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Money supply growth alert (cont.)



Over the most recent two-week period, the M2 measure of money supply has surged by $165 billion. Such rapid and sizable growth is highly unusual, and has happened in the past only during periods of panic-driven demand for cash liquidity (e.g., following 9/11 and in the wake of the financial market panic of late 2008). As I noted in my first post on this subject, normal M2 growth would be about $10 billion per week. From the Fed's data, we see that about $100 billion of this growth has come from increased savings deposits at commercial banks, $55 billion has come from increased demand deposits, and all the growth has occurred in the non-M1 portion of M2. What's going on? It's tempting to think that this is somehow a reflection of the end of QE2 and the beginning of Treasury's need to juggle funds since the debt limit is approaching, but I honestly don't know. Stay tuned.

UPDATE: (Aug. 4th) It now appears that this surge in M2 was the product of panic-driven demand for safe-haven cash as Europeans attempted to escape the potential contagion of PIIGS defaults.

PIIGS update




The message of these three charts is that a PIIGS default/restructuring is highly likely to occur, but that it does not pose a serious threat to Eurozone banks or the Eurozone economy.

The first chart shows the yield on 2-yr sovereign debt for each of the PIIGS countries. The extremely high level of yields on Greek, Irish, and Portuguese bonds is the market's way of saying that a significant default is highly likely to occur. The second chart shows Eurozone swap spreads and U.S. swap spreads. With swap spreads being a good proxy for systemic risk and the default risk of large banks, we can infer that the market assigns a very low level of risk to the U.S. economy and banking system, and a moderate level of risk to the Eurozone economy and banking system. Note that the probability of default in PIIGS countries has never been higher than it is today, but Euro swap spreads are still lower than they were in April 2010, when the Greek debt problem first surprised the world. The third chart is Europe's equivalent of our Dow and S&P 500: the Euro Stoxx 50 Index. What it says is that the Eurozone economy has been in muddle-through mode ever since the Greek debt crisis broke. Muddle-through, but not collapse by any means.

Today we received the news that a stress test of European banks found that only 8 would likely fail to survive a worst-case scenario—a significant economic slowdown. Furthermore, these banks had a combined capital shortfall of only $3.5 billion, which is a relative drop in the global capital market bucket. Whether or not you believe this was a serious or rigorous test, it does jibe with the level of swap spreads. Both are saying that yes, there are problems, but these problems are not likely to bring about widespread contagion or financial market collapse. Since the sovereign debt problem has been around for well over a year, it is undoubtedly the case that banks collectively have taken steps to shore up their capital and to reduce their exposure to the sovereigns most likely to default. It is therefore not unreasonable to assume that the market has enforced enough discipline on the system, and enough repricing and restructuring, to render a catastrophe highly unlikely.

As I note before in a post about the consequences of debt defaults, much of the bad news has already been priced in, and it is evident in the fact that the Eurozone economy has been growing at a disappointingly slow pace, similar to what the U.S., with its extraordinary deficits, is experiencing. Defaults are symptomatic of debt that has been used to finance wasteful or inefficient spending, and in this case of economies that have used scarce resources ineffectively. Massive, debt-financed government spending cannot stimulate an economy, but it can stifle the ability of the private sector to generate meaningful growth.

Bond market on the horns of a dilemma


Inflation and expected inflation are arguably the major determinants of interest rates. If the bond market appears to react to signs of growth, as it often does, then that is because the bond market—and the Fed—continue to think that growth and inflation are linked: i.e., more growth increases inflation risk, while less growth reduces it. We are now living in interesting times, however, because growth has been unusually weak and the so-called "output gap" (the amount of excess capacity, or the amount by which the economy is operating below its potential) has been huge—currently about 10% according to my calculations. Yet inflation by all measures has been rising. The bond market wants to rally, given how weak the economy is, but it is bumping up against the reality of higher inflation, as the chart above suggests.


