Thursday, April 12, 2018

Reading the yield curve's message

If you haven't already heard that an inverted Treasury yield curve is a good predictor of recessions, then either you haven't been reading this blog for long or you haven't been reading much in the financial press of late. (For background, see some earlier posts of mine on the subject here and here.) The subject has become the focus of attention in recent months because the yield curve has been flattening, which in turn has sparked concerns that the risk of recession is rising. These concerns are misplaced, as I explain below.

Chart #1


The top portion of Chart #1 is the standard way to display the status of the Treasury yield curve. It represents the difference between the two lines on the bottom portion: the difference or "spread" between 10-yr and 2-yr Treasury yields. The spread is effectively a measure of the slope of the yield curve, which indeed is relatively flat compared to where it was several years ago. But it's not flat nor is it inverted; it is still positively-sloped, and that means the market believes the Fed is justified in saying it plans to increase rates modestly over the next year or so. The relative flatness of the yield curve is not saying that the Fed is tightening too much or threatening growth, it's best characterized as the market's way of saying that economic growth expectations are neither exciting nor worrisome. I explain this a bit more below.

Chart #2

Chart #2 is another way of looking at the yield curve—a better way, since it gives us some important additional information. The red line in Chart #2 is similar to the blue line in Chart #1, but the blue line in Chart #2 is the important addition: it shows the real, inflation-adjusted Fed funds rate, which is the overnight rate that the Fed targets. The Fed these days has absolute control over the nominal funds rate, while the rest of the nominal yield curve is essentially a projection of what the market thinks the funds rate will average over time. Any yield curve analysis worth its salt should measure not only the slope of the Treasury curve, but also consider the level of the real Fed funds rate.

The Fed doesn't just target the funds rate. What it really targets—but rarely talks about—is the real funds rate. Borrowing money at 5% when inflation is 1% is one thing, but borrowing money at 5% when inflation is 10% is quite another (the former means borrowing is expensive, the latter means borrowing money is a good way to make money). Real borrowing costs are what truly affect behavior. When money is very expensive—when real borrowing costs are high—people are discouraged from borrowing and spending and are encouraged to save money; eventually, if real rates are forced too high, economic activity suffers. That's been the proximate cause of every one of the recessions in the past 60 years.

One thing that stands out in Chart #2 is that the real funds rate has been negative for the past decade. Doomsayers think this means the Fed has been flooding the world with money, and the sky will soon be falling. Monetarists reason that, since we have seen neither a collapse of the dollar nor soaring inflation over the past decade, this can only mean one thing: the demand for short-term financial assets has been incredibly strong for many years (another way of saying that the market has been very risk averse for most of the past decade), and, moreover, the Fed hasn't artificially depressed interest rates, nor has it flooded the market with money no one wanted. The Fed has kept rates low because the demand for money has been strong. See this post (The Fed is not "printing money") from five years ago for more background.

Chart #2 actually has two messages: 1) an inverted yield curve is a good leading indicator of a recession, and 2) very high real short-term interest rates are also a good leading indicator of a recession. When both those conditions hold, that's when you need to worry about a recession. Today we're not even close to having to worry. Despite the Fed having raised its target funds rate six times in the past 18 months (from 0.25% to today's 1.75%), the real funds rate is still in negative territory (-0.18% as of March 31 by my calculations), because inflation over the past year has been almost 2%. The Fed has raised its target for the real funds rate because the market has grown less risk-averse and economic growth expectations have improved somewhat. The Fed hasn't "tightened" in the sense that it is trying to slow things down. The Fed is just following the market.

Chart #3

Chart #3 is important because it gives us information about the slope of the real, inflation-adjusted yield curve. Real yields are just as important, if not more so, than nominal yields. The blue line, the real funds rate, is ground zero for the real yield curve, while the red line, the real yield on 5-yr TIPS, is the market's estimate for what the real Fed funds rate will average over the next 5 years. Today, the front end of the real yield curve is positively sloped (i.e., the spread between the two lines is positive), and it has actually been steepening since last summer. The message: the market agrees with the Fed that short-term interest rates, in real terms, will need to rise in coming years. Not by a whole lot, but by enough to rule out the notion that the market and/or the Fed are nervous about the health of the economy. The time to worry is when the real yield curve becomes negatively-sloped, as happened before each of the past two recessions (i.e., when the blue line exceeds the red line, because that means the Fed has tightened too much).

Another reason the Fed needs to raise real rates is to boost the attractiveness of the $2 trillion of excess bank reserves held by the banking system. Failing to do so would decrease banks' desire to hold excess reserves, and that in turn would lead to excessive lending, too much money, a weaker dollar, and rising inflation.

