Monday, January 27, 2014

Flirting With Recession

Investment Thesis: Treasury yields will fall further due to Fed tightening and sub-target inflation. Stocks will exhibit weakness until the decline in money growth is decisively reversed.

The Fed has been tightening for the past 18 months, since July of 2012. Money growth has declined from 10% in mid-2011 to 5% today. As a consequence, both inflation and nominal growth have also declined. Inflation has dropped from the targeted 2% to the current 1%, while nominal growth has declined from 5% to the current 3.4%. The economy has been slowing down in reaction to the Fed’s steady closing of the monetary spigot.

This slowdown has most recently manifested itself in the weak December jobs report, and will become visible in the 4Q13 growth numbers. (The strong 3Q13 growth numbers were a statistical anomaly; I expect the 4Q numbers to be much lower.) Until the slowdown is reversed by the Fed, the economy will flirt with recession. This will change the market’s psychology from “accelerating recovery” to “another slump”. The goldilocks scenario of continued recovery  will be discredited, which will be good for bond prices and bad for stock prices.

As readers of the FOMC’s emissions know, the Fed does not acknowledge that it has been tightening and insists that it has been providing “extraordinary monetary accommodation”. I don’t know why they say this when their own numbers say otherwise.

My opinion, as I’ve said before, is that the Fed has lost control of M2 and doesn’t want to admit it. Hence they only talk about what they can control, namely their own balance sheet. The fact that there is no observable relationship between the Fed’s balance sheet and the money supply is an embarrassing fact best left unmentioned. As QE had no impact, neither will the tapering of QE.

Given that Yellen does not wish to see the economy flirting with recession, I expect her to propose new policies to reverse the decline in money growth. These could include a money-growth target, a price-level target, or a reduction in the interest rate paid on excess reserves. She is very unlikely to do nothing, and she knows that her power will never be greater than it is on Day One. If she wants to be a success, she will have to act now.

Frankly, I don’t care what new policies the FOMC adopts. I’ve had it with new policy rabbits coming out of hats. All I care about is money growth, inflation and nominal growth. Theological discussions can go hang; it’s results that I’m looking for. I was disappointed in Bernanke’s failure, and I do not want to be disappointed again.

Investment Conclusion: Until current monetary trends are reversed by the Fed, bond yields will fall and stocks will be weak. Watch M2 growth and nominal growth. If they accelerate soon, all will be well. Otherwise, recession looms.

Thursday, January 23, 2014

Puerto Rico On The Brink Of Default

Investment thesis:
The Commonwealth of Puerto Rico will default soon.

It looks like the Puerto Rico debt crisis is rapidly coming to a denouement. The FT has a nasty story about Puerto Rico’s debt situation in today’s paper. The picture it paints is very bleak. CPR is a classic case of an over-indebted government which needs to borrow to finance operating deficits and to refund maturing debt. The government has run out of time to fix its finances. It needs to borrow more money than it can raise.

Three indicators suggest that the end is nigh: (1) Moody’s is very likely to  downgrade CPR to junk status in the near future, judging by the tone of its research; (2) the market rumor is that CPR will soon announce a debt moratorium; and (3) CPR’s creditors are meeting with debt restructuring experts.

It is impossible for a credit to recover from such a triple-whammy, whether a moratorium is planned or not. The government says it has enough cash to stay alive for the rest of the year, and it is hoping to issue new debt. Both facts may be true, but I am reminded of Enron and Lehman: a point is reached at which the credit cannot regain market confidence, and events  take charge.

Moody’s reports that CPR’s cash position is dwindling, and that a downgrade would make things worse: “The commonwealth has swaps and financings that include collateral and acceleration provisions in the event of a one-notch downgrade by any of the three major credit rating agencies. We estimate that a one-notch downgrade could result in liquidity demands of approximately $1 billion.” In the context of CPR’s proforma cashflows, $1B is material.

CPR has between $60-$70B of debt, depending on what you count, plus another $40B in unfunded pension liabilities. Moody’s compares CPR’s debt ratios to the 50-state median, which indicates that CPR’s indebtedness is an order of magnitude greater than the typical state. Debt to GDP is 72% for CPR and 2% for the median state. Debt to government revenue is 260% versus 42% for the median state. Although CPR doesn’t pay federal taxes, Moody’s says that its debt burden is “high by all comparisons”.

