To My Readers

I am currently publishing my commentary at Seeking Alpha. Here is the link:
http://seekingalpha.com/author/christopher-mahoney/articles

Barry, Just Barry, and Nothing But Barry

"I have little interest in streamlining government or in making it more efficient, for I mean to reduce its size. I do not undertake to promote welfare, for I propose to extend freedom. My aim is not to pass laws, but to repeal them. It is not to inaugurate new programs, but to cancel old ones that do violence to the Constitution, or that have failed their purpose, or that impose on the people an unwarranted financial burden. I will not attempt to discover whether legislation is ‘needed’ before I have first determined whether it is constitutionally permissible. And if I should later be attacked for neglecting my constituents' interests, I shall reply that I was informed that their main interest is liberty and that in that cause I am doing the very best I can" 
-- Barry Goldwater, 1960.

The Senate Blue Dogs

The 14 Blue Dogs who voted for the Keystone Pipeline against Harry Reid and Obama. How many of them will become "independents" in January?
Alaska Sen. Mark Begich 
Arkansas Sen. Mark Pryor
Indiana Sen. Joe Donnelly, 
Missouri Sen. Claire McCaskill 
Montana Sen. Jon Tester
Montana Sen. John Walsh
North Carolina Sen. Kay Hagan
North Dakota Sen. Heidi Heitkamp
Virginia Sen. Mark Warner
West Virginia Sen. Joe Manchin
Colorado Sen. Michael Bennet
Delaware Sen. Tom Carper
Pennsylvania Sen. Bob Casey
Louisiana Sen. Mary Landrieu

The Fed’s Inflation Target Is Losing Credibility

[Published at Seeking Alpha on Oct. 13, 2014]

• The Fed has been missing its inflation target for over two years.
• Both bond yields and expected inflation have been falling.
• Given Yellen’s weak leadership, the prospects for reflation are dim.
• The equity premium is rising.

This is how the FOMC describes its mandate with respect to inflation:

“The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Commit­tee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal con­sumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.”

However the Fed has failed to achieve the 2% target for the past two and a half years despite what it believes has been “massive monetary stimulus”. The most recent reading of the targeted inflation rate is 1.5%, which is 25% below the 2% target. The consistent failure to achieve the inflation target is eroding the Fed’s credibility and is lowering inflation expectations thus raising the real funds rate which is contractionary. The Fed is tightening in the face of a weak recovery.

So far this year, the 10-year Treasury yield has declined by 70 bips from 3.0% to 2.3% while 10-year expected inflation has declined by 30 bips from 2.3% to 2.0%.

The reason that the Fed has failed to hit its target is the combination of single-digit money growth and declining velocity. The economy is in a classic Keynesian liquidity trap which requires radical policy measures. Because both Bernanke and Yellen decided to give the hawks a veto over policy, radical measures are off the table and the Fed is heading in a decidedly European direction. Ten-year German bunds currently yield less than 1% which suggests that Treasury yields may have further to fall.

It is noteworthy that as bond yields have been declining, equity yields (e/p) are rising as the market has recently declined. Thus the equity premium is both high and rising. This would be an excellent juncture to take profits from longer-term bonds and buy equities with the proceeds. While bond prices may rise further, equities are much more compelling given the current ~5.5% risk premium.

The Selloff Is Noise; Do Nothing

• The market’s price swings are normal and within historic range.
• Value is unrelated to price, and is rising.
• Do nothing now, but keep an eye out for deflation risk.

There is nothing happening in the equity market these days that should matter to a buy-and-hold investor. If you’re a day-trader or a chartist, that’s different. But if you have your saving invested in the broad market, nothing is going on and you should do nothing.

The history of the post-Crash bull market is a history of steady price appreciation periodically interrupted by volatility. There have been many selloffs since March 2009, all of which were corrected. There were big selloffs in 2010, 2011, and 2012. This year, we have had slumps in January, April and July. Now we are having another one. The bottom of the January-February slump was 15400 (DJIA), while today’s price (10/15) is ~15,900.

