Monetary ease takes the edge off the panic

A coordinated easing move by the world's major central banks was well received by most markets today. Lower interest rates can't solve all problems, however, and they won't fix the fundamental problem of bloated Eurozone government spending, but they can take the edge off the panic by backstopping the financial markets. 2-yr swap spreads are a good indicator of the tensions in financial markets, and today they dropped by over 10 bps in the U.S. Eurozone swap spreads remain quite high, however, as do yields on PIIGS debt. The wider gap between U.S. and Eurozone swap spreads indicates an increased likelihood that the U.S. economy will be insulated from the fallout of a PIIGS default, and that is a very positive development. With lots of recent economic indicators showing marginal improvement in the U.S. outlook, any steps taken to foster continued improvement in the U.S. economy also provide some indirect support for the Eurozone economy as it struggles toward a solution. A solution which in the end must consist at a minimum of restructured debt and meaningful cutbacks in government spending. There is no painless way to fix the PIIGS' problems, but avoiding financial market panic is a good way to allow the process to proceed.

The chart above show the ratio of the Vix Index and the 10-yr Treasury yield, which is a good measure of panic (a high Vix index signals panic) and despair (a low 10-yr yield signals little or no hope for growth). We're still in red-zone territory, but it would appear that there has been some progress toward a resolution.

The employment outlook is improving modestly

I haven't seen any recent reports from the folks at ECRI, but I've got to believe they are getting nervous about the recession call they made a few months ago. Today's news from ADP was a definite upside surprise, in which they report that private sector jobs grew by 206K in November (vs. expectations of 130K), and they revised upwards the prior two months by 35K. Of course even these levels of job growth are puny compared with what we would expect to see in a normal recovery, but it sure is nice that things are improving—however modestly—instead of deteriorating as so many have been fearing. 

The Challenger survey of announced corporate layoffs in November also confirmed that there is no sign of any deterioration in the jobs market.

While I'm on the subject of good news, it is also nice to see that the mortgage purchase index (above chart) has registered some solid improvement in the past several months, albeit from very low levels. Things could be a lot better, to be sure, but a 20% pickup in new mortgage applications—which is echoed in a pickup of pending home sales—is a sign that consumers are able to respond to record-low mortgage rates, and the housing market is clearing.

Putting PIIGS debt into context

These two charts distill the essence of what is currently mesmerizing markets and economies around the world: the growing likelihood of one or more PIIGS defaults, which could potentially involve several trillion dollars worth of debt. Surely, the thinking goes, a multi-trillion dollar default would absolutely devastate the Eurozone economy, dragging most other economies down into an abyss even worse than the one we teetered on the edge of in late 2008.

Although "trillions" is undoubtedly a pretty huge number of dollars, the value of liquid, global bond and debt markets is about $110 trillion. The chart above shows the market cap of global equities, currently some $45 trillion. According to Merrill Lynch's indices of liquid bond markets, there are some $42 trillion of investment grade global bonds, and $21 trillion of high-yield global bonds. As the chart above also shows, the destruction (and creation) of trillions of dollars of equity cap happens routinely, sometimes on a daily basis. In one month alone (mid-September to mid-October '08), $15 trillion of global equity market capitalization was wiped out—not to mention the trillions that were erased from U.S. mortgage-backed securities—yet it was only a matter of 7-8 months before a global recovery got under way.

The world is a pretty big place, and markets are very deep. Italy's entire national debt is only 2% of the value of global capital markets, and much less if we add in the value of global property markets. Can the relatively tiny PIIGS tail seriously wag the huge global economy dog?

Stocks and bonds represent claims on future cash flows, and those cash flows in turn are generated by economies that are driven by billions of industrious workers utilizing hundreds of trillions worth of factories, roads, bridges, telecommunications systems, etc. Wiping out a few trillion of claims on those cash flows does not erase an economy's productive potential. It would be extremely disruptive, to be sure, but it's highly likely that at least 95% of those working today would be working and producing in the days, weeks, and months following even a multi-trillion dollar PIIGS default.

