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No shortage of money



M2, arguably the best measure of the amount of readily/easily spendable cash in the economy, has now surpassed the $10 trillion mark, a milestone of sorts. M2 has grown about 6% per year on average for a very long time, but over the past year it's grown at a 7.7% annualized rate. That's not exactly what you would expect from what many consider to be the Fed's massive money-printing operations. It's hardly enough to wreak inflationary havoc in the economy. As the second chart suggests, this extra growth probably reflects some capital flight out of the Eurozone.


Savings deposits, by far the largest component of M2, have been the source of most of the extra growth in M2 since 2008. Savings deposits, of course, pay next to nothing, so these days they are simply a repository for money that people want to keep safe. Savings deposits have grown by a staggering $2.4 trillion over the past four years, and that reflects just how concerned people are about the economic situation. The Fed can't force people to put money in savings deposits, so these deposits really represent the demand for safe money. Money demand, in other words, is the thing that has driven the ongoing increase in M2 in recent years. People want to hold on to money, and to hold on to more of it.


For all the talk of capital fleeing the Eurozone, their measure of the M2 money supply has not declined at all; it has grown at a 2.8% annualized pace for the past two years. As the chart above suggests, the extra money accumulated in the Eurozone in the years leading up to 2008—when the Eurozone was considered to be more attractive than the U.S.—has now largely been reversed. In any event, Eurozone M2 has grown by about the same rate as U.S. M2 over the long haul. Perhaps it's not a coincidence that inflation in the Eurozone has been substantially similar to that in the U.S.


One source of the increased amount of M2 money is Commercial & Industrial Loans, which have increased by almost $270 billion in the past two years, and are currently growing at strong, double-digit rates. This is good evidence that banks are relaxing their lending standards and that businesses are more willing to borrow, both signs of increased confidence and thus a portent of stronger growth to come.

On balance, it's hard to find anything scary in these charts. Money is not in scarce supply, and indeed it is probably just sufficient to satisfy the demand for money. If there is something to worry about, it is the mountain of bank reserves that sit idle at the Fed, some $1.5 trillion worth. To judge from the relatively tame inflation rate and the strong demand for money, the world's demand for idle bank reserves is strong, and so the Fed's creation of those reserves was apparently what was needed to restore needed liquidity to the system. We are in a sort of equilibrium for now, but that could change if the demand for safe dollar liquidity should decline. If the savers start spending the cash they have stuffed into bank deposits, and if banks start using their idle reserves to make new loans, then we could see a tsunami of money introduced to the system which would likely boost nominal GDP by a substantial amount. The biggest monetary risk we face is not knowing whether the Fed would be able to reverse its massive creation of bank reserves in a timely fashion should money demand fall, in order to prevent a significant surge in inflation.

Reminder: the world is not coming to an end




These charts serve as a reminder that no matter how much angst there is out there about an imminent U.S. recession, a Eurozone collapse, or a China implosion, key financial indicators currently are trading at relatively benign levels, even as valuations (e.g. PE ratios) remain depressed. Swap spreads in the U.S. are about as low as they get, suggesting that systemic risk is also very low and the outlook for the economy is for things to improve. Eurozone swap spreads are still somewhat elevated, but they have been moving down all year long, and that also suggests that things are more likely to improve in Europe than deteriorate. The implied volatility of equity options is very close to a multi-year low, suggesting that although investors believe that corporate profits will decline (as evidenced by relatively low PE ratios), they are reasonably comfortable that nothing serious is going to happen.

In short, even though the future doesn't look bright (yet), it's very unlikely that the world we know it is about to end.

Labor market fundamentals continue to improve


Now that all the seasonal noise has been washed out of the data, unemployment claims turn out to have been bumping along a bottom of roughly 360K per week for most of this year, and the most recent datapoint is down about 10% from a year ago. We still have modest improvement going on here, but perhaps more importantly, absolutely no sign of any labor market deterioration, especially of the type that presages recessions.


Meanwhile, the number of people receiving unemployment insurance continues to decline, and is down almost 17% over the past year. That's 1.1 million fewer people receiving checks for not working in just the past year. Some of them have undoubtedly gotten new jobs, and some of them are undoubtedly looking for a new job with new-found intensity. Others are not happy at all. Businesses, for their part, do not seem to sense any deterioration in their markets. All of this is an important change on the margin that affects the economy in many small ways, most of them good.

Still more evidence of a housing recovery



July housing starts were a bit lower than expected (746K vs. 756K), but building permits—which naturally come before starts—were higher than expected (812K vs. 769K). But all it takes is a quick glance at these charts of each series to know that residential construction is well into a significant recovery. To be sure, starts and permits today are only up to the worst levels ever seen prior to the Great Recession, but look how far they've come: starts are up 44% from last year's lows, and permits are up 58% from their recession lows. That's a huge recovery on the margin.


Home builders are definitely seeing an improvement in the housing market fundamentals, and they are responding accordingly. These folks are a lot closer to the action than you and I, and they are making some serious commitments. The housing market is looking better and better, and with confidence still quite low, there is still lots of room for improvement.

