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Happy $10 Trillion Day!
It seems that few people look at M2 money supply these days, so the fact that the odometer on the key money supply gauge rolled to $10 trillion today seems likely to remain unlamented. The trip from $9 trillion to $10 trillion took a mere 66 weeks, half the time that the trip from $8 trillion to $9 trillion took. The robust growth of money supply, even though money velocity continued to decline over most of the period (we will find out whether it declined in Q2 when tomorrow’s GDP figures are released), is clearly implicated in the rise of core inflation over the same period (see Chart, source Bloomberg).
The pace of M2 growth recently has softened to only 8.4% over the last year, and is likely to fall further over the next few weeks as the end-of-July spike from last year falls out of the data. Yet even a decline to 7% implies a faster rate of core inflation, unless velocity continues to decline as well. As commercial bank lending growth is now growing comfortably faster than 5% per year (most recently at 6% over the prior 52 weeks), this seems a bad bet, and I continue to expect core inflation in the U.S. and in other developed countries to move higher rather than lower.
The Fed, as it readies QE3, will not be acting alone. This is made evident by ECB President Mario Draghi’s statement this morning that “Within our mandate, the ECB is ready to do whatever it takes to preserve the Euro. And believe me, it will be enough.”
And yet, as of yesterday, Greek bonds are no longer good collateral at the ECB. The reports from the Troika out of Greece seem to make plain that no more rescue money will be headed to that country. I will note that a “planned” exit of Greece from the Euro, or at least a planned default, would surely include the refusal of Greek bonds as ECB collateral, because otherwise upon the event the ECB would be suddenly vastly undercollateralized or uncollateralized on its loans to Greek banks – not a good idea. I won’t go so far as to predict that Greece is about to be squeezed out of the Euro, but it is consistent with the following:
- Increased discussion of QE3 and the mooting of the question by presumed Fed mouthpiece Jon Hilsenrath of the Wall Street Journal.
- The ECB’s decision at its last meeting to cut the deposit rate to zero, and recent discussion of the possibility of a negative rate, even as Euro M2 last month rose to its highest year-on-year growth rate in several years (albeit still a feeble 3.4%), shows a renewed determination to get the pendulum of monetary policy swinging in a positive direction.
- The rejection of Greek bonds as good collateral at the ECB, as mentioned above.
- The story in Der Spiegel that declared the IMF wants to cut off Greek aid, which is after all a reasonable thing to do the moment it is clear that it has no chance of staving off Greece’s collapse and exit from the Euro.
- Increasingly us-against-them comments by Greek Prime Minister Samaras, who sill be responsible for rallying his country’s spirits and economy after the exit.
The timing of a Greek exit from the Euro is perhaps not ideal – that would have been last year, before so much money was wasted, when the European economy wasn’t yet in recession, and when the U.S. economy at least had some positive momentum – but it is not likely to get much better. From the Fed’s perspective, the timing of additional easing will get more difficult, especially if the domestic economy awkwardly begins to zig-zag back up. It is much more politically astute to do QE3 after a horrible Durable Goods number (like today’s, which pushed the 6-month average change in core Durables negative for the first time since 2009) than it would be to do it when it was obviously done to help Europe.
Moreover, headline inflation has recently dropped below core, but it will not stay below core for long as gasoline and food prices have recently begun to rise. So there is a limited window during which the doves can point to domestic economic weakness (this window may not be so small, but you never know) and the hawks can claim they see no inflation evil even with core inflation sitting at the Fed’s target. The Fed’s contribution would very likely be to drop the interest on excess reserves (IOER) charge to zero, which would also harmonize deposit rates with the ECB. This would be a significant policy move, spurring even more lending, while not looking as significant as a QE3 that involved further bond-buying.
In short, I think you should say your goodbyes to IOER and to Greece, because I expect neither of them is going to be around for very long.
There was another interesting development last week – a very significant story whose implications seem to have been largely overlooked. I will discuss this story, which has near-term bullish implications for both stocks and bonds, tomorrow.
Subprime Sovereign Europe Still the Focus
Like everyone else, I want to believe that the Greek bailout this time really is ‘done.’ Of course, my main reason for wanting that outcome is that I am weary of writing about all of the deals, which turn out not to be deals, which get trumpeted as deals again, and so on.
Over the weekend, we were assured that there was finally a solution to the Greek crisis. The ECB (and it turns out today, other European central banks) will swap their bonds for new Greek bonds that will not be subject to haircuts. Meanwhile, private bondholders will take a haircut and get new bonds worth a lot less, although this afternoon the head of the IIF (the group responsible for the PSI negotiations) told the BBC that this will only work if CDS owners don’t choose to trigger their payouts. So, as long as private-sector bondholders choose to take less money, this is all good. The IMF is also reportedly contributing less to the deal than had previously been expected. And all of this is subject to approval by a number of legislatures.
