Inflation -- Long Term

To study long term inflation potential, I derive a base inflation
rate by taking the 10 yr. growth rate of money M2 minus my
estimate of economic growth potential. Inflation potential did rise
over the past 10 - 15 yrs to roughly 3.5% per annum on a moderate
acceleration of money growth and a reduction in economic growth
potential, with the latter reflecting a slowing in the growth of the
labor force.

Inflation averaged about 2.6% over the past 10 yrs. compared to
inflation potential of 3.5%. The shortfall obviously reflects bookend
recessions, which impaired demand growth. But it also reflects a long
term downtrend in the rate of capacity utilization. In fact, the last
times the economy operated at effective full capacity was in the 1994-
98 interval. With low output growth over 1999 - 2009 also came a
substantial increase in the trade deficit reflecting in significant part an
influx of lower priced goods from abroad. This development coupled
with a sharp net increase in the off-shoring of jobs contributed to
lower labor costs. Even commodities prices, which did put upward
pressure on the inflation rate after 2002, collapsed over the back half
of 2008 before commencing to recover.

We start the new decade with very large excess slack in the US
economy and globally as well. Inflation potential over the next several
years will remain around 3.5%, but to sustain that kind of elevated
level will require a substantial increase of operating rates and
enough of a recovery in the labor market that workers can begin
demanding and getting stronger wage gains. Upward pressure on the
inflation rate from the occasional flare up of commodities prices is not
likely to prove sustainable without significantly higher levels of
facility and labor utilization.

Inflation Potential

I am looking for the 12 month CPI measured yr/yr to be about 2.5%
for 12/10. It was 2.7% for the comparable period over 2009, but
that is primarily because of the slide in prices over Half 2 '08 that
brought the CPI to depressed levels.

The inflation pressure gauges I use did recover strongly over the
course of 2009, but will have to rise much further over the course
of this year for the CPI to reach the 2.5% by year's end. The CPI,
when measured without food and fuels prices, is in a significant
downtrend presently, and this trend could last through at least Q 2
'10 if not longer (The yr/yr reading through 1/10 is 1.6%). Post
recession downtrends of inflation excluding foods and fuels can wear
on for 15 - 24 months. As matters presently stand, it appears that
commodities prices are going to have regain substantial upside
momentum as 2010 progresses to offset the drag effects of other
components if the 2.5% target is to be reached.

The broad CRB commods. composite rose sharply over much of
2009 but has been on a plateau since Nov. and has been losing price
momentum since mid-2009. Chart. So, we are going to have to see a
revival in the speculative juices of commodities traders to get this
index moving up again.

Another measure I watch closely is capacity utilization. That has been
rising sharply in recent months from very low levels to reflect
inventory rebuilding and strong export sales. Hefty rebounds in
both US and China maunufacturing remain in force and that is a
supportive force for inflation. Heavy inventory speculation in China
helped power commodities prices in 2009. A recent tightening of
credit standards by China banking authorities has cooled speculative
interest in raw materials both within and beyond China, but the
mandate from the top is to maintain strong growth there.

The CPI made its all time high in Jul. '08 and has yet to surpass that
level. So, technically, the US is still experiencing deflation. I use a
smoothed calculation of the CPI to drive my 91 day T-bill interest
rate model. The deflation the US experienced has not been steep
enough to warrant a ZIRP policy. The model currently implies the
"Bill" should be 2.1%. Clearly, then the Fed has waived off a
recovering CPI to support the financial system and an economic
rebound.

Stock Market & Liquidity -- Update

As I have discussed over the past six months, when the real
economy grows faster than the broad monetary/credit liquidity
aggregate, a type of liquidity deficit develops, as the real economy
drains liquidity available to the capital markets, especially the
stock market. When this occurs late in an economic expansion cycle,
it is usually because of monetary/credit tightening by the Fed and
is normally fatal to a cyclical bull market. But a liquidity deficit can
occur during an economic expansion if economic momentum is
strong and credit growth is modest or deteriorating. We last saw
this kind of liquidity deficit from y/e 2003 through mid-2005.

When a deficit occurs as in the 18 months out from y/e 2003, it can
act as a headwind for the stock market even if earnings are
progressing well and short term interest rates are not threatening.
In the 2004 through mid-2005 case, the SP 500 advanced about
6.5% or roughly 4.3% on an annual rate basis. That is sub-par
performance.

