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Bank reserves update

Just a quick post to once again revisit the issue of whether or not the Fed is "printing" massive amounts of money and thus threatening the world with some sort of financial Armageddon. This chart compares total bank reserves with excess reserves. The two series move in lockstep. Reserves have increased by about $1.45 trillion since Sep. '08, and Excess Reserves have increased by about $1.43 trillion. In other words, banks have effectively decided to hold on to virtually all of the increased reserves that have flooded the system. One big reason they are doing this is that reserves now pay interest, whereas before they didn't. That makes reserves a close substitute for T-bills. The Fed has essentially accommodated banks' desire to reduce the risk inherent in their balance sheets. As long as banks continue to hold their reserves and not use them to greatly expand the money supply, the Fed is not "guilty" of printing money. In order to tighten monetary conditions, the Fed can either withdraw those reserves by selling its massive holdings of Treasuries and MBS, or it can simply raise the interest rate it pays on reserves. Mark Perry has a similar post which adds to the discussion.

Greece will default, the only question is by how much

With Greek 2-yr debt trading at a yield of 22%, and spreads to Germany at record highs, the question the market is grappling with is not whether Greece will default, but by how much. As the chart below shows (HT: Zero Hedge), long-dated Greek bonds are now selling for 50-60 cents on the dollar, suggesting the market is expecting a default/restructuring that effectively reduces the amount Greece owes by almost half. We've seen massive restructurings like this before (Argentina comes to mind) but despite the magnitudes involved, life goes on. When debt is wiped out or cut in half, lenders lose but borrowers gain, in a sense. It's a wealth transfer, but it doesn't necessarily reduce the world's output, which is what provides the foundation for all wealth and all cash flows. And not surprisingly, therefore, despite the near-certainty of a massive Greek restructuring, global stock markets remain very close to their recent highs, and swap spreads in the U.S. and Eurozone remain relatively low.

Continued marginal improvement in the labor market

Although weekly claims (chart below) recently have ticked up a bit, perhaps the more important news is that, as the chart above shows, the number of people receiving unemployment insurance has hit a new post-recession low. Progress is slow, but it's still progress.

Stocks struggle against gold

The top chart shows over 80 years of the monthly stock/gold ratio, while the bottom chart shows daily values over the past three years. Over long periods, stock prices have edged out gold prices, but the ratio can be extraordinarily volatile at times. If stock prices are a proxy for productive assets, and gold prices a proxy for physical (hard) assets, then its reassuring to see that productive activities are more profitable over time than speculative activities. But it's a very rocky road.

Stocks need sound and stable monetary policy to flourish, as they did from the 1950s through the mid-1960s (when inflation was very low and stable), and from the early 1980s through the late 1990s (when inflation fell from double digits to a relatively stable 2%). The problem with stocks today is rooted not only in the potentially inflationary consequences of Bernanke's easy money, but also in the potentially crushing burden of excessive government spending.

Silver goes hyperbolic

For bubble enthusiasts, I offer this chart of silver in today's dollars. Chartists would note that silver is going hyperbolic, and that's quite something since the y-axis is also logarithmic. Caveat emptor big-time. As with gold, speculators may make a quick 70% or so as prices soar to prior highs in real terms (bear in mind however that those previous highs for silver were quite artificial, since the Hunt brothers had managed to briefly corner the market), but the reversal that could follow in its wake promises to be breath-taking. This is heady stuff and only for the most steeled of professionals.

Mortgage applications on the rise

The top chart shows an index of mortgage applications (all types), and the bottom chart shows the history of 30-yr fixed mortgage rates. Late last summer I noted what looked to be a new buying uptrend underway, and now it looks like the real thing. There has been a 29% increase in new applications for mortgages since last July, even though 30-yr fixed mortgage rates have been higher than they were last summer for the past 5 months. (Actually that's the wrong way to characterize what has happened: demand for mortgages is not up despite the rise in mortgage rates—mortgage rates are up because of the rise in the demand for mortgages, and the strengthening of the economy in general.) All in all, a healthy sign of improving housing fundamentals.

Bank lending update

With the inflationary potential of the Fed's $1.5 trillion injection of reserves into the banking system apparently held in check by 1) banks' reluctance to lend and desire to strengthen their balance sheet with excess reserves, and 2) the world's apparent reluctance to borrow, it's vitally important to keep track of new bank lending. The easy way to do that is to watch the growth of M2, since that should reflect the net impact of any monetary expansion driven by new bank lending. But as my previous post detailed, M2 doesn't reflect any unusual expansion in the money supply to date.

