Wednesday, October 9, 2013

Tracking important market prices

Last week I argued that the lack of government-provided statistics was not really a problem, since there are lots of real-time, market-based prices out there that speak volumes about the state of the economy. Here's an expanded list, with up-to-date charts, of the indicators I think are the most important to watch.  On balance, I don't detect anything going on that's particularly disturbing or encouraging, which means the economy is probably continuing to expand at a relatively slow pace.

1-mo. T-bill yield:

Yields on 1-mo. T-bills have jumped this month by about 25 bps, whereas yields on bills maturing in 3 and 6 months remain quite low. This reflects a modest degree of concern that the current government shutdown and debt ceiling debate may remain deadlocked and result in a temporary "default" on federal debt. If the risk of default were major and lasting, yields on all maturities would have spiked, but that is not the case, at least so far. This is akin to a tiny ripple on the pond of risk.

2-yr swap spreads:

2-yr swap spreads are about the best leading indicator of systemic risk that I'm aware of. (For more detail on what swap spreads are, see here.) Today, swap spreads in the U.S. are about as low as they have ever been, while swap spreads in the Eurozone remain somewhat elevated. This reflects almost a complete absence of any degree of risk in the financial and economic fundamentals in the U.S., and a modest degree of risk in the Eurozone economy. Conditions have not changed materially in the past year.

5-yr TIPS real yield:

As the first of the above charts shows, real yields on TIPS tend to track the real growth of the U.S. economy. Real yields have moved substantially higher in the past six months, and that is a good indication that the market believes the economic fundamentals of the U.S. economy have improved. But real yields are still quite low, suggesting that the market now expects the U.S. economy to grow at a sub-par rate whereas before the market was concerned about the potential for a double-dip recession. As the second chart shows, real yields have dropped about 50 bps from their recent high, reflecting a) some disappointment with the economy and b) less likelihood of a near-term Fed tapering. Under the new leadership of Janet Yellen, the Fed is probably less likely to taper and less likely to tighten aggressively. Real yields would have to decline further before I would worry that economic fundamentals were deterioriating.

Breakeven inflation spreads:

The above chart shows the market's implied inflation expectations for the 5-year period beginning in 5 years, which are derived from the yields of 5- and 10-yr TIPS and Treasuries. This is the Fed's preferred measure of forward-looking inflation. As the chart shows, inflation expectations today are almost exactly the same as the average of the past four years. Nothing much going on here—inflation is likely to remain subdued for the foreseeable future.

Gold vs. real yields:

The price of gold has been remarkably well correlated with the inverse of 5-yr TIPS yields (which is equivalent to saying that gold has been positively correlated with TIPS prices). I've argued that this is a sign that the world's demand for safe assets is beginning to decline. Not much has changed here in the past month or so, but this remains one of the more intriguing relationships I follow, especially since the demand for money and safe assets has been extraordinarily strong for the past 5 years. Strong money demand has led to a major decline in the velocity of M2, and has all but compelled the Fed to adopt its Quantitative Easing policy. As I've argued before, the primary function of QE is not to "print money," but to swap newly created bank reserves (functionally equivalent to T-bills) for bonds. Since there is no evidence of any increase in inflation as a result of the Fed's QE efforts, we can infer that the Fed's provision of bank reserves was likely just enough to satisfy the world's demand for safe assets. When the supply of money equals the demand for money, there are no inflationary consequences.

Gold vs commodity prices:

Gold and industrial commodity prices have tended to move together over long periods. The most striking thing in the chart above, in my opinion, is the degree to which gold "overshot" the rise in commodity prices coming out of the Great Recession. I think this reflected very strong demand for safe assets, very deep concerns over the potential for QE to be inflationary, very deep concerns about the long-term value of the dollar, and deep-seated concerns about global financial stability. But since these fears have not been realized, gold has begun to fall back in line with commodity prices, which have been relatively stable for the past few years. Not much has happened to gold in recent months, but if the world continues to avoid a disaster then I would expect gold prices to move lower. Relatively stable commodity prices tell me that there are no material changes in the strength of the global economy.

