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Bank lending continues to increase


I keep updating this chart because it represents good news that is not getting enough attention, especially these days with the banking panic in Europe and the mad scramble for safety that has pushed 3-mo. T-bill yields to zero. The story here is that for almost one year now, banks have been increasing their lending to small and medium-sized businesses; over the past six months, C&I Loans have increased at a 9.1% annualized rate. That's fairly impressive, and it directly contradicts the notion that the economy is being depressed because everyone is still trying to deleverage. It's not that more loans are good per se, it's that more loans are prima facie evidence that risk-aversion is on the decline. After all, it takes someone willing to accept risk before you can have productive investments that grow the economy. Companies are more willing, on net, to leverage up, and banks are more willing, on net, to lend more. It further suggests that the stress that is punishing the Eurozone banking system is not spreading to the US. There is hope for the future.

PIIGS update; the problem of public sector obesity


Judging from the rising yields on 2-yr Greek debt, Greece is very likely to default, and the likelihood of a significant default has only been rising in recent weeks. The prospect of a Greek default (which at this point would likely be equivalent to a "haircut" of 20-30% on its outstanding $500 billion of debt) has resulted in considerable angst in the financial markets, primarily because of the fear that if one of the PIIGS defaults, then others might too, and at some point (especially if Italy, with over $2 trillion of debt, were to default) the losses might overwhelm the eurozone banks, which own an awful lot of the stuff.


The above chart shows the Euro Stoxx Banks index, which rather dramatically illustrates these fears: the market value of Eurozone banks has fallen 78% from the 2007 highs; current values are down 45% from their 2011 highs; and current values are only 26% above their March 2009 lows. According to Zero Hedge, the decline in the market cap of the Euro banks from their 2007 highs now exceeds $1 trillion. Bad debts, in other words, have already wiped out one trillion dollars worth of Eurozone bank capital, and there's only $440 billion left.


The escalating losses being inflicted on Eurozone banks have likely sent over a half trillion dollars fleeing to the US banking system, as I discussed in a recent post. Such is the demand for US safe havens that the yield on 3-mo. T-bills has been approaching zero for the past two months (see chart above).

There is still reason to avoid outright panic, fortunately. As the top chart also shows, yields on non-Greek PIIGs debt have declined meaningfully in recent weeks. Whether this is due to ECB purchases of PIIGS debt, or to the conservative shift in the political winds in Europe is hard to say. But it becomes clearer every day that the underlying source of most of the world's problems these days is an obese public sector: too big, too inefficient, too intrusive, too burdensome, too regulating, too indebted, and too unionized. If the disease can be properly diagnosed, then there is reason to hope for a cure. But please, hold off on the tax hikes. We need to starve the beast, not feed it more.

Record-low mortgage rates


30-yr fixed mortgage rates have never been lower than they are today, thanks to record-low yields on Treasuries, a weak housing market, and plenty of loanable funds sloshing around the world's capital markets. For all those who can qualify for a refi, this is one more opportunity of a lifetime.


Refinancing activity understandably has surged in recent weeks and is likely to continue, though it seems unlikely we'll exceed the high that occurred in late May 2003 (see above chart of the Mortgage Bankers' Association Refi Index, whose latest value is 3915). That high occurred thanks to a plunge in 10-yr Treasury yields to almost 3%, which in turn was driven by the market's belief that the economy was mired in a jobless recovery. As history buffs will recall, the Bush II tax cuts were passed in June '03, and the economy subsequently staged a surprising recovery which vaulted 10-yr yields back up to 4.6% by the end of the summer. It would be wonderful to see history repeat itself.

UPDATE: Mark Perry has a collection of other interesting mortgage-related statistics here.

It's Europe, stupid (cont.)


This chart goes a long way to explaining the source of stock market angst in the past several months. The red line is the total return on the S&P 500 index, the green line the total return on the Euro Stoxx index, and the white line the total return on Bloomberg's Euro Banks and Financial Services index. Bottom line, Eurozone banks are getting crushed by fears that their holdings of PIIGS debt will wipe them out should a Greek restructuring prove contagious, and those fears are spreading to all markets around the world. By comparison, the U.S. is holding up far better than most.


Swap spreads confirm that there has been no material deterioration in the health of the U.S. banking system or financial markets, with spreads still at levels that reflect no unusual degree of systemic or counterparty risk. The problems are concentrated in Europe, where counterparty and systemic risk remain quite elevated.

