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M2 velocity suggests a stronger Q4 GDP


I'm going to leave it to others to tear apart the Q3 GDP number (which was a bit disappointing) and focus instead on where GDP is headed, from a top-down perspective. Quarterly GDP numbers aren't very useful, in any event, since they are old news by the time the first estimate comes out, and then they are subject to multiple revisions. The point of paying attention to the economy is to know where it's likely to go in the future, not where it's been.

Let's start with money. The M2 measure of money is arguably the best (and it's my long-time favorite): it is published weekly with only a minor lag, it's subject to only minor revisions, its definition hasn't changed materially over the years, and it's displayed the most stable relationship to nominal GDP over long periods of any measure of money.

This first chart shows M2 velocity, which is nominal GDP divided by M2. The inverse of this measure is money demand: how much of a year's spending the economy wants to hold, on average, in the form of currency, checking accounts, retail money market funds, small time deposits, and savings deposits. Note that, as the chart above shows, for the past 50 years M2 velocity has been virtually unchanged on balance, though it has oscillated up and down in the intervening years.

The big story behind the economy's collapse in 2008 was a huge surge in money demand (i.e., a huge decline in money velocity). People thought the end of the world was approaching, and so they stopped spending and started hoarding cash; the demand for money surged, and money velocity collapsed. The velocity of M2 fell almost 13% from the end of 2007 through mid-2009, the largest decline in velocity on record. This process has been partially reversed since the economy started growing in mid-2009, as M2 velocity has risen 1.9%. Confidence is slowly returning, and people are beginning to un-hoard some of their cash. Nevertheless, the revival of M2 velocity is still in its infancy.


M2 velocity only fell modestly in Q3/10, as nominal GDP grew at a 4.4% annualized rate and M2 grew at a 5.0% annualized rate. I suspect that it will be trending higher over the next several quarters as confidence continues to build, but let's assume that velocity is unchanged in the current quarter. With M2 currently growing at a 7% annualized rate over the past six months, and at a 8% rate over the past 3 months, we could reasonably expect M2 to rise at least 6% (annualized) in the current quarter. If it does, and velocity remains stable, that would imply a 6% nominal rate of growth for GDP in Q4/10. Of course, if velocity picks up, then nominal GDP could grow even more. Furthermore, if inflation in the current quarter remains at the 2% pace of Q3, then we could see real GDP growth in Q4/10 of 4% or more.

As one commenter mentioned earlier today, we would need to see at least 4.5% real growth in the fourth quarter in order for real growth to equal or exceed 3% for all of 2010. I don't think that's unrealistic at all. I know there are a lot of assumptions behind this forecast, but I don't think I've made any that are unreasonable, so I'm sticking with my call for 3-4% growth for the current year and for the average of the next several quarters. If I'm wrong it won't be by much. And given the market's penchant for seeing a double-dip recession around every corner, even if growth this year comes in at 2.5% that will be more than what I think the market expected to see.


In this last chart I've plotted the level of real GDP against a 3% trend. This gives us a proxy for what the so-called "output gap" might be, which I estimate to be about 7-8%. Growth has to exceed 3% for the output gap to close, and until it begins closing we are unlikely to see any meaningful reduction in the unemployment rate.

I think it's possible for growth to exceed 3%, especially in the wake of next week's elections. I firmly believe the elections will have a powerful influence on the course of fiscal policy, since they will send a clear mandate to Washington to a) slow the growth of government, b) roll back ObamaCare, c) keep cap-and-trade on hold, and d) extend the Bush tax cuts. This will result in a much-needed business confidence boost, which in turn should unleash at least a mini-surge in new investment and new jobs, not to mention a boost to M2 velocity.

If there is a dark cloud in this otherwise bright forecast, it is that inflation pressures are likely to gradually build, since the Fed—with its Phillips Curve/output gap mentality—is likely to be slow to respond to signs of an improving economy. But inflation concerns will be relegated to second place for at least awhile, while markets breath a sigh of relief.