Price fluctuations do not matter for the buy-and-hold investor, because the intrinsic value of a stock is independent of its price. Notwithstanding the EMH, the market’s price often deviates from its value--sometimes for very long periods, such as the fifties when it was underpriced and the sixties when it was overpriced.

Today the market is either fairly valued or is in value territory, depending upon how one evaluates the data. The CAPE says it is overvalued, but it has been saying that since the Crash. If you followed the CAPE, you would have missed the 9000 point run-up in the Dow over the past five years. Today’s high multiples reflect the very low yields on offer in the bond market. Year-to-date, bond yields have declined by one-third from 3% to 2%, while expected equity returns remain around 8%.

The ERP is a much better valuation index than the CAPE, and it continues to flash somewhere between “fairly valued” and “under valued”. At present, Damodaran’s ERP is around 5.5% (and rising), which is roughly the mean value for the post-Crash period. It’s been higher and it’s been lower, but it is not low. It was lower before the Crash, and was 2% in 1999 at the height of the tech bubble. I would worry if the ERP fell to 4% or below.

What is happening in the market now is mainly noise, assuming that the Fed can muster the will to prevent deflation or near-deflation. On that assumption, we are seeing a rising equity premium as the earnings yield rises and bond yields fall. That suggests doing nothing.

Fedwatch

The number to watch is PCE inflation which needs to stay where it is (1.5%) or to go higher. Should it fall below 1%, the forces of deflation might become too strong for the Fed to correct, given its feckless leadership and hawkish consensus. The declines in gold, oil and commodity prices are worrying. The ball is squarely in the Fed’s court to take action to prevent deflation. (I discussed this problem in a recent article.)

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Glossary

EMH: the efficient market hypothesis that says that equity prices correctly discount all available information.

CAPE: the cyclically-adjusted price earnings ratio calculated by Robert Shiller at Yale, which uses ten years of inflation-adjusted earnings instead of the trailing 12 months.

ERP: the equity risk premium, which measures the difference between expected equity returns and bond yields. This measure is calculated by Aswath Damodaran at NYU.

Venezuela On The Brink

The looming collapse of the Venezuelan economy provides an interesting case study. While many aspects of its crisis are typical in Latin American balance of payments crises (such as large fiscal deficits financed in foreign currency), there are other aspects that are peculiar to Venezuela.

The principal peculiar feature is that Venezuela (unlike all other Latin American economies) makes nothing and imports everything. The only export and the only source of government revenue is oil. The price of oil fluctuates, and oil production has been declining despite large reserves. If Venezuela were a capitalist country following orthodox policies, it could adjust to current account imbalances via the price mechanism: as oil revenue fell, the currency would depreciate and imports would be reduced by rising prices. In extremis, the currency could fall far enough that non-oil exports would develop and import-substitution would occur.

However, markets do not function in Venezuela. It is a socialist economy with a fixed exchange rate and domestic price controls and subsidies. The currency cannot depreciate, and hence demand is managed by rationing and shortages. An orthodox economist would prescribe a steady pace of currency depreciation and steadily rising domestic prices. However, the Chavista regime was elected by and is supported by the poor who depend upon cheap imported staples and cheap domestic gasoline. The regime has been unable to adopt a conventional adjustment program and is instead heading toward a classic--and potentially catastrophic--foreign exchange crisis.

Venezuela’s liquid dollar reserves are extremely low and its access to the international debt market is limited to concessional loans from China and/or Russia. The bolivar has fallen to one US cent on the black market, versus the official rate of sixteen cents.

Moody’s assigns a rating of Caa1 to Venezuela’s dollar bonds, which means that they are at risk of default. On September 15th, Moody’s said that the Caa1 rating “reflects increasingly unsustainable macroeconomic conditions, including high inflation and multiple exchange rate regimes. As government policies have exacerbated these problems, the risk of an economic and financial collapse has greatly increased….Despite the government's relatively small external financing requirements, rising government liquidity risk reflects the deterioration of market access and elevated borrowing costs on Venezuela's external debt. Foreign exchange reserves have fallen to very low levels”.

