Monday, August 9, 2010

Fed expectations reveal very pessimistic market psychology

I'm now back to civilization, and I find that the world is obsessed with whether tomorrow the Fed's FOMC is going to announce a new attempt to further ease monetary policy in order to rescue an economy that is apparently on life support and threatening to succumb to deflation. In any event, I'm happy to see that my one-month absence coincided with a pretty nice rally in the equity market—as happened when I went to Argentina for three weeks in mid-March last year—so perhaps I should plan more of these getaways in the future!

It's been my thesis for a long time that the equity market was trading at very cheap levels, mainly because the market was plagued by doubts and uncertainties of all sorts: would there be a double-dip recession? what about the soaring federal deficit? would tax rates be hiked massively? what about the burden of a new healthcare system and its attendant regulations and new taxes? how will the Fed avoid the inflationary consequence of a $1.3 trillion expansion of its balance sheet? These concerns have manifested themselves in credit spreads that have been chronically high (though tending to fall); in implied volatility that has been chronically high (though also tending to fall); in Treasury yields that have been exceptionally low (10-yr Treasury yields traded below 3% only briefly at the end of 2008 and before that only during the depression/deflation of the late 1930s—see chart below); and in equity yields (the inverse of PE ratios) that have been below average.

One other indicator that signals the depths to which the market's expectations for the future of the economy have sunk is the real yield on 5-yr TIPS, which today is trading just below zero for only the second time in history (the first being in March of '08 when the market first began to get concerned that the subprime mortgage market crisis could tip the economy into recession). You can think of real yields on 5-yr TIPS as a good proxy for the market's expectation for real GDP growth, mainly because there should be some reasonable connection between the risk-free real yield an investor can earn on TIPS over the next 5 years and the real yield on cash flows tied to the economy's performance via generic equity exposure. For example, if expectations for economic growth were healthy (e.g., 4-5% real GDP for the next several years), then an investor would be foolish to put his money in 5-yr TIPS that promised a zero real return. Cheerfully buying 5-yr TIPS with a guaranteed real yield of zero only makes sense if one has very grave doubts about whether the economy can generate any real growth at all in the coming years.

You can also think of the real yield on 5-yr TIPS as a good proxy for the market's expectation of the future stance of monetary policy. That's what the chart at the top of this past attempts to illustrate. The blue line is a proxy for what the market expects the real Fed funds rate to be one year from now (which I calculate by subtracting the year over year change in the core PCE deflator from the yield on eurodollar futures contracts—a good proxy for the expected funds rate—maturing one year in the future. The red line is simply the real yield on 5-yr TIPS. There's a remarkably good fit between these two lines, mainly because the front part of nominal and real Treasury curves are driven by expectations of future Fed policy. In short, what the Fed is expected to do exerts a powerful influence on the nominal and real Treasury curve.

That future 3-mo. real Libor rates are expected to be negative for the next year only makes sense if the market expects the economy to be miserably weak, and/or for inflation to be very low or even negative over the next year, since both conditions would almost certainly force the Fed to keep policy in an extremely accommodative mode. So it's not surprising that many are calling for tomorrow's FOMC announcement to include some new version of quantitative easing (QE2 as it's called), or perhaps some firm commitment to a very long period of zero interest rates.

My point here is that if you are worried about buying risky assets because you are deeply concerned that the economy is going nowhere fast and deflation is lurking around every corner, then rest assured you have plenty of company. Indeed, I would venture to say that for a bearish bet on the economy to pay off, you would need to see an actual recession set in and/or the CPI to be negative for the next few years at least. The market is priced to very bad news, so for the market to be disappointed, the news is going to have to be very bad indeed.

While I agree that there are plenty of reasons to be concerned about the future, I just don't believe things are going to be worse than the miserable conditions the market currently expects. I see modest 3-4% real growth ahead, and a gradual rise in inflation. I believe this to be the case because financial fundamentals (e.g., swap and credit spreads, implied volatility, the upward slope of the yield curve, corporate profits, gold, and commodity prices) either show absolutely no sign of deterioration or at the very least point to a future in which economic conditions gradually improve and/or deflation is nonexistent. I also believe the future will be better than expected because I have learned over the decades that it is very risky to underestimate the resilience and dynamism of the U.S. economy.

