Friday, November 30, 2018

The yield curve is not forecasting a recession

By now, most anyone who keeps up with financial matters knows that a flat or inverted Treasury yield curve is a good predictor of an impending recession. I've blogged extensively on this subject for almost 10 years. Recently, a few industrious pundits have found evidence that the front end of the Treasury curve is "close to flat." While it's hard to argue with their facts, an almost-flat curve is not the same as a flat or inverted curve. The latter occur only when the market looks into the future and sees good evidence that the Fed will no longer tighten policy and will very likely ease policy at some point. We're not there yet.

Here's a quick recap of where the yield curve stands:

Chart #1

Chart #1 shows us what the market has thought the target Fed funds rate will be in December of next year. One year ago, on the left end of the chart, the Fed funds futures market expected the funds rate to be 2.0% by December '19; it now expects the funds rate will be 2.7% by December of next year. That is essentially equivalent to two more Fed tightenings, from the current 2.25% to 2.75%. Currently the market does not expect the Fed to do anything more beyond December '19. "Two more rate hikes and the Fed is done" is the current meme. That implies that the economy is quite likely to continue growing for the foreseeable future, but not at a very impressive (nor worrisome) pace. Note that expectations for the future target rate have dropped by almost one tightening in past few weeks, and that in turn has been driven by news suggesting the economy is proving a bit weaker than previously thought. 

In any event, it's hard to get worried about a mere 50 bps increase in short-term interest rates for the foreseeable future.

Chart #2

Chart #2 looks at the front end of the real (inflation-adjusted) yield curve. This is arguably the only yield curve that really matters; real interest rates are the true measure of the cost of borrowing, not nominal rates. The blue line is the real Fed funds rate (the target funds rate (2.25%) less the year over year rate of inflation according to the Core PCE Deflator (1.8%), the Fed's preferred measure of inflation. The red line is the real yield on 5-yr TIPS (Treasury Inflation-Protected Securities), which can also be thought of as the market's forecast for what the real Fed funds rate will average over the next 5 years. This measure of the yield curve is still positively-sloped. Note that it has been inverted (i.e., when the blue line exceeds the red line) prior to the past two recessions. We're not there yet. This chart tells us that the market fully expects the Fed to tighten monetary policy further (by increasing the real funds rate), but not by much.

Chart #3

Chart #3 shows the most common and generally most-favored measure of the yield curve: the difference between 2-yr and 10-yr Treasury yields. The top portion shows the history of these two yields, while the bottom portion shows the difference between the two (i.e., the slope). Note first that the 2-10 slope quite often becomes flat or almost flat, and it does so sometimes many years in advance of recessions. It's almost flat now (20 bps), but that's hardly unusual during a period in which the Fed is raising interest rates.

Chart #4

Chart #4 effectively zooms in on Chart #3, showing the behavior of these yields and their spread over the past year. Note that this portion of the curve was actually a tiny bit flatter back in August than it is today.

Chart #5

Chart #5 is where things get more interesting. This shows the difference between 10- and 30-yr Treasury yields. This portion of the yield curve has been steepening since last July. Inversions in this portion of the curve have been reliable predictors of recessions, but we're definitely not there yet. To judge by this chart, a recession, if one is in the cards, might not occur for at least several years. And to judge by Charts #3 and #5, what is going on today in the yield curve is similar to what happened in the mid-1990s. Back then the economy was in the early innings of what would prove to be a very strong growth phase, which was followed by a mild recession in 2001.

In any event, it's possible, and likely, that good news on the global trade front could alter the bond market's expectations rather dramatically, resulting in a steeper yield curve and ultimately a stronger economy. 

Thursday, November 29, 2018

Steady as she goes

Fed Chairman Powell yesterday made it clear that Fed policy is not a threat to the economy or to the market. He's not on the rate-hiking warpath, and he's not worried that the economy, which is growing nicely, is in danger of overheating. Not surprisingly, markets breathed a sigh of relief. The economic and financial market fundamentals are healthy, and the market's recent spate of worries are just that: worries.

Yesterday's release of the second estimate of Q3/18 GDP growth was largely unchanged from the first (+3.5%). If there's anything disappointing in the news, it's that the economy is not stronger, given that corporate profits are very strong. According to the latest NIPA data, after-tax corporate profits rose 19% in the year ending Sept. '18. According to GAAP (reported) profits, earnings per share for the S&P 500 rose over 22% in the year ending Oct. '18. Fabulous profits, indeed, but business investment remains moderate, and that is a big reason the economy is not stronger.

