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Bank lending update


Commercial and Industrial Loans outstanding at all U.S. banks (a proxy for bank lending to small and medium-sized businesses) continue to rise: up at a 6.6% annualized rate year to date, and up at a 7.8% annualized rate over the past six months. This suggests a) an increased willingness on the part of banks to lend (i.e., less stringent credit standards), b) an increased willingness on the part of businesses to borrow (i.e., less deleveraging), and/or c) an increased willingness on the part of all parties to assume greater risk. Whatever the case, this is good news for the economy, since a general aversion to risk has contributed to the slow pace of this recovery.

Once burned, twice shy?



Several weeks ago I speculated that the PIIGS crisis might prove similar to Los Angeles' Carmeggedon. Carmeggedon was so named because the planned, 2-day closure of a key section of the 405 freeway was widely predicted to unleash total chaos on the streets of Los Angeles. As it turned out, nothing happened. At all.

Might the widely-anticipated, much-feared default of one or more of the PIIGS turn out to be a non-event? Since markets have had over a year to prepare for this eventuality, might it already be priced in? Might the consequences of an actual default prove far less catastrophic than is currently feared?

As the top chart shows, the market has already priced in a high probability of a substantial default or restructuring of Greek government debt. At a yield of 32.5%, Greek 2-yr bonds are trading at 66 cents on the dollar. A default of Portuguese or Irish debt is much less likely, with 2-yr Irish debt currently trading at 89 cents on the dollar. Although a potential Italian default has been making headlines of late, 2-yr Italian debt is currently priced at 96 cents on the dollar—thus making a significant Italian default (and by extension a Spanish default) not very likely.

As best I can tell, what most concerns the market is that should a PIIGS default occur, it could be contagious; for example, a Greek default might lead to an Italian default. And should both occur, then there are a dozen or so large European banks with substantial exposure to PIIGS debt on their balance sheet that could be brought down, and this in turn could bring down the entire European banking system and wreak havoc in the European economy. The second chart of swap spreads shows that Euro swap spreads have widened out significantly in recent days, reflecting precisely this concern: with 2-yr swap spreads at 90+ bps, the market is saying that systemic risk in Europe has reached significant levels. Not quite as high as last year's panic, however, but high enough to suggest that something distinctly unpleasant is likely to happen. Fortunately for us, U.S. swap spreads are still trading at perfectly normal levels, suggesting the spillover effects of any European default on the U.S. economy and financial market are likely to be quite small.

Whether the risk of a debt contagion that is sufficient to significantly and negatively impact the financial viability of the European banking system is a real and present danger—and by extension serious enough to negatively impact the global economy, or whether the rise in swap spreads is the knee-jerk response of a market still skittish and hyper-sensitive to the financial crisis of late 2008, is the issue at hand. I can't pretend to know the answer, but I am suggesting here that there is a decent chance that the financial panic we are witnessing is an overreaction, and that the reality of an eventual Greek default could be less painful and more contained than the market fears.

Weekly claims in perspective


Much has been made of the fact that weekly claims for unemployment have failed to fall below 400K for 17 or 18 weeks. From a purely historical perspective, 400K claims per week is indeed pretty high, considering the average of the past 40 years is 375K. But from a relative perspective, which acknowledges that today's workforce is much larger than it was 40 years ago, weekly claims are relatively low. The chart above shows claims as a percent of the number of people working; over the past 40 years that has averaged 0.36%, whereas today it is only 0.3%.

July jobs beat expectations, grow moderately


The July establishment survey of private sector jobs not only beat expectations (154K vs 113K), it also included upward revisions to prior months totaling about 50K. The BLS survey results now more closely align with ADP's estimates, as shown in the chart above. (A few days ago I noted that the BLS data appeared to be lagging the ADP data, and they have indeed played catch-up.)