And finally, I think there is good reason to be optimistic because of the sea change in the mood of the electorate, which augurs strongly for a rightward shift in fiscal policy as the November elections approach. Not being a Keynesian, I firmly believe that we can keep taxes low (and even cut corporate taxes), and cut government spending, without causing any long-term harm to the economy. In fact, I think that the combination of low taxes and reduced government intervention would prove to be a powerful tonic for both investor confidence and the economy. For proof, just look at what Canada has achieved in the past few decades—it's summarized nicely in "Canada, Land of Smaller Government" in today's WSJ. Excerpts:

America's northern neighbor has transformed itself economically over the last 20 years. ... change really began to take off in 1993. A socialist-leaning government in Saskatchewan started by reducing spending and moving towards a balanced budget. 
This was followed by historic reforms by the Conservatives in Alberta, who relied on spending reductions to balance their budget quickly. All government spending peaked at 53% of Canadian GDP in 1992 and fell steadily to just under 40% by 2008. 
Canadian taxes have also come down at the federal and provincial level. They were reduced with the stated goal of improving incentives for work effort, savings, investment and entrepreneurship. Beginning in 2001 under a Liberal government, even the politically sensitive federal corporate income tax rate has been reduced. It is now 18%, down from 28%, and the plan is to reduce it to 15% in 2012. The U.S. federal rate is 35%. Canada has also reduced capital gains taxes twice (the rate is now 14.5%), cut the national sales tax to 5% from 7%, increased contribution limits to the Canadian equivalent of 401(k)s, and created new accounts similar to Roth IRAs. 
Most strikingly, Canada is emerging more quickly from the recession than almost any industrialized country. It's unemployment rate, which peaked at 9% in August 2009, has already fallen to 7.9%. Americans can learn much by looking north.


Dr William J McKibbin said...

Scott, affirmation without discipline is the beginning of delusion, which is why some may be surprised by the Fed's response. There's more going on than measuring economic growth in the USA right now, as in human suffering...

Benjamin said...

Another good commentary by SG, one that has magnified every ambivalent impulse I have regarding the economy.

Yes, buy when everyone is bearish--and that means buy now.

On the other hand, a sustained deflation is quite possible--meaning assets will be worth less every year, not more. See Japan where reale state is off 75 percent from the peak.
That peak was two decades back.
If memory serves, the Nikkei Dow was over 40,000 at one point (1989), and now is under 10,000.

Most sadly, somehow even U.S. monetary policy has become politicized, with "conservatives" taking up battle lines against aggressive Fed action to thwart deflation. (Forget that Reagan embraced fiscal and monetary stimulus, running roughshod over David Stockman, and elbowing aside Volcker--a Carter appointee--in favor of Greenspan).

Obviously, when inflation turns to deflation, the Fed is not being aggressive enough.

Public Library said...

The similarities between the US and Japan circa 1990 are strikingly similar.

Our yield curve might as well be a replica, our demographics are what theirs were in the early 90's, we just went through a massive credit induced real estate bonanza, and we continue to support failed corporate institutions.

About the only thing different is America had no savings going into the 2008 plunge while Japan was flush with cash in the 90's.

Unless we create massive structural reforms, this boat is headed down. Cheap money directed at non-productive consumer oriented projects will only send us down more quickly.

Scott, this might be even bigger than your hopes and dreams can imagine.

I am betting Bernanke holds true to form and fires up QE2. However, the end game will remain unchanged unless the structure somehow changes.

Scott Grannis said...

Re parallels between the U.S. today and Japan in 1990. Sorry, but I fail to see any.

There is a gigantic difference between the U.S. today and Japan in 1990, and that is monetary policy. Forget demographics or savings rates or current account balances; there is no demonstrable connection between those variables and economic performance. Monetary policy, however, has a huge an undeniable impact on economies.

In the runup to 1990, when Japan then began to suffer from a huge collapse in its stock market, slow to negative growth, and low to negative inflation, the Japanese yen appreciated massively against all other currencies, commodities and gold. This appreciation can only be attributed to extremely tight monetary policy, and it was obviously the proximate cause of Japan's subsequent experience with deflation. The yen has maintained its relative appreciation vis a vis other currencies ever since 1990, thus confirming that the Bank of Japan has never effectively eased its monetary policy.

Japan suffered from deflation because its monetary policy was extremely tight for decades. The same can most certainly not be said of the U.S.

Japan's economy has been weak since 1990, most likely due to heavy government intervention and fiscal spending. In this sense there is an emerging parallel between the U.S. and Japan, but only in the past few years.

