We're closing out the year on a high note in many ways. I'm working on a review of my forecasts from a year ago, and thinking about what the future has in store for us. In the meantime, here is random collection of charts that I find very interesting, most of which also point to more good news ahead.
The stated purpose of the Fed's Quantitative Easing bond purchases was to artificially lower bond yields and thus to stimulate the economy. But despite three rounds of QE totaling some $2.8 trillion and a round of Operation Twist (which was designed expressly to pull long-term yields down relative to short rates), the exact opposite occurred: yields are higher and the yield curve is steeper. As the chart above shows, Treasury yields rose during each QE episode, and didn't change at all as a result of Operation Twist. 10-yr yields are almost 100 bps higher today than they were when the first QE was announced. It's paradoxical, but in a way the "failure" of QE to produce the desired results is proof that it worked, as I explain here.
In any event, this whole episode has taught us that the Fed can't manipulate rates, no matter how much they insist they can. Interest rates are determined by the market, and they are up because the economy has been doing better than expected. It's also interesting that the stock market always worries about higher interest rates—since by the Fed's logic lower interest rates are good for the economy—but in reality higher interest rates can be a very good thing. The tapering and eventual reversal of QE will also be a good thing, since it will remove a tremendous amount of monetary uncertainty that exists because of the almost $2 trillion of excess reserves that are sitting on the Fed's balance sheet today.
Gold was on a tear from the beginning of 2001 until a year ago—a fantastic winning streak that fed on investors' fears of a terrible economy and massive monetary expansion. In roughly the same time frame, real yields on 10-yr TIPS fell from 4% in 2000 to an almost unbelievable low of -1.8% earlier this year for similar reasons. Both have since reversed dramatically, as shown in the chart above, in a sign that the fear and risk aversion that have characterized this recovery are beginning to fade. If these trends continue, it will be because confidence is returning, and that bodes very well for the long-term economic outlook. Although it may also make the Fed's job of reversing QE more difficult, since as confidence returns the demand to hold cash and excess reserves will fall, and this could result in an unwanted expansion of the money supply and higher inflation.
Gold and commodity prices tend to track each other over time, but they diverged significantly beginning in late 2008. In the past year they have been coming back into alignment. Commodities are roughly unchanged for the past several years, but gold has been pounded. The age of speculation has ended. We hope it will be replaced by a new era of investment-led expansion in the coming years.
The yen has weakened considerably against the dollar over the past year, and Japanese stocks have skyrocketed, as shown in the first of the above charts. As the bottom chart shows, Japan may finally have broken the deflationary spell that had plagued the economy for the past several decades—most of which was due to an excessive appreciation of the yen. Easier money and a somewhat more stimulative fiscal policy augur well for the Japanese economy.
Corporate profits after tax have reached an unprecedented high of 10% of GDP, yet equity prices have not yet eclipsed their 2000 highs in real terms. However you look at equity valuation, I think it is hard to build a case for equities being overvalued today. Multiple expansion is likely to be the principal driver of higher equity prices in the year to come, but that's not yet something to worry about. As the chart above shows, equity multiples using the NIPA measure of after-tax corporate profits are still below average.