Dollar vs. other currencies:

As the first of the two charts above shows, the inflation-adjusted value of the dollar relative to a trade weighted basket of currencies is still unusually weak. However, the dollar has managed to increase somewhat in the past two years, which I take as a sign that the U.S. economy has done somewhat better than expected (or perhaps it's better to say "not as badly as expected"). The second chart looks at the nominal value of the dollar vs. major currencies for the year to date, and here we see that the dollar has only recently found a bit of support after declining from last summer's highs. There's not much love out there for the dollar, but neither is the dollar disastrously weak. On the bright side, there's a lot of room for improvement in the dollar if the outlook for the U.S. economy were to improve.

Baltic Dry Index:

This measure of shipping costs for bulk commodities has staged a remarkable comeback in the past four months. While it's difficult to draw firm conclusions from this (the index can be affected not only by demand for commodities but by changes in available shipping capacity), I think it's safe to say that global economic activity is not deteriorating, and may even be firming.

Credit default swap spreads:

CDS spreads are a very liquid proxy for the default risk of corporate bonds. That spreads are still very close to their lowest levels since the recession is a sign that the market detects no deterioration in the economic outlook. Spreads are still meaningfully higher than their pre-recession lows, however, which signals that the market is still relatively risk averse.

Vix Index:

The Vix index has jumped of late, a clear sign of increased market jitters. But from a longer-term perspective, it is still relatively low. The market is obviously concerned about the ramifications of the current government shutdown, but not terribly so. This is a contributing factor to the general mood of risk aversion that pervades most market indicators.

S&P 500 Index:

The first of the above two charts shows the PE ratio of the S&P 500 index. It's up from the lows of 2010, but is not unusually high. In fact, PE multiples today are almost exactly in line with long-term averages. I think this shows that the market is at the very least not overvalued. Indeed, since corporate profits currently are at record levels in both nominal terms and relative to GDP, I think this shows a remarkable lack of optimism. In other words, I take this as a sign that the market is still relatively risk averse, and that explains why the demand for safe assets is still relatively strong.

The second chart shows the index itself, which has been on an uptrend ever since March, 2009. Prices are near all-time highs, but valuations are still relatively subdued. There is still lots of upside potential if the market should start to feel less concerned about monetary and fiscal policy, and/or should the economic fundamentals improve.


NormanB said...

What does it mean that over the last two years our deficit has gone up by $2.4T whereas nominial GDP has gone up by only $1.2T?

Scott Grannis said...

It means several things. 1) debt financed spending does not necessarily boost the economy, 2) it is not unreasonable to conclude that debt financed spending actually hurts the economy (ie, the spending multiplier is negative), 3) adding to the country's debt does nothing to expand the economy because in this case, particularly, the spending was mostly transfer payments--taking from one person and giving to another. It is also probably the case that lots of spending, such as we still have today, is not good for growth regardless if how it is financed, because the government is very inefficient compared to the privates sector.

Benjamin said...

Great wrap-up by Scott Grannis.

I am not sure about one aspect of QE.

Many write that QE has only resulted in excess reserves in the banking system, and thus is somewhat inert at this point.

But there is no evidence that bond sellers to the Fed only put their money into the bank, where it joined mounting excess reserves.

Indeed, a "rational man" argument would come to a different conclusion about why someone would sell a US bond.

A holder of a US bond already is liquid (five days a week, an active market), has no credit risk, and had some yield.

What they cannot do is spend their money, or re-invest in another asset.

So, it does not make sense to sell a US bonds only to put it into the bank. Now you are very liquid, have no risk but no yield either. It is not a rational act.

Ergo, it makes sense that people sold bonds to the the Fed to spend the money, or to invest in stocks or equities.

And, indeed we have had rallies in stocks and property since QE3 started, and aggregate demand has grown! This picture suggest QE works, probably just needs to be bolstered. Some say cutting interest on excess reserves (paid by the Fed to banks) is another option.

The rise in bank deposits and excess reserves since 2008 could have many sources, such as savings, corporate profits parking and flight capital.

I share concerns that federal spending, especially agency spending, is runaway, and needs to be cut. Mounting debt-to-GDP ratios cannot augur well.

Surely Defense-VA-Homeland Security outlays could be cut in half, while entitlements take a 10 percent across the board cut.

No tax hikes!

