Friday, June 24, 2011
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.
Posted by Scott Grannis at 1:33 PM