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What's bad for gold is good for stocks




As the top chart shows, gold's brief recovery now looks more and more like a "dead cat bounce." Further weakness is likely in store, as the second chart suggests. As I mentioned last month, gold appears to be re-linking to commodities.


This is a big deal, as the chart above suggests. Gold had been trouncing just about everything for 10 years or so, but now things are reversing. Equities—productive investment—are now in favor while gold—speculative investment—is out of favor.

Weak housing starts? Permits are a better indicator

April housing starts were sharply lower than expected (853K vs. 970K), but building permits were much stronger than expected (1017K vs. 941K). The past behavior of these two series suggests that in cases like this where starts are this low relative to permits, they usually come back into line with permits in the subsequent month. Thus it's reasonable to expect that starts will bounce back next month, and that the boom in residential construction activity is ongoing.



Not surprisingly, building permits and housing starts tend to track each other very closely, and it's reasonable to assume that builders must first acquire a permit before starting construction. Logic would thus suggest that the sharp divergence in these two indicators should be resolved in the direction of permits.



The above charts show the long-term history of the level of starts and permits and their ratio (on the bottom half of each chart). Note that the ratio averages just about 1 over time, which means that indeed the two series are measure two sides of the same thing: residential construction activity. The top chart gives a long-term view, while the bottom chart zooms in on the past several years. Note that April 2013 marked the lowest level of this ratio in the past 13 years. In fact, it was the lowest ratio in the entire history of these two series going back to 1960, and this strongly suggests that April starts were the outlier. Something similar occurred in December 2010, when permits rose strongly but starts were flat. The following month the ratio shot higher as starts surged.

Starts and permits have been rising at about a 30% annual pace for over a year, and there is no reason to think that this boom has suddenly come to an end.

Big things happening in Japan

Japan is still the place where the biggest changes are happening on the margin. Stocks are still soaring as the yen falls, and now Japanese bond yields are soaring as well. Quantitative easing in Japan, which involves massive purchases of JGBs, has produced the counter-intuitive result: sharply lower bond prices. That's a good indication that monetary ease is working.


The strong inverse correlation between the yen and the Japanese stock market is a predictable result of monetary stimulus that reverses deflationary pressures that had been generated by the yen's relentless climb against all other currencies.


The chart above shows the yield on 10-yr Japanese Government Bonds (JGBs). Note that yields are now higher than they were when the BoJ announced last November its intention to start buying lots of bonds. Yields fell for several months, but in the past few days they have soared as the market begins to realize that monetary stimulus designed to get rid of deflation, coupled with the promise of fiscal stimulus and other growth-oriented reforms, have already managed to stimulate the economy. As Bloomberg notes in a recent release:

Prime Minister Shinzo Abe's stimulus probably helped the Japanese economy grow the most in a year, adding to pressure on 2013's worst-performing bond market. Gross domestic product likely expanded an annualized 2.7 percent in the three months through March ... Japanese bonds declined 14 percent in dollar terms this year ... Inflation expectations rose to the most since at least 2009. Abe's push for monetary and fiscal stimulus to overcome more than a decade of deflation is invigorating demand among consumers ... The economic rebound is also spurring expectations that consumer prices will increase as the yen tumbles, causing bond yields to surge in spite of a doubling of debt purchases under BoJ Governor Haruhiko Kuroda. Consumer sentiment is improving and consumption is gathering steam at an unexpectedly rapid pace... 

In short, to be effective, monetary stimulus must achieve the opposite of its stated goal, which is to reduce interest rates. Rising interest rates go hand in hand with stronger growth and rising inflation expectations.


The same scenario, but to a lesser degree, is now playing out in the U.S. As the above chart of 10-yr Treasury yields shows, yields are now higher than they were when the Fed announced its QE3 program in September, and when they increased the size of monthly purchases last December. Yields are up despite concerted buying by the Fed because the market is raising its expectations of U.S. growth.

