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Monetary policy update

Even as the evidence of rising inflation expectations mounts, it's important to not lose sight of the bigger monetary policy picture. The Fed has taken some extraordinary measures to ensure that the U.S. and world economies do not have to struggle with any shortage of liquidity. That involved the purchase of almost $1.5 trillion worth of MBS and Treasury notes. But the popular perception that they have expanded their balance sheet by printing massive amounts of new money (aka monetizing the deficit) is incorrect. Yes, they have created massive amounts of bank reserves, but almost all of those reserves are still sitting on the Fed's books—they have not been turned into newly printed money. The world probably has too many dollars, as suggested by the declining price of the dollar and the rising prices of gold and commodities, but the excess of dollars is not measured in trillions.

As I explained in a prior post, the Fed has not printed $1.5 trillion of new money—they have simply swapped $1.5 trillion of bank reserves for $1.5 trillion of notes and bonds. The bank reserves they have created are functionally equivalent to 3-mo. T-bills, and thus are viewed as among the very safest of asset classes on the planet. The Fed has apparently satisfied the world's demand for safe cash equivalents. By swapping reserves for notes and bonds, the Fed also has effectively shortened the maturity of outstanding Treasury debt. They haven't monetized the debt, they've shortened its maturity. That may well prove to be a very imprudent move from the government's perspective, especially if interest rates rise significantly, but it will shift a meaningful portion of the mark-to-market losses on notes and bonds in a rising interest rate environment away from the private sector and onto the Fed's books. Our government, and ultimately, taxpayers, are now more exposed to rising interest rates, whereas institutional investors are less exposed.

The charts that follow demonstrate that the only extraordinary result of the Fed's extraordinary actions has been an extraordinary increase in bank reserves. All other measures of the money supply are behaving within the range of historical experience. 


Bank reserves have increased by $1.4 trillion since September, 2008, when the Fed first began to implement its Quantitative Easing program. About $400 billion of that increase has occurred since QE2 began last November.



The Monetary Base (which consists of bank reserves and currency in circulation) has increased by about $1.6 trillion since quantitative easing started. $1.4 trillion of that increase represents bank reserves, and most of the remaining $200 billion consists of an increase in currency in circulation. As the second chart above shows, the growth of currency has not been exceptional at all when viewed in an historical perspective. In fact, currency growth was much faster during the 1980s and 90s, when inflation was generally falling. The most important fact to remember when it comes to currency is that the Fed only supplies currency to the world on demand. The Fed does not print up piles of currency and then dump them into the world. People only hold currency if they choose to hold it; excess currency can be easily converted into a bank account at any bank, and the Fed must absorb any unwanted currency at the end of the day, since banks are free to exchange unwanted (and non-interest-bearing) currency for interest-bearing reserves, and would be foolish not to.


The M2 measure of the money supply includes currency, checking accounts, retail money market funds, small time deposits, and savings deposits. As the chart above shows, M2 has been growing about 6% per year on average, after experiencing a "bulge" in late 2008 and early 2009 that was caused by an exceptional increase in the public's demand for liquidity. If banks had been turning their extra reserves into newly-printed money (which our fractional-reserve banking system allows), then M2 would be growing like topsy: $1 trillion of new bank reserves could theoretically support about $10 trillion of new M2 money, and nothing like that has happened.

So, at the end of the day, about all that has happened is that the Fed has exchanged about $1.4 trillion of bank reserves for an equal amount of notes and bonds. No new money has been created in the process, beyond that which would have been created in a normally growing economy with relatively low inflation.

That's not to say that banks will forever allow their reserves to sit at the Fed. In fact, banks appear to be stepping up their lending activities to small and medium-sized businesses, but these actions are still in the nature of baby steps. If the Fed fails to take action to withdraw unwanted reserves in a timely fashion, or to somehow convince banks to leave their reserves on deposit at the Fed, then we could have a real inflation problem on our hands. But that remains to be seen. The weak dollar and rising commodity and gold prices suggest we are in the early stages of a rise in the general price level that, in turn, would equate to a rise in inflation to, say, 5-6% per year. If banks begin to turn their reserves into new money in a big way, then we could potentially see inflation rise well into the double or even triple digits.

