Thursday, January 22, 2015

King dollar comeback

It was just over three years ago that the dollar hit an all-time low against most of the world's currencies. Since then it has come roaring back, especially in the past several months. Gains have been uneven—huge gains against the yen, but not much against the pound, for example—and on balance the gains have simply restored the dollar to something close to its average value since the early 1970s. These gains may continue and could become problematic if they are excessive and rapid—strong and stable currencies are the healthiest—but for now it's appropriate to cheer the return of King dollar. 

The dollar has gained 22% against the euro since last March, and it is up 40% from its all-time low against the euro in 2008. The green line represents my estimate of the euro/dollar purchasing power parity: the level of the euro that would make prices for goods and services in the Eurozone roughly comparable to those same prices in the U.S. At today's exchange rate, American tourists in the Eurozone are likely to come away thinking that prices over there are about the same as they are here. Changes in the level of the PPP exchange rate are driven by changes in relative inflation rates. The upward slope of the green line over the decades means that inflation has been higher in the U.S. than it has in Europe.

The Australian dollar soared coming out of the Great Recession, boosted by soaring commodity prices. A lot of that has been reverse in the past several years as commodity prices have weakened. Still, the Aussie dollar remains quite strong vis a vis the dollar, according to my PPP calculations.

Like the Aussie dollar, the Canadian dollar has been on a roller coaster ride, driven by swings in commodity prices. The dollar has gained 30% vis a vis the Canadian dollar since its low of 0.95 in 2011. Prices in the U.S. and Canada are approaching parity these days.

The British pound has been relatively stable against the dollar, on balance, for the past six years. However, higher inflation in the U.K. should tend to depress the value of the pound over time. The U.K. is still somewhat expensive for U.S. tourists.

The dollar has gained an impressive 55% against the yen in the past three years, rising from a low of 76 to 118 today, thanks largely to the Bank of Japan's aggressive monetary easing. The yen had been appreciating against almost all other currencies for decades, and had reached a very expensive level. With the yen now more "normally" priced, manufacturers and exporters should find some relief. But the economy is not likely to strengthen meaningfully unless and until fiscal policy becomes more growth-friendly.

Using the Fed's Real Trade-Weighted Dollar Index (based on the latest reading as of the end of November), I estimate that the dollar today has gained about 30% against a basket of major currencies in the past three years. This puts it about 5% or so above its average since 1973. That's an impressive comeback in three years, and it owes a lot to the fact that the U.S. economy—despite suffering  its weakest recovery ever—is arguably the strongest of all developed countries.

Wednesday, January 21, 2015

Housing continues to improve

December housing starts beat expectations (1089K vs. 1040K), but not by much, considering how volatile this series normally is, and how important seasonal adjustment factors can be. Missing from the headlines were upward revisions to the past two months. Pessimists will note that the level of starts in November 2013 was slightly higher than the latest reading, suggesting that starts have been relatively flat for the past year. I prefer to look at a 12-month moving average of starts: that shows starts last year were 8% higher than in 2013. That's pretty decent growth. Plus, as the chart above shows, the level of builder sentiment suggests conditions are likely to continue to improve, if only modestly.

From a long term perspective, housing starts today are still miserably low. That's depressing on its face, but the optimist in me sees the tremendous upside potential should underlying conditions continue to improve. Why couldn't housing starts double over the next 5 years or so?

Untapped potential is the story of the overall economy as well, as the chart above shows. The economy is currently about 10% or so below its long-term potential trend. If policymakers move in a growth-friendly direction (e.g., eschewing tax hikes, reducing regulatory burdens, simplifying the tax codes, lowering marginal rates, eliminating deductions and subsidies, lowering corporate tax rates) we could be on the cusp of some significant growth in the years to come.

It makes more sense to focus on what could happen if things go right, than to lament how many things have gone wrong.

UPDATE: The chart below shows an index of new mortgage originations (not refis). At the end of last year it had reached a multi-year low, reinforcing the widespread belief at the time that the housing market was running on fumes. But in the past three weeks, new mortgage initiations have jumped over 25%. (Caveat: this is a seasonally adjusted index, and this is the time of the year when activity is typically slow, so the adjustment factors are large and could easily be wrong.) We'll have to watch for further strength, but in the meantime this fits nicely with the noticeable pickup in bank lending in recent months that I noted yesterday.