I do not think a liquidity squeeze of the sort described above is
necessarily going to retard the stock market's cyclical progress,
but it is logical to think that it will, especially if ready portfolio
cash levels among the various funds are low. Since the latter
situation probably obtains today, it seems wise to keep the
liquidity deficit in mind.

It is likely that the current economic recovery will lose some of
its growth momentum by mid-2010, as low inventory levels are
finally replenished. Moreover, later in this year, we may see
a positive turn in private sector credit demand. Both developments
will ease the squeeze on liquidity and lessen its headwind effect on
the stock market.

Measured yr/yr, the $ cost of US production is up 1.9% after
months of deep negative readings (which created a liquidity surplus).
Looking yr/yr, my broad measure of credit driven liquidity is a
-3.7% through Jan. Thus the liquidity barometer I use is a sharp
-5.6. The deficit should increase in the months ahead before there
is a good chance for reversal.

Stock Market -- Short Term Technical

In the market technical post back on 2/1, I opined that the market
erosion had yielded up a tradeworthy oversold. We wound up with
an interval of choppy waters suitable for day traders, but a more
solid rally did start up last week. The significant short term oversold
has been eliminated. There is now upside to 1130 -1140 before a
challenging overbought would be in place.

Thanks for the rally. I'll leave the remaining short term upside to
others as I am curious whether some cyclic themes will play out
which suggest a more definitive shorter run bottom over the next
5 - 10 odd trading days. And, "curious" is the operant term here.
I have seen cycle action get busted enough times not to get
religious about them. But, since this cyclic play is one I happened
upon without any coaching, I look forward with enjoyment to see
if it plays out or if it is a mere passing phase.

S&P 500 chart.

Investment Grade Corporate Bonds

A cyclical uptrend in corporate bond yields turned into a rout in
the latter part of 2008, as economic free fall spread fear rapidly
through the corporate bond market. However, by late in the year,
investors began to recover confidence that strong companies and
their bonds could weather the storm. It was not smooth sailing
though as another wave of fear gripped the market over Q1 '09
before bond prices firmed again and yields fell.

In the early stage of an economic recovery, investment grade
corporate bonds can fare better than Treasuries as investors
gain confidence in the business outlook and do sector swaps from
Treasuries into high grade corporates and subsequently into lesser
quality credits. Moreover, the willingness to assume greater
credit risk can lead to rising corporate bond prices even as Treas.
prices fall. This rotational process can go on for an extended
period, especially if short rates are so low that investors push
extra hard to pick up yield.

So, it is interesting that high grade corporate yields have
stabilized and advanced in recent months. Top grades trade at
a roughly 200 basis point premium to 10 yr Treasuries when
it would not be surprising if they traded at only 100 bp over the
10 yr. Note also that yield spread between high grades and lesser
light BBBs is also still relatively wide. This does suggest that there
remains residual investor fear about how solid and durable the
economic recovery may be. The fast answer is that as the economy
proceeds with recovery, confidence will grow and yield spreads
will narrow further in the bond market. That is not a troubling
response as it stands. However, because high grade yields have
been moving more sympathetically with Treasury yields, players
have to keep in mind that further swapping out of Treasuries
into corporates could be accomplished as both yield levels rise
and that further swapping need not produce rising prices for
corporates and falling yields. In short, narrowing yield differentials
in quality may not assure the elimination of price risk as you
purchase corporates. If you are using bonds in your investment
portfolio, keep this issue in mind since an upturn in corporate
yields could accompany the same in the Treausry market.

Moody's BAA chart here.

Long Treasury Bond -- Strategy Issues

As I mentioned in the 2/9 post, I use a momentum indicator based on
the $ cost of industrial commodities production (6 mos. Ann./rate). I
long ago rolled this into a much broader macro measure and use the
latter, broad measure as a long Treasury direction measure as well.
Both guides are trending up, but momentum is slowing because
both industrial commodities and the broader CRB index have lost
thrust.

Interestingly, since 2004, the Treasury market has been less
sensitive to upsurges in the CRB commodities index as well as the
CPI. My guess here is that the Treasury market players regard a
fast rise in oil, petrol and natural gas prices as a tax on consumption,
figuring that it will penalize real incomes and confidence and thus
bring about slower real economic growth. This could be an instance of
a broader issue, namely that an acceleration of inflation which quickly
outstrips wage growth will eventually punish the economy, not to
mention force the Fed into tightening moves. So, in deciding about
the merits of the bond market, you may have to study the inflation
drivers and not just the CPI overall.