One more sign that deflation is history


The GDP deflator is the broadest measure of inflation, and with the release today of Q3 GDP statistics, we see that the deflator has been rising at just over a 2% annualized rate for the past two quarters. The deflator dipped into deflationary territory in Q4/08 (-1.2%) and again in Q4/09 (just barely, -0.3%), but it's been positive for the past three quarters. If we take recent Fed pronouncements at face value (i.e., inflation is unacceptable if it's less than 2%), then a 2% pace for the GDP deflator is close enough to perfection for government work. The time for stimulus has come and gone.

It's also very important to note that inflation has turned positive despite the fact that the economy remains far below its "full employment" level, with tons of "idle capacity." According to Phillips Curve dogma, which permeates Fed thinking, this is not supposed to happen. With the economy suffering from so much "slack," inflation pressures should be virtually nonexistent or most likely negative. This is the thinking that has propelled the Fed to the cusp of QE2: they feel they have to pump up demand or face some serious deflation. Well, so far it's not working out that way. That's one more reason why QE2 is unnecessary—the Phillips Curve theory does not adequately explain how inflation works.

Claims continue to slowly improve


If we ignore the outlier drop in claims last July—which occurred because factory layoffs weren't as large as the seasonal adjustment factors expected—then the most recent claims number marks a new low for the year. The reason? For the past few weeks, actual claims have not risen as is typical for this time of the year. A few more weeks of this and we would see a notable decline in the seasonally adjusted number, and that would be bullish for the economy's prospects.


Meanwhile, the number of people receiving unemployment benefits continues to decline—down by 4 million since the peak early this year. That is big news. Undoubtedly, some of those who have fallen off the dole have found work, while others are increasingly desperate. The combination of those two factors adds up to more people working and more people who are more motivated to find a job. Borrowing from commenter "brodero," I note that Gallup's Job Creation Index has moved to a new, post-recession high. Taken together, it must be the case that the economy continues to improve, albeit slowly.

QE2 rumored to disappoint, but that's good news

Today's WSJ article, "Fed Gears Up for Stimulus", appears to be a Fed leak that discloses a QE2 program "worth a few hundred billion dollars over several months," far less than the Wall Street pundits were predicting as recently as yesterday.

Not surprisingly, the stock market was immediately disappointed, though it later recovered much of its losses on the day. The Treasury market took it on the chin—also not surprisingly—though it would appear that suspicions of a disappointing QE2 must have been at work for the past two weeks, since 10-yr yields bottomed Oct. 11th at 2.39% and ended today at 2.71%. Gold peaked at $1387 on Oct. 14th, and ended today at $1328. Most encouraging, I think, was the fact that the dollar bottomed Oct. 15th and closed today up 2.7% from that low. All in all, these moves were predictable, given a disappointing QE2 announcement. Despite the 30 bps rise in 10-yr yields in the past few weeks, stocks are roughly unchanged.

Maybe this was a trial balloon from the Fed. If so, the takeaway should be this: there is NO NEED for QE2 at all. Faced with the prospect that QE2 would be quite small and dribbled out over months, the stock market barely budged, while Treasuries and gold suffered a drubbing and the dollar rose nicely. This means the market viewed QE2 as only marginally—if at all—important to the economy, but very important to the dollar and Treasury bonds. Another injection of money from the Fed was unimportant insofar as the economy was concerned, but the prospect of fewer dollars being jammed into the system was a great relief for holders of dollars and it gave pause to those running to gold for protection.

I'm quite pleased with today's action, since to me it is a sign of a market that is operating rationally. The message from the market to the Fed should be clear: we don't need your stinkin' QE2—it would only muddy the waters.

