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The decline in the Vix and swap spreads looks very bullish for stocks


The Vix index has dropped to 24 after spiking to 48 on May 21st. 2-yr swap spreads are now back to "normal" levels of 34 bps, after spiking to 64 on May 25th. The surge in the Vix and in swap spreads preceded the slump in the S&P 500, which reached a low on June 4th. It would appear to me that with fear, uncertainty and doubt fading fast, the equity market looks poised to enjoy some handsome gains in the days and weeks ahead.

Here's a close-up of the Vix and swap spreads:

Household financial burdens continue to decline, and that is good


The Federal Reserve today released their estimates of households' financial burdens, and the news continues to be good. The chart shows two measures of financial burdens: mortgage and consumer debt payments as a percent of disposable income (red), and total financial obligations (mortgage and consumer debt payments, auto leases, homeowners' insurance, and property tax) as a percent of disposable income. By either measure, financial burdens are no greater today than they were in the mid- to late 1980s. There is no evidence at all to support the notion that households are over-extended or at risk.

Households have been hard at work deleveraging their finances since the peak of 2007, but they were never seriously at risk to begin with. I've been showing this chart since Dec. 2008, when I argued that "once the financial system finishes writing down the value that has been lost to plunging housing values and collapsing commodity prices, we will discover that the basic economy (the consumer) is still in reasonably good shape." And so it appears today.

I would also point out that while so many commentators fret that deleveraging poses a serious threat to the economy's ability to grow, that is not the case at all. Consider that there has been considerable deleveraging since 2007 (as shown by the decline in financial burdens in this chart), but meanwhile the economy hit bottom about a year ago and has been growing ever since. Economic growth can be facilitated by increased debt, but debt is not essential for growth, nor does declining debt mean that growth must reverse.

Another high for gold portends higher commodity prices


Gold today closed at yet another new high against the dollar. The euro has jumped against the dollar of late, so gold is about €30 off its highs against the euro; ditto for the yen. The big story, however remains that all currencies have lost significant ground to gold in recent years. That all currencies have lost so much value against a gold benchmark at the same time overwhelms the movements of one currency vis a vis another.


As this next chart shows, gold is highly correlated with commodity prices (0.86 over this 30-year period), and gold tends to lead commodity prices. I've heard many arguments for why gold is marching to the beat of its own drummer these days (e.g., the Chinese and the Indians are flush with money and can't help but spend it on gold), but I would argue that it is very hard to dismiss gold when you consider how gold and commodities have tracked each other over the decades. Commodity prices have dipped a bit since April, but they are already on the rebound, and this chart suggests they could have substantial upside remaining. This would add significant fuel to the inflationary pressures that are already building (see earlier post).

A weaker dollar reflects good news for the U.S.


It's time to revisit this chart, since important changes are afoot. The dollar has suffered a sharp reversal in the past 10 days that coincides almost exactly with a rebound in equity prices. (Note that the dollar is plotted in inverse fashion, so the rise in the red line reflects a decline in the dollar's value.) This development most likely reflects a decline in concerns over whether the Euro debt crisis could threaten the global economy via another banking crisis. Demand for the dollar as a safe haven has declined, at the same time that the outlook for the U.S. economy—which so far shows few if any signs of Euro debt contagion, as reflected in the recent decline in swap spreads back to more normal levels—has improved. The Euro crisis remains a big concern in Europe, but markets are breathing a sigh of relief now that it appears that it will not be a serious threat to the U.S. or to the global economy.

It's not often that a weaker currency implies good news for an economy, but this appears to be the case now.

Inflation pressures are building in the production pipeline



These two charts compare headline and core inflation at the producer and consumer level. While it's true that the recent inflation statistics have been relatively mild (e.g., the recent two-month decline of 0.23% in the CPI) this year, if there is one thing these charts show it is that inflation at the producer level is rising relative to inflation at the consumer level. Note how year over year PPI inflation was consistently below that of the CPI throughout the 1990s and into the early 2000s (this is quite clear on a core inflation basis). Since 2003 the PPI has tended to equal or exceed the CPI on both a core and headline basis.

One reason for the difference between producer and consumer inflation is that commodity prices have a more direct and immediate impact on producer prices than they do on consumer prices. Commodity prices were very weak in the 1990s and through 2001, but they have been very strong since 2002. Same goes for the dollar, which was generally strong from 1990 through 2002, and generally weak ever since, and that ties in directly with the stance of monetary policy, which was generally tight throughout he 1990s and early 2000s, but has been accommodative ever since. A strong dollar helps keep commodity prices low, and it also tends to keep import prices low. Monetary policy, in short, is currently acting to boost inflation in the early stages of the production pipeline, and easy money will allow that inflation to eventually pass through the pipeline to reach the consumer. Call the PPI an early warning indicator of what is going to be happening to the CPI in a year or two.

