It’s anyone’s guess what Fed Chairman Ben Bernanke’s legacy will be, but the possibilities are still wide open.
For those who think monetary policy falls short of perfection these days, there’s reason to read the recent weekly updates on money supply and wonder what comes next. Seasonally adjusted M2 money supply shows a rise of 5.0% from a year earlier (using a 52-week formula), according to the latest numbers from the Federal Reserve. In fact, M2 money supply has been rising by 5.0%-plus now for the past three weeks relative to levels of 52 weeks previous. As the chart below illustrates, that pace represents something of a minor milestone in money supply trends. The last time money supply was rising at 5% or higher on a consistent basis was early 2005.

For confirmation that the rolling 52-week trend is no statistical anomaly, we also ran the numbers on seasonally adjusted M2 on a 10-week rolling basis. The trend, however, confirms what the 52-week analysis shows: the supply of money is rising at higher rate than in the recent past.
The question is whether the new bull market in money is temporary or the start of something big. That’s hardly an innocent question with fears of inflation threatening. Only the Fed knows what comes next in matters of money supply, but for those of us on the outside there’s reason to keep an eye on the Thursday dispatches from the central bank regarding the quantity of dollars in circulation.
The Fed is trying to win over the bond market’s respect and admiration, but we wonder how that project will ultimately turn out if the path of least resistance in money supply is upward. A few weeks a trend does not make, of course, when it comes to overseeing the near $7 trillion of currency swirling around in the system. But a billion here and a billion there eventually add up to something more than a footnote if the momentum isn’t checked.

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Crude is king when it comes to bull markets in the 21st century. The price of a barrel of oil in New York futures trading has climbed some 280%, as of last night’s close from January 1, 2002. As bull markets go, this one’s been extraordinarily profitable for those who’ve ridden the wave. This year alone, crude’s ascended by more than 30%, based on the near-$80-a-barrel mark set earlier this month. But every wave crashes, eventually, even one that’s driven by a potent supply/demand profile that drives the oil market.

Timing, of course, is everything when it comes to making predictions, and on that score we have no more insight than anyone else. But we do have eyes in our head, which informs our ever-cautious temperament when it comes to money.
Any analysis of where oil prices are headed necessarily starts with a survey of the geopolitical tension, which is also in a bull market. Front and center is the reality that Israel’s locked in a war with the Lebanon-based Hezbollah militia. A month ago it was hard to imagine how the Middle East could become more volatile, but the Israeli invasion of Lebanon has resolved that mystery. Not that there wasn’t already plenty of anxiety harassing the region and raising questions about the ramifications for oil. From Iran’s nuclear ambitions to the chaos that is Iraq, the Middle East had more than its share of worries. Unfortunately, the region’s recently descended down another notch into what is in the running to be its worst case of disorder and confusion in the modern era.
Suffice to say, the madness is deemed sufficient to warrant a fair amount of risk premium on a barrel of oil, perhaps as much as $40 by some estimates.
Human nature being what it is, it’s not impossible to imagine that that the situation in the Middle East could yet go from bad to worse in the coming weeks and months. We certainly don’t minimize that possibility. The United States, as we write, isn’t keen on imposing a ceasefire in the Israeli-Hezbollah fighting, and so it’s a safe bet that a ceasefire isn’t coming in the next few days. Forty-eight hours, we might add, can be an eternity these days in matters of Middle East politics.
The longer the war rolls on, the greater the potential that it could spin out of control and become a regional conflict involving Syria, Iran and other nations. In that case, the ceiling on oil’s price could shoot up dramatically in just one trading session. A hundred bucks a barrel, in other words, could be lurking just around the corner.
But oil prices could fall sharply too. Indeed, a review of the underlying fundamentals suggests as much. Inventories of crude oil in the OECD nations are the highest in 14 years, advises a research report issued yesterday by Bernstein Research (see graph below).

The report, penned by Ben Dell, also predicts a robust rise in global spare oil production capacity for 2006 through 2008, reversing last year’s dramatic drop, as the graph below from the report shows. Historically, the correlation of spare capacity to oil prices has been negative; that is, as spare capacity rises, oil prices tend to fall.

Obviously, that negative correlation has been suspended of late, although one might wonder if it’s due for a return engagement. Based on Bernstein’s analysis, oil prices are now more than $20 higher than the price/spare capacity correlation history implies. If spare capacity increases in the months and years ahead, as Bernstein forecasts, the current price of oil would look even more excessive.

