The Vampire Strikes Back
Friday was a relatively quiet day. Indeed, equity volumes dropped one-third from Thursday’s volume and back to what would have been considered for most of this year a very busy day but not catastrophe-like volume. Overnight into Friday, the S&P traded as much as 22 points lower before recovering; once the New York session opened, stocks traded in a comparatively sedate 19-point range on the S&P. Bonds rallied to finish out the week. The nominal 10-year yield fell 8bps to 2.26% while the 10-year TIPS rate fell 6bps to -0.02%. Commodities were roughly unchanged, along with the dollar.
That is not to say there wasn’t news, but traders just seemed unwilling to make large incremental position changes right before the weekend. Retail Sales for July was slightly stronger-than-expected at +0.5% and +0.5% ex-auto; there was also a small upward revision to June’s number. More dramatic was the swoon in Michigan Sentiment to 54.9 versus expectations for 62.0. Remember, this isn’t a series that spans 0-100 with a breakeven at 50. This is a series where 54.9 represents the lowest figure seen since Jimmy Carter – lower, even, than at the absolute nadir of the 2008 credit crisis (see Chart).
This number is subject to a revision later in the month, but as it stands now only two months in April and May 1980 recorded lower readings. What happened then? Well, in late April 1980 eight U.S. soldiers were killed in a mid-air collision during an aborted commando mission to rescue the American hostages in Iran. In May, Mount St. Helens erupted. Headline inflation had crested at 14.8% in March, but we didn’t know that yet. The Unemployment Rate rose in April 1980 to 6.9% from 6.3%, and then leapt again to 7.5% in May as 1980Q2 clocked a GDP of -7.9% annualized. It certainly seemed like the American century was ending prematurely.
I report those things for context, not for comparison. This level of consumer upset is incredible, and associated with quite literally some of the worst of times of the last forty years. In a sense, that should be encouraging, except for the fact that there are so many shoes which are yet to drop and almost assured of doing so: the European crisis is almost surely going to get worse before it gets better, equities remain generously priced, and inflation is low but unlikely to stay there. On the plus side, I’d like to believe that our politicians have started to notice that Americans want their government to live within its means, and that the deficit committee will generate real reform that shows other nations the way forward. I am skeptical of that possibility, but in 1980 almost everyone was also skeptical about almost everything. At some point, as bad as things are, something good will happen despite us and the vicious cycle will reverse – unless Americans are so beaten-down that they no longer can harness the optimism that has historically been their birthright. That wasn’t true in 1980, however, and I don’t think it’s true yet in 2011. After all, look where equities are priced with an entire continent ready to implode!
Also on Friday, Minnesota Fed President Kocherlakota issued a statement about his reason for dissenting at Tuesday’s FOMC meeting (so much for the blackout period, eh?). What is interesting about the statement (other than the fact that the statement was made at all) is this snippet:
In its August 9 meeting, the Committee changed this “extended period” language to say instead that it “currently anticipates economic conditions … are likely to warrant extraordinarily low levels of the federal funds rate through mid-2013.” This statement is designed to let the public know that the fed funds rate is likely to stay between 0 and 25 basis points over the next two years, not just over the next three to six months. Hence, the new language is intended to provide more monetary accommodation than before.
I don’t much care why Kocherlakota thought that much accommodation wasn’t warranted. I can do my own economic analysis and I could care less what the Fed thinks is the likely course of growth and inflation. They have, after all, been almost perfectly wrong for a very long period of time. What I care about is the great precision with which President Kocherlakota describes the new Fed policy. There is no wiggle room here about “extraordinarily low” meaning anything below, say, 1%. Extraordinarily low means, according to Kocherlakota, 0%-0.25%, period. He does still say “likely,” and we’re left with the conflict between the precise dating (two years – actually the FOMC said “at least” two years) and the hedge-word “likely.” But at least one Fed official viewed the FOMC statement as being pretty close to a promise to keep rates low.
And, as M2 surges, this could well present a problem. Now, in 2008-09 money supply expanded dramatically as the Fed pumped everything they could into the system. They did that because they anticipated – as we all did – that a sharp drop in leverage would parallel a decline in money velocity, necessitating a rise in money to offset it lest nominal output collapse (because MV=PQ). Indeed, had leverage really collapsed as much as many of us expected it to, the amount of money needed would have been vastly more. In the event, the leverage of domestic financial institutions really didn’t decline too much (and it took a while) and household debt not at all, so it worked out.
But in the current circumstance, money supply is surging without the disaster having hit. So we wait, and if there is a collapse in confidence sufficient to halt spending, or a sovereign default, or a major bank collapse, then we will be glad that money is already gushing into the economy. But if not, there is nothing the Fed can do about it. They can drain all the excess reserves, or at least until short rates start to rise, but that is all. They are pledged not to hike rates!
There is another hopeful possibility, and that is that the jump in M2 is temporary. Back when it started at the end of June, I raised my eyebrows but expressed that hope. So far, it hasn’t been the case, but there is one marginally promising sign: while M2 has been surging, the quantity of excess reserves has not been declining. That is, this surge is not due, apparently, to the flushing of excess reserves into transactional money. The water is still all behind the dam, and that’s encouraging. Maybe it’s just rain leading to the flood, not a dam bursting. If the money is sloshing into M2 because it’s fleeing European banks (although European M2 is not declining), then it’s likely low-velocity money and might not go into prices.
My models don’t make such a fine distinction, but the analysts’ job is to look behind the model and attach the appropriate caveats. Right now, I think the risks of significantly higher inflation completely overwhelm the risks of lower inflation, but the biggest risk – that excess reserves would suddenly flush into M2 – appears not yet to have come to pass.
This is something to keep in mind this week as we have CPI being reported on Thursday (on Monday, Empire Manufacturing for August (Consensus: 0.00 from -3.76) is the main release). Markets will still react more to European events than they will to economic data, but CPI is one point that the bond market at least will pay attention to.
 On the plus side, both Pac-Man and The Empire Strikes Back were released that May. But those took a few months to turn the mood in the country around.