Friday, June 24, 2011

2-yr Treasury yields fall to record low


As this chart illustrates, 2-yr Treasury yields today fell to a record low 0.33%. Bond market math tells us that this means the market expects the Fed funds rate to average 0.33% over the next two years (today it stands at 0.1%). According to the pricing of Fed funds futures, the market is expecting the Fed to remain on hold for at least another year, and then to raise its target rate only modestly beginning some time later next year and reaching 0.8% in two years' time.

This is the most pessimistic outlook for future interest rates hikes in modern history. Looked at another way, since Fed policy is strongly influenced by the health of the economy, the bond market is assuming that the outlook for growth over the next few years is dismal at best. By inference, the equity market must also be assuming similarly dismal prospects for future cash flows.

However, I find it very difficult to share the market's conviction that growth will be extraordinarily weak and inflation will be tame for the next several years. There are tensions building up in the market that could be resolved rather explosively (and positively) in coming months if the economy picks up as I expect.

How can the outlook for growth be so dismal when corporate profits are at record levels, both nominally and relative to GDP? When retail sales are up almost 8% in the past year? When private sector jobs are growing at the rate of almost 2% per year? When U.S. exports are growing at almost 20% per year? When business investment (capex) is increasing at a 10% annual rate? When commodity prices are only 5% off of their all-time highs? When households' net worth has increased over $9 trillion in the past two years? When financial market conditions are relatively healthy, liquidity is abundant, and the yield curve is extremely steep? (I've covered all these points in recent posts.)

My guess is that the market is ignoring all these positive fundamentals and instead is paralyzed by the mounting risk of a PIGS sovereign debt default, and by the ballooning size of the federal budget deficit. The Keynesian instincts which permeate the market's thinking are predicting economic disaster as a result of forced fiscal tightening. Budget deficits are going to have to be slashed, and to a Keynesian that means contraction.

But as Steve Hanke reminds us in today's WSJ, contractionary fiscal policy—and even budget surpluses—can coexist with a very strong economy. Moreover, it's a fact that despite the huge fiscal "stimulus" of recent years we have had the weakest recovery in modern times. Indeed, it just makes sense that as the government consumes less and less of an economy's scarce resources, that allows the private sector to blossom and expand.

The only thing we might have to fear about the coming fiscal "contraction" in the U.S. is that politicians try to replace excessive borrowing with higher taxes, thus avoiding a huge cut in spending. But a significant hike in tax rates at a time when growth is meager is going to be a very tough sell. And as Milton Friedman long ago taught us, the true burden of government is measured by spending, not borrowing or taxes. The only sensible—and the best—solution is to cut back government spending. There is no reason to think that would reduce growth, and every reason to think it could lead to stronger growth.

With 2-yr yields and confidence in the future at record lows, the potential rewards to being optimistic have almost never been better.

13 comments:

Benjamin said...

Sometimes i think the economy and markets are like dams ready to break out on the upside. Sheesh, there are mountains of capital on every sideline.

Jake said...

Devils advocate time.

How can the outlook for growth be so dismal when corporate profits are at record levels, both nominally and relative to GDP?

Reversion to mean... costs have been cut. Now need to grow top line.

When retail sales are up almost 8% in the past year?

After dropping the most since the Great Depression.

When private sector jobs are growing at the rate of almost 2% per year?

Less than the growth rate of the population.

When U.S. exports are growing at almost 20% per year?

Nominal imports are growing faster.

When business investment (capex) is increasing at a 10% annual rate?

Levels are still below those seen in 2008.

When commodity prices are only 5% off of their all-time highs?

Not sure how higher commodity costs are good. This only tells me input costs are higher.

When households' net worth has increased over $9 trillion in the past two years?

What does this looks like over the past three years? Negative.

TLDR; if you look at figures from the past two years, you are missing the fact that this is simply a rebound from a huge drop that took place three years ago. If a hedge fund had returns of 100% over the past 2 years (i.e. a doubling), but was down 90% in a year three years ago, they are still down 80%. Extreme example, but you get the point...

John said...

"there are mountains of capital on every sideline."

Not on my sideline. Robert Reich might say "it's the inequality, stupid."

He'd be right.

John said...

Reich never saw a government program he didn't like.

Very similar to last summer, investors and traders are wallowing in their pessimism. High quality dividend paying stocks are being indiscriminatly liquidated because of fears the global economy will sink if a minor european country is required to restructure its debt. It is (again) opportunity time. A year ago Scott was posting how and why it was an overblown fear. The equity market finished the year substantially higher. I believe the same will be the case again this year. Value investors are sitting back and taking the high quality shares the short sellers and frightened investors are dumping.

The Fed continues to send the signal that short term risk-free rates will continue to stay at virtually zero for a long time. Investors wanting a return must embrace some degree of volatility. Like last summer it is a great time to be cherry picking high quality dividend paying equities.

John said...

The big-time investors don't need an up trend, they play the daily volatility.

With HFT, an average share of stock is own for, what, 18 seconds?

Crazy

Benjamin said...

http://online.wsj.com/article/SB10001424052702304231204576403753705186010.html

The above is a WSJ blog to the effect, "If you want yield, buy a stock."

The article contends that 40 percent of stock market returns, over time, are in the form of dividends.

I have liked divvie stocks always. Get paid to wait, i say.

The above article also says profits will be up 14 percent in second quarter. Most companies will have no problem paying divvies, and boosting them.

septizoniom said...

why would you be more correct than the differentiated market? unlikely. you are blinded by a don quixote determination to turn the country around by dint of relentless chearleading.

Bill said...

Septizoniom:

"There is nothing either good or bad, but thinking makes it so."

-Shakespeare

John said...

About that cheerleading... fear, confidence drive the market down and up, respectively, either eroding or building weath.

Wealth is a state of mind.

John said...

Seems like a Ray Lamontagne market. Just don't know WHERE to put that bone!

septizoniom said...

bill: i'm not sure exactly what you mean. i don't think you do either.

Bill said...

Septizonium:

Here's the translation: optimism doesn't hurt. Are you an academic by any chance?

TradingStrategyLetter - Weekly Summary said...

It hard to soar with the eagles ...when yur thinkin' like a turkey!