Monday, January 11, 2010

Reading the bond market tea leaves

This chart compares the real Fed funds rate (using the Core PCE deflator as a measure of inflation to minimize the distortions of volatile energy prices) with the slope of the yield curve (using the spread between 1-year and 10-year Treasury yields). Note that these two series tend to move in opposite directions, and in lockstep. The easier the Fed gets, the steeper the yield curve gets, and vice versa. The yield curve is at an all-time steep because the Fed has almost never been easier. A steep yield curve is the market's way of saying that sooner or later the Fed will have to raise short-term rates by a lot.

The real Fed funds rate is a decent proxy for how easy or tight monetary policy is. High real rates are a sign of tight monetary policy, while low real rates signal easy policy. When interest rates are very high relative to inflation, it becomes very expensive to borrow and speculate. High real rates therefore increase the public's demand for money (rising money demand equates to a reduced desire to borrow), and this tends to make money scarce relative to goods and services. That in turn tends to depress the price of goods and services, which is another way of saying that tight money tends to reduce inflation. When real rates get very high, they can be the catalyst for a recession, since the economy becomes effectively starved for liquidity. Note that every recession in this chart was preceeded by at least a year or two of very high real rates. Similarly, every recovery was kicked off by a huge decline in real rates.

Short-term interest rates are clearly low enough in both real and nominal terms to kick off a recovery. This chart tells us there is no reason at all to expect the economy to face any difficulties in the foreseeable future. Instead, there is every reason to expect both a recovery and rising inflation.

Current monetary policy is about as easy as it has ever been; policy was easier only briefly in the mid-1970s. Easy money in the 1970s was what gave us rising inflation, but it wasn't all that bad for growth—contrary to popular perceptions—since the economy grew at a rate (3.3% per year from Mar. '70 to Mar. '80) that was actually faster than what we have experienced over the past 30 years (2.7% per year).

Monetary conditions today are designed specifically to reduce the public's demand for money, since it was an explosion of money demand in late 2008 (for precautionary purposes) that brought the U.S. economy to its knees. By paying essentially a zero rate on overnight money, the Fed wants people to feel free to borrow (i.e., to be short) as much money as they want. Reduced demand for money makes money more abundant relative to goods and services, and that tends to increase the price of goods and services. Thus, the Fed is trying very hard to counter the price-depressing excess capacity that exists in the economy by making money abundant. Recovery skeptics would do well to consider that the Fed has the unique capacity of always, eventually, getting what it wants.

While there are indeed many prices that are soft these days, all the evidence I see suggests that inflation is slowly rising despite all the supposed slack that exists in the economy. Consider: housing prices on average have been rising since last March, commodity prices are soaring, gold is soaring, and the dollar has fallen and is very weak (meaning all prices outside the U.S. are up). Inflation expectations, not surprisingly, are up as well: they were essentially zero at the end of 2008, and the 5-year, 5-year forward inflation expectation built into TIPS prices is now almost 3%.

The steepness of the yield curve is a good proxy for several things: economic growth, inflation, and the future of Fed policy. Today the curve is steeper than it has ever been. At 0.94%, today's 2-year Treasury yield is the market's best guess for what the Fed funds rate will average over the next two years. The eurodollar futures market tells us that the consensus expectation for 3-mo. Libor at the end of this year is 1.2%, which is consistent with a Fed funds rate of about 0.9%, and that is also consistent with what Fed funds futures are telling us. So the Fed is expected to raise short term rates a little bit this year, and just a little bit more next year (to just over 2%). This will happen only if the economy remains very weak and inflation remains very subdued.

I see a potential disconnect here. On the one hand the market is priced to a Fed response that only makes sense if economic growth is dismal (i.e., 2% or less) and inflation is very low (2% or less). Yet the Fed is virtually as easy today as it was in the 1970s, when we had plenty of inflation as a result and the economy managed to post pretty decent growth.

This brings me back to the message of credit and swap spreads, which I have addressed many times in the past. Although spreads have contracted significantly, they are still at levels which are consistent with dismal economic conditions.

So again I say that I see no signs in this market of exuberance or excessive optimism. I see a market that is terrified that growth is going to falter. I see a Fed and a bond market that share an abiding faith that a weak economy will prevent an eruption of inflation. I see virtually no sign (except in the steepness of the yield curve) that the economy has any chance of growing by a significant amount (say, 3-4% or more).

Bottom line: if you think there is a decent chance that the economy can grow by 3-4% or more (which would only equate to a very tepid recovery given the depth of the recent recession), then you need to be long risk assets and short Treasury bonds, since the market does not share your optimism in the slightest.