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Eurozone update



Two key measures of Eurozone risk have improved on the margin. The top chart shows 2-yr Eurozone swap spreads, and the bottom shows the yield on 2-yr Spanish government bonds. Both begin at the beginning of last year for some perspective.

The 10 bps decline in swap spreads in the past week or so is impressive by itself, and more so since it takes swap spreads back to the levels of late July last year, when the Eurozone crisis was just beginning to heat up. The ECB's liquidity injections have managed to restore a lot of confidence and liquidity to the Eurozone financial market, and that is an essential first step to allowing the crisis to play itself out.

The 100 bps decline in Spanish yields is also noteworthy, if only because it shows that the atmosphere of panic has been alleviated to some extent. Instead of worrying about how much one might lose if Spain defaults over the next year, the market seems to be paying more attention to how much extra yields one might ear if Spain doesn't default.


This chart of the Vix index shows that with the edge taken off of the panic in the Eurozone, U.S. markets have relaxed considerably. Implied volatility is still somewhat elevated, but it's nothing to be greatly concerned about.


Despite the fact that U.S. markets have calmed down considerably, the Vix/10-yr ratio remains very elevated. That's mostly due to the extremely low level of 10-yr yields, and that in turn is a reflection of the market's belief that the prospects for economic growth in the U.S. and the world are dismal.

Good and bad news: the risk of a catastrophe has declined significantly, but the market holds out very little hope for any significant improvement. Pessimism still reigns.

How government squanders money

"New York's $51.71/hour summer job." Thanks to a federal National Emergency Grant and some resourceful bureaucrats, this summer New York will be paying 150 youths $51.71 an hour to clean up storm damage in Fallkill Creek.

The story of how a simple and necessary public works project became a full-blown boondoggle is a classic tale of government excess and regulatory insanity.
The ultimate source of funding for the Fallkill cleanup is a federal National Emergency Grant, whose terms require paying wages at the highest of the federal, state or local minimum wage or at the comparable rates of pay for individuals employed in similar occupations by the same employer.
The state Labor Department decided that this meant the prevailing wage for public-works projects. But “prevailing wage” is a term of art that actually means a pay rate based on collective-bargaining agreements between labor unions and private employers.
For the Mid-Hudson region, the prevailing hourly rate for laborers comes to $51.71 — $30.71 in wages plus $21 in benefits. But the temporary workers on the Fallkill won’t be union members, so they’ll get the entire amount as a wage, the Labor Department ruled.

Read the whole thing, and weep. HT: Regina

Are falling commodity prices a problem?

Today's Bloomberg headline: "Stocks Drop with Commodities Poised for Bear Market." A quick check shows that indeed the great majority of commodity prices are falling since their highs of last year. Indeed, many would say that commodities are already in a bear market:


Crude oil is down 31%.


The Journal of Commerce Metals Index is down 27%.


The CRB Spot Commodity Index is down 17%. (note, however, that this broad-based index of industrial, energy, and agricultural commodities is up 2.7% in the past three weeks, mainly due to rising prices for foodstuffs)


Gold is down 17%, and silver is down 44%.

Commodity investors are suffering, no question. So what does this mean? Does this reflect a global economic slowdown that threatens to become another recession? The beginnings of another bout of deflation? Is the Fed too tight? Are debt burdens killing economic growth?

The answer to these questions, I would argue, is that it depends on your perspective. 

Consider the following long-term versions of each of the above charts:


In the past 13 and a half years, crude oil prices are up 550%, or almost 15% per year.


Industrial metals prices are up 260% in the past 10 and a half years, or 13% per year.


The CRB Spot Commodity Index is up 133% in the past 10 and a half years, or 8.4% per year.


Gold prices are up over 500% in the past 11 years, or 18% per year.

Wow. Is the commodity glass half full, or half empty? Looks pretty full to me. Just about any commodity you can find is up way more than the rate of inflation over the past decade or so. Is that because global growth is going gangbusters and we simply can't produce enough of the stuff? Or could it have something to do with monetary policy? Consider this chart of the CRB Spot Commodity Index in constant dollar terms:


I think this chart shows that monetary policy can have a huge impact on commodity prices. The big secular trends in real commodity prices coincide very closely with the big trends in monetary policy. Monetary policy was easy throughout most of the 1970s, then became tight under Volcker beginning in 1979 and throughout most of Greenspan's tutelage. Policy has been overtly accommodative for most of Bernanke's term as chairman, with the big exception being the late 2008 period, when the Fed was slow to react to a massive increase in money demand, and thus became inadvertently tight until quantitative easing was launched.

