Wednesday, June 25, 2014

The bond market's pessimism is vindicated

I've been a close observer of the bond market for over 25 years, and it continues to amaze me with its ability to see the future of inflation and real economic growth. 


I've been featuring the above chart for a long time, using it to argue that the market was quite pessimistic about the prospects for economic growth. My theory is that real interest rates ought to track the market's expectations for real growth, and indeed they have. Real growth and growth expectations were very strong in the late 1990s, and real yields on TIPS were very high. Since then, the economy has slowed down and real yields have fallen. 5-yr real yields on TIPS have been telling us for the past year that the market was braced for real economic growth to be as low as 1% or so. With today's revision to Q1/14 GDP growth, real growth over the past 2 years has been an anemic 1.4%. In effect, the bond market saw this slump coming a year ago. Needless to say, if the economy's prospects are going to improve going forward, we ought to first see real yields on TIPS rise to at least 1%. 


The extent of the weakness in Q1/14 growth can be appreciated in the above chart. We haven't seen such negative numbers for real and nominal GDP growth without being in a recession. Yet I'm pretty sure we aren't in a recession, since the preponderance of evidence suggests the economy continues to grow, albeit relatively slowly: e.g., business investment is rising, bank lending to business is strong, residential construction is rising, unemployment claims are very low, jobs are growing about 2% per year, industrial production is rising, monetary policy is accommodative, government spending has shrunk meaningfully relative to GDP, the yield curve is positively sloped, and real short-term interest rates are negative, to name just a few. All of these are consistent with an ongoing business cycle expansion. The first quarter weakness was most likely a by-product of terrible weather.


We are very likely still in a recovery, but the problem—as illustrated in the chart above—is that the economy is more than 10% below where it could or should be if long-term growth trends are extrapolated. This is without doubt and by far the weakest recovery in history. I think the reasons for this weak growth are a huge increase in regulatory burdens (e.g., Obamacare), a significant increase in top marginal tax rates, a hugely burdensome, complicated, and distorting tax code, and the developed world's highest corporate tax rates. Accommodative monetary policy is probably a contributing factor as well, since five years of extremely low and negative real short-term interest rates have likely created disincentives to save. In short, the economy has been growing in spite of all the government's "help," not because of it. Lift the burden of a smothering fiscal sector and we'll most likely see a much stronger economy.

8 comments:

Joseph Constable said...

"Yet I'm pretty sure we aren't in a recession, since the preponderance of evidence suggests the economy continues to grow, albeit relatively slowly: e.g., business investment is rising, bank lending to business is strong, residential construction is rising, unemployment claims are very low, jobs are growing about 2% per year, industrial production is rising, monetary policy is accommodative, government spending has shrunk meaningfully relative to GDP, the yield curve is positively sloped, and real short-term interest rates are negative, to name just a few."

Then somebody is lying. The IRS wouldn't lie. The EPA wouldn't lie. So what possible reason would the BEA lie for?

sgt.red.blue.red said...

It was the cold, or was it?

In my Inbox yesterday from Ted Cruz was the following:

"This morning it was announced that in the first quarter of 2014, our economy shrank 2.9% and the Obama Administration is trying to blame it on the the cold winter.

You know another time we had a very cold winter? 1985. But the economy still grew 4% in the first quarter of that year.

Why? Because in 1985 we had a President with a pro-growth, pro-jobs, and pro-liberty agenda -- not the far-left agenda we see today from the White House. And as long as Democrats control the Senate, they’ll protect President Obama’s big government, tax and spend, job-killing policies." ...

Hans said...

Excellent first two posts.

I have been saying for the past two years, despite all the beautiful charts presented hear - that America is in a PHONY RECOVERY.

Next year is going to be even worse, if not a recession in every household.

Benjamin Cohen said...

Cut taxes and regs, and replace Obamacare with something much, much, much simpler. Shrink the federal government welfare and warfare complex. Yes!

But monetary policy?