CPR is an interesting case, because its constitution prohibits bankruptcy, it is ineligible for federal bankruptcy, and it is required to service debt before all other expenses. The CPR government claims that this means it can’t default, but it can and it will. A deus ex machina rescue by the US Treasury is extremely unlikely. I don’t think that Treasury has any such authority, and I don’t see the House GOP caucus agreeing to bailout legislation (a bad precedent--and CPR doesn’t pay federal taxes). What is more likely is that Congress will establish a restructuring authority to administer the workout.

Will a CPR default be a big deal, or will it be a snooze? My sense is that it will be a snooze because it really has no implications for other credits, so there should be little contagion. It should raise credit spreads for weak municipal credits, but that is no catastrophe.

CPR can be analogized to the bad credits in the eurozone, in the sense that it lacks its own central bank, can’t print its own money, and can’t service its debts. Like Cyprus and Greece, its creditors will have to be “bailed in”. I haven’t looked at CPR’s banking system, but they are full-fledged members of the FRB/FDIC complex, which should provide a safety net.

Investment conclusion:
A CPR default should not be contagious, but will startle the muni market.

Tuesday, January 21, 2014

Look Out! The Fed Is Doing Something Strange

Investment thesis:
Money growth has to a dangerously low level. Unless this is reversed in the next couple of months, it will show up in both growth and equity prices. Watch M2 growth.

Money growth has been declining for the past two years, as has velocity. Given the quantity equation, we know that when both money growth and velocity decline, nominal growth declines arithmetically (MV = NGDP). The Fed has been tightening for two years, resulting in declining inflation and nominal growth. You are not going to see real growth accelerate as long as nominal growth is declining. Declining money growth and velocity forecast a negative growth surprise for either 4Q13 or 1Q14, or both. The revised 3Q13 growth number was a fluke.

What is even more alarming is that money growth has declined sharply during 4Q13, and is now running below 5%--the slowest rate of money growth since the crash itself.

What is going on? Why has the Fed been tightening for two years, and why has the it allowed inflation to undershoot the target by such a wide margin?

Here is what the FOMC says on the subject: “To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens.” (Minutes, 18 Dec. 2014)

In other words, the Fed denies that it has been tightening. Someone should buy the Fed a subscription to its own database: it could be quite eye-opening. In seriousness, the Fed must be aware of what I have just observed. But why won’t the FOMC publicly address the issue? Shouldn’t the “most transparent Fed in history” explain to Congress and the people why it is tightening when it says it is not?

Investment Conclusion:
Whether the Fed knows it or not, money growth is dangerously low and falling. No one is minding the store at the Eccles Building. This means that we are in for a negative growth surprise for 4Q13, and for the stock market. In this case, bad news is bad news.

Saturday, January 18, 2014

The Post-Crash Deleveraging Process Is Over

Investment Thesis: The post-crash unresponsiveness of the economy to monetary and fiscal stimulus has been due to the deleveraging phase of the credit cycle. However, the data suggests that the post-crash deleveraging process is nearing completion. Going forward, this should make conventional monetary policies more effective, and lay the groundwork for an eventual pickup in nominal growth. This will provide the basis for higher corporate earnings and higher inflation. Stocks should benefit, while bond yields will rise.

Economists, such as Larry Summers, have been seeking an explanation for the weak recovery. The need for an explanation is pressing, since the economy has been surprisingly unresponsive to conventional monetary and fiscal stimulus.

Here is Summers on the subject: “We are now 10%  below where we thought the economy would be now in 2007. There's been close to no progress in regaining potential measured relative to the judgments made at the time in 2007.”

Many explanations have been offered to explain the weak recovery, of both a structural and cyclical nature. Economists generally rule out structural factors because they are unmeasurable: if a factor cannot be measured, then it can’t explain anything. “Obama’s anti-business policies” and “Republican obstructionism” are both unmeasurable, and thus useless as explanations.

