy is in recovery mode. The only item of debate at this point is how fast the economy will recovery, not if. I see no reason to change my long-held expectation of 3-4% growth, which amounts to a moderate recovery, albeit one in which a lot of V-shaped sector recoveries, like this, can be found.

The essence of the Tea Party: leave us alone

Ed Crane, president of the libertarian Cato Institute, wrote a nice editorial in last Friday's Investor's Business Daily about the failure of our elected officials to understand what the people really want. As he puts it, we have a failure to communicate:


The communication problem involves the accelerating realization on the part of many Americans that the essence of America, namely, a respect for the dignity of the individual, ... involves the government leaving the individual alone.

One of the classic examples of the failure of politicians to communicate with the citizenry is found in a video of Romanian tyrant Nicolae Ceausescu, giving what turned out to be his last speech to the teeming masses gathered in a square in Bucharest.

Oblivious to the mood of the people, Ceausescu is at his bombastic, self-important best until he realizes that the chants from the crowd below are not praise, but something rather to the contrary.

The Declaration of Independence says governments are created to secure our rights to life, liberty and the pursuit of happiness. In other words, to leave us the hell alone.

... this is the encouraging thing about the Tea Party movement. It is made up of average Americans who are sick to death of politicians regulating, taxing, controlling and limiting individual choice.

[Congressmen] think we sent them to Congress to solve our problems when we sent them there to see to it that we are left alone to solve our own problems. Add to that the fact that many of our problems have been created by Congress, and we have the basis for a healthy, peaceful revolution.

Where's the angst?


Given the plunge in the euro and the rampant speculation that the euro is history and its coming dissolution will prove very painful for the Eurozone economy, you would think that German equities, measured in dollars, would be in free-fall. But you would be wrong, as this chart shows.

Note that the two y-axes on the chart are scaled to be identical—the high point on each axis is 5 times the low point. One thing this reminds us of is that equities have rallied by a factor of almost 3 in the past 15 years. Not too shabby: the S&P 500 index has risen a little over 6% per year, compounded, since the end of 1994. Measured in dollars, Germany's DAX index has risen about 7% per year. So much for the collapse of Europe and the demise of equities.

The chart also illustrates how closely the equity markets of the U.S. and Europe have tracked each other over the years. Most of the variations shown in the chart are due to currency fluctuations, but these tend to wash out over time. In fact, the DM today is about 5% stronger than it was at the end of 1994. So the almost 20% decline in the euro since its Nov. '09 high against the dollar was not so much a collapse as it was a reversion to mean. Just keeping things in perspective.

UK industrial production turns up


The U.K. economy has been especially hard hit by the recession, but even there we can find some green shoots. Industrial production finally appears to be picking up, after being flat for over a year, a good indication that the economy is once again growing.