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Prepare for a Greek default



Swap spreads tend to be good leading indicators of systemic risk. Swap spreads started rising in the second half of 2007, for example, fully one year before the 2008 financial crisis hit. So it is troubling to see that european swap spreads have been trending higher in recent months, even as U.S. swap spreads have been relatively low and flat (top chart). Swap spreads in both markets surged last May, when Greece teetered on the verge of default. US spreads settled back down, however, as it became apparent that a sovereign default, if it occurred, would be small potatoes for the huge US economy.

Now Greece is back in the news, as yields on 2-yr Greek government debt have risen to a post-crisis high (second chart). Other PIGS are in trouble as well (Portugal, Ireland, and Spain), but Greek government yields and credit default swaps tower over those of the other countries facing the risk of default. So despite the costly efforts of other Eurozone nations to bail out Greece, the market seems to be saying that a default of some magnitude is unlikely to be avoided. I would brace for that, even though I doubt it would have much of an impact on the global or the US economy. The fact that the euro is only marginally weaker against the dollar in recent months, and European stocks are near their highs, I think confirms that a Greek default won't be an earth-shattering event. With luck, markets have had enough time to price in this grim reality, so when it actually happens the impact won't be too painful.

No news from the money supply front



I've been a fan of the M2 measure of money for a very long time. It's been the most stable definition of money, and it's had the best correlation to the economy of any other measure. As these charts show, the behavior of M2 over the past 15 years hasn't changed much at all. There have been periods of faster growth (2001-2003, 2008-2009), but they have been followed by slower growth, with the result that M2 has grown on average about 6% a year. That's a little faster than the 4.7% annualized growth rate of nominal GDP over the same period, but not by much. Importantly, there is nothing here to suggest that M2 is growing faster or slower than it has for a long time; no sign of any inflationary impact from QE2, and no sign of anything that might be deflationary.

Some worry about the recent pickup in M1 growth, with M1 now growing at a 19.4% annualized pace over the past 3 months. But since M1 is a component of M2, and M2 shows no sign of any significant pickup in growth, then what is happening is that money is migrating out of the M2 definition of money and into the M1 definition. It's the same amount of money altogether, but some of it is shifting from one bucket to another. So there is no real message in rapid M1 growth.

Currency in circulation, another component of M2, is behaving normally, growing at a 6-7% pace.

So the news from the money supply front is that there is no news: no sign of inflation, no sign of deflation, and no sign that the economy is being starved for liquidity. I suppose that's good news, since for the time being there is no cause for great concern here.

The employment situation fails to improve


According to the December employment numbers, the employment situation failed to improve as I had hoped, and as had been suggested by the decline in unemployment claims and the surge in the ADP estimate of new private sector jobs. But while it failed to improve, neither did it deteriorate. Both the establishment and the household surveys report that the U.S. economy has been creating about 120,000 new private sector jobs a month, on average, over the past year, and the rate of growth has been fairly steady throughout the year.



Although this is about the rate of new job creation needed just to keep up with the 1% per year average growth in the labor force, the unemployment rate has declined because the labor force has shrunk (at least two million people have apparently stopped looking for jobs, so they are no longer considered to be part of the labor force). So while it's good that more people are working, we are far from a situation that might be called healthy or normal. In any event, it was probably premature to expect a pickup in job growth in December; the new and improved outlook for fiscal policy (e.g., the extension of the Bush tax cuts) didn't become a reality until after the elections, and few businesses are going to be reacting immediately—it takes time to make new plans and hire new people. Jobs, after all, are a lagging indicator of conditions in the economy. So if jobs growth doesn't pick up in the next several months, then it will be time to worry that something is amiss.

Claims continue to suggest a stronger labor market


On a seasonally adjusted basis, unemployment claims have fallen by about 15% in the past three months, and are now only about 25% higher than they might be (~325K) if the economy were growing normally and the unemployment rate were relatively low. This is a major, necessary, and welcome adjustment, but it needs to be followed by a pickup in new hirings. We're likely to see that tomorrow in the December jobs report, and we saw it yesterday in the ADP estimate of new jobs. The market is expecting 175K new private sector jobs tomorrow, but the ADP report is pointing to a lot more. This could be exciting.