The weakness of aggregate demand (AD) is generally considered a cyclical phenomenon, not a structural one, and AD should be responsive to macro policy. Keynesians say that the weakness of AD is a consequence of  inadequate fiscal stimulus, while monetarists point to inadequate monetary stimulus. Paul Krugman, on a lucid day, mentions both. But the economy has had massive inputs of both fiscal and monetary stimulus, and yet has remained far below potential for the past five years. The Keynesians need to explain why massive deficits didn’t do what they said they would, and the monetarists need to explain why massive bond purchases didn’t work either.

I have argued that, despite QE1, QE2 and QE3,  monetary stimulus has not been “massive”, as evidenced by sluggish M2 growth since the crash, which provides support for to the monetarist viewpoint. But I contend that the sluggishness of money growth is a symptom of a deeper phenomenon which explains the failure of the Fed’s efforts.

That deeper phenomenon is the credit cycle. Credit cycle theory was first proposed by Irving Fisher in 1933 and elaborated by Hyman Minsky in the 1970s. Modern proponents include Richard Koo of Nomura, and Steve Keen of the University of Western Sydney. According to credit cycle theory, inflection points in the credit cycle (i.e., Minsky Moments) force economic actors (including banks) to deleverage, and as long as the deleveraging process continues, the credit aggregates shrink and money growth is retarded. The bigger the debt overshoot, the longer the required repair period.

The US credit cycle experienced a Minsky Moment in the 2008-9 crash. Before the Minsky Moment, high financial leverage (especially in households, housing finance, banking and the securities industry) was acceptable. After the Moment, high leverage became diabolic as did all associated debt structures and obligors. The credit market shut down, forcing indebted actors to rapidly deleverage

The credit market had a major shock when Lehman defaulted, and has suffered from PTSD ever since. The deleveraging process took three years, from the end of 2007 to the end of 2010. Total credit did not begin to grow again until late 2010, and a number of sectors took much longer to complete the debt reduction process. Only now has the process finally ended, although the PTSD remains.

The debt market’s standards for acceptable leverage changed overnight after Lehman, instantly rendering uncreditworthy huge swaths of the economy including households, securities firms, finance companies, and banks. In order to regain market access, these actors had to unwind their pre-Crash debt accumulation in order to conform to new leverage standards, which has taken them a long time to accomplish. It took 15 years for the cycle to build up to the Minsky Moment, and it has taken five years to dig out from it. The credit cycle is at its root an artifact of psychology, and the recovery from a major shock does not happen quickly.

Market monetarists such as Scott Sumner discount credit cycle theory, on the argument that it is a derivative of monetary policy and can be overcome by competent monetary policy. I agree (I have to, since I believe the quantity theory), but I would argue that the credit cycle explains why the Fed’s “massive” stimulus policies have failed: the down-leg of the credit cycle creates huge headwinds for conventional policy. Only truly radical policies (e.g., helicopters) can combat the credit cycle, and they haven’t been tried.

How can we measure the credit cycle? The Fed’s “Flow of Funds” report provides data on credit stocks and flows for:
  • Households
  • Nonfinancial businesses
  • Financial businesses
  • State & local governments
  • The federal government

Here’s a quick summary of  the 21st century credit cycle (all numbers are sectoral  liabilities):

Rapid (12%) growth before the crash, negative growth during the crash, now very low growth at 1%. No recovery yet: banks are not making mortgages.

Rapid (13%) growth before the crash, mild contraction during the crash, now fully recovered to almost 10% growth. Business credit has had the strongest recovery. (The business credit cycle inflected in 2001.)

Rapid growth (12%) before the crash, severe contraction during the crash (-13%), now flat at 0%. No recovery yet; the bleeding has just stopped. The PTSD remains strong, and regulation hasn’t helped.

Modest (6%) growth precrash, low growth during crash, negative growth since the crash. No prospects for recovery.

Moderate growth precrash (5-10%), extremely rapid growth during the crash (35%), and now moderate growth again at 6%. Despite running big deficits during the crash, federal borrowing was insufficient to fully offset credit contraction by the private sector. (This supports the Keynesian argument that fiscal stimulus was too small.) The outlook for federal credit growth is not good; the declining deficit means that the pace of government borrowing will decline further, which will dampen overall credit growth.

This is the single most important data series in explaining the credit cycle. Total credit was growing at 10% before the crash, contracted modestly during the crash (despite big federal deficits), and has since “recovered” to an anemic 3% growth rate. Three percent growth is nowhere near full recovery; 8% growth would signal full recovery. The credit market is still a bit traumatized.