So the problems of subprime sovereign Europe have not yet been put wholly to rest. The markets seem unsure on this point. Stocks ended essentially unchanged after hitting new highs in the morning, on continued low volume. Bond yields rose, with the 10-year nominal bond up 5bps to yield 2.06% and 10-year TIPS 2bps higher to yield -0.24%. That would seem to indicate some marginal lessening of tensions, but with volumes thin and equities near-unchanged I think such a read would be premature. The VIX was higher on the day, although it remains lower than it was last week.
Commodities had a banner day, relative to equities, with the DJ-UBS index +1.35%. Precious Metals led the way with a 2.75% gain and Industrial Metals rose 1.6%. Energy, however, will get the headlines. Although Nat Gas blunted the performance of the group, NYMEX Crude rose to $105.50, the highest level since May and 40% above the October lows; Brent reached $121. Gasoline jumped a nickel to $3.0661/gallon, the highest since driving season and the highest print ever for the March 2012 contract.
This seems like the first time in a while that commodities have simply smoked equities, but since the beginning of the year they have kept pace…if you leave out Nat Gas. Our preferred ETF, USCI, is up 8.98% year-to-date compared with 8.32% for the S&P. The correlation has been far too high for our tastes, suggesting that both markets are trading QE3 rather than inflation expectations. But they too are higher: the INFL Deutsche-issued ETN is +5.0% year-to-date.
While all markets move in lock-step, it is hard for me to believe that the earthquake has happened. Whether it’s the earthquake of Greece failing and banks coming clean about their losses therefrom (and a potential unzipping of other subprime sovereigns), or it’s the earthquake of Greece getting bailed out successfully and causing the line of sovereign supplicants to extend around the block, there’s some kind of resolution coming that should fracture, at least for a while, these high correlations. I believe that in such a circumstance, commodity indices are the best-valued and most likely to come on top…but we will see.
However, Bloomberg claims that the S&P is the cheapest relative to bonds it has ever been, since 1962. I enjoy the presumably-unintended bias in construction. Why not say, “Bonds are the most-expensive, relative to stocks, that they have been since 1962?” Both would be true, if the metric they’re pushing (the spread of the ‘earnings yield’ to the 10-year Treasury rate) is the right metric, but one headline implies that stocks are cheap on an absolute basis while the other headline doesn’t imply that. Our equity culture is alive and well, sadly; but there are many more arguments to be made that both bond and stock prices are too high than there are to be made that both are too low. And of course, as I’ve pointed out before, saying that stocks are cheap relative to something else is not the same as saying they are cheap, in the sense they will have better-than-average returns. By the same token, TIPS are extremely cheap relative to nominal bonds, but I would not suggest owning them outright at a -0.25% real yield. So if you want to buy stocks and sell bonds, or you want to buy TIPS and sell bonds, you may have a winning trade…if you weight the trade right. Be assured that the correct weight is not equal notional amounts. That is, if you sell your short-term bond portfolio to buy an equity portfolio dollar-for-dollar, you probably have more risk to markets returning to fair value even though bonds are expensive to stocks.
On Wednesday, after an overnight session filled with updates, clarifications, exceptions, and corrections to the so-called Greece deal, we will get to enjoy the happy news about January Existing Home Sales (Consensus: 4.66mm from 4.61mm). Since the weather in January was better-than-average, it is fair to expect a strong number, which means the market ought to react more to any downside surprise than to an upside surprise. But the magic number is 5 million. Existing Home sales haven’t been there, except for a brief spike in late 2009, since 2007. But prior to 2002, a pace of 5-5.5mm Existing Home Sales was a fairly typical level (see Chart, source Bloomberg), and would imply that properties are finally starting to clear at something like normal rates. The data may be a little messy for a few months as bank REO property gets put back on the market (potentially driving up both inventory and sales numbers), but 5mm is the level to hope for.
Mister Market Is Cheery For Now
There was no news from Greece today, although optimistic journalists penned excited articles indicating “progress” such as the idea that the ECB (headed by Mario Draghi, not Mario Monti as I incorrectly wrote yesterday) might exchange its Greek bonds for new Greek bonds. It is unclear to me if this is progress, but it certainly isn’t big progress. The latest rumor is that “the deal will be completed on Monday,” with a little asterisk that “the deal” is the offer to Greece that has 24 preconditions that need to be completed by the end of the month. And “the deal” doesn’t include the private sector initiative. And “the deal” hasn’t been signed off on by any of the legislatures that would have to actually approve it. To me, it doesn’t sound like a lot of progress, but investors are clearly predisposed to be excited by anything that anyone calls “the deal,” even if it’s not.
