Wednesday, March 3, 2010

TIPS point to very slow growth


This chart is not meant to be scientific, it is meant to be suggestive of what the TIPS market may be implying about the outlook for real growth in the U.S.

The blue line represents the rolling, 2-yr annualized rate of real GDP growth. I've used a rolling 2-yr figure to smooth out the ups and downs in yearly data, and I think it's reasonable to assume that the market's outlook for the future tends to be influenced by the experience of the recent past. The red line is simply the yield on 5-yr TIPS.

The rationale for comparing these two is that real yields that can be purchased via the TIPS market should not be greatly different from expectations for real growth in the economy. If you invest in the broad stock market, your expectation for real returns should not be greatly different from the real growth of the economy. In other words, it would be difficult to expect positive returns if the economy were to be in a protracted recession, just as it would be reasonable to expect positive returns if the economy were to enjoy healthy growth. If markets are at all efficient, the real yield on TIPS should be somewhat less than the expected real returns on the average company (since TIPS real yields are guaranteed by the U.S. government, but equity real yields are not), and average real returns in the stock market should not be greatly different from the economy's average real growth rate.

From this I conclude that since yields on 5-yr TIPS today are only about 0.2%, the market is implying that expectations for real growth in the economy are only about 1-2% or so. And that is one reason I think the stock market is priced to very conservative, and even fearful assumptions about future growth. If real growth were expected to be 4% or more, real yields would almost certainly be higher than they are today, because the market would expect the Fed to tighten policy significantly if that were the case. The next chart is my rationale for saying that.


This chart compares the yield on 5-yr TIPS with my calculation of the market's expectation of the real Fed funds rate one year from now. The latter is a good proxy for how tight the market expects the Fed to be in the future. The impressive correlation of real yields to Fed tightening expectations is clear from the chart, and it also makes a lot of sense, since the Fed traditionally regards tightening or easing to be a function of how the funds rate changes relative to inflation. In other words, when the Fed wants to tighten, it must raise the funds rate relative to inflation. Thus, if the market expects a tightening in the future, then the market should demand a higher real yield from TIPS today. (The foregoing is just another way of saying that the Fed controls the level of real short-term rates, and it is the expectation of the real rate on Fed funds that drives the shape of the rest of the real yield curve.)

Currently the market is expecting the Fed to tighten monetary policy only slightly over the next year (with the definition of tightening being the level of the funds rate relative to inflation). That expectation, in turn, is driven heavily by the outlook for real growth. Neither the Fed nor the market expects real growth to be very impressive over the next year. If the economy were to strengthen unexpectedly, the Fed would tighten sooner and by more than the market currently expects, would it not? That the market expects the real funds rate to be -0.5% a year from now can only mean that the market's outlook for real growth is rather dismal.

UPDATE/CLARIFICATION: The point of this post is not to say that my expectation of growth is dismal, it's to point out how pessimistic the market's assumptions are. This in turn implies that it is unlikely that the equity market is overpriced. Thus my expectations for 3-4% real growth justify a bullish outlook for equities.

15 comments:

Benjamin said...

The world is generating gobs of excess capital, and it is being parked. I think that is holding down rates.
As I have stated, money will cheap for generations. High savings rates globally and an aging US population will mean lots of capital everywhere.
Cheap money, and smallish returns on passive investing...but should be good for economic growth.
Someone buying a TIP will break even in the years ahead, and that's about all they can expect.

Figure out where the money will flow next...money will chase perceived returns, swamping fundamentals.

Could be many sectoral booms and busts in years ahead

Bill said...

Scott,

Which is a better predictor of growth, TIPS or the ISM manufacturing index? The ISM seems to be pointing to better growth than 1-2%

Scott Grannis said...

Benjamin: have you considered that whatever "excess capital" is being generated (and I don't necessarily agree that is indeed the case) is being sucked up by gargantuan public sector deficits? The only source of "cash" money (money that is parked, not spent) that has increased significantly in the past year is T-bills.

