To begin with, the real yield on TIPS today is very close to an all-time low. In fact, real yields on TIPS are negative all the way out to 15 years' maturity. The chart above shows the real yield on 10-yr TIPS, and I have overlaid my view of how attractive or unattractive real yields happen to be. With real yields as low as they are today, investors in most TIPS are guaranteed by the US government to lose some portion of their purchasing power every year. Looked at another way, with yields super-low, prices are super-high, and that implies very strong demand for TIPS. And very strong demand for something means that it is not very attractive from an investor's point of view.
This chart compares the real yield on 10-yr TIPS to the nominal yield on 10-yr Treasuries. The difference between the two is the market's "break-even" or implied annual inflation rate over the next 10 years. Here we see that both TIPS and Treasuries enjoy exceptionally strong demand, because their yields are both very close to all-time lows. However, the market's expected rate of inflation is about average: 2.3% for the next 10 years, which is only slightly less than the 2.4% annualized CPI over the past 10 years. From this we can deduce that although TIPS are very expensive—trading very close to all-time high prices—it's not because investors fear inflation. Inflation expectations today are quite normal.
With this next chart I try to show how the real yield on 5-yr TIPS tends to track the economy's real growth rate over time. In the late 1990s, economic growth rates were very strong, and TIPS yields were extraordinarily high. That made perfect sense, because the real yield on TIPS had to be competitive with the real return on other securities, and other securities were delivering fabulous real returns because the economy was so strong. Today it's just the opposite. Real yields are low because the market expects economic growth to be very weak; as this chart suggests, the real growth expectations driving 5-yr TIPS are likely somewhere in the neighborhood of 0-1% on average over the next 5 years. There is so much fear about the future out there in the market that investors are happy to lock in a guaranteed loss of purchasing power with TIPS because they believe that the return on alternative investments will be much worse, and that is what one would expect if the economy were indeed to grow less than 1% per year over the next five years.
This next chart shows my calculation of the 5-yr, 5-yr forward expected inflation rate embedded in TIPS and Treasury prices (Bloomberg's calculation of this rate today is 2.74%, mine is 2.67%). Think of this as what the market's 5-yr inflation expectations will be, five years from now. Since the 10-yr expected rate is 2.3% and the expectation for the second half of the next 10 years is 2.7%, that means the market expects inflation to average just under 2.0% over next five years.
Contrast the situation today (super-low real and nominal yields) with conditions at the end of 2008 (low nominal yields, relatively high real yields). Back then, the market feared deflation more than anything else (the 5-yr, 5-yr forward expected inflation rate was less than 0.5%), and demand for TIPS was very weak. But today, the market fears very weak growth more than anything else, which is why both TIPS and Treasury yields are extremely low. On the margin, the market has been worrying more and more, over most of the past year, that inflation could creep up at some point in the future, even as the market has been worrying that the economy will be weaker.
To be in a situation where market expectations call for very weak growth for as far as the eye can see, while at the same time expecting somewhat higher inflation is remarkable, because it refutes the traditional Phillips Curve mentality that says inflation goes up only when the economy is very strong, and goes down when it is very weak. This is one more blow to Keynesian-type thinking, and I say good riddance.
In my view, the bond market is correctly evaluating the implications of today's very accommodative monetary policy coupled with today's very oppressive fiscal policy, and concluding that on the present track, we are heading towards a very weak economy with somewhat higher inflation.
Just because the deficit is still huge as a percent of GDP does not mean fiscal policy is expansionary. On the contrary, as Milton Friedman always taught us, it is the level of government spending more than anything else that is the important fiscal variable to watch. Whether a given level of spending is financed by borrowing or by taxes is not as important as whether the government is commandeering too much of the economy's resources. With federal spending currently running about 23.5% of GDP (12% higher than the 40-year average of 20.9%), I think spending (the bulk of which is transfer payments from the most productive members of society to the less productive) is too high and it is acting as a headwind to the economy's ability to grow. The government is wasting a significant portion of the economy's resources that could be better utilized by the private sector, in addition to creating perverse incentives.
All of the above adds up to one more reason why I continue to insist that the market is priced to very pessimistic assumptions, e.g., the Fed is going to make an inflationary mistake and there is very little chance that our bloated federal government will become less oppressive. If you agree with the market, then you stay in cash on the sidelines, and/or you buy TIPS and Treasuries in case things turn out to be even worse. If you think there is a chance that things could improve even just a little bit, then you avoid cash, Treasuries, and TIPS, and you invest in just about anything else: stocks, corporate bonds, and real estate. I exclude gold and commodities from this list, because I think they are priced to a very big inflationary mistake on the part of the Fed. If the Fed manages to keep inflation below 3-4% for the foreseeable future, then I would expect to see gold prices decline significantly, and that would imply very little, if any, upside potential for commodities.
Very good post. Thanks Scott.
ReplyDeleteNice graphs, insights.
ReplyDeletePerhaps some caveats.
The Cleveland Fed has an index of expected inflation, and it is hitting record lows. Inflation is dead. Microscopic increases in inflation or expected inflation don.t seem that important. We have reached a state of inflation-phobia.
On government transfer payments: Yes, they are a headwind, but many economists consider a worse structural impediment to be federal agency spending.
A transfer payment leaves money in the private sector; agency spending is the taking of tax money out of the private sector and into the nearly perfect;y wasteful and corprolitic federal civilian and military sector. Radical reductions in agency spending would be very stimulative.