Over the past several months, private sector jobs have been growing at an annual rate of just under 2%. That is more than enough to keep up with 1% natural growth in the working age population, but not enough to make much of a dent in the unemployment rate, especially since the public sector has been shedding jobs at an accelerating rate (about 650K public sector jobs have been lost since the recession peak in April '09). Curiously, 2% growth in private sector jobs is about the best the economy ever managed in the expansion following the 2001 recession, but it's less impressive now, since the unemployment rate was 4.5% in 2007 and 9.1% today.

So the economy is still growing at a moderate, sub-par pace, but these numbers show no sign of an imminent recession, which is what the market seems to fear. Regardless, judging from the market action so far, it would appear that the goods news in the U.S. (which is that there is no bad news) is not enough to counter the bad news in Europe (which is that things might get ugly if Italy defaults).


The ongoing—albeit disappointingly slow—improvement in the U.S. economy, coupled with impressive gains in corporate profits and a sinking stock market, have created an interesting contrast in valuations. As the chart above shows, the yield on long BAA bonds has declined to levels not seen since the mid-1960s, while the earnings yield on the S&P 500 is almost up to 8%, a level that exceeds bond yields by a margin that has rarely, if ever before, been seen. This can only mean that the market fully expects the economy and earnings to slump, if not collapse. Consequently, to be bearish on stocks today you need to be absolutely sure that a nasty recession is just around the corner.

This qualifies as a genuine panic


Here's an update to a chart I featured last June. Today's plunge in global markets qualifies as a genuine panic, according to this measure of how pessimistic the market is, and how much actual deterioration in the fundamentals there has been. The chart takes the Vix index of implied equity volatility and divides it by the yield on 10-yr Treasuries. The higher the Vix, the higher the degree of market uncertainty and fear; the lower the yield on Treasuries, the weaker the economy is perceived to be. So a higher ratio is bad, and a lower ratio is good. This is almost as bad as the first European sovereign debt scare which struck in April of last year. The Vix is currently over 28, and the 10-yr yield has dropped to 2.46%, which is only a few bps higher than the lows it hit last October when the market thought we were in a double-dip recession.


However, as this next chart shows, the Vix is still substantially below its previous peaks, so the driving factor behind the increase in the Vix/10-yr ratio is the very low level of 10-yr yields, which decline like this only when driven by fears of an imminent recession. This suggests that the market is very concerned about the onset of a global economic slump, triggered by PIIGS defaults which cause such great stress among European banks that contagion effects ripple throughout the world. Are we finally on the cusp of "the end of the world as we know it?" I doubt it. We've survived worse situations.

UPDATE: Here's the top chart with today's closing values (Vix = 32, 10-yr = 2.42%). It will be very interesting to see whether this panic can be arrested if tomorrow's jobs numbers are decent.


Good news: cheaper gasoline on the way



With almost everything collapsing today it's probably time to highlight some good news: the big drop in oil prices in recent days means we could see gasoline prices at the pump fall by about 15% in coming weeks.

The top chart compares the price of crude oil futures (white line) with gasoline futures (orange line). Gasoline futures appear to be lagging crude futures, which suggests that gasoline futures have further to fall, perhaps to $2.40/gal.

The second chart compares gasoline prices at the pump (white line, which comes courtesy of AAA) with gasoline futures prices (orange line). Based on past correlations, today's $86.6/barrel of crude oil should, if it holds, result in gasoline prices at the pump falling from $3.70/gal to $3.10.

European stocks plunge


This is a chart of the Italian stock market, and it's a good illustration of just how ugly things have gotten in Europe, and a big reason for why U.S. markets are swooning. Italian stocks are down 67% from their 2007 highs, and that is reminiscent of the plunge in Japan's Nikkei index, which is still down 75% from its 1989 high. By comparison, the S&P 500 is down only 22% from its '07 high, and the Dow is down only 12%.

Weekly unemployment claims were not disappointing



Interpreting economic data is an art, not a science, unfortunately. Some people can look at the top chart of seasonally adjusted jobless claims and see that claims remain at relatively high levels historically, they haven't fallen below 400K per week for 18 weeks, and this means the economy remains in terrible shape. Others can look at the bottom chart of non-seasonally adjusted claims and see that they remain in a downtrend, the most recent datapoint was the lowest since September, 2008, and this means that the economy continues to slowly improve. I'm in the latter camp, but given today's equity market rout, the bears appear to be in charge.