A big PIIGS default doesn't need to be earth-shattering. One important consideration that is often overlooked is that the world has had some 18 months to prepare for this. It won't be a "black swan" event that catches the world by surprise. The worst part of the financial collapse in late 2008 was just that: it came out of nowhere, totally surprising all but a very few, and the ensuing panic selling made things far worse than they otherwise would have been.

Apologies

My apologies to those who frequent this blog and by doing so "contribute to our national paralysis." In his NY Times column yesterday, former editor-in-chief Bill Keller laments that one of the downsides of the internet is that it brings out the worst in economic commentary, distracting us from the unifying principles of "mainstream economics." If the only ones to comment were "serious scholars," then we could solve our national economic problems quickly. Instead, "lesser economists are thrust forward for their moment of fame as witnesses on behalf of dubious claims." As an example, he cites the 132 economists who agreed that Speaker Boehner's policy approach would "do more to boost private-sector job growth in America in both the near-term and long-term than the ‘stimulus’ spending approach favored by President Obama."

Reputable number-crunchers like Moody’s Analytics and some top-tier economists of both parties said Boehner’s statement would have little or no impact on the short-term employment problem. So who were these 132 economists? With a few exceptions they were academics from off-the-beaten-path colleges (no offense to Dakota State University), bloggers (the Calafia Beach Pundit?) and economists from devoutly libertarian think tanks.

And he went on to say:

Surely this dilution of authority contributes to our national paralysis. At the very least it befogs the discussion and fosters a pervasive cynicism.

I hasten to add that while Bill Keller and I graduated from Pomona College within a year of each other, I would like to think my training in philosophy (under the expert hand of the late Professor Fred Sontag) allowed me to keep a more open mind. Wisdom and experience do not come only to those in positions of "authority."

UPDATE: Another of the 132 signers of Boehner's letter writes a devastating critique of Keller's use and mis-use of economic theory in his Forbes column.

Housing price update

The September release of housing price indices reveals that prices appear to be still in a gentle decline, especially after adjusting for inflation. But after adjusting for the fact that real incomes are growing and borrowing costs are at all-time lows, housing prices are more affordable today than at any time in recent decades, as shown in the chart (below) of housing affordability (when the index is 100, that means a family earning the median income has exactly the income needed to purchase a median-price resale home using conventional financing; levels higher than 100 mean that a median-income family has that much more income than needed).

Commodity recap

With the future of mankind supposedly hanging by a Eurozone sovereign debt thread, paying attention to anything other than the political struggles in Europe to avoid default would seem silly. But since the damage has already been done, all we are witnessing these days is a game of financial musical chairs: who will be the unfortunate holder of PIIGS debt once it is eventually restructured? The economic losses have already occurred, since the PIIGS spent their borrowed money in very inefficient and non-productive ways. Debt defaults occur all the time, and they needn't imply the end of the world as we know it, even if they are huge. That's mainly because a debt default does not destroy demand, it simply makes lenders poorer and borrowers less poor—debt is a zero-sum game. But meanwhile there is no reason why a combination of defaults—surely Greece will default on a significant portion of its debt—restructurings, and more prudent fiscal policies couldn't allow the global financial markets to avoid a total collapse. And if the fiscal policy changes are growth-favorable (e.g., they avoid higher tax rates, and focus instead on flattening the tax code and cutting back on the size of spending relative to GDP), the global economy might even emerge from this mess in better shape.

So while we wait for the music to stop to find out who the winners and losers are, it might be worthwhile to review the action in the commodity markets.

Crude oil still trades at about two-thirds of what it briefly was worth in mid-2008, but it is still orders of magnitude more expensive than it was 12 years ago.

In constant dollar terms, crude is worth about 15% more today than it was in the early 1980s.

But we spend about one-third less for energy today than we did in the early 1980s, thanks to huge gains in energy efficiency. So on balance, energy prices do not represent an unprecedented burden on the economy.

Non-energy spot commodity prices are down 16% from their April '11 highs, but are still way above the levels that prevailed throughout the 1980s and 1990s.

Copper prices are about 25% off their highs, but still way above the levels of 10 years ago.

