Connect with us

Economics

The Euro’s Death Wish

The Euro’s Death Wish

Authored by Alasdair Macleod via GoldMoney.com,

Last week’s Goldmoney article explained the Fed’s increasing commitment…

Published

on

This article was originally published by Zero Hedge

The Euro’s Death Wish

Authored by Alasdair Macleod via GoldMoney.com,

Last week’s Goldmoney article explained the Fed’s increasing commitment to dollar hyperinflation. This week’s article examines the additional issues facing the euro and the Eurozone.

More nakedly than is evidenced by other major central banks, the ECB through its system of satellite national central banks is now almost solely committed to financing national government debts and smothering over the consequences. The result is a commercial banking system both highly leveraged and burdened with overvalued government debt secured only by an implied ECB guarantee.

The failings of this statist control system have been covered up by a pass-the-parcel any collateral goes €10 trillion plus repo market, which with the TARGET2 settlement system has concealed the progressive accumulation of private sector bad debts ever since the first Eurozone crisis hit Spain in 2012.

These distortions can only continue so long as interest rates are suppressed beneath the zero bound. But rising interest rates globally are now a certainty — only officially unrecognised by central bankers — so there can only be two major consequences. First, the inevitable Eurozone economic recession (now being given an extra push through renewed covid restrictions) will send debt-burdened government deficits which are already high soaring, requiring an accelerated pace of inflationary financing by the ECB. And second, the collapse of the bloated repo market, which is to be avoided at all costs, will almost certainly be triggered.

This article attempts to clarify these issues. It is hardly surprising that for the ECB raising interest rates is not an option. Therefore, the recent weakness of the euro on the foreign exchanges marks only the start of a threat to the euro system, the outcome of which will be decided by the markets, not the ECB.

Introduction

The euro, as it is said of the camel, was designed by a committee. Unlike the ship of the desert the euro and its institutions will not survive — we can say that with increasing certainty considering current developments. Instead of evolving as demanded by its users, the euro has become even more of a state control mechanism than the other major currencies, with the exception, perhaps, of China’s renminbi. But for all its faults, the Chinese state at least pays attention to the economic demands of its citizens to guide it in its management of the currency. The commissars in Brussels along with national politicians seem to be blind to the social and economic consequences of drifting into totalitarianism, where people are forced into new lockdowns and in some cases are being forced into mandatory covid vaccinations.

The ECB in Frankfurt has also ignored the economic consequences of its actions and has just two priorities intact from its inception: to finance member governments by inflationary means and to suppress or ignore all evidence of the consequences.

The ECB’s founding was not auspicious. Before monetary union socialistic France relied on inflationary financing of government spending while Germany did not. The French state was interventionist while Germany fostered its mittelstand with sound money. The compromise was that the ECB would be in Frankfurt (the locational credibility argument won the day) while its first true president, after Wim Duisenberg oversaw its establishment and cut short his presidency, would be French: Jean-Claude Trichet. Membership qualifications for the Eurozone were set out in the Maastricht treaty, and then promptly ignored to let in Italy. They were ignored again to let in Greece, which in terms of ease of doing business ranked lower than both Jamaica and Columbia at the time. And now the Maastricht rules are ignored by everyone.

Following the establishment of the ECB the EU made no attempt to tackle the divergence between fiscally responsible Germany with similarly conservative northern states, and the spendthrift southern PIGS. Indeed, many claimed a virtue in that Germany’s savings could be deployed for the benefit of investment in less advanced member nations, a belief insufficiently addressed by the Germans at the time. The ECB presided over the rapidly expanding balance sheets of the major banks which in the early days of the euro made them fortunes arbitraging between Germany’s and the PIGs’ converging bond yields. The ECB was seemingly oblivious to the rapid balance sheet expansion with which came risks spiralling out of control. To be fair, the ECB was not the only major central bank unaware of what was happening on the banking scene ahead of the great financial crisis, but that does not absolve it from responsibility.

The ECB and its banking regulator (the European Banking Authority — EBA) has done nothing since the Lehman failure to reduce banking risk. Figure 1 shows current leverages for the Eurozone’s global systemically important banks, the G-SIBs. Doubtless, there are other lesser Eurozone banks with even higher balance sheet ratios, the failure of any of which threatens the Eurosystem itself.

Even these numbers don’t tell the whole story. Most of the credit expansion has been into government debt aided and abetted by Basel regulations, which rank government debt as the least risky balance sheet asset, irrespective whether it is German or Italian. Throughout the PIGS, private sector bad debts have been rated as “performing” by national regulators so that they can be used as collateral against loans and repurchase agreements, depositing them into the amorphous TARGET2 settlement system and upon other unwary counterparties.