Mister Market was cheerful today, though, and looked kindly on the positive economic data. Initial Claims recorded a new post-Lehman low at 348k, and Housing Starts approached a new high by printing 699k. The Philadelphia Fed was good, except for the “Number of Employees” subindex, which actually looks a little weak at the moment (see Chart).
That small blemish is no reason to toss out the entire carton of apples, though, and investors were justifiably upbeat about the data. I have more trouble explaining why Mister Market was so willing to ignore the awful news that Moody’s is preparing to slash bank credit ratings soon. I don’t think investors understand the implications, perhaps figuring that since a downgrade of the US didn’t cause any alarm then why should a downgrade of Morgan Stanley? I explained yesterday why it should, but today bank and financial shares outperformed the rest of the market.
No doubt, U.S. commercial banks are further away from insolvency than they have been in a while, and loan growth is showing it. The chart below (Source: Federal Reserve Board, H.8 report) is updated as of the latest available data: commercial loan growth is now growing at a 4.2% pace year/year, the fastest pace since November 2008.
Incidentally, that also means that the enormous cache of sterile reserves the Fed has added is no longer just sitting there. It is starting to circulate, which is one reason that M2 growth is still at +10% y/y, where it has been essentially since August.
But, getting back to the market: while current loan volumes are better than they have been in a while, that’s partly because banks don’t have many other ways to make a buck these days. And this data is backward-looking, while a downgrade is negative in the future. It isn’t as if these banks are good values even before a downgrade: Goldman is at 16x earnings, with revenues down 20% over the last year and ROE is 5.5%. Bank of America is at 8x earnings, with revenues -14.6% and ROE of 0%. I should add that Goldman is up 27% year-to-date and Bank of America is up 45%. (This is not an investment recommendation, and I’m not long or short either stock.)
The rally in stocks helped push bonds lower, and the 10-year yield again reached for the 2% level. Since November, the 10-year note hasn’t been outside of a 1.80%-2.10% range, which is amazing quiescence. There are two obvious pressures on bonds. On the bullish side, you have the fact that Europe is and will continue to be a basket case for some time. But on the bearish side, you have 2.2% current (core) inflation and the Fed targeting approximately that level; 2% nominal yields is clearly a losing proposition and clearly too low absent a significant deflation. At some point, this tension will be resolved and yields will move sharply. I will observe that the inflation and Fed targeting arguments aren’t going to go away for a long time, while the Europe story will eventually fade. I remain short fixed-income.
The crowning economic data point of the week (well, at least from my perspective) will be the CPI, released tomorrow. The consensus call for headline inflation month/month is +0.3%, and +0.2% on core inflation, leading the headline figure to drop to +2.8% year/year and leaving the core year/year number unchanged at +2.2%.
That actually implies that the market forecast for core is for a “soft” +0.2%, meaning something that rounds up to that figure. A true 0.2% should cause the year/year core rate to rise to 2.3%. Since we haven’t had a true 0.2% since August, this seems like a reasonable guess. I think it is a reasonable guess, but not because of the recent below-trend prints. The housing subindex of CPI has been rising at a faster pace than it probably should be, given the inventory overhang, and last month it decelerated on a year/year basis. I think this will probably continue for at least a few months, keeping core apparently tame. That also, though, means that we need to be careful to look at core ex-housing. The expected softness in housing is a wonderful gift to the Federal Reserve here, who could point to the core number and pretend they don’t know it’s because the unwinding bubble is still dampening the cost of housing. It means there may not be much pressure to reduce their accommodation even if inflation in the non-bubble economy continues. Core inflation ex-housing rose at a 2.5% pace for 2011, up from 1.1% for 2010. I expect a continued rise there although probably at a lower rate of acceleration.
Tomorrow’s report also involves revised seasonal adjustment factors, which happen to suggest that either the m/m headline figure will be a little softer than 0.3% or else the actual CPI index itself will be a little higher than 226.573, which is the consensus estimate (this latter figure matters only if you own inflation-indexed bonds; the rest of you may ignore it).
The U.S. markets will be closed on Monday, which also means that this author is unlikely to write then (I will probably write something after the CPI report, but then use the weekend and Monday to work on our firm’s Quarterly Inflation Outlook). Thanks to all of the readers who made last night’s article one of the most-viewed I have written in a long time. Do pass along these articles, or better yet links to them, to your friends. Tweet them! (And follow @inflation_guy. On Bloomberg, you can type NH TWT_INFLATION_GUY<GO> for my Twitter feed, something I just discovered). And let me know what you think about them.