The bond/equity disconnect resolves in favor of equities

Last week I noted the significant disconnect between rising equity prices and very low and falling bond yields. Low bond yields are symptomatic of dismal economic growth expectations, but rising equity prices point to improving expectations. One explanation for this disconnect that I offered was that equities are not necessarily pointing to a strong economy, but rather to an economy that is now seen to be less weak than it appeared to be a month ago. Bond yields remained low, I suggested, because the outlook for the economy is still weak enough to warrant extremely low short-term interest rates for at least the next several years, much as the Fed has been telegraphing. 


This week the disconnect between the two markets seems to be resolving in favor of equities. 30-yr Treasury yields are up sharply—nearly 50 bps—in the past three weeks, with most of that rise occurring in the past 12 days. Meanwhile, 2-yr Treasury yields are up less than 10 bps, which suggests that the market has not made any major adjustments in its expectations for near-term Fed tightening. (2-yr Treasuries can be thought of as the market's expected average Fed funds rate over the next 2 years.) Most of the action in recent weeks has come at the long end of the curve—from 10 to 30 year—which is consistent with my theory that the outlook for the economy has become less dire, and so the risk of deflation has been reduced considerably (the bond market typically views a very weak economy as posing deflation risk). But the economy has not improved enough to warrant any major change in the outlook for Fed policy. I'll stick with my view that equities are rallying not because the economic outlook is becoming healthy, but rather because it is becoming less awful—don't forget the drumbeat of expectations calling for the economy to now be in recession. This is still a reluctant rally.


Inflation is tame, no need for more QE


The CPI was unchanged in July, has actually fallen at a -0.8% annualized rate over the past three months, and is up at an annualized rate of only 1.1% in the past six months. However, virtually all the weakness in the headline CPI comes from declining energy prices. As the chart above shows, the Core CPI is up at a 2.2% annualized pace over the past six months. 




As the charts above show, energy prices are on the rise again, so the weakness in the headline CPI we have seen has already run its course. Gasoline prices at the pump are up over 10% in the past month, and crude oil prices are up almost 20%. It's best, therefore, to just look at the core CPI as the better measure of inflation for now.


The current rate of increase in core inflation is only slightly less than the increase in overall CPI inflation has been, on average, over the past 15 years. While it's certainly good that inflation is not higher, the best that can be said is that it has been averaging just above the Fed's target for quite some time. As the first chart in this post shows, the Fed was moved to engage in quantitative easing only when the core CPI threatened to enter deflationary territory. That is not the case today, and given the ongoing strength in industrial production and the ongoing increase in jobs, the Fed would have a very hard time justifying more QE at this time. The economy is struggling, but that's not a reason for more monetary stimulus.


In fact, as this next chart suggests, the Fed has been very accommodative for a long time, and may be overstaying its welcome in accommodative territory. This chart compares the level of capacity utilization, a proxy for the economy's idle capacity, to the real Fed funds rate, the best measure of how easy or tight monetary policy actually is. When capacity utilization rises, signaling declining idle capacity and increasing supply constraints, the Fed almost always tightens policy. When capacity utilization declines, the Fed almost always eases policy. Today the gap between the relatively high level of capacity utilization and the very low level of the real Fed funds rate is rather big and growing. The risk of the Fed remaining "too easy for too long" is rising. The market is sensing this, and it shows up in forward-looking inflation expectations, particularly in the 5-yr, 5-yr forward breakeven inflation embedded in TIPS and Treasury prices: over the past 11 months, this measure of inflation expectations (the Fed's favorite, in fact) is up from 2.0% to 2.7%.

Despite the relative tranquility of consumer price inflation, there is little if anything in the inflation and economic data that would justify further quantitative easing. Increasingly, it's looking like the Fed's next move will be a tightening, not another easing.

Industrial production remains healthy


Industrial production still shows no sign whatsoever of a recession. Production is up 4.4% over the past year, and it has risen at a 3% annualized pace in the past six months.


Manufacturing production, which strips out utility output from the total, looks healthy also, having risen 5.1% in the past year, and up at an annualized pace of 2.6% in the past six months.


Production of business equipment continues to be very strong, up 12.4% in the past year, and rising at an annualized pace of 10.3% in the past six months. This measure of industrial output has now clearly exceeded its pre-recession high. Remember the V-shaped recovery? It's been long forgotten, but not when it comes to business equipment.

The July industrial production numbers all but rule out the recession that many have been looking for. The economy went through a bit of a soft patch in the first half of this year, but now looks to be picking up. The folks at ECRI have a lot more 'splainin to do.

What if something goes right?


Smart investors always keep a sharp eye out for what might go wrong, and they build their portfolios accordingly, by not putting all their eggs in one basket.

Today, there are all sorts of things that might go wrong, and there is plenty of bad news to be found everywhere you look. Investors are right to be very worried.






