TIPS say the deflation "threat" has passed

According to the pricing of TIPS and Treasuries, the bond market has decided that the negative inflation shock of falling oil prices has run its course. In fact, inflation expectations have been rising since year end: the bond market now sees inflation (of the CPI variety) averaging 1.7% over the next five years, and 2.0% from years 5 through 10. With the labor market having improved in recent months and long-term inflation expectations now back to levels that the Fed deems appropriate, it's only a matter of time before the Fed begins to raise short-term rates. This long-awaited "normalization" of rates should come as no surprise and should not in any way threaten the health of the economy or financial markets.

The chart above shows the nominal yield on 5-yr Treasuries, the real yield on 5-yr TIPS, and the difference between the two, which is the market's expected average annual inflation rate over the next five years. Inflation expectations began to fall last summer, about the same time the oil prices began to decline. They reached a low of 1.2% late last year, and closed today at 1.7%.

The chart above shows the price of crude oil futures; note that prices have stopped declining and have been relatively stable since early January. Investors have been speculating that the bounce in prices marked the end of oil's decline, and the bond market action is confirming this.

The price of wholesale gasoline futures (see chart above) has actually been rising in the past month: in fact, prices today are up 35% from their mid-January low.

Gasoline prices at the pump have also been rising, as the chart above shows.

The rise in oil and gasoline prices could prove to be the proverbial "dead cat bounce," but the significant decline in active oil drilling rigs (chart above) confirms what the market is saying about oil prices having hit bottom. Lower prices are having the predictable effect of shutting down exploration efforts, which, in turn, will lead to reduced oil production in the near future. Supply and demand are likely to come back into balance somewhere around the current level of prices.

As the above chart shows, inflation ex-energy has been running right around 2% a year for the past 12 years. The market is saying we're likely to see more of the same in the years ahead. The result of falling oil prices is thus likely to be stronger growth rather than lower inflation. The Fed is correct in ignoring the recent decline in inflation.

The chart above looks at inflation expectations over the next 10 years, which are now around 1.8%.

Even though inflation expectations are back to "normal," the real yields on TIPS are very low (see chart above). The market is not afraid of inflation being any different than it has been in the past (~2%), but the very low level of real yields (and the correspondingly very high level of TIPS prices) suggests that the bond market holds out very little hope for any meaningful pickup in the outlook for real economic growth. TIPS are very expensive at these levels. Investors are willing to accept an almost insignificant real yield in exchange for protection against uncertainty. Rather than cheering cheaper energy, the market continues to worry about the lack of growth and opportunity, and is willing to pay up for safety.

This same preference for safety is seen in the chart above, which compares the price of gold with the price of 5-yr TIPS (using the inverse of their real yield as a proxy for their price). Both assets are still trading at fairly high levels from an historical perspective. This suggests that the market is still dominated by pessimism, not optimism. In a very optimistic market environment, the price of gold would be an order of magnitude lower, and the real yield on TIPS would be north of 3%. We are many years away from either.

The market may be right in its belief that inflation will remain in a 1.5-2% range and economic growth will remain sub-par. But if the market is wrong, I'm willing to bet that both growth and inflation will prove higher than expected in the years to come. I'm optimistic if only because the market seems to be still so pessimistic.

UPDATE: As of 8:00 am PST 2/27, markets have continued further in the direction of higher inflation expectations: the expected inflation rate for the next five years has increased to 1.8%. The real yield on 5-yr TIPS has fallen to -0.3%, which points to an even more cautious market.

Good news overseas

The outlook for Europe has improved significantly in the past month or so, a fact that still seems to be flying under the mainstream media's radar. On balance, the outlook for the global economy continues to improve. Very good news.

Released last Friday, the Markit Eurozone Composite Purchasing Managers' Index jumped to 53.5, as shown in the chart above. This means the outlook for the Eurozone economy has brightened considerably of late, no doubt due in part to a relaxation of Russia/Ukraine tensions and the likelihood of an acceptable solution to the Greek debt crisis. Even if Greece were to exit the Eurozone, its economy is so small that it wouldn't make much difference. The important issue here is to preserve the integrity of the Euro, a goal which appears to be widely shared among ECU members; if Greece exits, it will pay a price (i.e., the higher inflation that would follow a devaluation of its currency) that will deter others from doing the same. The experience of Argentina tells us that a big currency devaluation only provides a temporary boost to growth—as some of the capital that fled in anticipation of the devaluation returns—but in the end, the inflation that accompanies big devaluations is destructive, especially for the lower and middle classes.