So it would appear that the central scenario for Venezuela would be the exhaustion of foreign exchange reserves, default on external debt, collapse of the currency, and substantially higher real domestic prices. The ability of the government to provide its people with subsidized staples would be greatly curtailed, with potentially dire consequences for political stability.

With respect to the prospects for external support, the standard IMF/World Bank adjustment package seems unlikely given the kind of policy changes that would be required. Additional loans from China and/or Russia could postpone the crisis further, but would not resolve it. The underlying problem can only be addressed via severe domestic austerity, which would have undesired political consequences.

The regime has imported many Cuban officials to staff its security services, and it has been moving steadily in the direction of overt dictatorship. Opposition politicians have been jailed and the press is under siege. But it is unclear to me whether the state of affairs is such that the regime could survive an economic collapse in the way that the Castro family has. It should also be pointed out that Venezuela supplies Cuba with the cheap oil on which it depends for survival. That supply could be jeopardized if it meant subsidizing Cubans at the expense of the Venezuelan masses. Thus, a Venezuelan crisis would likely be followed by a Cuban crisis, which is a further reason why there will be no IMF bailout since the US would welcome regime change in both countries.

The Coming European Depression

[Published by International Banker on July 9, 2014]

Over the past five years, there has been a profound shift in the transatlantic bank regulatory regime. Following the 2008 crash, insolvent banks were recapitalized by governments, and bondholders and uninsured depositors were fully protected from credit losses. Indeed, a very large number of major banks in the US and Europe were rescued and recapitalized by governments during this period, at no loss to their creditors or depositors.                          

Subsequent to these unpopular bailouts, financial policy has shifted from protecting bank creditors to exposing them to loss in the event of a capital shortfall. This is variously called “private sector involvement”, “stakeholder bail-ins”, and “market discipline”.

The rationale for this shift is that taxpayer funds should not be spent to protect bondholders and depositors, that creditors should take losses prior to governments, and that creditors should “do their homework” before investing in a bank’s liabilities. This new policy is seen as fair and prudent, and it is expected to lead to better policy outcomes in future banking crises.

Going forward, bank creditors will be expected to discriminate between strong and weak banks on the basis of their external financial reporting. This concept extends even to uninsured retail depositors such as those that were wiped out in the Cyprus banking crisis.

The policy architecture of market discipline rests upon four fallacious assumptions: (1) bank creditors are skilled in bank credit analysis; (2) bank financial reporting is sufficiently transparent to enable creditors to discriminate between solvent and insolvent banks; (3) the default of a large bank upon its liabilities will not create contagion and a general bank run; and (4) a flight to quality would not impact the real economy.

Each of these assumptions is erroneous: few bank creditors or depositors know much about bank credit analysis; bank financial reporting bears little relationship to bank solvency; a major bank default will likely result in runs on other banks perceived as weak or illiquid; and banking crises have macroeconomic ramifications–deflation and depression.

Creditors Know Little About Bank Credit Analysis

The foundation of bank credit analysis consists in the entering the reported financial data of a banking peer group (e.g., Irish banks) into a multi year database on a comparable basis, and then calculating ratios to enable comparison across banks and across time periods. This, by itself, is a monumental and labor-intensive task, and is generally performed by data vendors on a subscription basis.

Retail depositors have no access to these databases, and would not know how to use them if they did. There are credit rating agencies who perform their own bank credit analysis and offer credit opinions, but are the rating agencies supposed to be the foundation upon which rests future financial and macroeconomic stability? Do the authorities really intend to outsource financial and economic stability to the credit rating agencies? If not, then bank creditors and uninsured depositors will face a very steep learning curve indeed, and are likely to make serious mistakes.

Bank Accounting And Bank Solvency Are Often Unrelated

Banks typically report good profits and strong capital ratios prior to rescue or failure. An analysis of the financial reporting of failed or rescued banks will reveal that almost all of them were reportedly profitable and solvent before they failed. This is for two reasons: (1) failing banks generally accrue interest on bad loans, recognizing this fictitious interest as income; and (2) such banks generally hide their bad loans and do not create remotely adequate loss provisions prior to their recaps (see: Bankia, Banca MPS, WestLB, Depfa, RBS, Anglo-Irish, BofA, Citi, etc.).