Figure 2 shows the growth of M1 narrow money, which has admittedly not been as dramatic as in the US dollar’s M1. But the translation of bank lending into circulating currency in the Eurozone is by way of government borrowing without stimulation cheques. It is still progressing, Cantillon-like, through the monetary statistics. And they will almost certainly increase substantially further on the back of the ongoing covid pandemic, as state spending rises, tax revenues fall, and budget deficits soar. Bear in mind that the new covid lockdowns currently being implemented will knock the recent anaemic recovery firmly on the head and drive the Eurozone into a new slump. There can be no doubt that M1 for the euro area is set to increase significantly from here, particularly since the ECB is now nakedly a machine for inflationary financing.

In the US’s case, rising interest rates, which the Fed is keen to avoid, will undermine the US stock market with knock-on economic effects. In the Eurozone, rising interest rates will undermine spendthrift governments and the entire commercial banking system.

Government debt creation out of control

The table below shows government spending for leading Eurozone states as a proportion of their GDP last year, ranked from highest government spending to GDP to lowest (column 1). The US is included for comparison.

Some of the increase in government spending relative to their economies was due to significant falls in GDP, and some of it due to increased spending. The current year has seen a recovery in GDP, which will have not yet led to a general improvement in tax revenues, beyond sales taxes. And now, much of Europe faces new covid restrictions and lockdowns which are emasculating any hopes of stabilising government debt levels.

The final column in the table adjusts government debt to show it relative to the tax base, which is the productive private sector upon which all government spending, including borrowing costs and much of inflationary financing, depends. This is a more important measure than the commonly quoted debt to GDP ratios in the second column. The sensitivity to and importance of maintaining tax income becomes readily apparent and informs us that government debt to private sector GDP is potentially catastrophic. As well as the private sectors’ own tax burden, through their taxes and currency debasement they are having to support far larger obligations than generally realised. Productive citizens who don’t feel they are on a treadmill going ever faster for no purpose are lacking awareness.

These are the dynamics of national debt traps which only miss one element to trigger them: rising interest rates. Instead, they are being heavily suppressed by the ECB’s deposit rate of minus 0.5%. The market is so distorted that the nominal yield on France’s 5-year bond is minus 0.45%. In other words, a nation with a national debt that is so high as to be impossible to stabilise without the necessary political will to do so is being paid to borrow. Greece’s 5-year bond yields a paltry 0.48% and Italy’s 0.25%. Welcome to the mad, mad world of Eurozone government finances.

The ECB’s policy failure

It is therefore unsurprising that the ECB is resisting interest rate increases despite producer and consumer price inflation taking off. Consumer price inflation across the Eurozone is most recently recorded at 4.1%, making the real yield on Germany’s 5-year bond minus 4.67%. But Germany’s producer prices for October rose 18.4% compared with a year ago. There can be no doubt that producer prices will feed into consumer prices, and that rising consumer prices have much further to go, fuelled by the acceleration of currency debasement in recent years.

Therefore, in real terms, not only are negative rates already increasing, but they will go even further into record territory due to rising producer and consumer prices. It is also the consequence of all major central banks’ accelerated expansion of their base currencies, particularly since March 2020. Unless it abandons the euro to its fate on the foreign exchanges altogether, the ECB will be forced to raise its deposit rate very soon, to offset the euro’s depreciation. And given the sheer scale of previous monetary expansion, which is driving its loss of purchasing power, euro interest rates will have to rise considerably to have any stabilising effect.

But even if they increased only into modestly positive territory, the ECB would have to quicken the pace of its monetary creation just to keep Eurozone member governments afloat. The foreign exchanges will quickly recognise the situation, punishing the euro if the ECB fails to raise rates and punishing it if it does. But it won’t be limited to cross rates against other currencies, which to varying degrees face similar dilemmas, but measured against prices for commodities and essential products. Arguably, the euro’s rerating on the foreign exchanges has already commenced.

The ECB is being forced into an impossible situation of its own making. Bond yields have started to rise or become less negative, threatening to bankrupt the whole Eurozone network as the trend continues, and inflicting mark-to-market losses on highly leveraged commercial banks invested in government bonds. Furthermore, the Euro system’s network of national central banks is like a basket of rotten apples. It is the consequence not just of a flawed system, but of policies first introduced to rescue Spain from soaring bond yields in 2012. That was when Mario Draghi, the ECB’s President at the time said he was ready to do whatever it takes to save the euro, adding, “Believe me, it will be enough”.

It was then and its demise was deferred. The threat of intervention was enough to drive Spanish bond yields down (currently minus 0.24% on the 5-year bond!) and is probably behind the complacent thinking in the ECB to this day. But as the other bookend to Draghi’s promise to deploy bond purchasing programmes, Lagarde’s current intervention policy is of necessity far larger and more destabilising. And then there is the market problem: the ECB now acts as if it can ignore it for ever.