Core inflation over the past six months is running at a 2.5% annualized rate. That doesn't sound like much, but as the top chart suggests, when core CPI is 2.5%, 10-yr Treasury yields tend to be in the neighborhood of 4.5%, and a 2% spread between inflation and bond yields is close to the long-term average. If long-term trends reassert themselves, Treasury yields could rise significantly. So the bond market is essentially caught on the horns of a dilemma: the lure of weak growth (perhaps made weaker by sovereign defaults) vs. the reality of rising inflation. We haven't seen a test of the Phillips Curve theory of inflation like this for a long time. The last time I remember such a test was in the late 1990s, when the economy was booming, and the Fed was fearful that the economy was "overheating" and inflation would rise. By the time the dust had settled, around 2002-2003, we realized that inflation had almost fallen enough to produce deflation. I think that when the dust finally settles on the current environment, we will see inflation rising some more, and Treasury yields rising by a lot more. 


In the meantime, there are two clear facts about inflation: 1) it has been extraordinarily volatile over the past 10 years, and 2) by all measures inflation has moved higher in the past year. At the very least, the volatility of inflation is a problem since it leaves the world uncertain as to what is really going on. The fact that inflation has risen, despite the very sluggish recovery and the existence of tons of excess capacity, is also problematic, because it directly challenges the theory that says inflation should be very low because the economy is so weak. Both of these realities weigh heavily on Treasury note and bond prices.

Inflation still alive and well at the producer level


June Producer Price Inflation came in a bit stronger than expected, despite the biggest decline in energy prices in two years. Although the headline PPI fell by 0.4% during the month, the more important number is the core PPI, which rose by 0.3%, vs. an expected rise of 0.2%. On a six-month annualized basis, the headline number is now 8.1%, and the core number is 3.7%. The core PPI hasn't risen this fast since April 1991.

That core prices are rising is a reflection of the strong gains in commodity prices that are making their way through the production pipeline. It is also a reflection of the fact that monetary policy is quite accommodative, since it is not trying to fight higher energy prices. If policy were tight, then higher energy prices would have forced declines in non-energy prices, but that is not happening. Since producer prices are more sensitive to commodities than the CPI, the PPI is thus like the canary in the coal mine, predicting higher inflation on the way in the CPI.

It's also important to note that rising inflation is showing up at the producer level, despite the substantial amount of economic "slack" that presumably exists in the U.S. economy. This casts doubt on the widely-held belief, which the Fed shares, that today's large output gap will be an important restraining force on inflation.

Much ado about nothing (cont.)

Today, seasonally adjusted claims for unemployment fell "unexpectedly," and the market is responding positively, just as I have been predicting for weeks. But in fact, all that has happened is that not as many people are getting laid off in the auto industry in July as the seasonal factors expected. That's because they were laid off last April instead.



The first chart above shows the seasonally adjusted level of claims, which have declined in July. The second chart shows the actual level of claims, which for the first time this year has risen meaningfully. Seasonal factors expected claims to rise even more, much as they did at this time last year, so they subtract from the actual number.

Whatever you might think is actually happening to the real economy, what this shows is that seasonal adjustment factors can actually be wrong, in the sense that the economy doesn't always behave as expected. Sometimes you have to be skeptical of jobs numbers (in particular the June employment numbers released last week). The market and the headlines are somewhat excited about today's claims number, but I'm not. I think it's just payback for the "unexpected" increase in claims last April, when auto layoffs happened earlier than expected. The reality is that the economy remains in a slow-growth recovery, and any pickup that is suggested by the claims numbers is illusory.

Federal budget update




Here's an update of the federal budget situation. It's still in awful shape, but on the margin things have improved a bit. Spending growth has slowed, revenues continue to grow faster than spending, and the deficit has consequently shrunk a bit.