Another reason for the difference is that consumer inflation is being kept low due to the very weak housing market, which in turn has put downward pressure on homeowners' equivalent rent, which represents about one-third of the CPI and which has declined (for the first time ever) by 0.3% since last August.

I think it's appropriate to focus on the monetary fundamentals here, and thus to pay more attention to the producer price index than to the CPI. That leaves me with the observation that inflation is currently running between 2-4%, as I noted in yesterday's post, not the 0-2% that is being registered in the CPI.

Leading Indicators still point to growth


I'm not a big fan of the Leading Economic Indicators published by the Conference Board, but as this chart suggests, there is not a whiff of evidence in these indicators that suggests we might be approaching a double-dip recession. Indeed, the behavior of the index is very much in line with what it has been in the early stages of every recovery over the past 50 years.

A strengthening economy calls for tighter Fed policy


I've been intrigued by this chart for a long time. What I think it shows is that the Fed has typically been very responsive to the state of the economy's health. The capacity utilization rate, shown in the blue line, is a pretty good proxy for how strong or weak the economy is. The real Fed funds rate (using the core PCE deflator) is a good proxy, in my view, for how easy or tight Fed policy is. In the view of those like the Fed that believe in the Phillips Curve theory of inflation, capacity utilization is also a decent proxy for the amount of "resource slack" in the economy, and thus an important input to monetary policy decisions. The logic goes like this: the lower the rate of cap utilization, the more idle resources there are, and the more idle resources, the greater the deflationary pressures on prices, so the more the Fed ought to ease. With cap utilization rates now rising rather rapidly, it would follow that monetary policy ought to begin to tighten.

The Fed doesn't always follow this model, however, as well as it probably should. As this chart shows, there are times when the Fed is proactive (tightening in advance of increases in capacity utilization with the aim of slowing the economy and thus preventing inflation from rising), and there are times when the Fed is reactive (responding with a significant delay to changes in capacity utilization). These different policy responses generally lead to inflation consequences. For example, the Fed was reactive throughout most of the 1970s, and inflation rose substantially. The Fed was proactive from the early 1980s through 1987, and that was a period of significant disinflation (falling inflation). The Fed was then reactive from the early 1990s through 1998, but inflation was relatively low and stable during that period, perhaps because the Fed had been so tight for so long in the decade prior. Since the early 2000s the Fed has generally been reactive, tightening policy with a significant delay in the wake of the strong economic pickup that started in mid-2003. Not surprisingly, inflation accelerated from 2003 through 2008.

The past year or two stand out as unusual in two respects: 1) the economy weakened sharply and to an unprecedented degree, but 2) the Fed took only limited action to ease. The latter can be explained away by noting that although the Fed could not deliver the negative interest rates, as their model (akin to the Taylor Rule) would have called for, it did engage in massive quantitative easing by expanding bank reserves by more than $1 trillion. In any event, we observe that for the past 18 months or so, inflation has been generally tame—does that not mean the Fed has done exactly the right thing?

I'm not ready to say that I have more respect for the Fed or their model of inflation, but I also don't want to ignore the facts. Of course, even the best model can have problems if political considerations overrule the model's policy prescriptions. In any event, going forward this model is saying that the Fed should begin raising rates sooner rather than later, otherwise it will end up committing the sin of reactivity that plagued monetary policy in the 1970s. It's something to think about.

A story of two spills


Source. HT: Dick Grannis

Time and culture


This is completely off-topic, but I highly recommend watching this very cool 10-minute video which is an illustrated talk about how our perceptions of time and our cultures are intertwined.

HT: Steve Root

Producer price inflation update


Here's the latest update on inflation at the producer level. The core PPI is only up 1.3% in the past year, but it is up at a 2% annualized pace over the past six months. Total inflation is up 5.1% over the past year, and 3.6% annualized over the past six months. Draw a line down the middle at you might conclude that the underlying rate of producer price inflation is somewhere in the range of 2-4%.


I like this next chart, which plots the level of the producer price index on a semi-log scale. The chart divides inflation history into "regimes" that are in turn based on the stance of Fed policy.