This is why, when a bank fails and has to be resolved, the cost of resolution will typically reveal an insolvency much deeper than ever suggested in its public financial statements. Often the insolvency is a multiple of the bank’s reported capital; the difference between 6% and 8% capital under such circumstances is irrelevant. Speaking from my personal experience, the single best source of information about bank solvency is market rumor–because that’s generally all there is besides the official lies.

Uncontained Bank Failures Create Contagion

When a major bank is allowed to default upon its liabilities, the market reacts by withdrawing credit from banks with a similar profile. This phenomenon occurred most recently in 2008, when the bankruptcy of Lehman Brothers Holdings lead to a withdrawal of credit from the other Wall Street banks, which necessitated the TARP bailout and the extension of extraordinary credit from the Fed. In a banking crisis, the mutual withdrawal of credit tends to be indiscriminate and fear-driven. The idea that, in the midst of a financial crisis, participants will choose to make fine distinctions between banks is not borne out by historical experience. In a flight to quality, many dominoes will totter. If one weak bank defaults, the market will attack the rest of the herd.

Banking Crises Have Macroeconomic Ramifications

Banking crises affect the macroeconomy in two crucial ways: credit contraction and monetary contraction. Following the shocks of the Lehman and Greek crises, credit contracted in both Europe and the US in what is characterized as a “Minsky Moment”. Prior to the shocks, credit growth was strong; after the shocks credit growth turned negative (credit growth did not merely decline; the credit aggregates contracted). Borrowers who were considered bankable before the shock instantly became unbankable afterwards. The desire of creditors to call in their loans during a crisis has immediate implications for confidence and growth because forced asset liquidations are deflationary. Economies cannot grow when credit is contracting. The “healing process” is in fact a prolonged disease.

Secondly, banking crises interfere with the efforts of the authorities to maintain adequate money growth as banks seek to shrink their balance sheets. Unless heroic measures are taken by the authorities to force money into the system, the money supply will contract along with the banking system, thus unleashing powerful deflationary forces. We saw this briefly in the US in 2009, and we are seeing such a deflationary spiral today in southern Europe, where money growth, inflation and economic growth are all near or below zero–and this is without any major bank failures so far.

The Coming European Depression

We are now awaiting the results of the ECB’s asset quality review of the largest banks in the Eurozone which, if it is honest, will reveal large unrealized loan losses at many banks, and not just in the Club Med countries. In some cases, it is likely that these banks will be unable to raise sufficient additional equity to restore their solvency, thus creating the preconditions for a bail-in, whereby creditors would be required to transform their debt claims into equity. Should the bail-in policy result in major debt defaults, the consequences will be highly contractionary no matter what the ECB does.

The European authorities have created a lethal policy brew, imposing deflationary monetary policies while withdrawing the financial safety net, repeating the American experiment of 1930-33. As Irving Fisher wrote in 1933:

“Unless some counteracting cause comes along to prevent the fall in the price level, a depression tends to continue, going deeper, in a vicious spiral, for many years. There is no tendency of the boat to stop tipping until it has capsized. Only after almost universal bankruptcy will the indebtedness cease to grow. This is the so-called natural way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation.” (The Debt-Deflation Theory Of Great Depressions)

There are two ways that Europe’s banking problems can be resolved: by default or by inflation. Inflation is regarded as sinful and “the easy way out”. Why take the easy way out when depression is so much more painful? Europe has chosen the path of default, deflation and depression, and in the process will relearn the lessons that Professor Fisher identified over eighty years ago.

The Scottish Referendum May Already Be A Black Swan

• A binary risk with a credible adverse scenario is a real risk today.
• There is a real risk today of a Scottish Black Swan.
• It could happen before the referendum on September 18th.