The goal should be federal government outlays at 15 percent or even less of GDP. (Now about 20-22 percent).

Jeff said...

Thanks Scott. Best source of economic info the web! But even with all the good news, why are guys like me still on the sidelines? Where is The I am still scared chart?

William McKibbin said...

The US desperately needs a balance is budget amendment to the Constitution -- unfortunately, I doubt that balanced budget amendment is in the making, at least in the near-term -- I have to wonder if either the military-industrial Republicans or big government Democrats are truly committed to spending reforms -- what the parties seem to be committed to is debating whether the cuts should come from guns or butter -- the logical compromise is to split the cuts between both, thus enabling a balanced budget amendment to proceed through compromise -- but again, I do not see such a compromise in the making -- hence, gridlock forever...

William McKibbin said...

PS: Perhaps another compromise to the above is to split the cuts proportionately between guns and butter based on current spending levels -- but again, I can only conclude that the military-industrial Republicans and big government Democrats are adamantly opposed to balancing the budget.

William said...

Jeff said..."why are guys like me still on the sidelines?"

Rest assured that you are not the only one waiting for a good time to invest in the equity markets. As Scott has said there was a "mania" for safe assets and many investors sold their stock positions and bought bonds, CDs, passbook savings accounts etc.

It was a kind of "group think". Millions of investors are trapped on the sidelines, waiting....

Jeff said...

I just need to figure out what I'm waiting FOR! Let me know when it comes. (It's NOT a 6 week clean CR / debt limit extension!)

Scott Grannis said...

By the time it becomes obvious that things are better it might well be too late to invest in equities.

randy said...

Jeff - #1 we need Washington to quit playing Russian roulette over and over, and #2 need capital directed into tangible productive investments rather than financial speculation. #2 is closely tied to Fed.

Both manufactured time bombs.

Scott Grannis said...

Benjamin: in re who is selling bonds and why. It is futile to consider the actions and motives of different groups of investors. You can only observe what they all did in aggregate: they sold bonds to the Fed and were content to hold bank reserves. Banks have only used a tiny fraction of their reserves to make new loans. Why? Because banks don't feel comfortable making more loans and/or because the private sector doesn't feel comfortable borrowing more.

Benjamin said...

Scott Grannis:

Thanks for your reply.

I am reluctant to toss the "rational man" under the bus just yet; indeed he is the archstone, the foundation and maybe the pillars of modern economics.

Yes, bank reserves swelled at the time of various QE programs. A correlation--but a causal relation?

Concurrently to growing excess bank reserves we had international flows of capital, and we had people "getting out of the stock market." And investors were certainly not going into the property markets.

And, as we have seen for the better part of 15 years, the globe generates incredible amounts of capital, as more and more nations adopt market economies and populations move up the income ladder. Aging populations in Europe and USA might play a role in capital formation as well.

It is unclear to me where the money came from that went into the banks and swelled bank reserves.

Why are you so sure it was from people selling bonds to the Fed?

Again, I come back to the rational man (one of my favorite figures in literature, fictional or otherwise. I always liked Mr. Spock, Star Trek):

Why sell a US government bond? Not because it is risky. Not because it is illiquid, except in the immediate sense.

You might sell as the yield is too low---but then you would not put the money from the bon sale in the bank. Or, you might sell as you want to spend the money (you want immediate liquidity).

If there is some sort of data stream that clarifies where bank reserves came from, I would be delighted to see it.


William McKibbin said...

The article below about how bond markets are driving fiscal and monetary policy seems to confirm Scott's view of the world -- in fact, the bond-centric perspective does seem to explain the seemingly bizarre behaviors of decision-makers across both fiscal and monetary policy-making regimes around the world.

Perry Stearns said...

Benjamin or Mister Benjamin of Vulcan if you prefer: You write, "Surely Defense-VA-Homeland Security outlays could be cut in half, while entitlements take a 10 percent across the board cut."

Wow! Just like that? Surely, not. Maybe on Vulcan it is possible to wave a magic-logic hatchet and lop that many jobs off the economy without very very serious social, political and economic consequences but here on Earth there are these things called constituencies and they must be taken under consideration. I would love to see some sacred cows get gored too, but I would of preferred even more if they had never been fattened so in the first place. Just call me Bones.