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Bank lending continues to pick up, liquidity is plentiful


Outstanding bank loans to small and medium-sized businesses have expanded by almost $200 billion in the past 18 months, as this chart shows. Moreover, loan growth has been accelerating: in the past six months C&I Loans are up at a 13.8% annualized rate, the fastest rate since the recovery started.


Consumer credit outstanding, shown in the chart above, is also on the rise, having expanded by $128 billion in the past 18 months, and at a 6.5% annualized pace over the past six months.


Increased bank lending is good evidence that banks are beginning to use some of the $1.6 trillion of new bank reserves that the Fed has created in recent years.


Required reserves have more than doubled since 2008, another sign that quantitative easing has resulted in a meaningful expansion of the money supply via increased bank lending and increased liquidity.




M2, a broad measure of liquidity, has grown at above-average rates in recent years, driven in large part by a flight to the safety of bank deposits in the wake of the financial crisis of 2008 and the Eurozone crisis of last year. Savings deposits now comprise almost two-thirds of M2, and their $2+ trillion growth in the past 3-4 years has been the principal driver of M2 growth.

Jobs growth didn't slow down in March


Did private non farm employment grow in March by only 121K (per the establishment survey), or by a very impressive 318K (per the household survey)? Take your pick: no one really knows which one is right, even though they paint dramatically different pictures of how strong the economy currently is.

In the 30+ years during which I have been following these two monthly surveys, there have been many times when they have diverged. Over time they tell the same story, but over shorter periods of a few months or even a few years, they can tell different stories. One shorthand way of resolving the problem of a divergence is to simply split the difference, since the truth is likely to be somewhere in the middle. Doing that for March gives you a private sector payroll gain of 225K, which is right around where expectations were, and which is also consistent with what we've seen in the past few months. I don't see any reason to think that the unexpected slowdown in jobs growth that surfaced in the establishment number reflects any actual slowdown in the economy; the economy never turns on a dime without there being a number of indicators suggesting that something big is going on.

If markets are going to post a big reaction to this number, then they will be mistaken. The truth is most likely that there wasn't any jobs slowdown in March at all.

Looking at the chart above suggests another way of resolving this divergence problem. Note that the growth of private sector jobs from early 2010 through just a few months ago according to the household survey (red line) was slower than the growth according to the establishment survey (blue line). In the past two months the household survey has made up for that lagging performance by posting growth of 740K jobs. Since early 2010, the household survey now reports the addition of 4.4 million jobs (164K per month on average), while the payroll survey reports just under 4.1 million (150K per month on average). That's pretty close, and it's certainly good enough for government work.


I note also that this recovery has been unusual in the sense that, until recently, the household survey was showing weaker jobs growth than the establishment survey, when the typical pattern has been that the household survey tends to report faster growth coming out of a recession. That happens because the household survey is better at picking up new jobs that are being created by new, smaller companies that are not included in the establishment survey. This recovery was an anomaly, but now we seem to be back on track since the household survey is once again in the lead.

Much ado about nothing: the economy is most likely still growing at a 3-4% pace.

Eurozone worries resurface, but are probably not significant


The outlook for the Eurozone has improved dramatically since late November, when Spanish and Italian 2-yr yields hit levels which suggested a serious risk of default (see chart above). But over the past month, Spanish yields are up some 80 bps and Italian yields are up almost 150 bps, reflecting concerns over these countries' ability to enforce necessary austerity measures. As one article puts it, "Spain is being drawn into a vicious circle of economic, fiscal and political collapse." Are things really that bad? Could this escalate into another bout of extreme Eurozone anxiety such as we saw in the second half of last year?


The rise in 2-yr yields is also reflected in a 10 bps rise in Eurozone 2-yr swap spreads, and this suggests that the concerns about Italy and Spain have for the moment stalled the progress that was being made towards reducing systemic risk and returning financial markets to more normal liquidity conditions.


The chart above compares Eurozone 2-yr swap spreads (orange) with the Vix index (white), and illustrates how the renewed concerns in Europe have infected the U.S. market with a modest (so far) case of the willies. Swaps spreads are up and the Vix is up, and the higher Vix has coincided with a (so far) modest decline in equity prices


The chart above shows that in the great scheme of things, all of these concerns are still relatively minor. U.S. swap spreads remain firmly in "normal" territory, so there has been no fundamental deterioration in U.S. fundamentals—it's mostly just a case of nerves.


This chart confirms that the problems of the Eurozone have not spread in any fundamental way to the U.S. economy, but they have been very painful for Europe. Since late November, when 2-yr Spanish and Italian yields hit their peak, the S&P 500 has outpaced the Euro Stoxx index by some 10%; since late June of last year, just before the Eurozone crisis started heating up, the S&P 500 has eclipsed the Euro Stoxx index by over 25%. The Euro Stoxx banking index is only 15% above its late-November '12 low, having given up more than half of its gains since then in just the past week or so.