A crucial credit sector with respect to economic behavior is the financial sector, which is a provider of both credit and money, since money is a liability of the financial sector. The cyclical volatility of financial credit has been pronounced. Financial credit grew at an unsustainable 13% before the crash, contracted very severely, and has not yet recovered (zero growth). Total financial credit remains 18% below its 2008 peak. This explains a large part of what has happened since the crash. Hospitalized banks don’t lend freely.

The current 3% total credit growth and 0% financial credit growth explain the inability of conventional monetary policy to stimulate money growth, inflation and NGDP growth.  The Fed has the ability to control the money supply, inflation and nominal growth, no less than do the central banks of Venezuela, India, Egypt, Iran and Argentina (which have all succeeded in creating inflation). 

The failure of the Fed to get control of the money supply is explained by the headwinds resulting from the credit cycle, particularly the financial sector, as well as its unwillingness to adopt sufficiently radical policies despite lip-service to the contrary. The Fed has missed its statutory employment and inflation targets for the past five years. The Fed allowed the credit cycle to overwhelm its stimulus efforts (as it did in 1930-33).

The crash had nothing to do with the corporate sector, which had already suffered its own inflection in 2001. Business credit growth rebounded quickly, which has been a major bright spot for the economy. The business sector today is very healthy, despite low nominal growth.

Money growth depends in part on the demand for credit, and the cyclical decline in credit demand has resulted in the buildup of excess reserves at the Fed (instead of bank loans). The reasons are: (1) a lack of credit demand because borrowers are repairing their balance sheets; (2) a lack of credit supply because credit providers are repairing their own balance sheets, and (3) credit providers have have raised their lending standards. 

Credit has not been flowing to the economy at a pace anywhere near the pre-crash rate. In fact, it’s even worse than that: credit growth today is lower today than at any point between WW2 and the Crash. Currently growing at 3%, it had never before dipped below 4% even during the worst postwar recessions. This is a huge drag on both AD and money growth.

(Yes, credit growth data is nominal, but I think that nominal data is more explanatory today than real data. Low nominal growth is the problem in the current circumstance, and it should not be disguised by the use of adjusted data.)

As I said above, the Fed has full control over the money supply, inflation and nominal growth, if it chooses to exercise it. The Fed has the power to overcome the credit cycle, as as did the Bank of England in 1931, FDR in 1933, and the Bank of Japan most recently. But, by refusing to adopt radical expansionary policies, the Fed has allowed the credit cycle to negate its efforts. Ultimately, the fault lies with the Fed, and Bernanke knows it.

The Outlook for the Credit Cycle
There’s good news and bad news in the outlook for credit growth. The dominant sectors are households (mortgages) and the federal government (deficits). Each sector has about $13T of debt outstanding. The good news is that households have stopped deleveraging and have (almost) begun to borrow again. Over time, household debt should grow as lending standards are relaxed, but that will take more time.

The bad news is that the pace of federal borrowing has declined sharply and will decline further given the current budget outlook. Taxes have been raised and the Budget Control Act remains largely in place. The period of federal pump-priming is over, and the private sector is now on its own. (This annoys Krugman and worries Summers.)

As I observed earlier, the all-important financial sector has stopped shrinking, and may be poised to start to grow, although there are many forces at play. The financial sector remains badly shell-shocked, and the revival of animal spirits will take time.

There is a better-than-even chance that private sector credit growth will more than compensate for the withdrawal of big deficits, and there is very little chance that credit growth will turn negative, since all of the confidence indicators are positive. Going forward, the Fed will no longer have to contend with fighting a credit contraction, and may get some wind at its back.

Summers has expressed the concern that the US economy is only able to grow during credit bubbles. I would restate that as: the US economy is only able to grow during periods of credit growth--and this is only true in the absence of competent monetary policy. The credit cycle can be fought.

The post-crash deleveraging process has ended, and credit has started to grow again. Much will depend upon the re-opening of the mortgage market and the pace of fiscal contraction. Nonetheless, the economy is now in a position to better respond to conventional monetary policy tools, which should give the Fed a greater ability to stimulate money growth. It is now up to the FOMC to do its job.