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The debate’s over: it’s slowing. No doubt about it. Now begins the next phase of the discussion: How long will it slow, how far will it dip, and will it bring recession?
Existing home sales declined 1.3% in June, the slowest since January and nearly 9% below the pace from a year ago, the National Real Estate Association reported yesterday. And while prices for existing homes kept rising last month, it was the weakest jump in more than a decade. But there are signs that something less is coming. Indeed, condo prices are already slipping on a year-over-year basis.
David Lereah, chief economist at the NREA, downplays the negative implications regarding yesterday’s news. “Over the last three months home sales have held in a narrow range, easing to a level that is near our annual projection, which tells us the market is stabilizing,” he said in a press release that accompanied NREA’s data update.
Is the transition to stability from red-hot bull market merely a step to a bear market in housing? No matter how you spin it, there’s no getting around the fact the housing market is cooling. By any number of metrics, the trend is clear. What’s more, there’s no mystery behind the falling volume of sales. Higher mortgages rates aren’t helping, which in turn is helping elevate the supply–a textbook case for predicting lower prices ahead.
Again quoting NREA’s Lereah, who explains that “a year ago we had a lean supply of homes and a sellers’ market, with monthly home sales at an all-time record high.” The lean supply has since blossomed into something meatier. Existing homes available for sale in June were at a 6.8-month supply at the current sales pace, up from a 4.4-month supply a year ago, according to NREA.
Paul Kasriel, who heads up Northern Trust’s economic research division, yesterday predicted that prices will fall for existing homes in the months to come so as to reduce the excess supply that currently prevails. “The knock-on effects of all this will be subdued consumer discretionary spending as those ‘home ATMs’ are not refilling as rapidly as before,” he wrote in a research note yesterday. “Another factor that will curtail consumer discretionary spending is slower income growth in housing-related industries as employment and sales commissions moderate further.”
The bottom line: the residential real estate market is now in a recession, Kasriel opines.

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Asset classes don’t go bankrupt, but neither do they consistently radiate value relative to the competition. Indeed, the value of any asset class waxes and wanes, providing an endless stream of opportunity and risk.
Deciding if one or the other dominates in one or more asset classes is the perennial challenge, a task that itself goes through its own peculiar cycles. Sometimes there are screaming buys, and sometimes valuations are at pinnacles of excess. Unfortunately, such extremes are rare. Most of the time, valuations are a gray area, making analysis uncomfortable and prone to error due to the whims of the moment. That, one could argue, describes the current climate for the major asset classes, where neither bargain nor excesses dominate.
The immediate source of this middling scenario is the fact that ours is a time of transition in the price of money. Interest rates, in other words, are climbing. The latest evidence comes from the world’s second-most populous country. The Reserve Bank of India (RBI) today raised its key short-term rate by 25 basis points to 6.0%–the highest in four years. The hike was billed as a pre-emptive attack on inflation’s gathering momentum on the subcontinent, subtle though it may still be at the moment. The source for the monetary anxiety remains the bull market in energy, explained RBI Governor Y.V. Reddy. “Fuel prices, which account for 35% of the increase in wholesale price index, constitute a major risk to headline inflation,” he said, as reported by India eNews.
India’s hardly alone in raising the price of money or worrying about the future for inflation. Central banks the world over are generally tightening the monetary strings, albeit after a lengthy period of easy money. Because rates around the world have been so low in real (inflation-adjusted) and absolute terms in recent years, the reaction by the capital markets has been sluggish compared with previous rounds of tightening. Indeed, the frog doesn’t jump out of the pot if the transition from cool to boiling water is slow. But at some point the frog realizes that he’s being cooked alive, at which point it may be too late to snatch victory from the jaws of defeat.
Something similar may be unfolding in the world’s capital markets, where optimism fueled by cheap money has helped investors see bull markets as the continued path of least resistance. The Federal Reserve has been more than a little complicit in this lethargic attitude adjustment, courtesy of its consistent delivery of “baby step” rate hikes over the past two years. But baby steps add up to something bigger eventually.

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When the last company dispatches its numbers for the quarter just passed, S&P 500 earnings will have risen by 13.6%, or so predicts First Call/Thomson Financial, via RTTNews. That would mark the 17th straight quarter of double-digit gains. As fundamentally driven tailwinds go, it doesn’t get much better than this for the stock market. So why is the S&P 500 slumping these days?
The highs for the year were set back in early May, when the S&P 500 closed above 1320 for four straight days. As of Friday’s close, the index has fallen about 6%. Technically, the market doesn’t look inclined to turn around any time soon: each rally since May has brought a lower peak than before.