From my supply-sider's point of view, Spain's plan to cut government spending is not a big problem, since Keynesian logic way overstates how contractionary this is. It's tax austerity that is creating the problem: Spain's desire to raise taxes in order to help reduce its fiscal deficit—at a time when the economy is struggling and unemployment over 20%—is likely to harm the economy and aggravate the deficit, rather than reduce it. Raising taxes is the problem because that is basically an attempt to validate a level of spending that is already way too high; furthermore, it asks the weakened private sector to carry an additional burden and spares the bloated public sector from needed adjustment. Spain would be much better off focusing on cutting spending (to boost confidence and return resources to the private sector) while cutting taxes wherever possible, to give the private sector an added incentive to work harder and invest more in growth-favorable activities. Spain needs to think outside the box: cutting taxes would most likely not aggravate the deficit, and it might well even contribute to shrinking the deficit if it helps the economy to grow. Will they do the right thing? I can't be sure, but it is clear that they are having a lot of trouble doing the wrong thing, so there is some hope.

Fortunately, Europe is not entirely stupid when it comes to taxes. The U.K. made the mistake of raising its top marginal rate to 50% last year, thinking that this would help reduce its budget deficit. Instead, they have discovered that the higher rate was not producing any new revenue, because upper income taxpayers were fleeing the country and high marginal tax rates were "distorting the economy." So they have now rolled back the tax hike, and this may help improve the situation. Spain could do the same thing.

What we are seeing is the slow, painful, supply-side education of Europe, administered by capital markets and, yes, by bond market vigilantes. In the end, Europe will have little choice but to cut back government spending while at the same time making life easier for the private sector by cutting taxes.

Continued good news from the labor market


Weekly claims for unemployment continue to decline. Compared to this time last year, claims are down 12%, and so far this year, claims are down at a 25% annualized pace. At this rate claims will be down to historic lows a year from now—it doesn't get much better than this. The message from claims is that layoffs now are just about as low as they can get, which means that businesses have already made almost all of the adjustments that were needed to cope with the Great Recession and the realities of our very sluggish recovery.


That's the same message that we get from the Challenger, Gray & Christmas tally of publically-announced corporate layoffs. Business is now lean and mean, so further expansion of the economy will almost surely translate into more hiring. All very good news.

Service sector follows moderate growth path


Although the level of service sector business activity remains well above a "neutral" 50, it is not particularly impressive from an historical perspective—only a little above average.


The Prices Paid index also remains well above 50, suggesting that a good many businesses in the service sector continue to see some inflation out there. Deflation has only been spotted a few times in the wild, according to this series, and then only during the depths of a recession.


The employment index was one of the bright spots, having now registered three straight months of fairly strong readings. This confirms the bigger-than-expected gains in the employment data in recent months.


Today's ADP estimate of private non farm employment gains in March came in close to expectations, but data for Jan. and Feb. were revised upwards. All of this suggests that Friday's jobs number will be at least as much as expectations (215K).

And so we see yet another string of data releases that show the economy continues to grow at a moderate pace (3-4%) with no sign of any emerging recession. Today's numbers fully justify the Fed's view, adopted at last month's FOMC meeting, that no further quantitative easing is required. Looking ahead, it becomes more and more clear that the Fed's next move will be to accelerate its timetable for raising short-term interest rates. If the economy continues to improve at its current pace, the rationale for keeping rates close to zero will collapse, sooner rather than later.

Household financial burdens have collapsed


The data for this chart comes from the Fed and runs through the end of last year. The message is strong: as a result of deleveraging (some of it forced by defaults), refinancing, very low interest rates, and rising incomes, household financial burdens (payments as a % of disposable income) are now as low as at any time in the past 30 years. This is a direct reflection of the accumulation of all sorts of big adjustments that have been made in the wake of the 2008 financial crisis and the Great Recession. This also reflects the dynamism of the U.S. economy: when faced with great adversity, great adjustments are made, and these adjustments in turn prepare the economy for renewed growth.

Auto sales miss expectations but still very strong


March auto sales came in below expectations, but as this chart shows, they have been and remain exceptionally strong. This is a series that is volatile on a month-to-month basis, so it's important to look at the larger trend, and in this case it is decidedly up. Sales are up 9.7% over the past 12 months, in fact, and the 3-month moving average of sales is up 11.5% over the same period. Over the past six months, the 3-month moving average of sales is up at a blistering 35.5% annualized rate.

