Friday, October 31, 2014

Japan shakes things up

Back in early January of last year I had a post titled "The biggest news is the weaker yen." Japan had shocked the world with news that it was finally getting serious about stimulating its economy. Perhaps most important was the news that the BoJ wanted to reverse the decades-long, relentless strengthening of the yen. The perpetually strong and stronger yen was the source of Japan's deflationary slump (even though there wasn't much actual deflation). A continually rising yen was strangling Japan's manufacturers and exporters, since they were continually forced to lower their prices to compete with overseas rivals. A weaker, more reasonably-priced and more-stable yen would be a significant first step to reinvigorating Japan's economy.

Today the yen dropped significantly, returning to levels last seen about seven years ago, on news that the BoJ was redoubling its efforts to provide monetary stimulation by aggressively expanding the monetary base. The stock market responded by also jumping to levels last seen seven years ago. The tight, inverse correlation between the value of the yen and the value of the stock market confirms that the strong yen was a big problem for the Japanese economy.

According to my calculations, the yen is now back to levels that are very close to what I consider "Purchasing Power Parity" with the dollar. It's reasonably priced. It's not weak, and it's not strong. It's now a neutral, rather than a negative factor for the economy. The future of the Japanese economy looks brighter. What will really make a difference, however, is a decision by the Japanese government to also adopt genuine fiscally-stimulative measures such as lower marginal tax rates, reduced government spending, and reduced regulatory burdens.

In the meantime, the world was also shocked this morning to learn that the investment guidelines of Japan's (and the world's) biggest pension fund, which currently holds most of its $1.3 trillion in assets in very low-yielding bonds. At least half of this sum will be departing bond land in the direction of equity land, and that is a pretty aggressive move. It's a solid chunk of evidence that the world is becoming less risk averse. That's the broader and most important trend to be found in economies and stock markets around the world these days.

Thursday, October 30, 2014

$2 trillion GDP shortfall

Third quarter real GDP grew somewhat faster than expected (3.5% vs. 3.0%), and on top of the 2nd quarter's 4.6%, that gives us annualized growth of just over 4%. Wow: has economic growth really ramped up than much? I'd like to think things have improved a bit of late, but in any event it's premature to reach that conclusion—we'll need to see at least another quarter's worth of stronger growth to be sure.

Abstracting from the quarterly numbers, which are always volatile, real GDP growth over the past two years has been 2.3% annualized (see chart above). It's also been 2.3% annualized since the recovery began in mid 2009. This has been a 2.3% growth rate recovery for over 5 years. Nothing much has changed, at least so far.

As the chart above shows, this has been the weakest recovery in history. The economy is now about 10% below its long-term trend growth potential. In other words, nominal GDP today would have to be $2 trillion higher to get us back on the economy's long-term trend. Due to a variety of factors (e.g., too much income redistribution, high marginal tax rates, too many additions to regulatory burdens, Obamacare, geopolitical uncertainty, unusually strong and persistent risk aversion, the retirement of the baby boomers), we are missing out on $2 trillion of annual income and 10 million or so jobs.

This is a big deal, and this is why the electorate is upset. We've made some terrible decisions and left an awful lot of money on the table.

But I do think it's likely that the economy is gaining strength on the margin. One reason for that is the big decline in government spending relative to GDP, which has dropped from a high of 24.4% to 20.3% in the past five years (see chart above), mainly because spending has not increased at all during this recovery. Spending is taxation, so what we've seen in the past five years is a huge decline in expected tax burdens. A considerable amount of weight has been lifted from taxpayers' shoulders. The private sector now has more breathing room. The private sector is now spending a larger share of its own money, and that means that spending in aggregate will be smarter, more efficient, and more productive. (Keynesians, by the way, get this all wrong: they think the economy has suffered because the government has not spent more and because the deficit has declined—that fiscal austerity is the culprit behind weak growth.)

Meanwhile, it seems increasingly likely that the electorate next week will repudiate the current administration's policies. At the very least we are likely to see congressional gridlock, which could keep spending from growing and reduce the burden of government further. More likely, we'll seen Congress make progress on reducing our onerous corporate tax rate, which could result in more new investment and more new jobs. We might even see some much-needed reform of our absurdly distorted tax code, and some sensible, market-based reforms to healthcare.

You can already feel the policy winds shifting. Instead of headwinds, we are starting to get tailwinds. This is very good news. There is a lot of ground to make up, and a lot of upside potential if we get things right in the next few years. It pays to remain optimistic.

Wednesday, October 29, 2014

QE3 R.I.P.

Today the Federal Reserve confirmed what the bond market has been expecting for many months: QE3 has ended, effective this week. What we don't know yet, however, is whether the end of QE3 will lead to another round of economic and financial market distress like we saw after the end of QE1 and QE2. I think we'll be OK this time around, because several key indicators today look a lot healthier than they did when QE1 and QE2 ended.

But first, let me point out once again that the real purpose of QE was not to print money or stimulate growth. It was to "transmogrify" notes and bonds into T-bill substitutes (aka bank reserves). QE boils down to the Fed simply swapping bank reserves for notes and bonds. Banks have been happy to hold most of the extra reserves as "excess" reserves, which means that they didn't use their reserves to collateralize a huge increase in lending. There was a huge demand for reserves qua reserves, and QE simply satisfied that demand. Without QE there would have been a critical shortage of safe, risk-free assets, and that would have threatened financial stability.

