It’s official: the M3 money supply series is no longer in use. According to the Federal Reserve, this isn’t a significant issue. For context on M3 and its discontinuation, you can read our previous post here.
In the latest weekly money supply report, the Fed stated that M3 does not provide any additional insights into economic activity that are not already captured by M2. The Board determined that the costs associated with collecting data for M3 outweighed the benefits it offered.
This decision might also be viewed as part of the Fed’s efforts to address the government budget deficit. Edward Nelson from the St. Louis Fed supports this viewpoint, emphasizing that a broader definition of money supply, which M3 represented in relation to M2, isn’t always optimal. In the April issue of Monetary Trends, Nelson argues that “a broader definition of money is not necessarily always preferable. Monetary analysis should distinguish between money and non-money assets, as some financial instruments do not share enough characteristics with traditional money to justify their inclusion in a monetary aggregate.”
Next week, during the FOMC meeting on March 27 and 28, will the Federal Reserve opt to raise interest rates again? This brings forth the question: is the central bank prepared to exacerbate the trends contributing to an inverted yield curve? If so, what message will they convey to the markets?
As of now, the yield on the two-year Treasury is slightly above that of the ten-year Treasury by four basis points. If the Fed raises the Fed funds rate by 25 basis points to 4.75%, it could further steepen the inversion by increasing the cost of short-term money. The current yield on the six-month T-bill is at 4.80%, and a 25-basis-point increase would exceed the 5% mark.
There seems to be little skepticism about another 25-basis-point increase next week, especially among Fed funds futures traders. The April contract has long been pricing in an expectation of the 4.75% rate.
In recent years, commodities have regained popularity among investors. This resurgence is arguably more strategic than the previous excitement during the 1970s and early 1980s, partly because of widespread research indicating the diversification benefits of including commodities in a portfolio of stocks and bonds.
However, there are concerns that the diversification benefits may diminish over time as an increasing number of investors enter the market. Monitoring the correlations of returns between commodities and other asset classes – primarily stocks and bonds – can provide insights into this trend. Recently, it appears that these correlations are increasing.
Consider that the rolling 36-month correlations between stocks and commodities have risen sharply over the past year, as shown in the chart below. Correlations between commodities and bonds have also seen a recent uptick, albeit less dramatically.
David Kotok, the Chief Investment Officer of Cumberland Advisors, is taking precautions regarding a potential outbreak of bird flu in the United States. Is this fear justified, or should we dismiss it?
Kotok emphasizes the importance of being cautious. In an email to clients last Friday, he stated that bird flu is a significant concern. Our conversation with him reveals his proactive approach.
It’s unclear if other financial professionals share his concerns, as anecdotal evidence suggests that worry about bird flu hasn’t gained much traction yet. However, this could change rapidly. For now, Kotok appears to represent a minority perspective in the financial world.
If you’re interested in hearing from this minority voice, Kotok is knowledgeable about bird flu and has consulted various officials on the matter. He believes that if risks increase, raising cash may become necessary, even advising selling equities entirely if the situation worsens.
At present, bird flu remains a distant threat, and cash-only portfolios are still primarily theoretical. Time will tell if this situation changes; however, the flu appears to be gaining traction, as evidenced by the chart below. Although the human death toll remains small, it is increasing, as is the number of countries reporting avian flu.
Source: US Health & Human Services Dept.
With the migratory season for Asian birds approaching, Kotok warns that vigilance is necessary. U.S. Interior Secretary Gale Norton echoed this sentiment, stating that “it is increasingly likely that we will detect a highly pathogenic H5N1 strain of avian flu in birds within U.S. borders this year,” as reported by McClatchy News Service via the Detroit Free Press.
(For more information on the government’s stance on bird flu, visit PandemicFlu.gov. For updates, Google offers news coverage on this topic. Stay informed and remain wary of unfamiliar wildlife in your vicinity.)
Effective asset allocation is critical for developing prudent, long-term investment strategies. One of the key considerations in this process is selecting the asset classes that will provide the most robust diversification benefits, and appropriately weighting these assets. Modern portfolio theory suggests there are three primary factors that influence this decision: return volatility, expected returns for each asset, and the correlation of returns among those assets.
Focusing on correlations reveals notable trends for strategically minded investors. While we will be publishing more on correlations soon, here’s a preliminary look at what we are tracking. Let’s explore the classic stock/bond combination, analyzing rolling 36-month correlations for monthly total returns between the Russell 3000 and the Lehman Aggregate Bond Index, starting from January 2001 to last month.
The chart below indicates that the historically negative correlation between equities and fixed income is shifting. While stocks and bonds still show a slight negative correlation, suggesting effective diversification, a continuation of this trend may prompt investors to rethink their expectations regarding the classic stock/bond mix. (Note: 1.0 indicates perfect correlation, 0 indicates no correlation, and -1.0 denotes perfect negative correlation).
In our previous post, we mentioned that “the trend is your friend.” However, it’s essential to clarify that, at times, trends can both support and detract from success, depending on the context and specific circumstances. In light of the ongoing deficit spending by the U.S. government, we recognize current trends and their context; only the eventual outcomes remain uncertain. Although we may speculate on financial implications, these remain mere suspicions for now.
Before delving into the $781 billion deficit at hand, we must clarify the numerous financial commitments within Congress. To avoid confusion, we are specifically referencing the Senate vote to raise the federal debt ceiling by $781 billion.