Trump has managed to reduce tax and regulatory burdens in impressive fashion, but his tweets and his tariff threats have created unnecessary distractions and unfortunate uncertainties, not to mention higher prices for an array of imported consumer goods. He's made America better, but not Great. Getting past the threat of trade wars, especially with China, will be the key to unlocking the future growth potential of the US economy, which remains Yuge. All eyes will be watching for the results of Trump's meeting with Xi in Buenos Aires later this week.

Chart #1

Thanks to plotting real GDP on a semi-log scale, Chart #1 makes it easy to see that the ongoing economic expansion has been the weakest in history. For many decades the economy averaged 3.1% annual rates of growth. But since the Great Recession ended in mid-2009, the economy has averaged only 2.3% annualized growth. Things have picked up a bit of late: in the year ending last September, growth was 3%. A decade of sub-par growth has created a potential GDP "gap" of at least $3.2 trillion. In the past year alone, the US economy has missed out on over $3 trillion in income—which averages out to over $20,000 per worker—that could have been earned if the economy had kept up with its previous trend.

Chart #2 

Chart #2 compares the 2-yr annualized growth rate of GDP with the real yield on 5-yr TIPS. There's a strong tendency for real yields to track the growth rate of the economy. Real yields began to rise just after the November '16 election, from -0.4% to 1% today. The outlook for the economy has improved, but we're still looking at moderate rates of growth in the 2.5-3% range. To get excited we'll need to see growth rates of 3-4%, and real yields of 2% or better. I remain optimistic that this will occur, but we aren't there yet. More confidence and more investment are what's needed, and a lower-tariff solution to our mounting China angst would be a wonderful tonic in that regard.

Chart #3

Chart #3 shows real gross private domestic investment. Like GDP, investment has been rising at a sub-par rate for the past decade. We need to see a lot more investment for the economy to get exciting. Chart #18 in my previous post shows a proxy for business investment—capital goods orders. They've been very unimpressive by historic standards. We've seen some nice improvement since late 2016, but this needs to continue.

Chart #4

Chart #5

Chart #6

Chart #4 compares after-tax corporate profits to nominal GDP, and Chart #5 shows the same profits as a percent of GDP going back 60 years. Corporate profits these days are close to their strongest levels ever relative to the economy, roughly 50% higher than their long-term average. Is it any wonder that the PE ratio of the S&P 500 (18.76 today, according to Bloomberg) is higher than average (16.85)? (see Chart #6)

Chart #7

If there is any message in the charts #4-6, it's that the market doesn't believe all this good news will last—despite record-level profits, valuations are only moderately above average. Chart #7 shows the risk premium that investors demand to hold stocks instead of risk-free 10-yr Treasuries. If PE ratios remained at today's level (18.75), and if corporations paid out all their profits in the form of dividends, then the dividend yield on stocks would be the inverse of the PE ratio: 5.33%. Yet if this were certain to persist, then only a fool would pass up stocks in favor of lower-yielding Treasuries. Instead, investors apparently figure that the corporate profits are likely to decline meaningfully relative to GDP. I made this same point three years ago and also seven years ago.

Chart #8

Chart #8 is one of my favorite recession-watch charts. Every recession has been preceded by a significant tightening of monetary policy, and that tightening can be measured by 1) a relatively high real Fed funds rate (2-3%), and 2) a flat or inverted Treasury yield curve. Currently the real funds rate is a bit less than 0.5%, and the yield curve remains positively sloped. Neither are threatening a recession, and neither is the Powell Fed. (I should note that the recent increase in the real funds rate is mainly the by-product of a decline in the PCE Core inflation rate.)

Chart #9

Finally, Chart #9 updates one of my favorites. 

Thursday, November 22, 2018

Still looking like a panic attack

A little over 3 weeks ago I opined that the the big October decline in US equity prices still looked like a panic attack. Shortly thereafter, equity prices climbed over 6%, but have once again returned to their late-October lows. I haven't made further comments because I didn't see that anything had changed. I'll comment now, but it still looks like a panic attack. Key economic and financial fundamentals remain healthy, but fear still dominates the landscape. One new development is the very recent 24% plunge in AAPL, driven by fears that demand for new iPhones is much weaker than previously thought. This has led many observers to theorize that global demand in general may be flagging, increasing the risk of a global recession that might spread to the US. To be sure, equity markets in Europe and Japan have dropped around 10% since late-October, but Chinese equities, surprisingly, have actually picked up a bit of late. It's not an easy diagnosis, but a global or even a US-only recession is far from an inevitable conclusion.