With all the talk in Washington about the need for higher taxes, I note that federal revenues have grown about 9% in the past year. That's what usually happens during a recovery, as more people return to work, incomes rise, corporate profits grow, and capital gains get realized. It doesn't take higher tax rates to get more revenue, it just takes a bigger and stronger economy. Considering that the economy has been recovering a pace that is definitely subpar, 9% revenue growth is actually pretty impressive. If we could get the economy to grow at 5% or better, we would probably see a huge pickup in tax revenues.

The biggest problem, therefore, is spending. Spending is very elevated by any measure, and it will only balloon further if current law and programs are unchanged (social security and Obamacare promise to be real budget-busters). As I've argued repeatedly, excessive government spending is likely one of the chief causes of a disappointingly slow recovery. Cutting back spending should be the top priority, and from what I see of the goings-on in Washington and the opinion polls, most people understand this. Higher tax rates are not only unnecessary, they could easily jeopardize the recovery by reducing the after-tax incentives to work and invest.

Gold and commodity prices thrive on PIIGS and growth


Today gold hit a new all-time high against the dollar and yesterday it made a new high against the euro. What's driving gold higher? Gold continues to be a haven for those who worry about the health of the world's financial markets (e.g., the eurozone sovereign debt crisis), and it continues to benefit from the ultra-low interest rates and accommodative monetary policies of most of the world's central banks (with the Bank of Japan being the notable exception). Gold is a safe-haven play, and it is an inflation play. That's the way it's always been with gold.


As this next chart shows, gold has a tendency to lead commodity prices, so the continued strength in gold prices suggests we will see a renewed rise in commodity prices, after their recent selloff. In fact, as the chart below of a popular index of commodity futures prices shows, many commodities have already recovered much of their recent decline. It's the non-speculative type of commodity (many of which are in the CRB Spot index charted above) that have yet to recover, but at this point it's likely they will. 


The action combined action in gold and commodity futures is a good indication that although investors are concerned about the risk of a PIIGS default, the global economy is not being impacted much, if at all, by the recent soft patch in the U.S. and the market's jitters. As the chart below shows, China's economy has grown by a massive 9.5% in the past year, and India's economy has been growing by 7-8% of late. Global trade is growing at strong double-digit rates, and commodity prices are trading very near all-time highs in almost all currencies.


Despite all the concerns out there, Euro swap spreads are still substantially below crisis levels, and U.S. swap spreads are perfectly normal. At the very least we can say that there does not appear to be any shortage of global demand, and no shortage of money. If there were, commodities would be a whole lot weaker, swap spreads and implied volatility would be on the moon, and equities markets would be collapsing.


To put the looming PIIGS debt default crisis in perspective, consider that the market value of global equity markets is north of $50 trillion, and the liquid global bond market (investment grade and high yield) totals over $60 trillion, according to the Lehman/Merrill Lynch bond data. Given that as a backdrop, it's hard to get overly concerned about the increasing likelihood that a few hundred (or even several hundred) billion worth of PIIGS debt—less than 1% of the value of outstanding global bonds—is likely to be written off. Especially since this problem has not exactly snuck up on unsuspecting market. The PIIGS crisis first surfaced over a year ago, so markets have had plenty of time to adjust prices and investors have had plenty of opportunities to reduce unwanted exposure.

More news which confirms the soft patch


The trade deficit expanded by more than expected in May, thanks mainly to higher petroleum prices, but as Brian Wesbury notes, oil prices fell in June so this should wash out and probably have little impact on second quarter GDP. But the contribution of trade to GDP is not as important as the ongoing, strong gains in exports, which have been growing at a 15-20% annual rate for the past two years and have surpassed their pre-recession high. This is very impressive, and good evidence that the U.S. economy is still among the world's most dynamic—strong export growth is helping to offset the weakness in finance and construction. It also reinforces the fact that global economic activity remains strong.


The UCLA/Ceridian Pulse of Commerce Index has been making slow upward progress for the past six months or so, providing more confirmation that indeed the economy has been in a "soft patch."