Understanding the rise of the yen


This morning in Japan, the yen flirted briefly with—yet failed to reach—a new record intraday high against the dollar (highest value to date is 76.25 on Mar. 17th of this year), thanks to forceful intervention by Japanese authorities. The yen and the Swiss franc have both been the beneficiaries of investors' concerns over the health of the U.S. economy and the prospect that the Fed, with the consent of Treasury, may seek a further depreciation of the dollar (which decline would supposedly boost the economy) by resorting to another round of quantitative easing.

The chart above seeks to put the yen's recent ascent against the dollar into the proper perspective, by comparing the yen/dollar exchange rate to a theoretical purchasing power parity exchange rate (which is calculated to equilibrate prices between the two countries). The reason that both the PPP and the actual value of the yen have been rising vis a vis the dollar is easily explained by the observation that inflation in Japan has been much lower than inflation in the U.S. In fact, Japan's CPI has not changed on net for the past 18 years, while the U.S. CPI has increased by about 56%. This rather large inflation differential would, by itself, explain the entire appreciation of the yen and then some. That's because the yen/dollar exchange rate needs to rise by the same amount as the U.S. - Japanese inflation differential in order to keep prices in the two countries from diverging. Put another way, higher U.S. inflation tends to produce an eventual weakening of the dollar vis a vis the yen, otherwise U.S. prices in dollar terms would rise relative to Japanese prices when converted to dollars.

Relative to its PPP, the yen is "overvalued" by almost 50% against the dollar. That means that the typical American tourist likely will find that prices in Japan tend to be about 50% higher than comparable prices in the U.S. The exchange rate market is willing to pay a premium for the yen in order to enjoy the virtues of its stable purchasing power and escape the ongoing decline in the value of the dollar. By comparison, I calculate that at the current exchange rate of 1.43, the euro is about 25% overvalued against the dollar, as can be appreciated in the chart below. European inflation has been only slightly less than U.S. inflation in the past 18 years, so the euro doesn't merit as much of a premium as the yen. That the euro is still trading at a premium, despite the ongoing and very real threat of a substantial restructuring of PIIGS debt, suggests that the market doesn't believe an ECU sovereign default will threaten the ongoing viability of the euro. By extension, it also suggests that the ongoing viability and purchasing power of the dollar is a risk to be reckoned with.


A weak dollar—which is undervalued on a PPP basis against almost every major currency on the planet, and whose real, inflation-adjusted value against a large basket of currencies is at or near an all-time low—has many unpleasant implications for the U.S. economy. For one, it means that foreigner's desire to invest here is weak, which is another way of saying that capital is expected to be more productive elsewhere. Two, it means that the purchasing power of all U.S. residents has been reduced significantly should a resident venture outside our borders. Third, it tends to put upward pressure on the price of all imported goods and services. Fourth, it encourages U.S. firms to raise the price of their exports, since otherwise they might be very cheap to foreign buyers. Fifth, if higher export prices hold, it then encourages firms here to raise their prices domestically. Sixth, it encourages foreigners to buy goods and services here in the U.S., particularly real estate which happens to be very cheap on its own merits. Finally, if the dollar sustains these low levels for long enough, inflation is bound to rise, thus undermining the purchasing power of all U.S. residents.

Some argue that a weaker dollar would strengthen the U.S. economy, but the arguments in favor of that proposition are notoriously weak. A weaker dollar might provide a temporary boost to export-oriented industries, but it would also tend to provide a more lasting boost to the prices of all imported goods and services, thus raising costs for everyone. Competitive devaluations in the end are a fool's game, and it can be said with some justification that no country has ever devalued its way to prosperity.

