Friday, March 17, 2017

Global outlook improves

It's not just a Trump Bump that is driving stocks higher, nor is it unwarranted or unsubstantiated optimism. Rising equity prices are most likely a response to an improvement in global economic fundamentals that is just now becoming clear. Global industrial production has been rising for the past 6-8 months, and the volume of global trade picked up noticeably toward the end of last year. More recently, today's release of industrial production statistics for February shows a significant pickup in U.S. manufacturing activity in the first two months of this year. All of this was foreshadowed by a pickup in chemical activity which I noted early last summer and which continues to suggest a meaningful improvement in overall industrial production in the months to come.

The market is usually pretty good at sniffing out developments in the economy that are not yet obvious in the stats, and this is the latest example.

Here are some charts that tell the story:

U.S. industrial production statistics have been unimpressive for years, due mainly to wrenching problems in the oil patch. Eurozone industrial production in the Eurozone has been abysmal relative to modest improvement in the U.S., but it has nevertheless been improving, and this improvement become noticeably stronger about six months or so ago.

After several years of almost zero growth, U.S. manufacturing production has jumped, rising at almost a 5% annualized rate since the end of November.

The volume of world trade is a key indicator of global economic health, since expanding trade is an unalloyed good thing: increased trade is arguably the best way to improve a nation's productivity, since it allows trade partners to strongly benefit from the things they do best. In the chart above we see that world trade volumes rose at a relatively tepid 2-3% pace for a number of years, which is consistent with the recent recovery being the least impressive in modern history. But in the second half of last year world trade volume rose at a 4-5% pace. This is very good news.

The Chemical Activity Barometer has done a pretty good job of reflecting—and sometimes leading—overall economic activity in the U.S. Starting last summer this indicator started picking up, and in the year ending February it has increased by over 5%.

The chart above shows that the year over year change in the 3-mo moving average of the Chemical Activity Barometer has been a reliable predictor of improvement in U.S. industrial production. Industrial production is now beginning to improve, as predicted, having increased modestly since last March after several years of decline. More improvement should be on the way.

The chart above shows the CRB Raw Industrials commodity index, which has been rising strongly since late 2015. It's now apparent that this has been driven not by a weaker dollar (as has typically been the case), but by an unexpected and significant improvement in global economic activity. The CRB Metals index (which consists of copper scrap, lead scrap, steel scrap, zinc, and tin) has surged almost 60% since early last year. Very impressive, and it's still ongoing.

So it's not surprising that Eurozone stocks have perked up of late, as has nearly every global equity market. The current equity rally is built on a sound economic base, not on flights of fancy.

Wednesday, March 15, 2017

Bonds pleased with Fed rate hike

Today the FOMC raised its target Fed funds rate to 1.0% as expected. However, Treasury yields fell 10-20 bps or so in the aftermath of the announcement, suggesting that the bond market had been nervous that the Fed would signal more aggressive rate hikes in the future—which it didn't. Once the dust had settled, we see that 5- and 10-yr Treasury yields are largely unchanged over the past three months, while 2-yr yields are up only 5-10 bps. This further suggests that the Fed and the bond market have been thinking along the same lines for the past several months; the bond market expects the Fed to continue deliver on its promise to raise short-term rates only gradually for the foreseeable future. Whether this expectation holds going forward is the real question at this point, and the answer will depend on the evolution of the economy and inflation. But for now, expectations and reality look to be in rough equilibrium. Not surprisingly, the stock market took heart from the relative calm, as prices firmed.

The charts below are updated versions of charts that I consider key to understanding the evolving stance of monetary policy:

One very important measure of the effective stance of monetary policy is the inflation-adjusted Fed funds target rate. By changing the real level of its funds rate target, the Fed attempts to influence the world's demand for money. Higher real yields are intended to increase the demand for money (while also making borrowing less attractive), whereas lower real rates do the opposite. Given the relative tranquility in the bond market and the economy in recent months, we can infer that the Fed's efforts to date have not made any significant change in the balance between the Fed's supply of money and the market's demand for it. In other words, the Fed's "tightening" actions to date have been largely offset by the market's decreased demand for money, a phenomenon which goes hand in hand with increased confidence and a modestly improved economic outlook. As the chart above shows, the real Fed funds rate (using the core PCE deflator—the Fed's preferred inflation gauge—to discount the nominal Fed funds target) has increased from -2% a few years ago to just above -1% today. That's not really a "tightening," and is better thought of as the Fed becoming "less easy."