What follows is a recap of the same charts I featured October 29th, plus a few extras:

Chart #1

As Chart #1 shows, market selloffs are typically accompanied by a rise in the market's fear and uncertainty. (The ratio I use to capture that is the Vix index divided by the 10-yr Treasury yield. The former is a direct measure of fear and also a measure of how expensive options are, while the latter is a proxy for the market's confidence in the outlook for the economy; higher yields typically reflect more confidence, while lower yields reflect uncertainty about the future.) It's worth noting that the "worry" level these days is significantly less than it has been at other times in the past several years, even though the market's response has been of similar magnitude.

Chart #2

Chart #2 shows the level of 2-yr swap spreads in the US and in the Eurozone. Swap spreads are excellent coincident and leading indicators of systemic risk and financial market liquidity. At today's levels, swap spreads tell us that liquidity in the US is abundant and systemic risk is low. The Eurozone isn't quite as healthy, however, since it struggles with Brexit and the Italian budget outlook, among other things such as generally sluggish growth.

Chart #3

Chart #4

Chart #3 shows the level of real and nominal 5-yr Treasury yields and the difference between the two, which is the market's expected annual inflation rate over the next 5 years. Inflation expectations today are very close to the Fed's 2% target. They have dipped a bit in the past week or so, and Chart #4 suggests that the reason is simply a sharp drop in oil prices. We have seen this pattern quite a few times in recent years. Today's 1.8% forward-looking inflation expectation is nothing to worry about. Indeed, it tells the Fed that there is no pressing need to tighten monetary policy, and that should be a source of comfort to the market. Indeed, in the past two weeks the bond market has priced out one Fed tightening, and now expects only two rate hikes (from 2.25% currently to 2.75%) by the end of next year, with no more rate hikes after that.

I note that gold has been flat for the past 5 years, and the dollar is only 4% above its 5-yr average. Neither suggest that the Fed today is too tight or too loose. The Fed is not likely the main source of the market's concerns.

Chart #5

Chart #5 compares the value of the dollar, relative to other major currencies, to an index of industrial metals prices. Note that there is tendency for these two variables to move inversely—a stronger dollar tends to coincide with weaker commodity prices and vice versa. The "gap" between the dollar's current level, which is on the strong side, and commodity prices, which are still relatively strong, suggests that the global economy is still healthy (i.e., demand for commodities is still relatively strong despite the relatively strong dollar). This runs directly counter to the current meme which holds that the global economy is slowing down meaningfully. 

Chart #6

Chart #6 shows 5-yr Credit Default Swap Spreads. These are highly liquid and generic indicators of the market's confidence in the outlook for corporate profits—wider spreads equate to more concern, tighter spreads to less concern. These spreads have increased somewhat as equities have experienced a sharp correction. But they are still relatively low from an historical perspective. This further suggests the market is still reasonably confident in the outlook for corporate profits and the health of the economy, despite all the concerns floating around.

Chart #7

Chart #8

Charts #7 and #8 show various measures of corporate credit spreads. Spreads in the energy sector have been hit the worst, due to the recent decline in oil prices, but the damage is nothing compared to what happened when oil prices collapsed from $110/bbl in mid-2014 to $30/bbl in early 2016. The recent decline has brought oil prices back to where they were a year ago. This is not a major problem.

Chart #9

Chart #10

Chart #9 shows Bloomberg's measure of the S&P 500's PE ratio, which uses trailing 12-month profits from continuing operations. Since January of this year PE ratios have plunged rom 23.3 to now 18.1 (-22%). This reflects a rather sudden loss of confidence in the long-term outlook, especially considering that profits continue to rise, and are in fact up 22% versus November 2017, as Chart #10 shows. Curiously, the bond market appears to be much more confident about the future than the stock market (given that credit spreads are up only modestly, whereas equities have suffered a significant correction). This further suggests the equity market may just be in the throes of a panic attack. Looked at from the positive side, the recent decline in PE ratios has made the market that much more attractive.

Chart #11

Chart #11 shows the equity premium of the S&P 500 relative to the 10-yr Treasury yield. The current earnings yield of the S&P 500 is 5.5%, whereas the current 10-yr Treasury yield is only 3.1%. That investors are apparently indifferent to an equity yield that is more than 200 bps higher than the risk-free yield on Treasuries suggests that the market doesn't have much confidence in the outlook for earnings. Risk aversion has been an important part of the market's behavior in the current business cycle expansion, and it hasn't gone away even as economic growth has picked up of late. Consider how optimistic the market was back in the 1980s, when the equity risk premium was solidly negative for many years. It's been solidly positive for most if not all of the current expansion. Selling equities in favor of bonds today means giving up yield, so sellers must have the courage of their convictions.

