Thursday, June 15, 2017

13 key charts say things are OK

Yesterday the FOMC raised its target short-term interest rate by a quarter point to 1.25%. This was as expected, but markets today are a little on edge. Since the rate hike came against a backdrop of a still-weak economy, a softening in inflation, and a flattening of the yield curve, there were questions: Is the Fed now too tight? Is inflation, now running at 1.5% or so, too low? Will the unwinding of the Fed's balance sheet (also announced yesterday) pose problems for the market in the future?

For now, I don't see any significant concerns.  The unwinding of the Fed's balance sheet will not likely start for several months, and it will be very gradual in the beginning, giving the Fed plenty of time for a mid-course correction should it prove problematic. Reading the bond market's entrails, I see no sign of distress, and no shortage of liquidity. Inflation has slipped modestly below 2%, but that's hardly something to lose sleep over, and it's likely due to the weakness in oil prices. Which is actually a boon for the economy, since cheaper energy makes it easier to generate growth. The world is "suffering" from a glut of oil that has been caused by a surfeit of supply, not a shortfall in demand.

If there's anything to worry about, it's that the market apparently is not very worried about anything. The implied volatility of stocks and bonds is quite low by historical standards, which means the market is reasonably certain about what it foresees. What it foresees is a continuation of what we have seen in recent years: modest economic growth of 2% or so, relatively low and reasonably stable inflation of 1.5% to 2% or so, modest growth in corporate profits, and a modest pickup in global growth.

The market is apparently unconcerned about the potential for geopolitical nightmares, such as might follow from further destabilization of the Middle East or a nuclear attack by North Korea. Few seem to worry about a failed Trump presidency, despite an unprecedented media onslaught—and it's hard to find evidence that the market is priced to a successful Trump presidency, in which tax rates are slashed and prosperity once again washes over the land.

Is the market too complacent and are valuations too high? We'll only know in the fullness of time. We've seen implied volatility remain low for extended periods without anything untoward happening. Then again, big shocks usually come at times of great complacency. About the only thing that one can say at times like this is that hiding out in the safety of cash is still relatively expensive. Cash only pays about 1% per year, at a time when the earnings yield on equities is 4.6% and 10-yr Treasuries yield less than 2.2%. Think back to the last time stocks were egregiously overvalued (late 1999/early 2000). Cash paid 5-6%, 10-yr Treasuries offered a 6.5% return, and the earnings yield on equities was only 3.5%. It was a lot easier to hide out in cash back then than it is now, but PE ratios back then were in the neighborhood of 30, whereas today they are 22. In short, it's not obvious that stocks today are overvalued, especially in the context of alternative investments.

What follows are 13 charts that illustrate key market and financial fundamentals, in no particular order, with some brief commentary on each. I want to get this out soon, because my oldest grandson is graduating from elementary school today and I don't want to miss the ceremony.

2-yr swap spreads are at very reasonable levels. This tells us that liquidity is abundant and systemic risk is low. If anything, the recent decline in swap spreads both here and abroad is a harbinger of better things to come. If the Fed were putting the squeeze on the banking system and/or the economy, these spreads would be a lot higher and rising.

As the chart above shows, there are two things that tend to happen in the bond market in advance of recessions: real yields become significantly positive, and the yield curve becomes flat or negatively-sloped. We may get there in a year or so, but for now neither of these indicators is threatening. The Fed hasn't so much tightened as it has become less loose.

Here's a closeup of the real Federal funds rate, using my estimate of the current level of inflation. Still quite low by historical standards. If you put your money in safe investments, you are probably going to lose some purchasing power. Not very exciting, nor very threatening.

The chart above shows two points on the real yield curve: overnight and 5 years. The red line is the market's expectation for where the blue line is likely to be in 5 year's time. The real yield curve has flattened, because the market doesn't expect the Fed to do much more tightening for quite awhile. The time to worry is when the bond market senses that the economy is so weak that in the future the Fed is going to have to cut rates.

Inflation expectations over the next 5 years have fallen to 1.6% or so, as evidenced by the price of 5-yr Treasuries and 5-yr TIPS.

As the chart above shows, the decline in oil prices probably explains the decline in inflation expectations. This is a good thing.

The prices of TIPS and gold have been falling on the margin, though they remain elevated. I take this to mean that the market is somewhat less willing to seek the safety of these two securities, which is another way of saying that the market is gradually losing its fear of the unknown. If the economy were really healthy, both of these prices would be a lot lower.

The decline in TIPS prices (and the rise in real yields) is the market's way of saying that it thinks real GDP growth could pick up a bit in coming years, as the chart above suggests.

Treasury yields generally track the ups and downs of inflation, but the level of yields is still relatively low compared to the current level of inflation. I take that to mean that the market is still willing to pay up for the safety of bonds. If the market were wildly optimistic and/or overvalued, Treasury yields would be much higher than the rate of inflation.

The implied volatility of both equity and bonds is historically quite low. It's not unprecedented for this to happen, and it doesn't necessarily argue for any negative surprises around the corner. Sometimes we get extended periods of relative calm like today's. If it means anything, it's that a negative shock would come as a shock to the market. If something bad happens, it's going to be bad, because the market is not expecting it. Shocking, I know.

All this chart says is that the market tends to sell off when fear and uncertainty raise their ugly heads. Nothing terrible is happening currently, according to the market, so equity prices are floating gradually higher. Shocking.

For over a decade the rate of consumer price inflation ex-energy has averaged about 2%. Currently that rate has slipped a bit from that trend, but by a very tiny amount. The decline in oil prices may be "leaking" into other prices. Terrible (not).

The TED spread (the difference between 3-mo. LIBOR and 3-mo. T-bills) today is quite normal, right around 25 bps. This means that the Fed has been successful in guiding short-term rates higher. T-bill yields are lagging the Federal funds rate by about 25 bps, while overnight bank lending rates are tracking the Fed's rate target; that's almost a textbook-perfect picture.  The Fed is not pushing on a string, and it has figured out how to push market interest rates higher without starving the banking system of liquidity (as it did in past tightening episodes, when the only way it could push rates higher was by draining bank reserves). This is good news, since it means the Fed is still in control despite never before having executed a tightening of policy in the presence of an abundance of bank reserves.

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