Chart #4

Chart #5

Chart #4 uses real and nominal 5-yr yields to give us information about the market's inflation expectations. Despite the Fed having kept real short rates negative for 10 years, inflation expectations today are no different from what they have been in the past. As Chart #5 shows, the CPI ex-energy has been on a 2% growth path for the past 15 years, and inflation expectations today, based on 5-yr TIPS and Treasury yields, are about 2.1%. That is effectively proof that the Fed has not been printing money or distorting markets. In monetarist parlance, the Fed has managed to keep the supply of money pretty much in line with the demand for money, though not completely, because inflation has averaged about 1.6% per year for the past 10 years.

Chart #6

Chart #6 shows that real yields on TIPS also provide us with information about the market's GDP growth expectations. The level of real yields tends to track the level of real growth, and that is not surprising at all. A stronger economy implies higher real returns, and real yields should therefore rise in a faster-growing economy. Conversely, as economic growth weakens, as it did following 2000, real yields should fall. Currently, real yields of about 0.5% on 5-yr TIPS tell us that the market expects the economy is likely to grow about 2-2.5% per year, according to my reading of the bond market tea leaves.

If last year's tax reform results in a significant increase in economic growth, as I expect it will, then the Fed is going to have to guide real yields significantly higher as well. And that of course means significantly higher nominal yields, assuming inflation expectations remain "contained."

But for the time being, today's yield curve holds no threatening messages for the economy, and I think the market intuitively understands this.

What's worrisome today is not the yield curve, but the threat of a possible trade war with China and the ongoing tensions in the Middle East. The volatility that we are seeing is the result of the turbulence one would expect when headwinds (trade war risk, Middle East tensions) collide with tailwinds (last year's tax reform). For now, the market's judgment is that the two opposing forces effectively neutralize each other, with the result that growth is expected to be unimpressive, while inflation is expected to remain in the neighborhood of 2%.

Friday, April 6, 2018

Despite a weak March, jobs growth still improving

The March private sector employment report was a big miss on the downside (102K vs. 188K), but the trend rate of growth in private sector jobs continues to improve. The monthly jobs numbers are notoriously volatile and subject to significant revision after the fact, so one month's number cannot possibly be significant. For years I've focused on the 6- and 12-month rate of growth in private sector jobs, and by those measures conditions in the labor market continue to improve, after hitting a low last September. Here are the relevant charts:

Chart #1

Chart #2

Charts #1 shows the nominal monthly change in private sector jobs, while Chart #2 shows the 6- and 12-month rate of growth of private sector jobs. Big swings such as we have seen in recent months are pretty much the norm, so any attempt to characterize the underlying dynamics of the jobs market must rely on at least several months. Over the last six months, private sector jobs have increased on average by 213K, which translates into a 2.0% annualized rate of growth. Over the past 12 months, private sector jobs have increased on average by 187K, for a 1.8% rate of growth. This represents a significant improvement since the low point in September of last year, when private sector jobs rose at a 1.6% rate over the previous 6 and 12 months. We're making progress, albeit slowly.

Chart #3

Another bright spot is the recent pickup in the year over year growth of the labor force (the number of people of working age who are employed or looking for work). This hit a low of 0.4% last October and now stands at 1%, which is close to its average in recent decades. Background: over the long haul, the labor force tends to grow by about 1% per year, and productivity tends to average about 2%: the combination of the two, 3%, gives you the long-range average rate of growth of the economy. The current recovery, the weakest on record, has seen annualized growth rate in the labor force of just 0.5% and annualized productivity growth of only 1.0%.

Chart #4


Chart #4 shows the size of the labor force, which for many years increased by a little over 1% per year. If that growth trend had persisted, there would have been another 12 million or so either working or looking for work, and the unemployment rate—currently 4.1%—would currently be a lot higher.

Chart #5

The Labor Force Participation Rate has been steady—and quite low—for the past several years, but with a hint of improvement. (This is the labor force—those working and looking for work—divided by the working age population.) This rate is going to have to increase in coming years if the economy is to grow by more than 3%. Which means that a good portion of the 12 million or so that have "dropped out" of the labor force are going to have to decide to get back in the game. There are hints that this improvement has begun, but progress is still slow. What will entice millions of folks to get off the sidelines and back to work? Better-paying jobs. Where will the extra money to pay higher salaries come from? From increased corporate profits, which are baked in the cake thanks to the recent tax reform, and which will increase the nation's capital stock as corporate investment improves. With more capital deployed in the economy, labor will become relatively scarce and thus more valuable—and better-paid.