The Fed was effectively a passive entity in the early 1960s, because we were on a strict gold standard. Not surprisingly, inflation was effectively zero back then. Beginning in 1966 the Fed began to stray from the gold standard, keeping interest rates low in spite of a gradual outflow of gold, and inflation became significantly positive. Inflation took off beginning in 1974, in the wake of the devaluation of the dollar, and the Fed was ineffectual at trying to stop it all through the 1970s. The Volcker Fed then brought it back into control in the early 1980s. But for the past six years inflation has been more volatile and generally higher than at any time since the early 1980s. Since 2004 the underlying rate of inflation has been about 3.5%. 2004, not coincidentally, was when the Fed switched to an overtly accommodative policy stance after having been generally restrictive since the early 1980s.

Inflation is not dead, it is alive and well. Deflation is not a risk.

U.S. industrial production in a solid recovery


U.S. industrial production has risen at a 8.8% annualized pace since hitting bottom in June '09. At this pace industrial production will have completely recovered to its former highs in 12 months. That's fairly impressive given the persistence of the view that we are in a "jobless recovery." It's not a jobless recovery of course, since the private sector has already added more than a million jobs this year. And with industrial production increasing like this you can be sure that many more jobs will be created in the months to come. Furthermore, I would add that the pace and the magnitude of the current recovery both exceed that of the recovery from the 2001 recession. I just don't see why the gloom and doom persists.

Housing market is still in a slow but uneven recovery


There are two ways to tell the story behind today's release of May housing starts: 1) (from Bloomberg) "Builders broke ground on fewer U.S. homes in May than anticipated after the expiration of a tax credit, indicating the real estate market will struggle without government incentives." 2) (from me) Despite an unexpected decline in May, the pace of new home construction was up at an annualized pace of 24% relative to its all-time low in April '09, while building permits were up at an 8.5% pace relative to their March '09 low, suggesting that the housing market's recovery from its unprecedented collapse will be uneven.

In any event, I'm having trouble connecting the May weakness in housing starts to the April expiration of the tax credit. Seems to me that the only way to take advantage of the  tax credit would have been to start construction long before April—as far as I know, we have not yet returned to the days when home buyers were so desperate to buy that they would sign a contract as soon as ground was broken. If the tax credit expiration were to have had a big impact on starts, we would have seen starts decline early this year, but they didn't. What we have is a typical pattern for this series, which is almost always volatile from month to month.


To me its clear that the outlook for the residential construction market has improved dramatically over the past year or so, and that view is confirmed in this index of the stock prices of 18 leading home builders, which is up 110% from its March '09 low. The "worst nightmare" collapse is a thing of the past, and now the issue is how fast the pace of recovery will be. For quite awhile I've expected to see a slow but gradual recovery in residential construction, and so far that's what it looks like. And it's important to recall that the current pace of home construction is still far below what is needed to keep pace with ongoing household formations, so for the foreseeable future the economy's pent-up demand for new homes will be rising every month.

UPDATE: The above charts and conclusions I believe are consistent with the weakness reported in the NAHB release for June that was reported yesterday, and is charted here:

Declining swap spreads are very bullish


I don't want to make too much out of this chart, but it is interesting to see how swap spreads have been leading commodity prices for the past several months; note in particular how swap spreads peaked in late May, followed by a bottom in commodity prices in early June. I've long been a fan of swap spreads as leading indicators, since they are real-time measures of financial market fundamentals such as confidence, fear, systemic risk and general liquidity. Commodity prices, on the other hand, tend to lag, but not by too much since they can be driven not only by economic fundamentals (which don't change as fast as financial market fundamentals) but in many cases by financial market speculation (i.e., via futures) which can change fairly fast.

This relationship does not always hold, however. But right now there is a logical link between swap spreads and risky asset prices due to the fears that have surfaced in regards to the Euro debt crisis. Declining swap spreads over the past three weeks are a good indication that Eurozone risks have not found traction in the U.S. economy, and thus that the Euro debt crisis is not going to morph into a threat to the global economy. As the risk of a double-dip recession recedes, it makes sense for investors to return to risky assets, just as it makes sense for corporations to be more inclined on the margin to undertake projects that require commodity inputs. Swap spreads have also been tightly correlated to equity prices recently, and have tended to lead them as well.

Bottom line: declining swap spreads are pointing the way to higher prices for a variety of risky assets.

