Market expects a very weak recovery

This chart shows the historical rate for 3-mo. Libor (green) and the market's expectation of the rate going forward (blue). Since Libor typically tracks the Fed funds rate rather closely, the blue line is a good proxy (if you subtract 30-35 bps) for where the market expects the funds rate to be. A funds rate of 1% only makes sense to me if the economy is struggling and at risk of further recession or deflation. By that standard (admittedly subjective), the market expects the economy to be in pretty bad shape for the next year. It's not until later next year that the market expects the Fed will be able to lift the funds rate above 1.5%, and even then, 1.5% is historically very low, so the market really doesn't see any significant improvement in the economy for at least a year or two. By the end of 2011 the market expects the funds rate to be about 3%; compare that to the average funds rate of 4.25% over the past 20 years, and you see how gloomy the market is.

There are plenty of good reasons for the market's lack of optimism, as I've detailed in numerous posts concerning the abysmal state of fiscal affairs and the almost total lack of truly stimulative policy. I've thought for some time now that bad fiscal policy was a key source of the market's pessimism and the economy's failure to recover earlier this year, since bad fiscal policy (e.g., higher taxes, wasteful spending projects, tax rebates) can certainly slow the economy's recovery. In short, pessimism is justified, and the market appears to have priced in some pretty pessimistic assumptions about the economy's future prospects.

One key to investing is to decide whether one's own views differ significantly from the views that are incorporated in current pricing. It's also important to avoid the mistake of projecting recent trends too far into the future. Lots of things can and probably will change in the next few years. Fiscal policy currently looks like a slow-motion train wreck: spending is going to be climbing for years, tax rates are going to soar, and the deficit could be measured in the trillions of dollars for as far as the eye can see. But is all that really going to happen, or might there be some important changes for the better? Fiscal policy this year has turned out to be far worse than almost anyone (including me) expected last year; might fiscal policy be better next year than it is today?

I'm an optimist, and I am encouraged by the growing signs that Obama's policies are not sitting well with the public. It doesn't take a high IQ to realize that raising taxes is a bad idea when the economy is weak. It shouldn't be too hard for people to realize that you don't fix our healthcare problem by turning the whole thing over to the government. The support for the new global warming religion is waning, and the number of dissenters is increasing daily. Blue Dog Democrats are feeling very uncomfortable with the healthcare and cap and trade bills.

I also think that despite all the bad news, this economy has been grappling with problems for two years now, and it wouldn't surprise me to see more news such as Goldman Sach's spectacular earnings announcement today. People and companies adjust given time. The profit motive is powerful. Big changes produce big opportunities. Virtually nobody is sitting still.

I see plenty of healthy fundamentals that confirm that positive changes are underway: swap and credit spreads have contracted significantly; commodity prices are up across the board; implied volatility is way down; global trade has restarted; retail sales have increased this year; equity markets are up strongly from their lows; weekly unemployment claims are down; manufacturing activity has improved; corporate layoffs are way down; deflation risk has all but disappeared; M2 velocity has stopped declining; housing is bottoming; confidence is rising.

In short, I think being optimistic can pay off.