Capex still strong


September orders for new capital goods were a bit weaker than expected, but this notoriously volatile series needs to be viewed from a perspective that includes several months or more. Over the past six months, orders are up at an 8.3% annualized rate, which is a good deal faster than the pace at which orders grew 15 months after the end of the 2001 recession. Over the past year, orders are up almost 14%, a pace that rarely has been exceeded in the past 20 years. I see nothing here to worry about, and it's worth noting that U.S. companies are still sitting on a trillion-dollar pile of accumulated profits; if the outlook for fiscal policy improves and corporate taxes are cut, that profits pile could power some truly impressive investment in the future.

QE2 is not only unnecessary but foolish (cont.)

As next week's FOMC meeting approaches and estimates of the size of Fed asset purchases range from $1 trillion to many trillion, I want to reiterate my view that another round of quantitative easing—regardless of size—is unnecessary and foolish.

QE2 would only be justified and warranted if deflation were a serious risk and/or the economy were displaying obvious signs of a liquidity shortage or liquidity crisis. Neither is the case today, and I offer the following as evidence:


The most recent measures of inflation are all positive. Over the most recent 12 months, the core CPI is up 0.8%; the CPI is up 1.3%; the PCE deflator is up 1.5%; and the PCE core deflator is up 1.4%. Over shorter time intervals none show any significant deceleration. (In any event, the CPI is the last place you would expect to find evidence of rising inflation.) The Producer Price Index is rising at a rate clearly above zero. Producer prices represent inflation pressures in the early stages of the inflation "pipeline." The PPI crude index is up 20% in the past year, while the PPI intermediate index is up almost 6% in the past year. As prices rise beginning at the early stages of production, they eventually get passed on to consumers. For example, we've recently heard from General Mills that they plan to raise cereal prices, which is in part a response to the 50% increase in wheat prices over the past four months. Price hikes such as this, and others announced by Starbucks, MacDonald's, Kimberley Clark and Goodyear, will almost certainly find their way into the CPI. (HT: Larry Kudlow)


Gold and non-energy industrial commodity prices are in a headlong dash to higher price levels. We haven't seen such widespread and powerful inflation at the commodity level since the inflationary 1970s. To think that prices of a broad range of industrial commodities can double or triple without having any positive or significant contribution to the general price level is beyond foolish. Gold is the most monetary of all commodities, and it typically leads. Gold is telling us that we haven't seen the end of the current rally in commodity prices.


The dollar is declining against almost all currencies, and is at or close to its all-time lows, both in nominal and real terms. When the dollar loses its purchasing power against gold, most commodities, and most currencies, that is about as close as you can get to a guarantee that it will lose its value against just about everything, on average, and that is the most fundamental definition of inflation that I know. The dollar is weak because the Fed is pumping out more dollars than the world wants; another QE2 will only make the dollar weaker by creating still more unwanted dollars. It is inconceivable that the dollar can fall further without at some point triggering higher prices throughout the economy.


All measures of money are growing at significantly positive rates. Over the past 6 months, M1 is up at a 10.4% annualized rate; M2 is up at a 6.5% annualized rate; MZM is up at a 7.3% annualized rate; and currency in circulation is up at a 6.6% annualized rate. The nominal increase in M2 since the onset of the financial crisis in Sep. '08 is a whopping $945 billion; currency in circulation has surged by $128 billion; and required reserves for U.S. banks have expanded by over 50%. This adds up to solid evidence that some portion of the $1 trillion that the FOMC has pumped into the banking system is being used to create new deposits and loans.

As evidence that there is no liquidity crisis, I offer my previous post which details the dramatic improvement in swap and credit spreads. Swap spreads are so low, in fact, that they virtually rule out even the hint of a concern about the health of our financial markets. As evidence that not only are deflationary expectations nonexistent but that inflation expectations are now rising, I offer my earlier post on how TIPS and Treasuries are priced to rising inflation.