Chart #6 

Chart #6 is another bright spot, since it shows that there has been zero change in the level of public sector employment since the end of 2007. (Note that the y-axis for both series shows a similar scale increase, namely 20%.) This means the relative size of the public sector workforce has shrunk by almost 10% over the past decade. That is a very good thing, since the private sector is much more productive. 

Monday, April 2, 2018

ISM optimism

The monthly surveys of the Institute for Supply Management are very timely (though not real-time) indicators of the health of the manufacturing and service sector industries, and that's a good reason to pay attention to each release on the first of the month. They aren't perfect, but when they register strong levels it is almost always the case that the economy is doing well. I dedicate this post to today's manufacturing sector release, which was uniformly positive. That's comforting, given the backdrop of tariff wars.

It's obvious that the market is more concerned about the threat of a tariff war, as evidenced by today's renewed decline in stock prices, than it is bolstered by the strong ISM surveys. Trump has mandated tariff hikes targeted to China, and China is now retaliating with its own tariffs on selected US goods. This way lies misery, and the real losers will be consumers in both China and the US, who will be saddled with higher prices for a wide range of products. We can only hope that these are negotiating tactics on both sides, and that in the final analysis trade between the US and China will become more fair and more free. If not, we will have a mess on our hands and Trump's presidency will end in ignominy. Can he really be so stupid as to carry this tariff war to its disastrous conclusion? Thank goodness he has Larry Kudlow at his side to warn him of this danger.

Chart #1

Chart #1 compares the overall ISM manufacturing index to quarterly GDP growth. The two don't track perfectly, but as I look at the chart it strongly suggests that Q1/18 GDP growth is very likely to exceed current estimates, which, according to the current output of the Atlanta and NY Fed's models, is likely to be just under 3%. I'd wager that if the ISM index remains at or near these levels for several more months, we are very likely to see some stronger-than-expected GDP numbers before too long.

Chart #2

Chart #2 tracks export orders. Although the March reading dropped from the very high level of the February reading, this survey still suggests that overseas economies are doing well, and US exporters are enjoying strong demand.

Chart #3

Chart #3 shows that a significant number of ISM respondents are experiencing rising prices. This could be a harbinger of higher inflation ahead, but it could only be a sign of generally strong global conditions.

Chart #4

Chart #4 shows that a meaningful number of manufacturing firms are planning to increase their hiring activity in the months to come. That in turn reflects a decent level of optimism on the part of industry executives.

Chart #5

Chart #5 compares the US manufacturing index to a similar index/survey of Eurozone manufacturing firms. Both have been quite strong of late, but conditions in the Eurozone appear to have softened a bit in recent months. Eurozone stock markets have been underperforming their US counterparts for many years, however, so somewhat weaker conditions in Europe are not "new" news.

UPDATE: Today's release of the ISM Service Sector surveys (4/4/18) adds to the growing list of indicators which point to stronger US GDP growth:

Chart #6

Chart #7 compares the monthly changes in private sector employment as calculated by the Bureau of Labor Statistics and ADP. We are seeing here preliminary signs of an increase in the trend rate of growth in private sector employment. I think there is a decent chance that Friday's jobs report will be somewhat stronger than the market is currently expecting (+190K).

Chart #7

The market is obviously torn between the good news, reflected in part by the above charts, and the bad news, which is a budding tariff war with China. Comparing the two, I'm inclined to say that "a bird in the hand (i.e., stronger US GDP growth) is worth two in the bush (i.e., the possibility of a trade war with China)." Tariffs are for the moment only in the threat stage, still months away from actually being imposed, whereas it is becoming more clear that the US economy is gaining upward momentum.

Sunday, April 1, 2018

Charts we never thought we'd see

Ten years ago we were in the early stages of what would later prove to be the most severe economic downturn since the Great Depression. We'd all seen the charts and read the history of that tragic event and its terrible impact on the country, and we hoped it would never happen again. But there were things 10 years ago that we never expected to see, which later unfolded to our lasting astonishment. Here are just a handful of charts, which I offer to remind us of the amazing economic and financial developments of the past decade, about whose nature economists are still debating.

Chart #1

Chart #2

Chart #1 shows the dramatic—and ongoing—decline in initial unemployment claims. Ten years ago the vast majority of economists would have said that claims could never decline much below 300K per week, since that was most likely the minimum amount of normal turnover in the labor force. Yet here we are today with weekly claims approaching 200K per week. And as Chart #2 (the ratio of weekly claims to total payrolls) shows, claims have NEVER been so low in recorded history, relative to the size of the workforce. The risk of a typical worker finding him or herself laid off has never been so low. Today, employers are more likely to complain that it is harder to find skilled workers than to complain about the workers they have.