Of course, GOP orthodoxy is to remain mute about agency spending, as it is a way to reward GOP constituencies.
On interest rates: Investors may also be looking at the 20-year secular trend in global sovereign debt interest rates. Down, down, down, down.
If trends continue, the developed world will enter Japan-land, that of the zero bound.
Regardless of your political beliefs, agendas, or anything else, this will mean central banks will be stripped of their conventional policy tool of cutting interest rates to stimulate growth.
If only by default, central banks will have to adopt QE as a conventional tool, if this environment continues.
I agree with Grannis, that federal entitlement and agency deficit spending is not stimulative, or, if it is is so wasteful as to be not be warranted,
Fact check: Medicare. Medicaid and Social Security makes up less than one-half of federal spending.
By a slim margin, most federal spending is agency spending or debt service.
Moreover, entitlements are largely funded by payroll taxes, while agency spending is financed by income taxes.
If you want to cut income taxes, then you have to cut agency spending.
Good luck with that.
From where I sit, robust growth in the US economy is impossible until the US Federal budget is balanced, which is not going to happen anytime soon -- once the Federal budget is balanced, robust growth will follow -- if the Federal budget cannot balance its budget, the USA should be dissolved -- even if the Federal budget is balanced, important restructuring will be required before robust economic growth returns in the US -- an economic recovery is not even on the radar at this point...
ReplyDeletePS: Now is the time to buy cheap equities, while maintaining a long-term investment horizon of at least 30-years...
ReplyDeletePPS: Only uniformed public employees should remain on the government payrolls...
ReplyDelete"I think spending (the bulk of which is transfer payments from the most productive members of society to the less productive) is too high and it is acting as a headwind to the economy's ability to grow."
ReplyDeleteGood thing you are an economist and not a politician.
Benjamin, from where did you get that word "corprolitic"? It ain't in the dictionary.
ReplyDeleteAs to which scenario to follow I've decided that the world's economies have stalled out and that low growth is ahead of us for quite awhile.
ReplyDeleteJapan has had about 0% real growth for 2o years. Europe is now in that category and their solutions are saving derelict countries and banks with the printing press. They have no real economic growth plans and in fact are electing Socialists. China has overbuilt by a wide margin and can't overbuild too much more. Plus though we think of their economy as a great monolith directed by a few elite that works, it really doesn't. We thought the same thing of the early USSR. We loved their steel production. So, nothing in the rest of the world looks good nor smart.
In the US we have the benefit of an improving housing market and a pretty well run business sector. So, domestically things are ok. But since so many companies are dependent on foreign profits and with the growth there (negative?) not good our big companies have to come off of their high horse of profits. Can we go it alone and have a good stock market with the FRB pumping it up? Probably ok but not great.
I would hope the author would tell us which way he's betting.
If my posts over the past 3-4 years have had one common theme, it would be this: markets have been overwhelmed by pessimism, priced to very bearish expectations, at times something akin to "the end of the world as we know it." When markets are priced to extremely negative expectations, it doesn't take much in the way of good news to spark a rally. My position has consistently been that the future was likely to turn out better than the market's expectations. Ever since early 2009 I've been forecasting a "sub-par" recovery; it's actually been a bit worse than that, but still, the economy has done much better than what the market was expecting, and that is why equity prices are up and credit spreads are down.
ReplyDeleteI still believe the market is dominated by pessimism and I still believe that the future is likely to be "less bad" than the market expects, and therefore I remain invested in equities, corporate bonds, and real estate. I still hold out the hope that things could improve significantly if the November elections send Washington a mandate for less government rather than more.
Scott,
ReplyDeleteI'm really not so sure that the market was expecting the economy to do this badly, for this long. Look at CBO projections of employment and GDP from 3 years ago, for today. They were too high, basically predicting a full recovery by now.
Likewise, I'd argue that the market is priced much closer to perfection than to fear. Profit margins are at record highs, and P/Es aren't cheap, indicating that the market thinks that the record margins are sustainable. VIX is low, indicating low fear.
The market is not the US economy. The market is doing fine, while the economy is not. But is that sustainable?
I think we're in a lull in a secular deflationary/deleveraging trend. The lull is propped up by gov't stimulus and loose monetary policy around the world.
Additionally, a balanced budget would definitely not be good for the US economy in the short run, as it would be sharply deflationary. In the long run, it would help our economy grow faster, but "long run" could be a while.
Re: the budget, government spending is inflationary, either by consuming goods and services from the market, or by "paying people not to work", as with farm subsidies, Social Security, etc.
Taxation is generally deflationary, removing money from the private sector, and thus reducing our ability to pay higher prices. It's been shown* that tax cuts on lower incomes are more stimulative than those on high incomes, as a tax cut on a higher-income person is more likely to be put towards savings. Likewise, spending cuts are even more contractionary than tax increases**.
Right now, the US government is enjoying "free money": record low interest rates. I don't see how spending or giving this money away could be contractionary. On the contrary, in large enough amounts, it's inflationary, but for now, it's just countering the deflationary trend resulting from years of offshoring, automation, and capital misallocation.
In short, I'm not really sure the evidence backs up what you Benjamin and Dr. McKibbin are saying.
* http://emlab.berkeley.edu/users/dromer/papers/RomerandRomerAERJune2010.pdf
** http://www.nytimes.com/2011/07/03/business/economy/03view.html?_r=2
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