Risk aversion slowly declines

I've been featuring this chart off and on for more than a year. I think it is arguably one of the best ways to track the degree of risk aversion that is embodied in market prices. This has been the most risk-averse recovery ever. You can see that in the fact that 1) gold prices are still very elevated, substantially above their 100-year, inflation-adjusted average of about $600, and 2) real yields on 5-yr TIPS are still very low. Both of those are shown in the chart above.

In short, we know that risk aversion is still high—but declining—because the market is willing to pay elevated prices for the safety of gold and TIPS. (I use the inverse of the real yield on 5-yr TIPS as a proxy for their price.) The price of gold and the price of TIPS has come down quite a bit over the past year or two, but their prices are still relatively high.

As the chart above suggests, real yields on 5-yr TIPS are consistent with real GDP growth of less than 1%. If the market were quite sure that the economy could continue to grow at 2-3% (which would still be quite modest by historical standards), then real yields on TIPS would be substantially higher. But it's important to note that on the margin, real yields are slowly rising—that suggests that the market is slowly regaining confidence in the economy's ability to grow. Once the economy is on solid footing and the market is no longer concerned about the threat of another relapse, real yields will be much higher, of that we can be almost sure. The late 1990s and early 2000s were the epitome of high confidence and strong growth. Real yields on TIPS were 4%, and the economy was growing at a 4-5% rate.

As risk aversion declines, gold prices will fall further and TIPS prices will fall further. At the same time, confidence will rise, and the public will feel less need to stockpile cash and cash equivalents and more inclined to take risk and invest. Banks are currently holding over $7.5 trillion in savings deposits paying almost nothing. If the demand for safety were to decline, the public would attempt to spend some fraction of that money on stocks, homes, cars, iPads, or whatever. But the money can't just disappear, since someone always has to hold it. So rising confidence will result in more money trying to be spent on "things" and that in turn will fuel faster nominal GDP growth (i.e., faster real growth and/or higher inflatino). It may well take years for confidence to fully return, but this is one of the most important developments that will shape economic activity and financial markets in coming years.