I also plan to watch the Treasury yield more closely compared to the
momentum of the leading indicators, since bond players clearly
now figure that once growth momentum fades, inflation pressures will
abate and the Fed may ease credit. Leading indicator momentum
here (Scroll down).

In summary on this point, bond players now regard inflation as both
limited and cyclical. That could all change in the future, but you will
need evidence which contradicts first.

The long Treasury yield has taken off rapidly against a ZIRP for
short rates. Bond players are figuring that sooner or later, the Fed
will push up rates as economic recovery proceeds and are not
waiting. By super long term historic standards of positively shaped
yield curves, a 4.60% long term Treasury implies a 3.0% 91 day
T-bill. Here, it is possble that once short rates lift, the Treasury
yield may exhibit below average sensitivity to it. Something to
consider. You also have to keep in mind that if economic momentum
slows during the ZIRP interval for short rates, bond traders could
anticipate a fast long side trade with Treasuries, reasoning that less
monetary accomodation will be postponed.

It is possible that with the large budget deficits on tap ahead, the
Treasury yield could develop a "supply premium" as investors
demand a higher yield in lieu of upcoming heavy new issue volume.
Too early to tell on this I think.

Bond analysis has become more complicated and dynamic, but I
think it is still manageable. I hope these additional comments prove
helpful.

The Fed's Exit Strategy

Today, chairman Bernanke presented to the House a plan of phased

withdrawal of the extraordinary monetary stimulus from the

financial system. I have linked to it here. It is an important

document and has the merit of being easy to follow. I discuss some

of my impressions below.

The plan is to end all stimulus programs by the end of Q1 '10. The

focus then will be on managing down the $1.1 tril. of excess reserves

as the economy continues to recover. The control levers for the

plan are term deposits offered to banks which "lock up" reserves,

the rates paid on reserves and on the deposits and a return to

normal discount window function. The Fed will also use "reverse"

repurchase agreements to drain reserves as needed to keep the

management of the special CDs to banks in trim. At the same

time, the Fed will conduct normal open market operations in

the overnight market. So, you will have to watch Fed Funds rate,

the rate paid on reserves, the term and rate structure of the CDs

and the discount rate as well as the repo operations.

It would be wise for the Fed to put this approach into practice

before the banks begin to lend more aggressively, although it is

not necessary. As short term credit demand expands, the Fed

plans to drain excess reserves permanently in an orderly

manner underneath the structure it has in place to manage the

reserves. I am guessing the Fed will ultimately drain about

$900 bil. of excess reserves, and allow the remaining $200 bil.

to flow into permamnent reserves as private sector credit demand

expands. Timing is uncertain.

Should banks exit the CDs at a rate faster than the Fed plans, it

will have the reverse repo facility at hand to counter the move.

The Fed will expand the dealer network it uses to engage in the

repo program and It appears confident it can generate large

enough volumes to do the job.

So, we are in for a period when there are more important moving

parts in the conduct of monetary policy, and my concern will be

how well the Fed balances the need to keep the system liquid

against eventual constrictions on credit. It is all well and good

to fight inflation, but not at the expense of too heavy a drain on

simple monetary liquidity. We've seen enough of that.

The operatiion of the plan will be reported on a timely basis and

will be sufficiently transparent to allow interested parties to see

just how the Fed is proceeding. Much of the dumb stuff published

about the alleged consequences of the Fed's actions for inflation

etc. can be safely ignored in place of observing what the Fed is

actually doing.

30 Year Treasury Bond

I want to post some work on the bond market, so I thought I would
start with my favorite -- the long Treasury. Inflation has been in a
long term downtrend for around 30 years. So has the long Treasury
yield. Moreover, as investors have gained confidence that inflation
was staying in its downtrend, they have demanded a smaller
premium in yield over the inflation rate as time has passed. To top
it off, the Treasury bond has been a good forecaster of the inflation
trend over time, and as investor confidence in the market has
increased, the bond yield has become less sensitive to shorter term
swings of inflation.