Allen Meltzer yesterday proposed one solution to this potential problem in yesterday's WSJ: "The Fed Should Consider a Bad Bank." He suggests that the Fed simply transfer all the extra reserves to a separate bank where they would be held until maturity, and thus unavailable to the banking system. I think it's also possible that the Fed could sell a significant portion of its reserves, by effectively reversing the swaps that created them in the first place. Would banks, and the financial system they serve, be willing to swap their risk-free reserves for notes and bonds? They might, especially if interest rates rise by enough, and if the world sees that the Fed has embarked on a viable exit strategy that will avoid totally undermining the value of the dollar.

The monetary policy picture is far from clear, and it is still potentially very disturbing. But it is not impossible or even catastrophic, not yet.

Inflation expectations continue to heat up




As a follow up to a recent post about how the bond market is worrying about inflation, I post these charts. The top chart shows the relationship between 5-yr TIPS and 5-yr Treasuries, with the spread between their real yields (which equates to the market's expectation for the what the CPI will average over the next 5 years) now within a few bps of an all-time high (2.85%). The second chart does the same for 10-yr maturities, and the spread there has now reached 2.63%, which is also very close to its highest level since 2005.

The message of both charts is the same: inflation expectations are rising significantly. Fed supporters would be quick to note that this could just be a rational reaction to the recent and continuing rise in oil prices. But Fed critics have more ammunition: the very weak dollar, the broad-based rise in commodity prices, the all-time highs in precious metals, and the substantial rise observed to date in the producer price indices and the ISM prices paid indices. There is no shortage of evidence that monetary policy is extremely accommodative and inflation pressures are building. The last refuge of the inflation doves (the Phillips Curve theory of inflation) is being dismantled almost daily, as prices all over the world rise even as there remains plenty of slack in the U.S. economy.

To his credit, Dallas Fed President Richard Fisher today sounded a pretty strident inflation alarm: "Inflationary impulses are gaining ground in the rest of the world ... this will result in some unpleasant general price inflation numbers in the next few reporting periods ... there is the risk that we might breach our duty to hold inflation at bay."

I think it is now clear that the Fed has way overstayed its welcome with QE2, and I find it hard to believe that the rest of the Fed governors will ignore the mounting evidence of such. The ECB has already made the first move to tighten, and meanwhile the figurative rats are abandoning the sinking USS dollar (see my prior post on Brasil). QE2 is scheduled to finish in a few months, but if it is abandoned now it will hardly be cause for concern, since the remaining Treasuries to be bought represent only a very tiny fraction of the total outstanding, and thus are very unlikely to make much of a difference to yields and/or the economy. What will make a difference, of course, is a Fed decision to ignore the evidence of rising inflationary pressures.

Bravo for Brasil


Brasil yesterday apparently gave up its quixotic quest to keep its currency from appreciating against a weakening dollar. Why follow the dollar down to the inflationary depths, when you can keep your currency stable against other currencies and minimize the impact of rising dollar-denominated commodities?

On balance, as the chart above shows, the real is the same today against the dollar as it was 12 years ago in 1999. (This is a milestone in itself; who would ever have thought the real could go 12 years without a devaluation against the dollar?) That would ordinarily be very good news for Brasil, except that the dollar has lost over 25% of its value against other currencies during that period. So the real has suffered equally (and this fact should be shoved in the face of any exporter who claims he has lost competitiveness as a result of the real's strength), but at least now those who invest in Brasil know they don't have to accept the fate of the dollar if it continues to decline.


The way is now open for Brasil's stock market to reach new all-time highs, both in real and dollar terms. I note that Chile's peso has also been strengthening against the dollar of late, and Argentina's peso has been a lot stronger against the dollar than its relatively high inflation rate would suggest. Even Mexico's peso has been appreciating against the dollar this year. Bully for them, and shame on the U.S. Fed. Oh, and by the way, this should be good news for emerging market debt and equities. Stronger currencies are always better than weaker currencies, since they reflect and encourage confidence in their countries, and that in turn promotes investment, growth, and prosperity.

Is It Immoral to Cut the Budget?