As a supply-sider, I have learned that it is very important to pay attention to market-based signals, since they can provide very good and timely information about the fundamentals of our economy and our financial markets. Currently, it's hard to find anything that is pointing in a healthy direction. And that is why I remain optimistic, because the world appears to be uniformly and profoundly pessimistic about the prospects for the U.S. economy, while I still hold out hope for improvement. For example, while the recent debt limit accord was far from perfect, it was a step in the right direction. And while the Tea Party is being painted as "terrorists," I believe they have the country's best interests at heart, and they will undoubtedly redouble their efforts to enforce some degree of fiscal sanity on Washington in next year's elections.

Thoughts on inflation and growth


This chart shows the 6-mo. annualized rate of change for the headline and core versions of the Personal Consumption Expenditures Deflator, the Fed's preferred measure of inflation. Both measures of inflation now equal or exceed the Fed's professed inflation target of 1-2% on the core measure of inflation. Note also that both measures exceeded the Fed's target most of the time from 2004 through 2008. That period, of course, was one in which the Fed pursued very accommodative monetary policy because the economy was perceived to be relatively weak and deflation was thought to be a threat.

As I mentioned last week, the GDP revisions that resulted in lower growth and higher inflation must have come as quite a surprise to the Fed, especially since the Fed holds to the theory that very weak growth (and growth well below potential) should result in lower, not higher inflation. Now, not only has inflation turned up when it should have turned down, but the Fed's understanding of what makes inflation tick has been called into question once again.

This is not to say that we have an alarming amount of inflation on our hands, because we don't, at least according to the official inflation statistics. The important thing here is that the Fed's theory of inflation (aka the Phillips Curve theory of inflation) has not done a good job of predicting or controlling inflation. Meanwhile, the classical theory of inflation—that it is fundamentally a monetary phenomenon and has nothing to do with how strong or weak the economy is or whether there is a lot of resource slack or not—has done a much better job. There has been abundant evidence for some time now that the Fed was being too accommodative by supplying more dollars to the world than the world wanted. The evidence has been in plain sight, and supplied by market-based indicators: the very weak dollar, the rising prices of gold and commodities, the very steep yield curve, and the rise in inflation expectations as embedded in TIPS prices.

The classical view of inflation says that as long as the evidence points to a surplus of dollars in the world, then inflation will tend to move higher. So once again I conclude that investors should pay more attention to the risks of higher inflation rather than to the risks of deflation. That translates into a preference for asset classes with exposure to rising prices, such as equities, real estate, and commodities. At the same time, it argues for extreme caution in regards to Treasuries, especially since they are trading at very low yields. Treasuries have done very well of late, but that is not a reason to like them, since the lower yields go the more than prices stand to fall in the future if inflation does indeed move higher.

Finally, this analysis also suggests that the Fed is going to find it very difficult to justify another round of quantitative easing. There's too much inflation and too much uncertainty right now about where it's headed (did I mentioned the huge increase in the volatility of inflation in the past decade that is evident in the chart?) for the Fed to risk another massive easing effort. The economy is not at all starved for liquidity; there is plenty of money out there.

What is lacking is the willingness of investors and corporations to risk their money in the pursuit of new and productive ventures. There's not enough confidence in the future, there's too much concern about increased regulatory and tax burdens, and there's too much concern about the future value of the dollar. When those concerns subside, new investment and stronger growth should follow.

Random charts and observations



The August ISM Service Sector indices weren't nearly as bad as the manufacturing indices. According to the Business Activity Index (top chart), conditions actually improved a bit last month. The employment index dipped, but remains at levels consistent with the sub-par growth we have seen so far in this recovery.


The ADP estimate of July private sector payroll gains fell a bit from last month's level, but as this chart suggests, it points to the likelihood that Friday's reported job gains will be a lot stronger than the previous month's, since the BLS data is probably going to "catch up" to the ADP data. Not surprisingly, according to Bloomberg, the consensus is calling for an increase of 115K private sector jobs, about double June's number. Again, slow growth, but still growth.


The Challenger survey recorded a jump in July announced corporate layoffs, but as the chart shows, such fluctuations are entirely within the range of what one might expect even when the economy is reasonably healthy.