The bull market in Treasury bond prices that has accompanied the
long run downtrend of yield has been one of the great fixed income
bulls of all time. And, since inflation pressure has subsided by such a
large margin over the years, it would be flippant simply to proclaim
the demise of the bull.

Over the 1988-98 period, the premium in the yield of the long Treas.
over the CPI (yr / yr) ranged primarily between 300 - 500 basis
points (3% - 5%). Since then, the premium has eroded to a range of
200 - 250 bp when monthly extremes of inflation / deflation
readings are X'd out. When I use a constant 3% inflation rate, the
range in premium is 130 - 230 bp excluding the outliers.

Short term changes to the inflation rate have heavily reflected the
swings in the commodities market over the past 10 years, most
notably oil, petrol and natural gas. So, in looking at the Treasury
market, I have grown more comfortable with the idea of a constant
3% inflation assumption. On this basis, the 30 yr. Treas. -- now
4.55% -- should yield between 4.30 - 5.30%. Since the present
yield is at the lower end of the range, I conclude inflation
expectations are subdued.

On a short term basis, the Treas. bond yield is most sensitive to an
index of the momentum of the $ value of sensitive materials
production. When the economy went into free fall starting in mid-
'08, that index stood at 117.9. It plummeted to an extraordinary low
level of 40.0 by 1/09. It has since shot back up to about 130. The
bond yield followed the same "V" pattern as you know. Since the
heavy industry momentum index is now at an unusually high level,
I suspect the upward thrust on the Treasury yield has seen its peak
in the short run.

I do not see much reason for upward pressure on the long Treas.
yield in the short term. However, as the economic recovery persists,
there will be a couple of more upswings in sensitive materials prices.
On top of that, the Fed will eventually push up short rates, and
broader cyclical pressure will lead to more acceleration of inflation
pressure. So, over the next 12 mos. it seems reasonable to expect
a cyclical rise in the long Treas. yield up toward 5.25 - 5.50%.

From a technical perspective, the bond market now has a slight
downward tilt to yield when measured by 26 wk. momentum.
It is neutrally priced against the 40 wk. yield m/a. 30 Yr. Chart.
Since I like to trade extreme readings above / below the 40 wk. m/a,
the bond is not interesting now.

Economic Indicators

Leading Indicators
The weekly leadings lost a little ground in recent weeks but remain
in strong uptrends. There were negative short term reversals in
unemployment insurance claims, sensitive materials prices and the
stock market. My reading of the weekly indicators is that they are
probably due to come off the powerful trajectories they have been
on. However, there has yet to be a break in % momentum of the
indicators when viewed yr/yr.

The monthly indicators -- heavily weighted to new orders -- did
hit a new cyclical high in Jan. Momentum here is strong but is
slowing. The services sector is on a moderate track and trails the
strong manufacturing sector by a significant margin. (The services
sector did not experience the inventory liquidation led free fall seen
in manufacturing over H 2 ' 08.)

Key $ Series
Retail sales, production in $, new factory orders, spending for
capital equipment and tech. and exports are also advancing with
exports the clear leader. Housing remains in the doldrums with
only a hint that new purchase mortgage applications could finally
be bottoming after a 50% decline over the past five years. Profits,
as mentioned yesterday, are also recovering rapidly.

Business Strength Index
This index has improved rapidly over the past year and now
stands at 130.6. The Fed normally raises short term rates when
the index breaks through 130 and gets into the 130 - 140 range.
An issue here is that capacity utilization is still low. Moreover, the
capital stock is now shrinking. If policy is for exports to be a
leader for the US as Pres. Obama insists, the Fed will have to be
even more mindful of operating rates going forward. After a boom
in the 1990's, the US is due for a new round of greenfield expansion
to put more productive equipment on line if it is to stay competitive
down the road.

Economic Power Index
This index gives a quick look at underlying consumer purchasing
power. Persistent decay over 2007 - mid-2008 helped underwite
the deep recession. When inflation fell away in latter 2008, a large
spurt up in the real wage saved the US from an even deeper
downturn. The index lost ground again over Half 2 '09, but did
improve sharply in Jan. as the real wage held up better, and as
total civilian employment increased. further improvement will
be needed over 2010 to secure continued economic recovery.

Capital Slack Index
This measure is improving from the lowest levels seen since the
end of WW2. With slack this ample, the odds favor a lengthy
period of economic recovery / expansion that could easily run
out to 2016 or longer before full tilt is hit.

