Friday, January 30, 2009

Deflation risk is disappearing -- extremely positive

For the past few months I have been highlighting the fact that the bond market was terrified of deflation. My most recent post on the subject is here, where I speculated that fears of deflation could begin to decline, and that this would boost TIPS. The only way to explain the existence of extremely low yields (2-3%) on long-term Treasury bonds was that the bond market felt that deflation was highly likely. In the past two weeks, there has been a significant reversal of this sentiment. Deflation risk is now declining in a big way, and that should be very good news for a lot of things.

This chart shows the nominal yield on 10-year Treasuries and the real yield on 10-year TIPS. The bottom (green) line is the difference between the two, which is the market's implied 10-year inflation rate (breakeven inflation). In the bottom right hand corner I've highlight the big change. Inflation expectations began to plunge at about the same time the stock market began collapsing, in early September. Investors were panicked that housing price deflation would be contagious, and that the general price level would decline for years. I noted in November that the valuations of stocks and corporate bonds implied that the market feared something worse than Depression and deflation. Then, about a month ago, inflation expectations started to turn up. As of today, the market's expectation for the average inflation rate over the next 10 years has risen by a full percentage point from its low around year-end. This is very big news.

For the past month, real yields on all TIPS maturing in 10 years or less have declined, while Treasury yields have risen across the board. This reflects a market that has suddenly shifted its concerns. In the fourth quarter of last year, all the action involved the rising risk of deflation and depression. TIPS were shunned, and their real yields rose as a result; Treasuries were preferred, and their nominal yields collapsed to levels not seen since the Great Depression. This past month, the reverse has happened as the market has once again come to appreciate TIPS for their inflation protection and their attractive real yields, while at the same time shunning Treasuries.

The bond market is not always right, but this time I think it is. The Fed together with all other major central banks are massively easy, and gold prices are closing in on $1000/oz. Core inflation is still quite positive, and most commodity prices are up from their lows. The economy is certainly weak, but that is no reason to think that all prices are going to decline for years to come.

Once the investing public accepts that deflation risk has been reduced significantly, as I and the bond market think it has, this should be extremely positive for corporate bonds, commodity producers, emerging market economies, and equities. Deflation is Bernanke's worst nightmare (and everyone's, for that matter), and he is doing everything he possibly can to avoid it; this is no time to question his resolve or his ability to achieve his objectives.

I am aware of the supposed "January effect" which says that when stocks produce negative returns in January (as they just have) then we are likely to see negative returns for the rest of the year. But the past never repeats in exactly the same way, and this period is so unlike any other that trying to draw parallels to the past is futile at best. I look at the fundamentals, and they tell me that deflation risk is disappearing. I see real estate at or close to a bottom. I see swaps and implied volatility gradually returning to normal levels. If people can lose their fear of a downward price spiral, then today's valuations are so compelling that money (and there is more money in the world than ever before) will be desperate to come back to all the markets that have been so depressed. This is very good news indeed.

Now, if we could just convince Congress that a massive spending bill is insane, the world could get on with its business. If we could convince Congress that tax cuts are in order, a panic rally would surely ensue.

The silver lining to the faux-stimulus bill

It looks to me like the "stimulus" bill that passed the House is rapidly losing support. That's not surprising, since it was so absolutely awful. If this disgraceful display of politics run wild does not cast serious doubt on the seriousness of Congress and the intelligence of our new president, nothing will. And that is the good news, because only something this bad can mobilize support for something that does make sense. The Senate needs to do its job now, and recast this effort to help the economy using reason, experience and logic, rather than pure partisan politics. Above all, our senators need to focus on the fact that simply handing out money to favored constituents and creating vast new spending programs that will take years to deploy is the worst possible way to stimulate the economy. True stimulus needs to focus on changing people's incentives to work, invest, and take risk. That means tax cuts, not tax rebates, and any changes should apply to anyone or any company that pays taxes.

If we're lucky, the debate in the Senate might last long enough that we discover that a stimulus bill is not really necessary after all.

Ben Stein reminds us just how awful the current bill was:
Eight hours of debate in the HR to pass a bill spending $820 billion, or roughly $102 billion per hour of debate.

Only ten per cent of the "stimulus" to be spent on 2009.

Close to half goes to entities that sponsor or employ or both members of the Service Employees International Union, federal, state, and municipal employee unions, or other Democrat-controlled unions.

This bill is sent to Congress after Obama has been in office for seven days. It is 680 pages long. According to my calculations, not one member of Congress read the entire bill before this vote. Obviously, it would have been impossible, given his schedule, for President Obama to have read the entire bill.

For the amount spent we could have given every unemployed person in the United States roughly $75,000. We could give every person who had lost a job and is now passing through long-term unemployment of six months or longer roughly $300,000.

Thursday, January 29, 2009

Japanese industrial production collapses

I featured this chart recently, and today we got new data for Japan. The Bloomberg headline reads "Japan headed for its worst postwar recession in December as factory output slumped an unprecedented 9.6%, unemployment surged and households cut spending." That's grim, and the chart puts it into global perspective. This is a globalized world, and the U.S. economy remains the most resilient of all, in part because trade is a much smaller part of our economy, and the last three months of 2008 were marked by a gigantic reduction in global commerce. One cause of the huge slowdown was the difficulty that exporters had getting letters of credit from a global banking system that was suddenly in complete disarray. I think that problem is going away rapidly, however, so we are not likely to see a more serious collapse, and should begin to see some recovery. As I noted recently, the Baltic shipping indices have picked up quite a bit of late, as have most commodity prices, suggesting that global trade is recovering.

Window closing on sub-5% mortgages

As an alert reader suggested several days ago, the window of opportunity to lock in sub-5% mortgages is closing as 10-year Treasury yields jump. There is a perverse dynamic in the bond market that accentuates swings in bond yields, and that dynamic is now kicking in with a vengeance, and that in turn could propel yields much higher in the next few weeks. This dynamic results from the ability of homeowners to refinance their mortgages with relative ease. As yields fall, the incentive to refinance rises. When yields plunge, as they did recently, there is a stampede of homeowners seeking to refinance. Indeed, refinancing activity rose by a factor of 7 between the end of November and early January. Now, with yields rising, refinancing activity is rapidly slowing.

Bond investors don't like to hold mortgage-backed securities (MBS) when yields are falling, because the duration (the responsiveness of MBS prices to changes in yields) drops. To compensate for this, they will typically buy 10-year Treasuries in an attempt to add back duration to their portfolios as yields decline. Thus, falling yields result in increased demand for Treasury bonds, which helps yields decline even more. We're now seeing the reversal of that: yields are rising and the same bond investors who recently were scrambling to buy T-bonds to add duration to their portfolios are now rushing to sell. And that puts more upward pressure on yields, in a form of vicious circle. If the current episode plays out like the last one did, in mid-2003, then yields could rise at least a hundred basis points more in fairly short order.