Scott Grannis said...

Bill: excellent question. I think the message from TIPS that the market expects very weak growth is a believable message. I think there are other confirming signals of this as well (e.g., credit spreads that are still very wide). The ISM index is a great coincident and a good somewhat-leading indicator of growth. The ISM index is signalling strong growth for the immediate future, but TIPS are signalling very weak growth for the next year or two. Conclusion: the market doesn't believe that the recent improvement in the economy will be durable. Again, this is a very skeptical market.

septizoniom said...

ONE OF YOUR BESTS POSTS OF THIS YEAR. BRAVO!

Benjamin said...

Scott-

Well, there seems to be little problem selling federal debt, even at close to zero real interest rates. That is not a sign of "crowding out," to use a term that has become antique from lack of use.

That's because of growing pools of capital, globally.
As Asia's middle and upper-classes grow, these pools of capital will grow. While official US savings rates are low, huge pools of capital in insurance companies is not counted as savings.
Even in the U.S., money funds, mutual funds, VC funds, private equity funds are all much larger than 10 and 20 years ago.

I think this is a very, very positive development--no good idea will go unfinanced, and many mediocre ideas will get financed. I am old enough to remember when VC funds were small, and getting financing often required "connections" (often familial, country-clubish, alumni etc) either at banks or VCs. It is a whole different world now.

New technologies will be developed rapidly, globally, and spread widely quickly.

This should lead to good growth, and higher living standards globally, in any country that at least roughly adopts free enterprise and democracy.

But money is cheap, and will stay cheap for generations.

It may be real estate has a bright future, and equities, although both sectors will be subject to occasional booms and busts. (We have had such since at least the Tulip Bulb days).

I think safe bonds will yield zero after inflation, maybe less.

The money in the future might might made in real operating businesses, the kind passive investors cannot get to--small manufacturing, farms, service firms and the like. They should enjoy a growing economy, and the possible exit strategy of selling to a larger shop.

Of course, I do not enjoy chronic red ink displayed by both parties in DC. I wish I had an option--a third party devoted to bona fide fiscal conservatism.

I think if we have a weak link in the US, chronic federal red ink is it.

That, and we still have exactly the same financial system we had two years ago--a system that collapsed. I don't wonder that investors are wary of US equities, when our financial system can become a highly leveraged house of cards at any time.

Benjamin said...

flastredScott-

Well, there seems to be little problem selling federal debt, even at close to zero real interest rates. That is not a sign of "crowding out," to use a term that has become antique from lack of use.

That's because of growing pools of capital, globally.
As Asia's middle and upper-classes grow, these pools of capital will grow. While official US savings rates are low, huge pools of capital in insurance companies is not counted as savings.
Even in the U.S., money funds, mutual funds, VC funds, private equity funds are all much larger than 10 and 20 years ago.

I think this is a very, very positive development--no good idea will go unfinanced, and many mediocre ideas will get financed. I am old enough to remember when VC funds were small, and getting financing often required "connections" (often familial, country-clubish, alumni etc) either at banks or VCs. It is a whole different world now.

New technologies will be developed rapidly, globally, and spread widely quickly.

This should lead to good growth, and higher living standards globally, in any country that at least roughly adopts free enterprise and democracy.

But money is cheap, and will stay cheap for generations.

It may be real estate has a bright future, and equities, although both sectors will be subject to occasional booms and busts. (We have had such since at least the Tulip Bulb days).

I think safe bonds will yield zero after inflation, maybe less.

The money in the future might might made in real operating businesses, the kind passive investors cannot get to--small manufacturing, farms, service firms and the like. They should enjoy a growing economy, and the possible exit strategy of selling to a larger shop.

Of course, I do not enjoy chronic red ink displayed by both parties in DC. I wish I had an option--a third party devoted to bona fide fiscal conservatism.

