More evidence of a bull market, except in Australia

One of my favorite indicators of financial market stress is Corporate bond spreads. The premium charged on the lowest level of investment-grade corporate bonds, over the equivalent 10-year Treasury yield, is a great measure of the level of financial market stress.

Moodys 10-year BAA minus Treasury yields

Levels below 2 percent — not seen since 2004 – 2007 and 1994 – 1998 before that — are indicative of a raging bull market. The current level of 2.24 percent is slightly higher, reflecting some caution, but way below elevated levels around 3 percent.

The Financial Stress Index from St Louis Fed measures the degree of stress in financial markets. Constructed from 18 weekly data series: seven interest rate series, six yield spreads and five other indicators. The average value of the index is designed to be zero (representing normal market conditions); values below zero suggest low financial stress, while values above zero suggest high market stress.

St Louis Financial Stress Index

Current levels, below -1, also indicate unusually low levels of financial market stress.

Leading Index

The Leading Index from the Philadelphia Fed has declined slightly in recent years but remains healthy, at above 1 percent.

Philadelphia Fed Leading Index

Currency in Circulation

Most recessions are preceded by growth in currency in circulation falling below 5 percent, warning that the economy is contracting.

Currency in Circulation

Current levels, above 5 percent, reflect healthy financial markets.


On the other side of the Pacific, currency growth is shrinking, below 5 percent for the first time in 7 years. A sustained fall would warn that the economy is contracting.

Australia: Money Supply

Further rate cuts, to stimulate the economy, are unlikely. The ratio of Household Debt to Disposable Income is climbing and the RBA would be reluctant to add more fuel to the bonfire.

Australia: Household Debt

There is no immediate pressure on the RBA to raise interest rates, but when the time comes the impact on the housing market could be devastating.

A bump for Donald Trump next year

From Tim Wallace at The Age:

Nine years on from the start of the financial crisis, the US recovery may be overheating, Legal & General Investment Management economist James Carrick has warned.

He has predicted a series of interest rate hikes will tip the US into a 2018 recession.”Every recession in the US has been caused by a tightening of credit conditions,” he said, noting inflation is on the rise and the US Federal Reserve is discussing plans for higher interest rates.

Officials at the Fed have only raised interest rates cautiously, because inflation has not taken off, so they do not believe the Fed needs to take the heat out of the economy.

But economists fear the strong dollar and low global commodity prices have restricted inflation and disguised domestic price rises. Underneath this, they fear the economy is already overheating.

As a result, they expect inflation to pick up sharply this year, forcing more rapid interest rate hikes.

That could cause a recession next year, they say. In their models, the signals are that this could take place in mid-2018.

I agree that most recessions are caused by tighter monetary policy from the Fed but the mid-2018 timing will depend on hourly earnings rates.

Hourly earnings are a good indicator of underlying inflationary pressure and a sharp rise is likely to attract a response from the Fed. The chart below shows how the Fed slams on the brakes whenever average hourly earning rates grow above 3.0 percent. Each surge in hourly earnings is matched by a dip in the currency growth rate as the Fed tightens the supply of money to slow the economy and reduce inflationary pressure.

Hourly Earnings Growth compared to Currency in Circulation

Two anomalies on the above chart warrant explanation. First, is the sharp upward spike in currency growth in 1999/2000 when the Fed reacted to the LTCM crisis with monetary stimulus despite high inflationary pressures. Second, is the sharp dip in 2010 when the Fed took its foot off the gas pedal too soon after the financial crisis of 2008/2009, mistaking it for a regular recession.

Hourly earnings growth has risen to 2.5 percent but the Fed is only likely to react with tighter monetary policy when earnings growth reaches 3.0 percent. Recent rate rises are more about normalizing interest rates and are no cause for alarm.

I am more concerned about the impact that rising employment costs will have on corporate earnings.

The chart below is one of my favorites and shows the relationship between employee compensation and corporate profits (after tax) as a percentage of net value added. Profit margins rise when employment costs fall, and fall when employment costs rise.

Profits After Tax v. Employment Costs as a Percentage of Value Added

Employee compensation is clearly rising and corporate profits falling as a percentage of net value added. If this trend continues in 2017 (last available data is Q3 2016) then corporate earnings are likely to come under pressure and stock prices fall.

Source: Warning of bump for Donald Trump next year with slide into recession

Monetary Base and deflation

The Monetary Base consists of currency in circulation and commercial bank deposits at the Federal Reserve. Currency in circulation includes notes and coins both in circulation and held in the vaults of commercial banks. Commercial bank deposits at the Fed can be further broken down into required reserves and excess reserves. Excess reserves on deposit have soared — since late 2008 when the Fed started paying interest on reserves — to a level of $2.6 Trillion.

By varying the interest rate payable on excess reserves the Fed can manipulate the amount of currency in circulation. It is no longer reliant solely on Treasury and MBS purchases and sales to increase or decrease the money supply: these are merely one tool in the monetary tool-kit. So announcing that QE (security purchases) have ended does not mean that currency in circulation and the working monetary base (excluding excess reserves) will stop growing or will contract. That would cause deflationary pressure similar to the European experience. Growth, instead, is likely to continue provided that excess reserves are drawn down to compensate for cessation of QE.

US Monetary Base minus Excess Reserves and Currency in Circulation ROC

Deflationary pressures are unlikely to surface provided currency in circulation and the working monetary base continue to grow at above 5% a year. Only if real GDP grew at a faster pace (a problem we would like to have) would we encounter a problem.

Australia has similarly been keeping on the right side of 5% growth since early 2012. Provided this continues we should keep out of trouble.

Australia Monetary Base and Currency in Circulation ROC