It's a brave new world for workers. But it makes central bankers nervous, since they worry that a tight labor market could result in higher wages that in turn could fuel rising inflation. This worry has its origins in the Phillips Curve theory of inflation, but that theory has never found substantiation in the data—it's the economic equivalent of an old wives' tale. Today's Fed governors are aware of this, so they are not necessarily sitting on pins and needles, but it is a source of policy uncertainty nonetheless.

Chart #3

Chart #3 shows what is arguably not only the most astounding economic or financial thing that happened in the past decade but also the most unbelievable. If you had asked any economist 10 years ago what were the chances of the Fed creating over $2.5 trillion of excess reserves in the space of a few years he or she would have stated flatly: ZERO. It couldn't possibly happen, because if it did it would herald the collapse of the dollar and an inevitable hyperinflation. The consequences of such an event were so terrible that the event itself was considered to be impossible. Yet here we are today with inflation running around 2% (as it has for more than a decade) and the dollar trading pretty close to its long-term, inflation-adjusted average vis a vis other currencies.

Prior to late 2008, when the Fed launched its Quantitative Easing program, excess reserves were measured in billions of dollars, not trillions. The Fed managed monetary policy by adding or subtracting reserves (which prior to late 2008 paid no interest) from the banking system: by creating a scarcity of reserves, banks would be forced to pay more to borrow them, and that would result in higher short-term interest rates. Today, with a previously-unimaginable abundance of reserves, the Fed has resorted to pegging the interest rate it pays banks that hold reserves, and that seems to be working. Regardless, we've been sailing in uncharted monetary waters for most of the past 10 years, and economists are still debating how everything is going to work out in the years to come. 

To this day there are still legions of observers who argue that what the Fed did starting in late 2008 was simply a massive amount of money-printing, a desperate monetary stimulus that was necessary to avoid a depression, and the economy has been running on fumes ever since. 

Others, myself included, believe that what the Fed did was not monetary stimulus at all. It was simply a rational response to an unprecedented increase in the public's demand for money and money equivalents, which in turn was the result of the near-collapse of the global financial system and the worst global recession in modern memory. The world was running very scared, so the demand for safe monetary assets was nearly insatiable. Unfortunately, there were not enough T-bills (the classic monetary safe haven) to go around. By deciding to pay interest on bank reserves, the Fed effectively made bank reserves equivalent to T-bills, and that was exactly what the world wanted: trillions more of safe, default-free, interest-bearing assets, and the Fed had the ability to create bank reserves with abandon if need be. And so it was that the Fed bought trillions of notes and bonds, and in the process created trillions of T-bill equivalents. I explained this in greater detail in a post five years ago ("The Fed is not printing money"). It did the trick, and now the Fed is beginning to slowly unwind QE, as it should, given how much confidence has returned in the last year or so.

 Chart #4

Chart #4 shows that the inflation-adjusted Fed funds rate has been negative for almost exactly the past 10 years. Never before in modern times has this occurred. Those same legions of observers that think QE was monetary stimulus in disguise argue that real interest rates have been artificially depressed by the Fed's actions. I and others, in contrast, argue that real short-term interest rates have been extraordinarily low because of extraordinarily strong demand for safe, short-term assets. If the price of a bond is bid up high enough, its yield will turn negative; it's a simple matter of bond market math. T-bills, and bank savings deposits, have been in such high demand that investors have been willing to accept zero or negative real yields. The Fed has not been artificially lowering rates, the market has driven rates to very low levels because of very strong demand for safety and very high levels of risk aversion.

Chart #5

Prior to the Great Recession, most economists would have said that the 2% yields on 10-yr Treasuries we saw in the post-Depression years would never recur, because those yields were the by-product of very weak growth and very low inflation. Yet those same 10-yr yields fell to an all-time low of 1.3% in July 2012, during a period in which the US economy grew at a 2.4% annualized rate and inflation was on the order of 2%. I believe the only way to explain these extremely low yields is to understand that they were driven to low levels by intensely strong demand for default-free assets. After all, the Fed doesn't control 10-yr yields; the market does. Today, inflation is about the same as it was in 2012, but the economy is a bit stronger and confidence is much stronger. Demand for safe assets has declined, as a result, and 10-yr yields have doubled. It all makes sense.

Chart #6

Finally, we come to what is arguably the most unexpected chart of them all, Chart #6. Prior to the Great Recession, the US economy had suffered many recessions, but after a few years it had always bounced back to its long-term trend. And in fact, the deeper the recession, the stronger the recovery. Milton Friedman formalized this observation in 1964, calling it the Plucking Model (see my discussion of this here). Unfortunately, the economy hasn't bounced back this time: growth since mid-2009 has averaged about 2.2% per year. I've attributed this slow growth to the heavy burdens of government spending, regulations, and taxes, all of which rose beginning in late 2008. If the economy had returned to its previous growth path, it would be at least $3 trillion bigger today.

