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Swiss Jeez

January 21, 2015 2 comments

The focus over the last few days has clearly been central bank follies. In just the last week:

  1. The Swiss National Bank (SNB) abruptly stopped trying to hold down the Swiss Franc from rising against the Euro; the currency immediately rose 20% against the continental currency (see chart, source Bloomberg). More on this below.

chfeur

  1. The ECB, widely expected to announce the beginnings of QE tomorrow (Jan 22nd), have quietly mooted about the notion of buying approximately €600bln per year, focused on sovereign bonds, and lasting for a minimum of one year. This is greater than most analysts had been expecting, and somewhat open-ended to boot.
  2. The Bank of Canada announced today a surprise cut in interest rates, because of the decline in oil prices. Unlike the U.S., which would see an oil decline as stimulative and therefore something the central bank would be more inclined to lean against, Canada’s exports are significantly more concentrated in oil so they will tend to respond more directly to disinflation caused by oil prices. This explains the very high correlation between oil prices and the Canadian Dollar (see chart below, source Bloomberg).

cadusd

Back to the SNB: the 20% spike in the currency provoked an immediate 14% plunge in the Swiss Market Index, and after a few days of volatility the market there is still flirting with those spike lows. The Swiss economy will shortly be back in deflation; the SNB’s addition of vast amounts of Swiss Francs to the monetary system had in recent months caused core inflation in Switzerland to reach the highest levels since 2011: 0.3% (see chart, source Bloomberg).

swisscpi

The good news for Europe, of course, is that the reversal will cause a small amount of inflation in the Eurozone – although probably not enough to notice, at least the sign is right.

Clearly the SNB had identified that trying to keep the Swissy weak while the ECB was about to add hundreds of billions of Euro to the system was a losing battle. In the long history of central bank FX price controls, we see failures more often than successes, especially when the exchange-rate control is trying to repress a natural trend.

But the point of my article today is not to discuss the SNB move nor the effect of it on local or global inflation. The point of my article is to highlight the fact that the sudden movement in the market has caused several currency brokers (including FXCM, Alpari Ltd., and Global Brokers NZ Ltd.)  to declare insolvency and at least two hedge funds, COMAC Global Macro Fund and Everest Capital’s Global Fund, to close. More to the point, I want to highlight that fact and ask: what in God’s name were they doing?

Let’s review. In order to lose a lot of money in this trade, you need to be short the Swiss Franc against the Euro. Let’s analyze the potential risks and rewards of this trade. The good news is that the SNB is going your way, adding billions of Swissy to the market. The bad news is that if they win, it is likely to be a begrudging movement in the market – the underlying fundamentals, after all, were heavily the other direction which is why the SNB was forced to intervene – and if they lose, as they ultimately did, it is almost certainly going to be a sudden snap in the other direction since the only major seller of Swiss was exiting. Folks, this is like when a commodity market goes limit-bid, because everyone wants to buy at the market’s maximum allowable move and no one wants to sell. When that market is opened for trading again, it is very likely to continue to move in that direction hard. See the chart below (source: Bloomberg) of one of my favorite examples, the early-1993 rally in Lumber futures after a very strong housing number. The market was limit-up for weeks, most of the time without trading. If you were short, you were carried out.

lumber

Of course, there was at least a rationale for being short lumber in early 1993. No one knew that there was about to be a huge housing number. There’s very little rationale to being short Swiss Francs here that I can fathom. This is a classic short-options trade. If you win, you make a tiny amount. If you lose, then you blow up. If you do that with a tiny amount of money, and make lots of small bets that are not only uncorrelated but will be uncorrelated in a crisis (it is unclear how one does this), then it can be a reasonable strategy. But how this is a smart strategy in this case escapes me. And as a broker, I would not allow my margining system to take the incredibly low volatility in the Euro/Swiss cross as a sign that even lower margins are appropriate. VaR here is obviously useless because the distribution of possible returns is not even remotely normal. Again, as a broker I am short options: I might make a tiny amount from customer trading or carry on their cash positions; or I might be left holding the bag when the margin balances held by customers prove to be too little and they walk away.

