Tuesday, August 18, 2015

TIPS see more growth, less inflation

Thanks to TIPS (Treasury Inflation Protected Securities), the U.S. bond market gives us a reliable and up-to-the-minute reading of the market's inflation expectations, unsullied by seasonal adjustment problems, immune to the ministrations of statisticians, and not subject to after-the-fact revisions. For the past several months, TIPS have been telling us that inflation expectations have been declining—though only moderately: deflation is still nowhere to be found. At the same time, the rise in real yields on TIPS tells us that the market is expecting somewhat stronger growth—though still far less than enough to erase the economy's huge output gap, which I estimate to be about $1 trillion per year.

It's a message that should do nothing to derail the Fed's plan to normalize interest rates at a somewhat higher level, and it should do nothing to provoke an outright tightening of policy. Slow and relatively stable growth, accompanied by relatively low inflation, is not very exciting, but it's not something to worry about either. It's supportive of continued, modest gains in equity prices.

In the chart above, the difference between the nominal yield on 5-yr Treasuries and the real yield on 5-yr TIPS gives us an expected annual (CPI) inflation rate of 1.27% over the next 5 years. This is relatively low compared to past history for this series, but it is nowhere near the levels that reflect deflation risk, such as we saw at the end of 2008.

As the chart above shows, the recent decline in this same expected inflation rate over the next 5 years is driven by and large by the price of oil. Lower expected inflation is not a symptom of tight money; it is the by-product of strong gains in oil production. As such, this is a welcome development, since a lower cost of energy enables a stronger economy.

The Fed's preferred measure of inflation expectations, the 5-yr, 5-yr forward expected inflation rate (derived from TIPS and Treasury prices) is 1.99%. The chart above shows the average expected inflation rate over the next 10 years, which is 1.59%. In other words, inflation is expected to average 1.27% over the next 5 years, 1.99% over subsequent 5 years, and 1.59% for the full 10 years. There's nothing unusual or worrisome with any of these numbers.

As the chart above suggests, the real yield on 5-yr TIPS tends to track the economy's growth rate. Which makes sense, since the real growth of the economy sets an upper limit on the real growth of its constituent parts. If the bond market is comfortable with risk-free real yields of 0.3% for the next 5 years, then real growth in the broad economy is quite likely to be somewhat higher. This year's increase in real yields suggests that the market is pricing in a modest acceleration in the rate of GDP growth over the next year or so. Nothing to get excited about, but nothing to worry about either.

The ISM manufacturing index has generally tracked the real growth rate of the economy. Its current reading suggests we should see GDP growth of at least 2-3% in the current quarter, a modest acceleration from the second quarter's growth rate.

July housing starts came in much stronger than expected (including revisions to prior months), and they are tracking well with a survey of builder sentiment. Housing has been expanding vigorously for the past 3-4 years, and there is every reason to expect further gains in the year ahead. This equates to a strong vote of confidence that the economy will remain healthy for the foreseeable future.

The physical weight of stuff carried by the nation's trucks increased 3.7% in the year ending July. This is a pretty good indication that the economy is growing. As the chart above shows, truck tonnage correlates reasonably well with the real value of U.S. equities. As the economy expands, real stock prices increase, which makes sense. The modest increase in truck tonnage in the past years suggests that the stock market is not in a bubble (neither undervalued nor overvalued), and is likely to increase modestly for the foreseeable future.


Benjamin Cole said...

Still, the public, stated target inflation rate for the US Federal Reserve Board is a 2% average inflation rate on the PCE, which runs about 40 basis points below the CPI.

But the 5-year TIPS market is telling us is that the Fed will undershoot its average inflation target by 110 basis points, while U.S leaves a trillion dollars of output on the table.

Maybe $50 billion a month in QE should be a conventional monetary policy.

For most of the last 30 years, economists have with great regularity overestimated pending inflation and interest rates.

The Fed has overestimated growth and inflation for five years running.

But then when ever did a federal agency respond to a change in reality?

Thinking Hard said...

Benjamin - I agree and so do others. Please see http://www.wsj.com/articles/raising-rates-now-would-be-a-mistake-1439939500 for an article detailing this exact argument from the Minneapolis Fed President.

Looks like we are setting up to delay raising rates which should help get the DJIA positive for the year. We have been trading in a very narrow range this year due to a wait and see attitude. The Fed holds the cards and everybody knows it. Insider sentiment as measured by the Gambill insider ratio is more bullish now than it has been in over 3 years. The AAII bear/bull ratio is now more negative (a good thing) than we have seen in 2 years. Investor psychology is setting up for a strong end to the year.

The probability of waiting to raise rates keeps going up. I never saw the intent to raise rates and will honestly be surprised by a rate hike this year. Insiders seem to agree that a rate hike will not effect buyback/profit/revenue any more than we have seen, or there will not be a rate hike. We shall see...

Scott Grannis said...

The CPI ex-energy is running just below 2%, and the core PCE is running just under 1.5%. I challenge anyone to explain how a 50 bps increase in the rate of inflation would make a significant difference to the strength of the economy. (I use the core because the headline rate has been depressed due to the collapse of oil prices. Monetary policy should not be geared to stabilizing oil prices.)

steve said...

I agree with scott. while their are reasons for fed to NOT raise rates, there are plenty to get off the snide. get on with it.

Benjamin Cole said...

Well...from 1982 to 2007, US GDP expanded by a little more than 3% annually and inflation was a little under 3% (CPI) annually.

That was not a bad stretch!

I cannot understand the current fashion for microscopic inflation rates.

In 1992 Milton Friedman bashed the Fed for being too tight - - - and inflation then was at 3%!

steve said...

confluence of factors leading to unusually low inflation; china is NOT growing at + 5%, emerging markets are really struggling, obviously commodities, especially oil literally tanking. if US wasn't as strong as it is, we could be looking at DEflation!

William said...

Not to take anything away from Scott's excellent analysis and commentary - just a supplement ;~)

The yield spread between US high-yield corporate bonds and the 10-year US Treasury is flashing orange. The yield on the Merrill Lynch junk bond composite is up 205bps from last year’s low of 5.16% on June 24 to 7.21% currently. The yield spread has widened from 257 bps to 501 bps over this same period. According to Dr Ed Yardini: "it is one of the best coincident and real-time indicators of bursting bubbles and recessions".

Also he notes: "Investors Intelligence’s Bull/Bear Ratio plunged from 3.14 to 2.05 over the past four weeks....mostly because of a big drop in the percentage of bulls who stampeded into the correction camp....The percentage in the correction camp jumped to 43.9% this week, the third highest reading on record."


Joseph Constable said...

Price is correct twice like a broken clock is right twice a day. On the way up price crosses value and is correct. Then when price is on the way down it crosses value and is correct again.

William is talking about investor sentiment. Others are talking macro economics.

Benjamin Cole said...

Well, Thursday was ugly on Wall Street. I hope for the best, but China has to go to a Euro-style or even a Japan-style devaluation, even if the Fed becomes growth-oriented.
Sooner or later, central bankers will have to acknowledge that sitting still at even low rates is not sitting still---it is keeping the monetary noose very tight around the neck of the modern economy.
The Bank of Japan learned this expensive lesson...and adopted QE as conventional policy...