So there are two key and related questions: Will a Greek default/restructuring bring down the Eurozone banking system? Will a collapse of the Eurozone banking system, bring down the U.S. and/or the global economy? Nobody has an answer to those questions, but to judge from market behavior, investors are becoming extremely concerned that a worst case scenario is in the offing.

Thoughts on next year's election

From a truly insightful essay, "The United States of Entitlements" by Bruce Thornton (HT: Glenn Reynolds):

... the 2012 elections will be a referendum on democracy itself, a contest between Plato and Protagoras. It will show whether a critical mass of American voters are able to see beyond their own private interests and make decisions that, while causing themselves some pain, are nonetheless necessary for the long-term fiscal health of the country—or whether, consistent with the ancient critics of democracy and the fears of the founders, they will choose instead a government that uses its power to benefit those who are, as Polybius put it, "habituated to feed at the expense of others, and to have [their] hopes of a livelihood in the property of its neighbors."

There can be no two opponents more suited to engage in this upcoming battle over the future of our country than Barack Obama, the most fervent advocate for a bigger, more redistributive government, and Paul Ryan, the most articulate spokesman for limited government, individual freedom, and the need for entitlement reform. Here's hoping that Paul decides to run for President.

Fear has been trampled by panic


As this chart of 10-yr Treasury yields and the year over year change in Core CPI suggests, the Treasury market is zigging when it should be zagging. Yields have plunged on fears of a double-dip recession, which in turn are being driven by fears of a financial market meltdown in Europe. The fears embodied in today's 2.0% 10-yr Treasury yields eclipse even those that prevailed at the end of 2008 when markets were convinced that The End of the World As We Know It was just around the corner.


While there are certainly many things to worry about, one of which is the half-trillion dollar run on European banks that I discussed a few days ago, I think that fear has been trampled by panic these past few weeks. There has been no deterioration in the fundamentals of the U.S. economy. Things are far from perfect, to be sure, since we are suffering from monetary policy which is too easy and fiscal policy which is smothering the private sector, the combination of which has resuscitated a moderate form of the 1970s stagflation. But even then it was not the end of the world, as the economy managed to grow 3.3% per year on average during that otherwise-awful decade.

Consumer price inflation continues to rise


The July CPI rose by more than twice as much as had been expected (0.5% vs. 0.2%), while the core CPI rose by 0.2% as expected. The trend in inflation by just about any measure is up. Over the past six months, the CPI is up at a 4.0% annualized rate, and the core CPI is up at a 2.6% annualized rate.

That both measures are rising is a testament to the fact that monetary policy is accommodative. It is also a testament to how wrong the conventional thinking is about what causes inflation. Inflation was not supposed to be nearly as strong as it has turned out to be, since the economy is operating at least 10% below its trend capacity, and according to Phillips Curve doctrine, an economy with so much "slack" or idle resources should be dangerously close to, if not already mired in, deflationary quicksand.

Instead of deflation, we are experiencing what so far could be called a mild-to-moderate case of stagflation: a weakly growing economy with rising inflation. This is the same sort of condition that characterized much of the 1970s. Both eras have some common monetary denominators as well: accommodative monetary policy, a weak dollar, low to negative real interest rates, and strong gold and commodity prices. Once again we are seeing proof that easy money doesn't stimulate growth, it just stimulates inflation.


Note in the above chart that when real yields were below their long-term average (e.g., from 1965 through 1980) inflation was generally rising. When real yields were above average (from 1980 through 2000), inflation was generally low and falling. As I explained in detail yesterday, low real yields are symptomatic of easy money, and they are part of the rising inflation process.

Please, Mr. Bernanke, take away that punchbowl! We don't need any more spiked Kool Aid.

Jobless claims continue to decline


On a seasonally adjusted basis, jobless claims were somewhat higher than expected (408K vs. 400K). But the actual data (see chart above) showed a decline of 12K. Relative to the same month last year, actual claims are down 15%. What to make of all this? Sometimes, especially with the claims data, seasonal adjustment factors can be off (i.e., the real world doesn't always behave the way the seasonal adjustments predict). If you compare things year to year, you see a clear decline. Conclusion: the job market is continuing to improve, in the sense that fewer people are getting fired.

Morgan Stanley had a report out yesterday titled "Dangerously Close to Recession." (The report was a bit sensational, since it also contained the words "recession is not our base case.") Europe has some legitimate concerns, but I don't see anything here in the U.S. that would suggest we are even close to a recession, and this chart would be Exhibit #1.

UPDATE: The chart below of the July Leading Indicators released today would be Exhibit #2. No sign at all of an impending recession.