Bond yields are doing an about face

This chart gives you a good idea of how wild it's been lately in the bond market. Yields on 30-year Treasury bonds were behaving pretty normally until they started plunging in early November. They dropped to 2.5%, which is the lowest yield ever recorded for 30-year T-bonds. Starting early this month they jumped up, and are now up over 100 bps from their recent lows. The main driver of the plunge in yields was widespread fear of significant deflation. That these fears are now reversing suggests the market is beginning to view the future with much less trepidation. It's nice to see more things get back to levels that are more normal.

However, as the chart suggests, bond yields are still pretty low relative to inflation. On average, long-term Treasury yields are at least 2-3% above inflation. So the current level of yields is consistent with inflation averaging no more than 2% per year forever. The CPI hasn't been 2% or less on a sustained basis since 1967. If the Fed's super-accommodative monetary stance gains traction and inflation rises even modestly from current levels, there is a lot more room for Treasury bond yields to rise.

Full disclosure: I am long TBT.

Treasury yields are turning up -- a very positive sign

The bounce in yields that started earlier this month is still in its infancy, but nevertheless it represents significant change on the margin. T-bill yields have risen from being slightly negative to now 0.21%. No longer are investors willing to accept a zero yield for the privilege of investing in the world's safest asset. 10-year Treasury yields are up 65 bps from their Dec. 30th lows, mainly because investors are now worrying less about deflation and more about inflation. (We know this because TIPS yields have declined while Treasury yields have risen; Treasuries are good for deflation, while TIPS are good for inflation.) 2-year Treasury yields are up 35 bps since their December low; since that yield essentially represents the market's estimate for the average Fed funds rate over the next two years, this suggests that the market's expectation for what the funds rate will be two years from now has risen by about 70 bps, and that is a good indication that economic recovery expectations are awakening.

So fear is declining (and the VIX index confirms this) and concerns about a deflationary depression are declining as well. The politicians would say that the massive stimulus bill looming on the horizon has done the trick, but I would say that things are improving despite the awful implications of a massive increase in government spending and the future taxes necessary to fund it.

Unemployment claims appear to be peaking

The dust is settling after the surge of new claims for unemployment in December and the 20% drop in early January. What we see is that the 4-week moving average of claims has been relatively steady for the past seven weeks; the high point occurred on Dec. 19th. This is not to say that claims won't go higher, but the past two months have been awful ones for layoff announcements and bad economic news in general, and they followed the abysmal market months of October and November. So it is not unreasonable to think we've seen something close to the worst of the layoffs by now. And to keep things in perspective, we need to compare the current level of claims to the size of the workforce. Using conservative assumptions, my numbers show that layoffs as a percent of the workforce in January will be only about 60% of what they were at the peak of the recessions of '75, '80 and '82. We'll have the actual numbers for that at the end of next week.

Capital spending has slumped only mildly

With data through December now available, we see that capital goods orders have dropped only mildly from their recent highs. Weakness in capital spending in this recession has been only a fraction of what it was in the 2001 recession. What is most notable, however, is that while capital spending today is running at about the same rate as it was just before the last recession, corporate profits (economic profits, as measured by the NIPA) have more than doubled. Corporations have amassed huge stores of profits, much of it in the form of cash, and that is helping to cushion this downturn. Once confidence returns—or better yet, if corporate tax rates are cut—we could see a significant improvement in capital expenditures which could power the economy to new highs in fairly short order.

Wednesday, January 28, 2009

Spreads and yields continue to decline

I've highlighted the predictive power of swap spreads many times so far, and it's been a month since I last featured this chart. Although the corporate bond market rally has been on hold for the past month, swap spreads have moved lower. 2-year swap spreads are almost back to their "normal" level of 30-40 bps. Yields on investment grade bonds have fallen dramatically from their high of almost 10% last October, to just over 6% today. Spreads on those same bonds are still unusually high, but that's mainly because Treasury yields are still amazingly low. The current yield on investment grade bonds is only 60 bps above the average of the past 5 years, so borrowing costs for most large corporations have come back down to pretty reasonable levels. Speculative-grade bond yields, as this chart shows, are way down from their highs but still extremely high; they need to fall a lot more before borrowing costs become reasonable for those folks.

This all adds up to some pretty impressive improvement on the margin, even if all is not yet back to normal. It would be nice if the Congress types would pay some attention to this good news. But if they did it might spoil their fun, because they love thinking that spending our money will be good for everyone.

With the Fed pledging today that the days of easy money will be with us for quite some time, it is reasonable to expect that money will find its way into the nooks and crannies of the economy and lubricate the wheels of commerce at least a little bit. Easy money will help offset the slump in demand, and likely keep default rates from rising as high as many still fear. Easy money is also a good antidote to the deflationary forces that the bond market still fears. Easy money is already at work in commodity land, helping to push most commodity prices up after their vertiginous plunge from July through late November. I think this adds up to a good case for liking high-yield and emerging market bonds.

Full disclosure: I am long HYG and EMD.

Economists to Obama: more government spending is NOT what we need

The Cato Institute has done the public a great service by taking out full-page ads in major newspapers with the names of hundreds of respected economists who strongly disagree with the need for a big government spending "stimulus" package. It appeared in today's New York Times, and is scheduled to appear in tomorrow’s Washington Post and later this week in the Los Angeles Times, Chicago Tribune, and Washington Times. You can read the full text with all the signers here. Cato has more on the subject here.

Let's get the word out—it's not too late to kill this monstrosity!

Thoughts on the market

Lots of things going on today. The Fed confirmed its intention to keep short-term interest rates very low for quite some time. The House is supposed to vote on a mega "stimulus" bill today. Bond yields rose sharply, and the Treasury-TIPS spread widened further as inflation expectations increased. 3-mo. T-bill yields are now up to 0.17%. Volatility fell and swap, agency, and credit spreads fell. Commodity prices and the Baltic Dry Index rose, but gold fell and the dollar strengthened. The S&P 500 index only needs to rise as much tomorrow as it rose today (3.4%) in order to be in positive territory for the month of January. (And if that happens, the technical guys say that will be a very bullish sign for the rest of the year.)

Without trying to read too much into one day's market action, though, I think the message the market is sending us over the past month or two is that the economy is on the mend; that we have likely seen the worst of the economic news.

I don't think the stimulus bill is going to stimulate anything. Indeed, I think if it passes as is, then it will prove to be a drag on the economy because it will waste enormous amounts of economic resources. Plus, it will end up making the economy less efficient because government will control a larger portion of the economy. But since the market has been fearful of a massive expansion of government since before the election, the passage of a faux-stimulus bill won't necessarily be a negative for the market.