The RadarLogic survey of home prices shows prices (measured on a per square foot basis and using a weighted average of the past three months) have increased over 4% from last February's lows. This is a typical seasonal pattern, however, so I include this chart of the past 5 years to show that the current reading (185.9) is only 5% below the same week's reading in 2009. Prices have fallen only modestly in recent years, despite a significant increase in distressed sales and foreclosures.


The impressive decline in fixed mortgage rates is a story with several themes. Very low mortgage rates suggest that the demand for mortgages is very weak, and indeed, new applications for mortgages are at levels that are significantly lower than what we saw several years ago (see chart below). However, I note that the chart also shows a modest increase new mortgage applications over the past year. Very low mortgage rates also suggest that the supply of mortgage lending funds has generally exceeded the demand for those funds in recent years. In other words, there is no shortage of money; the problem lies more with a shortage of borrowers (lots of people still trying to deleverage, strong demand for rentals, and lots of foreigners buying homes with cash) and stricter lending standards. Looking back at the chart above, I note that the spread between conforming and jumbo loans has shrunk from a high of just over 200 bps in March 2008, to only 40 bps currently. This is a direct reflection of the improved liquidity conditions in the mortgage market and the return of market efficiency. Prior to 2007, the spread averaged just over 20 bps, so conditions have almost returned to "normal."

In short, there has been an awful lot of adjustment going on in recent years, thanks to market pricing (i.e., the price of homes and the price of money) which has enabled this very distressed market to clear without significant disruptions in recent years. Things are getting better on a daily basis, in fact, as excess housing inventories are worked off.

Record lows in TIPS yields reflect deep pessimism


Real yields on TIPS of all maturities today reached a new record low. The main cause of lower real yields is falling nominal yields, since the difference between the two (aka expected inflation) has been largely unchanged. Long-term inflation expectations remain "anchored" around 2.5%, although shorter term inflation expectations embedded in TIPS and Treasury pricing point to inflation of around 3%. The main cause of lower nominal yields, in contrast, is the market's concern that the economy is very weak and liable to slip into a double-dip recession, as reflected in the chart below.


Undoubtedly the market remains concerned that the ratings agencies may downgrade Treasury debt in spite of today's accord to raise the debt ceiling. It is more likely, however, that the market is being driven by its Keynesian instincts which say that the big cuts in spending in today's bill will weaken the economy at a time when it is already weak.

I think these concerns are overblown. To begin with, as I outlined in a post last week, there will be no spending cuts at all. The "cuts" contained in the debt accord add up to a very modest reduction in the future growth rate of government spending. If the huge pickup in government spending failed to "stimulate" the economy, then a modest reduction in the growth of spending going forward is very unlikely to kill the economy. By gradually reducing the share of the economy that is managed by the federal government over time, today's bill should result, eventually, in a modest increase in the economy's growth because the private sector will increase its control over the economy's scarce resources and that, in turn, will result in greater efficiency, productivity, and growth.

The other side to the record-low real yield story is that the market remains concerned about inflation. Inflation expectations have not declined materially even as the economy has slowed substantially this year. The record highs that gold continues to post ($1658/oz. as I write this), coupled with a dollar that is very close to its record lows, confirm that inflation fears are alive and well. Rising gold prices also reflect, I think, a market that looks at all the sound and fury that was expended on the debt negotiations, and the paltry sums that were promised to be shaved from future spending hikes, and concludes that Washington is still miles away from where it needs to be to restore fiscal sanity.

In short, the big decline in yields this past week is the sound of deflating confidence in the future, a sentiment expressed in light-hearted fashion in the cartoon below.

Manufacturing weakens, but it's not a death knell


The July ISM Manufacturing Index was disappointingly weak, and so was last week's GDP report. But as this chart suggests, the current reading on the ISM index does not imply a recession nor does it imply that growth in the current quarter will be weaker than it was in the second quarter. The correlation between the ISM manufacturing index is reasonably strong, but far from perfect. In any event, the level of the July ISM index is consistent with third quarter GDP in the 2-3% range; as the chart suggests, it would take a much weaker ISM index (e.g., below 47) to point to a double-dip recession.