This is also a good illustration of my long-held view that the Fed cannot artificially manipulate interest rates. Treasury yields have been very low not because of Fed bond purchases, but because the market was very pessimistic about the prospects for economic growth. Rates are now moving higher despite ongoing Fed purchases because the market is adjusting upwards its expectations for growth.


The above chart attempts to show how real yields on TIPS tend to track the underlying growth potential of the U.S. economy. When the economy was booming in the late 1990s, TIPS real yields were about 4%. But in recent years economic growth has moderated significantly, and real yields have fallen. The recent increase in 5-yr TIPS yields doesn't look like much in this chart, but it has been on the order of almost 60 bps, and that is significant. Despite the recent increase, the current level of TIPS yields is still consistent, I think, with a market that holds little hope for any meaningful economic growth in the years to come.



Is a QE exit really scary?

With the publication over the weekend of a story by John Hilsenrath discussing the Fed's plans for exiting Quantitative Easing, it is clear that the time is rapidly approaching when the Fed will begin scaling back its monthly purchases of Treasuries and MBS. Once new purchases cease, the next step will be for the Fed to reduce its holdings of Treasuries and MBS, and at some point in this process, short-term interest rates will almost certainly begin to rise. The only thing newsworthy about this is that the unwinding of QE might start a bit earlier than the market has been expecting. In fact, the Fed could well start scaling back its purchases within a few months. So how scary is this?

It's very scary if you believe that the Fed's aggressive expansion of its balance sheet has been the main force sustaining and powering the recovery. Without continuing injections of tens of billions of bank reserves each month, how can the recovery continue, and won't higher interest rates threaten the recovery?

It's not scary at all if you believe, like I do, that the primary goal of QE was not to "print money" or stimulate the economy, but rather to satisfy the world's apparently insatiable appetite for safe-haven, risk-free assets. It's not unreasonable to think that now, after four years of recovery, with over 6 million jobs created, with industrial production having staged an almost-complete recovery, with housing starts and auto sales growing at double-digit rates, and with global equity market capitalization only 8% shy of its 2007 all-time high, the demand for risk-free assets is beginning to taper off. If the world is now beginning to feel more comfortable with the fact that economic and financial conditions have improved, and thus the risk of another collapse has receded, then it would be entirely appropriate for the Fed to begin tapering its balance sheet expansion, simply because there is no longer a need for it.

It's not scary if you realize that higher interest rates typically accompany a recovering economy. Higher interest rates only become a threat to growth after at least a few years of aggressive Fed tightening—when real interest rates approach 3-4% and the yield curve becomes inverted. We are still many years away from conditions such as these. The Fed is likely to get really tight only if the economy and/or inflation start to really boom.

It's also not scary if you realize that the end of Quantitative Easing means the end of an unprecedented experiment in monetary policy that held the potential for dramatically increasing inflation and undermining the value of the dollar—and that was thus a major source of uncertainty. The unwinding of QE means the beginning of the end of a major source of risk-stifling uncertainty, not a new source of uncertainty. It's just plain old good news. Maybe that's why the market today reacted to the news with equanimity.

I've explained in detail here how the Fed's purchases of Treasuries and MBS were not the equivalent of printing money; how they were instead the equivalent of swapping newly-created, risk-free T-bills for more risky notes and bonds; and how banks have been quite content to hold on to virtually all the extra reserves the Fed has created in the process. As I show in the charts that follow, there is no evidence in the money supply numbers of any unusual growth, and there is no evidence of unusual dollar weakness. Gold's recent decline and the relatively flat performance of commodities are more evidence that QE has not been an exercise in massive money-printing. Moreover, short- and long-term inflation expectations remain quite normal.


The chart above shows that Fed tightening has been the source of all the recessions since the late 1950s. Tightening shows up as a rise in the real Fed funds rate, and in an inversion of the Treasury yield curve. Currently, the real Fed funds rate is still negative, and the yield curve is still quite positively sloped. Monetary conditions are easy, and extremely unlikely to lead to a recession.


Financial conditions are about as good as they get. No sign in the above chart of any financial stresses or deterioration.