This time around, it looks like the demand for safe assets like bank reserves has declined and there's more financial stability, which means there is no longer a need for QE. Here's a quick look at the evidence:

The chart above shows the history of QE and 10-yr Treasury yields. Most of the Fed's quantitative easing efforts were focused on longer-term Treasuries, in a professed attempt to artificially depress yields and thus stimulate lending and the economy. But as the chart demonstrates, 10-yr yields rose over the course of each episode of QE. Moreover, 10-yr yields were unchanged during the period of Operation Twist, in spite of the fact that OT placed extra emphasis on bringing down 10-yr yields by buying long bonds and selling short bonds. In short, QE never achieved its intended result. I think that's because monetary policy is incapable of artificially manipulating long-term Treasury yields. Those yields are not determined by the size of Fed bond purchases, but rather by the bond market's perception of underlying economic and inflation fundamentals. Yields rose despite QE purchases because QE addressed a fundamental problem—a shortage of risk-free assets—and thus QE improved the outlook for growth.

It may sound strange, but despite the Fed's massive purchases of notes and bonds (totaling over $3 trillion), the Fed today holds about the same percentage of outstanding Treasuries as it did 10 years ago (see chart above). To be fair, a good portion of the Fed's holdings of Treasuries prior to the Great Recession were T-bills (a little over 30%). The Fed sold almost all of its T-bills in the first half of 2008 as it tried to respond to the market's desperate desire for risk-free assets. But it wasn't enough, and that is one of the reasons the Fed decided to embark on QE1.

In any event, after all those purchases of notes and bonds, 10-yr yields today are right around the same level as they were when QE1 was first launched. As the chart also shows, the correlation between big changes in the Fed's bond holdings and the level of 10-yr yields is not what we were told to expect. Big increases in Fed bond purchases (i.e., periods in which the blue line rose) were supposed to produce big declines in yields, because lots of Fed bond buying would push bond prices up. More often than not, however, the reverse occurred (i.e., both the red and blue lines moved together).

The chart above compares the S&P 500 index to the Euro Stoxx index. Both suffered serious corrections following the (largely unexpected) end of QE1 and QE2. The market is understandably concerned that this might happen again, now that QE3 has ended. Note, however, that equity valuations are significantly better today than they were at the end of QE1 and QE2, even though the end of QE3 has been known with reasonable certainty for many months. QE1 and QE2 were never tapered, by the way, they just ended all of a sudden. In contrast, the Fed has been tapering QE3 for the past 10 months. The end of QE3 cannot be a surprise or a disappointment to anyone at this point. If anything, it's a relief to know that it's over.

The chart above compares the level of 2-yr swap spreads—excellent coincident and leading indicators of systemic risk and economic and financial market health (see longer explanation here)—in both the U.S. and the Eurozone. Note that swap spreads rose significantly in advance of the recession and declined significantly in advance of the beginning of recovery. Note that they also rose following the end of QE1 and QE2. The major source of risk in the past four years has been the Eurozone, which has struggled with sovereign default risk and a double-dip recession. Eurozone banks were desperate to shore up their balance sheets throughout, thus creating significant demand for risk-free assets. Eurozone swap spreads were already elevated—symptomatic of rising systemic risk—in the runup to both QE1 and QE2, and they widened further after they ended. U.S. swap spreads rose in sympathy with Eurozone spreads, but to a lesser degree and starting from a lower base. Today, swap spreads in both regions are comfortably within "normal" territory. This, along with higher equity prices, suggests that the end of QE3 will not be painful.

The chart above compares the price of gold to the price of 5-yr TIPS, using the inverse of their real yield as a proxy for their price. Both of these are unique types of risk-free assets. Gold, because it is a classic refuge from political and monetary risk, and TIPS, because they are protected against inflation, they pay a government guaranteed real yield, and they are relatively short-term in nature. As the chart shows, the prices of both of these risk-free assets have been declining for the past few years. In other words, the market's demand for risk-free assets is lower (and falling on the margin) than it was when QE1 and QE2 were terminated. Again, this suggests that the end of QE3 should not result in tears. The market is no longer in need of more risk-free securities.

QE3, R.I.P.

Tuesday, October 28, 2014

Climbing the latest wall of worry

As I mentioned about three weeks ago, stocks have been climbing walls of worry throughout the recovery which began some 5 ½ years ago. Almost every selloff in the past two years has been accompanied by/caused by an emotional response to new or recurring sources of uncertainty and fear. The latest wall of worry was built on a foundation of concern for the health of the Eurozone, the Chinese economy, and the spread of Ebola.

But as long as the economy avoids a recession, it is hard to keep stock prices down, especially when cash yields almost nothing and earnings are robust. If the fears aren't realized, emotions drop and prices pop back up.