Nevertheless, the bond market continues to behave as if we are on the verge of a recession, with 10-yr yields today falling to 2.74%, and closing in on the lows that we saw last October when the market thought a double-dip recession was in the bag (but which subsequently failed to show up). I might be more worried about the weakness in the ISM index if there were other fundamental indicators pointing towards recession, but there are none that I consider important to be found. Consider this quick recap of important and leading fundamental indicators:


This chart focuses on the monetary and bond market precursors of recessions. Every recession in the past 50 years has been preceded by a significant rise in the real Federal funds rate (blue line), and a flat or inverted yield curve (red line). Currently we have just the opposite: negative real yields and an unusually steep yield curve. This points to an extremely low probability of recession, and a high probability of continued growth. Negative real yields mean very low borrowing costs for many businesses, and a steep yield curve means very juicy profits for banks, since they can borrow at very low rates and lend out at much higher rates. A steep yield curve also means that the bond market sees stronger growth in the future.


Swap spreads are excellent indicators of systemic risk and have predicted the last three recessions. Currently, swap spreads are very low, a good sign that the banking system is sound and the market's risk tolerance is healthy. If the market sensed the approach of a recession, spreads would be much higher as investors attempted to lay off risk in general and avoid counterparty risk in particular.




Credit spreads are also good predictors of recessions. Although the first chart above shows that average credit spreads currently are at levels that preceded the past two recessions, they are far below their highs of 2008 and 2009, and show no material increase in recent months. The main reason that these spreads are so high is that Treasury yields are extremely low—spreads aren't predicting a future increase in corporate default rates, they are one way the market can express a view that extremely low Treasury yields are likely to be somewhat temporary. As the second chart above shows, spreads on long-dated corporate bonds (which are less affected by the extremely low level of short- and medium-term Treasury yields) are relatively low and show no unusual behavior. The third chart above, which compares the yields on A1 industrials with the yield on 5-yr Treasuries, confirms that the somewhat-elevated level of corporate spreads in no way reflects a material increase in corporate borrowing costs or a scarcity of money; indeed, many large corporations today can borrow at the lowest rates in many generations.



Commodity prices show no sign whatsoever of any material weakness in economic activity. Indeed, prices remain very close to all-time highs, suggesting that at the very least global demand and manufacturing activity remain robust. Strong commodity prices also signal that monetary policy is very accommodative, and thus poses no threat per se to the economy.


Commercial & Industrial Loans—a good proxy for bank lending to small and medium-sized businesses—have been growing for over seven months. This suggests that banks are slowly relaxing their lending standards, and businesses are finally reversing their deleveraging efforts. Both are consistent with an increased tolerance for risk and are thus a predictor of growth in investment and rising economic activity.


Bloomberg's index of financial conditions has declined a bit over the past month, but it is not low enough to signal any material deterioration in key financial market indicators or the onset of a recession.


New orders for capital goods are a good proxy for business investment, and they continue to rise. Business investment is an essential ingredient for healthy economic growth.


Despite all the economic weakness we've seen in the first half of this year, and despite the fact that tax rates haven't risen (payroll taxes have actually been cut this year) federal revenues have risen by almost 9%. This is fairly impressive, and suggests that this year's economic weakness likely has been caused by temporary and emotional factors (e.g., the Japanese tsunami which disrupted the manufacturing supply chain, unusually bad weather, and concerns that the U.S. government might default or Treasury debt downgraded), rather than any meaningful deterioration in the economic fundamentals.


Despite the weak economy, corporate profits are at record highs. We've never seen a recession come on the heels of a surge in profits.

All of this adds up to a picture of an economy that is weak in general, but with pockets of still-impressive strength; not an economy that is headed for a recession or even further weakness. Important measures of economic and financial fundamentals are still in good shape, and many point to improving activity in the months ahead.