Looked at from a long-term perspective, and viewed against the backdrop of monetary policy, it looks to me like commodities are still in a bull market, and the recent declines have been in the nature of a correction. As such, I don't think that the recent decline in commodity prices, painful though it has been, reflects a major deterioration in the global economic outlook.

If anything, the recent decline in commodity prices is a correction from overly-strong gains—call it a bubble perhaps—that in turn were likely driven by the expectation that monetary policy was far more inflationary than it has turned out to be. Commodity speculators—and this goes double or triple for gold speculators—are realizing that commodity prices overshot the inflation fundamentals by a lot. The future hasn't turned out to be as inflationary as they expected. Speculative excess has sowed the seeds of the commodity price drop, since dramatically higher prices have encouraged a lot of new commodity production at the same time that expensive prices have curbed demand. This is not an economic contraction we're seeing, its a market correction.

Rather than fret over "weak" commodity prices, we should be rejoicing that oil prices are well off their highs and gasoline prices are declining.

UPDATE: I thought I would add a chart of copper prices to again make the point that it's not that commodity prices are suddenly weak or suggestive of an impending or developing recession—it's that commodity prices are somewhat "less strong" than they were a year ago. Just as monetary policy is "less easy" today than it was a year ago. At today's price, which is almost 30% off its all-time high of last year, copper is still up 450% from its late 2001 low. I would argue that this is not necessarily indicative of any serious global economic weakness, since it could well be due to the simple ebbing of the speculative fever which drove prices to levels last year that were previously unimaginably high, coupled with the increased production that very prices have encouraged.


Housing price update




The top chart shows real median home prices for sales of existing single family homes on a non-seasonally-adjusted basis (prices typically rise in the first half of each year, then typically decline). The bottom chart shows the year over year change in these prices in order to factor out the seasonal trends. As both charts suggest, we have likely seen a bottom in home prices, at a level that extends back to the 1970s. Real home prices hit decades-low levels and in effect they were even much cheaper thanks to record-low financing costs.

Message: the housing market has found a market-clearing level of prices, and demand is now picking up. Demand could outstrip supply—even if all those foreclosed homes held on banks' balance sheets were released for sale—if the public begins to catch on to the fact that homes are beginning to rise in price at a time when prices are still incredibly low. The very low level of mortgage rates tells us that the demand for purchasing homes is still incredibly weak; there are likely legions of buyers who have been sidelined for fear that prices would continue to decline given the economy's ongoing weakness and the overhang of under-water homeowners.


Although May sales of existing homes were slightly lower than in April, I think this chart makes the larger point that the volume of sales is trending higher from recession lows. There is lots of pent-up demand and it is slowly but surely coming back.

No more quantitative easing is a good thing

Today the FOMC announced that it did not see any reason to further increase the supply of bank reserves (i.e., there would be no QE3). But as a concession to those who still worry deeply about the economy, the FOMC did decide to extend its "Operation Twist" by buying another $267 billion of longer-term Treasuries while simultaneously selling an equal amount of shorter-term Treasuries.

Stocks initially sold off, Treasuries rallied, and gold fell, all signs that the market was disappointed there would be no more quantitative easing. But as often happens, the market's initial reaction was subsequently reversed. What that tells me is that, upon reflection, the market has decided that the Fed did the right thing. We don't need more QE to get the economy going.

The one thing the Fed could do to help would be to more forcefully explain to the world that monetary policy cannot stimulate growth. The Fed has done just about all it needs to do in order to accommodate the world's massive appetite for dollar liquidity; doing more would only risk inflation and a weaker dollar. To get the economy moving again we need stimulative fiscal policy, and by that I mean government spending cuts, a broadening of the tax base via the elimination of deductions, loopholes, and tax credits, and a lowering and flattening of tax rates.

Just in case you missed it, do read David Henderson's essay today which explains how gigantic cuts in government spending at the end of WW II not only failed to tank the economy but actually led to a huge boom. The Keynesian view that cuts to government spending would hurt the economy are unfounded. With government spending now close to record post-war levels, reducing the burden of government would unleash powerful private sector forces that would almost surely boost economic growth.