Whatever ails the stock market, no one can say that weak earnings are to blame. But as the bears are quick to point out, there is any number of other reasons to sell these days, ranging from geopolitical tension to fears that an economic slowdown is coming.
But the bulls shouldn’t despair, writes Milton Ezrati, senior economic and market strategist at Lord Abbett. If equities moved sideways for the rest of this decade, as some predict, that would make this decade’s stock market performance since the 1930s, he observes in a research note published Friday. “If the popular forecast is correct and the S&P 500 were to show no further gain thorough the end of the decade,” he asserts,

the market would have no better performance than the Great Depression—an unlikely event, to be sure, especially in light of today’s positive fundamentals. If the index, aside from dividends, falls short of a 14 percent annual rise during the next 3½ years, this first decade of the 21st century would fall well short of any 10-year stretch of the past 30-plus years. We believe the implication of these statistics clearly is that matters are very likely to improve going forward. History is indeed on the side of the bulls.

Perhaps, although history is a guide to the future, not a guarantee. That said, it seems likely that when the Fed is truly done with its current round of rate hikes, there will be a relief rally that lasts more than a day or two. No less was suggested last Wednesday, when stocks rose sharply after Fed Chairman Bernanke made what some thought were dovish comments about monetary policy in testimony to Congress.

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Is the economy slowing or isn’t it? As usual, the answer depends on the numbers one chooses to emphasize (or ignore).
For those who still see the glass half full, this week’s industrial production and leading indices offer reasons for hope. But any optimism from these dispatches were minimized by signs of cooling elsewhere, notably in the real estate sector. Indeed, housing starts fell by more than 5% last month.
In theory, a slowing economy makes it easier for the Federal Reserve to cease and desist with its current round of interest rate hikes. In practice, life’s more difficult, thanks to the worrisome rise in core CPI in June, delivering the third monthly advance of 0.3%, a pace that some economists say is above the comfort zone for keeping future inflation contained.

Federal Reserve Chairman Bernanke has been hailed as one of the country’s foremost authorities on monetary economics, but that doesn’t necessarily mean Ben is a monetarist. In fact, in Bernanke’s Congressional testimony yesterday, he snubbed the idea the idea that the quantity of money is the ultimate arbiter of inflation’s level.
“FOMC participants project that the growth in economic activity should moderate to a pace close to that of the growth of potential both this year and next year,” Mr. Bernanke said, as reported by the GlobeandMail.com. “Should that moderation occur as anticipated, it should help to limit inflation pressures over time.”
History doesn’t necessarily agree, as any card-carrying monetarist will point out. One the clearest examples can be found during a two-year stretch through the first-quarter of 1975. During that period, the economy contracted by 1.6%, with real (inflation-adjusted) GDP falling to $4.24 trillion by March 1975 from $4.31 trillion (in chained 2000 dollars) as of March 1973–a decline otherwise known as a recession. But while the economy stumbled, there was no reprieve from core inflation (less food and energy), which climbed sharply over those 24 months, jumping to a seasonally adjusted annual pace of more than 11% in March 1975 from 3.2% two years previous, as the chart below illustrates.

Since this measure of consumer prices excludes energy prices, we must consider other catalysts for the unleashing of the inflationary dogs at that moment in history. In fact, we find a suspect in money supply, which suspiciously indulged in a sharp burst skyward in the months and years preceding the rapid rise in core inflation during 1974-75. As the chart below shows, seasonally adjusted M2 money supply, based on a rolling 12-month change, exploded upward starting in 1971 through much of 1973. In June of 1970, M2’s 12-month rise was under 3%; by March 1971, it was advancing at a double-digit pace, a trend that was maintained through July 1973.

Monetarists have reason to think that inflation is more than a byproduct of economic growth. Mr. Bernanke thinks otherwise, or so one could reason after sifting through his latest comments. Welcome to the new new age of debating the causes of inflation.