Chart #7

Chart #7 shows how productivity (output per hour of those working) has been extraordinarily low for the past 10 years; this is the main explanation for why growth has failed to snap back to its long-term trend. Prior to the Great Recession, productivity averaged about 2% per year. But productivity has been much less than 2% over the past 10 years. As I've noted, the lack of productivity can easily be traced to weak business investment, which in turn is a natural response to increased tax and regulatory burdens.

Although extraordinary and wholly-unexpected things have happened over the past 10 years, there is still a logical way to understand what has happened and why. And it follows, therefore, that it is reasonable to assume that things could get a lot better in the future if the Fed continues to slowly unwind QE and the federal government continues to reduce our onerous regulatory and tax burdens.

As it has since 2009, I believe it pays to remain optimistic.

Thursday, March 22, 2018

The Fed is not tightening monetary policy

Yesterday the FOMC raised its short-term interest rate target (and the rate it pays on bank reserves) to 1.75%. This move was widely anticipated, and so it matters little. Regardless, monetary policy is nowhere near being "tight," and the Fed's plan to raise rates by another 100 bps or so over the next year is not necessarily a cause for concern. The tightness of monetary policy should always be judged in real terms (i.e., by subtracting inflation from interest rates—higher real yields increase the demand for money and when they get high enough, eventually slow economic activity). Yesterday's rate hike has already been offset by a recent rise in inflation (the PCE Core deflator rose 1.52% in the 12 months ended January, and my estimate has it rising 1.8% in the year ending this month). As result, in the past year, real interest rates have only risen modestly, in synch with a modest pickup in real growth, much as theory would predict. In short, the Fed is following the market's lead, and adjusting real rates higher in line with somewhat healthier growth. This not only makes sense, it's a welcome step in the right direction.

However, while monetary policy isn't currently threatening, trade wars are indeed a cause for concern. Trump is engaged in brinkmanship with China, in an attempt to force China to respect intellectual property rights and reduce punitive tariffs on some US exports to China. Today, some Chinese officials threatened retaliatory tariffs on US exports, particularly grains, and that raised the stakes, which in turn explains why the market fell meaningfully. Nobody benefits from tariff wars, particularly a tariff-imposing country's own consumers. If a tariff war were to escalate—heaven forbid—the results could be devastating, as happened with the Smoot-Hawley tariffs and the Great Depression. But everyone could benefit from freer and fairer trade, and I think that's what Trump is aiming for. If we've learned anything about Trump in the past year or so, it's that he is a clever negotiator who scares people from time to time. He undoubtedly believes that you've got to take great risks to achieve great results.

While we nervously await the outcome of the Trump vs. China war of nerves, it's helpful to remember that the growth fundamentals of the US economy are "beautiful," to borrow a phrase. Corporate tax cuts have set the stage for a significant pickup in investment, jobs growth, and real incomes, but it will take awhile before we see the results. The outlook is promising, but we're sweating through a lot of uncertainties at the moment. I think it pays to remain optimistic, but it's clear that uncertainty and risk are a bigger factor today than they have been in more than a year.

Here are some charts which are relevant to my comments above:

Chart #1


Chart #1 is number one on my Recession Watch list. It shows that recessions have always been preceded by a severe tightening of monetary policy. That tightening in turn consists of 1) real short-term interest rates of 3% or more, plus 2) a flat or inverted Treasury yield curve. Currently, real rates are  still unusually low, and while the yield curve has become a lot less steep in recent years, its current slope is consistent with continued growth. The curve is positively sloped because the market believes the Fed will indeed raise rates in coming years, though not excessively.

Chart #2


Chart #2 compares the real yield on 5-yr TIPS (red line) with the real Fed funds rate (blue line). The former is effectively equal to what the market believes the latter will average over the next five years. Thus, the market currently expects only a modest amount of monetary policy tightening for the foreseeable future. That is normal, and it is consistent with the slope of the nominal Treasury yield curve.

Chart #3


Chart #3 shows how real yields (blue line) have risen gradually and in line with a modest strengthening of real GDP growth. It also suggests that if economic growth were to accelerate meaningfully (e.g., 3-4%), then we should expect to see real yields move up to at least 1.5-2.0%.

Chart #4

Chart #5

Industrial production is booming, both here and in the Eurozone, as Chart #4 shows. And it's not just utilities, as Chart #5 shows: after subtracting utility output from the IP data, we see that manufacturing output has in increased meaningfully in the past year, after several years of only modest gains.