Nothing says it better than the chart above. The ratio of the Vix index (a proxy for the cost of options that reduce one's equity risk) to the 10-yr Treasury yield (a proxy for the market's confidence in the health of the economy) spiked at precisely the time the equity market hit its recent lows. Since then, the Ebola crisis seems less likely to spiral out of control, the Eurozone appears to be stabilizing, and we continue to get positive readings on key economic stats here. Here are some of the latest signs of strength and expansion:

I don't usually pay much attention to the regional Fed economic activity indices, but today's release of the Richmond Fed's Manufacturing Index piqued my interest. It's normally quite volatile—which is why it should be taken with a few grains of salt—but the latest reading was the third strongest in the current business cycle expansion, and over the past 20 years it has only rarely been this strong. Something good must be going on in the Richmond area.

September capital goods orders were down a bit, but this series too is quite volatile. On a year over year basis, orders are up a solid 7.6%. Using a rolling 3-mo. average, the index is up at an annualized pace of 11% over the past six months. By just about any measure, this proxy for business investment looks healthy and strong. It hasn't yet exceeded its prior high in inflation-adjusted terms, and that's disappointing, but then again we know that the current expansion has been sub-par, and weighted down by pervasive risk aversion. The important thing to focus on is the change on the margin, and that is undeniably positive. The broader durable goods orders (ex-transportation) is up at a 6.4% annualized pace over the past six months.

The Markit survey of Eurozone manufacturing conditions in October ticked up a bit, suggesting that at the very least the region is not headed down a black hole. The Eurozone is seriously lagging the U.S. economy, but it is not collapsing.

Falling energy prices are virtually certain to make a positive contribution to growth both here and abroad. Crude oil is down almost 30% from its 2011 high, and gasoline prices at the pump (see chart above) are down by 25%. Pump prices will likely keep falling to at least $2.90/gal., according to the current price of gasoline futures. It takes energy to run an economy (consumers spend about 6% of their total consumption expenditures on energy), so when energy becomes cheaper the GDP pie tends to grow since money is freed up for other things.

UPDATE: (Oct. 31st am) The stock market has now reached a new high, completely recovering from the recent panic-driven selloff. Interestingly, the Vix/10-yr ratio is still somewhat elevated. People are still nervous about what's going on, and the 10-yr yield remains quite low, a sign that investors don't believe that Japan's surprise stimulus measures announced early today will do much to jolt the U.S. economy out of its weak-growth doldrums.

Monday, October 27, 2014

How I see things

A quick recap of how I see the current state of markets and the economy:

Inflation: Contrary to the expectations of many monetarists, including myself, inflation remains subdued. This can only mean that monetary policy has not, contrary to what most believe, been "stimulative." Inflation happens when the supply of money exceeds the demand for it; that we haven't seen higher inflation is proof that the Fed has not been printing money, as I've long argued. Quantitative Easing has been all about swapping bank reserves (T-bill substitutes) for notes and bonds. Demand for safe assets like T-bills and short-term notes has been intense, and the Fed has effectively accommodated the market's demand for safe assets. It's been a very risk-averse recovery, and had the Fed not engaged in QE, there would have been a severe shortage of the things the market has most wanted.

Growth: It's been a sub-par recovery, despite massive fiscal "stimulus." Actually, it's more correct to say that it's been a sub-par recovery because of too much government spending. Government spending, which has been dominated by transfer payments, wastes money and creates perverse incentives. It's also been a sub-par recovery because the world has been so risk-averse. Corporate profits have been abundant, but businesses have been reluctant to invest those profits due to persistent risk aversion. The U.S. economy has grown mainly because of its inherent dynamism and ability to overcome adversity, and because most people here naturally want to improve their lot in life by working harder, saving, investing, and taking risk.

The dollar: Until recently, the dollar has been very weak against virtually all currencies. This was the by-product of 1) the Fed's QE policy (which many thought would severely debase the dollar), 2) the government's massive deficit-financed spending (which increased expected tax burdens, thus depressing investment and growth), and 3) the huge increase in regulatory burdens (think Obamacare and Dodd-Frank) which have also depressed growth and investment. The dollar has improved of late because 1) the economy has done better than dismal expectations, 2) the U.S. economy is outperforming the Eurozone economy, and 3) the policy outlook is improving as elections approach and the Obama administration's agenda (which consists of a relentless effort to expand government's power and influence over the economy, which in turn dims the prospects for healthy growth) shrinks to near-nothingness.

Interest rates: It should now be abundantly clear that QE was not about lowering interest rates, and low interest rates do not stimulate growth. Interest rates have actually risen during each episode of QE. Monetary policy cannot fine-tune economic growth, and it cannot create growth out of thin air. Low interest rates may be good for borrowers, but not for lenders; in a sense, the Fed's attempts to manipulate interest rates proved to be a zero-sum game (at best). Today's low interest rates are symptomatic of the persistence of risk aversion: zero interest rates on high-quality risk-free securities reflect intense demand for those securities and that safety. In a booming economy, cash is a drag; in today's economy, cash is a refuge from uncertainty.

Equities: The stock market is not artificially inflated. Prices are up because the economy has consistently exceeded expectations, and because corporate profits are at near-record levels, both nominally and relative to GDP. The current level of PE ratios is only modestly higher than their long-term average. The earnings yield on stocks compares very favorably to the yield on corporate bonds, which is again symptomatic of a market that is risk averse.