The problems in Europe may well have taken some of the edge off commodity prices, but by just about any measure, commodity prices are still relatively high. I think that reflects the fact that a) global demand remains sturdy, and b) monetary policy at most central banks remains very accommodative. I fail to find any sign in the commodity markets of a significant deterioration in the underlying economic fundamentals.

Consumers continue to deleverage

According to the Fed, delinquency rates on consumer loans have fallen significantly since the last recession. This is a sure sign that consumers have been actively deleveraging, and that is good. The most recent reading on all consumer loans, 3.15%, is below the 3.5% average since this series began in 1987. The most recent reading on credit card delinquencies, 3.5%, is substantially below the 4.5% average since the series began in 1991. As I've noted before, this is also evidence that deleveraging does not destroy demand or otherwise necessarily weaken an economy. When a borrower pays down his debt, the lender must do something with the money received; either loan it to someone else or spend it on goods and services. Indeed, consumer deleveraging is a very normal part of a business cycle recovery, as this chart illustrates; it is not something to be feared.

HT: Mark Perry. And as he notes, if we could only get the U.S. government to demonstrate the same kind of financial responsibility as U.S. consumers have....

The demise of the euro has been greatly exaggerated

With all the talk these days about the eurozone crisis, a coming eurozone crash, the death of the euro, etc., I thought it might be helpful to include this chart of the history of the euro from its inception through today, vis a vis the dollar. Maybe both are going down together, but the euro is still strong relative to the dollar. From the looks of this chart alone, you would never guess the euro is in serious trouble. Perhaps because it's not?

Maui sunset

Last night we were treated to a spectacular sunset. By the way, I took this photo with my iPhone 4S—hand-held, no special settings or adjustments. The sun is setting behind the island of Lanai.

Maui morning

Idyllic Napili Bay in northwest Maui, where we are staying. The island of Lanai is in the background on the right.

Weekly unemployment claims show continued improvement

As both these charts show, the trend in weekly unemployment claims remains down, and that reflects positively on the health of the U.S. economy. No sign of a double-dip recession here.

The real question, of course, is whether the U.S. economy's growth path—which is hardly robust—can withstand the deterioration going on in Europe.

As this chart shows, Eurozone stocks have really been clobbered relative to U.S. stocks in the past year (down by about one-third), and the Eurozone sovereign debt crisis is the most likely culprit. The chart also shows that the big trends in Europe and the U.S. have a strong tendency to coincide. (Actually, all major economies tend to move in synch these days.) I'm tempted to think that Europe's problems are fairly unique, and that a sovereign debt default or two will not result in a serious deterioration in the Eurozone economies. Thus, it shouldn't derail the U.S. recovery. What we have seen so far is a lot of anguish over this question that has not yet translated into any hard evidence of U.S. economic deterioration.

Capex still strong

October capital goods orders were weaker than expected, but that is in line with the seasonal vagaries of this index (the first month of every calendar quarter has a strong tendency to be weak). A 3-mo. moving average solves this problem, but that measure was flat in October. Does this mean that capex is rolling over? Hardly. On a year over year basis, capex is still up 9.2%.

Maui pics

Took these with my iPhone 4S on our walk this morning. (it has completely replaced my Canon pocket camera and even takes better pictures) The first photo was taken while walking up Pineapple Hill in the Kapalua area (northwestern portion of Maui), looking out over the Bay Course and with Lanai in the background. Second shot was taken while walking the Maui Coastal Trail which runs along this north-facing beach, also in the Kapalua area. Tiger Wood's house is right on the trail, approximately behind my head.

Corporate profits are still very strong

My wife thinks I'm insane to be pecking at the computer when a view like this is right outside our door, but I thought the news on corporate profits released today was worth a post.

Along with the revisions to Q3/11 GDP—which were not significant—we now have the first estimate of 3rd quarter corporate profits, and they continue to surprise on the upside. After-tax corporate profits increased 11.4% in the year ending Sep. '11. 

Relative to GDP, corporate profits are now at a new all-time high of 10.3%. This recovery may have been the most tepid on record, but the surge in corporate profits is unprecedented. This is grist for a lot of philosophizing, which I might attempt at a later date.