The chart above, which focuses on bank lending to small and medium-sized businesses, is a more narrowly-focused look at bank lending, and it shows a clear and continuing uptrend in lending activity. It's still rather tepid, since this measure has only grown at a 7% annualized pace since December, but it marks an important inflection point and the start of a new lending cycle. Most importantly, it also reflects increased confidence on the part of banks and businesses, and that is a key ingredient for future growth in the economy.

Show me the money

I keep coming back to the issue of money, QE2, and inflation because it is so important.

Here's a summary/clarification of my most recent post on the subject, as well as other related comments I've made along the way:

The Fed has expanded bank reserves and the monetary base massively, creating the potential for hyperinflation. (In our fractional reserve banking system, each new dollar of reserves potentially can support about $10 new dollars of bank deposits.) But so far, none of this "money printing" has shown up in traditional measures of the money supply (e.g., currency, M1, and M2), which display no unusual level of growth in recent years. (In fact, they are growing at a much slower rate today than they did in the inflationary 1970s.) Indeed, virtually all of the reserves created by the Fed to pay for its security purchases are sitting idle, in the form of excess reserves, at the Fed. 
Without a huge increase in the actual amount of money in the economy, we are unlikely to see a huge increase in inflation. Alternatively, a significant decline in the demand for money could support a rise in the price level, but there is no evidence to date that this is occurring (except for the fact that the dollar is trading at record lows).
Meanwhile, market-based and leading indicators of inflation strongly suggest that the Fed has supplied more money to the world than the world wants (e.g., the extreme weakness of the dollar, soaring gold and commodity prices, the very steep yield curve, and rising breakeven inflation rates on TIPS). It is an over-supply of money that debases a currency's value, leading to a general rise in the price level, just as an oversupply of houses relative to housing demand has led to a significant decline in housing values in recent years.
So while there is no obvious evidence that the Fed has committed a major inflationary faux pas, there is evidence to suggest that inflation is headed higher. And although banks have yet to utilize their huge stock of excess reserves to greatly expand the money supply, there is no reason to think that won't happen in the future, nor any compelling reason to think the Fed will be able to respond (by cancelling QE2 and/or withdrawing reserves) in time to prevent banks from doing so (e.g., how aggressive can the Fed get if the economy is still struggling to recover?). Conclusion: investors need to be prepared for higher inflation, but there is no reason yet to panic.
The chart below shows a 16-year history of M2, in order to underscore the point that to date, there has been no unusual expansion in the amount of money sloshing around the economy. M2 has grown about 6% per year on average since 1995. Over that same period, the GDP deflator (the broadest measure of inflation) has risen about 2% on average, and real GDP has increased about 4.6% per year on average (all compounded, by the way). In other words, the amount of money in the economy actually has grown by a little less than the growth in the nominal size of the economy (i.e., 6% vs. 6.7% per year).

There are still some important questions to be answered, however. How can there not have been any new money printed, if the Fed has purchased almost $1.5 trillion of Treasuries and MBS since late 2008? What happened to the $1.5 trillion that the sellers of those securities received? Can the quantitative easing process continue indefinitely without inflationary consequences? What will happen if/when quantitative easing stops?

The short answer to the first question (why no new money?) is that at the end of the day, two things happened: 1) banks were willing to hold on to the new reserves, and not use them to increase their lending, and 2) the world in aggregate did not want to increase its dollar borrowings. Another way to put this is that the extra reserves satisfied the world's demand for additional safe and liquid assets. At the same time, the Fed effectively swapped reserves (a kind of T-bill equivalent) for T-Notes and MBS, thus shortening the maturity of federal debt and reducing the private sector's exposure to rising interest rates.

Can this continue indefinitely without inflationary consequences? I doubt it. But there is a certain vicious-cycle aspect to all this that is troubling. The more the government borrows (with the federal deficit on track to hit 10% of GDP, a very large number by any standard), the more the government spends; the more the government spends, the less efficient the economy becomes; the less efficient the economy, the slower it grows; the slower the economy, the fewer attractive investment opportunities there are, and thus the more attractive Treasury debt becomes, even if interest rates are very low relative to inflation. This same dynamic may help explain why Japan has had deficits of more than 10% of GDP for many years, yet the yields on government bonds remain extraordinarily low and economic growth has been disappointingly slow.

Is the end of quantitative easing going to be painful? Not necessarily. The end of QE2 means only that the Fed will stop swapping reserves for longer-maturity securities. There will still be a mountain of excess reserves in the system. Even if the Fed were to start "tightening" immediately after the end of QE2, that "tightening" would hardly be considered problematic, since it could take years to reverse all the injections of reserves. And in lieu of actually reverse its reserve injections, the Fed could simply decide to pay a higher rate of interest on existing reserves. This would have the effect of raising short-term interest rates without reducing the supply of reserves. The steepness of the yield curve is proof that the market is already braced for short-term interest rates to rise by hundreds of basis points. The issue is not whether the Fed will tightening or by how much they will tighten; the issue is when and how fast they will start raising rates.