The Fed has been very vocal on the subject of QE2, and that probably means that they are preparing the ground for a QE2 announcement which is almost universally expected to come next week. But the Fed governors are not unanimously behind QE2. Fed Governor Hoenig yesterday said that more quantitative easing would be a "dangerous gamble." Fed Governor Fisher last week said that the "Fed is not committed to further asset purchases," and that the "debate on possible easing may not be completed in November."

There is no need for any QE2, and certainly no need for trillions more of asset purchases. Therefore, I think there is a strong case to be made for a QE2 announcement next week that "disappoints." Why couldn't the Fed announce a token QE2 (e.g., a hundred billion in installments) to reinforce the fact that they are committed to avoiding deflation, but also unwilling to provoke too much inflation? While such an announcement would seem likely to result in an equity selloff, I would view it as very good news from a long-term perspective, and thus an excellent buying opportunity. If the Fed does the right thing, that can never be bad. Downplaying the risk of deflation and the need for a massive QE2 would also send a strong message of badly-needed optimism.

UPDATE: Art Laffer, in a letter to clients today, points out that the Bernanke Fed has suffered an unprecedented level of dissension. "Of the 32 FOMC policy decisions under Greenspan's watch, there were three that received a dissenting vote ... under Bernanke's stewardship, 19 of 42 FOMC policy decisions have faced a dissenting vote, with 21 total votes against." Moreover, quite a few of the FOMC Governors and regional Fed Presidents have questioned the benefit of, actively criticized, or pointed out potential negative consequences of further quantitative easing: Fisher, Hoenig, Kocherlakota, Lacker, Plosser, Warsh, and even the perennially dovish Yellen. In short, there is good reason to suspect that the FOMC decision next week may fall short of market expectations. The market may view that as bearish for the economy, but I would view it as ultimately bullish. Too much monetary ease is not something we need or should be hoping for at this juncture.

Spread update: still room for improvement




The spread between the yield on risky bonds vs. risk-free Treasury bonds is a key indicator of all sorts of things: financial market health, general liquidity conditions, risk-aversion, economic health, and counterparty risk, to name a few.

I start here with swap spreads, since they are the most liquid part of the credit market. Swap spreads in the U.S. have been very low this year, suggesting that liquidity is abundant and the economic fundamentals have improved dramatically; the behavior of U.S. swap spreads could even be interpreted as pointing to a stronger-than-expected recovery over the next year. Swap spreads in Europe jumped earlier this year on concerns that a Greek or PIGS default would provoke a financial crisis, but since then they are gradually settling back down, suggesting that crisis conditions in Europe are slowly passing. But considering that German 2-yr yields have doubled since early June—which marked the height of the Greek crisis—the modest but ongoing decline in Euro swap spreads might even be interpreted as pointing to a substantial recovery in the Eurozone economies in the next year.

The second chart features credit default swap spreads on 5-year securities. These spreads have come down dramatically, reflecting sharply lower expected default rates, which in turn has a lot to do with improving economic fundamentals and accommodative monetary policy. When the economy is improving and money is in abundant supply, it's much easier for companies to service their debt, so default rates tend to fall. Despite the rather spectacular decline in spreads since late 2008, spreads are still quite high relative to where they could be if economic and financial conditions were more normal.

The third chart features spreads on corporate bonds in general. Here too we see substantial  improvement and lots of room for further gains. Note that today's spreads are at or close to the levels that preceded the 2001 recession. In short, despite all the improvement, the market is still priced to the expectation that conditions will be challenging in the months to come. (We've come a long way from late 2008, when the credit markets were priced to Armageddon; now they are priced to a garden-variety recession.)


Swap spreads have often been leading indicators of other spreads, so the message of these charts is that there likely is a lot of good news still in the pipeline for investors in corporate debt—particularly of the high-yield variety—and a lot of good news regarding the outlook for the economy in general.