The chart above is my attempt to create a PE ratio using the S&P 500 index as a proxy for the value of all corporate equities, and the after-tax NIPA profits figure as the earnings. The level of the ratio is not as important as the relative changes that occur, since I'm using a normalized figure for the S&P 500 index. By this measure, equities have never been cheaper; the last time this PE ratio was this low was in the late 1970s and early 1980s, times which would have been fabulous buys with the benefit of hindsight. Extremely strong profits coupled with historically low PE ratios is a strong sign that investors are extraordinarily pessimistic about the future. This market is most definitely not suffering from an excess of enthusiasm. On the contrary, the pessimism is so thick you could cut it with a knife.

This chart compares NIPA profits to S&P 500 reported profits. Not surprisingly, both follow the same pattern over time, but NIPA profits appear to lead reported profits, and are also more stable. That would suggest we still have more good news to come for reported corporate earnings.

This chart compares total corporate profits to the profits of nonfinancial domestic corporate profits. Since both lines have tracked each other very well over long periods, there is no a priori reason to think that foreign-source profits today are unusually large, or that the profits of financial companies are out of line with historical experience.

All in all, some very welcome good news on profits, even if Q3/11 GDP was revised down a touch. Since the weather here in Maui is fabulous and the views are spectacular, it's time to go for a walk and enjoy the sights. With corporate profits still so strong, the world can't be a very dangerous place.

UPDATE: The fact that profits are up so much but equity prices are not is simply the market's way of saying that profits are likely to decline significantly in the future. In other words, one could argue that the market is priced to the expectation that profits will be mean-reverting in relation to GDP; instead of profits being 10% of GDP, the market expects profits to be 6% of GDP at some point in the future. Either nominal profits will decline or they will cease to grow as GDP expands. So if profits do fall or grow at a very slow rate in the years to come, that won't necessarily be bad for equity prices, because the market already expects that to happen. In a sense, profits must perform miserably just to validate the market's expectations. Profits could well prove to be mean-reverting, but if that occurs in an environment of relatively fast GDP growth and a benign fiscal and regulatory climate, then equity prices could advance significantly in the years to come.

Panic exhaustion revisited

Comparing the level of the Vix Index of implied equity volatility to the level of the 10-yr Treasury yield is a handy way of gauging how extreme market sentiment is. The Vix index is a good proxy for fear (because the implied volatility of options determines how expensive it is to purchase options in order to limit one's downside risk), and the 10-yr Treasury yield is a good proxy for the market's long-term outlook for growth and inflation. When you combine a high level of the Vix with a low level of the 10-yr, you have a market that is not only very fearful but also very pessimistic about the future. The top chart shows the ratio over the past two decades, while the bottom chart zeros in on the ratio over the past 4 years. Bottom line, we are living in times of great fear and pessimism.

I wrote back in July ("Carmageddon, free markets and the PIIGS crisis") about how fear, knowledge and time can short-circuit prophesied disasters, and I suggested that the PIIGS crisis might therefore end with a whimper instead of a bang. I still think that is possible, and the more time that passes, the greater the likelihood that of even a multiple PIIGS default will prove to be much less awful than the market currently fears. After all, the world has had almost a year and a half to adjust to the risk that the PIIGS countries were in trouble and might default. That's a lot of time, and any sentient investor or risk manager with serious exposure to a PIIGS default most likely has taken steps to reduce his exposure. When risk is hedged it is diversified, so PIIGS default risk has likely been spread out over much of the world; and of course the ECB and Germany have in the meantime been willing to shoulder a good deal of that risk.

To judge by the Vix/10-yr ratio, markets and investors have only been so consumed by fear, uncertainty, doubt, and pessimism once before—the period starting with the collapse of Lehman in 2008 and ending with the beginning of the current recovery in mid-2008. But back then we did have monster defaults and we saw the decimation of banks and their balance sheets, and we did have a global economic collapse and a financial panic that brought us very close to the feared abyss called "the end of the world as we know it." Today we have been waiting 18 months for this to happen again. I reiterate what I described three weeks ago, in my mid-September post on panic exhaustion: debt defaults don't destroy demand, banks can be recapitalized, government spending cuts actually make the outlook rosier, and most of the damage from too much debt has already happened. "The failure of a bank is simply the last chapter in a book about money being flushed down the toilet. It's not the end of the world."