In the final analysis, the only way that government policy can make a significant difference to the economy is by changing incentives (e.g., raising or lowering tax rates in order to change the after-tax rewards to work, investment, and risk-taking). The stimulus bill currently under consideration won't do any of that. There's still a chance for some last-minute compromise that might prove significant—a cut in corporate tax rates, for example, would be hugely positive. But barring that, I think it's time to accept that many hundreds of billions of dollars are going to go down a rat-hole and we are going to be burdened by more government in the future. We are also likely to be burdened with higher inflation in the future, because it is likely that the Fed will not be able to reverse its massive monetary accommodation in a timely or proactive manner.

But we need to remember that Fed policy has been terribly erratic and misguided for at least the past decade, so this is nothing very new. The politicians will want the credit for an eventual recovery, but they will forget that bad policies (e.g., Freddie and Fannie, the Community Reinvestment Act, failures to exercise regulatory oversight, bungled takeovers of Wall Street firms and banks) are what got us into this mess in the first place.The stock market has made zero progress since 1997, and it wouldn't be crazy to blame it on a decade of bad fiscal and monetary policy.

If one is to be optimistic about the future, optimism must be based on an improvement in the economic fundamentals. This economy has an incredible ability to grow and overcome adversity. Recall, for example, that the 9/11 tragedy came almost at the very tail-end of the 2001 recession—it hardly registered on the GDP scale.

I've been documenting improvements in the fundamentals for quite some time now, and I think the seeds for a recovery have already been sown. Financial markets have digested the bulk of the subprime losses; massive deleveraging has already taken place; all measures of financial stress have declined significantly; housing prices have erased almost all of their excesses; asset prices in many markets have gone through wrenching adjustments; new signs of life are appearing every day.

So I still think we're on the path to recovery, and I am still optimistic, even though I view the stimulus bill as a massive boondoggle, a massive waste, a fountain of corruption, etc. It just means the future won't be as bright as it otherwise could have been. We are going to pay the price of decades of bad policies, and that price will be slower growth and living standards that don't rise as high as they otherwise might have. It's not a rosy picture, but it's not the end of the world by any stretch.

Tuesday, January 27, 2009

The economic stimulus plan is a gigantic boondoggle

Read all about it here. Paraphrasing the immortal words of P. J. O'Rourke, someone should take this bill out behind the barn and kill it with an axe. (Obama already killed Nancy Pelosi's embarrassing proposal to stimulate the economy by spending more on contraceptives.) It does very little to stimulate new economic activity, and way too much to create new goverment programs (36 new programs costing over $136 billion). Only 3% of the bill is directed to road and highway spending. The CBO estimates that only 25% of infrastructure dollars can be spent in the first year.

Update on falling home prices

In inflation-adjusted terms, home prices in 20 key markets in November fell about 29% from their peak in 2006, according to the Case-Shiller Composite-20 Index. I've discussed this before, noting that the index overstates the current level of prices by quite a bit because of reporting lags and the way it is calculated. Adjusting for this, I would guesstimate that housing prices today are down about 37% from their highs in real terms. That would put them back to levels last seen in mid-2001, and that would imply that most or all of the housing price "bubble" has been reversed.

Anecdotally, the house next to the one my daughter rents in Claremont was put on the market last Friday, and sold before the Open House on Sunday. The house has a little over 1500 sq. ft., with 3 bedrooms and 2 baths. They were asking $500,000 and that's presumably what it sold for. estimated the house was worth only $400,000. Prices in many markets have fallen enough to stimulate real buying interest. Again, I think we are getting close to the bottom of the housing market, and that is very good news indeed.

Monday, January 26, 2009

Geithner very wrong re China's "currency manipulation"

In Tim Geithner's written responses to questions from the Senate Finance Committee that recently approved his nomination to be our next Treasury Secretary, he says that President Obama "believes that China is manipulating its currency."

I would agree with him that China has been "manipulating" its currency, but only in the sense that the rate of exchange between the yuan and the U.S. dollar has been far more stable than if it had been left to the vagaries of the market. I would hasten to add, however, that most of those who accuse China of "manipulating" its currency also believe that the Chinese currency should be far stronger against the dollar than it currently is (and, by inference, the U.S. dollar should be far weaker). I take great exception with anyone, especially our Treasury Secretary, who believes the U.S. dollar should be weaker against any currency. A strong currency is always in every nation's best interest, because it provides the bedrock for confidence, investment, and progress. Geithner is starting off on the wrong foot.

In any event, as this chart shows, the Chinese yuan has been strengthening against the dollar for the past 14 years. What more do weak-dollar advocates want? The Chinese are guilty of "manipulating" their currency only to extent that they have sought to slow the pace of its appreciation vis a vis the dollar. But is that "manipulation" in the sense of doing something wrong? No.

According to the teachings of international finance, a country can manage its currency in only one of three possible ways: by targeting an interest rate (typically the overnight lending rate); by targeting the quantity of money in circulation (e.g., Volcker's targeting of M2); or by targeting its exchange rate vis a vis another currency or basket of currencies. When you target one monetary variable, the others find their own level and the economy adjusts. The Chinese economy has had plenty of time to adjust to its currency target.

Since 1994, the Chinese have targeted the exchange rate of the yuan vis a vis the dollar. They have done this by buying up most of the capital inflows (call them dollars) that were seeking to enter the red-hot Chinese economy. If they hadn't bought the excess dollars seeking to purchase yuan and yuan assets, the yuan would have appreciated much faster. This is perfectly acceptable; by purchasing the excess of dollars (a trillion or so), the Chinese central bank created new currency, which was then absorbed by an economy growing in excess of 10% per year. And by amassing a huge pile of foreign reserves in the proces, the Chinese central bank has given the yuan rock-solid status, and that is a boon to the Chinese economy because it guarantees that investments in China won't be wiped out by a devaluation. A strong Chinese economy that can sell us cheap and quality goods is a win-win for everyone.

Geithner was confirmed with haste, and his sins were overlooked, all in the name of responding quickly to the current economic crisis. That sounds a lot like what the Obama administration is trying to do with the stimulus package. These are ill-considered moves, wrapped in the cloth of urgency, which are more likely to result in a permanent expansion of government than a quick resolution to our problems.

And this is one more reason why our stock and corporate bond markets are so depressed.

Early sign of global recovery

I've mentioned the Baltic Dry and Capesize Indices before, most recently here. These indices are published by the London-Based Baltic Exchange, and are designed to provide "an assessment of the price of moving the major raw materials by sea." The Capesize index is up about 150% from its low in early December. It covers only 10% of the world dry shipping fleet, but 62% of Dry Bulk Traffic. The global economy is showing increasing signs of life.