It wasn’t always like this. The euro started with the promise of being a far more stable currency replacement for national currencies, particularly the Italian lira, the Spanish peseta, the French franc, and the Greek drachma. But the first president of the ECB, Wim Duisenberg, resigned halfway during his term to make way for Jean-Claude Trichet, who was a French statist from the École Nationale d’Administration and a career civil servant. His was a political appointment, promoted by the French on a mixture of nationalism and a determination to neutralise the sound money advocates in Germany. To be fair to Trichet, he resisted some of the more overt pressures for inflationism. But then things had not yet started to go wrong on his watch.

Following Trichet, the ECB has pursued increasingly inflationist policies. Unlike the Bundesbank which closely monitored the money supply and paid attention to little else, the ECB adopted a wide range of economic indicators, allowing it to shift its focus from money to employment, confidence polls, long-term interest rates, output measures and others, allowing a fully flexible attitude to money. The ECB is now intensely political, masquerading as an independent monetary institution. But there is no question that it is subservient to Brussels and whose primary purpose is to ensure Eurozone governments’ profligate spending is always financed; “whatever it takes”. The private sector is now a distant irrelevance, only an alternative source of government revenue to inflation, the delegated responsibility of compliant national central banks, who take their orders from the economically remote ECB.

It is an arrangement that will eventually collapse through currency debasement and economic breakdown. Prices rising to multiples of the official CPI target and the necessary abandonment by the ECB of the euro in the foreign exchanges in favour of interest rate suppression now threaten the ability of the ECB to finance in perpetuity increasing government deficits.

The ECB, TARGET2 and the repo market

Figure 3 shows how the Eurozone’s central bank balance sheets have grown since the great financial crisis. The growth has virtually matched that of the Fed, increasing to $9.7 trillion equivalent against the Fed’s $8.5 trillion, but from a base about $700bn higher.

While they are reflected in central bank assets, TARGET2 imbalances are an additional complication, which are shown in the Osnabrück University chart reproduced in Figure 4. Points to note are that Germany is owed €1,067bn. The ECB collectively owes the national central banks (NCBs) €364bn. Italy owes €519bn, Spain €487bn and Portugal €82bn.

The effect of the ECB deficit, which arises from bond purchases conducted on its behalf by the national central banks, is to artificially reduce the TARGET2 balances of debtors in the system to the extent the ECB has bought their government bonds and not paid the relevant national central bank for them.

The combined debts of Italy and Spain to the other national central banks is about €1 trillion. In theory, these imbalances should not exist. The fact that they do and that from 2015 they have been increasing is due partly to accumulating bad debts, particularly in Portugal, Italy, Greece, and Spain. Local regulators are incentivised to declare non-performing bank loans as performing, so that they can be used as collateral for repurchase agreements with the local central bank and other counterparties. This has the effect of reducing non-performing loans at the national level, encouraging the view that there is no bad debt problem. But much of it has merely been removed from national banking systems and lost in both the euro system and the wider repo market.

Demand for collateral against which to obtain liquidity has led to significant monetary expansion, with the repo market acting not as a marginal liquidity management tool as is the case in other banking systems, but as an accumulating supply of raw money. This is shown in Figure 4, which is the result of an ICMA survey of 58 leading institutions in the euro system.

The total for this form of short-term financing grew to €8.31 trillion in outstanding contracts by December 2019. The collateral includes everything from government bonds and bills to pre-packaged commercial bank debt. According to the ICMA survey, double counting, whereby repos are offset by reverse repos, is minimal. This is important when one considers that a reverse repo is the other side of a repo, so that with repos being additional to the reverse repos recorded, the sum of the two is a valid measure of the size of the market outstanding. The value of repos transacted with central banks as part of official monetary policy operations were not included in the survey and continue to be “very substantial”. But repos with central banks in the ordinary course of financing are included.

Today, even excluding central bank repos connected with monetary policy operations, this figure probably exceeds €10 trillion, allowing for the underlying growth in this market and when one includes participants beyond the 58 dealers in the survey. An interesting driver of this market is negative interest rates, which means that the repayment of the cash side of a repo (and of a reverse repo) can be less than its initial payment. By tapping into central bank cash through a repo it gives a commercial bank a guaranteed return. This must be one reason that the repo market in euros has grown to be considerably larger than it is in the US.

This consideration raises the question as to the consequences of the ECB’s deposit rate being forced back into positive territory. It is likely to substantially reduce a source of balance sheet funding for commercial banks as repos from national central banks no longer offer negative rate funding. They would then be forced to sell balance sheet assets, which would drive all negative bond yields into positive territory, and higher. Furthermore, the contraction of bank credit implied by the withdrawal of repo finance will almost certainly have the knock-on effect of triggering a widespread banking liquidity crisis in a banking cohort with such high balance sheet gearing.