It is entirely conceivable that a rise in interest rates that results from a Fed tightening will have the effect of increasing the world's demand for longer-maturity securities, thus obviating the need for the Fed to continue swapping reserves for longer-maturity securities.

I hope it's clear that I'm trying to take an objective and dispassionate view of things. There is reason to be concerned, but not yet any reason to panic.

UPDATE: I want to clarify my views on inflation, since on the one hand I argue that the Fed hasn't committed an obvious monetary policy error (because M2 growth is still normal), but on the other hand I note the symptoms of rising inflation (weak dollar, rising gold and commodity prices) and worry that it will continue to rise. Contrary to what some conclude, I am not saying we don't have an inflation problem. I think that 6% M2 growth, if it persists, will be a strong force limiting the rise in reported inflation to 10% at the most, but even 5-6% inflation is enough to qualify as a problem in my book. With 6% M2 growth, inflation could exceed 10% only if we see a meaningful decline in money demand (M2/GDP) and a pickup in M2 velocity (GDP/M2). That is not impossible at all, but it has yet to occur.

Housing update--waiting for the rebound

Housing starts have been bouncing along the bottom for over two years now, after a record-setting collapse from 2005 through 2008. The industry has been in a deep slump that has lasted over 5 years. Residential construction is now only a mere 2% of GDP. If it were going to contract even further, you would think it would have happened by now.

I see the very low and flat trend of starts over the past two years as a good indicator that the housing market has found a market-clearing price and a market-clearing level of activity. Major adjustments have been made, and enough time has passed for the healing process (reducing the level of unwanted housing inventory) to be well underway. For the past two years, housing starts have been far below the level needed to keep up with population growth; therefore, it is only a matter of time before we see signs of a housing shortage and a renewed uptrend in prices.

Keeping things in context

Markets get jittery at times, and when they do it's helpful to review the fundamentals. As the top chart shows, swap spreads haven't budged at all in recent weeks, and are only slightly higher today, despite the headline news to the effect that the official outlook for the U.S. economy has been downgraded by S&P, and Greece is on the cusp of a default (which I anticipated a few months ago, based on the behavior of swap spreads and sovereign debt spreads). Low and relatively stable swap spreads mean that systemic risk is also low. Whatever is going on does not pose a serious threat to the health of the economy, or to the financial markets. Europe is going to have to digest a Greek default, but it shouldn't prove to be the end of the world.

As the second chart shows, the Vix index has moved up of late, but it's a pretty minor case of the jitters when looked at in the context of the past few years.

As the third chart shows, equity prices have been recovering to their long-term trends (choose whichever trend growth line you want, the result is the same), but still have a ways to go before raising valuation questions. The equity market has not overshot, and is not overpriced, as I've been arguing for quite some time.

We're still climbing walls of worry, and today's worries should not be too difficult to overcome.

Why smart investors ignore the ratings agencies

Today we discover that the outlook for the U.S. economy has suddenly deteriorated, according to the analysts at Standard & Poor's:

"Because the U.S. has, relative to its 'AAA' peers, what we consider to be very large budget deficits and rising government indebtedness and the path to addressing these is not clear to us, we have revised our outlook on the long-term rating to negative from stable," the agency said in a statement.
If large U.S. budget deficits and rising government indebtedness are news to you, then you shouldn't be making investment decisions. A smart investor doesn't need to wait for S&P to figure out that the U.S. government has a huge problem—that problem has been obvious for at least the past two years. What is amazing is that the market today had a negative reaction to the S&P announcement of the obvious. That sounds like a buying opportunity to me.

Ratings agencies rarely are the first to uncover important changes to the fundamentals behind a security or a country. More often than not, they are the last ones to figure out what is going on. Smart investors need to understand and react to changing fundamentals long before they are revealed in a rating agency press release. Ratings agencies cannot pay enough to hire staff smart enough to routinely beat the market.

The irony of today's announcement is that we are not on the cusp of some new and serious deterioration in the fiscal fundamentals of the U.S. economy. On the contrary, we are now on the cusp of what could prove to be a new and very positive trend in the fiscal fundamentals. For the first time in many years, Congress seems finally aware that it must make some serious attempt to cut spending. If the analysts at S&P were on top of their game, they would have upgraded the outlook for the U.S. today.