TIPS are a steal (4)

Last November I was saying that TIPS were an extremely attractive investment. Real yields had climbed to very high levels because the bond market was convinced that deflationary forces were so powerful that nobody wanted or cared about TIPS's inflation protection. I argued that the government-guaranteed real yield on TIPS was compelling regardless of one's view on inflation. Since I thought deflation was unlikely to persist, and was very unlikely to be as lasting as the market feared, then TIPS were doubly attractive because they offered a juicy real yield and very cheap inflation protection.

A little over two months have passed, so it's time to review the situation. As the second chart shows, real yields have dropped significantly, which means that the prices of TIPS have risen significantly. That has been offset to a degree by two months' worth of negative CPI announcements. The market's view of future inflation has risen somewhat, because some of the expected deflation has occurred. But with oil and energy prices stabilizing and even rising over the past month or so, negative CPI months are much less likely to occur going forward.

TIPS are like the Swiss Army Knife of the bond market, since they can work for you in a variety of ways. They are the only instrument in the world that guarantees you a real yield (a guaranteed inflation-adjusted yield), because of the way they are structured and because they carry a U.S. government guarantee just like Treasury bonds. They are also the only instrument in the world that guarantees to pay you whatever the rate that consumer price inflation happens to be. They are good hedges against recession, since real yields tend to decline in a recession.

Today the real yield on 10-year TIPS is at a level that I consider to be "fair value:" neither very attractive nor very unattractive. But if you don't require the "on-the-run" issues (which have been bid up in price because they offer greater protection against a period of sustained deflation), then you find that real yields on TIPS are in the range of 2.3-2.6%, and I consider that to be a level which is cheap to extremely cheap. So the average TIPS bond, or a fund like TIP that invests in all TIPS issues, offers a real yield that is historically quite attractive. (Buying an indexed TIPS fund is probably a good idea for small investors, since the bid/ask spread for small amounts can be prohibitively expensive.)

The first chart shows that the market is expecting the CPI to average about 0.8% over the next 10 years. Off-the-run issues have inflation expectations that are even lower. In other words, TIPS are priced to the expectation that inflation is going to be extremely low for many years. Much lower, in fact, than anything we've seen in our lifetimes. If you are worried that the Fed's extremely expansive monetary policy is going to generate inflation that is at least as high as what we've seen on average over the past 10 years (2.6%), then TIPS offer you a very cheap way to benefit should the market's expectation of very low inflation prove to be wrong. For example, let's say you buy the TIPS index, which today offers a real yield of about 2.4%, and that over the next 10 years CPI inflation averages only 2.5%: you would receive a total return of about 5% per year (minus transactions costs fees of course). Bear in mind that's 5% a year guaranteed by the U.S. government; a risk-free return. Stocks might do a lot better, but their return is not guaranteed at all.

So TIPS offer a very attractive real rate of return, and they provide inflation insurance that is very cheap. On a risk-reward basis I think they look much more attractive than almost any low-risk investment alternative. If you must keep your money safe for the next few years, and/or you are worried about rising inflation, than TIPS are still a steal.

Full disclosure: I am long TIPS bonds and TIP.

Real estate market is stabilizing

Despite all the bad news bombarding people in November and December, sales of existing homes did better than expected. And thanks to a faster pace of sales, lower home prices, and lower financing costs, the inventory of unsold homes on the market has dropped back to levels not seen for the past 18 months (see chart). This is a picture of a market that is fixing itself. I know that many worry about another avalanche of foreclosed properties being dumped on the market and depressing things further, but to date the evidence tells me that prices are adjusting and this is allowing the market to clear. So even if more homes hit the market, there will likely be buyers ready to scoop them up. Anything can be sold if the price is right; problems occur when sellers refuse to accept that their home is worth less than they think it's worth. It's taken a little over three years, but the market is finding the price that will move the inventory of homes. Meanwhile, builders have cut the construction of new homes to extremely low levels, and that is helping the situation as well.

Friday, January 23, 2009

Dollar up, gold up

The relationship between the value of the dollar and gold has apparently changed of late. For most of the past year, dollar weakness went hand in hand with gold strength, and vice versa. In the past week or so, however, gold has risen (note that gold in the chart is inverted) while the dollar has also risen. I'm not sure I have a convincing explanation of why this is happening or what it tells us. On the surface, gold is rising because geopolitical tensions and trade frictions are rising (e.g., Geithner is bashing the bashing the Chinese for "manipulating" their currency, and Congress wants to insert "buy American" wording into the stimulus package). Why the dollar should also be rising, though, I'm not sure. Perhaps it's just that the dollar in the final analysis is still the world's reserve currency, and so it is the currency of choice when things get ugly.

Thursday, January 22, 2009

Housing starts are still falling, but the bottom is near

Housing starts have truly collapsed. I've been thinking we were getting very close to the bottom in residential construction, and while the December numbers show no signs yet of a bottom, the level of starts is now so low that its relevance for the health of the larger economy is fading fast. Residential construction is now at its lowest point relative to the economy (about 3%) since data were first collected. The next big story out of the housing market will not be one of weakness, but of renewed strength. That might still take several months, but we're closing in on that point fast.

Bond yields are bouncing

Yields on 10-year Treasury bonds are up over 50 bps from their recent year-end (and essentially all-time) low. Does this reflect a lessening of fears (less demand for risk-free assets) or new fears of an upcoming avalanche of bond sales to finance the mega-stimulus package being put together in Congress?

Short-term Treasury yields (e.g., 3-month T-bills, 2-year Treasuries) haven't gone up nearly as much as bond yields, so the demand for safe-haven assets hasn't changed that much. Gold is even down a little since the end of the year, while the dollar is up. The answer can be found in the TIPS market, where real yields are flat to down since the end of the year. With Treasury bond yields rising but TIPS real yields flat to down, the wider spread (i.e., the breakeven inflation rate) tells us that the rise in Treasury yields is being driven by rising inflation fears. The market is expecting somewhat less deflation in the near term, and somewhat more inflation in the longer term. Still, the breakeven spread on 10-year TIPS is only 0.6%, meaning the market expects the CPI to average 0.6% a year for the next 10 years. That's pretty tame, but it's higher than the 0.1% we saw at year-end.

So you might say that the bond market is not yet concerned about the borrowing implications of the stimulus package, but it is beginning to get concerned about the inflationary implications of the Fed's quantitative easing program.

Wednesday, January 21, 2009

British Pound plunges

Commodities have plunged, and so has the value of the Pound. By my reckoning, the Pound is now somewhat undervalued relative to its purchasing power parity level, which I calculate to be about $1.45. It's been a lot weaker in the past (e.g., 1984), so if currency markets do their typical thing (e.g., overshoot) then we could see even more Pound weakness (and by inference more dollar strength).