Investment Conclusion: Stronger nominal growth will increase earnings and support higher equity valuations, while exerting downward pressure on bond prices. The up-leg of the credit cycle will accelerate, and could last quite a few years: the last one lasted 15 years. This is good news for both investment and employment.

Friday, January 10, 2014

December Jobs Report: What Recovery?

Investment thesis: The markets will continue to reflect economic stagnation until the Fed takes effective steps to meet its mandates. Bond prices should be supported, while earnings growth will moderate further. However, strong corporate buybacks support current equity valuations.

Readers may recall that last month the third quarter real growth number was raised to 4.1%, which is quite high. Market economists and pundits believed this number, and said that it signaled an accelerating recovery.  You may also recall that I said at the time that the revised third quarter number was a meaningless blip, and that the outlook for growth and employment remained bleak.

Well, the December employment data support my negative view (not that one month of data is in any way conclusive). Nonfarm payrolls rose by only 74,000 in December, the smallest increase in three years and far short of the growth that economists had predicted: the median forecast of 90 economists called for an increase of 197,000. The labor force participation rate fell to 62.8%, its lowest level since the Carter administration. The broader U-6 unemployment rate remained unchanged at 13.1%, about double what it should be at this stage of a recovery, and much higher than the peak level of prior recessions. We are looking at a weak, stagnant economy.

The lead steers in the market and the media just don’t spend enough time looking at the data. They seem to be overly headline-sensitive, and to lack a coherent model of the economy. Once the lemmings pick up the mantra of a “stronger recovery”, they won’t let the data stand in their way:
"If there ever there was a curveball, this was it," said Marcus Bullus, trading director at MB Capital in London. "These limp numbers are as puzzling as they are surprising."
Not to readers of this blog.

The pundits recommend that we ignore the December data, either because it was cold in December*, or because, as CNBC says: “Anyone reading the Labor Department report can see that the focus is on the trend, and according to the Labor Department and other general economic observations, the trend is still favorable”. Convinced? 

I hope it didn’t come as too big of a shock to the economists at DoL that it was cold in December. Are they aware that it could be cold in January and February too? They can improve their forecasts by consulting the Farmer’s Almanac.
It has been said that the best prediction of a future datapoint is that number today, and that you need a coherent rationale to predict otherwise: the future will resemble the past, ceteris paribus. When I look at the macro dashboard, what I see is stagnation at a low level, with a flat or downward trendline. Money growth is declining, as is velocity; inflation is declining; nominal and real growth are flat at low levels; the overall employment picture is recessionary; fiscal policy is contracting.
I scratch my head when I read that “the trend is still favorable”.  To what data are they referring? My data just aren’t going that way.
What does this mean for the new Fed chairman, Ms. Yellen? It means that the burden will fall heavily on her to spur the Fed to adopt more effective policies. I can’t imagine that her to-do list says “Continue current ineffective policies in order to miss both statutory mandates and further erode the Fed's credibility".
It may be a bit impolite to unearth a “discredited” and “outdated” economic theory, but the old Phillips Curve still explains a lot of the current economic phenomena: there is a trade-off between inflation and unemployment. The Fed has elected to choose “low inflation and high unemployment”. The unemployed are standing guard to ensure that we don’t experience 2% hyperinflation. The Fed needs to select “higher inflation and lower unemployment”, just as it was forced to do in 1933 and 2008-09.
Investment Conclusion
My 2014 forecasts** assumed that the newly-energized Yellen Fed would meet its mandates this year. But nothing has been done on that score yet; it’s a prediction not an observation. For now, the outlook is for continued stagnation and stable bond and stock prices (until Yellen can change policy). 

If you don’t buy my “Yellen wins” scenario, then you should expect falling bond yields and some negative earnings surprises. With NGDP growing at around 3%, the outlook for topline growth is modest, and post-recession productivity gains are almost exhausted. Supporting stock prices is strong free cashflow funding continued buybacks--instead of wealth-destroying M&A. Animal spirits in the boardroom are always bad for stockholders--even in Omaha.
That is why I am still moderately bullish.
*”The Labor Department data included signs that the hiring slowdown was at least partly due to colder-than-usual weather last month, a factor that suggests the December reading isn't necessarily the beginning of new downward trend.” (WSJ)
**  “My 2014 Predictions: Still Bullish”, Seeking Alpha, 3 Jan. 2014.