Inflation is rising and real rates are falling


July producer prices rose more than expected, both at the core (0.4% vs. 0.2%) and total (0.2% vs. 0.1%) level. Producer price inflation has now been trending irregularly higher for almost 10 years, after trending irregularly lower throughout the 1990s. Over the past six months, the core PPI has increased at a 3.6% annualized rate, a level that was exceeded only once (in early 2008) in the past 20 years. Inflation is definitely alive and well.



These next two charts focus on the behavior of inflation and interest rates. Over long periods, inflation is the main determinant of interest rates, but over shorter intervals of as much as several years, interest rates and inflation can diverge, with interest rates tending to lag changes in inflation. Monetary policy is typically an important contributor to this divergence.

For example, currently the Fed is bent on keeping interest rates as low as possible, presumably in order to help stimulate the economy and to avoid the risk of deflation. The Fed's accommodative monetary policy stance can "fool" the bond market for awhile, especially since both the Fed and the bond market believe that inflation fundamentals have a lot to do with the strength or weakness of the economy. The economy is perceived to be so weak today that both the Fed and the bond market believe that even though inflation is rising, there is little risk that it will continue to do so.

But the divergence between interest rates and inflation can also serve to amplify the effects of monetary policy. When interest rates are substantially lower than inflation, as they are today (see third chart above), then investors, speculators, and corporations discover that it can be very profitable to borrow cheap money and buy "things" that are rising in price. Negative real interest rates thus encourage people to borrow more and more and speculate on rising prices, and the Fed is more than happy to accommodate this rise in the demand for borrowed money.

Just the opposite happened throughout most of the 1980s and 1990s. The Fed wanted inflation to fall, so it tightened monetary conditions by keeping interest rates high. Borrowing costs were much higher than the rate of return on the prices of "things," and over time this punished borrowers and eventually caused the demand for borrowed money to decline. Money gained new respect, and the demand for money increased. The dollar strengthened and commodity prices fell, and inflation proved to be low and relatively stable.

The confluence of forces today is much more reminiscent of the inflationary 1970s than of the low-inflation 80s and 90s. And it's quite simple in fact to determine whether inflation is likely to rise or to fall. All you need to know is whether the Fed wants to be accommodative or easy, and whether the Fed's professed policy stance is confirmed by real interest rates. Today there is almost no doubt that the Fed wants to be accommodative, and real interest rates confirm that, since they are substantially negative. Thus we can predict that inflation is likely to continue to trend higher in the next several years.

Borrowing money at today's exceptionally low interest is consequently likely to prove profitable. And as more and more people discover this, and the demand for money declines (increased demand for borrowing money is equivalent to a reduced demand to own money), then the dollar will tend to lose value and the prices of "things" will tend to rise. The gold market is well aware of that, and has likely priced in a lot of this already.

This is all very unfortunate, of course, since what is being fueled by all this is not a stronger or healthier economy, but a more speculative economy with higher inflation. A speculative economy is not a healthy economy, since speculation does not tend to produce productive things. Indeed, speculation leads to bubbles and the misallocation of resources, and over time this can be very inefficient and squander scarce resources. Thus it is that, instead of being "stimulative," the Fed's current monetary policy stance is acting to slow the economy's growth.

Meanwhile, the Bernanke Fed has put its reputation on the line by promising to keep short-term interest rates exceptionally low for at least the next two years. If the above analysis is correct, it won't be too long (another year?) before they are forced to change course and tighten policy, at great cost to their credibility and to the purchasing power of the dollar.

Why is it so hard for Washington to understand that the combination of easy money and fiscal spending stimulus is not at all a prescription for growth? A weak economy is the predictable outcome of easy money and too much spending. Instead of being even easier and more "stimulative," policy should emulate the combination that produced strong growth and a strong dollar in the 1980s and 1990s. Monetary policy should be focused on strengthening, not weakening the dollar. Fiscal policy should be focused on increasing the incentives for the private sector to work and invest and take risk—by lowering and flattening tax rates and eliminating tax preferences—not on spending more. Fiscal policy also needs to focus on radically reforming entitlement programs, which will otherwise grow like Topsy and skew incentives towards less work, less investment, and more idleness.

Housing still flat, but manufacturing is picking up


Housing starts essentially have been flat for two and a half years, at the lowest levels in recorded history. There is anecdotal evidence that residential construction activity is picking up in the remodeling category—I should know since we have been doing a bit of that ourselves—but so far there is no sign of life in the new construction industry. The longer this goes on, the smaller the excess inventory of homes on the market, and the more that new construction will have to ramp up in the future to catch up with ongoing housing formations that almost surely exceed the current pace of housing starts.