The biggest risk to corporate debt right now is that Treasury yields are likely to soar if and when the economic news improves. A significant rise in Treasury yields could put some upward pressure on corporate yields (causing lower prices), but the fact that spreads are still unusually wide should provide a decent cushion against losses. Plus, since higher Treasury yields would likely occur concurrent with improving economic news, spreads would very likely contract in a rising Treasury yield environment—as has almost always been the case in the past.

Full disclosure: I am long investment grade and high-yield debt via a variety of mutual fund vehicles at the time of this writing. (Note to retail investors: buying and selling individual bonds can be extremely expensive for non-institutional investors, due to very wide bid-ask spreads, so commingled vehicles are highly recommended.)

The $25 trillion recovery


Here's another milestone in the current global recovery: the market cap of global equities has risen $25 trillion from last year's low, a very impressive gain of no less than 100%. Millions of pessimists hanging out in cash since then have left a lot of money on the table.

Housing price stability


According to the Case Shiller index of home prices in 20 major markets around the country, housing prices have been roughly stable for 18 months. In nominal terms, prices have actually risen by almost 5% from last year's lows (on a non-seasonally adjusted basis they are up about 7%); the chart above shows prices in real terms, which are up only slightly. Relative to early 2000, when the housing boom was only just getting started, prices in real terms are up only 16.5%, but real personal income is up 20.6%. And since mortgage rates have fallen from over 8% in 2000 to a mere 4.25% today, housing affordability has skyrocketed; homes today are effectively cheaper than they have been in many decades. It's not surprising, therefore, that the housing market is clearing, and has been clearing for quite some time.

I am well aware of all the many forecasters calling for a renewed bout of housing price weakness, to be brought on by banks dumping tons of foreclosed homes on the market. But I am more impressed by the confluence of positive fundamentals: We've had 18 months of relative price stability, which no doubt owes something to the lowest mortgage rates in history. The housing market has had almost 5 years to adjust to new realities, and during that time, home building activity has dropped nearly 75%. Residential construction is now by far the smallest relative to the overall economy (2.5%) that it has ever been. As a consequence, excess home inventories have been reduced to a substantial degree, and prices in real terms have adjusted downwards by more than one-third. The economy has been recovering from recession for 16 months; incomes are rising, and employment is rising. All measures of money are growing at very healthy rates, and the Fed is undertaking extreme measures to ensure that monetary conditions present no obstacle to further recovery.

Taken together, these facts strongly suggest that the housing market stabilization we have observed over the last year or so is the real thing, not just a chimera.

TIPS update: dismal growth and rising inflation


The real yield on 5-yr TIPS has been negative for more than a month now, marking a new milestone of sorts for the almost-14-year-old TIPS market. And as the top chart shows, the real yield on 10-yr TIPS is approaching zero, another new record low. What does this mean? In my view, the behavior of the TIPS market tells us that 1) the market has very low expectations for U.S. growth, and 2) the market's inflation expectations are rising, increasing the demand for TIPS.

One way to think of negative real yields on TIPS is like this: demand for TIPS today is strong enough that investors are willing to give up some portion of expected future inflation (equal to the amount by which real yields are negative) in order to gain the protection of TIPS. When real yields on TIPS are positive, investors can expect to receive the future rate of inflation plus a real yield "lagniappe." Those who purchase 5-yr TIPS today can expect to receive the future rate of inflation minus 55 bps per year. To be willing to give up some portion of future inflation is a sign of pretty strong demand for inflation protection, just as almost-zero real yields (and record-high prices) on 10-yr TIPS is a sign of very strong demand.


This next chart shows how real yields on TIPS have been depressed by declining yields on Treasuries. Inflation expectations (the difference between nominal and real yields) today are not too different from what they have been on average over the past decade, but nominal yields on Treasuries are at modern-day record lows. TIPS yields have to decline by at least as much as Treasury yields if inflation expectations are to remain constant. What we've seen since late 2008, on balance, is that TIPS yields have declined by more than Treasury yields as inflation expectations have risen. So a big reason for zero or negative real yields on TIPS is simply that Treasury yields are incredibly low.

