Category: Money Moves Markets

Friday’s US employment numbers for May were reported as being disappointing because of a smaller-than-expected gain in private-sector payrolls. A revival in private employment incomes is a necessary component of a sustainable economic recovery.

The reaction, however, looks exaggerated, for three reasons. First, the small May rise followed strong gains in March and April, so the three-month increase remains solid at 0.4%, or 1.6% annualised.

Secondly, employees worked longer hours on average in May, compensating for the smaller jobs increase. Aggregate private-sector hours have risen by an unusually-strong 1.3%, or 5.4% annualised, over the last three months – see first chart.

Thirdly, an alternative measure of private-sector employee jobs derived from the monthly household survey shows a stronger recent gain – second chart. This measure is more volatile but may be a better indicator around turning points in the cycle, partly because it should pick up trends in smaller firms that are underrepresented in the payrolls survey.

A prior post drew attention to a sharp increase in the US and Eurozone monetary base – currency plus bank reserves – during the first half of May, suggesting that this would contribute to a short-term rally in equity markets and other risk assets. This rise, however, has been partially reversed over the last fortnight – see first chart.

Lows in the US monetary base have preceded US equity market troughs by between two and four weeks since early 2009 – see earlier post. The base bottomed in the week to 5th May while the lowest close for share prices during the recent decline was on 26th May. The base was still 2.7% above its early May trough in the week to Wednesday.

Recent developments echo June / July 2009. The US monetary base fell back after an initial recovery but equities continued to rally strongly – first chart. This may have reflected offsetting stimulus from a large increase in the Eurozone base in late June, resulting from a 12-month ECB lending operation.

The Eurozone monetary base has again risen by more than its US counterpart in recent weeks, though by less than in June 2009. The ECB has curbed the increase by issuing one-week deposits to sterilise the impact of bond purchases under its securities markets programme. Banks, however, are likely to regard these deposits as a close substitute for reserves. An expanded monetary base definition including term deposits has risen by 9.6% since late April.

Measures of equity market sentiment, meanwhile, have recovered from oversold extremes as prices have rallied but are not yet signalling exuberance. The 10-day moving average of the CBOE put / call ratio, for example, remains above levels reached before recent short-term market peaks – second chart.

The current rally, therefore, may have further to run but is likely to face increasing headwinds unless monetary base expansion resumes. The wider macroliquidity backdrop, moreover, remains cautionary, with global real narrow money, M1, growing more slowly than industrial output, suggesting insufficient monetary fuel to power sustained market strength.

The ECB was forced to step up its support for Greece during April as the run on the country’s banking system gathered pace.

The Bank of Greece has yet to release full statistics on its website but its monthly financial statement shows lending to credit institutions of €84.8 billion at the end of April, up from €67.0 billion in March. The increase of €17.8 billion represents an acceleration from gains of €7.2 billion in March and €12.5 billion in February – see chart.

ECB / Bank of Greece lending of €84.8 billion is the equivalent of 17% of the assets of the Greek banking system at the end of March, the latest available month. It exceeds the ECB’s capital and reserves of €77.3 billion, according to its latest weekly statement.

The ECB has acquired an additional exposure to Greece of €25 billion via purchases of government bonds under its securities markets programme, according to press reports.

National central bank statements show little change in ECB lending to banks in Ireland, Italy, Portugal and Spain during April, suggesting that a Greece-style run has yet to develop in these economies. The largest increase was in Portugal, where Banco de Portugal lending to domestic banks rose from €16.1 billion to €18.4 billion.

Foreign investors continued to buy gilts and Treasury bills on a large scale in April, probably reflecting a flight of capital from the Eurozone as its sovereign debt crisis reached a crescendo. Gilt and bill purchases were £13.1 billion and £1.3 billion respectively versus £14.2 billion and £4.4 billion in March. Total buying was a record £42.1 billion in the three months to April – almost sufficient to finance a public sector net cash requirement of £42.6 billion.

Other features of the April monetary data include:

• Broad money, M4, rose by a further 0.3%, pushing three-month annualised growth up to 6.6% versus just 0.2% in January. This acceleration defies pessimists who claimed that M4 would contract when the Bank of England stopped gilt purchases. (M4 here refers to the Bank’s preferred measure excluding money holdings of non-bank financial intermediaries.)

• Banks and building societies have partially compensated for the end of official buying, purchasing £6.3 billion of gilts in April and £13.5 billion in the latest three months.