Chart #6

Billings at major architectural firms have also picked up in the past year, as Chart #6 shows. There is a lag of at least 9 months between a pickup in billings and the resultant pickup in construction, so this is a good leading indicator of better news to come in the commercial construction sector. 

 Chart #7

Chart #7 compares an index of truck tonnage (orange line) with the S&P 500 index (white line). I like the truck tonnage index because it is a fairly contemporaneous measure of the physical size of the economy]Both have improved significantly in the past year or so, and both have dipped of late.

Chart #8

Skeptics call Chart #8 the "mis-" leading indicators, since this series doesn't do a good job of anticipating important changes in the economy. It's best thought of as a good contemporaneous indicator. In any event, the Leading Indicators index is up 6.5% in the year ending February, and that is a pretty good indication that we are still in the growth phase of the current business cycle.

Chart #9

When talking about debt and deficits, it is imperative to express them as a percent of economic activity. Chart #9 does just that, showing the federal deficit as a percent of nominal GDP. Although the $706 billion that the government has borrowed in the past year sounds like a lot, it is a smaller percentage of GDP than the Reagan deficits were in the 1980s. Another thing to note about this chart is that the burden of deficits (their size relative to GDP) always declines during periods of growth, while it always increases during periods of economic weakness. Growth is the key variable when talking about debt and deficits. I've explained before that the deficit has been increasing of late not because the economy has been weak, but rather because people have been anticipating tax reform and consequently accelerating expenses and postponing income. Now that tax reform is not only a reality but significantly pro-growth, we should see faster economic growth, more jobs, and a bigger tax base that should ultimately result in an improving fiscal situation (i.e., a declining deficit/GDP ratio).

This is not to ignore the long-term risks to the fiscal outlook, which center around the growth of entitlement spending. We're not yet on a collision course with fiscal disaster, but that remains a major source of concern for the long haul. In the meantime, more growth would mitigate those concerns.

Chart #10

Chart #10 shows how market worries (as proxied by the red line, which is the ratio of the Vix "fear" index to the 10-yr Treasury yield) have affected stock prices. The current "wall of worry" is not too high; we've seen much worse in recent years.


Thursday, March 15, 2018

10 key charts updated

The economy grew 2.5% last year, which is a bit stronger than its annualized rate of growth during the expansion which began in mid-2009, and there's evidence that growth picked up a bit over the course of the year, likely due to a significant increase in business and consumer confidence. Regardless, my reading of the market tea leaves suggests that the market's expectation for future growth is only slightly higher than what we've seen in the current expansion. Although the sharp cut to the corporate income tax rate has found its way into a substantial rise in stock prices (because reducing the tax rate means that the discounted value of future after-tax earnings translates into a one-time boost to current valuations), the market has yet to price in a substantial increase in future growth fueled by the increased investment and jobs creation that the tax cut was designed to achieve. (And to be sure, there is still no convincing evidence of a significant pickup in business investment.) The market is moving in an optimistic direction, of course, as witnessed by rising real and nominal yields, but we're still in the early innings.

Chart #1

I've been posting updated versions of Chart #1 for many years now. It shows how unique the current business cycle expansion has been in the economic history of the US economy. From 1965 through 2007, the US economy grew at a trend rate of about 3.1% per year. It slipped below this trend during recessions, and exceeded the trend during boom times. But it invariably returned to trend given a few years. (Milton Friedman in 1964 wrote a paper about this, calling it the Plucking Model.) The current expansion has been by far the weakest on record. Relative to its previous trend, the US economy is more than $3 trillion smaller, in 2009 dollars, than it might have been had things played out this time as they have before.

What's the cause of this underperformance, especially considering that since late 2008 the Fed has massively expanded its balance sheet? My list of reasons lays the blame on two major factors: 1) an oppressive expansion of government, in the form of increased regulatory and tax burdens, and 2) a shell-shocked market that has only recently regained its former level of confidence in the wake of the Great Recession of 2008-9.

Chart #2

Chart #3

Chart #4

Confidence has returned, but only in the past year or so, as shown in Charts #2 and #3. This may be the precursor of increased business investment—of which there is no sign yet—but it does explain the recent surge in the labor force, as shown in Chart #4. It's only very recently that we have seen a big increase in the number of people looking for work. 