Last week I discussed the financial implications of a Scottish “Yes” vote in the referendum on September 18th. Today I would like to discuss the risk that exists today because of the referendum. There is no doubt in my mind that a Yes vote next week would constitute a Black Swan event for the UK capital market and possibly beyond. A Yes vote would materially raise the level of uncertainty associated with UK financial assets. I don’t think that is in doubt.

But what I want to say today is this: The risk today of a Scottish Yes vote may be enough to move markets in advance of the referendum. A rational investor needs to think now about positioning his portfolio for a possible Yes vote. Such anticipatory market activity could have a self-fulfilling impact. For example, if investors worry that a run on Scotland could result in a deposit moratorium, a run could occur before the 18th. Furthermore, a run on Scotland could prompt a run on UK financial assets. Already the pound has fallen by 6% over the past two months. I’m pretty sure that sterling will fall further next week in the absence of official intervention.

The Independent reports:

“Figures from investment bank Societe Generale showing an apparent flight of investors from the UK came as Japan’s biggest bank, Nomura, urged its clients to cut their financial exposure to the UK and warned of a possible collapse in the pound. [Nomura] described such an outcome as a ‘cataclysmic shock’...Investors have been pulling out for weeks and months, according to data on UK stock market funds cited by Societe Generale, which show a worsening exodus of global money from shares in British companies. From its best position this year of a little under $14bn (£8.6bn) flowing out from the UK earlier this year, the flight has accelerated to nearly $20bn (£12bn).”

This is still small potatoes, but the Yes risk is only now being analyzed in board rooms and investment committees around the world.

Thus, the risk today is not that Scotland ultimately redenominates, but rather that there can be no insurance against such a scenario, and that poses a risk right now. Two weeks from now, the risk could be gone, or it could be very real. Goldman: “Even if the Sterling monetary union does not break up in the event of a ‘Yes’ vote, the threat of a breakup would provide investors with a strong incentive to sell Scottish-based assets, and households with a strong incentive to withdraw deposits from Scottish-based banks.”

Moody’s: “The new Scottish government would, in all likelihood, need to issue its own currency, into which many if not all domestic private sector debts would be redenominated….One form of debt that would certainly face redenomination risk is bank deposits...It is inevitable that at least some types of deposits would come to be denominated in Scottish currency rather than pound sterling.”

I may be an alarmist from time to time, but I would not accuse Nomura, SoGen, Goldman or Moody’s of being alarmist. The next ten days could be very exciting, especially in London.

Financial Implications Of A Scottish Yes Vote

• A Yes vote would create great uncertainty about the future of the Scottish financial system.
• Both a new currency and sterlingisation are very risky.
• The shock could be immediate.

Should we be spending our time worrying about Scottish independence? I’ve got to say yes, because it is a major contingent risk that should be understood before it happens, if it happens. The polls are quite close, and the referendum is only weeks away.

I don’t want to discuss the long-term issues such as viability or governance. I’d prefer to focus now on the short-term risks. Goldman Sachs has just published a paper on the short-term risks of a Yes vote. Among other risks, it discusses the adverse implications for Scottish assets and Scottish banks:

“Even if the Sterling monetary union does not break up in the event of a ‘Yes’ vote, the threat of a break-up would provide investors with a strong incentive to sell Scottish-based assets, and households with a strong incentive to withdraw deposits from Scottish-based banks. The Bank of England would retain responsibility for the whole of the UK financial system until 2016 (at least), so it would be able to prevent the worst of the short-term consequences. However, the decision as to whether Scotland remains part of the Sterling monetary union will ultimately be a political one, so the BoE would be unable to credibly commit to the currency union remaining unbroken (implying some negative consequences for Scottish-based assets, even in the short term).”

Douglas Flint, chairman of HSBC, recently wrote in the Telegraph that “At the extreme, uncertainty over the Scotland’s currency arrangements could prompt capital flight from the country, leaving its financial system in a parlous state.”

