Monetary Sedition

By: Michael Ashton | Mon, Apr 16, 2012
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Is it really necessary to have a canary in the coal mine when the mine is belching clouds of noxious smoke? Today's Empire Manufacturing Report surprised on the weak side by printing only 6.56 for April, the weakest number of the year so far although still well ahead of the lows from last year (see Chart, source Bloomberg).

Empire State Manufacturing

With most recent data being acceptable, albeit not robust, this early current-month data will worry some observers. It doesn't worry me very much, partly because the series clearly has some choppiness to it but more because I'm already fairly worried about how rapidly the European situation is unraveling again. I am generally towards the more-skeptical end of the spectrum, which tells me that it's probably true that most observers thought that surviving the cliffhanger over the Greek funding package bought us 3-6 months, if not a year, of relative calm. That includes both the Pollyannas who really thought the worst was over, and those of us who were confident that the last chapter had not been written by a bailout that added to the debt burden of Greece.

The first hint was that the new Greek bonds immediately started trading with yields to maturity of 18-20%, but it is still striking that the dogs were only put at bay for one solitary month.

Because now that Spanish yields are officially back above 6% in the 10-year sector and Spanish economic ministers are publicly pleading with the ECB to buy bonds to support the market, the blood is back in the water. On Friday (but not getting much play until the weekend) there was also a report that net borrowings by Spanish banks from the ECB rose 49% in March, and that Spanish banks represent about 29% of the long-term borrowings from the ECB to Euro-area banks. The "net" number, which recognizes that some of the money that banks borrowed in LTRO was immediately re-deposited with the ECB, indicates that Spanish banks account for 60% of that "net" lending.

Curiously, equity markets took only executive notice of the rising temperature in Spanish debt markets, with the US bourse closing unchanged measured by the S&P. Indices with more Apple exposure closed weaker, and indices with less Apple closed stronger, as the Nifty One stock continued the now-stomach-wrenching decline started last week (see Chart, Source: Bloomberg).


It should be noted that 26% of Apple's 2011 revenues, and about 21% of its growth in revenues from 2010 to 2011, came from Europe. I make no predictions about Apple's future trajectory, but I will note that I was stunned to find that revenue for Apple's hugely popular iPod line actually declined last year to a level last seen in 2005, when it was 40% of the company's revenues as opposed to 7% now (as the iPhone is 44% of revenues in 2011). I wonder aloud (without stating a conclusion) whether a high-teens multiple ought to be attributed to a company that needs to reinvent whole product lines every six years. I guess the market is asking the same question, as the P/E is now down to 16.5. (By contrast, Microsoft has an 11.5 multiple, and its revenues have been roughly 30% "Business Division," 30% "Windows Division," and 20-25% "Server and Tools" for quite a long time. And MSFT pays a higher dividend. Disclosure: I have no position in either stock).

The other topic that was distracting from Spain discussions was the sharp decline in gasoline futures. Front gasoline futures fell to $3.267/gallon. Retail gas is up around $3.91, but this is almost the lowest that gasoline futures have been since early April. Brent Crude dropped to the lowest level since February, although NYMEX Crude didn't decline very much. Some observers attributed these declines to agreement among the UN Security Council members (plus Germany) to go meet Iranian delegates in late May to talk about Iran's nuclear program, but the fact that Brent and Gasoline fell further than NYMEX Crude suggests the real reason is more likely the growth fears emanating from Europe.

Interestingly, inflation markets mostly ignored the decline in energy markets. I wonder if the relative buoyancy of TIPS lately has anything to do with the persistent elevation of money supply growth. I have been harping on the steady rise in the broad transactional aggregate for a while - for at least 36 weeks, in fact. That's how long that year-on-year M2 has been above 9.2%. To find a longer streak of such rapid money growth, you have to look back to 1983-84, when M2 rose at a 9.2%-or-faster pace for 56 consecutive weeks (see Chart, Source Federal Reserve).

M2 Rates of Change

There is some sign, at least, that there is starting to be some introspection around the Federal Reserve system about this money growth; perhaps rebellion is more like it. I pointed out on February 29th the article by St. Louis Fed economist Daniel L Thornton in which he said "While discussions of the money supply are nearly nonexistent in modern monetary theory and policy, both economic theory and historical experience suggest that a significant and persistent expansion in the money supply will be associated with a significant increase in the longer-run inflation rate." Today, on the Federal Reserve Bank of Atlanta's "macroblog," senior economist Mike Bryan introduced a new animated video the Fed has created (the ostensible reason for the blog entry) by citing Fisher's explanation of the difference between two types of inflation - one of which is purely monetary:

"If it can be shown, for instance, that today the good things of this world are becoming scarce on the one hand while money and its substitutes are not becoming plentiful it would be reasonable to conclude that the fault lies with goods and not with money. If, on the contrary, it can be shown that money and its substitutes are becoming plentiful and that goods are not becoming scarce, it is reasonable to conclude that the fault lies chiefly on the monetary side."

Clearly, in the current instance the latter definition is the dominant force. It is interesting, isn't it, that as far back as 1913 economists recognized that money could cause inflation even without growth-driven demand pushing on prices? And yet, today, this point is difficult for some economists to accept.

By the way, the video explaining the difference between increases in the cost of living (real prices) and inflation is very good (except that it makes you wonder why the Fed is letting the money supply grow so rapidly), and worth the four-minute investment.

I don't necessarily think that the cheeky blog entries by the Atlanta Fed and the "Economic Synopsis" articles by St. Louis Fed economists indicate that the Board is about to rein in money growth, but it is heartening that the "nearly non-existent" minority opinion that money matters is starting to become at least a little more vocal. There is no rebellion, but there is sedition in the ranks.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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