As fear subsides, prices rise


As time passes and the Euro debt crisis fails to paralyze the global banking system (the Greece debt crisis first erupted last January), the world gradually recovers its confidence. Measures of fear, uncertainty and doubt, such as the Vix Index and swap spreads, are declining, at the same time that prices of risky assets, such as equities and speculative commodities (e.g., gold, oil, copper) are rising on the margin. As the demand for a safe haven declines, the dollar has dropped about 3% from its recent highs. This is all very logical and unsurprising, and should continue until the next "crisis" or "wall of worry" appears on the horizon, though I have no idea what or when that might be.

A comment on the ECRI leading indicator


This chart shows the Economic Cycle Research Institute's Weekly Leading Indicator. The pronounced drop in the index which began in early May has been the subject of much concern, since some have taken it to imply the imminent onset of a double-dip recession. Business Insider has a nice summary of the controversy here. The key point is that outsiders have misused or misunderstood this index: "ECRI itself has never used WLI growth going negative as as a recession signal." In short, the concerns are much ado about nothing. ECRI further explains that a decline in the WLI would have to be accompanied by a "pronounced, pervasive and persistent decline" in their Long Leading Index before they would predict the onset of a recession. While I have not seen the LLI, presumably it has not given such a signal yet. I think the main message of the current decline in the WLI is that economic growth going forward may be a bit weaker than it has been in the past several months, but that is not at all the same as saying we are headed for a double-dip recession.

I do not follow the ECRI indices religiously, but I do hold them in great respect, since in my experience their economic calls have tended to be similar to my own. I would be surprised if they were to predict a recession that was not obvious to me. They have a good record of predicting recessions and recoveries, and in fact, they predicted the current recovery in April '09, in advance of the consensus. I would note that I also predicted the recovery, but even earlier, in this post dated Dec. 31, '08.

I would reiterate here that I do not see any signs in the economic or financial market data that would lead me to expect a double-dip recession. I continue to believe, as I have since my 12/31/08 prediction, that we are in a recovery that will be sub-par "due to the drag of increased fiscal spending and slowly rising inflation." The economy would be growing much faster, in other words, if it weren't for all the so-called "stimulus" spending that has made the economy less efficient by redistributing nearly one trillion dollars from the productive sectors of the economy to the non-productive sectors. And if monetary policy weren't so accommodative and potentially inflationary, the economy would be stronger today because investors would have more confidence in the future and companies would be more willing to make productive (and risky) investments.

Swap spreads and implied volatility are subsiding



The first chart shows 2-yr swap spreads, and the second shows the Vix index. Both are good measures of the level of fear and uncertainty plaguing the markets. From the looks of things, the negative impact of the Euro debt crisis on the U.S. economy is fading. Not surprisingly, stocks (below) appear to be finding a bid. Even European stocks are doing better on the margin (last chart). I continue to believe that the Euro debt crisis, while not inconsiderable, is not the end of the world by any stretch, and the market may be coming around to agree with that view. The important thing is that it is not degenerating into widespread uncertainty, as happened with the subprime mortgage crisis. If the problem is limited to writing down the value of Greek debt (and possibly that of a few other countries), then the global bond market is plenty big enough to absorb the hit. Relatively large debt writedowns have occurred with some frequency throughout history (I'm reminded of the Latin debt crisis in the early 1980s), yet economic disaster did not necessarily follow.


Shipping update


Here's an update to the Harpex Shipping Index, a measure of container shipping costs in the Atlantic. Since I last posted this chart in late May, the index has jumped another 9%. This makes a nice counterpoint to all the doom and gloom news coming out of Europe these days. And while economic bears are pointing to the recent decline in the Baltic Dry Index, from a longer-term perspective the current decline is fairly modest and it appears to still be in a rising trend.

Global industrial recovery continues


Industrial production in the Eurozone economy in April rose rose by more than expected (0.8% vs. 0.5%), and data for prior months were revised upwards. In the past year Eurozone industrial production is up 9.5%; Japanese industrial production is up 26%; and U.S. industrial production is up 5.2%. The U.K. economy is the clear laggard, as this chart shows, with production up only 1% in the past 12 months.

To be sure, global industrial production is still well below the highs of 2008, but it is nonetheless expanding at a pace that will eventually lead to a full recovery. All the talk about a double-dip recession is puzzling to me, given that so many regions and sectors of the global economy are still in the process of recovering. With production levels still well below prior levels, the world still has plenty of idle capacity, and this capacity costs almost nothing to tap (it's already built)—so production can rise by a very impressive rate during a recovery and that is what we are seeing in most areas. Rising production leads to more income, more jobs and more spending, and that feeds back into decisions to expand production further. This process is effectively a virtuous cycle that will be hard to derail.