That's the title of an excellent op-ed in today's WSJ by Roger Pilon of the Cato Institute. Roger is a superb champion of liberty and a master of Constitutional law. In this article he reminds us that the federal government never should have gotten into the business of providing charity and redistributing income; those are the activities that are in fact immoral. The article is so good that everyone should read it, but I will repeat it here with some edits in the hopes that it can be more widely read and appreciated:

'What Would Jesus Cut?" So read the headline of a full-page ad published in Politico last month by Sojourners, the progressive evangelical Christian group. Urging readers to sign a petition asking Congress "to oppose any budget proposal that increases military spending while cutting domestic and international programs that benefit the poor, especially children," it was the opening salvo of a campaign to recast the budget battle as a morality play.
Well, if morality is the plain on which the federal budget battle is to be fought, let's get on with it. At the least, as the Sojourners say, the budget is a statement about the nation's priorities—much like a family's budget reflects what its members think important, or not.
But the similarity ends there because a nation, unlike a family, is not bound by tendrils of intimacy and affection. America, especially, is not one big family.
"We the People" constituted ourselves for the several reasons set forth in our Constitution's Preamble, but chief among those—the reason we fought for our independence—was to "secure the Blessings of Liberty to ourselves and our Posterity." Yet nowhere today is that liberty more in jeopardy than in a federal budget that reduces us all, in so many ways, to government dependents.
Our tax system sucks the substance and spirit of entrepreneurs and workers alike, filters that substance through Washington, then sends it back through countless federal programs that instruct us in minute detail about how to use the government's beneficence. Manufacturing, housing, education, health care, transportation, energy, recreation—is there anything today over which the federal government does not have control? A federal judge held recently that Congress can regulate the "mental act" of deciding not to buy health insurance.
The budget battle is thus replete with moral implications far more basic than Sojourners seem to imagine. They ask, implicitly, how "we" should spend "our" money, as though we were one big family quarreling over our collective assets. We're not. We're a constitutional republic, populated by discrete individuals, each with our own interests. Their question socializes us and our wherewithal. The Framers' Constitution freed us to make our own individual choices.
The Good Samaritan is virtuous not because he helps the fallen through the force of law but because he does so voluntarily, which he can do only if he has the right to freely choose the good, or not.
Americans are a generous people. They will help the less fortunate if left free to do so. What they resent is being forced to do good—and in ways that are not only inefficient but impose massive debts upon their children. That's not the way free people help the young and less fortunate.
And it's not as if we were bereft of a plan for determining our priorities as a nation. Our Constitution does that quite nicely. It authorizes a focused but limited public sector, enabling a vast private sector of liberty. But early 20th-century Progressives— politicians and intellectuals alike—deliberately shifted that balance. Today the federal government exercises vast powers never granted to it, restricting liberties never surrendered. It's all reflected in the federal budget, the redistributive elements of which speak to nothing so much as theft—and that's immoral.

Central bank update: the Fed is behind the curve


Today the ECB was the first of the major central banks to raise its target rate since the 2008-09 recession. As this chart suggests, it is likely only a matter of time before the other central banks follow suit. Moreover, this first tightening is still only a baby step, and it will almost certainly not be the last.


Canada's central bank started hiking rates almost a year ago, charting a proactive course—relative to the Fed—for the first time in recent memory.


Australia's central bank stands head and shoulders above the rest. They started hiking rates back in October, 2009, and rates are far higher now in Australia than they are in any other developed economy.


The gumption of the Aussie central bank goes a long way to explaining why the Aussie dollar has never been so strong against the US dollar, as the chart above demonstrates. Interesting footnote: in Aussie dollars, gold is worth the same today as it was two years ago, and the CRB Spot Commodity Index is no higher today than it was back in October 2008. Message: gold and commodity prices can tell you a lot about how well a central bank is protecting the purchasing power of its currency.


And, not surprisingly, the same can be said for Canada's central bank and its currency—the Bank of Canada has been proactively tightening and the Canadian dollar is about as strong, relative to the US dollar, as it has ever been.

The dollar is as weak as it is because the Fed is perceived to be the central bank that has eased the most and the central bank that will be the last to tighten; the Fed is falling behind the inflation curve. By over-supplying dollars to the world, the Fed has contributed significantly to weaken the US dollar, impoverishing us all and threatening to deliver years of uncomfortably high inflation. Will someone please forward these charts to Chairman Bernanke?

Buying gold is a doomsday trade


This chart of inflation-adjusted gold prices omits (because it plots only month-end data) the speculative frenzy that briefly drove gold prices to almost $900/oz in January, 1980, which in today's dollars would be about $2500/oz. If you want to see a chart with that included, Mark Perry has it. If you think gold might revisit its former highs in real terms, then be my guest and buy gold today, and you might make a quick 70% on your investment if you're nimble and can get out before it collapses, because I seriously doubt that gold can sustain prices of $1500-2000 for very long. Gold is as high as it is today because there is a lot of bad news supporting its price, and it's priced for even more bad news: the explosion of the Fed's balance sheet, which potentially could lead to a gigantic rise in U.S. inflation; the record weakness of the dollar, which threatens to collapse; the multi-trillion dollar federal deficits that could stretch as far as the eye can see; and the turmoil in the Middle East that could threaten a major portion of the world's oil supply, for starters.