U.S. industrial production in July proved to be much stronger than expected (up 0.9% vs. expectations of up 0.5%), and May and June numbers were revised higher. Over the past three months, production is up at a 6.1% annualized rate, which is close to the rate which prevailed in the second half of last year. It's pretty clear that the soft patch earlier this year—triggered by supply chain disruptions following the Japanese tsunami—has passed, and activity is gearing back up. Although Europe appears to still be lagging, there is no sign here of any double-dip recession in the U.S. This underscores the likelihood that the recent equity selloff was inspired almost entirely by fears of PIIGS-related financial troubles in Europe, and was not based on any evidence of a downturn in the the U.S.


I've featured this last chart before, even though it is somewhat of a curiosity. The Phillips Curve theory holds that high levels of capacity utilization—which correspond to low levels of resource slack—cause inflation to rise, and vice versa. As the chart shows, the fit between capacity utilization rates and inflation (with inflation taking about 17 months to respond to changes in utilization rates) was very strong in the 70s, but much less strong (even nonexistent some would say) in the 80s and 90s. My explanation for why this is so is twofold: first, while the correlation was strong, it was not necessarily because of causation; and second, monetary policy was very reactive in the 70s, and very proactive in the 80s and 90s. Proactive monetary policy anticipates changes in inflation, and thus dampens inflation over the course of a business cycle, whereas reactive policy only augments inflation.

Monetary policy has since become more reactive in the 00s, which helps explain why the correlation between inflation and capacity seems to be picking up. If that is indeed the case, then the big improvement in industrial production augurs for a meaningful pickup in core inflation in the next year or so.

Stormy weather?

I've reverted to a "stormy" Calafia Beach photo in the banner in recognition of the recent extreme volatility in the markets, and because the looming debt and banking crisis in Europe is not likely to fade away soon. I'm not sure how this will all play out in the near term, but there is one thing the encourages me: the recent problems all revolve around the fact that quite a few sovereign governments (including ours) have exceeded rational limits of spending, intervention, and market manipulation. We are living through the initial stages of that wonderful maxim: if a trend is unsustainable, it won't continue. Greece is going to have to cure its profligacy, because the market is already demanding an impossibly high price if it doesn't: 35% interest rates on 2-yr money. Italy, the U.K., and even the U.S. are being forced to reevaluate the role of government, and it seems quite likely at this point that government will emerge smaller, rather than larger, once the dust settles. That is fine by me, but the statists will not give up easily. Battles will be fought, and nerves will be rattled, and markets consequently will be volatile. Waiting in the wings is a dynamic private sector that is just waiting to pounce once the public sector begins to weaken, and that moment is approaching.

Note: I'm not saying that the outlook is negative, only that the recent volatility is likely to continue. Things could bounce around a lot before good news has a chance to solidify the uptrend in equity prices.

Money supply growth alert (cont.)


This is a follow up to some posts from last month, in which I noted the surprising jump in M2 growth. As this chart of the M2 measure of money supply shows, it has gone on to experience a gigantic surge in the past seven weeks. M2 has risen almost $420 billion since the week of June 13th, on average almost 60 billion per week. To put this in perspective, annual M2 growth has averaged about 6% per year since 1995, and growth at this rate would translate into about $10 billion per week. In other words, M2 normally would have grown by $10 billion a week, but instead has grown six times faster. M2 has never grown this fast in a seven week period for at least the past 50 years. No matter how you look at it, this is a major event.

Where is the growth in M2 coming from? Virtually all of the increase can be traced to savings deposits (up $267 billion) and checking accounts (up $148 billion). Now we know why several large banks have announced they will now begin to charge customers who have over $50 million on deposit—they don't know what to do with all the money coming in.

The last time M2 growth approached these levels was in the first quarter of 1983, at a time when inflation was still very high but starting to collapse, the dollar was booming, and the economy was just beginning its first of what would prove to be seven years of exceptionally strong growth. Rapid M2 growth back then was driven by a surge of confidence in the U.S. economy, but that is clearly not the case today. The recent growth of M2 surpasses even the explosive safe-haven demand for money that accompanied 9/11 and the financial crisis of late 2008. Something big is going on, and it can only be the financial panic that is sweeping Europe, as money flees a banking system that is loaded to the gills with PIIGS debt. In short, it looks like there is a run on the European banks, and the U.S. banking system is the safe haven of choice.

Given the lags between real time and when data hit M2, it's quite likely that Europeans already have shifted substantially more than half a billion into U.S. banks in the past two months. I suspect we haven't seen the end of this story either.