It's not that the suspense of a PIIGS default is killing us. The longer the suspense lasts, the less likely it is to kill us.

Markets are still priced to a very ugly outcome

This chart recaps the level of systemic risk in the U.S. vs. the Eurozone, using 2-yr swap spreads as the proxy. By this measure, the situation in Europe today is almost as bad as it was during the global financial panic of late 2008. But systemic risk in the U.S., though somewhat elevated, is still relatively low. Investors worry a lot about the possibility of contagion from Eurozone defaults, but in practice no one is demanding an excessively high premium to take on U.S. counterparty risk.

This chart compares the level of swap spreads to the average yield on junk bonds. Since Treasury yields have been extraordinarily low for some time now, the level of yields is arguably a better indicator than spreads for the actual difficulties faced by high-yield-rated companies. Both measures of risk are somewhat elevated, but they are nowhere near as bad as they were in 2008. The problems in the Eurozone are having only a modest impact on conditions here in the U.S., and investors are willing to accept counterparty and low quality credit risk for a relatively low premium.

This chart compares 5-yr swap spreads to spreads on 5-yr A1-rated industrial bonds. Here again we see that the premium necessary to convince investors to accept these risks is still relatively low.

Now contrast the relatively low levels of systemic risk and investor fear that can be found in the bond market to the very high level of fear that can be found in the equity market. The chart above shows the PE ratio of the S&P 500 compared to the 1-yr forward consensus view of earnings. Investors are only willing to pay a multiple of 11.7 times expected earnings, which is equivalent to saying that the expected earnings yield that investors demand in order to hold equity exposure is 8.5%. Investors today are almost as reluctant to hold equity exposure as they were at the end of 2008, when the global economy was in free fall and financial markets were terrified by the fear that the global banking system would collapse. The same analysis holds for Eurozone stocks (second chart above), although PE ratios in general have been much lower for European stocks then they have for U.S. stocks (presumably because the long-term growth outlook for Europe has for a long time been less robust than for the U.S.).

Circling back to the bond market, the level of 10-yr Treasury yields is extremely low, and is consistent with the view that the outlook for the economy is utterly dismal.

I'm not sure I have a good explanation for these disconnects. Spreads in the U.S. are priced to a modest level of concern, while spreads in Europe are priced to an extremely high level of concern. Treasury yields and PE ratios, in contrast, are priced to the gloomiest of outlooks. But however you look at it, there appears to be no shortage of pessimism in today's market pricing. In fact, optimism is very difficult, if not impossible, to find. AAPL, for example, has a forward-looking PE ratio of only 10.9 according to Bloomberg, which means the market is extremely skeptical of analyst's earnings projections. AAPL's current PE of 13.6 is only slightly higher than the S&P 500's 12.8, and this for a company that has grown earnings at a spectacular rate for years.

So I come back to the theme that has been dominant for the past three years: markets are very, if not extremely, pessimistic, and valuations are therefore very attractive if one believes that the U.S. and global economies are not going down the toilet. Even holding only a modestly positive outlook for the future makes one extremely optimistic relative to the outlook embedded in market pricing. By the same logic, being bearish today (i.e., hiding out in cash that pays nothing) is a very expensive proposition, and is likely to pay off only if the U.S. and global economy really get bad.

M2 update

Reader "unknown" noticed that M2 jumped by almost $50 billion this week, and suggested that might be a sign that money was once again fleeing Eurozone banks for the safety of U.S. banks. However, as this chart shows, the latest jump is merely a reversal of an earlier decline. On average over the past 13 weeks, M2 is growing at a 6.3% annualized pace, which is right in line with its 15-year trend. There was a noticeable "bulge" in M2 which began around the time the Eurozone crisis started heating up last summer, but it hasn't gotten any bigger since mid-August. Meanwhile, a similar bulge in M1 is also reverting to trend growth, and dollar currency is only rising at a 5% annualized pace; big increases in currency growth tend to coincide with global panics in which the dollar becomes the safe haven of choice.