Chart #12

Chart #12 compares the real Fed funds rate (a good measure of how loose or tight monetary policy is) with the slope of the Treasury yield curve. Recessions have always been preceded by a substantial tightening of monetary policy and a flattening or inversion of the yield curve. We're a long way from those two conditions today. Neither of these variables have changed meaningfully since late October. Real short-term yields are still very low, and the yield curves still positively-sloped. 

Chart #13

Chart #14

Chart #13 compares the value of the Chinese yuan with the level of China's foreign exchange reserves. The yuan rose relentlessly from 1994 to 2013, despite the central bank's repeated interventions (i.e., buying dollars and selling yuan) to keep it from strengthening even further. But since then the yuan has been under pressure, and the central bank has had to sell foreign currency (any buy yuan) to keep it from declining further. This represents a sea change in the outlook for the Chinese economy. Before 2014 it was a magnet for capital, whereas now capital is fleeing the country. Still, capital flight has not been severe; the central bank has "lost" only about $1 trillion of its once $4 trillion in forex reserves.

As Chart #14 shows, the real value of the yuan vis a vis the world's currencies is still much stronger than it was throughout most of China's modern past. But on the margin it has been weak for several years now, and China's economic growth rate has slowed from 12% in 2010 to now only 6.5%. The bloom is off the Chinese rose, and if recent trends continue, China's economy could prove to be the world's weakest link.

Chart #15

Chart #15 shows how incredibly weak the Chinese equity market has been relative to the US equity market since China first entered the developed-country world in 1995. Chinese equities have suffered significantly more this year than any other developed countries' equity markets. This once again makes the point that China is the country that is hurting the most. If China doesn't find a way to deal with President Trump, what's bad for China could prove to be bad for everyone. I continue to believe that a deal is possible, since it would be in everyone's best interests to have lower tariffs and more respect for international property rights.

Chart #16

Chart #16 compares the US and Eurozone equity markets. The US has been outperforming Europe for the past decade, and to a sizable degree.  

The global winds are at our back, but that doesn't mean we can ignore local headwinds. The following charts highlight some areas of weakness in the US economy that bear watching.

Chart #17

As Chart #17 shows, there has been a remarkable tendency for the physical volume of goods transported by US trucks and the level of the S&P 500 stock index. As the economy grows, so do equity prices. Truck tonnage was weak in the third quarter, and that appeared to foreshadow the October-November weakness in the stock market. But the latest reading of the Truck Tonnage index shows a significant 2.2% increase. On the surface, this would suggest that the economy is entering the boom phase that supply-siders have been looking for ever since Trump's impressive reduction in corporate tax rates. But it's also possible that trucks these days are scurrying around trying to deliver a flood of imports that were purchased in the hopes of avoiding increased tariffs scheduled for January.

Chart #18

Chart #18 shows the real and nominal level of capital goods orders, which in turn are a good proxy for business investment. By this measure business investment has increased by an impressive 16% since the November 2016 election. But investment has gone relatively flat in recent months, and it is far from impressive by historical standards. This could and should be better. What are companies doing with all their new-found profits? Buybacks are one answer, but they are still only a fraction of the current market value of US equities and thus not a satisfying answer. 

Chart #19

Finally, Chart #19 shows how the wind has been knocked out of the residential construction industry in recent months. Most disturbing is the big decline in homebuilders' sentiment last month. We know that rising prices and higher mortgage rates have made housing much less affordable. But the current level of new housing starts is still far below its 2006 peak, and still below the level required to replace aging structures and accommodate new families. I've argued that this adds up to a pause or consolidation, not the beginning of another crash. Why can't prices stop rising or decline a bit, without that leading to the wholesale collapse of everything like what we saw in 2006-2008? Why can't the relatively strong economy continue to boost incomes and drive demand for more housing? Household leverage today is far below the levels that preceded the Great Recession, and mortgages are not being extended on ridiculous terms as they were back then. Still, it remains the case that what's bad for housing tends to be bad for the economy.

The horizon is not empty of threats, but the worst one (China) can be avoided or seriously mitigated by a trade "deal" that is in everyone's best interests. Free trade is a wondrous tonic for global growth, and free trade benefits all parties, contrary to what Trump's clueless Peter Navarro happens to think. All we need is for clearer heads to prevail. How hard is that?