Any or all of these developments could create havoc and even chaos all over the world. I'm not saying that it won't happen, but I do believe that "the end of the world as we know it" is a low-probability event. Those who buy gold at today's levels must believe it's a relatively high-probability event, because they are paying a price that historically, in real terms, is very high. In today's dollars, the average price of gold over the past century has been about $450/oz.

Dollar update, and related thoughts


At the request of "Adam Smith" and as a public service, here is a chart of the inflation-adjusted, trade-weighted value of the dollar against a broad basket of currencies, with data through the end of February, 2011. (The nominal version of this chart can be seen below.) Today the dollar is essentially at an all-time low against other currencies on both a real and nominal basis, and that marks something of a "misery milestone" if you will. The dollar's extreme weakness reflects a combination of factors: a) the Fed's concerted effort to maximize the dollar liquidity available to the world (in the hopes that this will stimulate the economy and avoid the risk of deflation); and b) the world's weak demand for the dollar, which in turn is likely fueled by concerns related to potentially inflationary monetary policy, massive federal budget deficits, a lack of U.S. leadership, and the relatively tepid U.S. recovery.


The dollar's extreme weakness is a problem in itself, since it automatically reduces the purchasing power (and wealth) of all U.S. residents, and it will exacerbate inflation pressures, since over time most imported goods prices will tend to adjust upwards to compensate for the dollar's weakness. You can't have a weak and falling currency without eventually having rising inflation. Inflation is nothing if not a measure of the loss of purchasing power of a currency.

One other important and related development is that many countries have traditionally viewed their own currencies as being either pegged to, or broadly tracking the dollar; with the dollar in decline, they have attempted through various means (e.g., lower interest rates than they would otherwise have chosen) to "follow the dollar down" in order to avoid having their currencies appreciate vis a vis the dollar and thus rendering their domestic industries uncompetitive (or so goes the thinking—I've never seen a country devalue its way to prosperity). Thus we see that commodities, energy prices, and gold are rising against almost all currencies—although I hasten to add that of late, gold is making new highs mainly against the dollar, and not against most other major currencies. A weakening of all currencies increases the potential for a global rise in inflation in coming years.

I've worried about rising inflation for the past two years or so, but measured inflation so far has been relatively tame. Headline inflation is beginning to pick up, but the Fed argues this is being driven mainly by food, energy, and commodity prices, and central banks should not try to control those naturally-volatile prices. They further argue that the large degree of "slack" in the U.S. economy creates a powerful deflationary effect on the general price level. They focus on "core" prices, in the belief that food and energy prices will eventually track core prices, and the heating-up of inflation that we see in the PPI and the headline CPI will subside with time.

Despite all my concerns, I have noted that to date there is no evidence of any unusual increase in the various measures of the U.S. money supply that might support a significant rise in inflation, and to date there has been no significant decline in the demand for money that might also support a higher and rising price level. Quantitative easing looks and feels very inflationary, but so far nothing much has happened—except for the very weak dollar. Almost all of the Fed's massive injection of bank reserves has been willingly held by a public that apparently still craves the safety and liquidity of those T-bill equivalents. But at the end of the day, the significant decline in the dollar's value is prima facie evidence of an excess supply of dollars relative to the demand for dollars, and that is how inflation gets started.

U.S. monetary and fiscal policy levers have been in max-stimulus mode for quite some time, yet the only obvious result has been a weaker dollar and a struggling economy. This is not surprising to non-Keynesian economists, of course. Supply-side and classical economists know that you can't create growth via the printing press; too much money only reduces confidence and increases speculation, to the detriment of genuine investment. Furthermore, increased government spending only wastes resources that could be put to better use by the private sector, and income redistribution schemes only create perverse incentives (rewarding those who don't work and penalizing those who do).