Commodities are bouncing (2)

I first noted this in early January, and it's still the case: commodity prices in general appear to have bounced in the past few months. The big selloff in commodities happened over the course of the fourth quarter, and it certainly looks like this had a lot to do with the unwinding of carry trades, the unwinding of speculative commodity positions, and the deleveraging and drawdowns of hedge funds.

Interestingly, though, the pattern applies even to commodities that are not traded on futures exchanges. That tells me that two things were going on in the fourth quarter: 1) liquidation of speculative long positions, and 2) a major slowdown in global demand for commodities. Now we're on the other side of that trade. Leverage is starting to look much more attractive on the margin, now that large institutions can borrow at 1% or less, thanks to easy money from the Fed. Plus, commodity prices are down hugely from earlier highs. But perhaps most importantly, higher prices for raw industrial prices suggest that global demand is once again picking up.

I note also that a large number of commodities, including the energy complex, appear to have hit bottom at levels that were last seen in 2004. That was the year when the global economy started roaring ahead. U.S. exports surged 13% that year, thanks to strong global demand. Commodity prices rallied strongly in late 2003 and 2004 as demand for just about everything picked up. That prices have only fallen back to levels last seen when the global economy was robust is another indicator that fears of deflation are overblown, and it also suggests that we have seen the worst of the economic news.

Large cap stocks are set to outperform (2)

Here's an update of an earlier post that is still relevant. The chart shows the ratio of the price of small cap stocks (Russell 2000 index) to large cap stocks (S&P 500 index). The pattern I'm seeing is that changes in monetary policy appear to coincide with changes in the relative performance of these types of stocks. When money gets easy, small cap stocks tend to outperform because easy money typically follows in the wake of big economic slowdowns, and smaller companies are more nimble and better able to profit from improving economic conditions. Large cap companies tend to do better when monetary policy starts to tighten, since tighter policy is one way the Fed tries to slow the economy down and/or reduce inflation pressures. Large companies have a franchise which helps them survive in tougher economic times.

Monetary policy is currently about as easy as it could possibly get, so the next big chapter in Fed policy will almost certainly be a major tightening, and that should benefit larger companies. Stocks in general are very attractive, being priced to disastrous economic conditions, and large cap stocks are historically cheap relative to small cap stocks. That makes large cap stocks a double-bonus buy.

Full disclosure: I am long IVV.

Tuesday, January 20, 2009

No relief from Obama's speech

The stock market has succumbed to fear the past few days, and Obama's plan to have bigger government save us has only made it worse; the prospect of a massive increase in the size and scope of government creates greater uncertainty, not less. Meanwhile, the banking system is plagued by concerns of massive insolvencies. These are the times that try investors' souls.

I remain optimistic, and my optimism resides in the hope that the market mechanism can fix our problems well before government attempts to.

The question IS whether government is too big or too small

I wasn't very impressed by Obama's inaugural speech. Too much gloom and doom, and a new role for government that is potentially boundless: "The question we ask today is not whether our government is too big or too small, but whether it works..."

As Congress works feverishly to pass a mega-stimulus bill, consider some simple facts which help to put the size of the proposed $800 billion stimulus bill in perspective:

From the Economic Report of the President for the current fiscal year:

Total Federal spending: $3,133 billion
–Defense: $682 billion
–International Affairs: $40 billion
–Health: $713 billion
–Income & Social Security: $1,087 billion
–Interest: $228 billion
–Other: $383 billion

Federal spending can also be broken down this way:

–Consumption expenditures: $954 billion
–Transfer payments: $1,795 billion
–Interest: $343 billion
–Subsidies: $48 billion

Fully 90% of the current federal budget ($2,820 billion) was projected to be spent on transfer payments (social security, welfare, health care, tax rebates, etc.), defense, and interest. That leaves $313 billion to be spent on mundane things such as the day-to-day operations of the government, schools, infrastructure, research grants, etc.

The Democrats' stimulus plan calls for spending some $500 billion or so on infrastructure, schools, research grants, etc. It's not unreasonable therefore to say that Obama's stimulus package calls for more than doubling the size of the federal government's spending on discretionary items. That is, on things other than transfer payments, defense, and interest. At the same time, he wants this all to happen very quickly.

It seems to me that this borders on the absurd. How can Washington double its discretionary spending in a matter of months without creating massive waste, inefficiency, and corruption? How can anyone in the Obama administration possibly know that all that money will be spent only on things that "work?" And if it takes years to spend most of the infrastructure money, as The Congressional Budget Office said today, how is that going to address the current crisis?

Above all, let's not forget that the whole notion of fiscal stimulus is deeply flawed. Some excerpts from a Chicago Tribune article are appropriate reminders:

John Cochrane, a professor at the University of Chicago Booth School of Business, says that among academics over the last 30 years, the idea of fiscal stimulus has been discredited and in graduate courses, it is "taught only for its fallacies."

New York University economist Thomas Sargent agrees: "The calculations that I have seen supporting the stimulus package are back-of-the-envelope ones that ignore what we have learned in the last 60 years of macroeconomic research."

I will be amazed if more than a fraction of the stimulus plan actually passes. I think that the more people realize the vast scope of the spending, and all the messy things it would entail, the less likely it will be to pass. The feeding frenzy alone could be very off-putting. By reaching way too far in his bid to radically expand the role of the federal government, Obama may find he ends up with very little. And fortunately, that would be a good thing.

UPDATE: Total corporate income taxes at the federal level are roughly $300 billion. Eliminating the corporate income tax entirely would "cost" much less than half of Obama's proposed stimulus (although corporate taxes foregone would be $300 billion, income taxes would likely rise due to increased employment). Most importantly, however, it would result in an instant stimulus; no need for anyone in Washington to try to guess what the best projects are out there. Plus, corporations that have stashed mountains of profits overseas might repatriate a good deal of that money.

Monday, January 19, 2009

Calafia sunset

On the eve of the coronation (i.e., inauguration) of Obama, we were treated to one of nature's spectacular sunsets on Calafia Beach. We've enjoyed quite a few days of 80º weather and blue skies. Catalina Island is in the distance on the right and San Clemente Island is just barely visible on the left, being some 50 miles away.

Friday, January 16, 2009

No shortage of money (7)

The Monetary Base (currency plus bank reserves, both of which are under the direct control of the Fed) has now doubled in size since mid-September, thanks to the Fed's extraordinarily aggressive quantitative easing program. In the past four months, in other words, the Fed has created more money than it created in its entire history. Most of the growth in the base has been bank reserves, but no matter which measure of the money supply you look at, growth rates are up sharply and rising.