The auto sector remains one of the most impressive sectors of this recovery so far. After suffering one of its worst disasters in history, that's not all that unusual, but still, the recovery in sales has been spectacular given that the labor market is still far from making a decent recovery. Three years ago, no one would have guessed that the auto sector would stage such a remarkable comeback. This is a very important change on the margin that has stimulative, ripple effects throughout the economy.

With no shortage of liquidity, more QE is unnecessary

Here are some charts which recap my argument that there is no evidence that liquidity is in short supply, and thus no need for further quantitative easing from the Fed.


Swap spreads are excellent indicators of systemic risk, which can be aggravated by an effective shortage of liquidity. At 26 bps, 2-yr swap spreads reflect no sign of any such liquidity shortage. Swap spreads at current levels are fully consistent with "normal" liquidity conditions.


The dollar is up on the margin since last summer, but it is still very low from an historical perspective. If dollars were in short supply, the dollar would likely be a lot stronger.


Even with today's $35 drop, gold prices are still extremely high, both from a nominal and a real perspective (the average price of gold over the past century in today's dollars is about $500/oz.) Gold is a very sensitive indicator of monetary imbalances, and today's selloff comes not as  result of a future shortage of money, but rather from the fact that the market is now expecting monetary policy to be less easy—but still very easy—than previously expected.


Commercial and Industrial Loans are growing at double-digit rates. Banks are lending to small and medium-sized businesses once again, and business is booming on the margin. No sign here of any need for the Fed to push harder on the monetary accelerator.


Growth in the M2 measure of the money supply has been abundant. The Fed has eased monetary conditions in response to surging demand for liquidity—as it should—but in the absence of further shocks there is no reason for further easing measures. In the meantime, there are trillions of dollars of cash (savings deposits at U.S. banks have increase by more than $2 trillion in the past 3 1/2 years) sitting on the sidelines that have the potential to "reflate" the economy as confidence improves.


Commodity prices are still off their recent highs, but they have been rising for the past 3-4 months and they are generally higher today than they were prior to the last recession. The collapse of commodity prices in 2008 was good evidence that the Fed was slow in easing policy in response to the financial crisis, but the recent drop looks much more benign. Moreover, oil prices remain quite strong, and gasoline prices continue to rise. If anything, the behavior of commodity prices is more consistent with an abundance of liquidity (i.e., monetary policy that is very loose) than with any shortage of liquidity. Since the Fed started easing in 2001, commodity prices by this measure are up over 140%.


This chart compares the spread between 2- and 30-yr Treasuries (a good measure of the steepness of the yield curve) with the inflation expectations embedded in Treasury yields. Both have been rising for the past several months, an indication that liquidity conditions actually have been easing. The market essentially has been realizing for months now that what the Fed was doing (by keeping short-term rates very low for an extended period) was effectively increasing the supply of liquidity to the market. Again, no reason for the Fed to do more than it is already doing.

No more QE is good news

Today's Fed news—at their last meeting the FOMC saw no need for further stimulus unless the economy were to deteriorate—seems to have disappointed the market: bond yields jumped, the dollar jumped, and equities sunk. One can infer from these moves that the market was counting on another round of QE to boost the economy. I think the market's initial reaction to this news is mistaken, because, as I have argued in many recent posts, the economy is improving on its own and more monetary stimulus was not only unnecessary, but would have been harmful. Monetary stimulus can facilitate a recovery if the problem is a lack of liquidity, but that is not the case today. Monetary policy cannot create growth out of thin air (via the printing press) if their is no shortage of liquidity in the system. The Fed's decision to finally ease off on the monetary accelerator is welcome and probably a bit overdue. The gold market is right to be disappointed, and a stronger dollar makes sense—because monetary policy is turning out to be somewhat tighter than the market had expected—but this is not a reason for the economy to weaken or for equities to fall.

Consequently, I view the selloff in equities as a buying opportunity.


This chart is a reminder that bond yields have been very low despite the fact that the economy has been slowly improving and the equity market has been rallying for the past six months. The bond market was counting on some more Fed "stimulus" to keep bond yields low, but the equity market was reluctantly responding to improving economic data (e.g., lower unemployment claims, strong corporate profits). With the promise of QE3 now shelved until evidence of renewed weakness turns up, bond yields have lots of upside potential.

The Fed is right to put QE3 on hold, because the economy doesn't need more monetary stimulus. Doing the right thing is never bad. Indeed, I think today's news from the Fed should reassure markets that monetary policy will not spin out of control. Plus, with this news the Fed has effectively given the economy a vote of confidence, and the equity market should sooner or later realize this and strengthen.