In short, there's not much going on with M2 of late, which suggests that although the Eurozone sovereign debt crisis has been intensifying, it is not resulting in a wholesale run on the Eurozone banking system.

Good morning from Honolulu

We're in Honolulu for a few days, visiting our son and doing some business-related stuff. I snapped this photo (using my new iPhone) about 20 minutes ago from his window looking West—a magnificent rainbow. I thought this would make a nice contrast to the gloom that has once again descended on the markets. It's also a reminder that even as hundreds of billions of debt gets wiped out on the other side of the planet, life still goes on everywhere. The buildings don't disappear, and people keep going to work every day. The U.S. economy is growing. There are all sorts of problems in the world, but chances are good they will get resolved one way or the other without plunging the world into another Dark Age. Billions of free people working in free markets have a remarkable capacity to withstand adversity and overcome seemingly impossible obstacles.

Next week we'll be in Maui for a family reunion, a present to ourselves for having made it through 40 years of married life and having raised four wonderful children. Lots to look forward to, so blogging may be on the light side for awhile.

Housing starts and claims show improvement

October housing starts came in a bit above expectations, but nothing to write home about. Still, this chart, with its semi-log y-axis, shows that the trend in starts is slightly positive, reinforcing my comments yesterday about emerging improvement in the housing market. From a low of just around 500K in early 2009, starts now are up over 25%. The level of starts is still abysmally low, of course, but the critically important change on the margin is positive.

Whereas the best that could be said for most of this year was that weekly claims for unemployment were not rising, it's become clear in recent weeks that claims are now declining. We are now entering the time of year when claims normally begin to rise—next month's claims numbers will really tell the tale, since seasonal factors expect a significant rise in claims. But so far it looks like the rise in claims is less than normal, which in turn means that employers have been running a tight ship (having cut staff to the bone) and underlying economic fundamentals are reasonably solid. Since claims are one of the most real-time of all economic indicators, this is very good news.

The marginal improvement in both these indicators—echoed in many others such as capital goods orders, industrial production, retail sales, and rising levels of employment—is doubly important given that it is all occurring in the shadow of increasingly dismal news coming from Europe. Imagine how excited markets would be if Europe were also improving instead of teetering on the cusp of a financial meltdown.

So this begs the question: as Eurozone swap spreads approach crisis levels, and as U.S. swap spreads get dragged up to levels that show some emerging stress, are U.S. equities crazy over-priced? Not necessarily. I think it would take a very ugly worst-case scenario to unfold in Europe before the U.S. economic and financial fundamentals would take a hit. Our markets are already very concerned, as reflected in the S&P 500's forward earnings PE ratio of 11.7, in 10-yr Treasury yields of 2%, and in 2-yr swap spreads that have reached 53 today. For things to get nasty, we will need to see some serious defaults in the Eurozone, bad enough to wipe out a good portion of the Eurozone banking system, and bad enough to affect commerce and spark the sort of panic that characterized the economic free-fall we saw here in the latter part of 2008. That could all happen, of course, but it requires some heroic assumptions to be confident that we are on the verge of another catastrophic financial and economic collapse that cannot be prevented. At this point, the absence of more bad news from the Eurozone should count as good news for U.S. markets.

Meanwhile, markets have already priced in a default on Greek debt of monster proportions: 75% (i.e., Greek government debt is priced at about 25 cents on the dollar). That would make an eventual Greek default worse even than Argentina's record-setting default of about 10 years ago. Italian debt is now priced to a 20% default, and that is big news considering the Italian government owes more than $2 trillion. Between Greek and Italian debt, the market has already wiped out about $750 billion. This loss has already happened. The PIIGS long ago borrowed lots of money and used it to sustain living standards instead of to improve their economic fundamentals. Their economies did not grow enough to service their debt. The market understands this, and has discounted the debt accordingly. Here's what we don't know: is this discount is deep enough or maybe too deep? Who is going to have to write these losses off on their bottom line, and will that cause enough companies and/or banks to collapse to bring down the world economy?