Wednesday, January 8, 2014

It's Time For The Fed To End QE

Remarks by Bill Dudley of the NY Fed and the most recent Fed minutes reveal what I have been saying for almost a year: No one has any idea what the purpose of QE really is or how it works.

Here is what Dudley said:
“We don’t understand fully how large-scale asset-purchase programs work to ease financial market conditions—is it the effect of the purchases on the portfolios of private investors, or alternatively is the major channel one of signaling?”

Here is what last month’s FOMC minutes say about QE:
“Most participants viewed the program as continuing to support accommodative financial conditions, with a number of them pointing to the importance of purchases in serving to enhance the credibility of the Committee's forward guidance about the target federal funds rate.”

Is that clear? The Fed doesn’t know why it is buying bonds, but figures that QE signals an accommodative “stance” and enhances the “credibility of its forward guidance”. No one mentions the fact that the Fed’s credibility has been badly wounded by the failure to achieve either of its mandates over the past few years.

Did the committee have a thought-provoking discussion concerning the steady decline in money growth over the past two years, and what to do about it? No, it was not discussed. It was noted without remark that "M2 contracted in November." But this rather inconvenient fact did not dampen the committee’s self-congratulation, noting that “The projected improvement in economic activity was expected to be supported by highly accommodative monetary policy.” Negative money growth is highly accommodative, if you turn the chart upside down, or stand on your head.

So we have a situation in which money growth is low, unemployment remains high, inflation is far below target, and QE is being withdrawn--although no one is quite sure what QE does.

The Fed should cease this farce and end QE now, immediately. Since QE has no measurable effect on anything, and no logical rationale, let’s get it out of the way. It is an excuse that allows the committee to advertise that it is providing a “highly accommodative monetary policy” while doing nothing of the kind. It's a place-holder for real policy.

I would recommend that the Fed unearth the old Bernanke textbook, and implement price-level targeting (PLT), such that the more the Fed undershoots on the inflation rate, the more it will need to correct. The committee should target the price level that would have been achieved had the Fed been fulfilling its 2% target. Yes, nominal output targeting would be even better, but price-level targeting is radical enough: sufficient unto the day is the unconventional policy thereof.

If the Fed were to implement PLT, it would have quite a bit of catching up to do, requiring a few years of above-target inflation. The announcement of PLT would raise inflation expectations, lower the real funds rate, and stimulate demand. The measure of success would be widening TIPS spreads and rising bond yields (which should be at least 4% at this stage of the recovery).

All of this is old hat for the committee. Inflation and/or price-level targeting has been on the table for at least 15 years. As Bernanke told the Japanese in 1999:
“A target in the 3-4% range for inflation, to be maintained for a number of years, would confirm not only that the BOJ is intent on moving safely away from a deflationary regime, but also that it intends to make up some of the price-level gap created by eight years of zero or negative inflation.”

It may be that Bernanke was wrong, and that there is some fatal flaw in a PLT policy. Fine--let the FOMC debate it. It’s frustrating that the Fed minutes read like those of the Titanic’s health and safety committee: much discussion of the irrelevant, and no discussion of what matters. What matters right now is inflation.

Wednesday, January 1, 2014

My Predictions For 2014

I will review the accuracy of my predictions for 2013, and make new predictions for 2014. 

My 2013 Predictions
Here are my predictions from a year ago*, and what actually happened:
1.Dow up by 2000 points from 13000 to 15000. Actual: up 3600 points to16600.
2. Monetary base to grow by $1 trillion. Actual: up $1 trillion. (I don’t distinguish between the monetary base and the Fed’s overall balance sheet; they’re about equal.)
3. Nominal growth above 5% by yearend. Actual: 6% nominal growth in the third quarter (which I expect to be lower in the fourth quarter).
4. Lower bond prices. Actual: bond prices fell by 15%.

Overall I did well. I got the directions right, and my predictions were pretty good. I placed my faith in QE3, and my faith was rewarded, at least on the surface. But my predicted chain of causality proved to be seriously flawed. I based my scenario on an acceleration in money growth, which didn’t happen. Money growth slowed in 2013, despite $1 trillion in additional QE. Had I known that money growth would decline, my predictions would have been very different.  