• While the M4 pick-up is welcome, the sectoral breakdown is less encouraging, showing money holdings of non-financial corporations falling over the last three months. The corporate liquidity ratio, nevertheless, has recovered significantly since early 2009, supporting expectations of a revival in business investment and hiring – second chart.

• Narrow money trends, also, are slightly disappointing, with M1 expansion slowing to 2.7% annualised in the latest three months. Annual growth of 4.8% is much lower than in the Eurozone – 10.7%.

• M4 lending to households remains sluggish while non-financial corporations continue to repay bank borrowing, reflecting their strong net free cash flow surplus. Weakness in credit demand, however, could be starting to abate – the stock of unused facilities granted by banks rose slightly in the three months to April.

Monetary trends, overall, remain consistent with solid economic growth and may not prevent a continued inflation overshoot – the non-inflationary rate of broad money expansion has probably fallen well below historical norms as the demand to hold money has been depressed by negative real interest rates.

Dollar industrial commodity prices fell by 8% during May but are still up by 15% from six months ago, as measured by the Journal of Commerce index, covering 18 materials used in manufacturing production including crude oil and natural gas.

The six-month rate of change of commodity prices continues to correlate closely with that of industrial output in seven large emerging economies (the “E7”) – see first chart. This relationship suggests that 1) the recovery in commodity prices since early 2009 has been driven by “fundamentals” rather than speculation and 2) prices will rise further unless E7 six-month output growth slows to below about 3%, or 6% annualised.

Such an output slowdown, meanwhile, is unlikely while E7 real narrow money, M1, continues to expand strongly – second chart.

Monetary pessimists on Eurozone economic prospects cite recent weakness in broad money, M3 – down by 0.1% in the year to April. A detailed examination of the data, however, suggests that monetary conditions are consistent with an ongoing economic recovery and little risk of Eurozone-wide deflation:

• M3 has been depressed by a shift of funds into longer-term bank instruments – deposits with agreed maturity of over two years or subject to notice of over three months and securities of over two years’ maturity. These instruments are excluded from M3 but would be captured by the UK’s M4 definition, which includes all sterling deposits together with securities of up to five years’ original maturity. A Eurozone M4-type measure rose by 1.7% in the year to April, above the latest annual growth rate of UK M4 of 1.2% (in March) – see first chart. (UK M4 here refers to the Bank of England’s preferred definition, excluding money holdings of non-bank financial intermediaries.)

• M3 and M4 have picked up recently, rising by 3.3% and 2.9% annualised respectively in the latest three months.

• As in other major economies, with the exception of Japan, broad money demand of households and financial institutions has been reduced by negative real interest rates, so slow overall expansion has not prevented a strong recovery in corporate money holdings – M3 deposits of non-financial corporations rose by 6.1% in the year to April. With firms continuing to repay bank debt, one measure of the liquidity ratio (i.e. corporate M3 deposits divided by bank loans of up to five years’ maturity) is at a record high – second chart.

• Narrow money M1 – comprising currency and overnight deposits – has been a better leading indicator of the economy than M3 historically and should be less affected by the recent shift in demand. It is still growing strongly – by 10.7% in the year to April and 9.8% annualised in the latest three months.

At yesterday’s close, the Dow Industrials index was 7% below the six-bear average and only 2% above the bottom of the six-bear range – see chart and prior post for background.

The ECB has been at pains to distinguish its securities markets programme (SMP) from US- and UK-style quantitative easing (QE). The differences, in practice, look minor.

Bond buying to date has been on a larger scale than suggested by the stated objective of restoring depth and liquidity to dysfunctional markets. €26.5 billion of securities were purchased in the first seven days (assuming T+3 settlement), equivalent to a weekly rate of €18.9 billion. If this pace were sustained for three months, the ECB would acquire a portfolio of €246 billion, equivalent to 2.6% of Eurozone broad money, M3, and 33% of the outstanding government debt of Greece, Ireland, Portugal and Spain (15% if Italy is also included).

The ECB claims that the SMP will have no impact on monetary conditions because buying will be sterilised. This is oversimplistic. A purchase of bonds from a non-bank investor results in an increase in both the investor’s bank account balance, included in the broad money supply, M3, and bank reserves, a component of the monetary base. If the ECB sterilises the purchase by conducting a reserves-draining operation with the banking system, the rise in the monetary base is reversed but not that of M3. (The M3 increase is reversed only if sterilisation involves a sale of assets to the non-bank private sector. Note that M3 is unaffected if the initial purchase is from a bank rather than non-bank.)