There is a further issue over collateral quality. While the US Fed only accepts very high-quality securities as repo collateral, with the Eurozone’s national banks and the ECB almost anything is accepted — it had to be when Greece and other PIGS were bailed out. High quality debt represents most of the repo collateral and commercial banks can take it back onto their balance sheets. But the hidden bailouts of Italian banks by taking dodgy loans off their books could not continue to this day without them being posted as repo collateral rolled into the TARGET2 system and into the wider commercial repo network.

The result is that the repos that will not be renewed by commercial counterparties are those whose collateral is bad or doubtful. We have no knowledge how much is involved. But given the incentive for national regulators to have deemed them creditworthy so that they could act as repo collateral, the amounts will be considerable. Having accepted this dodgy collateral, national central banks will be unable to reject them for fear of triggering a banking crisis in their own jurisdictions. Furthermore, they are likely to be forced to accept additional repo collateral rejected by commercial counterparties.

In short, in the bloated repo market there are the makings of the next Eurozone banking crisis. The numbers are far larger than the central banking system’s capital. And the tide will rapidly ebb on them with rising interest rates.

Inflation and interest rate outlook

Starting with input prices, the commodity tracker in Figure 6 illustrates the rise in commodity and energy prices in euros, ever since the US Fed went “all in” in early 2020. To these inputs we can add soaring shipping costs, logistical disruption, and labour shortages — in effect all the problems seen in other jurisdictions. Additionally, this article demonstrates that not only is the ECB determined not to raise interest rates, but it simply cannot afford to. Being on the edge of a combined government funding crisis and with a possible collapse in the repo market taking out the banking system, the ECB is paralyzed with fear.

That being so, we can expect further weakness in the euro exchange rate. And the commodity tracker in Figure 6 shows that when commodity prices break out above their current consolidation phase, they will likely push alarmingly higher in euros at least. The ECB’s dilemma over choosing inflationary financing or saving the currency is about to get considerably worse. And for probable confirmation of mounting fear over the situation in Frankfurt, look no further than the resignation of the President of the Bundesbank, who has asked the Federal President to dismiss him early for personal reasons. It was all very polite, but a high-flying, sound money man such as Jens Weidmann is unlikely to just want to spend more time with his family. That he can no longer act as a restraint on the ECB’s inflationism is clear, and more than any outsider he will be acutely aware of the coming crisis.

Let us hope that Weidmann will be available to pick up the pieces and reintroduce a gold-backed mark.
 

Tyler Durden
Sun, 11/28/2021 – 07:00


















Author: Tyler Durden

Economics

M2 and Nominal GDP Update: still growing rapidly

I am fascinated by the fact that these days hardly anyone is talking about the very rapid growth in both M2 and nominal GDP. Both suggest that inflation…

I am fascinated by the fact that these days hardly anyone is talking about the very rapid growth in both M2 and nominal GDP. Both suggest that inflation is alive and well, and very likely to continue.
The big news this week was that the Fed is doing its best to avoid an aggressive tightening of monetary policy. Which makes it strange that the market sold off on the news that the Fed plans to accelerate (ever so slightly) its tapering of asset purchases while also planning to begin to lift short-term interest rates (in gingerly fashion) in about two months. As I’ve been arguing for awhile, the threat of tight money is a problem that still lies well into the future; it’s certainly something to worry about, but not for now. Monetary policy today is still extremely accommodative, and almost certainly the culprit behind our inflation problem. 
Today the Fed said that they plan to start raising short-term rates in early March. The bond market expects the Fed will ratchet up rates by 25 bps at a time until reaching a “terminal rate” for their Fed funds target of about 2.5% in about 3-4 years’ time. In my book, that hardly rates as tight money. Actual tightening involves a significant rise in the real Fed funds rate (e.g., to at least 3%). It also involves a flattening or inversion of the Treasury yield curve, which is still moderately steep. We’re not even close to those conditions, and the Fed has virtually assured us they are unlikely to slam on the monetary brakes anytime soon. 
Most observers these days argue that inflation is the result of too much demand (fueled by government stimulus payments) and not enough supply (e.g., Covid-related supply bottlenecks). Hardly anyone talks about the unprecedentedly rapid growth of money, aside from me and a handful of other economists (e.g., Steve Hanke, John Cochrane, Ed Yardeni, and Brian Wesbury). Moreover, I’d wager that the great majority of the population doesn’t understand that supply and demand shocks can only affect the prices of some goods and services, but not the overall price level. If all, or nearly all prices rise, that is a clear-cut sign of an excess of money relative to the demand for it. That is how inflation works.