Higher bond yields go hand in hand with stronger growth


Treasury yields and equity prices are facing upward pressure as the economic news gets better. Bond yields and equities have been moving more or less in tandem for most of the past year, and both have been good indicators of sentiment regarding the strength of the economy (which is not unusual at all). Deflation fears have also played a role, as suggested by the bottom in both yields and equities in late August, just before the Fed first floated the idea of another round of quantitative easing; a concerted QE2 effort to vanquish deflation has succeeded, and that has helped lift the economy. As deflation fears are replaced by rising inflation expectations (the 5-yr, 5-yr forward breakeven inflation rate embedded in TIPS has risen from 2.0% last August to 2.9% today), and as double-dip expectations are replaced by stronger-than-expected economic news (e.g., declining unemployment claims, strong auto sales, solid ISM numbers, a blowout ADP report, and rising commodity prices), bond yields and equity prices are rising.

The forces of recovery have been building for 18 months, and they are now being reinforced by rising confidence, which in turn has been boosted by a very favorable change in the fiscal policy climate. Despite the magnitude of QE2, I think its effects have been mainly limited to quelling deflation fears rather than directly boosting growth. After all, there still is no sign of any outsized growth in any of the money supply aggregates, and QE2 can hardly claim to have lowered long-term borrowing costs for anyone. We now have a virtuous cycle at work which will be very difficult to derail. Higher bond yields won't kill growth because they are the by-product of stronger growth.

Full disclosure: I am still long TBT and equities at the time of this writing.

The employment picture is looking much brighter


This measure of announced corporate layoff activity hasn't been so low since 2001. There has been nothing short of a stunning decline in layoff activity since early last year, a clear sign that the economy has put the difficulties of the recession in the past. Businesses have done just about all the downsizing they need to, and so now the next shoe to drop must be a substantial pickup in new hiring activity. Judging from the surprisingly strong December ADP announcement (next chart), it has already started.

Service sector strengthens


The December ISM service sector report was a good deal stronger than expected. This chart above shows the Business Activity Index, which has surged in recent months after some very disappointing numbers in the third quarter (a period we now know was an economic "soft patch"). Both this and the Service Sector Composite Index are now higher than they have been at any time since 2005-6, in a very clear sign of strength. The service sector has been lagging the strength of the manufacturing sector for most of this recovery, but now we see that it is catching up. This is very good news.


The prices paid component of the NAPM indices show that fully 70% of those surveyed report paying higher prices. The CPI may be registering very low inflation, but in the real world there is something else afoot, and it's not deflation.

The economic strength and the inflation pressures displayed in the ISM indices do not jibe at all with the FOMC's recent assessment of the economy (i.e., it still needed help from QE2). Bureaucrats are usually late to the party, so that is not too surprising. But the Fed can't and shouldn't ignore these numbers for much longer.

Automobile sales record strong gains


December auto sales continued to register impressive gains, rising at a 17% annual rate since hitting bottom early last year; moreover, sales are up at a very impressive 25% annual rate in the past six months. December sales beat estimates by 1.9%. Although the pace of sales is still low from an historical perspective, the recovery to date has been very impressive. This is a strong vote of confidence in an ongoing recovery, and a sign that consumers are in better shape than is commonly thought, given the still-high level of unemployment. The fact that sales have been exceeding expectations for some time now, without the help of government subsidies, means that there will undoubtedly be ripple effects throughout the economy as production targets ramp up to meet unexpectedly strong demand. What's good for General Motors, as they say, is good for the economy. Unquestionably bullish.

Thoughts on the national debt


News stories today are reporting that as of the end of December, the national debt has passed the $14 trillion mark. Technically that's not true, since $4.6 trillion of that amount is debt that the federal government owes to itself (e.g., money which Treasury has "borrowed" from social security), according to Treasury. Our debt to other parties currently totals $9.4 trillion, which works out to about 63% of GDP, and it has risen by more than $3 trillion since Q3/08.

I'm not trying to belittle the deterioration in our fiscal health, just trying to be more precise. Social security payments are not the same sort of obligations that are incurred when Treasury sells a bond. If Treasury were to default on its debt obligations, that would be very serious indeed, since Treasury debt is the bedrock of the world's financial system. But our national government can change the future payout of social security in ways that could drastically reduce the future unfunded obligation of that program (which, I reminded one of my nephews last night, is one of the worst scams ever perpetrated on today's young people—he would be far better off if he were allowed to direct his FICA contributions to a private investment/retirement account). Two very easy solutions that would make a world of difference: raising the retirement age, and adjusting future payments for the CPI instead of using the rise in incomes (which includes a real component in addition to inflation). If in addition to these changes we were to follow the example of Chile and allow people to opt out of social security voluntarily, in exchange for directing their own (mandatory) contributions to a private investment account, the social security problem might fade into relative obscurity before too long.