Meanwhile, we recently learned that the German economy expanded at a 2.8% annualized rate in the fourth quarter of last year, up from zero in the second quarter. This is quite encouraging. After a pause in the second half of last year, the Eurozone economy appears to have re-synchronized with the U.S. economy, as both continue to grow. That is an important and positive change on the margin.

As the first of the two charts above shows, since the end of last year Eurozone equities have outperformed U.S. equities by an impressive 10%, after lagging miserably for the preceding five years. But don't get too excited, because in dollar terms, Eurozone equities are still down almost 8% from last summer's post-recession high. The recent relative outperformance of Eurozone equities is overshadowed by a much weaker Euro from a U.S. investor's perspective. Nevertheless, that doesn't negate the fact that Eurozone investors do see an improved economic outlook.

Japanese equities are now at a new 15-year high. The recent improvement in the equity market closely tracks the weakening of the yen, as seen in the first of the two charts above. But unlike the situation in the Eurozone, Japanese equities are up 30% in dollar terms in the past two years (i.e., equity market gains have been much larger than the weakening of the yen). On balance, the market is telling us that things have really improved in Japan in recent years.

As the second of the two charts above shows, the yen is for the first time in 30 years approximately equal to its Purchasing Power Parity value vis a vis the dollar—according to my calculations. It's not that the BoJ has severely depressed or devalued the yen, it's that the yen is now more "normally" valued. The BoJ appears to have successfully switched from a deflationary monetary policy to a neutral monetary policy, and that, in turn, has been a positive for the economy.

Even China is doing better these days: the Shanghai Composite index is up over 60% since last summer, even though growth in the Chinese economy has "slowed" to 7% a year. If only we could all grow 7% a year....

Positive developments overseas add up to a new all-time high for the value of global equities, as shown in the chart above. In the past six years, the market cap of global equities (in dollar terms) has increased more than 160%, rising from its March 2009 low of $25.5 trillion to over $67.3 trillion today. That's a gain of almost $42 trillion! Excluding the $16.8 trillion increase in U.S. equity valuations over this same period, the value of stock markets overseas has increased by $25 trillion. We are talking real, serious money, and a genuine recovery. That's not to say things couldn't or shouldn't be a whole lot better, but the improvement is impressive nonetheless.

Not everyone is doing so well, unfortunately. The Brazilian economy stands out in this regard, with its stock market having lost about 60% of its value in dollar terms in the past four years. Many emerging market economies (e.g., Argentina, Brazil, Venezuela) are burdened by weak commodity prices, poorly-designed fiscal and monetary policies, and endemic corruption.

The 65-year trends in equity prices

It's taken almost 15 years, but the S&P 500 has finally exceeded its August 2000 high in inflation-adjusted terms (though just barely). Here's how I see the long term trends for this index, in nominal and real terms:

The nominal index is now 37% above its 2000 high, and over the past 65 years it has risen at an annualized rate of about 7.7% per year. The trend lines I've drawn represent annualized growth of just over 6%.

In inflation-adjusted terms, over the past 65 years the S&P 500 has risen at an annualized rate of about 3.9%. The trend lines represent 3% annualized growth. The CPI has risen at an annualized rate of 3.6% over the past 65 years. 

Technicians can argue all day about what this means. In my view, I don't see anything unusual going on. Stocks can be very volatile over shorter time horizons, but over time they do pretty well. 

Reading the market tea leaves: swap and credit spreads still relatively benign

Swap spreads are excellent coincident and forward-looking indicators of the general health of the financial markets and the economy. (See my short primer on the subject here.) They are therefore one of the most important indicators for investors to follow. The news of late has been mixed to negative, with a modest pickup in growth in the U.S. economy overshadowed by increased tensions in the mideast, weak economic growth in Europe, the return of the "Grexit" problem (the potential for a default on the part of the Greek government, or a decision to leave the Euro), the collapse of oil prices (which has threatened the economic viability of Russia, Venezuela, and heavily indebted oil companies), and the ongoing slowdown in China (which nevertheless continues to grow at a pace that would be the envy of every other nation on the planet). On net, markets have gotten worried, as I've noted in many numerous posts of the "climbing walls of worry" variety.