And I suppose the bottom line is this: you cannot know for certain that your broker or hedge fund manager is being wise about this sort of thing. But you sure as heck need to ask.

What Risk-Parity Paring Could Mean for Equities

October 9, 2014 14 comments

The stock market, the bond market, the commodities markets (to a lesser extent), FX markets – they are all experiencing a marked increase in volatility.

Some observers want to call this bearish for equities, mainly because they already are bearish. This is a very bad reason. While really bad equity returns almost always occur coincident with a rise in volatility – the old maxim is that stocks go ‘up on the staircase and down on the escalator’ – that does not mean that volatility causes bad returns. Or, put another way, there are also periods of increased volatility that do not precede and are not coincident with bad returns.

However, there actually is a reason that increased volatility might lead to poor short- to medium-term returns, that isn’t based on technical analysis or spurious correlations. Moreover, a relatively new phenomenon (the rise of so-called ‘risk-parity’ strategies) is starting to institutionalize what was already a somewhat natural response to volatility.

In ‘risk-parity’ strategies, the weight of an asset class (or a security within an asset class, sometimes) is inversely proportional to the risk it adds to the portfolio. Generally speaking, “risk” here is defined as variance, because it is easy to estimate and there are markets where symmetrical variance trades – i.e., options markets. But what this means is that when volatility (sometimes realized volatility, and sometimes option “implied” volatility) rises in stocks, then risk parity strategies tend to be shedding equities because they look riskier, and vice-versa. Right now, risk parity strategies are likely to be overweight equities because of the long period of low realized and implied volatility (even though the valuation measures imply quite high risk in the sense most of us mean it, in terms of the probability of return shortfall). Risk parity strategies are probably superior to ‘return-chasing’ methodologies, but by being ‘risk-chasing’ they end up doing something fairly similar when they are all operating together.

Note that while risk-parity strategies are comparatively new – well, not exactly because it is an oldish idea, but they have only recently become a big fad – this general phenomenon is not. The natural response to greater equity market volatility is to pare back exposure; when your broker statement starts to swing around wildly it makes you nervous and so you may start to take some profits. This is also true of other asset classes but it seems to me to be especially true in equities. Nobody who gets involved in commodities is surprised at volatility: the asset class suffers from a midguided belief that it is terribly volatile even though commodity indices are just about exactly as volatile as equity indices over time. But equity investors, contrariwise, seem perennially surprised at 2% moves.

So, while the recent volatility doesn’t mean that a move lower in equities is assured, it increases the probability of such because risk-parity strategies (and other investors reacting nervously to overweights in their equity exposure) will begin to scale back positions in the asset class in favor of positions in other asset classes, probably mostly bonds and commodities. At this point it would be good for me to point out that only the very short-term volatility measures have moved up dramatically; the VIX is well off its bottom but only up to 18.8 and it has been there numerous times in the last few years (see chart, source Bloomberg). But the longer the volatility continues like we have seen it for the last week or two, the bigger the chances that the asset-allocation boxes start to make important shifts (and the quant hedge fund boxes will probably move a bit before those asset allocation boxes do).

vix

As an aside, the tendency for asset allocation shifts to follow volatility shifts is not the reason that the VIX displays a strong inverse directionality. Neither is the main reason for this inverse directionality because the VIX is a “fear gauge.” The main reason is that the VIX weights near-the-money options more heavily than out-of-the-money options. Because options skews almost always imply more downside volatility for stocks than upside volatility[1], when the market declines it tends to bring more “high volatility” strikes into play and so part of the VIX increase in a down market is simply mechanical.

I am not calling for a sharp decline in stocks, nor for an extended decline in stocks. My position and view is as it has long been, that the prospect for attractive real returns from equities over the next 5-10 years is quite small and beaten handily by commodities’ prospective returns at that end of the risk spectrum. I don’t think that most investors (me included!) should swing asset allocations around frequently in response to technical indicators or such things as “momentum”, but rather should focus on evaluating expected long-term returns (which are somewhat predictable) and invest for value. And I must admit I also think that “risk-parity” is a clever marketing gimmick but a pretty absurd way to assemble a portfolio for almost everyone. My point here is to highlight one little-considered aspect of herd behavior, and how that herd behavior may have become more institutionalized as late, and to consider the risks that herd behavior may create.