The U.S. might be entering a decade of slow growth if government spending is not checked, but I see no reason for it to experience a decade of deflation.

Jack Brown, CFA said...

It's interesting that the Fed expectations (first chart) are pessimistic while the financial fundamentals (referenced later on) are brighter. I'll root for the latter.

Scott, your views are often similar to that of Brian Wesbury, who coincidently made the same point about Canada today (

Welcome back...

Benjamin said...

You are right in that central bankers round the globe glory in zero inflation, and consider that a more-worthy goal than economic growth.
Just hope our own central bankers are not similarly infected.

Warning: Most central bankers talk about minor deflation the way teen-age boys talk about sex.

John said...


That we ARE Japan is seemingly the new mantra for the pessimists. The financial media is full of it. (one may take that however one wishes)

The appreciation of the Yen over many years vs gold and most all other currencies is to me the biggest discrepancy. As you point out Japan's monetary policy differed from ours significantly.

There is another difference you did not mention but I think is a factor...the people. Japan was then populated largely by a still defeated population insecure and dependent on the United States for virtually everything from physical security to economic security (their exports were mostly to us). This deep seated insecurity fed a powerful need to export and save against things they feared and had no control over. Being a homogeneous society (virtually no immigration) and a powerfully conformist national psychology, conspicuous consumption was frowned upon and few indulged in it. Savings were very high with inflation low or even deflation existing for periods of time there was no reason to spend. Prices would just be lower later. The government was unsuccessful at changing this mindset.

While many of our pessimists see the United States as a 'defeated' country by some (mostly their) standards it is far from the case. Our population is a polar opposite of the homogeneous Japan. And we are anything but conformist. We are an aging but still reasonably young people of the widest ethnicity on the planet. Every culture's diaspora is within our borders working, saving, spending, investing, building a life for themselves and their children. We have never been invaded (save 1814 and 2001) and our military is unchallengable. Our Navy dominates the world's oceans. Our natural resources are massive and our political and legal institutions are as strong as they get. Our currency is the world's choice for security and our language is the speech of global business.

Many pessimists will doubtless argue some of these things and some of their points will be valid. However the real point is, there is no other nation in the world comparable to the United States of America. We ar NOT Japan, or ANYBODY else.

John said...

Hey Benj,

How do teen age boys talk about sex??? It's been a looooong time since I was a teenager!

Inquiring minds want to Know!!

Public Library said...

I had a long comment but it was deleted or something...

Benjamin said...


Well, back in the days of mimeograph machines and rotary telephones, teenage boys (like me) talked about sex with deep knowledge (gleaned almost exclusively from the embarrasingly illicit Playboy magazine)and pent-up desire.

Don said...

Scott and John,

Well said. I have been traveling to Japan for 20+ years and we are definitely not Japan. The lack of labor efficiency is one thing that comes to mind. How many young women does it take to bow welcome to the elevator. Like Milton Friedman said when viewing the thousand workmen digging with shovels...if this is a make work program why don't you have them use spoons? Check productivity growth in the land of the rising sun for these past 20 years to get an idea of why they have had a lost two decades.

Benjamin said...


According to these stats, Japan's output per hour has been rising at more than 3 percent annually for a long time..not as good as the USA...and we are below that of Sweden.

Frozen in the North said...


Sorry to rain on your parade but up in in Canada we know that corporate taxes are not 18%, they're 18% if you exclude provincial corp taxes, which bring the lot closer to 40% -- more o less the same as the U.S.

I don't understand the WSJ, they have a tendency to get news about Canada about 90% wrong on average. The tax issue is an excellent example, but they did the same when talking about the Canadian banking system a few months ago.

John said...


I seem to recall something of rotary dial phones but I do remember Playboy magazine quite well. I think it was the articles that were so good....heh heh.

I have a very good friend here in Miramar who is a retired SAP exec and who is just back from his native Sweden. He says the economy there is doing well. Sweden's economy is linked strongly to Germany and German business confidence right now is high.

Scott Grannis said...

Frozen: I'm obviously not an expert on Canada, but I do keep seeing things that impress. You might argue about the details of the banking system in Canada, taxes, and the housing market, but the facts show that only a few Canadian banks have failed, the economy is doing better than ours, and the housing market is also doing better—not to mention the spectacular performance of the Canadian dollar. Canada must be doing something right, or at least something better than we are.