Gold: Gold prices are still quite elevated relative to their long-term inflation-adjusted average, which I calculate to be roughly $600/oz. Gold rose because investors feared a host of potential calamities: a global financial collapse, a Middle East meltdown, and a QE-fueled explosion of inflation. Gold has fallen in recent years because those fears have been largely unrealized. Gold is still very expensive, however, because investors are still very risk averse, only somewhat less so than a few years ago. Commodity prices have tended to follow gold prices, but they are not as overextended as gold prices today.

The future: There are abundant signs that the U.S. economy continues to grow, albeit relatively slowly. This is likely to continue, and it is possible that growth could improve somewhat in the foreseeable future because: 1) government spending as a % of GDP has shrunk dramatically, thus reducing the drag of spending on growth, and 2) the policy outlook should improve in the wake of next week's elections, as policy is likely to become more business- and growth-friendly.

The Fed: Members of the FOMC are overly-impressed with their ability to "guide" the U.S. economy, and overly-concerned with the relatively low level of current inflation. Monetary policy was never meant to be an instrument for fine-tuning growth, much less creating or promoting growth. Monetary policy that is good and proper can facilitate growth, but it cannot create growth. Growth comes only from working harder, investing, and taking risk, and low interest rates do nothing in that regard. Massive changes in the way monetary policy is conducted only create uncertainty which depresses investment and growth. One key source of risk going forward is that, because of the Fed's hubris, FOMC members may fail to react in a timely fashion to signs of improving confidence and declining money demand: a failure to reverse QE in response to a decline in the demand for safe assets could result in an unwelcome abundance of money and higher inflation. At today's levels, Treasury yields offer hardly any cushion at all for this risk and are thus very unattractive. Deflation, contrary to widespread claims in the punditocracy, is not a threat to growth, and is not a black hole that captures and annihilates slow-growing economies.

All of these themes have appeared in my posts over the past 5-6 years. If anything has changed of late, it is that risk aversion appears to be on a slow decline, and the outlook for fiscal policy is improving, if only because the misguided policies of the past 5-6 years have failed so miserably. One long-enduring theme has been that the equities were likely to do well because the economy was likely to exceed expectations, which were dismal because of all the risk aversion, fears, and uncertainties that have existed.

The world doesn't change on a dime, and so many of these same themes are likely to survive for another few years at least.

Thursday, October 23, 2014

Claims collapse

On a four-week moving average basis, weekly initial claims for unemployment in April 2000 were a few thousand lower than they were last week (top chart), but compared to the size of the workforce, they have never been lower than they were last week (second chart). 

The only potentially disturbing thing about this is that recessions tend to follow lows in unemployment claims. Maybe, if things can't get much better, they are likely to get worse? I think that's a premature concern, if not an meaningless concern. Low levels of firings don't cause recessions. Low levels of firings usually happen when the economy is humming along and inflation is increasing. That—rising inflation and strong growth—is what prompts the Fed to tighten monetary policy, and tighter policy inevitably results in the economy sliding into a recession a year or so later. The current recovery stands in sharp contrast: it's the weakest on record, the Fed has never been more accommodative, and the Fed is probably years away from tightening policy by enough to strangle the economy.

Plus, one of the reasons this is a weak recovery is that the pace of hiring has been relatively tepid. If this were a normal economy we might have as many as 10 million additional jobs by now. Businesses have yet to become euphoric and over-build and over-hire. Businesses instead have been very cautious this time around, keeping their operations lean and mean and their bottom lines strong. This increases the odds that the current recovery still has years of life left. Recessions usually follow periods of over-confidence; confidence today is still relatively low, and caution is still prevalent.

With firings at very low levels, it's not surprising to see that the number of persons collecting unemployment insurance hasn't been as low as it is today for the past 14 years. In less than a year the number has dropped by more than half, from 4.65 million at the end of last year to only 2 million last week. From the all-time peak of 2010, almost 10 million people have dropped off the unemployment claims rolls in just five years.

Those are dramatic changes, especially in an era which transfer payments (unemployment insurance, welfare, food stamps, disability, medicare, social security, etc.) have risen to a new all-time nominal high ($2.5 trillion)) and a new all-time high relative to total federal spending (72%). Never have so few received government assistance for losing their job, and never have so many received so much for not working.

It's not just the weakest recovery, it's the craziest.

Wednesday, October 22, 2014

Robust construction and CRE conditions

Surely this news is not widely appreciated:

According to the American Institute of Architects (AIA), their September billings index "shows robust conditions ahead for [the] construction industry." The billings index, shown in the chart above, is registering new highs for the current business cycle. Furthermore, "the recently resurgent Institutional sector is leading to broader growth for the entire construction industry.”

According to the CoStar Group, "demand [for commercial property] continues to outstrip supply across major property types, resulting in tighter vacancy rates and continued investor interest in commercial real estate." Furthermore, "price gains in [their] equal-weighted U.S. Composite Index, which is influenced more by smaller non-core deals, accelerated to an annual rate of 13.6% in August 2014." And, "rising occupancies have bolstered net operating income across a number of markets."

The outlook for the construction and commercial real estate (CRE) sectors of the economy hasn't been this strong for many years.