To judge by the level of swap spreads, however, the problems that beset many parts of the world are not particularly worrisome. Swap spreads remain relatively low, with the bulk of the widening confined to the energy sector. Even there, we find that spreads have narrowed in recent weeks from their initial panic highs. The following charts tell the story:

The chart above emphasizes the role of Quantitative Easing in both the U.S. and Europe. QE's major impact was directed to the financial markets (not to the economy, as so many assume), since QE basically involved the provision of liquidity to the banking system: the Fed purchased notes and bonds and paid for them with the issuance of bank reserves, which are functionally equivalent to T-bills. 2-yr swap spreads. Banks needed liquidity and the world's investors were desperate for safe asets—both were in very short supply—and QE addressed that problem. But QE1 and QE2 were both ended prematurely, as evidence by the widening of swap spreads that occurred around the time of their demise. QE3, on the other hand, ended at the right time. Swap spreads have only increased marginally since the end of QE3, mainly because of the concerns surrounding Greece, falling oil prices, etc., that I mentioned above. The current level of swap spreads is fully consistent with "normal" financial market conditions.

The chart above shows 2-yr swap spreads in an historical context. Here again we see that the current level of spreads is relatively benign. The world's investors may think there is a lot of risk out there, but swap spreads tells us that the financial system is able to support the risk. Markets can manage risk very efficiently if the government refrains from intervening.

The biggest source of risk these days, arguably, is the stress that many oil producers are feeling as the result of the almost 50% decline in petroleum prices since last summer. Spreads on high-yield, energy-related debt spiked several weeks ago, but have since subsided somewhat. Oil prices have stopped declining, and the market has had a chance to better assess the risks involved. The oil industry is facing a big problem, but at this point it does not look like it will intensify or prove contagious to the rest of the world.

The chart above shows the average level of credit spreads for investment grade and high yield debt. Spreads are up from their lows, but they are still quite low from an historical perspective.

On balance, therefore, swap and credit spreads in general are telling us that the likelihood of a major economic or financial market collapse is very low. We are not on the cusp of another recession or another Great Recession. We're more likely in the midst of the sort of one of the run-of-the-mill problems that beset markets from time to time and that are eventually resolved without serious consequences.

Things I'm watching

Here are some charts which I have been paying close attention to of late, and why.

February housing starts are due out tomorrow, but today we got the latest builders' sentiment index—which dropped a little. But as I see it, both series appear to be improving gradually, with the sentiment index leading the way, not surprisingly. What it says is that residential construction is still relatively weak, but it continues to improve, and there is still plenty of room on the upside for further improvement.

The price of gold and the real yields on 5-yr TIPS have tracked each other in a rather impressive fashion for most of the past 8 years. What possible connection could these two totally different and independent variables have? I think they are both good measures of the world's demand for "safe" assets. Or, to put it differently, they reflect the market's level of risk aversion. Prices for both had reached rather extraordinary levels a few years ago (signifying lots of fear and risk aversion), and now both are declining. (I'm using the inverse of real yields on TIPS as a proxy for their price.) They are both still rather high, but importantly, they are trending lower as risk aversion declines and confidence slowly rises.

The difference between real yields on 5-yr TIPS and nominal yields on 5-yr Treasuries is a measure of the market's expected average annual inflation rate over the next 5 years. The chart above suggests that while the market expects inflation to be about 1.5% a year on average over the next five, there is not even a hint that the market is worried about too little or too much inflation.

I've long argued that risk aversion has been one of the defining characteristics of the current business cycle recovery, and that continues to be the case. The market has suffered through repeated bouts of nervousness—as measured by the ratio of the Vix index to the 10-yr Treasury yield—but when fears of economic collapse fail to materialize, equity prices move higher. This is healthy, since enduring bull markets are usually challenged by ongoing worries that the good times won't last. If everyone were optimistic and unconcerned about downside risks, that would be the time for a prudent investor to be worried.

There's a raging debate out there over whether stocks are over-valued, under-valued, or just right. Bloomberg's calculation of PE ratios, shown above, suggests that equity valuations are slightly above their 55 year average. I don't find that disturbing, especially considering the extremely low level of Treasury yields.