[1] This in turn is not due so much from the tendency of markets to have more downside volatility than upside volatility, but from the fact that buying protective puts and selling “covered” calls are both considered “conservative” options strategies. So, out-of-the-money puts tend to be too expensive and out-of-the-money calls too rich.

Why So Many Inflation Market Haters All of a Sudden?

September 25, 2014 6 comments

The inflation market offers such wonderful opportunities for profit since so few people understand the dynamics of inflation, much less of the inflation market.

One of the things which continually fascinates me is how the inflation trade has become sort of a “risk on” kind of trade, in that when the market is pricing in better growth expectations, reflected in rising equity prices, inflation expectations move with the same rhythm.[1] The chart below (source: Bloomberg) shows the 10-year inflation breakeven rate versus the S&P 500 index. Note how closely they ebb and flow together, at least until the latest swoon in inflation expectations.

beistocks

Your knee-jerk reaction might be that this is a spurious correlation caused by the fact that (a) bond yields tend to rise when growth expectations rise and (b) when bond yields rise, the components of bond yields – including both real rates and expected inflation – tend to rise. But look at the chart below (source: Bloomberg), covering the same period but this time charting stocks versus real yields.

realplusspx

If anything, real yields ought to be more correlated to movements in equities than inflation expectations, since presumably real economic growth is directly related to the real growth rates embedded in equity prices. But to my eyes at least, the correlation between real interest rates and equity prices, for which there is a plausible causal explanation, doesn’t look nearly as good as the relationship between stocks and inflation expectations.

It doesn’t make any sense that long-term inflation expectations should be so closely related to equity prices. I know I have mentioned before – in fact, regular readers are probably sick of me pointing it out – that there is no causal relationship between growth and inflation. Really, it is worse than that: one really needs to torture the data to find any connection at all, causal or not. The chart below (source: Bloomberg) shows quarterly real GDP in yellow against core inflation in white.

coreandgdptimeseries

I’ve pointed out before that the big recession in ’08-09 saw almost no deceleration in core inflation (and none at all if you remove housing from core inflation), but it’s hard to find a connection anywhere. The next chart (source: Bloomberg) makes the point a different way, simply plotting core inflation (y-axis) against real GDP (x-axis) quarterly back to 1980.

gdpcoreinflationregression

In case anyone out there is protesting that there should be a lagged relationship between growth and inflation, I am happy to report that I was able to get an r-squared as higher as 0.257 with a lag of 12 quarters. Unfortunately, the lag goes the wrong way: high inflation precedes high growth, not vice-versa. And I don’t know anyone who proffers a reasonable explanation of a causality running in that direction. Lags the other way fail to produce any r-squared over 0.1.

So, how to explain the fact that since the end of August we have seen 10-year real rates rise 29 basis points while 10-year breakevens were falling 12bps (producing a net rise in nominal rates of only 17bps)? The explanation is simple: the market is wrong to treat breakevens as a “risk on/risk off” sort of trade. Breakevens have cheapened far too much. I don’t know if that means that TIPS yields have risen too much, or nominal yields have risen too little (I rather expect the former), but the difference is too narrow. The short end of the US curve (1 year inflation swaps are at 1.44%) implies either that core inflation will decline markedly from its already-depressed level well below median inflation, or that energy prices will decline sharply and much further than implied by gasoline futures.

I think that one of the reasons US inflation has been under pressure is that it is currently at a very large spread versus European inflation, and earlier this month it was at the highest level in at least a decade (see chart, source Enduring Investments).

USCPIHICPxt

This may look like an appealing short, perhaps, but based on our internal analysis and some historical relationships we track we actually believe the spread is too low by about 50bps. And think about it this way: if Europe really is in the process of inheriting Japan’s lost decade, then 10-year expectations for the US ought to be much, much higher than in Europe. I don’t really think Europe will end up there, because the ECB seems to be trying to do the right thing, but it is not unreasonable to think that there should be a hefty premium to US inflation over Europe.