While the ECB is sterilising its bond purchases, moreover, it has reverted to supplying unlimited funds in its three- and six-month lending to the banks, in addition to the main one-week repo operation. The monetary base, therefore, is being determined by banks’ demand for ECB credit, which has increased as weaker institutions have suffered funding shortfalls. Accordingly, the base has risen by 3.8% in the first two weeks of the SMP and is up by 7.4% since late April.

The ECB’s method of sterilisation – auctioning one-week deposits to banks with surplus liquidity – is, in any case, cosmetic. Banks are likely to regard these deposits as a close substitute for reserves. The effectiveness of sterilisation may depend on the length of time reserves are removed from the system, with permanent asset sales having the largest impact.

The SMP, so far at least, appears to pass the QE “duck test”. Opposition from Bundesbankers and their ECB allies, however, could yet derail the programme.

As expected, GDP growth in the first quarter was revised up from 0.2% to 0.3%. More importantly, the profile of output over the three months implies a strong starting base for the second quarter.

The chart shows quarterly GDP together with a monthly estimate based on services and industrial production, which have a combined weighting of 93%. After a 0.7% fall in January, partly reflecting weather disruption, monthly GDP rose by 0.6% and 0.7% respectively in February and March. The March reading was 0.6% above the quarter average.

GDP inflation, meanwhile, picked up further last quarter. The deflator for gross value added (GVA) at basic prices – which fully adjusts for the VAT hike and may therefore understate the underlying trend – rose by 1.0%, or 4.0% annualised.

Nominal GVA expansion, therefore, accelerated from 3.6% annualised during the second half of 2009 to 5.1% in the first quarter. Such a growth rate, if sustained, is unlikely to be compatible with the 2% inflation target over the medium term.

The US monetary base (currency plus bank reserves) rose again in the week to Wednesday and is now up by 3.7% from its low a fortnight ago, following a 9.4% contraction between late February and early May. A recovery in the monetary base preceded a rally in equities by three weeks in February / March 2009, by two weeks in June / July and by four weeks in January / February this year – see first chart.

The Eurozone monetary base also rose in the week to last Friday and is up 9.7% since late April – first chart.

Some measures of equity market sentiment look extremely oversold. The Chicago Board Options Exchange equity put / call ratio, for example, is at its highest level since the bear market ended last March – second chart.

The sustainability of any rally in equities may depend on whether central banks continue to expand liquidity. The Fed may be reluctant to reverse fully the earlier contraction of the monetary base unless it believes that market turbulence is a serious threat to the economic recovery. The impact on the base of its dollar swap lending to European central banks has so far proved small – the ECB’s 84-day tender of dollars this week attracted bids of only $1.0 billion. The ECB, meanwhile, continues to state that it will sterilise the liquidity effect of its “non-standard” measures.

A signal that the Fed was turning more expansionary would be an announcement of a reduction in the “supplementary financing programme”, under which the Treasury has issued an additional $200 billion of bills, placing the proceeds in a special account at the central bank. The Treasury could repay maturing bills by running down the balance in this account, thereby boosting bank reserves and the monetary base.

A further reason for caution about any rally is the still-unfavourable balance between global economic and monetary growth. G7 real narrow money, M1, is continuing to expand more slowly than industrial output – third chart.

The fourth chart shows regional equity market performance, including currency, relative to the World index. Europe ex. the UK has underperformed significantly so far this year but the price relative has made higher lows recently, hinting at a turnaround. Extreme investor pessimism about Europe and the euro is already reflected in positioning, while real M1 is growing faster in the Eurozone than in the US, Japan and UK.

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COMMENT:
AUTHOR: APB
EMAIL:
IP: 217.43.167.171
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DATE: 05/24/2010 11:26:13 AM

Excellent work, Simon – thank you. You are always a superb read!
On a technical point – on your chart 3 – am I right in thinking that %ch 12mth in Real M1 and G7 Ind Output gives better asset allocation signals than % ch 6mth…?
I remember thinking that from some of your earlier posts…
Thanks
APB

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COMMENT:
AUTHOR: Simon Ward
DATE: 05/25/2010 10:12:20 AM

Many thanks and, yes, I put greater weight on the 12-month growth rate relationship, though have not formally tested the difference.