For five years (at least) Scott Grannis has contended that Fed policy has been too accommodative and too easy.

Yet the record shows the last five years have had the lowest rates of inflation in the postwar era, and very low interest rates. As Milton Friedman said, you do not get to low inflation and low interest rates through easy money.

If Scott Grannis was right---the Fed has been easy--we would have seen galloping, runaway and accelerating inflation by now (note that inflation ever threatens to accelerate, gallop and runaway. For some reason, the threat of inflation is never that it will settle at a level a couple of points above present levels).

The truth: If the Fed had been any tighter in the last five years, we would have be in deflation! And we were for parts of the last five years, of course. If you believe the hardcore right-wing George Mason economists, we may be in deflation now---they say the CPI and PCE overstates inflation.

(Whenever I use an iPad or smartphone, I wonder if the George Mason boys are not right. To an old fogey like me, an iPad surely must sell for a few million dollars).

There is another vexing paradox: The Fed cannot tighten and get to higher rates, especially now. A central bank cannot tighten its way to permanently higher interest rates. A tight money policy results in deflation or low inflation, and low growth--all of which lower interest rates, as Milton Friedman noted.

Lastly, I heartily recommend to Scott Grannis (and anyone else) a recent Bain & Co. study entitled "A World Awash in Money."

Huge pools of capital are being generated globally, and we have global capital markets today. These pools are not necessarily market-driven. China may compel savings, or Japan may have a savings culture, and there are numerous sovereign wealth funds in the Mideast. There are also public pension plans globally, that must accumulate capital continuously and do so by rote. Everywhere assets are insured, and insurance companies are also huge pools of capital. There are higher incomes globally, allowing capital pools to form.

See: http://www.bain.com/publications/articles/a-world-awash-in-money.aspx


Why Scott Grannis posits that low American savings rates are limiting growth puzzles me. There are capital gluts, not shortages. That is another reason why interest rates are so low.

There are mountains of investable cash everywhere in America, on corporate balance sheets, in bank deposits, in mutual, hedge and private equity funds, in insurance companies, in pension funds.

The market is trying to send a signal to savers (but can't, due to ZLB): Your savings are not valuable. We have plenty of savings. Capital is everywhere.

What we lack is demand!

Oddly enough, if we want higher real growth and higher real interest rates, we will have to put the peddle to the metal in terms of expanding the money supply. The Fed should taper up, not down, and probably do so for years.

The Fed needs to get aggressive about promoting growth, and sustaining that aggressiveness.

Unfortunately, with a liberal weakling Janet Yellen in charge, I think all we can expect is more dithering and middling policies from the Fed.







Hans said...

Some very interesting economic chars.

http://seekingalpha.com/article/2182623-more-on-the-gdp-mystery

William McKibbin said...

Argentina needs to default on its debt -- the US, too...

William said...

Ed Yardini:Are Households Really Deleveraging?

"....One of the big drags on home sales has been a dearth of first-time buyers because many people who might otherwise be buying their first homes have graduated from college with onerous student loans. These are included in nonrevolving consumer credit along with auto loans. This category rose to a record $2.3 trillion during April, with student loans accounting for roughly half of this total.

"Large student debt burdens disqualify many young adults from getting mortgage loans, especially if they have been delinquent in their payments. Many of the individual loan balances are equivalent to the amount of down payment for the houses they might have bought but for their student debt burdens. That helps to explain the drop in the homeownership rate of adults under 35 years old from a record high of 43.6% during Q2-2004 to 36.2% during Q1-2014.

http://blog.yardeni.com/2014/06/are-households-really-deleveraging.html

Scott Grannis said...

Student Loans became a special type of debt once the federal government took over the industry in early 2009. I'm reasonably confident that much of this debt will never be paid off, and that it will ultimately be charged to the taxpayers. Student loans are a bubble that is in the process of bursting. It's too easy to borrow too much, thanks to our government's largess. It's one more example of how the government makes a mess of things.