[1] Of course, the correlation of levels won’t be very good because stocks have an upward bias over time while inflation expectations do not. To run the correlation, you’d have to de-trend stocks but I’m trying to make a visceral point here rather than a quantitative one.

Setting Up For a CPI Surprise?

Heading into the CPI print tomorrow, the market is firmly in “we don’t believe it” mode. Since the CPI report last month – which showed a third straight month of a surprising and surprisingly-broad uptick in prices – commodity prices are actually down 4% (basis the Bloomberg Commodity Index, formerly known as the DJ-UBS Commodity Index). Ten-year breakeven inflation is up 1-2bps since then, but there is still scant sign of alarm in global markets about the chances that the inflation upswing has arrived.

Essentially, no one believes that inflation is about to take root. Few people believe that inflation can take root. Indeed, our measure of inflation angst is near all-time lows (see chart, source Enduring Investments).

inflangst

…which, of course, is exactly the reason you ought to be worried: because no one else is, and that’s precisely the time that often offers the most risk to being with the crowd, and the most reward from bucking it. And, with 10-year breakevens around 2.22%, the cost of protecting against that risk is quite low.

I suspect that one reason some investors are less concerned about this month’s CPI is that some short-term indicators are indicating that a correction in prices may be due. For example, the Billion Prices Project (which is now Price Stats, but still makes a daily series available at http://bpp.mit.edu/usa/) monthly inflation chart (shown below) suggests that inflation should retreat this month.

monthlybpp

However, hold your horses: the BPP is forecasting non-seasonally-adjusted headline CPI. The June seasonals do have the tendency to subtract a bit less than 0.1% from the seasonally-adjusted number, which means that it’s not a bad bet that the non-seasonally-adjusted figure will show a smaller rise from May to June than we saw April to May, or March to April. Moreover, the BPP and other short-term ‘nowcasts’ of headline inflation are partly ebbing due to the recent sogginess in gasoline prices, which are 10 cents lower (and unseasonally so) than they were a month ago.

But that does not inform on core inflation. The last three months’ prints of seasonally-adjusted core CPI have been 0.204%, 0.236%, and 0.258%, which is a 2.8% annualized pace for the last quarter…and accelerating. Moreover, as I have previously documented the breadth of the inflation uptick is something that is different from the last few times we have seen mild acceleration of inflation.

None of that means that monthly core CPI will continue to accelerate this month. The consensus forecast of 0.19% implies year/year core CPI will accelerate, but will still round to 2.0%. But remember that the Cleveland Fed’s Median CPI, to which core CPI should be converging as the sequester/Medical Care effect fades, is at 2.3% and rising. We should not be at all surprised with a second 0.3% increase tomorrow.

But, judging from markets, we would be.

This is not to say I am forecasting it, because forecasting one month’s CPI is like forecasting a random number generator, but I think the odds of 0.3% are considerably higher than 0.1%. I am on record as saying that core or median inflation will get to nearly 3% by year-end, and I remain in that camp.

Growling Dogs Sometimes Bite

I think it’s really interesting that suddenly, we are hearing from both hawks and doves on the Federal Reserve that the Fed is starting to worry whether some “complacency” has snuck into the market.

No kidding?

It is sort of a strange claim, since a really important part of QE and about how it was supposed to work was through the “portfolio balance channel.” In a nutshell, the idea of the portfolio balance channel is that if the Fed removes sufficient of the “safe” securities from the market, then people will be forced to buy riskier securities. Thus, the Fed was intentionally trying to substitute for animal spirits. And they were successful at it, which I illustrated in this post more than a year ago.  So now, the Fed is surprised that the riskier asset classes are getting very expensive?

It is sometimes hard to keep track of all of the Fed’s arguments, since they seem to shift as frequently as necessary to make them appear to be on the right side of the data. Honestly, it’s a little bit like the way politicians work the “spin” cycle. The portfolio balance channel was good, and a goal of policy; now it’s surprising. You need to take good notes to keep this stuff straight.