There are other reasons to think the recent stock market selloff is overdone, if not premature. Credit spreads—which measure actual stresses in the economy—are still relatively low. Swap spreads—which are a good indicator of liquidity—are very low. Together, these spreads tell us that liquidity is abundant, economic stresses are low, and the outlook for corporate profits—and by inference the economy—is healthy. Ironically, the main problem for now is that the Fed is not prepared—yet—to do anything that might slow the rate of inflation or threaten the economy for the foreseeable future. They’d rather lay the blame for inflation on Congress than take the heat themselves. And don’t forget that Powell is up for renomination soon. 
Chart #1
Chart #1 shows the growth of currency in circulation, which represents about 10% of the M2 measure of money. After surging at 20% annualized rates in Q2/20, the growth of currency has slowed to about a 5% annualized rate, which is somewhat slower than its long-term trend growth of about 6.6% per year. As I’ve explained before, the supply of currency is always equal to the demand for currency, which means that currency growth is not contributing to our recent inflation problem. Currency growth was quite rapid last year because the demand for currency was very strong, fueled by all the uncertainties of the Covid threat. But the fact that currency growth has since slowed significantly since then suggests that precautionary demand has faded: this is arguably a good leading indicator that the demand for money balances in checking accounts and bank savings account is also softening or beginning to soften. In the absence of any slowing in the growth of M2, any reduction in the demand for money in the system is precisely what fuels a rise in the general price level. If the Fed does nothing in response, such as raising short-term interest rates and draining reserves from the banking system, inflation is very likely to continue
Chart #2
Chart #2 shows the growth of the M2 monetary aggregate. Here again we see explosive growth in Q2/20 and a subsequently slower—but still quite rapid—rate of growth which continues to this day. For the past year or so, M2 growth has been averaging about 12-13%. That is twice as fast as its long-term trend rate of growth, and it shows no sign of slowing, even though the Fed has been tapering its purchases of securities (to be fair, tapering does nothing to reduce inflation). This is good evidence that M2 is growing because banks are lending money by the bushel, which is the only way the money supply can expand. The public’s apparent demand for loans is thus strong, and that is symptomatic of a decline in the demand for money. 
 
Chart #3
Chart #3 shows the growth of M2 less currency, which is equivalent to all the money that has been supplied by the banking system via lending operations. It’s important to remember that the Fed cannot create money directly; the Fed only has the power to limit bank lending by limiting bank reserves, and to influence the public’s demand for money via increasing or decreasing the overnight lending rate. Again we see the same pattern: explosive growth of M2 in Q2/20 followed by a slower (but still rapid) 13-14% pace since then that shows no signs of slowing (as of the recently-released data for December ’21). The growth of money on deposit in our banks is growing at more than twice its historical rate, and that has been the case for the past 18 months. Needless to say, this is nothing short of extraordinary. And it is the stuff of which inflation is made.
Chart #4
Chart #4 shows that the M2 money supply is now equal to about 90% of the economy’s nominal GDP. Since the latter is roughly equivalent to national income, this means that the average person or entity today is holding almost one year’s worth of his annual income in a bank deposit of some sort. This is a level that was only exceeded in Q2/20, at the height of the Covid panic, and it is far above any level we have seen for many decades. People have effectively stockpiled an unprecedented amount of money in bank accounts and savings accounts that pay almost no interest! On its face, this would suggest that the demand for money (non-interest bearing money) has been intense. But will that demand remain strong? The fact that inflation has surged in the past year is good evidence that money demand is already declining: people are trying to get rid of unwanted money by spending it, and that is what is driving higher inflation.
Chart #5
Real GDP grew by a very healthy 5.5% in 2021, but 85% of that growth came from inventory rebuilding—so we are very unlikely to see another such number. The general price level rose by 5.9%, which means that nominal GDP grew by a whopping 11.7%, which is not surprising since the M2 money supply rose by 13.1%. As Chart #5 shows, both M2 and nominal GDP have a strong tendency to grow by about the same rate over longer periods. When they diverge from this trend it’s due to a change in the public’s desire for money balances. Referring back to Chart #4, we see that money demand grew by about 1.6% last year, but most of that increase happened in Q1/21 when Covid uncertainty was still raging. Money demand has been steady for the past 9 months. If M2 continues to grow at a 13% annual rate, as it has for the past year, then nominal GDP growth is very likely to continue grow at double-digit rates. And since the economy is very unlikely to sustain a 5% growth rate for much longer, inflation is going to be at least 7-10% for as long as M2 growth remains at current levels. 
An important note: it is going to be many months before the Fed adopts policies (e.g., draining reserves and lifting the Fed funds rate to a level at least equal to inflation) that will slow the growth of money by increasing the public’s desire to hold money. Banks have been the source of the explosion in M2 growth, and the only thing that will change this for the better are policies designed to make holding money more attractive; banks need to be less willing to lend to the public and the public needs to be less willing to borrow. Much higher short-term interest rates are thus the cure for our inflation blues. But we won’t be seeing them for a long time.
Chart #6
Chart #6 shows how increases in housing prices tend to lead inflation by about 18 months. Housing prices have been rising at a 15-20% annual rate for the past year or so, and that is very likely to add substantially to consumer price inflation for at least the next year. Owner’s equivalent rent comprises about 25% of the CPI.
Chart #7
Chart #7 compares the real yield on the Fed funds rate (blue line) to the slope of the Treasury yield curve (red line). Note that every recession (gray bars), with the exception of the last one, has been preceded by a significant increase in real yields and a flattening or inversion of the yield curve. Both of those conditions are highly indicative of “tight money.” We won’t see anything like that until at least next year, given the Fed’s obvious desire to avoid shocking the bond market and/or risking another recession.