This lends support to my belief that the U.S. economy is doing better than most people realize or expected. That's been the case for this entire business cycle. That's why the equity market has been moving higher even though this has been the weakest recovery in history.

Tuesday, October 21, 2014

How China could explain the decline in gold

In January, 2013, I wrote a post titled "Developments in China explain the end of gold's rise." I speculated that China's spectacular growth over the previous two decades, which included a monster accumulation of foreign exchange reserves and a significant appreciation of the yuan, could have been the driver for the the incredible rise in gold prices. I then noted the slowing in China's accumulation of forex reserves, the slowing in Chinese economic growth, and the beginnings of stabilization of its currency, and asserted that "the boom in gold is over." Shortly thereafter gold suffered a significant decline which I followed up on in a post in April, 2013: "Gold is relinking to commodities."

Here's the short version of how the link between China and gold works: the outstanding stock of gold doesn't change very fast, growing only about 3% a year. But the spectacular growth of the Chinese economy beginning in the mid-1990s created legions of newly prosperous Chinese whose demand for gold pushed gold prices to stratospheric levels. China's economic boom attracted trillions of foreign investment capital, which China's central bank was forced to purchase in order to avoid a dramatic appreciation of the yuan, and to provide solid collateral backing to the soaring money supply needed to accommodate China's spectacular growth. China's explosive growth and new-found riches were what fueled the rise in gold prices. But in recent years the bloom is off the rose.

I think these same dynamics are still in play. Chinese economic growth has definitely slowed, China's forex reserves only increased by 6% in the year ending September, the yuan is unchanged over the past year, and gold prices are down by one-third from their 2011 peak. Here are some updated charts to illustrate what's going on.

China's economy is no longer booming, but 7% growth still ranks as very impressive. China's economy is not collapsing, it's maturing. Even 7% growth is unsustainable for long periods. We ought to expect further slowing in the years to come.

The growth in China's foreign exchange reserves was exponential for many years, but now it's slowed to a trickle. Capital inflows (money wanting to invest in the China boom) have slowed, while outflows (money looking for diversification overseas and money to pay for China's growing appetite for foreign goods and services) have picked up, and the two are coming into balance. That means the BoC doesn't have to buy up capital inflows to keep the currency from appreciating. The yuan is likely to be much more stable going forward.

As it is, the real value of the yuan has appreciated by an astounding 83% in the past 20 years, despite the valiant attempts by the BoC to prevent excessive appreciation. Slower growth and more balanced capital flows mean there is no more need for currency appreciation.

A strong currency and a strong economy have enabled China to enjoy a low rate of inflation for the past 15 years or so. Happily, inflation in the U.S. and China has converged. China's economy has accommodated to its strong currency, and capital flows are coming into balance. On a PPP basis, there is very little pressure for the yuan to keep appreciating.

The spectacular rise in China's forex reserves paralleled the outsized growth of its economy and mirrored the equally spectacular rise in the price of gold. Lots of newly rich Chinese (and Indians, for that matter) were eager to acquire gold for the first time, but that demand appears now to be largely sated.

Gold is still trading well above its long-term average in real terms (I calculated that the average price of gold over the past century in today's dollars is about $650/oz.), so without the onslaught of newly rich Asian buyers its price is coming back down to more closely track those of other commodity prices.

I continue to believe that the downside risks to owning gold are much greater than the upside risks, even though I worry that central banks may inadvertently spark a round of higher inflation in the years to come (as I explained in yesterday's post). If I had to reconcile those two views, I would say that today's elevated real price of gold has effectively priced in a lot of higher inflation in the future.

Monday, October 20, 2014

Reading the bond market tea leaves

Nominal 10-yr Treasury yields have fallen from 2.6% in mid-September to as low as 1.9% last week, followed by a rise to today's 2.2%. The decline mainly reflects a moderation of inflation expectations which in turn are being driven by a 20+% decline in oil prices since June. Real yields on 5-yr TIPS—which I believe closely track the market's real GDP expectations—have gyrated in the past month or so because the bond market has been worried about the "contagion" risk that the U.S. economy faces because of slower growth in the Eurozone and Asian economies, and a "Black Swan" outbreak of Ebola. These fears have subsided of late, mainly because of no new cases of Ebola.

The chart above shows the nominal yield on 5-yr Treasuries and the real yield on 5-yr TIPS, and the difference between the two, which is the bond market's implied inflation expectation for the next five years. The bond market's current expectation for the average change in the CPI over the next five years is 1.6%, which is somewhat lower than the 1.9% long-term average 5-year inflation expectation since TIPS were introduced in 1997. But it's not even close to the deflation expectations that gripped the market towards the end of 2007. Inflation expectations are down because oil prices are down over 20% in the past three months. That has already resulted in a slowing in headline consumer price inflation: the CPI rose at an annualized rate of only 0.6% over the past three months. Meanwhile the core CPI is running just under 2%.

As the bond market sees it, inflation is going to be a little lower in the next few years than it has been in the past few years, thanks to lower energy prices. But over the next 10 years, as the chart above shows, the bond market is expecting the CPI to average 1.9%. That's somewhat lower than the 2.3% annualized rate of CPI inflation over the past 10 years, but it hardly smacks of deflation fears. We've seen levels this many times in the past. Inflation expectations appear to be "well anchored."