That being said, it is not usually a coincidence when three Fed officials use nearly the same words in consecutive speeches, particularly when those three Fed officials include both hawks (Fisher, George) and doves (Dudley). The difference here is that Fisher and George are probably making this argument because they’d like to see the Fed pull back on the reins a bit, while Dudley probably doesn’t intend to do anything about the fear of complacency other than talk about it.

What does this mean?

  1. I am not the only person who is worried about not being worried (see my article from Monday).
  2. At least some people at the Fed are concerned that they have gone too far. This isn’t really news; the only news would be if that’s starting to be a majority opinion.
  3. At least some people at the Fed think that policymakers should be trying to ‘talk down’ markets.

Why do I include the third point? Because, if the Fed really was planning to do anything about it, they would just do it. Talking about complacency might cause some people to decrease their risky-market bets, but putting Treasuries back on the street and taking in cash would force the de-risking to happen. Call it the portfolio “rebalance” channel. No doubt, there is plenty of fear at the Fed about the possibility that the complacency might break suddenly in a sloppy, discontinuous way, but there are a couple of decades of experience with the lack of success of FOMC “open mouth policy.” Does the phrase “irrational exuberance” mean anything to you? Did Greenspan’s utterance of that phrase in December 1996 affect in any way the trajectory of the over-complacent equity market? Nope.

Ironically, I think what really galls the Fed is that market measures of policy rate expectations over the next few years imply a lower trajectory than the Fed feels they have laid out as their road map. The Committee, it seems doesn’t mind surprising the market on the dovish side but is wary of surprising them on the hawkish side. I predict that, if the short end of the rates curve steepens just a little bit, Fed officials will stop worrying so much about “complacency” even if stocks continue to ramp up.

In any case, it is worth listening when the Fed starts talking with one voice. There are lots of other reasons to be the first person to shed complacency, but here is a new one: whether it’s a bona fide signal or just central banker bluster, there is a new tone coming from Fed speakers. Beware of dogs that growl; sometimes they bite.

Worried About Not Being Worried

June 2, 2014 4 comments

I am beginning to worry about my own complacency. As a person who has been a participant in the fixed-income markets for a long time, I have become quite naturally a very cautious investor. Such caution is a quintessentially fixed-income mindset (although you might not guess that from the way bond people behaved in the run-up to the global financial crisis) – as a bond investor, you are essentially in the position of someone who is short options: taking in small amounts on a regular basis, with an occasional large loss when the credit defaults. A bond investor can greatly improve his performance in the long run relative to an index by merely avoiding the blow-ups. Miss the Enron moment, and you pick up a lot of relative performance. (The same is true of equities, but there is much more upside to being an optimist. The stock market selects for optimists, the bond market for pessimists.)

This is a lesson that many high-yield investors today, chasing near-term carry, seem to have forgotten. But my purpose here isn’t to bash those involved in the global reach for yield. I am merely pointing out that this is how I tend to think. I am always looking for the next disaster that hangs a portfolio with a big negative number. As Prince Humperdinck said in The Princess Bride, “I always think everything could be a trap – which is why I’m still alive.”

And I am starting to worry about my own complacency. I don’t get the feeling that we’re gearing up for Round 2 of the global financial crisis. Something bad, perhaps, but not catastrophic.

To be sure, there are a large number of potential pitfalls facing investors today, and I think market volatilities underestimate their probabilities substantially. We are facing an inflection in policy from the ECB this week, with analysts expecting a substantial additional easing action (and it is overdue, with money growth in Europe down to a feeble 1.9% y/y, near the worst levels of the post-crisis period – see chart, source Bloomberg). Absent a major change in policy, liquidity on the continent is going to become increasingly dear with possible ramifications for the real economy as well as the asset economy.