To recap the state of monetary policy, the chart above shows bank reserves, which are currently about $1.6 trillion following the Fed's two rounds of quantitative easing.


Of that total, $100 billion of reserves are currently "required" in order to back bank deposits per our fractional reserve banking system. That leaves $1.5 trillion which are "excess" reserves sitting idle on the Fed's balance sheet. Banks have been slow to use the massive amount of reserves the Fed has dumped into the system via its purchases of MBS and Treasuries. That's mainly because reserves are now functionally equivalent to 3-mo. T-bills, since the Fed now pays banks interest on the reserves they hold. In fact, reserves are even better in a sense than T-bills, because reserves earn an interest rate of 0.25% while 3-mo. T-bills only yield 0.09%. Banks are holding reserves because they want to bolster their balance sheets and because they are still very risk averse. The extremely low level of yields on T-bills is proof of the intense demand for safety. Indeed, if the Fed had not engaged in quantitative easing there would have been an acute shortage of risk-free dollar liquidity, and that could have precipitated a global depression and/or deflation.


The entire world in fact is still very risk averse, and you can see that in the huge growth of savings deposits in U.S. banks, which now total some $6.3 trillion. Savings deposits have surged from a low of 10.6% of GDP in 1982 to over 40%, and much of that increase has occurred over the past 4 years, as can be seen in the chart below, which shows the ratio of savings deposits to nominal GDP.


Other signs that the Fed has done enough quantitative easing can be found in the following charts.


2-yr swap spreads are back to normal, a sign that the banking system is functioning normally and systemic risk is low. Banks have access to all the liquidity they need; the world is not starved for liquidity.


Not only is there no shortage of dollars, there is actually a relative abundance of dollars in the world to judge by the dollar's weakness relative to other currencies.



As the first of the two charts above shows, credit default swap spreads have fallen significantly from their recession highs, a good sign that credit conditions have improved dramatically. Spreads are still somewhat elevated, however, but I would argue that has little to do with Fed policy and everything to do with the ongoing Eurozone financial crisis and the extremely low level of short-term Treasury yields, which in turn is being fueled by the world's extreme risk aversion. As the second of the two charts above shows, corporate bond yields are about as low as they have ever been: credit spreads are still elevated because low corporate yields are being compared to exceedingly low Treasury yields. The fact that the world is happy to buy investment grade corporate debt with yields as low as 3.8% suggests the outlook for corporate profits is excellent. And indeed, corporate profits are very close to record-high levels, both nominally and relative to GDP.


On the margin, gold and commodity prices are off their recent highs. Many analysts argue that this is a sign that the Fed has inadvertently tightened policy and that more quantitative easing is therefore necessary. My interpretation is somewhat different: I think the recent "weakness" in gold and commodity prices is a sign that monetary policy has become "less easy." Gold and commodity prices are still trading at very lofty levels compared to where they were 10 years ago when the Fed first embarked on an ambitious program to easy monetary policy. Monetary policy was indeed tight in the late 1990s and early 2000s, but that's certainly not the case today.


Finally, as this chart shows, forward-looking inflation expectations are not displaying any evidence at all that the Fed is too tight. This chart shows the market's implied 5-yr inflation rate 5 years in the future (i.e., the expected average annual inflation rate five years from now for the subsequent 5 years, as derived from TIPS and Treasury prices; i.e., the expected average inflation rate from 2017 through 2022), and it is right around where it has been for a long time—neither high nor low. This is the Fed's preferred measure of inflation expectations. In the absence of any decline in inflation expectations, such as occurred in late 2008, and in the fall of 2010 and 2011, it would have been very hard for the Fed to justify another round of easing today. If anything, I would note that inflation expectations have increased slightly this year.

Light at the end of the Eurozone tunnel



As these charts show, 2-yr Eurozone swap spreads have dropped to their lowest level since last July. Spreads are down almost 45 bps from the late December highs, and that is a very healthy development—even though at current levels spreads are still "elevated." The Eurozone is not out of the woods by any means, but the level of systemic risk and the liquidity of the Eurozone banking system have improved significantly so far this year. Swap spreads are often leading indicators of the health of an economy, so lower spreads are pointing to an improvement in the Eurozone economy that could become evident in the next several months.

The improvement in spreads undoubtedly reflects the ECB's successful efforts to shore up the Eurozone financial system, by ensuring that banks have access to liquidity.