Chart #5

Thanks to TIPS (Treasury Inflation-Protected Securities), we have real-time knowledge of the market's expectation for risk-free, inflation-adjusted returns. (TIPS pay a real rate of interest in addition to whatever the inflation rate happens to be. The price of TIPS varies inversely with the market-determined level of the real yield on TIPS.) As the chart above shows, the level of real yields on TIPS tends to track the economy's trend real growth rate (I use trailing 2-yr annualized growth as a proxy for what the market perceives the current trend to be), much as common sense would suggest. When economic growth was booming in the late 1990s, TIPS paid a real rate of interest of about 4%, since they had to compete with the market's expectation for 4-5% real economic growth. But with the trend rate of growth having now slowed to just over 2%, the real rate of interest on TIPS is only modestly positive: 0.5% for the next 5 years, as of today. If the market thought the US economy were on track to deliver 3%+ rates of growth in the years ahead, I'm confident that the real yield on 5-yr TIPS would be in the neighborhood of 1-2%, if not higher. As it is, I think the market is currently priced to the expectation that real growth will average about 2.5% in the next few years. That's good, but nothing to write home about.

Chart #6

Chart #6 compares the real yield on 5-yr TIPS (red line) with the ex-post real yield on the Fed funds rate, using the Fed's preferred measure of inflation, the PCE Core deflator. This is akin to viewing two points on the real yield curve: overnight rates and 5-yr rates. Using bond market math, the red line is the market's expectation for what the real Fed funds rate is going to average over the next 5 years. And of course, the real Fed funds rate (blue) is the rate that the Fed is actually targeting. As you can see, the market expects only a modest amount of tightening from the Fed in the years to come. That makes sense only if both the market and the Fed agree that the economy has limited upside growth potential. If the market thought the economy were set to grow at a 3%+ rate for the next several years, the market would immediately assume—and the Fed would probably agree—that there would be a a more aggressive series of rate hikes in the future, not just 3 or 4. Even still, when the Fed raises rates in response to stronger growth expectations, that is not a tightening, it's more a following action. To be really tight, the Fed would have to raise real rates to at least 3%, and the yield curve would have to flatten or invert.

Chart #7

Chart #7 compares the real and nominal yields on 5-yr Treasuries (red and blue lines) with the difference between the two (green line), which latter is the market's expectation of what the CPI will average over the next 5 years. With 5-yr inflation expectations today at 2.15%, the market is reasonably sure the Fed will be able to hit its 2% inflation target (on the core PCE deflator, which tends to run about 30 or 40 bps lower than the CPI). Looking ahead, the market sees pretty much the same amount of inflation that we have seen over the past few decades. The market is thus fairly confident that the Fed is not going to do much going forward, and whatever it does, the Fed is unlikely to be too tight or too easy. You may not agree with that assessment, but that's what the market tea leaves are saying.

Chart #8

Chat #8 shows how sensitive the stock market is to bouts of anxiety, as proxied by the ratio of the Vix "fear" index to the 10-yr Treasury yield. The latest market correction was triggered earlier this year by concerns that rising nominal yields might threaten economic growth, but that quickly faded, only to worry more recently that Trump's tariffs might spark a global trade war. Whatever the case, the market is not very worried these days, nor is it very optimistic.

Chart #9

Chart #10

A general lack of concern about the economy's health is evident in Charts #9 and #10. Swap spreads—an excellent coincident and leading indicator of economic and financial market health—are up a bit of late, but still within what might be considered a "normal" range. The swap market is reflecting a relative abundance of liquidity and little if any concerns about systemic risk. Credit Default Spreads—highly liquid and coincident indicators of the market's perception of credit risk—are also up a bit of late, but still relatively low.

As I noted last October, and as has proven recently to be the case, rising growth expectations would almost surely result in an unexpected rise in real and nominal interest rates. Higher-than-expected rates would depress bond prices, and, in similar fashion, could depress the market's PE ratio (which is the inverse of the earnings yield on equities, and thus similar to a bond price), thus limiting further gains in equity prices to a rate that is somewhat less than the increase in earnings. The days of booming equity markets are fading, but there is still decent upside if and when the market begins pricing in faster growth and the business community follows through with increased investment and faster jobs creation. Meanwhile, there is no obvious reason to worry about a recession or a major stock market correction.

Thanks and congratulations, Larry!

My career as an economist began in 1980, the day I stumbled upon John Rutledge's CEI Forecasting Conference on the campus of Claremont McKenna College. At the time, I was in the midst of the MBA program at Claremont Graduate University, having previously received a BA in Philosophy at Pomona College (economics, I would learn, draws heavily from philosophy and business). Larry Kudlow happened to be the key speaker at the conference. He spoke of inflation, gold, the dollar, and economic growth, and all those things strongly resonated with me, as I had recently returned from four years in Argentina (1975-1979). I remember thinking there was nothing in the world that could be more exciting than to follow in his footsteps. Thanks, Larry, for being such an inspiration.