The chart above shows the 5-yr, 5-yr forward measure of bond market inflation expectations (i.e., what the market believes inflation will average from 2019 through 2024), which is currently about 2.3%. Note again the absence of anything suggesting deflation. This expectation is fully in line with historical experience.

Putting this all together, we find that the bond market is expecting inflation to be a little below 2% for the next several years, followed by a modest pickup to just over 2% in subsequent years. On average, the bond market sees inflation in the next 10 years being only moderately less than it has been in the past 10 years. There's nothing unusual about any of this.

What is unusual is the bond market's apparent conviction that the massive expansion of the Fed's balance sheet, which has resulted in the creation of $2.7 trillion of excess reserves in the banking system, will not result in any unusual increase in inflation. It's hard to argue with the market, but at the same time it requires a leap of faith of sorts to believe that banks will not want to greatly increase their lending activities to take better advantage of their huge holdings of excess reserves, which currently pay only 0.25% (and by so doing, create an excess of money relative to the demand for it—the classical source of higher inflation). It's theoretically possible for the Fed to increase the interest rate it pays on reserves by enough to keep banks content with holding $2.7 trillion of idle reserves, but we're all in uncharted waters on this subject.

One reason the bond market does not find it difficult to ignore the risk of rising inflation is the chronic weakness of the U.S. economy. This remains by far the weakest recovery ever. Weak growth has been strongly associated with low inflation risk ever since the invention of the Phillips Curve, which postulated that inflation was a by-product of strong resource utilization, particularly labor. High unemployment, a hallmark of recessions and weak economies, was thought to lead to low inflation, and vice versa. The Fed repeats this mantra all the time: the economy is likely to continue to have lots of slack, and that will keep downward pressure on inflation, so they probably won't have to raise rates much for a very long time.

I've preferred to view the absence of inflation as a phenomenon associated with strong risk aversion—not weak growth. Banks—and most everyone in fact— have been extremely risk averse in the current recovery. The demand for money and safe assets like bank reserves has been very strong. Banks have thus been content to accumulate excess reserves, and businesses and consumers have preferred to deleverage rather than leverage up, and banks have taken in mountains of savings deposits. But risk aversion is on the decline, and bank lending is picking up on the margin.

Confidence is picking up, but it is still well below its former peak, as the chart above shows. But if confidence continues to build, then the dynamics of the bond market and inflation could change meaningfully. Banks would feel more comfortable lending, and businesses and consumers more comfortable borrowing. Businesses might feel more comfortable expanding too. All of this would be consistent with a decline in the demand for money and safe assets at the same time as bank lending and the amount of money in the economy increase. That is how we could get to higher inflation: it only takes a return of confidence.

And confidence might turn more positive before too long. Republicans look set to take control of the Senate in a few weeks, according to the latest pricing in the Iowa Electronic Markets. As the chart above shows, the probability that Democrats lose control of the Senate has risen to 92%. It's not unreasonable to think that Congress will attempt to pass more business- and growth-friendly legislation before too long (e.g., lower and flatter tax rates for corporations, scaling back Dodd-Frank, lower marginal tax rates for individuals in exchange for fewer deductions, and market-style reforms to Obamacare). Would Obama want to take a strong stand and veto everything, even as his popularity has collapsed and faced with yet another big electoral defeat for his party? Would Democrats refuse to override his veto considering so many of them these days are trying to distance themselves from his growing list of failures? I doubt it. A friendlier tailwind from Washington would reinforce the trend to rising confidence and could push economic growth up a notch or two.

It could also push inflation higher as well, if the Fed waits too long to ratchet up short-term interest rates. Start worrying if the mood of the country improves and the Fed is slow to react.

Thursday, October 16, 2014

Still no signs of deflation

Fears of deflation are all the rage these days. Phrases like this can be found everywhere: Europe is "perilously close" to deflation, major economies face the "specter" of deflation, Eurozone "deflation threat" looms, the clear and present "danger" of deflation, the risk of deflation fuels global fears, etc.

It's completely overblown. Deflation is not like a black hole that sucks economies in once they cross the zero price change event horizon. Just because Europe's CPI increase is approaching zero doesn't mean the Eurozone economy is going to collapse or that something urgent needs to be done. Japan's problems over the years are commonly attributed to deflation, but that ignores completely the fact that Japan's fiscal policies have been abysmally bad for decades (e.g., way too much government spending). Deflation doesn't necessarily lead to recession or even slow growth. The U.S. economy boomed in the late 19th Century despite years (or actually because of) years of deflation; falling prices dramatically increased consumers' purchasing power and fueled a huge rise in living standards. Deflation is often necessary for an economy to adjust to external shocks.

In any event, although a decline in producer prices in September captured the headlines yesterday, there is no evidence at all that producer prices are falling. Producer prices are notoriously volatile from month to month, and the often decline in one month only to rise the next month. As the chart above shows, over the past year producer prices are up 2%, and they are probably trending higher at a 1.5% annual rate.