Swap spreads have traditionally been excellent coincident and leading indicators of financial market and economic health. Absolutely no sign here of any unusual systemic risk. Liquidity conditions are excellent. It would highly unusual for there to be any near-term economic deterioration given the current health of financial markets.




M2, arguably the best measure of the money supply, is growing only slightly faster than it has grown for the past 18 years. Faster M2 growth is most likely a sign of increased money demand, since the lion's share of M2 growth has been in bank savings deposits, a classic refuge of safety in times of uncertainty. Faster money growth that is driven by rising money demand is not the kind of money growth that creates inflation. We would have to see a significant decline in money demand for inflation to rise, and so far there is no sign of that.


To date, the Fed has injected over $1.8 trillion of bank reserves into the banking system as a result of its purchases of Treasuries and MBS. Of this amount, only $115.8 billion are "required" to back up the deposits of the banking system. That means that banks have been willing to accumulate over $1.7 trillion of reserves on their balance sheets, earning only 0.25%. Why? Because banks are unwilling to lend more and many people and many businesses are still reluctant to borrow and many are still trying to deleverage. There clearly has been no excessive lending taking place, and thus no unusual growth in the money supply. Banks see reserves as substitutes for T-bills: as safe assets with which to bolster their balance sheets in times of uncertainty. This may well change in the future, of course, and the Fed will need to withdraw reserves in a timely fashion lest they be used by banks to engage in a wild, free-for-all lending spree.


Gold and commodity prices can be very sensitive to monetary excesses and shortages. Both declined in the years leading up to 2002, a time when the Fed was demonstrably tight. Both rose in the wake of the Fed's dramatic attempts to ease policy from 2003 through 2007. Both fell as the financial crisis of 2008 unfolded, as the world's demand for safe money rose precipitously but the Fed was slow to react. Both rose from 2009 on, as the world began to fear that Quantitative Easing would unleash tremendous inflation pressures. Both have been flat to down in the past year or so, as it has become increasingly evident that monetary policy has not produced the much-feared results.


It's not surprising that the dollar is quite weak from an historical perspective, given the Fed's overtly accommodative policy and the disappointingly slow U.S. recovery. But the dollar is not collapsing, and it has actually strengthened a bit over the past year or so. No sign here of any unusual excess of dollars in the world.



The first of the above two charts shows 5-yr nominal and real yields and their difference, which is the market's expectation for the consumer price index over the next 5 years. The second chart shows the same relationship for 10-yr yields. Both show that inflation expectations remain "firmly anchored" as the Fed is wont to say.

All things considered, there is nothing very scary going on. The only thing to be worried about is that the Fed fails to reverse QE in a timely fashion, since that could unleash a tidal wave of inflation. In the meantime, it's a good thing that the Fed seems to want to accelerate the reversal of QE.

Retail sales grow moderately

April retail sales beat expectations, but mainly because they weren't as weak as expected (+0.1% vs. -0.3%). Growth in sales has moderated somewhat this year, probably due to the expiration of the payroll tax holiday, but the slowdown has not been as big as many had feared. 



As the second chart above shows, the year-over-year growth in retail sales is now just under 4%. Over the past six months, the annualized growth rate was 3.4%. So we've definitely seen a decline in the growth rate of sales, but it's not a serious slowdown, and falling gasoline prices explain a good deal of the recent slowdown.


The chart above shows the retail sales "control group," which excludes auto, building materials, and gasoline station sales. The result is a much less volatile series that until about a year ago was growing at a reasonably healthy 5-6% rate. It's now growing at a 4-5% rate, a bit less than the long-term average 5% leading up to the Great Recession. The roughly 10% "shortfall" in sales since 2008 can be explained by the reduction in the labor force participation rate and the rather disappointingly slow growth in jobs. This suggests the economy is about 10% smaller than it could have been, and that's very disappointing, but regardless, the economy still shows every sign of continuing to grow.

Once again, I think the most important takeaway from data such as this is that the economy continues to avoid recession. For investors, avoiding recession is all that matters.