The chart above compares the real funds rate (red) with the market's expectation of where the real funds rate will be in 5 years (blue). As long as the future expected rate is higher than the current rate, the bond market is expecting the Fed to continue to raise its target real rate. But when the red line exceeds the blue line—as it did prior to the last two recessions, this is an excellent sign that the market expects that the Fed will sooner or later be forced to lower its target rate because the economy is expected to weaken. An inverted real yield curve (when short-term real rates exceed longer-term real rates) is thus an excellent indicator of a coming recession, and the market's way of telling the Fed that monetary policy is too tight. Today the market is signaling "steady as she goes," which translates into continued moderate and measured increases in short-term rates—much as the Fed is promising.

The chart above gives us another way of measuring the effective stance of monetary policy, by comparing the level of real short rates to the slope of the Treasury curve. When real rates are very high and the yield curve is inverted (i.e., when short-term rates exceed long-term rates) monetary policy is very tight and the economy inevitably succumbs to recession (think of the economy being starved of liquidity and subsequently collapsing). We are likely years away from such a confluence, since real short-term rates are still very low and the yield curve is positively sloped.

The level of expected real short-term rates (blue line) also tells us about the market's willingness to pay up for "safety." As the chart above shows, gold prices and TIPS prices (using the inverse of their real yield as a proxy for their price) have been moving together for many years, and both have been slowly declining since 2012 (when fears of a Eurozone collapse triggering another global recession were intense). This suggests the market has slowly been regaining confidence and losing its risk aversion as the memory of the 2008 crisis fades, the economy proves resilient, and an era of improved fiscal policy approaches. So far, nothing dramatic has happened, and I would argue that both TIPS and gold prices still embody a good deal of caution with regards to the future.

As the chart above shows, the underlying trend of the consumer price index (ex-energy) has been about 2% per year for the past 14 years.

Over the past six months, the core CPI is up at a 2.2% annualized rate, which further suggests that the core PCE deflator is currently rising at just under 2%, which is close enough to the Fed's target to effectively rule out any risk of deflation or fear that the Fed has been raising rates too much or too fast.

The level of expected real short rates (blue) also tells us a lot about the market's expectations for economic growth. Here we see that the recent rise in real short rates is very modest, and that means that growth expectations have only firmed modestly in the past year or so. Conditions today are a far cry from where they were in 2000, when the market fully expected economic growth to average 4% a year or more for the foreseeable future.

Right now it looks like the market is priced to 2-2 ½% growth for the foreseeable future. That further suggests that if Trump manages to deliver decent supply-side policy changes (e.g., significantly reduced regulatory burdens and lower marginal tax rates), and if those policies result in growth of 3-4%, then we ought to expect interest rates to move substantially higher. So far the market is taking a wait-and-see, albeit modestly-optimistic attitude.

Tuesday, March 14, 2017

30-yr fixed mortgage rates on the rise

Those in the market for a fixed-rate mortgage should be sure to study this chart. It's not yet common knowledge that 30-yr fixed conforming mortgage rates hit an all-time low of 3.3% less than 6 months ago, and have since risen to at least 4.2%. It's probably hard to find anything lower than 4.4% today, according to this report (HT Calculated Risk). The days of 3-handle 30-yr mortgage rates are probably a thing of the past.

So will rising mortgage rates kill the housing market? According to Case-Shiller, nationwide housing prices have risen at a 6.5% annualized clip for the past 5 years, and have now eclipsed their 2006 highs.  In real terms, however, housing prices today are still about 15% lower than they were in 2006, as seen in the chart below:

Higher mortgage rates increase the effective cost of owning a home, so at some point higher rates are likely to slow down the housing market. But for now, I would argue that it's best to think that higher rates are a by-product of a stronger economy and stronger demand. Mortgage rates and housing prices are rising because demand for housing remains strong at a time when lenders are becoming less willing to lend at what are still relatively low rates from an historical perspective. It's all part and parcel of increased confidence and stronger growth fundamentals.