Debt musings and misconceptions

The world is obsessed with the problem of too much debt and the threat it poses to the civilized world. Greece is very likely to default on its debt, and so are Ireland and Portugal. Meanwhile, the U.S. wrestles with its own burden of debt. Total outstanding debt owed by the U.S. government to the public now stands at $9.75 trillion, or about 64% of GDP. That’s the highest level of federal debt relative to the economy since the early 1950s, when the U.S. government was working off its huge debt (well over 100% of GDP) incurred while fighting WW II. If the federal deficit continues at the current level of 9-10% of GDP, total debt will exceed 70% of GDP one year from now, and eventually it could exceed GDP.

Does all this debt and its attendant problems mean the economic outlook is inescapably bleak? Will PIIGS defaults result in a collapse of the Eurozone banking system? Will debt default contagion bring about another global recession? Will debt defaults intensify lingering deflationary pressures? The short answer is that most of the bad effects of too much debt have already happened.

Debt has certainly become problematic, but the threat it poses to the world is likely being exaggerated. That’s because there are a number of popular misconceptions about debt, and because many ignore that the market has already factored in the likely consequences of defaults.

Debt is a zero-sum game, since one man’s debt is another man’s asset. Debt is an agreement between two parties to exchange cash now with a reversal of that exchange, plus interest, in the future. If the borrower fails to repay his debt (i.e., he defaults), then the borrower benefits by being relieved of some or all of his debt service obligations, and the lender suffers by not receiving some or all of his expected cash flows. Part of the interest the lender charges the borrower goes to offset the risk of default.

Debt payments by a borrower are not equivalent to flushing money down the toilet. The money borrower B pays to lender A is money that A will spend on something else. The amount of money available to the economy doesn’t change when debt is serviced or paid off. Demand doesn’t change, money simply changes hands. Similarly, the issuance of new debt does not create new demand. When A loans money to B, A must spend less in order for B to spend more.

Credit expansion is not the same as money creation. Central banks, not credit markets, control the amount of money in an economy. They typically do this by targeting the price of money (e.g., short-term interest rates), and that in turn increases or decreases banks’ ability to lend, and increased bank lending is what leads to new money creation. Credit expansion does not create any new money because the issuance of new debt only causes existing money to change hands.

Credit outstanding can grow faster than the amount of money in an economy without there being any inflationary consequences, because credit does not create new money or new demand; it simply redistributes existing money. Similarly, credit contraction can occur without there being any decline in overall output or any deflation, provided the central bank is properly overseeing the amount of money in the economy. Credit contraction, aka deleveraging, is a sign of increased money demand, which should be offset by an increased supply of money. The Federal Reserve has been doing exactly this with its quantitative easing program: responding to the private sector’s desire to reduce its debt burdens. That's why quantitative easing to date has not been inflationary.

Borrowing with new debt can be a good thing for both parties to the transaction, provided borrower B spends the money that lender A saved on something productive. Investing in productive assets or activities generates the cash flow that is needed to pay the interest on the debt. Debt can be a drag on growth, however, if B spends the money on something unproductive. For example, Greece has borrowed hundreds of billions over the years, in part to fund generous retirements for people who retired at a relatively young age. Greece now finds that its economy hasn't grown enough to generate the cash flows it needs to repay its debt. The damage has been done, and no amount of EU assistance to Greece can alter the fact that Greece in effect “wasted” the money and has nothing to show for it. Borrowing money only to spend it on unproductive things is already reflected in the slow growth of the Greek economy; Greece has been squandering its scarce resources. Markets now understand that a default is highly likely and have already priced in a significant Greek default.

A nation that defaults on its debt does not necessarily need to suffer a decline in its GDP or national income. GDP is determined primarily by the number of people working and the productivity of their labors. Debt defaults and/or restructurings can lead to positive outcomes if steps are taken to increase productivity. Relieved of some of the burden of its debt, but much less likely to qualify for new loans, Greece could move forward by cutting spending, trimming retirement benefits, and encouraging new investment and business formation. Many unproductive retirees may need to go back to work, and they might be encouraged to do so if enough new and attractive jobs are created.

