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Commodity recap

These charts represent the major components of the Journal of Commerce Index of commodity prices (top chart is the entire index). As should be obvious, there has been significant price appreciation over the years in all commodity prices. I've indexed all the charts so that they are equal to 100 in early Nov. 2001, which was the bottom for an overwhelming number of commodity prices. Gains since then range from 80% for miscellaneous commodities to 400% for petroleum prices. (My thesis has long been that this low in commodity prices was in large part the result of very tight Fed policy from 1995 through 2000.)

When so many commodities (the majority of which do not have futures contracts tied to them) rise by so much over the same period, I think it is logical to assume there is a common denominator or two at work behind the scenes. The prime suspects would be a) accommodative monetary policy and b) global growth. And the implications for investors is also straightforward: there is no reason to worry about a double-dip recession or deflation.

Stocks reconnect to corporate bonds

One month ago I noted the puzzling disconnect between equity prices and junk bond prices. They had been joined at the hip for a long time, but equities had drifted down while junk bond prices had drifted higher. I speculated that the corporate bond market was the one to follow in this case, since it has led the equity market many times in the past. I'm happy to report that this looks to have been a good call, with equities up almost 10% in the past month, and high-yield bond prices (using HYG as a proxy) up a bit less than 2%.

HT: Stephen Cook, for bringing this to my attention.

Capex continues very strong

Capital goods orders rose 4.1% in August, and July orders were revised up almost 3%, thus snuffing out any concerns that arose last month about a possible double-dip. Over the past six months orders are up at a very strong 23% annualized pace. This is undeniably good news, since it means that businesses are confident enough in the future to be investing in new plant and equipment, the seedcorn of new jobs and future productivity gains.

Update: I had some trouble getting this chart to show up correctly, but I think it works now. I'm also now more convinced that this series suffers from some faulty seasonal adjustment, since the first month of every quarter is always strong. So I'm going to stick with a 3-mo. moving average which gets rid of that problem. In any event, the 6-mo. annualized growth in capex is over 20% no matter how you measure it.

No shortage of money

Ever since late 2008 I have been making the point that whatever is wrong with the economy, it's not a shortage of money that is problem. That remains the case today. There are no signs that money is in short supply, either nominally or relative to the demand for money. Therefore there is no reason to worry about deflation or a deflation-induced slump in demand. 

The best measure of money is M2, because it's definition hasn't changed much over time and for decades it has had a relatively stable relationship to GDP. I think most economists would agree on this. The first chart above shows the level of M2 over the past 16 years. As should be evident, M2 has grown on average about 6% a year. Sometimes faster, sometimes slower, but it always seems to revert to something like 6% a year, which also happens to be very close to the annualized growth rate of nominal GDP over the past 20 years or so. The slower growth of M2 in the past year or so is simply "payback" for very rapid growth in 2008, when a surge in money demand pushed up all monetary aggregates. 

It was therefore not a coincidence that the the peak in M2 growth coincided almost exactly with the bottom of the stock market (March 2009). That was a big turning point, because what occurred was a rise in confidence accompanied by a decline in the demand for money. Money velocity picked up as people started spending the money they had hoarded, and that process continues to this day.

Meanwhile, the Fed force-fed $1 trillion to the banking system, swelling the monetary base and bank reserves by an unimaginable amount. Most of the extra reserves are still sitting idle at the Fed, though, since the world's demand for dollars remains elevated. (When demand for money is high, the demand for loans is weak. That's another way of saying that the world is still trying to deleverage, so demand for bank loans is not very strong.)

The recent increase in the M2 growth rate (M2 is up at 4.6% annualized rate in the past three months reflects a bit of an increase in money demand over that period, and that is likely a reflection of the confidence shock that resulted from concerns over the possible collapse of the european banking system. It is also the case that renewed concern over the health of the economy helped drive yields lower, and that in turn resulted in a surge of refinancing activity, which in turn has a strong tendency to increase money in circulation temporarily.  

In short, I see nothing in the money numbers that is strange or foreboding—except, of course for the massive amount of bank reserves that lie in waiting to accommodate renewed loan demand. They haven't presented a problem so far, but at some point they could result in a significant expansion of bank lending which in turn could feed the fires of inflation if the Fed doesn't react in a timely fashion to drain those reserves. That's been a big worry for a long time, but so far nothing untoward has happened. 