So, as it turned out, my predictions were right but for the wrong reasons. How can we explain such positive macro outcomes despite a decline in money growth? 

I have emphasized the role of credit growth in facilitating money growth. Credit growth did pick up last year (bullish), but had no apparent impact on money growth! So that explanation doesn’t work.

There is no doubt about the decline in money growth: it is reflected in all of the aggregates, both official and unofficial. There is no mistake. And an increase in velocity is not the answer, because velocity continued to decline.

Here is a stab at an explanation for what happened in 2013:
1. The Dow rose, not because of an acceleration in growth, but rather due to a decline in fear: the risk premium fell. There were no major black swans in 2013, and confidence is returning.
2. Nominal growth remains low despite the third quarter data, as I have explained in earlier posts.
3. Bond prices fell because the market has been spooked by false signals, namely the taper and the 3Q growth blip. 

Given the above hypotheses, we need to ask how much the equity risk premium can decline further. If the only thing holding stock prices up is confidence, what’s the outlook for confidence? I think it’s reasonably good. All of the financial stress indices remain low. Bank stocks are way up, which is a clear sign of confidence. So now to 2014.

My Predictions for 2014 (YoY):
My macro outlook has two scenarios: (1) Janet Yellen succeeds where Ben Bernanke failed; or (2) Yellen also fails. It all hinges on Yellen’s ability to create a consensus on the FOMC that the Fed must do more to meet its mandates. This is a political question, not an economic one. It is about group psychology, and leadership. 

Yellen and Bernanke are very close ideologically, but different in personality. Bernanke is a low-key academic who placed a high priority on consensus and institutional credibility. He wanted to cure the recession while preserving the authority of the institution. The price of this decision has been subpar growth and high unemployment. Bernanke was not going to go to war with the hawks, and allowed them to stymie his efforts.

Yellen, by contrast, is an outspoken dove who might be more willing to jeopardize consensus to achieve a more muscular policy. In other words, she might sacrifice institutional credibility in order to achieve the Fed’s statutory mandates. (Only in central banking can you weaken your credibility by achieving your goals.)

I am going to put my chips on scenario #1, in which Yellen succeeds in pushing the committee in a more dovish and unconventional direction. I’m not talking about the pace of the taper which is only symbolic. I am talking about moving the needle on money growth and inflation by doing something more radical. By more radical I mean things like reducing interest on reserves, new asset purchase categories, or price-level targeting. All the kind of things that Bernanke used to advocate before he became chairman.

Based on this "Yellen Succeeds" scenario, here are my predictions for the key indices one year from now:

1. Fed policy:
Last year the Fed’s balance sheet grew by $1 trillion under “full” QE3. This year I would expect a slow taper, given prior guidance. The Fed’s balance sheet should grow by another $500 billion to $4.5 trillion.

2. Money growth:
Yellen can’t be happy with 5.5% money growth and 1% inflation. I expect her to find ways to accelerate M2 growth to a range in the vicinity of 7-8%.

3. Nominal growth:
If Yellen can get M2 growth up to 7-8%, nominal growth should rise from the current 3.4% to a more comfortable 5%, which would be a major achievement. The Holy Grail would be 6% nominal growth.

4. Real growth:
Real growth on a year-on-year basis is now running at 2%, about half of what it should be. By this time next year, I would look for 3.0-3.5% real growth; better than now but still inadequate.

5. Inflation:
I expect that Yellen will be able to achieve the 2% target by year-end.

6. Bond market: The 10-year is now at 3%. Assuming Yellen can move the needle on money growth and inflation, the year-end yield should be between 3.5 and 4%, but not soon. Bearish for bonds.

7. Stock market:
If the foregoing growth and inflation scenario proves correct, the Dow will be supported by continued earnings growth, offset by higher bond yields. I predict that the Dow will close the year somewhat above where it is now: around 18,000. If there is risk, it is on the upside. Cash and bonds remain unattractive.

Just as was the case last year, everything hinges on the Fed's policy effectiveness. I am giving Yellen the benefit of the doubt, on the idea that the committee will grant her some initial deference as the new chairman. The $64 question is how hard she is prepared to pound the table.
*“2013: The Year Of Printing Money”, Dec. 16, 2012