Wednesday, March 3, 2010
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.
Posted by Scott Grannis at 2:56 PM