This leads to the conclusion that we need less "stimulus" if we want to really stimulate the economy. Monetary policy needs to demonstrate a deeply held conviction to preserve the purchasing power of the dollar—to give the value of the dollar precedent over the state of the economy. Bernanke and his fellow Fed governors all profess to believe this, but their actions leave much to be desired. Still, I think it is premature to conclude that the only possible outcome of QE2 is a dollar meltdown, which in turn would lead us to the "end of the world as we know it." There has been no unusual expansion in any of the common measures of the dollar money supply, so any actions that increase the world's demand for dollars could go a long way to fixing the relative over-supply of dollars that is depressing the dollar's value. For example: to quickly boost the demand for dollars, Congress could adopt a new and healthier fiscal policy; and the Fed could embark on a sooner-than-expected tightening of monetary policy. Plus, if the economy continues to improve, as I think it is, this would also boost dollar demand by increasing confidence in the future.

Fiscal policy needs to shrink the size of government by spending less and redistributing less, thereby freeing up resources that can be better utilized by the private sector and creating better incentives to work and invest. Paul Ryan's proposal goes a long way to accomplishing this, and even if Congress does not embrace it I think fiscal policy is now headed in the right direction.

So the weak dollar is a serious problem, but there is no reason yet to abandon all hope.

Bank lending points to continued growth


Continuing evidence of an important change on the margin: Commercial & Industrial Loans (bank loans to small and medium-sized businesses) have been rising at an annualized rate of 5.8% for the past six months. This is important evidence of growing confidence among the nation's banks and among smaller businesses. The recession was largely the consequence of a huge loss of confidence in the global banking system, and a pronounced reluctance of banks to lend and businesses and individuals to borrow (manifested in a significant deleveraging of the economy). Therefore an important component of the recovery has been the recovery of this lost confidence. We had a panic-induced plunge in economic activity, and we are still in the midst of a slow but steady process of rebuilding that confidence.

There is still lots of room on the upside, since markets are still characterized by caution, not optimism. Bank lending is only in the early stages of a recovery, and the economy's demand for liquidity (manifested by the desire to deleverage) is still strong.

The $29 trillion recovery


Since the low of early March, 2009, the capitalization of global equity markets has more than doubled, rising by $29 trillion. Valuations now are only $7 trillion shy of their late 2007 high. It would be an understatement to say that "fortunes" have been won, lost, and won again in the past several years—the magnitude of the collapse and the rebound have been more than anyone could have imagined. It is a testament to the resilience of markets, risk-takers, and workers that the global market economy has not collapsed under the weight of the fiscal and monetary policy errors that contributed to this extraordinary volatility. There are still plenty of problems left to deal with, but the recovery to date inspires hope that the problems can be overcome with time.

Bonds are worrying about rising inflation


The bond market has a poor record of anticipating major changes in inflation. Treasury yields lagged the rise in inflation throughout most of the 1970s, with the result that real yields were generally low and even negative during the period, and cheap borrowing costs helped fuel inflation fires. Treasury yields also lagged the decline in inflation we experienced in the 80s and 90s, with the result that real yields were generally high during the period, and expensive borrowing costs helped keep inflation low.

But the bond market is not entirely oblivious to what is going on. As the chart above shows, the breakeven inflation rate embodied in 10-yr TIPS and 10-yr Treasuries now stands at almost 2.6% (i.e., the market is priced to the expectation that the CPI will average about 2.6% per year over the next 10 years). That is substantially higher than the 2.0% average breakeven rate that has prevailed since TIPS were first introduced in 1997, and it is only 18 bps shy of its highest level in 2005, just before the CPI recorded a 4.7% year over year gain. Moreover, TIPS 10-yr breakeven spreads have now risen over 250 bps from close to zero at the end of 2008.

All of this adds up to a fairly dramatic statement about how the Fed's quantitative easing program has not only eliminated deflation risk, but now threatens to raise inflation beyond the relatively low levels we have enjoyed for the past three decades.

Kudos to Paul Ryan

Paul Ryan is one of those rare politicians who not only understands how the government and the economy really work, but is willing to say and do what is necessary to get us out of the deep spending and deficit-drenched predicament we are in today. His vision of reform, laid out in today's WSJ op-ed, may not be perfect, but it is bold, brave, and a big breath of fresh air from my perspective. Lesser politicians will criticize his plan at their peril.

UPDATE: Mark Perry adds some good information on how Paul Ryan's plan compares to the Bowles/Simpson plan, and what his driving philosophy is, here.

Service sector weakness highlights inflation risk


The March ISM service sector indices fell more than expected, but remain at levels that are consistent with continued economic growth.