In this I believe

As a supply-side libertarian, I firmly believe in the power of free markets, capitalism, the rule of law, and limited government. I believe in these things because they have proved to be the best way yet discovered to create the most prosperity for the greatest number of people. So naturally I believe that fiscal policies which respect free markets, capital, the rule of law and limited government are superior to those that do not. As an investor, I believe that such policies are more likely to lead to stronger economic growth, rising incomes and more widespread wealth gains.

Investors cannot live in a political vacuum, because politics and economics are firmly entwined; one can never underestimate the ability of policies to change the outlook, whether for better or worse. Policies informed by left-leaning politicians tend not to respect the things I believe in, while policies informed by right-leaning politicians do tend to. There exists the very real possibility that the November election may reinforce the message of the Nov. 2010 election, and lead to a rightward shift in policies going forward which could have huge and positive consequences for economic growth and financial markets. Moreover, the Supreme Court's decision on Obamacare, due out any day now, could have far-reaching consequences since it could put important limits on the scope and size of government.

Deirdre McCloskey has penned an eloquent summary of how the views of liberals and conservatives contrast, (HT Don Boudreaux) and I'm compelled to post this extract:

The liberals' narrative:

Modern life is complicated, and so we need government to regulate. Government can do so well, and will not be regularly corrupted. Since markets fail very frequently the government should step in to fix them. Without a big government we cannot do certain noble things (Hoover Dam, the Interstates, NASA). Antitrust works. Businesses will exploit workers if government regulation and union contracts do not intervene. Unions got us the 40-hour week. Poor people are better off chiefly because of big government and unions. The USA was never laissez faire. Internal improvements were a good idea, and governmental from the start. Profit is not a good guide. Consumers are usually misled. Advertising is bad.
Externalities, asymmetrical information, and other collective action problems are . . . pervasive in economic life. Countless ways of conducting business reap gains for some while imposing unjust costs on others. Create a cartel. Stuff rat feces in sausages. It is a truism to say that in order to achieve the benefits of an efficient market economy (increasing productivity, greater economic output, increasing productive capital, etc.), the basic rules of property, contract, and exchange must be structured [by government] to realize efficient market relations.

The conservatives' narrative:

Externalities do not imply that a government can do better. Publicity does better than inspectors in restraining the alleged desire of businesspeople to poison their customers. Efficiency is not the chief merit of a market economy: innovation is. 
... anyone who after the 20th century still thinks that thoroughgoing socialism, nationalism, imperialism, mobilization, central planning, regulation, zoning, price controls, tax policy, labor unions, business cartels, government spending, intrusive policing, adventurism in foreign policy, faith in entangling religion and politics, or most of the other thoroughgoing 19th-century proposals for governmental action are still neat, harmless ideas for improving our lives is not paying attention.
In the 19th and 20th centuries ordinary Europeans were hurt, not helped, by their colonial empires. Economic growth in Russia was slowed, not accelerated, by Soviet central planning. American Progressive regulation and its European anticipations protected monopolies of transportation like railways and protected monopolies of retailing like High-Street shops and protected monopolies of professional services like medicine, not the consumers. “Protective” legislation in the United States and “family-wage” legislation in Europe subordinated women. State-armed psychiatrists in America jailed homosexuals, and in Russia jailed democrats. Some of the New Deal prevented rather than aided America’s recovery from the Great Depression.
Unions raised wages for plumbers and auto workers but reduced wages for the non-unionized. Minimum wages protected union jobs but made the poor unemployable. Building codes sometimes kept buildings from falling or burning down but always gave steady work to well-connected carpenters and electricians and made housing more expensive for the poor. Zoning and planning permission has protected rich landlords rather than helping the poor. 

Plus much more; read the whole thing, especially the comments section, where Deirdre addresses numerous criticisms.

The housing market has definitely turned the corner

Just in case there are still people who doubt that the residential construction industry has turned the corner, I offer these charts:


May housing starts dipped from an upwardly-revised April level, but as this first chart shows, starts are up a solid 30% since early last year. Compared to their recession low, starts are up 48%. This is almost irrefutable evidence that the residential construction industry is on the rebound, after suffering the six worst years of its existence.


This chart shows an index of home builders' sentiment, and it too clearly shows a rebound from recession-era lows. Conditions are still miserable, to be sure, but they have definitely improved.