Global
The rest of the world went off the economic cliff with the US over
Half 2 ' 08. Global recovery is underway, but its momentum, when
measured in new orders data, has leveled off. I would have to say
this is a disappointing development as weaker foreign credits like
Greece and Spain need to see rising business and household cash
flows to buttress their revenue take.

Dragon Has Hoarded Materials
With official China now signalling that a touch of moderation of its
aggressive monetary policy may be in order, inventory speculation
by China companies may be easing . Check out copper.

Stock Market

I covered the cautious technical picture in the 2/1 post (below).
Today, I focus on fundamentals and a bit on psychology. The SP 500
closed today at 1063 after a sharp fall. But the market has really
spent most of its time closer to the 1100 level for a good several
months. At 1100, the market is discounting 12 mos. earns. of $67.
That's about where the consensus forecast is for 12 mos. earns.
through mid-2010. So, I view the market as having stalled out
after it discounted earnings recovery out to the middle of this year.
For my part that represents reasonable behavoir, as it gives time
for the underlying trend of earnings to catch up and "verify" the
advance.

As I discussed in the 2/1 post, I think the first leg of this cyclical
bull market was completed in recent weeks, with the sharp
ascent reflecting rapidly recovering profitabilty from a first
ever small operating loss for the "500" in Q 4 '08, to a quarterly
net per share earning power of around $17 currently. The
recovery move was accomplished by the very aggressive cost
cutting of the component companies, advancing sales volumes
off a low base, and of course, the elimination of the bankrupt from
the index.

As we go forward, we will see the development of modest yr/yr
sales growth spread over reduced cost structures, which will
support further earnings recovery over the second half of the
year. the cost cutting is a done deal, so now the focus for investors
is on the sales recovery. At this point, the leading economic
indicators suggest that sales will continue to recover through
the year on a yr/yr basis, but do not as yet provide signals on
the momentum of sales growth after mid-year. Again, it is
understandable to me why the market would pause as it has.

From a psychology standpoint, I think it is also reasonable for
investors to get a case of the shivers in the wake of a severe combo
recession / financial crisis. It was a harrowing time and
subsequent concerns about growth or credit viability can work to
re-generate some fears as mentioned back in the 9/18 piece
when I first suggested some caution on the market. The classic
example was the 1932 - 33 period when the market rallied
furiously off its low in the summer of '32, was then engulfed again
by fears that hung around for more than six months, and with this
to be followed by a double to the upside in short order.

I think the economy is going to do ok and that the market advance
will resume. But I do not know whether the current sabbatical will
last until tomorrow morning or whether it will persist for a number
of weeks. The current round of "hot" shorter term cycles (13-15
wks) suggest a bottom this month. We'll see.

Stock Market -- Technical

I gave the charts a thorough review over the weekend. Back on Sep.
18, '09 when I started turning cautious on the market, the SP 500
went out at 1068. It closed at 1074 this past Friday. So, despite a
measure of intervening strength, the market staged a round trip
over the said time frame. Over this interval, the market changed
complexion. A lengthy period of winnowing volatility ended in mid-
Jan. when a "fake" upside breakout ended and a correction began.
That change in volatility plus the existence of three distinct uplegs
in price off the 3/09 low strongly suggests to me that the first
major leg of this cyclical bull market has ended.

The recent price correction has eliminated overbought conditions
ranging out to 40 weeks and did leave the market with a tradable
oversold for short term players. However, to count on the
development of a significant new upleg off the 1/29 low appears to
me to be an against-the-house bet. History suggests that when the
stock market comes off the kind of massive overbought condition
we saw develop in latter 2009, it tends to have a relatively sterile
period until the bulls can once again regain command. Unfortunately,
there is no ready time measure to suggest when another upleg might
get started, but it rarely takes less than a good several months. I
have also observed that when the market does come off a giant
overbought, it more often than not corrects / consolidates until it
tests its 40 wk m/a (The SP 500 weekly chart linked to below shows
that the large gulf between the index and its 40 wk m/a is closing
fairly quickly).

It does need to be said that when the stock market corrects after a
period of consolidation as we have recently seen, one has to concede
that stocks could be transitioning to a more vulnerable period. That
test may come over the next two weeks.

Weekly chart.