Tuesday, June 11, 2013

Soaring real yields are good news

The biggest change on the margin in the financial markets continues to be the rise in real yields, so this update to my earlier post is both timely and important. Higher real yields reflect not only an improving outlook for growth but also a decline in inflation expectations, and that is a sanguine combination.

Real yields on 5-yr TIPS (see chart above) have soared almost 110 bps since the end of March, to their highest level in more than 18 months.

Ditto for real yields on 10-yr TIPS, which are up 100 bps from their December lows.

As the chart above shows, both real and nominal yields are up on the margin, but real yields have increased by more than nominal yields, thus reflecting a moderate decline in inflation expectations. Inflation expectations are still within a "normal" range, however, and do not reflect any serious risk of deflation.

As I've argued before, government-guaranteed real yields that are available for purchase in the TIPS market can tell us a lot about the market's expectations for real economic growth. As the chart above suggests, the negative real yields on TIPS that we saw earlier this likely reflected market fears of very slow GDP growth. Investors were willing to lock in a negative real yield on TIPS because they feared that the real yields on alternative investments would be even worse, the by-product of collapsing real growth. Real yields are now moving back up towards levels that are more consistent with economic growth of 1-2% per year in the years to come. So this is not a market that has suddenly become optimistic; it is a market that has become less pessimistic. That's not unreasonable at all, given the modest to moderate growth signals we see from other indicators.

The recent decline in the price of gold is also consistent with the message of TIPS. Gold had reached exceptionally high levels not too long ago, arguably driven by fears that the Fed's QE policy might lead to a serious increase in inflation, as well as by fears that the economic outlook was fraught with risk stemming from huge increases in government debt in most developed economies. We now see that the U.S. federal deficit has declined significantly, and TIPS are telling us that inflation risk has also declined, and that the Fed is now likely to reverse QE sooner than expected, thus reducing the likelihood of failure. As I've suggested in a prior post, it looks like gold prices are now coming back down to a level more consistent with other commodity prices. That spot commodity prices are still quite elevated relative to where they've been in the past few decades arguably confirms that the outlook for global growth is far from precarious, so there is no sign here that a Fed reversal of QE poses any serious threat to growth.

As the above chart shows, every recession in the past 50 has been preceded by a significant rise in real yields (the result of concerted Fed tightening), but the current rise in real yields still leaves real yields at very low levels. A true Fed tightening involves not only very high real yields (on the order of 4% or more) but also an inversion of the yield curve. Neither of those conditions exist today. The yield curve is still quite steep, and that implies that monetary policy is still expected to be accommodative for the next several years at least.

The recent jump in nominal and real yields does not threaten the health of the economy. Rather, higher yields reflect a market that is adopting a healthier expectation for growth in coming years. Higher rates normally accompany a healthier economy; they only rarely weaken an economy. This is all very good news.


Benjamin said...

Boy, I sure hope the Fed does not halt QE, let alone reverse it.

The Bank of Japan ran a QE program 2001-6, and it was a success, according to John Taylor, Stanford, a very, very conservative economist.

Then the BoJ stopped, and japan never really recovered.

So the BoJ stayed with QE four years, and it looks like they quit too soon.

I see no problem staying with QE for an extended length of time, maybe several years yet.

Remember, there are only benefits and no costs to QE. It reduces our nation's outstanding debt burden, and it puts more cash into banks, where it can be deployed into productive enterprises.

The putative cost is supposed to be inflation: Yeah, and we see what is happening on inflation---0.7 percent y-o-y in last reading, on the PCE.

You know, some pundits screamed we would no longer have single-digit inflation if the Fed went to QE.

They were right! We are now below single-digit inflation.

I ask Scott Grannis, or anyone else: What is the cost of QE? If it doesn't lead to too-high inflation, there are no costs, but only benefits. I for one, am happy to pay down the national debt.

On commodities: Do not confuse one-time run-ups in commodity prices with general price inflation. We could also look at natural gas prices.

Or corn prices, which were on a long-term down path all through the 1990-2000s, then perked up, when the USA mandated a socialized corn-based ethanol program.

Corn prices are higher today not because of any monetary policy, but because the federal government mandates the use of corn in gasoline, it is the biggest renewable energy program we haven by far.