I believe that 5-yr real yields on TIPS are a good proxy for the market's view of the economy's near-term growth potential. The rather low level of real yields in the past 6 years suggests that the market has been very pessimistic about the outlook for growth. That has changed somewhat in the past two years, as real yields have moved higher and the market has come to accept that the economy is likely to continue growing but at a rather tepid pace. Last year marked an uptick in the economy's real growth rate, but the market is still reluctant to accept that the good times will endure. Troubles in China, the mideast, and the Eurozone are all good reasons for the market to remain skeptical. Not to mention the problems that still plague the U.S. economy: e.g., high tax and regulatory burdens.

All of these charts are consistent with a market that is slowly regaining confidence, and that's good.

January retail sales were not miserable

Zero Hedge, a reliable source of negatively-spun information, summed up today's retail sales report like this: "Retail Sales Plunge Twice As Much As Expected, Worst Back-To-Back Drop Since Oct 2009." On the surface, the news was indeed disappointing, with overall retail sales falling much more than expected (-0.8% vs. -0.4%). But considering the plunge in gasoline prices in recent months (which is actually a very positive development), sales weren't bad at all.

The chart above shows total retail sales adjusted for inflation. Here we see that January's weakness is almost insignificant. Real retail sales rose 2.9% in the 12 months ended January, and that's almost exactly the average annual rise we saw in retail sales in the years prior to the Great Recession.

Abstracting from autos and gasoline, sales were up 5.7% in the past year. Nothing unusual going on here.

Abstracting from the most volatile sectors of the retail report (building materials and gasoline), and adjusting for inflation, there was actually a decent pickup in growth over the past year. This measure of sales rose 3.9% in the 12 months ended January, and that was the fastest such growth in the current economic expansion. As the chart above shows, however, sales are still quite low compared to where they could have been had this been a normal recovery. 

This has indeed been a sub-par recovery, but there are still no signs of emerging weakness. And in some respects, the outlook is even improving on the margin.

The good and bad of federal finances

Good news: January's federal budget statement showed that federal revenues continue to exhibit strong growth, rising at an 8-9% rate. The bad news, however, is that federal spending is once again growing, at a 5-6% rate, after five years of no growth. Unless Congress manages to rein in the growth of entitlement spending, the budget deficit is going to start growing again. It's a difficult task, given the huge constituency that thrives on transfer payments, which increased 5.6% last year (in contrast to a 2.1% increase in CY 2013), and which now make up almost 20% of disposable income and consume over 71% of federal spending.

Conventional wisdom has held that the absence of growth in federal spending from 2009 through early last year was a significant drag on growth, since it reflected "austerity." Supply-siders see things differently: zero growth in spending meant a shrinkage in the burden of government on the private sector, and this was a stimulus to growth. A shrinking public sector allfowed the private sector to manage more of the economy's scarce resources more productively than the government could, and this served to strengthen the economy. This shrinking-government "tailwind" to growth is now beginning to fade, albeit very gradually. But if left unchecked, growth in entitlement spending could become a huge problem in the years to come.

Flat growth in spending coupled with strong growth in revenues resulted in a huge reduction in the federal budget deficit. If the deficit were to never grow beyond its current level, we wouldn't have a problem. A deficit of 2-3% of GDP is eminently sustainable, and is arguably even necessary in order to ensure the continued liquidity and efficiency of the Treasury debt market—which serves as the backbone for the world's bond and stock markets. 

Strong growth in federal revenues was driven primarily by individual income tax receipts, which in turn were driven by the growth in jobs, as the chart above shows. In short, economic growth is the main source of revenues for the government.

The chart above shows federal transfer payments as a % of disposable income. This is now by far the largest component of federal spending, comprising 71% of federal outlays. Transfer payments have mushroomed from 32% of federal spending in 1968 to more than twice that today, and from 5% of disposable income in 1951 to almost 20% today. They will continue to rise as baby boomers retire and healthcare subsidies increase, not to mention the myriad other entitlement programs which always seem to exceed expectations (e.g., student loans, food stamps, disability insurance, medicare).