If Greece's creditor banks fail to receive their expected cash flows, many may go out of business. But that won't change the cash flows and the incomes that are being generated by all the people working in the world. The PIIGS may end up defaulting on hundreds of billions of debt, but that won’t necessarily cause Eurozone GDP to decline; it’s already depressed because the money that was borrowed was spent unproductively. If anything, the painful restructuring that would inevitably follow in the wake of a default would likely result in higher living standards in the future. The world has survived large sovereign debt defaults many times in the past without disastrous economic consequences. Argentina's 2001 default on $132 billion comes to mind.

The disruption and fear that may be generated by bank failures could, however, disrupt growth insofar as investors become reluctant to accept risk and prefer instead to buy risk-free securities from governments like ours that have dubious uses for the money. Come to think of it, that has been happening a lot in recent years—Treasury has been borrowing trillions at extremely low interest rates from lenders seeking to minimize their risk, and spending the money in ways that are much less productive than if the money had been put to use by the private sector. The damage has been done, and it is reflected in disappointingly slow growth and relatively low valuation multiples.

In short, much of the disruption that can be expected from debt problems has already happened. Instead of fretting about defaults, the world should turn its attention to the aftermath of default, the new policies and adjustments that will be required, and the brighter prospects that these will entail for the future.

ECB debt contagion fears continue to rise


This chart helps to put the European debt crisis—which is focused on the debt of Portugal, Ireland, Italy, Greece and Spain—into perspective, since the yield on 2-yr government bonds is a good proxy for the market's guess as to the likelihood and magnitude of default. The real risk of default is concentrated in Greece, Portugal, and Ireland.

An investor today can choose between buying Greek bonds that are highly likely to default in some fashion, or he can buy rock-solid German bonds. An efficient market would leave the investor indifferent to the choice. Assuming that Greek bonds will lose 40% of their value in a restructuring tomorrow, then buying them today at a yield of 31% would produce a total return comparable to what could be had by buying a 2-yr German bond today. Here's the math: 0.6 * (1.31)^2 = 1.03, which is slightly more than the 2.53% total expected return on German 20-yr bonds. So one could argue that Greek bonds are priced to an almost certain and immediate default (or "haircut") of 40%. The same math suggests that Portuguese and Irish bonds, with yields of around 17%, are priced to an almost certain and immediate default of about 25%. (There are other ways of calculating the likelihood of default, but this is the simplest.)

Although the rise in yields on 2-yr Spanish and Italian debt is making headlines today, they are still far from likely to default, since their yields are only a few percentage points higher than comparable German yields. If there is a risk of "contagion" from a Greek default, the market is saying that it will most likely be limited to Portugal and Ireland.

I would emphasize that a significant default or restructuring of the bonds of Greece, Portugal and Ireland has in effect already been priced in by the market. Greek 2-yr bonds are currently trading at about 66 cents on the dollar, and Irish 2-yr bonds are trading at about 82 cents on the dollar. The market has known for months that big losses are inevitable, and losses have been taken by the holders of those bonds. The only unknown at this point is the exact amount of the eventual losses. If they are more than 40% in the case of Greek bonds, then there is more pain to come; if they are less than 40%, then that will be good news.


As the above chart of 2-yr swap spreads suggests, the level of systemic risk (using 2-yr swap spreads as a proxy for systemic risk) is still quite low in the U.S., and in Europe it is no more elevated today than it was when the ECB sovereign debt crisis first erupted in May of last year. And as the top chart reminds us, the likelihood of default was much lower last year than it is now. This looks consistent with the following conclusion: a significant default or restructuring of the debt of Greece, Portugal and Ireland is highly likely, but the risk of further contagion is likely to be low. Moreover, the risk that European sovereign debt defaults will prove destabilizing to the Eurozone economy is only moderate, while the risk that all this will have a significant or deleterious impact on the U.S. is very low. I suspect the headlines and the pundits may be exaggerating the dimensions of the problem.