Thursday, July 31, 2014

The 2.1% recovery gives us 2.5% yields

We now know that the big negative GDP number in the first quarter wasn't the beginning of another recession (I didn't think so). Turns out it was a combination of bad weather and the vagaries of GDP accounting; sometimes those things just happen, and then they are reversed. As we learned yesterday, the first quarter's growth was revised to -2.1%, and the second quarter came in at 4%. For the past five years, the economy has grown at a 2.1% annualized pace, and that's pretty close to what we saw in the first half of this year after all the dust had settled. Ho-hum, not very exciting, and it still looks like the economy is moving forward at about a 2-2½% pace. Things aren't likely to get much better until fiscal policy becomes more growth-friendly. The one thing that could make things worse is the situation in Ukraine; European stocks have taken a 6% hit, and the Euro is 4% off its recent highs. The Vix index has jumped from 10.3 early this month to today's 16.7. The markets are nervous, so equities are down. But the fundamentals have not deteriorated, and there are still plenty of signs of growth, albeit of the modest variety.

The graph above shows the year over year real GDP growth of the U.S. economy. It's averaged only slightly more than 2% in the past five years, comparing poorly to the prior expansion, and especially poorly to the heady growth of the 1980s and 1990s.

This graph shows the 2-yr annualized growth rate, which smooths things out a bit and makes it easier to see how the current recovery pales in comparison to prior recoveries.

As the graphs above show, quarterly growth rates have been quite volatile in recent years, even though the economy has been plodding along in unspectacular fashion on average.

The graph above shows inflation as measured by the GDP deflator, the broadest and most comprehensive measure of inflation. It's been hugging 2% or so per year for the past two decades. Importantly, there is no sign of any dangerous flirting with deflation.

The graph above compares real yields on 5-yr TIPS to the 2-yr annualized growth rate of the economy. The two should normally move together, since the economy's growth potential is an important determinant of real yields, and the real yield on TIPS is the risk-free real yield that all other real yields should be compared to. With real yields on TIPS still in negative territory, it sends a message, I think, that the market expects real economic growth to be somewhere in the neighborhood of 0-1% for the foreseeable future. In other words, the current level of risk-free real yields is indicative of a market that is priced to a very pessimistic growth outlook. Compare today's yields to those that prevailed in the late 1990s, when real growth was a solid 4-5% and the bulls were in charge.

The graph above shows that over time the 2-yr Treasury yield tends to closely mirror nominal GDP growth. But in the past decade it hasn't, especially in the past 4-5 years. 2-yr Treasury yields are equivalent to the market's forecast for the average Fed funds rate over the next 2 years. The market has been very bearish on the economy's prospects, and willing to accept at face value the Fed's promise to keep short-term rates very low for the foreseeable future because the economy really needs help; that's why 2-yr yields have been so low for so long.

Short-term real interest rates are as low as they are because the market holds little hope for any meaningful economic growth. Nominal yields carry an inflation premium on top of real yields that is very much in line with what inflation has been for the past 15 years or so. There is no sign in the above graph of any Fed-induced distortion of interest rates. If the Fed were truly pumping massive amounts of liquidity into the economy, there would be plenty of evidence in the bond market of inflation fears and higher interest rates. But there's not, and the Fed isn't.

Ditto for 10-yr nominal and real yields. Long-term inflation expectations are very much in line with the past 15 years' experience. The bond market is not worried that the Fed will make an inflation mistake as it unwinds QE. Neither is the bond market worried about deflation. The main reason nominal yields are as low as they are today is the market's pessimistic expectations for real economic growth. Growth is expected to be low and boring for the foreseeable future, much as it has been for the past 5 years. That is why 10-yr yields are 2.5% and 2-yr yields are 0.55%.

Whether the market is right to expect growth to be low and boring, and inflation to be relatively low and stable, is the question that investors need to ask themselves.

I'm not worried about weaker growth, and although I expect somewhat stronger growth in the future, I doubt it will happen unless and until we get some relief on the fiscal policy front: lower and flatter taxes (especially a lower corporate tax rate!), and less burdensome regulation. The runup to the November elections should shed some light on this.


Anonymous said...

I think it is funny that on a 4% growth GDP report the Dow drops 300 points.

The Q1 GDP report was purposely knocked down so it could be purposely knocked back up so the Obama media can crow about how great Obama's economic policies are starting the run up of the mid-term elections.

The first estimate of Q3 is right before the election. It is guaranteed to be 5 to 6%. The BEA is staffed by the same people as the IRS. It reminds me of the Soviet Union. Everyone in government was one party. And they don't have to be told from the top what to manipulate because they already know.

Ari Hermansyah said...
This comment has been removed by a blog administrator. said...

Scott, Regarding inflation, I read this research report from the Dallas Fed. I wanted to elicit your thoughts.

Inflation Is Not Always and Everywhere a Monetary Phenomenon by Antonella Tutino and Carlos E.J.M. Zarazaga

I didn't want to attach it to your tribute article to Milton Friedman.

Scott Grannis said...

Here we have the Dallas Fed attempting to throw cold water on Milton Friedman's theory of inflation, but I'm not convinced at all they are right.

Friedman's theory is straightforward: inflation happens when the supply of money exceeds the demand for it.

What the Dallas Fed failed to address is the obvious fact that the demand for money (in this case the demand for bank reserves) has been exceedingly strong from day one of QE. The huge increase in the supply of money was met with a similar increase in the demand for money, and that explains why we have had no inflation.

Meanwhile, fiscal policy since day one of QE has been all over the map: huge increases in deficit-financed spending followed by a huge decline in relative terms of spending relative to GDP. Debt relative to GDP has soared, and this must have reduced the public's confidence in the ability of the federal government to make good on its promises.