I think if we have a weak link in the US, chronic federal red ink is it.

That, and we still have exactly the same financial system we had two years ago--a system that collapsed. I don't wonder that investors are wary of US equities, when our financial system can become a highly leveraged house of cards at any time.

Benjamin said...

PS-
"flastredScott" is a mistype. It should say "Scott." My word verification was entered into the message box.

brodero said...

This is great stuff....There is no blog out there that provides this sort of information....

brodero said...

Moody's BAA yield started the year at 6.39...it is 6.26 today...

W.E. Heasley said...

Mr. Grannis:

We speak of “consumer/business expectations”. The media likes to spend time reporting on “consumer sentiment” and “consumer confidence” surveys. The sentiment and confidence surveys appear to be more of a present snap shot of some components of the broader concept of consumer/business expectations.

Consumer/business expectations is a major driving variable in economics and its also one of the hardest variables to measure. A discussion of expectations is generally a discussion of past and future trends extending over 12, 24 or even more months. Your TIPS discussion is more of the expectations analysis/indicator stretching into the past and future rather than the snapshot survey results regarding consumer confidence/sentiment surveys.

We do know that consumer/business expectations are somewhat related to the stock market concept of “uncertainty”. That the greater the uncertainty the lower the expectation. The uncertainty concept also finds its way into supply-side economics regarding marginal tax rate policy or tax rate policy in general. That is, tax reductions with longer time horizons (certainty) work so much better than one time rebate tax cuts in regards to expectations. That the certainty of a tax reduction, for say 10 years, gives a long enough time horizon and does affect consumer/business expectations and consequently behavior were as the one time rebate has no impact on expectations and consequently behavior.

Hence the TIPS analysis shows low expectation which immediately requires a focus on uncertainty. Its clear that the Obama administration has created a hyper-environment of uncertainty. Socialized Medicine and consequential price increases and/or tax increases, Cap and Trade leading to energy price increases, stimulus plans bloating the deficit/debt leading to either inflation (hidden tax) or tax increases to follow, expiration of the Bush tax cuts, other broad tax increase proposals, and unsustainable government size and scope. Add in a 17.3% real unemployment rate as measured by u6, and you get a world of uncertainty as never seen in years.

The high level of uncertainty is politically generated. Yet the same politicians continue to add policy that they view as simulative yet the policy merely adds to uncertainty. If you removed socialized medicine, removed cap and trade, stopped deficit spending, either hold tax rates at current levels or reduced taxes, and reduced size and scope of government, would uncertainty fall and expectations rise? Of course expectations would rise as negative uncertainty is removed. With uncertainty reduced economic behavior changes and consumption, investment, and private capital formation flow and unemployment is positively affected.

Its not the “economy stupid” tag line of the past, its “the politics stupid” of the present.

Scott Grannis said...

WEH: very good points. Politics has played a huge role in creating fear, uncertainty and doubt. If the political direction of the country changed, we could see growth expectations skyrocket. I think we're going to see progress on the political front this year. Actually, there has already been a lot of progress, since a year ago people were expecting us to be in a depression by now.

W.E. Heasley said...

Mr. Grannis:

Agree.

The political tide has turned and continues to turn daily. Plus the political anger factor is further fueled by high persistent unemployment.

The sixth year of the Carter Administration is turning out to be The Battle of Waterloo and the armies of the Seventh Coalition. The only difference, come November, is that Waterloo will appear mild to the coming defeat. Matter-of-fact, people will probably stop using Waterloo as a reference and start using 11-10 as a reference for massive defeat.

ronrasch said...

Scott, I read an article on the Gilder Forum that the 3 month tresurey acution displayed a lact of competitive bidders and the fed had to soak up the bonds. Could this be a preditor of the higher rates that you are looking for.

Scott Grannis said...

If true, that would certainly be an indication that animal spirits are stirring and risk aversion is declining.