The recent slowdown in capex is not a reason to worry


New orders for capital goods (a good proxy for business investment) have been flat for the past six months. Does this portend an imminent recession? It might, but I think this is a fairly isolated event—I don't see any other signs of a looming recession, such as 1) an inverted yield curve, 2) very high real interest rates, 3) a significant widening of swap or credit spreads, or 4) a significant increase in first-time unemployment claims. In fact, all those classic recession indicators are behaving just the opposite, suggesting that a recession is nowhere in sight. I note further that, despite the slump in the past six months, capital goods orders are still up a strong 9.2% in the past year.


Capital goods orders are a subset of the much larger Factory Orders series, shown in the above chart. Here we see that orders are also up 9.2% in the past year, as well as being up at an 8% annualized rate in the past six months. No slump here, and these growth rates are very strong in an historical context.

One likely explanation for the recent slowdown/slump in capex was the expiration at the end of last year of business tax incentives such as immediate expensing of some capital goods: this had the effect of accelerating orders into last year and thus "borrowing" them from this year. If this is correct, then we should see capital goods orders resume their upward trend by summer.

Stocks are still attractive

With the end of a pretty exciting quarter for equities just behind us, what does the future hold? Here's my simplistic view, which remains optimistic because I continue to see signs that tell me the market remains pessimistic. 


As the chart above suggests, the S&P 500 is currently right about in the middle of its long-term upward trend. The 6.8% annualized trend lines that I've drawn translate into a total return of over 8% a year when you included reinvested dividends, and this trend is consistent with the 11.1% annualized total return of the S&P 500 since the end of 1949. The existence of many trillions of dollars "sitting on the sidelines" in the form of cash and cash equivalents that pay almost nothing, while stocks have reaffirmed their ability to move higher over time by at least 6.8% a year, is a good indicator that the market as a whole has very little confidence in the long-term outlook.


As of the end of March, the trailing 12-month PE ratio of the S&P 500 was 14.56, which is about 12% below its 52-year average. No sign of excessive optimism here: in fact, since reaching a peak of 30 in June 1999, multiples have fallen by more than half while after-tax corporate profits (as calculated by the National Income and Product Accounts) have surged some 160%. This is a market that holds out no hope that profits will do anything but languish and/or decline in the years to come.



Another way of looking at profits is to compare the earnings yield on stocks (the inverse of the PE ratio) with the yield on corporate bonds. The first of the two charts above uses the average yield on long-term BAA-rated corporate bonds as a proxy for yield on the typical corporate bond. Here we see that earnings yields are still substantially higher than bond yields, a condition that has been relatively rare over the past 52 years. When the market is very confident in the ability of earnings to rise over time, as it was from the early 1980s through the early 2000s, earnings yields were consistently below the yield on corporate bonds, because investors were willing to forego a portion of the relative safety of bond yields in order to capture the expected price appreciation of equities.

The second of the two charts above compares the earnings yield on stocks to the yield on 10-yr Treasury bonds. When Treasury yields are higher than equity yields, it's a good sign that the market is distrustful of the ability of earnings to grow. "Distrustful" is a rather timid description of investors' outlook today, since the market is essentially indifferent to earning 2.2% on risk-free bonds while stocks are offering 6.9%. That spread of 4.7% today is much wider than the 3.2% recorded at the market's bottom in early March 2009, and only moderately tighter than the all-time high of 6.2% recorded late last September. In short, the sizable gap between the current yield on equities and the yield on risk-free Treasuries reflects a very pessimistic outlook embedded in current prices.

Of course, the market may well be correct in its belief that the outlook for the economy and corporate profits is miserable. But everything I see tells me that the economy continues to grow, albeit relatively quite slowly given the depths of the recent recession. The story of the equity rally to date is one of stocks moving higher because the reality has continually proved to be less awful than the expectations, and I think this will continue to be the case for the foreseeable future.

Construction spending going sideways


February construction spending was quite a bit weaker than expected, and, coupled with a downward revision to January figures, the uptrend that was emerging a month ago now looks less clear. I continue to believe, however, that we have seen the worst of the news for this sector and that conditions will gradually improve over the course of the year.

Manufacturing remains healthy


The March ISM manufacturing index was a bit stronger than expected, and as the above chart shows, at this level the index is consistent with overall economic growth of 3-4%. Nothing spectacular about that, of course, but perhaps more important is the fact that there is no sign of any unusual weakness here. I'm hearing a lot of analysts arguing that Q1/12 GDP growth was less than Q4/11, but today's ISM news doesn't support that.


March export orders were the weakest component of the ISM report (54 in March, down from a very strong 59.5 in February), and many point to an emerging recession in Europe and a substantial weakening of the Chinese economy as the likely culprits. That may be the case, but a reading of 54 still suggests improving conditions. And offsetting a less-strong export number, the employment index rose to 56.1; as the above chart shows, that is a pretty strong number from an historical perspective. On balance, the manufacturing sector continues to look healthy, suggesting first quarter growth is likely to be at least as strong as fourth quarter growth.