The chart above shows the contribution to the burden of our national debt (total debt held by the public divided by nominal GDP) that can be attributed to various presidential administrations. As of December, 2014, the increase in the federal debt burden under the Obama administration was 26.5 percentage points, rising from 47% when Bush left office to 73.5% today. That was almost as much as the net federal debt burden accumulated by all the presidencies prior to Nixon (29.3%). (Note that the red bars in the chart represent increased debt burdens, while the green bars represent reductions in the debt burden.) In all of our nation's history, today's debt burden was surpassed only by the WWII-related debt burdens of the 1940s which were substantially paid off during the 1950s.

Lots of reasons to be optimistic

Beginning a little over one year ago, there have been quite a few developments that have positively impacted the economy. Many signs now point to a noticeable improvement in the economy's underlying growth fundamentals that bode well for the future.

The Fed began tapering QE3 in early January of last year, and ended its purchases of notes and bonds last October, with the result that the amount of reserves held by the banking system has not increased appreciably for the past 10 months. Unlike the previous episodes of QE, which ended prematurely, this one appears to have achieved its objective. The following charts explain why:

The chart above compares the real yield on 5-yr TIPS to periods during which the Fed was actively engaged in Quantitative Easing. (The "OT" period was Operation Twist, which was an attempt to flatten the yield curve by selling short-dated notes and buying longer-dated bonds.) It is my firm belief that 5-yr real yields on TIPS are a good proxy for the market's medium-term outlook for U.S. real growth. That real yields fell throughout the Fed's QE1, QE2, and OT programs is a good indication that the Fed's efforts were unsuccessful in improving the economy's fundamentals. But QE3 was successful, because real yields rose appreciably. QE3 satisfied the world's demand for safe assets, stabilizing the banking system in the process and restoring confidence in the future. (Important note: the Fed never tried to artificially depress real yields, but instead focused the bulk of its efforts on 10-yr nominal yields. The Fed only purchased a total of $57 billion of TIPS since 2008, compared to $3.7 trillion of nominal Treasuries and MBS. So the real yields on 5-yr TIPS are arguably determined mainly by market forces.)

Swap spreads confirm that QE3 was successful. As the chart above shows, swap spreads rose significantly following the end of QE1 and QE2; that was a good sign that financial markets were still under a lot of stress—liquidity was scarce and systemic risks were still significant. Today, more than 3 months after the end of QE3, swap spreads both here and in the Eurozone remain at benign levels. This suggests that financial markets are in good health, liquidity is abundant, and systemic risks are low. A healthier economy typically follows healthier financial markets. And indeed, the economy has improved over the past year.

Congress allowed the Emergency Unemployment Compensation Insurance to expire at the end of 2013. Since then, the number of people receiving unemployment compensation has declined by almost 40%, as shown in the first chart above. 1.83 million fewer people today are "on the dole," while total employment has increased by 3.37 million and the labor force (those working and those looking for work) has increased by 2.13 million. In the past 12 months, jobs have increased 2.33%, the largest such gain in the current business cycle recovery. It would appear that paying people for extended periods to not work was not a good way to stimulate the economy.

Bank lending to businesses began to accelerate early last year. Commercial and Industrial Loans, shown in the chart above, are up $221 billion since the beginning of last year, for a gain of 14%. In the past three months, C&I Loans have increased at an annualized rate of 13.5%.

Bank lending is up by $855 billion since early last year, a gain of 8.6%. Over the past three months, bank credit has grown at an annualized rate of almost 12%. That's by far the fastest growth in bank lending since the Great Recession.

The faster pace of bank lending is a good sign of rising confidence. Banks are more willing to lend, and businesses are more willing to borrow. It should not be surprising, then, to see that job openings have surged more than 25% in the past year, as shown in the chart above. Private sector businesses, the source of most of the economy's underlying strength, are expanding at a faster pace than at any time in the past 5-6 years.

The chart above shows an index of small business optimism. It has picked up noticeably, starting about a year ago, and this is consistent with the pickup in business lending and hiring.

Lest I be mistaken for an Obama supporter—especially one desperate to show that the economy is improving—let me reiterate that I think Obama's policies (which have greatly increased tax and regulatory burdens, while focusing on redistributing income rather than rewarding work and risk taking) have amounted to significant headwinds which have retarded the economy's progress for the past six years. That the economy is doing somewhat better over the past year is testimony not to any improvement in fiscal policy but rather to the U.S. economy's inherent dynamism. The economy is doing better in spite of Obama's efforts to punish success, not because of them.