Housing market remains weak

The National Association of Realtors reported today that existing home sales rose only marginally in August, leaving them at very depressed levels (third chart above). The National Association of Homebuilders' survey of market conditions was flat in August (first chart above) and remains at depressed levels. About the only thing positive to be gained from current news on housing is that the inventory of homes for sale (second chart above) has been relatively flat for the past year or so. This, despite the expected flood of foreclosed homes coming on the market. All of this is consistent with the relatively depressed levels of new applications for home mortgages, and with the very low level of mortgage interest rates.

Housing is still very weak. Residential construction has fallen to 2.5% of GDP, it's lowest level in recorded history. This is not new news—it's been making headlines for many months. Are conditions deteriorating even further? That is possible, judging from the drop in existing home sales in recent months. But the recent decline in sales may also be payback for the burst of sales late last year and earlier this year, both of which were propelled in large part by government subsidy programs. If that's the case, then the recent weakness is just an unintended consequence of government meddling in the markets. That's not surprising.

Whatever the case, housing is not contributing to the economy's strength. Growth has to come from other sectors, and without a housing rebound it's going to be tough to post impressive growth numbers for at least the next year. But we've known that for some time—this is not new news.

Are other sectors of the economy growing? Absolutely, yes. Industrial production is up significantly. Exports are up significantly. Tax collections are up (meaning incomes and profits are up). Commodity prices are rising across the board. Private sector jobs are up 1.8 million so far this year, according to the household survey of employment. Default rates are way down (suggesting much stronger than expected cash flows for most businesses). On balance, the weight of evidence continues to point to growth, albeit growth that is still quite short of the levels which we should be seeing if this were a normal recovery. The economy is fighting the headwinds of a massive expansion of government spending and regulations, and all the uncertainty surrounding a rapid buildup of debt. The future course and strength of these headwinds will be decided within the next few months by the electorate. I think the electorate is going to vote overwhelmingly for Change, and the change will be a positive for the economy.

Weekly claims have been flat this year

As the top chart shows, weekly unemployment claims—abstracting from two periods in which seasonal adjustment factors proved faulty—have been essentially flat all year, averaging 465K, which also happens to be the latest weekly reading. No message here; this is entirely consistent with the sub-par recovery we've had so far.

As the second chart shows, however, the number of persons receiving unemployment compensation insurance is once again declining. In fact, the number has dropped by 1 million since the beginning of August. This could mean that more people are finding jobs, or it could mean that more people are sitting at home discouraged, or probably some of both. I think it's more of the former, and I note (again) in that regard that the household survey of private sector employment has recorded 1.8 million new jobs this year through August.

All this adds up to moderately positive news, consistent with a sub-par recovery. And again, not even a hint of a double-dip recession.

Leading indicators still point to growth

The Leading Indicators index rose a bit more than expected, and as the chart shows, the year over year change remains quite positive—a good indication that the economy is still growing. There is nothing in this series that would even suggest that the economy is slowing enough to qualify as the "double dip" recession that remains an obsession with so many observers. Instead, the index is behaving exactly at it has coming out of every recession in the past. It's natural for the growth in the index to slow as the economy continues to expand.

Commercial mortgage-backed securities are doing very well

This is a chart (source here) of the price of a AAA-rated basket of commercial mortgage-backed securities, most of which were originated in the heydays of 2007. Issued at par, this issue (which was assumed by almost everyone to be bullet-proof because of its AAA rating) fell to an unbelievable low of 55, but it has now rallied back to 92.7. You can check the prices of other AAA- and AA-rated securities issued earlier, and the story is basically the same—there has been a stunning recovery.

What this means is that in the depths of the depression and deflation fears, the market was priced to the expectation that almost half of the mortgages backing this security would default (or more likely, that 70% of the securities would default with a recovery value of 35%). It's not necessarily the case that the market was actually expecting a catastrophic default rate, but more likely, that the market's liquidity had evaporated at a time when many banks, and institutional investors were forced to sell at the height of the financial panic. Prices collapsed since lots of people wanted/needed to sell, and there were precious few buyers willing to buy.

Those institutions that decided to hold the securities were forced to write them down—with the losses going straight to their bottom line—because they were considered to be "impaired" according to accounting rules. But now the securities have almost doubled in value, yet the value recovered has in most cases not been recognized. This means there are lots of unrecognized profits on the books of institutional investors who were brave enough to hold these securities when everyone thought the sky was falling. I assume this is also good news for a lot of banks. And it's a vivid example of how illiquid and/or panicked markets can price securities to extremely unreasonable and even absurd assumptions. Markets are not perfect, and they can make huge mistakes. For an in-depth explanation of how this worked, I should once again recommend the book "Panic" by Redleaf and Vigilante.