As I have been pointing out for many months, whatever is causing this crisis, it's most definitely not a shortage of money. There is more money out there than ever before. Some large banks have disappeared, but banks in aggregate are expanding their overall lending; total bank credit rose at a 12% pace in the fourth quarter.

This is a crisis of confidence, and there is a shortage of people willing to buy risky assets for fear of suffering losses. Once people recover their confidence and once all the subprime losses have been realized, this crisis could pass surprisingly fast.

Industrial production hits air pocket all over the world

If you think the U.S. economy has suffered the worst economic slowdown in generations, pity the poor Japanese, where manufacturing activity has dropped almost 15% in the past year, about twice the rate of decline in the U.S. As the old adage goes, "if the U.S. sneezes, the rest of the world catches a cold."

With massive and sharp cutbacks in production all over the world, it is time to start thinking of the rebound, since it could be surprising on the upside. Inventories are surely being depleted as everyone takes precautions in the face of a sudden reduction in consumer demand. But jobs and output in general have not declined by nearly as much as industrial activity, and China is now embarking on a $500 billion stimulus plan. New orders for industrial raw materials have arguably led to a 120% increase in the Baltic Capesize index of shipping costs in just the past month, confirming the signal we see in other commodity prices (e.g., the 8% rise in the CRB raw industrials commodity index in the past month) that global activity is beginning to rebound.

But the way the market is priced, if the reality ends up being simply that global economic activity is stabilizing (not growing, but no longer contracting), that would be bullish. A return to growth would be extremely bullish.

Most of the deflation is behind us

The consumer price index fell 5 months in a row, from August through December. December's decline of 0.7% was actually a bit less than the market's -0.9% forecast, and the great bulk of all the declines was due to a collapse in energy prices. With oil no longer falling (in fact, Arab Light crude is unchanged for the past two months and higher today than its December average), and gasoline prices at the pump up about 12% from the end of December, it's a good bet that we've seen the end of consumer price deflation. Core inflation has moderated a bit, but remains positive.

In contrast, the market (as defined by the difference between Treasury yields and TIPS yields, and as implied in the extremely low level of Treasury yields) is expecting the CPI to be negative for at least the next few years. (Clarification: when I say we've seen the end of monthly declines in the CPI, I'm not talking about the year over year change in the CPI, which is likely to become significantly negative for the next 6-7 months. The TIPS market is ruled by monthly changes in the CPI, not year over year changes.) That's a pretty radical forecast, in my view, considering that monetary policy is massively accommodative all over the world, gold is still well above $800, and commodities as well as energy appear to have bottomed and are now rising.

This means that the market is extremely vulnerable to any signs of an economic rebound, and/or any signs that the overall price level is not declining on a month-to-month basis. Good news, of the kind that would surprise the market and cause equity prices to rise and Treasury bond prices to fall, only has to be "not terrible." That's how bad the pricing is, and how attractive the valuations are in today's market.

So I think the equity market remains extremely attractive, and TIPS, despite their rally since I recommended them a month or two ago, are also attractive. TIPS have been in the dumps for awhile, because who wants inflation-indexed bonds if you expect inflation to be negative? As I noted a month ago here, the end of monthly deflation would be very good news for TIPS, and indeed the prospect of that has led savvy traders to bid their prices up recently. There's still plenty of room for improvement, especially at the front end of the TIPS yield curve, since the curve is significantly inverted (short-dated real yields are higher than long-dated real yields). If the market started to lose its obsession with deflation, then TIPS would become much more attractive and their real yields would fall, while Treasury yields would likely rise.

Full disclosure: I am long TIPS bonds and long TIP.

Thursday, January 15, 2009

Why I like Apple

I bought my first Mac in 1987, and I've used Macs and PCs almost every day since. I bought AAPL stock back in 2002 when many thought the company was going to fold. At the time I was very impressed with Apple's new operating system (OS X), and very impressed with the new iPod. The company had something like $6 per share in cash and was trading for less than $8. Apple was David challenging the Microsoft Goliath. Apple's market share was in the low single digits.

Apple's operating system is superior to Windows, as most experts will attest. To date there have been no succesful virus attacks on OS X, and there exists no spyware to slow down Mac computers. Macs are easier to use and they work great right out of the box. You don't need to buy anti-virus or anti-spyware software for the Mac OS. They will do anything a PC can, and more. If you want to use Windows programs you can run them right alongside your Mac programs using virtualization software such as Parallels or VMware Fusion (I should know, I've been doing it every day for over a year).

Apple has grown its share of the personal computer market from the low single digits to almost 10% in the past six years, and it's not just because the iPod has captured almost the entire MP3 player market. It's because Macs are way ahead of computers using Windows in almost every aspect. Critics like to say that Macs are more expensive, but that's true only from a penny-wise, pound-foolish perspective. If your time is worth anything, the best Macs are cheaper than the bottom-of-the-line PCs, because you'll spend a lot less time keeping a Mac running than you will a PC, and you'll be more productive in the process.

Today Apple has about $28 per share in cash, and it's trading around $80-85. Investors have been worried about Steve Jobs' health, and yesterday we learned he would be taking medical leave through June. Steve Jobs was the key to Apple's success, but will the company falter if he can't return? I think that Apple has built such a compelling operating system, and is so focused on industrial design and innovation, that it will almost surely continue to gain market share in computers, consumer gadgets, and smartphones for the foreseeable future. Jobs has created a culture of excellence and innovation at Apple, and it rests on the bedrock of a solid operating system; that's a winning combination even if he can't resume his leadership of the company.

If you can't bring yourself to buy the shares, you should at least go out and buy one of their computers. Only 10% of the people who read this use Macs.

Full disclosure: I am long AAPL.

These guys are going to save us?

Here you have two ordinary guys who say they are going to save the world from climate destruction (Waxman) and save the U.S. economy from falling into the abyss (Obey). How do you feel about entrusting them to restructure the entire U.S. economy and spend a trillion dollars or so of your money? You really should read Obey's blueprint for American Recovery and Reinvestment, just released today. It was written by politicians who think that throwing money at ideas, problems, and people will make the world a better place. It tries to justify everything by quoting the alleged conservative economist Mark Zandi, to the effect that "the economy is shutting down." It's all preposterous, and it's time to fight back. We don't need a massive Congressional spending boondoggle to save the economy. Just give it some time and stop trying to fix it, and the economy will solve its own problems in due course.