Tuesday, January 20, 2015

Bank lending surges, another sign of rising confidence

Confidence is making a comeback, and that's important because this recovery has been the weakest ever and the most risk-averse ever. Since last June, sharply lower oil prices have given a big boost to confidence, as I pointed out last week. Now we have the evidence of a substantial increase in bank lending, which reflects increased confidence on the part of banks and borrowers (banks more willing to lend, borrowers more willing to borrow). That's good, because easier access to credit can translate into more investment, more jobs, and more productivity. But there's an often-overlooked downside, which I pointed out one year ago. Increased confidence which results in more lending and more borrowing can eventually tip the supply/demand balance of monetary policy in an inflationary direction if the Fed doesn't react in a timely manner to a reduced demand for money.

Increased lending is indicative of a decline in the demand for money, because borrowing is the opposite of accumulating money. That's important because the demand for money during the current recovery has been extraordinarily strong, and that was what prompted the Fed to engage in Quantitative Easing. QE allowed the Fed to accommodate a huge increase in the demand for money and for safe assets by transmogrifying notes and bonds into bank reserves, which are functionally equivalent to short-term T-bills, the world's safe asset of choice. The monumental increase in bank reserves failed to spark any increase in inflation because banks wanted those reserves, and had little or no desire to use them to support increased lending. Banks preferred to lend money to the Fed, even at paltry interest rates, than to lend money to the private sector. As I've noted before, banks lent substantially all of their deposit inflows to the Fed, rather than to households and businesses.

Now, as the demand for money and safe assets recedes, the need for QE not only disappears but begins to reverse. Sooner or later the Fed will need to accommodate declining money demand by shrinking its balance sheet (i.e., by selling its store of notes and bonds in order to pay off the money it has borrowed from the banking system) and/or by raising the interest rate it pays on bank reserves. If banks today are willing to lend more (at a rate which far surpasses what they can earn by lending money to the Fed in exchange for bank reserves), then they are at the same time less willing to hold a huge supply of excess bank reserves which pay only 0.25%. The excess reserves of the banking system are now about $2.6 trillion (see chart above). Interest paid on reserves (IOR) might need to be quite a bit higher than today's 0.25% to keep banks interested in holding billions of excess reserves and not over-lending to the private sector.

Now let's look at the facts:

Total bank credit for many years rose at a little over 8% a year. That changed completely in the wake of the 2008 financial crisis, when bank lending virtually ceased. Banks were extremely reluctant to lend, and businesses were extremely reluctant to borrow, with many businesses and households preferring to deleverage instead. It was all the result of a collapse of confidence in the future, and a fear that another global collapse lurked just around the corner.

A closer look at the recent past (see chart above) shows that the pace of bank lending started picking up about one year ago. In the past year, bank lending has increased 8.2%, and over the past three months, bank lending has risen at a 10.6% annualized pace, by far the fastest pace since the Great Recession. Bank credit has increased by $840 billion since early January 2014. That's some serious money creation.

About one-fourth of the increase in bank lending has taken the form of direct loans to small and medium-sized businesses (see chart above). C&I Loans are up over $200 billion in the past year, for a 13.5% increase. Through their ability to lend, banks can create money, and they are doing it in spades. The Fed has enabled banks to lend virtually without limit through its ample provision of bank reserves.

In its classic formulation, inflation happens when the supply of money exceeds the market's demand to hold that money (think "too much money chasing too few goods and services"). Until recently, despite flooding the banking system with reserves, there was no unwanted increase in the money supply; banks were happy holding mountains of excess reserves and increasing their lending activity at a modest rate. Now they are less happy holding tons of excess reserves paying a paltry 0.25% and have stepped up the pace of lending. This is the first step in what could prove to be an over-supply of money and a subsequent rise in inflation. It might take 6-12 months before this shows up in the inflation statistics, but in the meantime it bears close scrutiny and argues strongly for caution when deciding whether to hold Treasuries at today's historically low interest rates. Rising confidence implies faster growth, and, in today's post-QE world, the threat of rising inflation. Both spell bad news for Treasuries.