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June 17, 2013

"We won't know who's swimming naked until the tide goes out."

THE WEEK IN REVIEW...

Emerging economies:

• A little liquidity goes a wrong way: It took only a few words by the Bank of Japan (BoJ) and the US Federal Reserve (Fed) about the end of easy money, and emerging market bond and stock markets got sideswiped. Both investment-grade and other markets felt the pressure, as thinly-traded markets amplified the damage. Kaushik Basu, chief economist of the World Bank, sounded unconcerned, saying he didn't think the trauma "...will last for too long",¹ once markets adjust to the understanding that limitless liquidity won't last forever.

US:

• Even small businesses are cheering up. June's optimism index from the National Federation of Independent Business (NFIB) came in at 94.4, well above expectations and the highest in 12 months – though still below its long-term average. Subcomponents improving the most: expectations of economic improvement and real sales increases, and "now a good time to expand". Best signs that companies are willing to bet on their own optimism: rises in "current inventory" and "plans to increase inventory".
• Oil: US crude production rose by over 1 mn barrels a day in 2012, the largest increase (14%) in US history and the year's largest increase in the world, counterbalancing political strife and maturing oil fields in countries including Nigeria and Venezuela.

Asia:

• China: Oil and troubled waters. Among the major shifts in supply and demand for oil in 2013 is China's decreasing need for fuel as its economy slows. The International Energy Agency reported "...mounting signs that China's oil use, like its economy, may have shifted to a lower gear."² The World Bank seems to agree, cutting its growth forecast for this year to 7.7% from 8.4%, citing, among other factors, that Chinese household debt is between two and three times higher than before the 1997 Asian financial crisis.
• Japan: Timing is everything. Growth in 1Q2012 beat initial estimates, coming in at an annualized 4.1% rate, providing a temporary respite to the equity market rout which started in late May. Equity, bond and currency markets have been highly sensitive to policy pronouncements in recent weeks, with the BoJ announcement of a pause in monetary easing echoing both throughout Asia and in emerging markets worldwide.

Europe:

• On trial: The European Central Bank (ECB) presented the keystone policies of its 2012 rescue of the euro to review by Germany's Federal Constitutional Court in Karlsruhe, with German central bank president Wiedmann and ECB executive board member Joerg Asmussen representing the two sides. The central issue: the legality of the ECB's acceptance of financing from the German government. While some may consider the issue moot given the success of the ECB's untested promise to do "whatever it takes" to preserve the euro, the case seems likely to rattle around the European legal system for years to come.
• Bonds and economies: Italy's industrial production fell 0.3% in April after falling 0.9% in March, with GDP³ still in decline. Bond yields rose to the highest level since April, but still substantially below levels reached at the height of the crisis of 2012. Bond yields also rose in Spain and Germany against similar bleak economic news.

SIGNS OF THE TIMES:

Retail Sales in U.S. Increased More Than Forecast in May – Bloomberg

Inflation at 53-Year Low Belies U.S. Demand Vigor – Bloomberg

S&P revises U.S. credit outlook to 'stable' from negative – Reuters

U.K. Industrial Output Increased on Mining in April – Bloomberg

World Bank Forecasts Slower but Smoother Growth – New York Times

CHART OF THE WEEK:

A turn for the better—rising rates could mean an improving economy

Real 10-year US Treasury yield and the velocity of money, Mar 2003 – June 11, 2013

Source: Bloomberg. Past performance is not a guarantee of future results. The graph above is for illustrative purposes only and is not reflective of an actual investment. Real 10-year US Treasury yield is a measure of the yield adjusted for inflation. It is derived from the yield of 10-year US Treasury Inflation-Protected Securities (TIPS), issued by the US, and designed to track US inflation. Money Zero Maturity (MZM) is a measure of the liquid money supply within the economy; it represents currency in circulation and certain non-interest-bearing checking accounts, less time deposits, plus all money market funds. MZM velocity is calculated by dividing nominal GDP by the level of MZM, and can be thought of as the rate of turnover in the money supply.

The bottom line:

• Rising inflation-adjusted interest rates in the US could be a sign of progress rather than a cause for concern.
• The key – looking for the reason behind the rate rise rather than the rise itself.
• One measure to watch for confirmation: the velocity of money in the US economy.

Context and perspective:

• Interest rates are a measure of the cost of money, which in turn reflects the demand for funds. And one important reason for increasing demand is the need to fund future growth. If the economy is bidding up interest rates, it could be a reflection of increasing business optimism.
• Another good sign: real, inflation-adjusted 10-year rates have recently turned away from the negative level of the past few months. If this continues, it could put to rest fears of a pernicious deflationary spiral.
• One place to look for confirmation: monetary velocity, which is the rate at which money turns over – the number of times each dollar is used to purchase the economy's goods and services – that is, its GDP
• If monetary velocity begins to rise, it might imply that banks are beginning to make more of their excess reserves available to borrowers for potentially productive economic pursuits.
• Other market/economic indicators could be confirming that today's rise in real yields reflects an improving growth outlook: a sharply lower gold price, higher stock prices, easier lending standards, steady (if unsatisfactory) jobs growth and a healthier housing market.
• The Fed appears to be looking at the same pattern: recent hints from some Fed officials that "tapering"—reducing the amount of assets it purchases in the market each month—could reflect central bank thinking that the underlying real economy is on a sounder footing.
• But it's important to approach this analysis with caution. An increase in velocity wouldn't mean that raging optimism would suddenly replace lingering pessimism. But it could be evidence that the economic recovery has become sustainable.
• If so, a period of adjustment for markets, interest rates and economic expectations could be ahead, which could also lead to higher volatility – and increased opportunity for investors.

The graph:

• The chart shows the level of real 10-year interest rates, as measured by the 10-year TIPS yield and the pace of monetary velocity on a quarterly basis over the past decade.
• Both have been in general decline since the recession began in 2007, but real interest rates have increased sharply in recent weeks from -76 basis points on April 5th to +6 basis points on June 12th.
• The spike in real yields that occurred in 2008 was driven by deflation fears that have since subsided.
• Monetary velocity increased briefly from late 2009 into 2010 as nominal GDP accelerated, but rolled over as nominal GDP slowed in subsequent quarters.
• The latest reading of 1.4 means that the dollar value of nominal GDP is 1.4 times the level of MZM (Money Zero Maturity) money supply. Stated another way, each available dollar is changing hands in an economically productive transaction at a rate of 1.4 times per year.
• The latest available data for monetary velocity is as of March 31, 2013; observers will have to wait until July to see if velocity reflects improvement.

...AND THE WEEK AHEAD:

GLOBAL ECONOMIC CALENDAR: June 16 – June 22

Sources: Bloomberg, Wall Street Journal, The New York Times, Financial Times, Reuters, US Dep't of Labor Bureau of Economic Analysis, US Federal Reserve, Market News International

¹ Market News International, June 13, 2013.

² Quoted by Bloomberg, June 12 2013.

³ Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.

⁴ The Treasury International Capital system (TIC) is a US Treasury Dep't program which keeps track of flows of funds between the US and other countries.

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