In a similar vein, high-yield securities at the end of 2008 were priced to the expectation that an incredibly large percentage (as much as 50%) of companies would default on their obligations over the following 3-5 years. Yet we learn today that the default rate for high-yield securities will be less than 3% by the end of this year, according to Moody's.

Again, markets can and do make huge mistakes, especially when emotions are running high.

And, as should be obvious, conditions today are not nearly as bad as most people thought they would be.

Lowest 30-yr fixed mortgage rates in history

Thanks to 2.5% yields on 10-yr Treasuries and the ongoing improvement in the efficiency and liquidity of the mortgage-backed securities market (which has resulted in a tightening of the spread between conforming and jumbo rates), homebuyers today can take advantage of the lowest 30-yr fixed-rate mortgages in history, whether for a conforming or a jumbo loan.

One reason rates are so low is that demand for mortgage loans is also relatively low, as reflected in the above chart, which shows a measure of all mortgage applications for the purchase of a single-family home. The volume of new mortgage applications has fallen significantly since the peak of the housing market in 2005, but I note that the current volume is still higher than pre-1997 levels. Things have really cooled off, but they haven't ground to a halt by any means.

The other reason for low rates is that demand for high-quality yield is very strong. Investors are willing to accept 2.5% yields on 10-yr Treasuries and 3.4% yields on MBS because they worry about the ability of alternative investments to do better on a risk-adjusted basis. As I've noted before, the last time yields were this low for any meaningful period of time was in the late 1930s and 40s, when investing attitudes were powerfully shaped by depression and deflation.

Looking at both sides of the mortgage equation thus reveals great fear and uncertainty about the future: homebuyers worried that prices might fall further, and investors worried that the entire economy is at risk of a double-dip. That's one more reason to believe there is a lot of bad news that has been priced into today's market. This affords the investor an excellent cushion, since the mere absence of bad news ends up being a positive for prices.

Fed policy restarts the reflation trade

The FOMC's announcement today didn't reveal any signs of panic on the part of the Fed, but it did further open the door to another round of quantitative easing (aka QE2): "... the committee is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate." The market rationally interpreted this to be yet another sign that the Fed would rather err on the side of more inflation rather than less (or deflation). Predictably, measures of inflation expectations rose across the board. Gold has risen some $37/oz. so far this month, reaching yet another all-time high today. Gold is up against almost all currencies this month, but more so against the dollar, since it has fallen about 1.2% against a basket of major currencies.

TIPS are a reliable, if conservative, hedge against inflation, and TIPS yields/prices reached a new all-time low/high today. This is a direct reflection of investors' demands for inflation hedges, just as are record-high gold prices. Real yields on 10-yr TIPS have fallen 20 bps so far this month, while yields on 10-yr Treasuries are up 10 bps on the month; this translates into a 30 bps increase in average annual CPI expectations over the next 10 years. A more sensitive measure of inflation expectations, which is preferred by the Fed, is the 5-yr, 5-yr forward breakeven inflation rate; it has risen by over 50 bps so far this month, to a current 2.54%.

Other sectors of the bond market also reveal a recent increase in inflation expectations. As the chart above shows, the spread between 10- and 30-yr Treasury bond yields is now about as high as it has ever been (on a daily basis, we saw a record-high spread of 124 bps in early August). By insisting that short-term rates will remain low for a long time come what may, the Fed has helped 10-yr yields fall. But investors in 30-yr bonds have little or no reason to worry about what the funds rate will average over the next 10 years (a factor that does weigh heavily on the decision whether or not to buy the 10-yr), and they have decided that inflation risk outweighs carry concerns; as a result, 30-yr yields are up 25 bps on the month while 10-yr yields are up only 10 bps.

So we have now reached the point where the Fed's actions and its talk are definitely boosting reflationary expectations. By the same token, deflationary fears are declining. Monetary policy is "gaining traction," as economists are wont to say. Much as I hate the thought of higher inflation, I am not surprised to see equity prices up almost 9% so far this month. Reflation is good news for the equity market (and for high yield bonds) because a) it perforce reduces deflation risk, and b) it increases expected future cash flows without (so far) causing any significant rise in long-term interest rates.

My sense is that with the economy still on the mend—albeit slowly (i.e., modest growth of 3-4%, enough to bring down the unemployment rate in a very slow and painful fashion), and reflationary monetary policy gaining traction, we are now seeing a virtuous cycle kicking in that will at the very least act to help the economy grow. Consumers and businesses that have been hoarding massive amounts of money (as reflected in 12% decline in the velocity of M2 since the end of 2007) are now feeling increased pressures to unhoard some of that money, releasing it to be spent in a fashion that boosts nominal and real GDP. In the latter stages of this reflation process we would likely see an obvious buildup of inflation pressures, but for now this is of secondary concern.