And since Medicare represents a huge potential unfunded liability, we could deal with the lion's share of that by simply changing the tax code to treat health insurance costs the same, whether one gets his insurance from an employer or pays for it out of his own pocket. Just let everyone deduct the cost of healthcare, or no one. That would soon result in a reversal in the decades-long march towards a system where today a third party pays for most people's healthcare costs. When someone else is paying the bill, you have very little incentive to shop around or otherwise cut costs, and competition among healthcare providers never gets much of a chance to make the healthcare market more efficient.


In any event, the chart at the top compares the burden of our national debt to the level of long-term bond yields. I've long been fascinated by this chart, since it shows what appears to be a very non-intuitive relationship: as the burden of our debt fell from WWII through 1980, interest rates rose; and as the burden of the debt rose from 1980 on, interest rates generally fell. The theory that government debt "crowds out" private debt by pushing interest rates higher just doesn't hold water according to this chart. The main determinant of interest rates, of course, is inflation, and there is no necessary connection between the amount of Treasury debt and the level of inflation. Unless, that is, the Federal Reserve decides to monetize the debt....  We may discover in coming years just how this works, now that the Fed has quasi-monetized almost 10% of our national debt. This will be the focus of intense interest over the next few years.

UPDATE: For more on federal deficits and how relatively easy it should be to balance the budget, see my posts here and here.

Stocks for the long haul


The S&P 500 is up 90% since its intra-day low of early March '09 (+94% including dividends), so I thought it might be helpful to put this rally in perspective. As this charts suggests, equity prices are still below their long-term trend, depending on how you like to draw your trend lines. Stocks are not yet ebullient, they are still somewhat depressed. That's consistent with the message of credit spreads and implied equity option volatility, both of which are still somewhat elevated relative to where they have been during "normal" times. It's also the message of PE ratios, which are still somewhat below their long-term average.

Construction activity relatively stable but weak


November construction spending was a bit stronger than expected, and prior months were revised upwards. This changed the picture from one of a bit of emerging weakness into one of relatively stable activity. As I eyeball this chart, it strikes me that construction spending has been relatively flat for a year or so. I doubt we'll see much change in the months ahead, but eventually (within a year?) this sector of the economy will be overdue for some very strong growth.

UPDATE: The following two charts show lumber futures prices and an index of major homebuilders' stock prices, respectively. Both suggest some firming in the construction sector. Lumber prices are now up 115% from their March '09 lows, and homebuilders' stocks are up 137% over the same period. At the very least these charts strongly suggest that we have seen the worst of the news for the construction sector.


Strong manufacturing report


The December ISM manufacturing index came in about as expected, but it continues to point to stronger-than-expected economic growth. As this chart—one of my favorites that I have been using for more than 10 years—suggests, the recent behavior of the ISM index is pointing to GDP growth of 4% or more, leading me to expect that Q4 GDP will be much stronger than the 2.5% reported for Q3.



The Prices Paid component of both ISM indices continues to point to the absence of deflationary pressures and the persistence of inflationary pressures. Some of this could be explained by the rising price of crude oil, as the second chart suggests, with the rest being explained by rising commodity prices, a cheap dollar, a relatively strong global economic backdrop, and accommodative monetary policy.


The Employment component of the ISM index dipped in December, but remains at what is a relatively lofty level. Altogether, the ISM report continues to paint a picture of a relatively strong, ongoing recovery in the manufacturing sector, and this strength is likely to spill over into other sectors of the economy as the year unfolds.

The long-term view of Treasury yields


Just for the sake of putting things in perspective, here is a look at the last 85 years of 10-yr Treasury yields. The green line marks the 2010 closing level: 3.3%. It took a depression and massive deflation to drive yields lower, back in the 30s and 40s. I continue to believe that the relatively low level of Treasury yields today is an excellent indicator that the financial market is terribly worried about the ability of the U.S. economy to grow and prosper. That leaves plenty of upside potential for the optimists, of which I am one.

A return to prosperity


As we start the new year, we can give thanks for the very impressive comeback in equity valuations that has played out over the past 21 months. The capitalization of global equities is now only 16% shy of its all time high, which occurred in late 2007, and just over double what it was at that awful bottom in early March 2009. A full recovery to the 2007 high will add $10 trillion to global market cap, and I see no compelling reason to think it won't happen within the next year or two. Two years ago, financial markets were all but convinced that the global economy would be mired in a deep, deflationary depression for the next several years at least. Fortunately, the future turned out to be a whole lot better than what it was supposed to be.

Mark Perry has some related comments here.