In some contexts, $781 billion represents a substantial sum. To illustrate, this amount could purchase over 39 billion copies of the paperback edition of Ben Graham’s Intelligent Investor, more than 24 million Lexus ES300 cars, or nearly 2.68 million homes at the average U.S. price as of January, based on Census Bureau data. Yet, within Washington’s budgetary framework, $781 billion is relatively minor, totaling under 9% of the overall government debt of approximately $9 trillion.
The recent consumer price data for February has encouraged those who believe inflation is under control. According to the Labor Department, consumer prices rose only 0.1% last month, a significant decrease from the 0.7% uptick in January, leading to a collective sigh of relief on Wall Street. The core rate (excluding food and energy) also increased by just 0.1% in February.
In February, housing starts dipped by 3.2%, as reported by the Commerce Department.
For now, the Federal Reserve is receiving commendation for effectively managing inflation while moderating the housing market. Some argue that a cooling housing market is overdue, particularly to counterbalance the growth seen in recent years, which some claim was fueled by the Fed’s previous low-interest-rate policies.
In light of contained inflation, a decelerating housing market, and recent economic reports supporting a robust economy, even the bond market is witnessing renewed buying interest, with the benchmark 10-year yield resting at 4.66%—down from near 4.80% just days ago.
While it may not be perfection, the current environment supports optimism about the economy’s performance. Risky assets have been rewarded handsomely in the stock market thus far this year, with small-cap stocks outpacing large caps. According to sector analysis of the S&P 500 and S&P 600, certain sectors have experienced substantial gains without any reported losses so far this year, as highlighted in the following charts.
In the large-cap category, telecom services have surged almost 14% through March 15. Meanwhile, small-cap materials have risen nearly 18% year-to-date. Though momentum may not always guarantee long-term success, opposing the current trend has proven to be a costly endeavor thus far.
Recent reports indicate that the U.S. current account trade deficit soared to an all-time high of $225 billion in the fourth quarter, marking a 21% increase from the previous quarter, according to the Bureau of Economic Analysis. This record-high deficit for 2005 represents a significant uptick in both absolute dollar terms and as a percentage of the economy.
One might expect this news to unsettle bond traders, suggesting the possibility of rising interest rates. However, contrary to expectations, fixed-income markets exhibited optimism. As a result, buying activity was evident on Tuesday, and the 10-year Treasury yield dropped sharply, falling to just under 4.70% from nearly 4.78% the previous day.
One could argue that this decline in yield is merely a temporary adjustment in what has been a rising trend in long-dated bond prices. The 10-year yield previously dipped below 4.3% in January but was threatening to exceed 4.80% by the start of the week.
Despite various global tensions, stock markets have largely continued to rise. This phenomenon could be attributed to either justified optimism or an overt disregard for risk; regardless, it is clear that 2006 has been a favorable year for equities. While the future remains uncertain, the results thus far are difficult to contest. Indeed, many investors have already accrued substantial gains by March.
All 29 regional and world benchmarks in the S&P/Citigroup Global Equity Indices series have shown improvements this year as of March 13, building on strong performances from the previous year. Though total returns vary by market, diversifying investments globally has generally proven profitable.
Among regional/world indices, the standout performer this year (through March 13) is European Emerging, which has seen a remarkable total return of 17.32%. Meanwhile, Asia Pacific, despite being the lowest performer, is still in positive territory with an increase of 1.64%.
Some optimistic analysts predict further potential for growth in global equity markets. In fact, bond market participants are currently apprehensive that economic growth may exceed previous projections, a revelation that often invigorates equity buyers.
Nonetheless, amidst the buoyant stock market, it is crucial to identify regions that may seem overpriced versus those presenting better value. However, accurately determining these disparities is challenging and may lead to misleading interpretations. Moreover, external, unforeseen threats could emerge, potentially disrupting market equilibrium without warning.
Today’s data enthusiasts might feel a bit of a void, as there are no significant economic releases scheduled. Fortunately, the Federal Reserve’s quarterly Flow of Funds report for the fourth quarter was updated and released last Thursday. This report provides ample data to satiate even the most avid number enthusiasts. To alleviate any withdrawal symptoms, we present a key excerpt from the report via the following chart:
Amid rising anxiety in the bond market, signs suggest that consumer willingness to amass further debt has slowed. Consumer credit contracted in the fourth quarter for the first time in a long while, while growth in home mortgage credit also decelerated. Is this a sign that consumers are reevaluating their spending habits? If so, could this impact the recent economic momentum?
This question carries numerous risks, and the fixed-income market seems to respond with a resounding “no.” In fact, as we write, the yield on the benchmark 10-year Treasury is just under 4.80%, the highest it has been in 20 months.
The Flow of Funds report is retrospective; however, the future is what captures the market’s attention. There seems to be a consensus that the drop in consumer credit could be a short-term anomaly. Based on the futures market, the Fed is anticipated to raise interest rates by 50 basis points to 5.0% by June. If this is accurate, the current yield of nearly 4.80% on the ten-year will appear deceptively low.
This scenario presents a challenge for the bond market: should the current yield-curve inversion be maintained, or is it a fading concern? Additionally, it’s important to consider that interest rates are slowly rising around the globe. Although the shifts are subtle, the direction of movement speaks volumes. Specifically, the European Central Bank seems poised to tighten its monetary policy, as does the Bank of Japan, which has drawn attention amidst speculation that deflation may finally be a thing of the past.
With rising yields both domestically and globally, the week ahead promises a wealth of new data to either affirm or challenge market sentiments. Expect updates on retail sales for February, import price changes, consumer prices, and industrial production throughout the week. Regardless, this upcoming week will not lack in drama.