The employment index also fell, but only modestly. It continues to signal ongoing economic growth.


The prices paid index fell modestly, and is still quite high from an historical perspective. One theme that is repeated often these days—and here—is that inflationary pressures persist even though the economy is well below its full-employment capacity. This directly contradicts the widely-held Phillips Curve theory of inflation, which holds that high levels of unemployment exert downward pressure on prices and thus keep inflation low. The Fed should be looking at numbers such as this and concluding that there is no longer any need for quantitative easing, and that in fact it is past due time to begin raising short-term interest rates. That they aren't is one good reason why the dollar is trading at or near all-time lows and the equity market is trading far below levels that could be considered fully-valued.

Too much monetary stimulus is not a good thing, just as too much government spending (disguised as stimulus) is not a good thing. The private sector could be a lot healthier (more confident and more willing to invest in new jobs) if our government were to reduce monetary policy risk and reduce its consumption of a sizable portion of the economy's resources.

Equities are not over-valued


There are different ways to interpret corporate profits, and different ways to measure them, so it's possible that intelligent people can come to different conclusions about the state of profits and whether profits are being appropriately valued by the market. I'm of the belief that profits are quite strong, and the market is almost certainly not overestimating their value.

The top chart shows profits as a % of GDP, using after-tax adjusted corporate profits as calculated in the National Income and Product Accounts. This is a consistent measure of economic profits that goes back a long way. As you can see, profits have almost never been as strong as they are today, and profits have rebounded sharply (the V-est of V-shaped recoveries) in the past few years even though the recovery has been tepid. Given how strong profits have been, and how low interest rates are, you might think that equities would be at or near all-time highs, but you would be wrong. As a reminder, the S&P 500 index today is about the same as it was 12 years ago.


This next chart compares NIPA profits to accounting profits as reported by the S&P 500 companies. Over time, the two measures are well correlated, but I note that NIPA profits tend to lead accounting profits. NIPA profits are quarterly annualized numbers, whereas accounting profits are trailing 12-month totals, so they they have a built-in tendency to lead. Even taking that into account, NIPA profits tend to lead accounting profits, and NIPA profits are pointing to further gains for accounting profits in the year to come.


This third chart uses NIPA profits as a proxy for corporate earnings, and the S&P 500 index as a proxy for the value of corporate equity, to come up with a sort of economy-wide PE ratio.  Here we see that the valuation of corporate equities is substantially below its long-term average, even though profits are very near their all-time high as a percent of sales (using GDP as a proxy for sales). One easy conclusion is that equities are definitely not expensive. I note also that the standard S&P 500 PE ratio, currently 15.5, is below its long-term average of 16.5.


This last chart compares accounting earnings per share (i.e., equity yields) to BAA corporate bond yields. In a perfect world, earnings per share would be lower than bond yields, since equity owners are lower in the capital structure and bond owners get first claim to earnings; equity owners should be willing to accept a lower yield since they can benefit from higher equity prices and higher top-line growth. Instead, we see that earnings yields are higher than bond yields, a situation that has occurred fairly rarely in the past. I take this to mean that the equity market is leery, to say the least, about the potential of corporate profits to remain as strong as they are. It's as if the equity market believes—as suggested by the top chart—that profits as a % of GDP is mean-reverting, and thus the market is pricing in dismal profits growth for years to come. This is not an unreasonable position, but it is definitely not symptomatic of exuberance or over-valuation.

Full disclosure: I am long equities of all sorts at the time of this writing.

Credit spread update


I see more and more people arguing that corporate bonds, particularly of the high-yield variety, are fully priced and thus no longer attractive. While junk bonds have certainly enjoyed a huge rally in the past two years from extraordinarily depressed levels, I think it is premature to assume they are now overpriced. As evidence, I offer the chart above, which plots option-adjusted spreads on investment grade and high-yields bonds, as calculated by Merrill Lynch.

While junk bond spreads are a bit lower than their average of the past 14 years, they are still substantially higher than they were at their lows in early 2007 and in 1997-98. And of course those latter periods were in retrospect times of overvaluation as spreads subsequently began to rise significantly. I remember very well the 2005-06 period, when spreads were unusually low and implied volatility was unusually low. Tranquility was the norm for over two years, leading many to assume that we had entered a new era of tranquility that would last for a long time. (It's dangerous to extrapolate trends.) I worried that the market was being set up for a nasty surprise coming out of left field, but I had no idea what that might be. In any event, spreads today are still meaningfully higher than they would be if the market were complacent and willing to believe in tranquility for as far as the eye can see.