One important thing to keep in mind is that debt represents an agreement to transfer future cash flows. If debt is wiped out, then the cash doesn't get transferred from the debtor to the creditor; the debtor gets to keep it, and the creditor has less than he expected to have. The underlying economic fundamentals—the roads, bridges, buildings, factories, and workers that generate the cash—are not affected. Wiping out debt does not wipe out production or demand. The losses that will eventually be written down have already happened, because the money the PIIGS borrowed was squandered long ago; they never built the added economic capacity to service the debt that lenders expected them to. Bad luck for lenders, but this isn't the end of the world.

Charts and thoughts

There's nothing particularly noteworthy in the economic news today, so what follows is a quick recap of major releases, with some observations along the way.

October Industrial and Manufacturing Production came in stronger than expected, but the bigger picture is that industrial output is rising at a moderate 4% rate: nothing to get excited about, but nothing to worry about either.

A survey of home builders' sentiment ticked up—surprisingly—this month, and this adds some weight to the case that we have seen the worst in the housing market and may be on the cusp of some improvement. The second chart, showing an index of homebuilders' stocks, also suggests we have seen the worse and are seeing some gradual improvement on the margin. Painfully slow, to be sure, but the trend appears to be heading up. The home vacancy rate also suggests that we have seen the worst and things are improving, although of course there needs to be a whole lot of improvement before we can get back to "normal" conditions. Even though we are still a long way from seeing what might be termed "strength" in the housing market, simply ruling out further weakness is nevertheless quite comforting. As excess housing inventories are worked off and the economy continues to grow and as household formations continue to exceed new construction starts, the case for a rebound in residential construction and a rebound in prices gets stronger.

As was the case with yesterday's PPI release, October consumer price inflation showed some moderation. On a year-over-year basis, there is nothing alarming going on here. However, declining energy prices have played a big role in moderating overall inflation in recent months, and that is almost surely going to reverse in coming months, since crude oil has now broken above $100/bbl. (up almost 35% from the early October low).

This chart compares the yields on 30-yr Treasuries to core inflation. In an ideal world, bond yields would be at least 2 percentage points higher than inflation, and this chart is set up to show that is the case when the two lines are on top of each other. Reality rarely matches the ideal, of course, but the chart is nevertheless helpful in gauging the valuation of bonds on a real return basis. On that score, in the past several decades, bonds have only been less unattractive at the end of 2008 (not to mention several times back in the rising-inflation 1970s). And considering that core inflation has been trending up while bond yields have declined to very low levels, the real-yield-valuation case for owning long Treasuries is very weak. Long bonds are only attractive as an antidote to fear: fear of an implosion in European financial markets that will rock the global economy and deliver us into years of recession or even a global depression. You have to be extremely worried about the future to want to own long Treasuries these days.

This chart compares the year over year growth rate of the consumer and producer price inflation. Both are trending higher, and the PPI seems to be leading the CPI in recent years, suggesting that the rise in the core CPI is likely to continue.

I add this chart to show some long-term perspective on core inflation. Note the extremely low levels of inflation in the early 1960s, when monetary policy was constrained by the gold standard, the dollar was the king of the hill, and the economy enjoyed very strong growth. Note also how this measure of inflation has crept higher since 2002-3, which was when the Fed first started to ease aggressively and the dollar began to decline. I don't think it's a coincidence that growth has been very disappointing in the past four years. With a weak dollar and very low real interest rates, speculative activity becomes more appealing than investing in the real economy. Business investment is rising, but it is lagging woefully behind the growth in corporate profits.

If there is a theme that ties this altogether it is one of growth inhibited by fear and uncertainty. The economy is growing, but only moderately. The value of the dollar is up in the air. The risks of a Eurozone implosion are palpable. Bloated government spending has suffocated economies everywhere, making debt burdens intolerable. Fiscal policies need to change radically, but the political will to do so seems lacking, and crony capitalism is on vulgar display too often. Accommodative monetary policy—which seeks to encourage more borrowing—is not a good solution to a situation made bad by an excess of borrowing, and it only weakens confidence in the future value of currencies. Gold at $1800; wild gyrations in oil prices; high-frequency trading; widening spreads on Italian and French bonds—all are symptomatic of a market that believes that there is more profit to be made in speculation than in new business investment. Speculation is what you get when you weaken the incentives to invest in productive activities for the long haul.