Take out falling energy prices, and you find that core producer prices—shown in the chart above—show absolutely no sign of declining.

Forget about the deflation bogeyman. Deflation is not a threat and it's not happening in any event.

Industrial production is quite strong

September gains in U.S. industrial production far surpassed expectations (+1.0% vs. +0.4%). Gains in the past year are well over 4%, which marks an acceleration relative to the first three years of the current growth cycle, when gains averaged about 3% per year. This stands in stark contrast to the emerging weakness in the Eurozone economy, where industrial production is flat to down a bit over the past year. The U.S. economy is emerging as an island of strength in a sea of slowing growth. Markets worry that the rest of the world will drag the U.S. down, but it doesn't have to be that way.

U.S. industrial production has grown by leaps and bounds compared to the Eurozone. The one bright spot in Europe is the U.K., where industrial production is up 2.5% in the year ended August. Japan's industrial production is down over 5% year to date.

Manufacturing production in the U.S. is up a solid 3.7% over the past year, and the production of business equipment is up by an even stronger 4.6%. These are real gains that point to at least a modest acceleration in overall GDP growth. This is terrific news.

By far the strongest sector of the U.S. economy is mining, shown in the first of the two charts above, which in turn is being led by the surge in crude oil production, shown in the second chart. The output of the mining sector is up over 40% since the end of 2009. This is nothing short of spectacular. Yet it's my impression that these gains have been given short shrift by most analysts. Oil and hydrocarbons in general are not favorites of the politically correct crowd—it's somehow sort of "dirty." But as Mark Perry and I've been saying for years, it's hard to over-estimate just how much the fracking revolution is impacting the overall economy.

Surging U.S. oil production, in combination with slowing growth in Asian economies, is finally working to push oil prices down. Crude prices have plunged 25% year to date! The U.S. economy is going to benefit broadly from a huge reduction in the real cost of energy, the first "lucky break" we've had since the Great Recession. Again, it's hard to underestimate the ripple effects of these very positive developments.

The only thing that poses a serious downside risk to the U.S. economy at this point is a widespread Ebola outbreak. If it weren't for that, we'd have clear sailing for the foreseeable future.

Wednesday, October 15, 2014

$3 trillion in taxes trumps Ebola risks

At a time when the Eurozone is flirting with its third recession in the past six years, the Chinese economy is slowing down measurably, and the Ebola virus has leapfrogged the Atlantic, investors are naturally nervous that the five-and-a-half-year-old equity party could be coming to an end. Fear is entering the range of panic proportions, in fact, with the Vix Index today spiking to 31 today and the 10-yr Treasury yield sinking to almost 1.85% at one point. The Vix/10-yr ratio thus attained its fourth-highest value (16.7) in history today, behind the Lehman collapse ((27), and the two Eurozone debt crises (24 and 18).

I don't pretend to be an expert on pandemic diseases, but I note that Nigeria, Africa's most populous state, located not too far from the Ebola hotspot of Liberia, has not had any new cases of Ebola in over 42 days. (HT Don Luskin) This is not necessarily the pandemic disease that promises to wipe out civilization as we know it, even though it's premature to rule out that possibility. But the mere prospect of a virus that could theoretically mutate and kill 70% of the population of the world in 2 years or less understandably has investors nervous. 

(Might I suggest that if indeed the world population were to collapse in short order, most of those who managed to survive would face bleak prospects at best; the machinery of the global economy would be effectively broken, and modern civilizations would be hard-pressed to survive. What good would it do to sell everything you own today? Investing in anticipation of the "end of the world as we know it" is a questionable exercise at best. If you are convinced we are faced with an inevitable global catastrophe, then buying plenty of guns, ammunition, food, and a private, isolated island is probably your best strategy. Nevertheless, it is worthwhile noting that the world has managed to survive quite a few end-of-the-world-as-we-know-it events: The Cold War, the Crash of '87, Y2K, AIDS, bird flu, the 2008 financial crisis, and the PIGS debt crisis.) 

In any event, the massive size and momentum of the U.S. economy is a force to be reckoned with. Despite all the world's problems, the federal government in the 12 months ended September 2014 collected just over $3 trillion in taxes, mainly because the economy managed to grow just a little over 2% a year. That's an increase in revenues of about 50%, or $1 trillion dollars, in just the past 4 ½ years. And because federal spending has not grown at all in the past five years, the federal budget deficit has collapsed from a high of $1.5 trillion to less than $0.5 trillion, from a max of 10.5% of GDP to only 2.8% of GDP. It wasn't too long ago that the world quaked at the prospect of trillion-dollar federal deficits for as far as the eye could see, yet today the federal deficit is unquestionably manageable and many years from potentially spiraling out of control due to unchecked growth in entitlement programs. 

We have managed to avoid yet another end-of-the-world-as-we-know-it event, and almost totally unexpectedly.

This is not a defense of the Obama administration. I think the good things that have happened have occurred in spite of all the mistakes that have been made (e.g., the ARRA faux-stimulus, Obamacare, Dodd-Frank). This has been the slowest recovery on record not because the government hasn't spent or stimulated enough, but because the government has spent and regulated way too much. My point is that it never pays to underestimate the U.S. economy's ability to overcome adversity. It's probably fair to say as well that one shouldn't underestimate the ability of modern science to check the spread of Ebola.