EUM2

The Federal Reserve is facing a more-serious policy inflection point, with no agreement amongst FOMC members (as far as I can tell) about how to transition from the end of QE to the eventual tightening. I’ve pointed out before – while many Fed officials were whistling Dixie about how easy it would be to reverse policy – that there is no proven method for raising interest rates with the vast quantity of excess reserves sitting inert on bank balance sheets. Moreover, raising interest rates isn’t the key…restraining money growth is. The key point for markets is simply that there is no plan in place that removes these reserves, which means that interest rates are not likely to respond to Fed desires to see them rise. And, if the Fed uses a brute-force method of raising the interest paid on excess reserves, then rates may rise but we don’t know what will happen to the relative quantities of required and excess reserves (and it is the level of required reserves that actually matter for inflation). It is a thorny problem, and one which the markets aren’t giving enough credit regarding the difficulty thereof.

Valuation levels are high across the board (with the exception of commodity indices). They’re doubly high in stocks, with high multiples on earnings that are themselves high with respect to revenues. And yes, this concerns me. I expect more volatility ahead, and perhaps serious volatility. But the fact that I am just saying “perhaps,” when all of my experience and models say “there is no escape without some bad stuff happening,” means that I am being infected – relative to my usual caution – by the general complacency.

In other words, I am worried that I am not worried enough.

The interesting thing is that equity bulls said during the entire march higher that “it doesn’t matter what the fundamentals are, the Fed is pushing the market higher and spreads tighter.” I still don’t believe that was an inevitable outcome to the Fed’s QE, but the fact is that people believed it and they were correct: that was enough to keep the market going higher. I can’t be comfortable going along with the crowd in that circumstance, but in retrospect it would have been better to abandon the models, throw caution to the wind, and ride along with the fun. And perhaps this regret is one reason for my developing complacency.

But that way lies madness, since the problem is not the ride but the getting out when the ride is over. The Fed is no longer providing QE (or, in any event, QE will shortly end altogether). So what’s the excuse now? It seems to me that everyone is still riding on the fun train, and just watching carefully to see if anyone jumps off. I think the market rally is on very tenuous footing, because if faith in the market’s liquidity goes away, the value anchor is very far from these levels. Yet, part of me is skeptical that a market which hasn’t corrected in more than two years can actually return to those value anchors. I should know better, because the bond-market mindset reminds me that market gains are generally linear while market losses are discontinuous, sloppy, and non-linear. Especially, I ought to be thinking, when market liquidity is so poor thanks to the government’s assault on market makers over the last few years.

I keep wondering if there is one more pulse higher in stocks coming, one more decline in commodities before they begin to catch up with money growth and inflation, one more rally in bonds before they begin to discount a higher inflation path. And this is very possible, because while I worry about my own developing complacency most investors are not concerned about their own.

Complacency or no, insurance is cheap. The low current level of implied volatilities in almost every asset class makes portfolio protection worthwhile, even if it costs a bit of performance to acquire that protection.

Gravity

April 7, 2014 1 comment

Is there anything different about the current downturn in stocks, already two whole days old?

It is difficult to get terribly concerned about this latest setback when in one sense it is right on schedule. The modest down-swings have occurred at such regular intervals that the chart of the VIX looks quite a bit like an EKG (see chart, source Bloomberg).

vixekg

A rise in the VIX to the 19-21 zone happens approximately quarterly, with minor peaks at the same intervals. Eerie, ain’t it?

So is there anything particularly ominous about the current pullback? There is no clear catalyst – I am reading that the selloff is being “led” by tech shares, but the tech-heavy indices look to me as though they have fallen similarly (adjusted for the fact that they have higher vol to begin with. The S&P is down around 3%, and the NDX is down 4.6% over the same period. To be sure, the NDX’s recent peak wasn’t a new high for the year, and it has penetrated the 100-day moving average on the downside, but it doesn’t look unusual to me.

Nor do the economic data look very different to me. The Payrolls number on Friday was in line with expectations, and beat it comfortably when including the upward revisions to the prior two months. The generation of 200k new jobs is not exciting, but it is pretty standard for a normal expansion. My main concern had been that the “hours worked” figure in the employment report had plunged last month, but it rebounded this month and assuaged my concerns (although Q1 growth is probably still going to be low when it is reported later this month, it will be reasonably explained away by the weather).

Two things are different now from previous setbacks, but one is positive and one is negative. They are related, but one is somewhat bullish for the economy and the other is somewhat bearish for risky assets.

We will start with the negative, because it segues nicely into the positive. It is nothing new, of course, to point out that the Fed is tapering, and will be steadily continuing to taper over the next several meetings. Despite the well-orchestrated chorus of “tapering is not tightening,” such Fed action clearly is a “negative loosening” of policy – if you don’t want to call that tightening, then invent a new language, but in English it is tightening.

Now, I never want to short sell the notion that President Clinton taught us all, including market denizens, that if you say something ridiculous often enough, it comes to be regarded as the truth. At times, the market meme clearly has kept the market moving upward even though rational analysis argued for a different outcome. For example, in the early part of the equity bear market that started in 2000, the market meme was that this was a “corporate governance” crisis or a “tech selloff”, when in fact it was a broad-based and deep bear market. In the more-recent credit crisis, it started off as a “subprime” crisis even though it was clearly much more, from the beginning.

So I am loathe to bet about how long markets can run on air before the market meme falters. The challenge, obviously, is being able to distinguish between times when the market meme is correct; when the market meme is incorrect, but harmless; and when the market meme is incorrect, and obfuscating a deeper, more dangerous reality.

“Tapering is not tightening” is one of those thoughts that, while not as serious as “this is a corporate governance problem” or “this is about subprime,” is also clearly mistaken, and possibly dangerous. The reason it might actually be dangerous is because the effect of tightening doesn’t happen because people are thinking about it. Monetary policy doesn’t act primarily through the medium of confidence, any more than gravity does. And, just as gravity is still acting on those aboard the “Vomit Comet,” monetary tightening still acts to diminish liquidity (or, more precisely, the growth rate of liquidity) even when it appears to be doing nothing special at the moment.

The eventual effect of diminished liquidity is to push asset prices lower, and (ironically) also may be to push money velocity higher since velocity is correlated with interest rates.

Now, don’t be overly alarmed, because even as Fed liquidity provision is slowing down there is no sign that transactional money growth is about to slow. Indeed (and here is the positive difference), commercial bank credit has begun to rise again after remaining nearly static for approximately a year (see chart, source Enduring Investments). (As an aside, I corrected the pre-2010 part of this chart to reflect the effect of recategorizations of credit as of March 2010 that caused a jump in the official series).

cbc_mb

If you look carefully at this chart, by the way, you will see something curious. Notice that during QE2, as the monetary base rose commercial bank credit stagnated – and then began to rise as soon as the Fed stopped buying Treasuries. It rose steadily during late 2011 and for most of 2012. Then, commercial bank credit began to flatline as soon as the Fed began to buy Treasuries again (recall that QE3 started with mortgages for a few months before the Fed added Treasuries to the purchase order), and began to climb again at just about the same time that the taper began in December.

I don’t have any idea why these two series should be related in this way. I am unsure why expanding the monetary base would “crowd out” commercial bank credit in any way. Perhaps the Fed began QE because they forecast that commercial bank credit would flatline (in QE1, credit was obviously in decline), so the causality runs the other way…although that gives a lot of credit to forecasters who have not exhibited much ability to forecast anything else. But regardless of the reason, the fact that bank credit is expanding again – at an 8% annualized pace over the last quarter, the highest rate since 2008 – is positive for markets.

Of course, an expansion and/or a market rally built on an expansion of credit is not entirely healthy in itself, as to some extent it is borrowing from the future. But if credit can expand moderately, rather than rapidly, then the “gravity” of the situation might be somewhat less dire for markets. Yes, I still believe stocks are overvalued and have been avoiding them in preference to commodities (the DJ-UBS is 7.3% ahead in that race, this year), but we can all hope to avoid a repeat of recent calamities.

The problem with that cheerful conclusion is that it depends so much on the effective prosecution of monetary policy not just from the Federal Reserve but from other monetary policymakers around the world. I will have more to say on that, later this week.

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