Chart #8
Chart #8 compares the growth of nominal GDP (blue line) with two different long-term trend lines. (Note that the chart uses a semi-log y-axis, which shows constant rates of growth as straight lines.) The economy grew by 3.1% per year[ on average from 1966 through 2007. Since 2009, it has grown by about 2.1% on average. Unless policies become more growth friendly, we are thus unlikely to see GDP exceed 2% on a sustained basis. That again highlights the fact that 13% M2 growth, if it continues, will likely result in sustained inflation of 10% or more this year.  
All eyes should be glued to the growth of M2, which is released around the end of the third week of every month.
Chart #9

Chart #9 compares the growth of the personal consumption deflators for services and durable goods. Of interest is the explosive growth in durable goods prices. 

Chart #10

Chart #10 shows the behavior of the three main components of the PCE deflator since 1995. I chose that date because it marks the debut of China as a major source of cheap durable goods for the world. As the chart shows, all prices are now on the rise, with durables leading the way after decades of falling, and services prices (which are strongly correlated to wage and salary growth) now beginning to accelerate. 
This is the very definition of true inflation: when nearly all prices rise, not just a few.
Chart #11
Chart #12

Finally, Charts #11 and #12 recap the status of swap and credit spreads. They tell us that liquidity is abundant nearly everywhere, and that the outlook for corporate profits is healthy. We are very unlikely to be on the cusp of another recession. That’s the good news.
The bad news is that sustained inflation of 7-10% will cause significant problems in the months and years to come. Inflation will be a boon to federal government finances, but it will be the bane of the rest of the economy, because inflation is essentially a hidden tax that all holders of money end up paying the government. Over time that will work to sap the economy of its energy, resulting in slower economic growth. 

inflation
monetary
policy
money supply
interest rates
fed
monetary policy

Continue Reading

Economics

A Market Green Light or No?

Was “selling the rumor” responsible for the recent weakness? … how are traders sizing up Wednesday’s Fed release? … what’s important in today’s…

Was “selling the rumor” responsible for the recent weakness? … how are traders sizing up Wednesday’s Fed release? … what’s important in today’s market

Wall Street traders often front-run major events that are likely to move the markets.

It’s the old adage of “buy the rumor, sell the news” (though in reverse).

Is that what’s been happening with the market weakness over the last few weeks? Have traders been bailing on stocks based on the rumor of what the Fed will do, preparing to buy back stocks after the fact?

Our technical experts, John Jagerson and Wade Hansen of Strategic Trader believe that’s what’s been happening.

From their Wednesday update:

Traders like to be ahead of the curve by both buying before the news is confirmed and then taking their profits off the table once the news is official.

The opposite phenomenon frequently occurs as well; traders sell their stocks before the news is confirmed and then buy back into their previous positions once the news is official.

While there isn’t an old saying that goes, “Sell the rumor; buy the news,” we think that is what has been happening in the stock market.

Traders have been worried for the past two weeks that the Federal Open Market Committee (FOMC) might signal the following things in today’s Monetary Policy statement:

  • More than four rate hikes this year…
  • An individual rate hike larger than a 0.25%…
  • An accelerated tapering of its bond-purchase program…
  • And a dramatic reduction of its $9-trillion balance sheet this year.

This worry has caused traders to sell into the rumor… or the worry, in this case.

As you know, the Federal Reserve released its policy statement on Wednesday.

How did it impact these fears? And what does that mean for a market rebound?

Let’s find out.

***Is Wall Street “buying” the news now?

For newer readers, John and Wade are the analysts behind Strategic Trader. This premier trading service combines options, insightful technical and fundamental analysis, and market history to trade the markets, whether they’re up, down, or sideways.

In their Wednesday update, they dove into the details of the Fed’s policy statement. They identified language that speaks directly to the fears that have been weighing on Wall Street traders.

From the update:

The FOMC just released its statement, and here’s what it said:

  • It will likely start raising rates in March.
  • “With inflation well above 2 percent and a strong labor market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate.”
  • It is not planning on more than four rate hikes in 2022, but it’s not taking the option off the table.
  • “In assessing the appropriate stance of monetary policy, the Committee will continue to monitor the implications of incoming information for the economic outlook. The Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee’s goals.”
  • It will be accelerating its tapering… slightly.
  • “The Committee decided to continue to reduce the monthly pace of its net asset purchases, bringing them to an end in early March.”
  • It has no plans to start dramatically reducing its balance sheet.
  • “The Federal Reserve’s ongoing purchases and holdings of securities will continue to foster smooth market functioning and accommodative financial conditions, thereby supporting the flow of credit to households and businesses.”

John and Wade sum up by saying they believe that this statement should ease Wall Street’s worries.

Now, that doesn’t automatically mean these traders will push stocks higher. Rather, it just removes this overhang from the market. But traders are still highly sensitive to economic data and earnings.

***On that note, we’re beginning to see a pattern of Wall Street shrugging off strong earnings, focusing on weaker guidance

Take Tesla.

On Wednesday, this market darling reported strong fourth-quarter results that included a record number of vehicle deliveries.

Adjusted earnings came in at $2.52 per share versus the forecast of $2.36 per share. Revenue rose 65% year over year in the quarter, while automotive revenue totaled $15.97 billion, up 71%.

Great quarter, right? Deserving of a nice pop in the share price?

Nope. Wall Street decided to focus on the potential for problems in the months ahead.

Tesla sold off 5% after hours on Wednesday. And the pressure continued yesterday, with the stock ending the day down 12%.

Here’s CityIndex explaining why:

Tesla warned its ability to meet its ambitious target to grow deliveries this year will depend on the availability of equipment, maintaining operational efficiency and ‘stability in the supply chain’.

It is that last factor that markets fear the most.

Tesla has so far proved to be far more resilient to the supply constraints hampering the global automotive market compared to its rivals, but the company is not immune and warned supply chain issues are ‘likely to continue through 2022’.

***It was similar with Netflix’s earnings last week

The streaming giant beat on its bottom line and was in-line with revenue expectations. But shares plummeted in after-hours trading based on fears of slowing subscriber growth.

From The New York Times:

Netflix added 8.3 million subscribers in the fourth quarter, raising its worldwide subscriber base to 222 million, but the company said on Thursday that it expected growth to slow in the opening months of 2022.

That news, in the company’s earnings release, prompted the stock to drop nearly 20 percent in after-hours trading.

Netflix ended up falling more than 30% over ensuing trading sessions and remains down 26% as I write.

Chart showing NFLX still down 26% after last week's selloffSource: StockCharts.com

Now, compare Tesla and Netflix to Apple, which released earnings yesterday after the bell.

The world’s most valuable company smashed its revenue record, also topping earnings of $30 billion for the first time.

Most importantly, CEO Tim Cook said that the supply chain challenges are improving. Though Apple hasn’t given formal guidance since the beginning of the pandemic, here were Cook’s comments:

What we expect for the March quarter is solid year-over-year revenue growth.

And we expect supply constraints in the March quarter to be less than they were in the December quarter.

Bottom-line, Apple’s growth story remains intact. So, its share price is benefitting, up 6% as I write.

This all points toward a reality of today’s market…

What matters now is growth.

Can a company continue to grow despite inflation, a rising rate environment, and the threat of a slowing economy?

If so, Wall Street will reward it. If not, watch out.

***Looking at growth on a macro level, we received encouraging GDP news yesterday

Gross Domestic Product grew at a 6.9% annualized pace in the fourth quarter. That’s much higher than the 5.5% estimate.

Plus, consumer spending, which makes up more than two-thirds of GDP, climbed 3.3% for the quarter.

So, there are positives here (despite today’s massive inflation number…but that’s no surprise anymore).

Just make sure any trade you’re considering is similarly rooted in fundamental strength – which means growth.

Returning to John and Wade, they believe some short-term bullish trades are setting up.

They’re not pulling the trigger yet. Instead, they’re giving the market a few more days to digest recent news. But they’re feeling cautiously bullish.

I’ll give them the final word:

What matters most is not whether the Fed will raise the overnight rate in March and then again in the second quarter – traders are already pricing that in. What is important is whether the underlying fundamentals are still positive…

We don’t want to fall into the trap of ignoring the bad news in favor of the good, which is why we are recommending patience before adding more risk to the portfolio.

However, it’s essential to be aware of the solid prospects the market still has in the near term to rally and provide easy profits.

So, for now, we don’t recommend making any changes to our trades. Still, we think the likelihood of new opportunities and some profitable exits over the next few days is high.

Have a good evening,

Jeff Remsburg

The post A Market Green Light or No? appeared first on InvestorPlace.


monetary




monetary policy

Author: Jeff Remsburg

Continue Reading

Economics

All The Curves, From Supply To Demand To Yield

Technically speaking, the rebound from the 2020 recession wasn’t strictly a supply shock. That was a huge part of it, no doubt, but a near-concurrent…

Technically speaking, the rebound from the 2020 recession wasn’t strictly a supply shock. That was a huge part of it, no doubt, but a near-concurrent demand shock, if you will, also materialized. The combination of the two left the public bewildered, believing it an actual inflationary impasse which could only be further passed on into this year.

Consumer prices did rise, of course, and they still are rising, though not because of (monetary) inflation. Rather, the first half of 2021 was an anomaly rather easily explained by simple, small “e” economics.

The first part of it, supply, that was all the impediments imposed by both non-economic (lockdowns, reconfiguring product lines) and economic (money and credit) factors which left the supply curve far more inelastic. This simply means suppliers and producers (along with shippers) are less responsive to changes in demand.

Sketching supply inelasticity out like any middle-schooler might upon their very first introduction to economics, the basics of it would look something like this:

It must be noted that these changes were applied globally and not just to or in the United States. Various national parts of the global economy were affected by them differently and to different degrees, by and large this was a universal phenomenon.

What then followed the evolution of supply inelasticity was the demand “shock” in the form of various government interventions; again, not just domestic US, all over the world. Those originating from the American government were the most pronounced, therefore created the biggest bounce to the right for the demand curve. Others followed to lesser extents.

The combined result is somewhat surprising considering how much the economy has been described, repeatedly, especially in America, as red hot and dangerously overheating. On the contrary, supply inelasticity means that most of the effect is illusory in terms of price whereas overall output doesn’t necessarily increase much at all.

Though these drawings are admittedly cartoonish, they aren’t very far off the actual data. Look at GDP or Industrial Production all over the world. Prices went up, especially here, but output not so much.

This has been excused as difficulties sourcing raw materials and whatnot, but that’s baked right into the inelasticity of the supply curve! And while others blame a purported labor shortage, it’s far more easily and readily explained by producers who aren’t producing nearly as much therefore aren’t as willing to pay market clearing wages (or even hire more workers).

Either way, as the supply curve shifts back more elastic, prices begin to come down as output actually rises…only if all things are equal (ceteris paribus). We know, however, they are not equal.

Even as the supply side twists slowly back toward its long run stable state, unless there’s (actual) monetary expansion behind the demand shift, demand won’t stay toward the right, either. Instead, it’s going to migrate back to the left toward its own long run stable state.

Depending upon other factors, output might rise again but much more slowly or in more limited fashion than it otherwise could have, all the while prices descend in the direction of their own starting equilibrium (assuming there is such a thing, or that there is one which could be stable).

Viola, there’s yesterday’s generally ugly GDP figures along with the PCE numbers (monthly) published today. The general supply curve is becoming less elastic (pumping out massive inventory into the supply chain) while the effect of the previous government interventions (including Uncle Sam) fade further and further into the past.

Prices haven’t yet backed off, though they have started to exhibit the general tendency toward deceleration (not all at once, therefore three camel humps that I’m told can’t describe a camel at all). In some places, though, we’re seeing perhaps the beginning stages of outright reversion (like China’s producer prices or US services prices).

The biggest macro problem is that the private economy’s actual state is obscured underneath this “inflation.” Labor shortage, red hot, etc. Because the mainstream treats each and every outbreak of consumer price acceleration as the same thing, especially those times when it is due to something other than money (true inflation), it can only result in mass confusion.

In fact, at some point, the bottleneck of forced price increases actually inhibits the demand curve staying to the right; prices rise faster than the economy’s ability to maintain even the same levels of demand (because it’s not caused by monetary expansion). Thus, what we saw in yesterday’s GDP along with today’s Personal Income and particularly consumer spending:

Even though the labor market has likewise struggled to recover (consist with the low changes in output) despite the artificially-fueled spendy frenzy, incomes have been rising though nowhere near enough to absorb the equally artificial increase in the general price level.

As such, private economy labor falls further and further behind (fails to catch all the way back up) exacerbating the demand curve shift back left.

Economists (capital “E”), however, they all believe (without evidence, only regressions) such interventions as last year’s massive helicopters produce lasting effects – a more durable perhaps permanent move in the (aggregate) demand curve out to the right. Furthermore, after the extreme price changes last year, most (Larry Summers!) are more worried that the curve had been pushed too far to the right and will remain too far out that way.

This group now includes the FOMC whose members then add psychological hokum to their even more primitive curve graphics thereby manufacturing the hawkish double-taper, triple-maybe-quadruple rate hikes for 2022 all the while real markets reject all these things.

True economics, the lack of money impulse, and now more upon more data all bely these mainstream interpretations. It’s only a “growth scare” in the context of merely assuming those first, that Economists and central bankers employing standard DSGE assumptions have anything worthwhile to say about the situation.

Rather than “growth scare”, the actual situation appears to be nothing more than the other side of last year’s double anomalies. One supply. One demand. None monetary.




monetary expansion

Continue Reading

Trending