Market expectations are dismal

As we wait for the Fed to tell us that not much has changed and they expect to keep rates low for a long time, I thought it would be interesting to show what market expectations are for future Fed actions. This chart shows the expected Fed funds rate one year in the future (using the one-year forward futures contract on Fed funds). Today the expected rate for Sep. '11 is 0.3%, which means that the market is not really expecting any chance of a tightening in monetary policy for the next year.

To my mind, this is characteristic of a market that has very little hope for an economic recovery, and very little concern about rising inflation. It is also the least optimistic view of the future that we have seen since before the recent recession started. This market is braced for bad news. In the absence of bad news, risky asset prices would likely rally.

UPDATE: With the FOMC's statement suggesting that the Fed continues to believe that the economy is on a slow path to recovery (i.e., the Fed is not panicking), equity prices have rallied.

Residential construction still in a bottoming formation

August housing starts came in a bit higher than expected, and remain consistent with a view that residential construction bottomed in the second quarter of last year, but has since made little progress. (Housing starts are the green line in the above chart.) Always on the lookout for market-based indicators that may lead the numbers put out by government agencies, I note that the Bloomberg index of 17 major homebuilder stocks (red line in the above chart) may fit the bill. It bottomed in the first quarter of last year and has spent about 18 months consolidating. It also predicted the modest slump in housing starts in May-July, and the modest upturn in August. Millions of investors on the ground and crunching numbers may prove better at divining the course of the housing industry than the folks at the U.S. Census Bureau who put out the housing starts number each month.

At the very least, I would venture to say that with housing starts and homebuilders' stocks failing to reach new lows after hitting bottom well over a year ago, one can say with some degree of confidence that we have seen the worst of the housing recession. More and more the issue becomes the timing and the strength of the recovery.

UPDATE: Here is a long-term chart of housing starts. Note how the past two years have seen the most severe drop in residential construction in recorded history, and the weakness has persisted far longer than in any prior recession. The good news is that once the excess inventory of homes is depleted, the rebound in construction—which does not appear imminent, but should be starting within the next 6-9 months—should be fairly dramatic.

Commodities: onward and upward

Commodities continue to rise, with gold making new highs again today, and non-energy industrial commodity prices (as measured by the CRB Spot Index) having essentially completely reversed their 2008 plunge. I've been highlighting rising commodity prices for well over a year as a good indicator of improving global economic health (most recent post here) and as a good indicator of the fact that monetary policy around the world is accommodative and therefore the risk of deflation is practically nil. Rising commodity prices are thus a good antidote to the doom, gloom, and deflation concerns that seem to be holding back so many investors who are content to leave significant sums in zero-interest-rate cash.

Before I proceed, this may be an opportune time to respond to a reader's request that I clarify the difference between contraction and deflation. A contraction refers to a shrinkage in the volume of economic activity, whereas deflation refers to a general decline in most if not all prices. These two conditions need not occur simultaneously, contrary to popular belief. In fact, it is quite possible for an economy to shrink even as prices rise; you have only to look at Argentina during its flirtation with hyperinflation in the 1970s and 80s to see this combination in action. This has relevance to the current situation in the U.S., since it seems that a great number of people are concerned that the dismal performance of, and the substantial "slack" that exists in the U.S. economy (all of which are summed up in the phrase "weak demand"), combine to almost ensure the onset of deflation. Deflation, in turn, is presumed to lead to a self-perpetuating economic slump, eventually ending in depression and deflation. What the deflationists ignore is the ongoing and impressive rise in gold and commodity prices, the 8 1/2 year slump in the value of the dollar (which means that most prices outside the U.S. have risen relative to our prices), the 2.5% annual inflation expectations embedded in TIPS prices, the negative real Fed funds rate, and the unusually steep Treasury yield curve, all of which argue strongly against deflation.

Instead, the deflationists believe that weak demand currently and prospectively will lead to falling prices. Weak housing demand has certainly led to falling housing prices, but weak demand shows up nowhere in the commodity markets. Some sectors of the U.S. and global economies are weak, and that weakness is reflected in falling prices, but that is not a statement that can be generalized. Some prices are falling, but lots of prices are rising, and since there is no evidence that money is in short supply, we have no reason to expect that all prices will fall in the future. Deflation, after all, happens only when there is a shortage of money relative to the demand for it, just as inflation happens when there is a surplus of money relative to the demand for it.

