Lousy economy, but great job security

The economy is still in the midst of its weakest recovery ever. But the news is not all bad: the chances of a worker being fired today are lower than at any time in the past 50 years.

As the chart above shows, the 4-week moving average of initial claims for unemployment has fallen to its lowest level since 1973.

As a percent of the workforce, initial claims are the lowest they have been since records were first kept in 1967. In the past 4 weeks, initial claims dipped to a mere 0.18% of the 143.6 million people working.

Inflation is alive and well

I suspect a good many people would be surprised to learn that, if you abstract from volatile energy prices, consumer price inflation in the U.S. has been running at an annualized rate of 2.0% for the past 10 and 20 years. In fact, the CPI ex-energy is up 2.1% in the 12 months ended February and it has even risen at a 2.3% annualized rate over the past six months and 2.5% over the past three months. Inflation is far from dead, and the deflation concerns you've heard about in recent years are all the by-product of collapsing energy prices, which, by the way, are now a thing of the past.

The FOMC undoubtedly will take note of this fact in their deliberations today, and it will encourage them to move—albeit slowly—to raise short-term interest rates to a higher level. This should not be surprising nor scary. On the contrary, it would be scary if they ignored the behavior of core inflation.

The chart above shows the year over year change in the CPI (total) and the CPI ex-energy. Note how much more volatile the total is compared to the ex-energy version. Note also how the most recent period, during which oil prices have collapsed—is similar to the 1986-87 period, when oil prices fell about as much in percentage terms as they have in the past 22 months. In both periods, the total CPI suffered a significant decline followed by a significant rebound, while the ex-energy version was relatively unchanged. There is every reason to believe that the headline (total) CPI will register 2% year over year growth (if not more) within the foreseeable future, since oil prices are no longer declining and have even rebounded some 40% in the past month or so.

The Fed's preferred measure of inflation, the Core Personal Consumption Deflator rose 1.7% in the 12 months ended January, and it is likely to post a slightly higher rate of growth in February. This is entirely consistent with the behavior of the CPI, since the PCE deflator tends to register about 30-40 bps less than the CPI. What this means is that the Fed's preferred inflation gauge will soon be very close to the top end of its 1-2% target range.

Memo to FOMC: Raising short-term interest rates to 0.75% in the next few months—thus leaving real short-term rates still deep in negative territory—would not only be fully justified, it might even be too little too late.

The deflation/recession threat recedes

Exactly one month ago, many thought the world was about to tumble into a deflationary abyss.

Oil prices had collapsed to $26/bbl, high-yield spreads had soared to almost 900 bps, HY energy spreads were within inches of hitting 2000 bps, 5-yr inflation expectations had fallen to 1.0%, the Vix index was approaching 30, 10-yr Treasury yields had plunged to 1.66%, and the S&P 500 was down 15% from its all-time high.

What a difference a month can make. Today, all of these key indicators have reversed significantly. Oil is up 45% and approaching $40/bbl, high-yield spreads are down and approaching 650 bps, 5-yr inflation expectations are back up to 1.5%, the Vix index is down to 17, 10-yr Treasury yields are just shy of 2%, and the S&P 500 is only down 5% from its all-time high.

I note that one key indicator hasn't changed at all in the past month: 2-yr swap spreads remain very low (5-6 bps). As I've said numerous times in recent years, swap spreads are excellent coincident and leading indicators of financial market health. Very low swap spreads tell us that liquidity is abundant and systemic risk is low. Low swap spreads mean the underlying mechanisms of the financial markets are working just fine, allowing the market to spread risk from those who cannot bear it to those who can. Liquid, functioning financial markets are key to a healthy economy, just as are free-market prices. Price signals (e.g., cheap oil) have persuaded producers to bring their production more in line with demand. Markets have short-circuited a deflationary collapse.

We're fortunate that governments haven't stepped in to try and "fix" things that weren't broken to begin with (unlike what happened in the latter half of 2008).

I also note that one month ago there were signs that indicated we weren't headed for the end of the world as we know it. Industrial commodity prices were beginning to turn up. The CRB Metals index is now almost 20% above its January lows (see chart above).

It's tempting to say that yesterday's ECB announcement (i.e., more QE) made all the difference, but I'm not convinced. The turn for the better has been underway for the past month, and maybe the ECB announcement provided an additional nudge. For what it's worth, here is a recap of what's been going on in chart form:

Above: oil prices have rebounded sharply from their Feb. 11 lows. The fact that the active rig count in the U.S. has collapsed by 75% in the past 15 months is an excellent sign that producers have cut back production. Meanwhile, oil demand is up around the world.

High-yield Credit Default Swap spreads have tumbled, as higher commodity prices reduce the risk of corporate debt defaults.

The 5-yr expected rate of inflation embedded in the prices of 5-yr TIPS and 5-yr Treasuries has surged from 1.0% a month ago to almost 1.5% today, as higher oil prices mean that the headline CPI is likely to be much higher than the market feared. 

One more installment in the Walls of Worry chart that I've been featuring periodically. Fears are receding, and the prices of risk assets are rising. It's the same pattern we've seen repeated numerous times in recent years.

Good as all this has been, we're not out of the woods yet. As the chart above shows, the prices of gold and 5-yr TIPS are still relatively high, which means the market is still willing to pay up for the protection these unique assets offer. Gold rose to almost $1250/oz on Feb. 11, and today it is a bit higher at $1260. The real yield on 5-yr TIPS fell to 0.1% on Feb. 11, and today they are a bit lower still (the chart uses the inverse of real yields as a proxy for TIPS prices). You might not see it in the headlines, but elevated gold and TIPS prices tell us that the market is worried about the future direction of inflation being up instead of down. With a strong bounce in commodity markets occurring at the same time that major central banks have their policy pedals to the metal, it's not impossible that we could see inflation rising above target before too long.