Producer Price Inflation not dead (2)

The "headline" number for producer price inflation recorded a decline of 1.9% in December and a decline of 0.9% for the year 2008. That doesn't mean inflation is dead, though, since the decline was almost entirely due to falling energy prices, and energy prices appear to be stabilizing over the past month or so. The core measure of producer prices (stripping out food and energy) rose a substantial 4.3% last year. Inflation is far from dead, but go tell that to the Treasury bond market, where widespread expectations of years of deflation still prevail. The only economic justification for Treasury yields being as low as they are is that inflation will prove to be negative for at least the next several years.

Unemployment claims still look toppy

I noted last week the huge plunge in weekly unemployment claims. It could have been an anomaly, or as we later learned, a problem with many offices being so deluged with claims that reporting systems broke down. The question has been partially answered with this week's number, which showed a large rise in claims (thus implying the previous week was indeed an anomaly and could have been the result of a lack of reporting). Whatever the case, however, if we look at a 4-week moving average (shown in this chart) or any measure of the growth rate of claims, it still looks like the worst is behind us. December could prove to be the peak month for unemployment claims, averaging 553K a week, while today's tally was 524K.

Wednesday, January 14, 2009

Less uncertainty puts a floor under prices

The retail sales air pocket has the markets spooked. Lots of talk about how stocks are going to test their November lows before this is all over. FUD (fear, uncertainty, doubt) is very much in the air. But as this chart shows, one measure of FUD, the Vix index, has improved significantly since the November lows. There really isn't as much uncertainty today as there was just a month or two ago. We know more about Obama, we know more about the economy, and key prices (e.g., swap spreads, the TED spread, etc.) are improving on the margin. The Fed remains extremely accommodative, and the risk of a banking system collapse is an order of magnitude less than what it was a few months ago. The market has been priced to a catastrophically bad economy, but every day it seems less likely to happen.

Less uncertainty should lead to higher, not lower prices.

Retail sales hit air pocket

Retail sales literally collapsed from August through December, falling at an annualized 24% rate. A good portion of this was due to falling gasoline prices, but there's no avoiding the fact that we've never seen anything like this in modern times in this country.

If this were to continue we'd be in a depression before too long. But it's important to remember that there is a lot of psychology in these numbers. People cut back on their spending because the financial markets were in free-fall and our leaders were warning that the situation was dire and massive government intervention was necessary to avoid catastrophe. My wife and I cut back on our spending, just to be prudent. Everyone I know has cut back; it's no wonder that the line on this chart has turned down with a vengeance. Our political leaders couldn't have done a better job of eroding confidence.

Like jobs, which are a lagging indicator, I see retail sales as also a lagging indicator. That's why I pay much more attention to what's happening on the margin in real-time markets: e.g., swap spreads, implied volatility, the TED spread, credit spreads, commodity prices, shipping rates, currencies, gold, etc. All of these things have registered significant improvement in recent weeks and months. I continue to think we've seen the worst of the news, and that the economic and financial fundamentals are on the mend. Sooner or later this will bubble up to the level of newspaper headlines, and consumers' fears will be assuaged. Spending has the potential to bounce back almost as fast as it declined.

It's also important to track changes in the likely direction of policy: for example, the risk of higher taxes has fallen significantly in recent months, and it's now increasingly likely that some taxes will be cut. Obama seems to be backing off on his pledge to unilaterally renegotiate NAFTA. He even had dinner last night with George Will and a host of leading conservatives—imagine that!

Calafia morning

After taking a quick look at the markets and the news, I decided to get back in touch with reality and so headed down to the beach. Sure enough, the world out there hasn't changed a bit. It's going to be 80º today—So. California must be sucking up all the world's heat.

Tuesday, January 13, 2009

Trade hits an air pocket, but will likely survive

Data through November point to global trade hitting a virtual "air pocket." July was the peak month for trade, and it was just after July that things started really going south. Exports fell $25.5 billion (at a seasonally adjusted monthly rate) through November, probably the most rapid decline since the Smoot Hawley tariffs that helped trigger the Great Depression. But imports fell $46 billion, almost twice as much. The GDP data will record this as a significant boost to growth, interestingly, since exports did much better than imports.

And so it is that trade acts as a shock absorber for consumers' sudden reluctance to spend, and the rest of the world shares our pain. Adding to the problem of consumers' reluctance to spend as the financial crisis deepened, trade was also impacted by banks' unwillingness or inability to extend letters of credit, an essential component of cross-border trade. Shipping activity declined sharply, as reflected in the collapse of the Baltic Dry Index (shipping costs) from 11,000 in May to a mere 663 in early December.

Fortunately, it appears that trade is no longer in free-fall. The Baltic Dry Index has risen 34% since its low in early December. Similarly, but in magnified fashion, Dryships (which owns and operates drybulk carriers) shares have risen 340% since their low in late November (HT to Mike Churchill). With Libor rates down significantly (reflecting banks' renewed willingness to lend to each other), and shipping rates and commodity prices up, we can deduce that banks are once again making letters of credit and trade is ramping back up. This all adds up to good news for our economy as well as for the global economy.

Monday, January 12, 2009

Huge decline in mortgage yields and spreads

This is unprecedented. Since the end of October, the yields on FNMA mortgage-backed paper have fallen over two and a half percentage points, to an all-time low of 3.42% today. Yields on the reference 10-year Treasury have fallen one a half percentage points over the same period. The spread is almost back to "normal" levels now. All that is missing is for 30-year fixed rate conforming mortgage yields to fall to 4.5%, but that should follow shortly.

Several things are at work here. On the one hand, yields are unbelievably low in general because the market is convinced that deflation is going to be with us for many years. On the other hand you have the Fed, which is promising to keep short-term interest rates close to zero for a long time time; this effectively forces people to move out of cash and into longer-term and riskier investments in order to pick up yield. And then there is the fact that the Fed is now buying mortgage-backed securities directly (though in such relatively small quantities that I don't think that can explain the bulk of what has happened). Finally, we can't ignore the fact that the demand for mortgage loans must be weak, at least relative to the desire of investors to own mortgage-backed loans.

If anything is going to dispel the deflationary gloom that seems to pervade the market, it's things like this. Refinancing activity is already up significantly, and will likely rise much more. New applications for mortgages are up a bit, but should rise considerably in the months to come. We have two powerful forces converging—sharply lower mortgage rates and steadily declining home prices—and I don't think the savvy American homebuyer is going to fail to take notice of the arrival of an opportunity of a lifetime. People respond to incentives, and I would be very surprised if we don't see a bottoming in housing prices before summer.

The crisis is passing (5)

The TED spread (the difference between 3-mo. Libor and 3-mo. T-bill yields) continues to narrow, falling to 108 bps today. This is direct evidence of improving confidence in the health of the banking system, since it primarily reflects a market that is willing to accept a lower and lower yield increment in order to place money with banks rather than with the U.S. government. It is still abnormally high, to be sure, but this chart should make it clear that the improvement in recent months has been dramatic.