Deflationists also misunderstand the behavior of inflation following recessions. It is true that inflation almost always declines in the wake of recessions. But that's not because weak demand pulls prices down. It's because almost all recessions have been caused by very tight monetary policy. Very tight monetary policy—easily seen in the form of an inverted yield curve and a very high real Fed funds rate—first acts to disturb economic activity, then acts to bring inflation down. The lags are long and variable, of course, but today the Fed is more accommodative than ever before, and that is the biggest reason to ignore deflation risk.

Before worrying about deflation or even a decline in commodity prices, we would need to see at the very least some steps taken by the Federal Reserve to rein in the supply of dollars—either by withdrawing reserves from the banking system, or by raising interest rates and substantially flattening or inverting the yield curve. We would also need to see those moves result in a strengthening of the dollar relative to other currencies and relative to gold. I'm not holding my breath for any of these events to happen, and that's unfortunate since it means there is a lot of inflation uncertainty out there that makes it difficult for investors to have confidence in the future.

I am not saying that a lot of inflation is good for an economy or for the equity market. But right now the issue is not whether we have a lot of inflation or not; the issue is whether we have deflation or not. Once the market has overcome its fear of deflation, then it will be time to worry about how high inflation is likely to rise. For now, rising commodity prices are a direct reflection of declining deflationary and recessionary risks, and that is one of the factors driving the equity market higher.

November's Choice: Free markets or managed capitalism

Somehow I missed this article by Arthur Brooks and Paul Ryan in last week's WSJ: "The Size of Government and the Choice This Fall." As a devoted fan of free markets and a believer in limited government, I think the article deserves some special mention, especially since it is quite good and in the best tradition of the Tea Party, of which I am also quite fond. Here are some excerpts, but read the whole thing if you haven't.

As we move into this election season, Americans are being asked to choose between candidates and political parties. But the true decision we will be making is this: Do we still want our traditional American free enterprise system, or do we prefer a European-style social democracy? This is a choice between free markets and managed capitalism; between limited government and an ever-expanding state; between rewarding entrepreneurs and equalizing economic rewards.
We [must] decide which ideal we prefer: a free enterprise society with a solid but limited safety net, or a cradle-to-grave, redistributive welfare state. Most Americans believe in assisting those temporarily down on their luck and those who cannot help themselves, as well as a public-private system of pensions for a secure retirement. But a clear majority believes that income redistribution and government care should be the exception and not the rule.
Unfortunately, many political leaders from both parties in recent years have purposively obscured the fundamental choice we must make by focusing on individual spending issues and programs while ignoring the big picture of America's free enterprise culture. In this way, redistribution and statism always win out over limited government and private markets.
Individually, these things might sound fine. Multiply them and add them all up, though, and you have a system that most Americans manifestly oppose—one that creates a crushing burden of debt and teaches our children and grandchildren that government is the solution to all our problems.
More and more Americans are catching on to the scam. Every day, more see that the road to serfdom in America does not involve a knock in the night or a jack-booted thug. It starts with smooth-talking politicians offering seemingly innocuous compromises, and an opportunistic leadership that chooses not to stand up for America's enduring principles of freedom and entrepreneurship.
As this reality dawns, and the implications become clear to millions of Americans, we believe we can see the brightest future in decades. But we must choose it.

I share the authors' optimism, and their belief that voters will make the right choice in November. This is one of the major reasons I have remained optimistic since late 2008, despite the onslaught of Big Government. Too much government spending, too much income redistribution, and too much oppressive regulation have been major headwinds to economic recovery. With any luck this sea-change in the mood of the electorate that has been brewing since April 2009 will be able to reverse our statist course and eventually restore the economy to health.

And did I mention that I like the idea of Paul Ryan for President in 2012?

HT: Russell Redenbaugh 

The recession is officially over

It's not often that an economist makes a near-perfect forecast, so I deserve to take a moment to toot my own horn. In my 2008 year-end forecast, "Predictions for 2009," I wrote that "the economy is going to recover sooner than the market expects, with the bottom in activity coming before mid-2009." Back then the market was expecting a prolonged depression/deflation: 10-yr Treasury yields were approaching 2%, and corporate credit spreads had reached unimaginably high levels.

Today comes the official news, from the National Bureau of Economic Research, that the recession ended in June 2009. You heard it here first, 15 months ago, when I noted in a June 18, 2009 post that "we have very likely seen the end of the recession."