Of course, the pickup in growth this past year is still a drop in the bucket. As the chart above shows, the economy is still more than 10% below where it could have been if this had been a "normal" recovery. The shortfall in growth is significant, equal to about $2 trillion in lost income every year. That's the equivalent of over $12,000 per year for every member of the economy's labor force.

It's been the worst recovery in history, but that shouldn't obscure the fact that the economy's underlying fundamentals are improving.

Jobs growth is up, and the Fed needs to move

The January jobs report beat expectations, and, coupled with upward revisions to prior months, confirmed that conditions in the job market have improved over the past year. I've argued for most of the past year that the expiration of emergency unemployment claims at the end of 2013 would result in an improvement in the economy (if you pay people less to not work, more are likely to work), and it now appears that this is indeed the case. John Cochrane discussed this recently, and he cites various studies that confirm that unemployment insurance weakens the job market and the economy. The economy is still far below its capacity, but on the margin things are improving—thanks in part to less government meddling with the labor market—and this is very good news.

The relative lack of growth in the labor force (see above chart) since 2008 mirrors the drop in the labor force participation rate (the percentage of the population that is either working or looking for work) over that same period. As the chart above suggests, some 10 million people have simply "dropped out." On the margin this appears to be changing, however, as the labor force rose by 1.1% in the past 12 months, with the entrance of 1.7 million to the workforce. (Over the previous year, the labor force contracted marginally.)

As the charts above show, there has been a noticeable pickup in the growth of private sector jobs over the past year. In fact, the rate of jobs growth now exceeds that of the best years in the previous business cycle expansion. Yes: the jobs market today is doing better (in terms of growth) than at any time in the past decade. So why is the Fed keeping short-term interest rates at zero? That's a good question, and there is only one reasonable answer: because the market is still very worried that the good times won't last. There is still lots of risk aversion and worrying going on out there. The demand for money (cash, cash equivalents, and risk-free assets including bank reserves and T-bills) is still very strong, and the Fed has been forced to accommodate that demand with QE. Banks are apparently very willing to hold on to tons of excess reserves paying only 0.25% because their demand for those reserves is very strong. Similarly, individuals are willing to hold some $7.7 trillion in bank savings deposits (up strongly from $4 trillion at the end of 2008), despite the fact that they pay almost nothing.

But things are changing on the margin. As the chart above shows, bank credit has grown 8.4% in the past year, and it has expanded at a 10.7% annualized pace over the past three months. Over the past year, banks have begun to use their reserves (finally!) to expand their lending activity. Banks are more willing to lend, and businesses are more willing to borrow: Commercial and Industrial Loans are up 13.7% in the past year, and they have increased at a blistering 15.1% annualized pace in the past three months (see chart below).

Given the meaningful improvement in labor market conditions, and the substantial pickup in bank lending, we can infer that confidence is increasing and the demand for money is declining on the margin. That means that the Fed should be moving sooner rather later to raise short-term interest rates (and drain reserves), in order to offset the decline in money demand. The longer it waits, the more the risk of an over-supply of money that could fuel rising inflation.

The current consensus of the market is that the FOMC will raise rates at its mid-June meeting. My growing sense is that's too long to wait. Nevertheless, I'm comforted by the dollar's impressive strength, and the decline in commodity prices, since both reflect a relative shortage of dollars. However, although gold has dropped 5% in the past two weeks (which also suggests a relative shortage of dollars), it is still trading at levels that are roughly twice the inflation-adjusted average price of gold over the past century, and that suggests a substantial over-supply of dollars. So the monetary tea leaves are mixed.

I may just be overly cautious, but I don't see how raising rates to 0.5% or 1.0% in the next 3-6 months could be a bad thing, given how much economic fundamentals have improved over the past year. In any event, it's important to keep in mind that the purpose of moving rates up and down is not to slow down or to goose the economy, it's to keep the supply and demand for money in balance so that inflation remains low and stable. All the signs (rising confidence, increased lending, more jobs) suggest that money demand is declining on the margin, which means the Fed should be moving to offset that decline by increasing the rate it pays on bank reserves, and by draining the supply of reserves.