Spreads are a good measure of the value inherent in corporate bonds, and for the market's estimate of default risk, but what about the risk of rising Treasury yields, which form the basis for measuring corporate spreads? What if Treasury yields rise? Wouldn't that push corporate yields higher? Well, not necessarily.


This chart compares the yield on junk bonds with the 2-yr swap spread. Swap spreads have typically been good leading indicators of the health and attractiveness of corporate bonds. Swap spreads currently show absolutely no sign of any impending danger or lurking systemic risk that might disturb the relative tranquility of the corporate bond market. Furthermore, junk bond yields today are at about the same level as they were in early 2007, when spreads were much lower and Treasury yields were much higher (10-yr yields were 4.5-5% in the first half of 2007, and they are currently a bit less than 3.5%). So I could argue that in a sense, junk bonds are already priced to a rise in Treasury yields of at least 100 bps. 10-yr Treasury yields could rise by 100 bps and junk bond yields could remain steady, and spreads would decline by 100 bps, leaving them still wider than they were in early 2007.

Once again, here is evidence that markets are still priced to fairly conservative and cautious assumptions. Put another way, I can't find evidence to support the notion that prices of corporate bonds and equities have been artificially or unrealistically inflated.

Putting oil and commodity prices into perspective

Commodity prices just keep on rising. Does this pose a threat to economic growth? I don't think so, and this post offers a few reasons why. 



The CRB Spot Commodity Index is my favorite measure of non-energy commodity prices. While it is indeed making new nominal highs almost daily (first chart), and prices have almost tripled in the past 10 years, on an inflation-adjusted basis these same commodities cost about the same today as they did in 1970. Believe it or not, we have seen commodity prices do a complete round trip over the past several decades, and they are now back to where they started. (Incidentally, this same index of commodity prices rose about 15% from 1960 to 1970 in nominal terms, while it fell about 8% in real terms.) 

As the second chart above suggests, monetary policy has had a lot to do with the big, secular swings in real commodity prices. Easy money throughout the 1970s induced a worldwide preference for hard assets, and commodity prices were relatively expensive back then as a result. Tight money in the 1980s and 90s undermined that preference by making financial assets (especially bonds, which offered unusually high real interest rates during most of that period) more attractive, and by increasing the effective demand for money by restricting its supply. For most of the past 10 years, the Fed has been generally accommodative (especially in the past two years), and the world has once again gained a new appreciation for hard assets. If tight money depressed commodity prices in the 80s and 90s, easy money has now removed that depressant from the market. And if commodities were cheap in the 80s and 90s, they are now no longer cheap and perhaps only somewhat expensive relative to their long-term historical price range. 


Oil prices are still a bit shy of their all-time nominal highs, but they are rising daily, and at this rate we could see $145/bbl oil again (the high-water mark in mid-2008) before the year is out. As the chart above shows, peaks in oil prices have a strong tendency to coincide with recessions. Is this causation or coincidence? I would argue that high oil prices are not the cause of recessions, but rather are symptomatic of the easy money and rising inflation that have lead the Fed to tighten monetary policy—and it is tight money that has caused almost all recessions. Regardless, should we worry about a double-dip recession because of rising oil prices today? For one, I seriously doubt we'll see a recession anytime soon, because monetary policy is not going to be tight enough to cause a recession for a long time. On the contrary, monetary policy is currently very accommodative, and this significantly mitigates the negative impact of rising energy prices.


Another good reason not to worry about rising oil prices is that the U.S. economy has become much less dependent on oil over the years, and real oil prices are only marginally higher today than they were in the early 1980s. As the chart above shows, our economy requires 58% less oil to produce a unit of output today than it did in 1970.


The major surge in oil prices in the 1970s led to a massive effort to reduce oil consumption and become more energy efficient. As a result, U.S. oil consumption today is about the same as it was in 1980, even though the economy has grown by 125% in the intervening years.

Meanwhile, today's relative high oil prices are already encouraging more drilling and exploration; Baker Hughes reports that world oil and gas drilling activity has soared 75% since mid-2009. And expensive oil will undoubtedly encourage more conservation and further the search for and development of alternative energy sources.

Oil is once again expensive, and gasoline is about $4 per gallon. That's unfortunate and painful for many, but it's not a catastrophe by any stretch.