Gravity

By: Michael Ashton | Mon, Apr 7, 2014
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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).

VIX

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).

Commercial Bank Credit versus Monetary Base

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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Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
E-Piphany

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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