Some charts to back up the points made above: 

Federal spending has not increased at all in over five years. This is simply amazing, completely unexpected. Excellent news, also, since it means the government is shrinking relative to the economy.

The chart above documents the virtual collapse of the federal deficit. Again, completely unexpected and a cause for celebration. Keynesians have a hard time dealing with this, however, since they view big declines in budget deficits to be contractionary. Supply-siders, in contrast, view declining deficits which result from spending freezes to be a positive force, since the government is consuming fewer of the economy's scarce resources. Moreover, most of the increase in revenues has been due to an expanding tax base (e.g., higher incomes, more profits, more capital gains), not to increased tax rates. The U.S. compares very favorably to the Eurozone on this score, since, as Brian Wesbury notes in today's WSJ, Eurozone public sector spending is about half of GDP, whereas total public sector spending in the U.S. is only 36.5%.

Federal spending relative to GDP is now back to its long-term average (over the period shown in the above chart), as are revenues. Five years ago, nobody would have believed that progress like this was possible. There is now no reason to raise tax rates, another reason for cheer. Indeed, slashing and flattening tax rates (while eliminating deductions and subsidies) would likely have very powerful and positive consequences—exactly what is needed to "jump-start" the economy and get it back to its long-term trend.

The chart above is further proof that big declines in government spending relative to GDP do NOT weaken the economy.

The federal deficit has now shrunk to a size that is manageable, because—at the current level of interest rates—the burden of the federal debt (i.e., total debt relative to GDP) is no longer increasing. Even in a rising interest rate scenario, the increase in the federal debt burden would not likely prove to be exponential, given how relatively small the deficit is today.

As the chart above shows, the Obama administration has overseen the largest post-war increase in the federal debt burden of any administration in history. Thank goodness it is no longer increasing. (Red bars in the chart signify that the debt burden increased over the presidential term, while green bars signify the debt burden fell.) There is hope for the future.

Tuesday, October 14, 2014

Positive fundamentals could overcome Black Swan fears

The equity market is beset by fears, (see this post for an explanation of the above chart) but several important economic variables are in favorable territory. Money is easy, systemic risk is low, and energy prices are falling. Disaster can always strike (e.g., in the form of a Black Swan), but in its absence, the positive fundamentals are likely to carry the day.

The chart above compares the real Federal funds rate (blue line) with the slope of the Treasury yield curve (red line). What it shows is that every recession in the past 50+ years has been preceded by very tight monetary policy. Monetary policy becomes very tight as the real Federal funds rate rises to 4% or more, and the slope of the yield curve becomes flat or negative (i.e., when long-term rates are equal to or lower than short-term rates). In effect, tight money starves the economy of liquidity. Today, however, liquidity is plentiful. Banks are lending-constrained only insofar as they are risk averse—they have enough excess reserves on deposit at the Fed to sustain virtually unlimited lending. Meanwhile, bank lending to small and medium-sized businesses has been growing at double-digit rates so far this year.

Swap spreads are excellent indicators of the health of financial markets and good leading indicators of economic health. Although swap spreads have risen a bit of late, they are firmly within the range of what we would expect to see during periods of "normal" economic conditions (e.g., 20-35 bps). Swap spreads are confirming that liquidity is abundant, systemic risk is low, and the economic fundamentals are healthy. Swap spreads in the Eurozone are also down to "normal" levels, even though the Eurozone economy is distinctly weaker than the U.S. economy. All of this suggests that economic activity both here and in Europe is unlikely to deteriorate and more likely to improve over time.

The chart above compares the real price of crude oil with the real Federal funds rate. What it shows is that expensive crude oil prices and tight monetary policy can squeeze the life out of a recovery (note how the gap between the red and blue lines narrows in advance of recessions). Each of the past recessions has occurred at a time when real crude oil prices rose and monetary policy tightened. One reason the current business cycle expansion has been the weakest on record could be due to the fact that energy prices have been very high. The Fed has in effect attempted to offset expensive energy prices with cheap money, but they can only do so much. Now, cheaper energy prices and easy money may have the effect of strengthening the recovery going forward. At the very least, cheaper energy should serve to limit the downside economic risks.

Within the next few weeks, gasoline prices at the pump are likely to post a 20% decline relative to where they were at the end of June, barely four months ago. That's the message of the chart above, which compares gasoline futures prices (orange line) with the nationwide average of regular gasoline (white line).

The miracle of free markets is that prices adjust to match supply and demand. What we are seeing today is energy prices adjusting downwards in response to increasing energy supplies and weaker demand. Higher options prices (as reflected in a rising VIX index) are serving to match some investors' increasing desire for safety (because owning options limits one's downsize risk) with other investors' willingness to take on more risk. When markets are free to adjust, as they are today, this acts as a shock absorber for the real economy, and that in turn helps mitigate disruptions that arise from unexpected developments.

UPDATE: Today (Oct. 15) markets are succumbing to escalating fears, with a taste of panic. Weakness in the Eurozone and concerns about Ebola seem to be the driving factors.

A longer-term chart for perspective:

Equity markets in long-term perspective: