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A new high for the yen


Today saw a rather depressing milestone: the dollar has hit a new all-time low against the yen. This chart helps explain why: the yen's long-term appreciation against the dollar has been largely driven by the fact that inflation in Japan has been much lower than U.S. inflation since the late 1970s.

According to Japan's Nationwide General Price Index, prices are on average at the same level today as they were in March 1993. Meanwhile, over that same period, the U.S. Consumer Price Index has risen by 58%. This alone would account for a 58% appreciation of the yen vis a vis the dollar since 1993, since that is what would be required to keep prices stable between both countries (if the yen/dollar exchange rate had not changed, U.S. prices would have risen 58% relative to Japanese prices). So its not surprising to find that the yen has risen about 50% against the dollar since then. The green line in the chart above shows how the value of the yen should have moved over time in order to keep price levels constant between the U.S. and Japan. It moves consistently higher because U.S. inflation has been consistently higher than Japanese inflation.

The fact that the current exchange rate is 76 yen/$, while my calculation of Purchasing Power Parity is 117 yen/$, is one way of estimating how strong the yen is. I figure it's about 50% "overvalued" relative to the dollar, which means that a U.S. tourist in Japan would find that, on average, things there cost about 50% more than they do in the U.S. This is also an indication of how little confidence the world has in the underlying fundamentals of the dollar relative to the yen.

The market is up, but still terrified


The stock market has made a nice comeback since the gut-wrenching lows of October 3rd. Are we out of the woods? Not yet. We still need to see what happens in the aftermath of the inevitable Greek default, and many are not convinced at all that the U.S. economy is going to avoid a double-dip recession. The following charts recap just how nervous the market still is. The rally this month has not been driven by optimism; equities are up because things haven't been as bad as the market had been expecting.


This chart shows the consensus 1-yr forward PE ratio of the S&P 500. Multiples are almost as low today as they were during the total panic that gripped the market in the fourth quarter of 2008. By this measure, the market is still terrified of the future.




The first chart above shows the ratio of the Vix index of implied equity volatility to the 10-yr Treasury yield. The second shows the Vix Index in an historical context, and the third chart shows the 10-yr Treasury yield in an historical context. The Vix index is a good proxy for the market's fear and uncertainty about the future, since it measures how cheap or expensive it is to buy options that limit one's risk. At today's level of 32-33 it is not hugely elevated, but it is almost three times its long-term average. 10-yr Treasury yields are only inches from their all-time low, and that is a good proxy for the market's expectations of future economic growth—which are just plain dismal. The ratio of the two shows that fear is high, uncertainty is high, and economic growth expectations are extremely low.


This long-term look at the Vix/10-yr ratio sums it up: at today's value of 15, the psychology and expectations underlying the market rank right up there with the worst we have seen in the past 20 years.


High-yield, option-adjusted credit spreads are about 150 bps off their recent highs, but as this chart shows, they are still very elevated from an historical perspective—still consistent with levels that have been associated with recessions in the past. The market, in other words, is braced for a recession. By this measure, however, the expected recession is not nearly as bad as what was feared at the end of 2008. This provides some solace, but it remains the case that the market is priced to very bad news.



As the first chart above shows, 2-yr swap spreads—an excellent and forward-looking indicator of systemic risk, market liquidity, and financial market health—are up a bit from their recent lows, but from a long-term perspective they are still within the range of what might be considered "normal." This provides a huge measure of comfort in my view, since it means that our banking system and financial markets are still fundamentally healthy. As the second chart shows, however, swap spread in the eurozone are still very high. Eurozone financial markets are extremely worried about the solvency of their banking system, and about the fallout from one or more sovereign debt defaults. As I have been arguing for many months, Europe is the primary source of the fears that are weighing so heavily on U.S. markets.

So it's all a big waiting game right now. When will Greece finally default? How will it be managed? Will other countries be tempted to follow suit? Will European bank balance sheets and capital ratios be able to withstand the losses? Will there be a contagion effect to U.S. banks and to other financial markets around the globe? Will economies take another nose-dive?

No one has the answer to these questions of course. But markets are braced for a very unpleasant and possibly catastrophic outcome. If the denouement of the sovereign debt crisis results in anything less that a deep and prolonged global recession, the chances are good that risk markets could stage an impressive rally. And anyway, the world has been worrying about this for the past 18 months, so it can't possibly be the sort of "black swan" event that comes out of nowhere and catches markets completely off guard. I think there is still lots of room for optimism these days, considering the rampant pessimism that is still pervasive in almost every market.

Yield curve signals growth (cont.)




Further to my post of yesterday, here are some more measures of the shape of the yield curve. We know the Fed is trying to manipulate the bond market, first by QE, and second by Operation Twist. So it's possible the yield curve could be sending false signals. But I am of the belief that while the Fed can absolutely control short-term interest rates (it's policy target is the overnight rate), it has very little control over the yield curve from 5-10 years and out. That's because longer term interest rates are determined by inflation fundamentals and market expectations of what the Fed will do in the future.

Today, we know the Fed can't stay at zero forever; at some point the economy will pick up and the Fed will begin increasing short-term rates. Looking at the forward Treasury curve, we see that the market expects 3-mo. T-bill rates to rise from zero today to 0.71% in two years. 2-yr Treasury yields are expected to rise from 0.3% today to 1.3% in two years. 5-yr Treasury yields are expected to rise from 1.1% today to to 2.2%. In short, a positively-sloped yield curve is driven by the expectation that short-term rates will rise in the future. That is always the case when the yield curve is positively-sloped.

As the top two charts show, despite the Fed's attempts to depress long-term interest rates, the curve out to 30 years remains very steep by historical standards. That is fully consistent with the expectation that the economy will improve. It is not at all consistent with the view that we are on the cusp of another recession. If the latter were the case, the yield curve would be flat, especially in the 2-5 area. Yet even that part of the curve, where Fed expectations are very strong drivers of yields, the curve still has a definite positive slope. No matter how you look at it, the market fully expects things to improve in the future, not get worse.


Yield curve continues to suggest growth


The slope of the yield curve has been a good indicator of the headwinds facing the economy: a flat or inverted curve is a sign of tight monetary policy and a relative shortage of liquidity, while a positively sloped curve is a sign of easy monetary policy and an abundance of liquidity. This chart looks at the slope between 2- and 5-yr Treasuries, and there is no indication here that the economy is facing any serious monetary headwinds. The Fed may be up against the zero boundary for short-term rates, but the market expects that the Fed will be raising rates over the next several years.


This chart looks at the spread between 1- and 10-yr Treasuries, and the message is the same: the yield curve is plenty steep and non-threatening. It also shows the real Federal funds rate (using the PCE Core deflator), which is another way of measuring how easy or how tight monetary policy happens to be. By this measure, monetary policy has rarely been this easy. Every recession in the past 50 years has been preceded by a marked flattening of the curve, and all business cycle recoveries have been accompanied by a relatively steep yield curve and relatively easy monetary policy.  Conclusion: key indicators of monetary policy show absolutely no threat to continued economic growth.

Misery Index update



The Misery Index has been rising since 1998, due mostly to rising unemployment, but also due to rising inflation. It has now reached the levels that prevailed in the early years of the Carter presidency. The top chart recaps the Misery Index, while the bottom chart shows its components.

Claims show continued, slow improvement


Weekly claims for unemployment are important because they are very timely and can thus be early indicators of a change in the economy's dynamics. With the exception of some noisy seasonal adjustments earlier this year—when claims plunged in February only to surge in April—the trend in claims has been clearly down since the beginning of last year.


The chart above shows unadjusted claims and their 52-week moving average. Here it is easy to see how the trend in claims has been trending gradually down all year, and all indications point to that continuing.


The number of people receiving unemployment insurance also continues to trend lower, as people exhaust their eligibility and/or find a job. The total number of people "on the dole" has plunged from about 11 million early last year to about 6 million currently. This creates frustration for some, but it also increases the incentive to find and accept a job for many others.

In short, there is no sign in the claims data of any deterioration in the economy's employment fundamentals. The employment fundamentals continue to slowly improve.

Argentina's lessons for today

I first visited Argentina in 1970, when I spent my summer there visiting my soon-to-be wife. The country has intrigued, fascinated, and frustrated me ever since. Though I have been spending most of my research time on the U.S. and Europe this year, a brief dip back into the Argentine statistics today proved quite rewarding, yielding lessons that are relevant to several of today's most pressing problems.

We lived in Argentina for four years, 1975-79, during which time inflation averaged about 7% per month, if I recall correctly. During that time, the disastrous government of Isabel PerĂ³n was overthrown by a military coup, and martial law was imposed. (I recall several instances when I was stopped at roadblocks and saw soldiers all around with rifles pointed at me.) After a few years of relative stability under a military dictatorship, things began to deteriorate about a year or two after we returned to the States. (Our timing couldn't have been better.) By the  late 1980s, Argentina was spinning out of control, as its annual inflation rate peaked at over 20,000%. But inflation subsequently fell to zero by the mid-1990s, thanks to the government's decision in 1991 to peg the peso at 1-1 to the dollar.

Here's where the lessons of Argentina have relevance to the eurozone sovereign debt crisis: As the dollar appreciated against other currencies, it carried the peso along with it to levels that created severe deflationary pressures beginning in the late 1990s. Falling prices collided with huge deficit-financed government spending increases to produce one more collapse, in which the currency "floated" from 1-1 to almost 4-1 against the dollar in 2002, and the government converted all dollar-denominated deposits into pesos at a fraction of their former value. As if stealing the life savings of many of its citizens were not enough, the Argentine government subsequently defaulted on some $130 billion of its debt to foreigners, eventually restructuring the debt at about 30 cents on the dollar. (This reminds me a lot of Greece's current predicament: being tied to the euro made it easy for the Greek government to finance huge increases in spending by issuing mountains of euro-denominated debt at relatively low interest rates. Greece's now-inevitable default will have to result in the impoverishment of its citizens, whether through reduced salaries, seized wealth, or a devalued currency. That will come on top of the loss to Greece's creditors, but that is a loss that is reflected today in the market value of Greek bonds, which are trading at about 35 cents on the dollar.)

Although the Argentine economy has since recovered—after several years of extremely painful adjustment—Argentines are once again enjoying a measure of prosperity. I know, because the number of Argentina visitors to our house has increased by an order of magnitude in the past two years. Sadly, however, the government is now engaged in new tricks which promise the return of another collapse. One of those tricks involves a blatant effort to under-report consumer price inflation, beginning in early 2007. The objective was to avoid reporting a budding surge in inflation, and to keep reported inflation low to minimize public dissent in the runup to this weekend's presidential election, which current President Fernandez is almost sure to win. Keeping reported inflation low also helps the government because it also reduces the cost of inflation-adjusted pensions and healthcare benefits. In a vain attempt to deflect criticism of its CPI tinkering, the government has resorted to imposing stiff fines on any private forecaster who dares report that inflation is at least two or three times higher than the official number, which is currently about 10%.



The first chart above shows the "official" consumer price inflation rate, which has been suspiciously flat at about 10% since early 2007. Fortunately, while its not too hard for the government to game the CPI, it is almost impossible to game the overall rate of inflation which is used to calculate the economy's real growth. The true inflation rate is revealed in the GDP deflator, which is shown in the second chart. According to the deflator, inflation is now at least 30% (through June '11). No wonder everyone laughs at the government's CPI data.


All of this leads up to the third chart, which compares the level of the deflator and the CPI to the peso/dollar exchange rate. International monetary theory says that prices inevitably follow the path of currencies; if country A's currency doubles in value relative to country B's currency (for example, if country B devalues its currency by 50%), then prices in country B will eventually double also. Argentina may be a disaster as a country, but it serves as a valuable laboratory for economic experimentation: we now see that with the dollar more than quadrupling in value relative to the peso since 2001, prices in Argentina have also more than quadrupled. Q.E.D. The tinkered-with CPI, however, is woefully lagging, and now understates true inflation by about 35%.

There are several lessons here: One, a currency cannot depreciate relative to other currencies without there being a corresponding rise in inflation in the fullness of time. If the dollar continues to decline relative to other currencies, U.S. inflation will perforce increase. If the principles behind the gold standard have any validity, then the dollar's decline relative to gold almost guarantee the inflation will accelerate in the years to come. Two, controlling the value of one's currency can be an extremely effective method of controlling inflation. This has important implications for China, since it has pegged its currency to the dollar for the past 18 years, thus tying its price level to that of the U.S. It is thus quite unlikely that the yuan is significantly undervalued relative to the dollar. Three, massive sovereign debt defaults, while very likely to cause serious economic disruption, need not spell the end of the world as we know it, although they are extremely painful for many. Four, for those Argentines who worry that the peso is overvalued today relative to the dollar, yes it is. It is almost exactly as overvalued today as it was at the end of 2001, with one important difference: in late 2001 the dollar was quite strong relative to most other currencies, whereas today it is quite weak. Bottom line: although the peso is still strong relative to the dollar—and still appreciating, since the peso is falling at the same rate as prices are rising—it is weak relative to most other currencies and to commodities, so the Argentine economy is likely to suffer from continuing inflationary pressures.

Inflation and bond yields


Consumer price inflation came in a little higher than expected in September, and both the core and headline measures registered some acceleration. Inflation is alive and well, but not terribly high.


Subtracting energy, the CPI is up at a 2.9% annualized rate in the past six months, and that is almost the fastest pace in the past decade. As I've argued repeatedly, the fact that non-energy inflation is up despite the huge amount of economic slack prevailing in the economy is prima facie evidence that monetary policy has been and continues to be quite accommodative. There is no shortage of money out there, and that negates the deflationary concerns that have contributed to the market's malaise. Things could be a lot worse if we had not only a weak economy but also a general decline in the price level.


If you believe that core measures of inflation (ex-food and energy) are the appropriate ones by which to judge monetary policy (I don't necessarily agree, but the Fed pays more attention to core inflation than to headline inflation), then the chart above suggests that the bond market in the past three months has zigged when it should have zagged. Long bond yields are now only about 1% above the year-over-year rate of core inflation, when they typically exceed core inflation by at least 2% (note how the y-axes in the chart above offsets yields and inflation by 2%). The last time this happened (at the end of 2008), the decline in yields proved very fleeting, and already we have seen 30-yr bond yields jump by almost 50 bps from their lows earlier this month.


This last chart compares 10-yr Treasury yields to the core CPI over a shorter time frame, and it too shows that yields have fallen to very low levels relative to inflation. Bond market vigilantes have been lulled into complacency by the events in Europe—the threat of sovereign defaults seems to have created mass panic over the prospects of another recession and a return of deflation. But the longer we go without these fears being confirmed by terrible events in Europe—not just a Greek default, but also a wave of bank failures and a collapse of economic activity—the more upward pressure there will be on bond yields. More and more, I'm coming around to the idea that a Eurozone collapse has been so widely feared for so long that when Greece finally does default, the aftermath won't be nearly as ugly as the expectations.

Good news on housing



This may be another head-fake like April '10, when housing starts jumped to 687K, but I think the evidence supporting the notion that housing has bottomed is getting pretty strong. Today's release of September starts was the second-highest since this recovery began, and it exceed expectations by over 10%. For the past five years, housing construction has suffered its worst slump in history, and its about time things started to get a little better. (I'm told that the head of a large local construction recently said "I've been working for charity for the past five years.") At the very least it's safe to say that we've seen the worst, and things can only get better from here.

A powerful recovery in housing starts is not likely imminent, but it is inevitable. Our population is growing and our economy is growing, but the current level of starts is substantially below the level of household formations—if construction doesn't pick up we will soon face housing shortages.


I note further that the Bloomberg index of homebuilders' stocks (see chart above) is up 25% so far this month, after hitting a two-year low (it was as high as 440 in mid-2005). Things are definitely stirring, and the long-term upside is potentially huge.

Producer inflation continues to surprise on the upside



The September rise in the Producer Price Index far exceeded expectations (+0.8% vs. +0.2%), bringing the year over year change in this measure of inflation to an elevated 7%. Actually, producer inflation has been pretty consistently exceeding expectations for the past several years. The best way to see this is to compare interest rates to inflation, which the bottom chart does by subtracting producer inflation from 10-yr Treasury yields. Treasury's real cost of borrowing, measured by the amount of inflation at the producer level, is now very negative: -4.8%. For the past few years, Treasury has actually been making money by borrowing at extremely low interest rates, because it can repay the debt with dollars that get cheaper at a rate faster than its cost of borrowing money.

With federal deficits now measured in the trillions of dollars, it may be of some consolation to know that the burden of the accumulating debt is already being addressed in part, thanks to accommodative monetary policy from the Fed. Unfortunately, inflating one's way out of debt does little if anything for the health of the economy.

Today's environment is disturbingly similar to that of the 1970s, when inflation invariably exceeded both the expectations of the market and of the Fed, the dollar was exceptionally weak, and gold and commodity prices were booming. Inflation expectations were slow to catch up to reality back then, and the same holds for today. The economy struggled in the 1970s, and it is struggling today, and the Phillips Curve thinking that drives inflation expectations remains deeply ingrained in the bond market: that's why the majority of observers—and the Fed itself—continue to repeat the mantra that with the economy so weak, inflation is bound to subside. But it doesn't. In fact, inflation has been accelerating for the past 2 1/2 years, even though the economy has been exceptionally weak. The reason, of course, is that inflation is driven by monetary fundamentals, not by growth fundamentals.


At the intermediate level, producer inflation is running at double-digit rates. It's important to note that the acceleration of inflation according to this measure has been underway since 2002, which (not coincidentally) happens to be when the Fed first began shifting to an accommodative monetary stance.

Complacency on the part of bond market vigilantes is an essential ingredient to a rising inflation environment, because inflation that is unexpected can have far more consequences than inflation that is expected. When the consensus of opinion finally comes to terms with the reality of rising inflation, that will lead to big changes on the margin, and those changes will push the prices of many things much higher. Individuals and businesses will scramble to borrow more (thus pushing interest rates higher), reduce their holdings of money, and buy more inflation hedges (in particular real estate, which is the most price-depressed of all tangible assets these days). Money velocity will turn up (because money demand will fall), which will cause nominal GDP to accelerate. Money demand is exceptionally strong right now, and it has enormous potential to decline in the years to come (see chart below). Accelerating nominal GDP growth will result in stronger-than-expected cash flows, which in turn will exceed the expectations of an equity market that today fears a collapse of future cash flows. So the future looks grim for Treasuries, but not so bad—and maybe even quite good—for equities.


Whether the Fed will be able to respond to rising money velocity/falling money demand by raising interest rates enough to short-circuit a further rise in inflation is the big question. The Fed's response to the rising inflation of the 1970s was always too little, too late, and this allowed inflation to accelerate to double-digit levels. But Fed Chairman Volcker finally figured out what needed to be done, and interest rates soared in the early 1980s. One way or another, interest rates are going to have to increase significantly from current levels; the only question is when. Either the Fed will raise rates, or a decline in money demand will push rates higher, or both.

Miscellaneous updates

No sign in these charts of anything like a double-dip recession or even a meaningful economic slowdown.



September industrial production data show that US manufacturing production expanded 3.9% in the past year, and rose at a 5.9% annualized pace in the third quarter of this year. This, plus other signs of growth, suggest that Q3/11 GDP is likely to come in above market expectations of 2.5%.


Commercial & Industrial Loans at U.S. banks (a good proxy for bank lending to small and medium-sized businesses) have increased by just over $100 billion since last November, and are up at a robust annualized rate of 10.6% in the past six months.


After surging by $400 billion or so from last June through late August, the M2 money supply appears to have settled back down to its normal routine of 6% annualized growth. The bulge in M2 corresponds closely to the rising concern that the European banking system is at risk of collapse should one of the PIIGS default, but those concerns have apparently not intensified further.



Despite the 10-15% drop in commodity prices since last April, and despite widespread concerns that global economic activity—and especially that of China—has slowed, these two measures of shipping costs for bulk commodities in the Pacific have jumped significantly since their February lows.


Over the past few months the dollar has risen about 4-5% against a basket of major currencies, thanks to a flight to safety sparked by Eurozone default concerns. But as this chart shows, it still remains at very weak levels from an historical perspective.

Talking to your computer

Apple announced the new iPhone 4S almost two weeks ago, and I knew it would be a hit. "It's going to go viral." We now know that more than 4 million new iPhones were sold over the weekend, by far the most spectacular new product launch in history. I got one of them late Friday afternoon, and I have been continually amazed at how great it is.

The two stand-out features are the camera and Siri, the new digital personal assistant. The camera takes fantastic pictures, it launches in seconds, and it has already made pocket cameras obsolete. But Siri is the real star. (My wife is jealous of Siri, that's how incredible she is.) The first question to my new phone was "Hi Siri, how are you today?" She replied, "I'm fine, thanks. What can I do for you today?"

While driving on Saturday, my wife mentioned that I needed to look at her car because it might have a fluid leak. I'll have to remember to do that when we get back, I said. She said, "why don't you ask your new assistant to remind you?" So I activated Siri, and said "Remind me Tuesday morning to check Norma's car." Siri immediately repeated what I had said and asked if that was correct. Yes, I replied, and she said "I've created a reminder for you."

Siri's ability to understand things amazed our guests over the weekend, and her ability to dish up facts and figures is astonishing (What is the circumfernce of the Earth? How many miles to San Francisco from here? Can you find an Argentine restaurant nearby?). Plus, she can take dictation with amazing accuracy.

The iPhone 4S must have been named that way for Siri. We can now talk to our computers, and this is only the beginning. (Siri is still in beta, and is bound to improve with time.) But you won't believe it until you have talked to this phone yourself.

Words of wisdom

From Steven Hayward:

While our financial structures are certainly still shaky, a much larger problem is the regulatory structure that has clotted the arteries of the economy by making it cumbersome and difficult to get anything started. Consider the Keystone XL pipeline, which would generate over 20,000 construction jobs, and lot of other permanent jobs after it is finished. It is going to be approved. Eventually. Is the long hearing and litigation process really contributing to reducing the environmental impact the project is going to have? Surely not. And to the extent the long review process does lead to mitigations of harms, are there any changes that couldn’t have been figured out in the first 90 days of the whole story? A country serious about job creation wouldn’t tolerate this kind of process. I’m convinced the purpose of the whole regulatory process today is to extort things from the private sector, and/or to simply wear out the opposition to new things before the government finally says “yes.” We can’t afford this frivolousness any more.