Restoring confidence in the banking system is an essential part of the recovery process, and we continue to make significant progress to that end.

Sunday, January 11, 2009

Obama's fatal conceit (2)

I just finished browsing the paper written by Obama's economic advisors (Christina Romer and Jared Bernstein) to justify his $800 billion stimulus plan. My first thought was that they wrote the conclusion to the paper first (i.e., spending all this money on a combination of tax cuts, rebates, and government spending programs will produce the desire effect of saving or creating at least 3 million jobs), then backed into the the details necessary to justify the conclusion. My second thought was that as with all economic forecasts, the most critical variables are the assumptions one uses. As a former colleague of mine (Michael Bazdarich) who is proficient in econometric forecasting models always used to say, "tell me your assumptions and I'll tell you your conclusions."

As Greg Mankiw notes, it is remarkable (and, I would add, most troubling) that one of the most critical assumptions they make runs directly opposite to the results of Christina Romer's own research. Namely, they assume that the multiplier effect of tax cuts is only 0.99. Romer's prior research suggested that tax multipliers were in the range of 3 (i.e., one dollar of tax cuts yields three dollars of GDP). They justify the numbers they use because they are the average of the ones used by "a leading private forecasting firm and the Federal Reserve’s FRB/US model."

If they had used Romer's own tax multiplier, the stimulus package would have had to include a far larger share of tax cuts than the one being proposed, since she found that tax cuts are a far more effective source of stimulus than spending. But since that doesn't fit with Obama's current preference for making tax cuts about 40% of the overall package, they presumably chose multipliers that justified the desired conclusion, and those were not hard to find or to justify. That the package includes tax cuts at all (since they are assumed to be much less effective than government spending), is solely because they acknowledge that tax cuts can be put into effect much faster than spending, and fast-acting stimulus is judged to be important. To think that this is the way modern day technocrats work to support politicians who believe that rearranging over 5% of our $15 trillion economy will make us all better off!

My hope at this point is that Obama's proposal generates a storm of discussion and disagreement. It is so huge in scope, so difficult to implement, so fraught with complexity, and so swollen rich with money that the political and lobbyist vultures are already circling. Perhaps someone will question the critical assumptions behind the plan. Others will argue whether spending money on A is be better than on B. Perhaps the public will begin to comprehend the massive potential for corruption and waste that lurks beneath the surface of these plans, and react with horror as it did with HillaryCare. And maybe enough people will raise their hands and point out that taking money from one person and giving it to another is hardly likely to make a quick and lasting improvement in overall living standards. If the plan can be delayed long enough, we may discover that in the end it's not really necessary.

Friday, January 9, 2009

Ayn Rand deja vu

An alert reader brought to my attention an outstanding article in today's WSJ by Steve Moore. In it he reminds us of the many disturbing parallels between "the economic carnage caused by big government run amok" as described in Rand's novel Atlas Shrugged, and the perils of "each successive bailout plan and economic-stimulus scheme out of Washington ... Our current politicians are committing the very acts of economic lunacy that "Atlas Shrugged" parodied in 1957."

Read the article, and if you haven't read Rand's novel, by all means do. Steve reminds us that "as recently as 1991, a survey by the Library of Congress and the Book of the Month Club found that readers rated "Atlas" as the second-most influential book in their lives, behind only the Bible.

Jobs are a lagging indicator (2)

Here's a better version of the chart in my previous post. I've marked the high and low points for both equities and jobs over the past 10 years. The equity market turned down about 7 months before we saw the job losses that marked the 2001 recession. Equities then turned up about 7 months before jobs began to grow in late 2003. This past year things have unfolded much quicker, and the lag between equities and jobs turning down was only about 3 months.

Equities and jobs have fallen faster this time around, and the economy certainly looks weaker than it did in 2001. But if the lag between the bottom in equities (Nov. 20th) and improvement in jobs is again 7 months (and if Nov. was indeed the bottom in equities), then we would expect to see jobs hit bottom in the next few months and begin to turn up by mid-year. Even if jobs fell another 1-2 million in the meantime, that would still leave us short of a depression. Most recessions are policy-induced, with extremely tight monetary policy almost always the driving force behind the downturn. This recession has been essentially fear-induced; the fear of subprime-related losses, the fear of an imploding banking system, and fear of badly-managed government bailouts. It's happened all very fast, so it could easily end just as fast.

This is all highly speculative, of course, there being way too many variables to forecast with confidence. I post it mainly to show that financial markets can and do lead changes in the real economy. With significant improvement evident in key measures of the health of the corporate bond and stock markets over the past several months, with pessimism rampant, with deflation fear high despite extremely easy monetary policy, and with corporate bond and commodity prices rebounding, I don't think it is unreasonable to think that the economy is in the early stages of bottoming, and that a recovery is possible my mid-year.

Job losses were horrible, but jobs are a lagging indicator

Today's employment report was simply awful—a loss of 524K jobs according to the establishment survey, and a loss of 854K jobs according to the household survey—but it was also in line with expectations. Financial markets collapsed starting last September in anticipation of a mega-depression, and what we've seen so far is merely a nasty recession. Jobs are going to have to continue to fall at this pace for quite some time before a mega-depression sets in, but that's the fear that is making everyone sick to their stomach.

It's always tempting to project that current conditions will continue in the future, but to do so is to ignore how all the things that have happened change the dynamics of the economy going forward. Houses were terribly unattractive a few years ago, but now they are much cheaper and financing costs have dropped to new all-time lows. Surely there are many would-be homebuyers who were depressed two years ago but who are getting excited today. With cash now yielding zero and equities, corporate bonds and emerging market debt now yielding far more, investors are being offered a mighty incentive to take risk again. Banks have an almost unlimited supply of reserves to support new lending, and it's hard to believe they won't try to seek out new business; already we see significant growth in all measures of the money supply.

Financial markets are almost always the first to react to a change in the fundamentals. Large-cap stocks began falling in the second half of 2000, and job losses began showing up in April 2001. Stocks began rising in the first half of 2003, and jobs started turning up in October 2003. This chart shows a similar pattern. Stocks collapsed in October as fear gripped the financial markets. This fear spread to the general public; consumers sharply pulled back on their spending; businesses reacted by laying off workers. There's a lag of some 3-6 months between the time financial markets react to changing conditions and the time that businesses become convinced that conditions have changed enough so that they need more workers or fewer.

So it's not unreasonable at all to think that the recent improvement in financial market conditions (e.g., lower swap and credit spreads, reduced volatility, higher prices for corporate debt and equities) is a leading indicator of improved conditions in the labor market that should begin to show up in the next several months. We've already seen commodity prices turn up, and that may be the very first indicator that the economy is putting in a bottom.