So if you’re looking for something to worry about,, you should worry about the immediate future of the Scottish financial system. Yes, maybe the UK will relent and agree to monetary union. But right now, the risk is not that the monetary union will break up, but that it might. The UK has said that monetary union is off the table, and the EU has said that Scotland must have its own central bank. Remember that the EU wants to discourage regional secession from its member states. Almost every country in Europe has a region that seeks greater autonomy-- or worse. Scotland will have no friends in Brussels or Frankfurt.

Whether Scotland decides to print its own money, or whether it decides to unilaterally adopt sterling, there are substantial risks to holders and issuers of Scottish financial assets. If Scotland decides to print its own money, the currency will be entirely novel, and Scottish monetary and fiscal policy are complete unknowns. If Scotland instead decides to unilaterally “sterlingise”, its banks will lack a lender of last resort. In either case, there are substantial risks. A Yes vote would create great uncertainty for a very long time.

In addition, the rump UK’s credit would suffer if Scotland chose to repudiate its debt, which has been discussed. This would leave the UK with a higher debt-to-GDP ratio, since the UK can’t repudiate its own debt. Every pound of UK debt is a liability of HM Treasury.

The Taper Is Bullish For Both Bonds And Stocks

• Conventional wisdom  says that the Fed’s taper is bearish for bonds and stock.
• In fact, the taper is bullish for stocks and bonds.
• Falling bond yields do not signal higher bond yields.

The common wisdom for understanding the behavior of the capital market since the Crash: “The Fed launched QE in order to artificially depress bond yields, resulting in the lowest bond yields in modern history. The tapering, ending and reversal of QE will remove this source of artificial demand, resulting in higher bond yields. The stock market has also been propped up by QE and will decline once this stimulus is withdrawn.”

The common wisdom, however, is untrue. The intended (if unspoken) purpose of QE was to lower the real funds rate by raising inflation expectations. Money printing is inflationary and raises expected inflation and thus bond yields. The withdrawal of QE is inherently deflationary and should lower inflation expectations and bond yields.

In his famous deflation speeches, Bernanke provided excellent explanations of the need to raise expected inflation in order to lower the real funds rate. In a nutshell: the real funds rate is the nominal rate minus expected inflation. To stimulate the economy requires a negative funds rate. When the nominal rate is zero, the only way to make it negative is by raising the expected rate of inflation. This is what Bernanke was trying to do with QE. He was ultimately able to get the real funds rate down to minus 2%, which was stimulative (but inadequate and too late).

The tapering of monetary stimulus has resulted in lower bond yields. When the Fed began to taper in January, the 10-year bond yielded 3%. Now, eight months into the taper, the 10-year yields 2.4%, a decline of 20%.  In January, TLT was at 102; today it is at 118. Bond prices have risen during the taper, and continue to rise. This is because when the Fed shuts down its printing press at the end of this year and then begins to reverse QE, the impact on money growth should be negative. It’s true that QE did little to goose money growth, but its ending and reversal are unlikely to be stimulative. Depending on which monetary aggregate one chooses, the Fed has been tightening since 2012 (M2) or since January (MB). Tighter money, lower inflation, higher bond prices.

This discussion is not only relevant to the bond market; it is also crucial for equity valuation. There are now two schools of thought with respect to the level of stock prices: the CAPE school (bearish) and the ERP school (bullish). The CAPE school says that PE ratios are too high, while the ERP school says that today’s high PEs are justified by low bond yields. The CAPE fraternity says that today’s low interest rates are artificial and should be ignored in the calculation of expected equity returns. They argue that there is no rational justification for today’s elevated multiples. Once the Fed withdraws QE, bond yields will normalize and stock prices will fall. If they are right--if bonds yield rise--then the CAPE school would be vindicated. But that is not happening.

The equity valuation argument hinges on the outlook for bond yields (and inflation). In my view, falling bond yields provide conclusive evidence that the market does not expect higher bond yields. The evidence to date suggests that bond yields are already normalized and that the elevated equity premium will persist until stock prices rise to much higher levels. In a later article I will explain further why I don’t expect higher bond yields or higher inflation.

Investment Conclusion

The taper has resulted in higher bond and stock prices. The end and eventual reversal of QE should provide further support.