The ethanol program is probably inflationary. Fed policy? Well, at 0.7 percent inflation, and falling.....

theyenguy said...

You relate "Higher real yields reflect not only an improving outlook for growth but also a decline in inflation expectations, and that is a sanguine combination."

I reply that higher yields have nothing whatsoever to do with an improving outlook for growth.

The only number that matters is the Interest Rate on the US Government Note, $TNX, its jump higher in May 2013, constituted a hard frost, that is a quick freezing, causing the death of fiat money.

More specifically, the death of fiat money came with a parabolic steepening of the 10 30 US Sovereign Debt Yield Curve, $TNX:$TYX, seen in the weekly chart of the Steepner ETF, STPP, rising parabolically in value, May 2013.

Fiat money, consisting of Aggregate Credit, AGG, Stocks, VT, Major World Currencies, DBV, and Emerging Market Currencies, CEW, seen in their ongoing Yahoo Finance Chart, died on May 24, 2013 with the failure of currency carry-trade investing, ICI, and disinvestment out of Junk bonds, JNK, as bond vigilantes called the Interest Rate on the US Government Note, ^TNX, higher to 2.01%, on the failure of the world central banks’ monetary authority, and especially the failure of Bank of Japan’s Kuroda Abenomics monetary policies.

Yield bearing investments have been the hardest hit by higher interest rates

Yield bearing investments trading lower included EMFN, BRAF, EPI, EUFN, DRW, TAO, DGS, DLS, EDIV, SEA, PSP, DBU, AUSE, also, FNIO, KBWD, REM, REZ, turned IYR, and ROOF, lower.

Higher interest rates mean lay offs and diminishing capital improvements at bond intensive infrastructure employers such as Utilities, XLU, DBU.

The death of money means the decline of GDP and global economic trading.

Competitive currency devaluation coming from higher interest rates has decimated the banking infrastructure of the nations of Argentina, ARGT, on lower banks, BMA, BFR, BBVZ, and Brazil, EWZ, EWZS, on lower banks, ITUB, BBDO, SBR, BBD, and India, INP, SCIN, on lower banks, IBN, HDB. With hollowed out banks, these countries stand as tombstones on Liberalism increasingly desolate landscape. Under Authoritarianism, diktat will establish new banking, economic, and political infrastructure; this infrastructure will consist of statist public private partnerships between regional government superstructures and corporations.

And I do not call that particularly good news, unless one believes that the purpose of this is to direct one's hopes out of financial and fiat economic life and into spiritual economic life in Christ where one perceives that Christ is dispensing Himself into the believer so he can experience the divine nature of peace and joy, as presented in Ephesians 1:10.

steve said...

higher yields may be suggestive of a stronger economy but I fail to see how they could portend higher stock prices. given that stocks have advanced very strongly under a LOWER yield umbrella, it would be a stretch to think they may do the same after a reversal of yields.

William said...

Contrary View from Jim O'Neil retired Chief Economist at Goldman Sachs

Excepts from Bloomberg Editorial Jun 11, 2013:

And a so-called “return to normality” implies benchmark 10-year Treasury bonds yielding 4% or more, which won’t happen all at once, but it will mark a “recovery of the equity culture and the cooling of investors’ protracted love affair with bonds,” O’Neill says. He says the current situation is similar to that of 1994....

“Many policy makers will bore you endlessly with what they’ve learned from past mistakes, on their superior understanding of the hazards, their improved communication skills, and so forth. This time, they say, when the Fed and others make their move to withdraw monetary stimulus, the fallout will be nothing to worry about....Recent weeks suggest transparency doesn’t mean clarity. The Fed can talk about ‘tapering’ QE all it likes; it can’t change the basic laws of economics and valuation.”....

But for equity markets, it’s a brighter picture says O’Neill. “Longer-term investors will want more exposure to equities, not less. Normality means a reversal in the popularity of the two main asset classes: As people fall out of love with bonds, they’ll fall back in love with equities,” he says.


Gloeschi said...

The NSA 'boundless' spying is also good news, since now it cannot be leaked anymore.
Scott, please run a correlation analysis between stocks and a) implied inflation expectations and b) stocks and nominal yields. You will find that correlation to nominal yields is very low. Correlation with inflation expectations, however, is much higher. So your story about how declining inflation expectations is great for the stock market is flawed.

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