How much lag resides in the lagging indicator known as core CPI? It’s a potent question on a day when the Labor Department reported that the core rate of inflation (less food and energy) in June rose by 0.3%–the fourth straight month at that pace, which is above the Fed’s comfort zone. On a year-over-year basis, core CPI has now climbed by 2.6%, the first time the rate of increase has topped 2.4% since 2002, MSN Money reported.
“With 2.6% year over year, it is a number that’s way too hot for the Federal Reserve,” Anthony Chan, chief economist of J.P. Morgan Private Client Services, told CNBC’s “Squawk Box.” via MSN Money. “It’s certainly out of the comfort zone.”
Against the backdrop of that worrying trend were comments from Fed Chairman Bernanke, who today told Congress that the economy was slowing and inflationary pressures would therefore moderate going forward. If there was any question about Bernanke’s message that the past isn’t necessarily prologue when it comes to inflation, he offered this clarification: “The lags between policy actions and their effects imply that we must be forward-looking, basing our policy choices on the longer-term outlook for both inflation and economic growth,” he said, as reported by Bloomberg News.
Core CPI is, of course, a lagging indicator. Indeed, all economic data is lagging in the sense that it reflects yesterday’s trends. The question is how to project tomorrow from yesterday. It’s a thankless job, and one that economists tackle routinely, albeit it with less than perfect results. That’s the nature of forecasting, an art form that only slightly resembles science. The future, dear readers, is forever and always unknown.
Having proclaimed that revelatory observation, your editor is back to square one, namely, Now what? To be sure, we come neither to praise nor to bury core CPI, but to point out what should already be obvious: inflationary pressures have been bubbling in the recent past, raising the odds but not necessarily insuring that inflationary pressures will bubble in the near future.
If the Fed feels compelled to snuff out this bubbling, the message was somewhat garbled by Bernanke. “Bernanke’s comments on inflation make it seem [that] the Fed is really getting close to the end of its rate-hike cycle,” Jason Schenker, U.S. economist at Wachovia Corp., told Reuters today. “That is more than enough to give stocks a boost.”

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In June 2003, the 10-year Treasury did something extraordinary by yielding around 3.07% at one point in that month. That was a generational low, and it’s proven to be the nadir for the 10-year ever since. Judging by this morning’s report on producer prices, the odds improved again for 3.07% remaining the low for the foreseeable future.
As of last night’s close, the 10-year’s yield was some 200 basis points higher from the low of three years ago. The great question coursing through the financial markets is whether the elevation that the price of money has accumulated over the past 36 months will suffice to stifle the mounting inflationary pressures that appear to be bubbling in the economy.
Producer prices advanced by 0.5% in June, the Bureau of Labor Statistics reported today. In addition to being well above the consensus forecast, 0.5% represents a sizable jump from May’s 0.2% rise. On the other hand, the core PPI (which removes energy and food from the mix) slipped a bit last month, increasing by 0.2%, down from 0.3% the month before.
If any of this gives investors reason to wonder about the primary trend in wholesale prices, a rolling 12-month gauge of PPI offers a more-enlightening picture. On that score, there’s reason to worry: PPI has climbed 4.8% over the past 12 months, the second-highest rate this year. Yes, the trend looks less ominous after subtracting energy prices. But in the real world, we all consume energy and pay market prices, ensuring that energy’s threat on inflation is more than theoretical.
Granted, there’s a sizable risk premium built into the price of oil these days. Neil McMahon, an oil analyst in Sanford C. Bernstein’s London office, writes in a research note to clients today that a $27-a-barrel premium is embedded in crude’s price. “In the absence of the perceived risks the market is factoring in, we believe prices would be below $50/bbl based on the supply demand balance, and current levels of spare capacity which has been steadily expanding for the last 12 months,” he writes.

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Optimism is on the defensive at the moment because the world is a dangerous place. Dangerous, and getting more so with each passing day.
Danger is hardly new, nor is the capital markets’ capacity for digesting and pricing peril a recent innovation. Crises come and go, and the markets reprice as events require. And still the disciplined long-term minded investor manages to make a buck. No less will be true in the future, but no one said it’ll be any easier than it has been in the past. In fact, it may get tougher relative to the already challenging standard that has been investing in the 21st century. Indeed, as one looks out over the escalating warfare in the Middle East, it’s hard to see an endgame in the near future that leaves investor sentiment on the mend.
We’re talking, of course, about the war between Israel and Hezbollah, the guerrilla group in Lebanon. The accelerating conflict is wreaking havoc in the two countries, and raising tension in a region that’s already tense from the ongoing state of chaos, otherwise known as Iraq. Adding to the bull market in instability is long shadow of Iran, which has become increasingly confrontational in promoting its anti-Western agenda. Iran, courtesy of its massive petrodollar-infused bank account, has the means to back up its inclination to run interference in the West’s (read: America’s) political agenda in the Middle East. That includes funding Hezbollah, which reportedly draws no trivial degree of financial help from Iran.
‘Tis easier to tear down confidence than it is to build it up. To the extent that such disorder and bedlam serve wider political objectives, pursuing turmoil and confusion is path that’s tragically easy to follow and difficult to repair. Investors the world over must understand this risk, even if it only informs only partly informs their decision-making process.

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