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Glossary:

QE: quantitative monetary easing via Fed purchase of government and mortgage securities.

TLT: an exchange-traded fund which seeks to track the investment results of the Barclays U.S. 20+ Year Treasury Bond Index.

M2: the measure of the money supply used by the Fed and most economists.

MB: the monetary base, which approximates the size of the Fed’s balance sheet.

CAPE: Robert Shiller’s cyclically-adjusted price earnings ratio which uses 10 years of inflation-adjusted earnings rather than 12 months as in the trailing PE.

ERP: the equity risk premium which measures the difference between the expected return from stocks versus government bonds.

Where Are We In The Credit Cycle?

• The deleveraging process has ended, but overall credit growth remains low.
• The culprits are the housing sector--and the Fed.
• Low growth supports current bond and equity valuations.

The US economy has begun to dig out from the post-Lehman deleveraging process, but the current level of overall credit growth is anemic. (I am using the Fed’s flow of funds data series from FRED.)

Total Credit Growth

Total credit was growing at 10% before the Crash, contracted in 2009-10, and is now growing at 3.5%, which is low enough to be acting as a drag on money growth and the recovery. This is mainly due to the low level of activity in the mortgage sector.

Households

Household credit was growing at 11-12% pre-crash and then contracted for four straight years: 2009-12. Only last year did the contraction end, and growth is now de minimis. The mortgage sector has not recovered from the collapse of the housing bubble. This is the main drag on growth today.

Corporations

Corporate credit was growing at 14% before Lehman, contracted in 2009-10, and has since recovered to a healthy 9% growth rate. Business is not starved for credit. This is a major positive for overall growth.

Financial Sector

During the bubble, the financial sector was growing in the low teens, then contracted very sharply, and has not yet resumed growth. Like housing, the financial sector has not yet recovered from the crash.

Federal Government

Pre-crash, federal debt was growing at a modest 3%. During the crash, it grew very rapidly (2009). Following the Fiscal Cliff, federal debt growth has fallen to 6% which is neither contractionary nor stimulative. One could say that government finance has normalized at “neutral”.

I believe that the current low level of overall credit growth is acting as a drag on the Fed’s monetary policy by countering the Fed’s efforts to grow M2. Larry Summers has suggested that the US economy can only grow rapidly during credit bubbles. I don’t agree. I would reformulate that to say that the nominal economic growth rate will tend to grow at the nominal rate of aggregate credit growth. You can’t have economic growth without credit growth, but it need not become a bubble. We don’t need 12% household credit growth to achieve 6% NGDP growth; we can make by with household credit growth in the mid-single digits.

At present, aggregate credit growth is stalled at 3.5%. If it can accelerate (i.e., if housing and/or inflation can pick up) then I would expect to see the benefits of the quantity equation, resulting in higher nominal growth. Of course, that is almost a tautology. It would appear that everything hinges on the bugaboo of the bubble years: house price appreciation and the availability of mortgage credit.

I do not mean to contradict monetarism or to absolve the Fed of its unwillingness to accelerate money growth. I am only saying that by handcuffing itself the Fed is making the economy hostage to the housing market. The growth rate of the nominal economy is within the control of the Fed, if it is prepared to reflate. The Fed’s ongoing satisfaction with inadequate inflation means that we are swimming on our own. At present, neither the government nor the Fed are providing any stimulus.

Investment Implications

We are looking at an economic dashboard where almost every dial is on LOW: credit growth, money growth, velocity, inflation, nominal growth. This suggests to me that the outlook for inflation and bond yields remains low. This in turn supports current stock and bond valuations, and it explains why the bond market yawned when the FOMC minutes were published. The fact that the Fed is plotting to reverse QE is deflationary, not inflationary. In fact, I am reminded of the monetary fiasco of 1937-38, when the Fed hit the brakes much too soon. The FOMC continues to be “Austrian Lite”. Monetarism is nowhere to be found.

Bottom line: current bond and stock prices are supported by the low trajectory of credit and money growth.