Now, Treasury yields are incredibly low because the market believes that the Fed is not only going to engage in QE2, but that the Fed is also going to keep short-term interest rates close to zero for at least the next 12 months. Check the evidence: Fed funds futures contracts maturing in Feb. '12 are priced to the expectation that the funds rate will average 30 bps that month (note that it has averaged 20 bps for the past six months). In fact, since 2-yr Treasury yields are a mere 0.35%, this implies that the market expects the funds rate to average 35 bps over the next two years. In short, the market expects extremely low short-term rates for at least the next 2 years. This belief in low short-term rates for a long time automatically depresses yields on Treasury securities out to 10 years or so.

Admittedly, we are in uncharted waters here, with the prospect for another round of quantitative easing. But it's not unreasonable to say that expecting the Fed to keep rates close to zero for a very long time equates to a belief that the outlook for U.S. economy is nothing short of dismal. Imagine how yields would soar if the market (and/or the Fed) began entertaining the notion that the economy was starting to grow at a more health pace!


This next chart shows the recent, but strong correlation between the steepening of the long end of the Treasury yield curve and the market's 5-yr, 5-yr forward expected inflation rate. The former can be thought of as a measure of how much the Fed is artificially depressing 10-yr yields with QE2 and promises to keep the funds rate very low for a very long period. The latter is the Fed's preferred measure of the market's inflation expectations. By both counts, inflation expectations are rising, and rising in line with expectations that QE2 is essentially a done deal. The dollar has weakened and gold has strengthened as well (since the end of August when QE2 talk started getting serious), confirming that QE2 is likely to rekindle inflationary pressures.


As the next chart shows, there is a very strong and enduring correlation between the level of real yields on 5-yr TIPS and the market's expectations for future Fed policy (which I've proxied by comparing the 1-yr forward expectation for short-term interest rates to current levels of inflation). Real yields decline as the market expects the Fed to ease (with easing being defined as a reduction in the real short-term rate), and they rise as the market expects a future tightening. This makes sense if you realize that tighter monetary policy should reduce inflation fears, and that in turn should result in reduced demand for TIPS, which in turn means lower TIPS prices and therefore higher TIPS real yields.

Note that real yields today appear to have "overshot" expectations for future monetary ease. If I used a higher-than-current inflation rate, however, this overshoot would disappear since the 1-yr forward real LIBOR rate would become more negative. So this chart provides more evidence that the market is bracing itself for rising inflation.

From an investor's perspective, buying TIPS for inflation protection has become an expensive proposition. That's because the market is now embracing the idea that inflation is likely to rise (albeit not by very much), and the market demands that you "pay up" for protection. TIPS are also expensive because the Fed has pushed Treasury yields down to extremely low levels. Plus, both the Fed and the market have embraced the notion that the U.S. economy is going to be very weak (with a large "output gap") for a long time. If you expect to make money via rising TIPS prices, we're going to have to see the economy sinking into a double-dip recession, and/or the Fed surprising with a bigger-than-expected QE2 (since that would further depress Treasury yields). That's what it would take for TIPS yields to decline further (and TIPS prices to rise).

The real risk to TIPS today is not that inflation fails to rise, though that might depress their prices somewhat. The real risk is that the Fed fails to engage in QE2, or that the amount of QE2 disappoints the market's fairly aggressive assumptions. If the Fed disappoints and/or the economy improves, both real and nominal yields could rise significantly.

This is just one more way of saying that the extremely low level of Treasury yields is only tenable so long as the market and the Fed believe that the economy is in dismal shape. Investors have many trillions of dollars sitting in cash and in Treasuries because they have a deep and abiding fear of the future of the economy. Optimism is in very short supply these days, despite the the growing likelihood that next week's elections are going to mark a sea change for the better in the course of U.S. fiscal policy.