Finally, this chart of the stocks of 18 leading home builders also shows that there has been a distinct improvement from the recession lows.

The industry can now look forward to many years of continuing gains, as home building will eventually have to catch up with the ongoing growth in home formations, and what could prove to be widespread shortages of housing. Already there is anecdotal evidence of a lack of homes for sale in some areas of the country, and even reports of bidding wars.


With everything pointing to better times ahead for the housing market, and with mortgage rates at rock-bottom, historical lows, today's conditions represent a homebuyer's dream.

The U.S. continues to avoid Eurozone contagion




The Greeks yesterday voted to keep trying to fix their problem, but there remains much to be done and markets were understandably unimpressed. Still, I note some encouraging signs. As the charts above show, there has been virtually no contagion effect of the Eurozone crisis on the U.S. Conditions remain tenuous in the Eurozone, with swap spreads still uncomfortably high (though not extremely so), but systemic risk in the U.S. is remarkably normal. The Eurozone crisis has been brewing for over two years, and although U.S. markets have had their confidence shaken a few times, in the end the U.S. economy has continued along its path of slow improvement while the Eurozone economies have for the most part slipped into recession; the S&P 500 has climbed irregularly higher, while the Euro Stoxx index has slipped irregularly downward.


This next chart tells the same story but with a different twist. It compares the ratio of the Vix index (a measure of fear) to the 10-yr Treasury yield (a measure of the market's confidence in the U.S. growth outlook) with the yield on Spanish 2-yr bonds (a measure of the near-term likelihood of a Spanish default). This shows how rising tensions in the Eurozone have tended to coincide with bouts of increased fear and despair in the U.S. Interestingly, over the past year the Vix/10-yr ratio has tended to lead the Spanish 2-yr yield, and so the recent decline in the Vix/10-yr ratio could be telling us that the worst of the Eurozone crisis has passed and that Spanish yields could once again decline in the next several months. In any event, I note that despite today's record-setting high in Spanish 10-yr yields (reflecting acute investor distress over the prospect of an eventual Spanish default), the Vix/10-yr ratio today is only about half as high as it was late last September, when the Eurozone was on the verge of its second panic attack. Message: the Eurozone is really taking a hit, but the U.S. remains largely insulated.

With markets here still dominated by fear (e.g., PE ratios significantly below average, the 10-yr yield close to record lows, and $6.3 trillion sitting in banks savings accounts earning almost nothing), the longer the U.S. economy avoids a calamity, the more likely it is that risk assets rise. That is a plausible explanation for why U.S. equities and commodity prices have moved up this month even as Eurozone yields and fears have increased. Conditions in the U.S. are far from terrific, but in comparison to the Eurozone they are pretty good.

One more public sector pension scandal

I'm a long-time California resident and I'd like to think I'm about as well-informed as anyone when it comes to California's budget woes, but I was shocked to read this article about how California legislators' decision in 1999 to retroactively boost the retirement benefits of state employees has cost taxpayers an extra—and unexpected—$2 billion per year.

... On Sept. 10, 1999, [California legislators] decided that investment gains would cover 100 percent of the cost of retroactive pension increases they granted that day to hundreds of thousands of state workers. 
The politicians made the wrong bet -- and the result has been a penalty to California’s budget that has averaged $2 billion a year ever since and that will cost the state billions more for decades to come. Promising that “no increase over current employer contributions is needed for these benefit improvements,” and that the state pension fund would “remain fully funded,” the proposal, known as SB 400, claimed that enhanced pensions wouldn’t cost taxpayers “a dime” because of healthy investment returns.

Since then, the pension system has earned only 75 percent of what it had hoped. Because the state is unconditionally on the hook, the state budget has had to make up the difference. As a result, the state has spent $27 billion on pensions, $20 billion more than Calpers projected. 
To finance the $20 billion of extra cost for pensions, the state has cut spending on services and raised taxes. As one example, spending on the University of California and California State University systems declined 18 percent from 2002 to 2012, while state spending on pensions rose 214 percent.

This issue—the huge and still under-appreciated burden on taxpayers of public sector pension benefits—is going to remain front and center for a long time. Politicians make business and investment decisions—in this case overly-generous pension promises—that end up failing spectacularly, saddling taxpayers with the losses. This kind of stuff has got to stop. It's one more good reason for limiting the size and scope of government.