In fact, sovereign bond markets are proof that investors everywhere are extremely concerned, because yields on most sovereign debt are extremely low. 10-yr Treasury yields are a paltry 1.6%; German 10-yr yields are 1.4%; and Japanese 10-yr yields are a mere 0.8%. It's simply amazing that 2-yr German and Swiss yields are now negative. You only buy bonds with extremely low yields like these if you are terribly worried about the risks of other investments. Bottom line, markets everywhere are beset by predictions of doom and gloom.

That's because it's no secret that the Eurozone is in a recession, and that some Eurozone countries seem utterly incapable of coming to terms with their bloated public sector spending, and so the risk of major sovereign debt defaults remains relatively high. It's because the whole world has seen China's economy slow meaningfully, and we know that many developing economies are struggling. Who is unaware that almost every major central bank in the world is up against the "zero boundary," unable to stimulate further by reducing interest rates, and therefore forced to resort to quantitative easing which could potentially threaten a big increase in inflation if not reversed in timely fashion? Iran is getting close to having atomic weapons, and Israel is not the only country worried about the consequences.

Everyone knows that the U.S. unemployment rate, which is still very high at 8.3%, nevertheless severely understates the effective unemployment rate, which is much higher. Nearly everyone bemoans the fact that the U.S. economy has been growing at a very slow rate ever since the recovery started, and that this is the most miserable recovery in our lifetimes.

Pundits remind us every day that there are millions of homeowners who are underwater with their mortgages, and that banks are still holding millions of foreclosed properties (REO) on their balance sheets; thus the "shadow inventory" of properties that could get dumped on the market is huge, and prices could suffer another collapse. So it's no wonder that mortgage rates are extremely low—it's because there is a relative shortage of people willing to borrow to buy homes, even though homes are more affordable now then ever before.



The stock market is studiously ignoring today's extremely strong level of corporate profits, focusing instead on how much profits are likely to decline, which is why PE ratios are below average.

Meanwhile, the U.S. government continues to run trillion-dollar deficits, while the unfunded obligations of social security and medicare are staggeringly large. It's dismaying that there don't seem to be any politicians—with the exception of that right-wing whacko Paul Ryan—willing or able to tackle this challenge. And of course, the "fiscal cliff" looms at year end.



In short, if you don't know that the world is beset with problems and threats of mega proportions, then you just haven't been paying attention. And if you have been paying attention, you're extremely worried about all the things that could wrong, and it's a good bet that your portfolio is extremely conservative. The charts above tell the story: for the past three years, investors have been pulling money out of equity funds and stuffing it into the relatively safety of bond funds, despite the ongoing rise in equity prices. Markets everywhere are depressed because of all the concerns over all the things that might go wrong. Forecasts for future growth range from a depression to, at best, 2.5-3% real growth. Contrarians take note: no one is forecasting growth in excess of 3-4%.

Ok, fine, lots of things could go wrong, but what if something goes right? That, I would submit, is the key risk you face today. Is your portfolio positioned to take advantage of an economy that continues to grow? of a housing market that doesn't collapse again, and in which prices begin to recover, albeit modestly? of corporate profits that fail to collapse?


Markets have actually been grappling with these sorts of questions for some time now. As the chart above shows, equities appear to be rising reluctantly, because the economic fundamentals (using first-time claims for unemployment as a proxy) continue to improve instead of deteriorating. When markets are braced for the worst, if the worst doesn't happen, then prices almost have to rise.


Declining unemployment claims aren't the only thing going right either. As the chart above shows, 2-yr swap spreads—a great indicator of systemic risk and a good leading indicator of economic health—are at very low levels, levels that are consistent with an economy that is very likely to avoid collapse, recession, or even stagnant growth.



Eurozone swap spreads have improved significantly this year, and 5-yr credit default swaps have declined substantially. Both developments suggest that the risk of a Eurozone collapse has declined meaningfully. Not surprisingly, Eurozone equity markets are up over 16% in the past two months. Not because the future is looking brighter, but because the future is looking less grim. 

If just a few things go right, then it is likely that risk assets (in particular equities, real estate, and commodities) could continue to rise in price. And economies could do a little better than expected, even if sovereign yields rise. Indeed, rising sovereign yields would be a sure sign of an improved outlook. 

Whereas owning sovereign debt has traditionally been a good way to hedge against the risk of something going wrong with the economy, these days you should consider that being short sovereign debt (or just not holding any, or borrowing at fixed rates) is a good way to hedge against the risk of something going right.

Socialism light

The November elections will indeed present a very stark choice between two visions of where this country is headed.

Obama: "a new vision of an America in which prosperity is shared"

Is it me, or is that just a euphemism for "socialism light?"

Romney/Ryan: "We promise equal opportunity, not equal outcomes"

HT: Drudge

No shortage of money (cont.)


Bank loans to small and intermediate-sized businesses continue to grow at strong, double-digit rates: 13-15%.

It's not the amount of loans generated, it's the fact that they are increasing relatively rapidly that's important, since that means that a) banks are more willing to lend on the margin, and/or b) businesses are more willing to borrow, and both imply an increased confidence in the future. Either way, new bank lending is expanding the supply of money, which is growing faster than its long-term 6% annual rate.