While living in Argentina I had the "privilege" of surviving inflation that raged at well over 100% per year, suffering gargantuan swings in the value of the peso (which lost over 95% of its value), and witnessing the military takeover of the failed government of Peron's widow, Isabel. Following macro-economic variables daily in Argentina was critical to survival, and in Larry I saw that my experiences in Argentina could serve as the foundation for an economics profession in the U.S. One year after seeing Larry speak, I was working for John Rutledge and meeting the likes of Larry, Art Laffer, Jude Wanniski, Bob Mundell, David Malpass, and Steve Moore. I grew up on the supply- and monetarist-side of the economics profession, because I became convinced that those disciplines held the key to best understanding how economies and markets work. Politically I'm a libertarian, because I'm convinced that governments and bureaucrats can never be as effective and efficient as free markets, and more government necessarily means less individual freedom, and that can never be a good thing.

Larry was the first economist who inspired me, and we've been close in our thinking ever since (he even reads this blog). Although we haven't always agreed on everything, and neither of us can claim to have forecasted the Great Recession, we share the most important values: a strong and stable dollar (which implies low and stable inflation), strong and steady economic growth, limited government, rule of law, and free markets (which imply free trade). We both know that any country that embraces those values is bound to be a place of opportunity and prosperity. Larry's whole life has prepared him for a position in which he can help influence the policies that will make the U.S. strong and prosperous. Congratulations, Larry, you've made it.

So naturally, everyone wants to know why Trump picked Larry, and why Larry chose to accept, since they have diametrically opposing views on trade and tariffs.

The best explanation that comes to mind is that Trump has persuaded Larry that higher tariffs are 1) temporary and 2) a tool with which to pressure China into opening its markets to more foreign goods and services and respecting intellectual property rights. A minor transgression, if you will, that will eventually yield a greater payoff. If nothing else, Larry's presence at the NEC will be a critical offset to Peter Navarro, and a voice of reason and experience that may keep Trump from wandering into "left" field. That Trump chose Larry, knowing his opposition to tariffs, speaks well to Trump's judgment.

Larry is a good man, an excellent economist, and a seasoned persuader. He is a great choice for director of the White House National Economic Council.

For more, today's WSJ has two excellent articles which faithfully round out the person that is Larry Kudlow: here, and here.

Friday, March 9, 2018

Early signs of a stronger jobs market

February private sector job gains were substantially stronger than expected (287K vs. 205K), and prior months were revised higher. This is good news, but we are still in the early innings of what is likely to be a more powerful and sustained improvement in the jobs market. That's what I anticipated in my 2018 predictions: waiting for GDP. For the past few months I've argued that the market has priced in the one-time impact of a significant reduction in the corporate income tax rate, but the market has still not yet priced in the expectation of a significant boost to future GDP growth. "Waiting for GDP" is still the meme to watch for, and today's jobs number is the first sign that this meme may in fact be realized, but it's too early to know for sure. Of course, once it's clear that GDP growth could exceed 3% or so on a sustained basis, the stock market will be making new highs. For now, we can be hopeful that this will be the case.

Chart #1

Chart #1 shows the monthly change in private sector jobs from an historical perspective. February was strong, but it's hardly a unique occurrence; we've seen numbers like this from time to time and in the end they have proved transitory, not the start of something big. We'll need to see more such numbers (e.g., job gains of at least 300K per month) before it's clear that the economy has kicked into a higher gear.

Chart #2
 

Chart #2 shows the 6- and 12-month annualized rate of change of private sector jobs growth. You can't come to any conclusions with just one strong number, you've got to see a series of strong numbers. Jobs data are notoriously volatile and subject to significant changes after the fact. So far, all we've see in recent months is that private sector jobs growth has risen from 1.7% to just under 2%. Hold the applause until jobs growth exceeds 2% by a substantial margin—we're not there yet.

Chart #3

Since the unemployment rate is quite low—4.1%—we need to see a sustained increase in the labor force participation rate. Many millions of workers have "dropped out" of the labor force, and they will have to elect to return if the jobs market is to generate more than 300K new jobs every month. Fortunately, today's jobs number suggests this process may be beginning. Labor force growth has picked up significantly, as Chart #3 shows. 

Chart #4

But it's still early, since the labor force participation rate (the percentage of people eligible to work who are working or looking for work) currently is only 63%, and the rate hasn't changed on balance for the past several years. We'll need to see it increase to 64% or more. Chart #4 gives you an idea of how low it has been (it started to decline in early 2009) and where it could go in the future if optimism returns in a serious fashion—as happened in the boom years of the late 1980s.