Wednesday, February 24, 2021

Reflation update: it continues!

The reflation theme is alive, well, and prospering. Today, Fed Chairman Powell himself told the world that.

He sees a long road to recovery, he's not concerned about rising prices, and he plans to keep short-term rates low for a long time.

And it's not just stocks that are benefiting. Here is a modest collection of charts that I'm currently tracking with interest:

Chart #1

As Chart #1 shows, copper prices are exploding to the upside even as gold prices hold relatively steady. The world is rebuilding and speculators are jumping on the commodity price bandwagon. The dollar is somewhat weak, but I think the chart tells us that a weaker dollar is not telling the whole story. Today the dollar is only slightly weaker than its average over the period of this chart, but copper prices (adjusted for inflation) are much higher than their average. Gold, by the way, is not looking good even though the world is reflating. That can only suggest that gold hit an all-time high several years ago in anticipation of what we are seeing today.

Chart #2

Chart #2 compares 10-yr Treasury yields (red line) to the ratio of copper to gold prices (a good proxy for global growth expectations). This reaffirms the view that we're in a reflation. Not only are inflation expectations rising, but industrial commodity prices are too, as is construction activity in general. 10-yr Treasury yields are up because the world is feeling a little less concerned about the economy remaining weak forever. More inflation and more growth mean higher yields, it's that simple. And yields have plenty of room on the upside (i.e., bonds are a terrible investment these days).

Chart #3

Chart #3 updates a chart I haven't featured for a long time. Given all the weakness in the economy in the past year, I was surprised to see that commercial real estate prices last December reached a new all-time high. Malls may be empty and downtown businesses and restaurants may be abandoned, but no one is giving up on the idea that we'll get back to normal before too long. Easy money, low borrowing costs, and the fact that life is not going to go dormant anytime soon all add up to the expectation that the physical side of the economy is going to be picking up for the foreseeable future. SPG (Simon Property Group) has more than doubled since early November. 

Chart #4

Chart #4 is a perennial classic that shows how equities are performing relative to gold prices. Typically, equities underperform in times of hardship and outperform in times of plenty. This ratio has a ways to go before it returns to the 5-handle highs last seen in 2000. 

Chart #5

Chart #5 is also a long-time favorite that I haven't featured in awhile. As I see it, the equity market tends to lead truck tonnage (a proxy for the health of the physical economy). Equities are effectively pricing in a full recovery and the eventual attainment of new all-time highs for GDP. This may worry the bears, however, but I would argue that the economy won't be at serious risk of a downturn until the Fed tightens by a ton, the yield curve flattens, and real yields rise significantly. And we're a long ways from those things happening.

This is not to say, however, that I see real GDP growth averaging more than 2% per year in the years to come. Things are definitely improving right now, but I think one's enthusiasm should not go unchecked. The policies favored by the Biden administration are not going to optimize economic health or maximize economic growth. And a multi-trillion dollar "stimulus" plan is going to do just the opposite of stimulating the economy. I'm hoping that clearer head prevail in Congress. Beware economic "stimulus" plans: they never work and they usually just make things worse. The government simply cannot spend money more efficiently than letting people spend their own money.

Chart #6

Chart #6 shows the makeup of inflation expectations that are priced into the bond market. Inflation is expected to average almost 2.5% per year for the next 5 years. We've seen something like this before, but nothing much worse than that. (I think we'll end up seeing worse.) Note especially the extremely low level of real yields (blue line). This can mean two things: 1) the market expects economic growth to be sluggish for the foreseeable future and that means low real yields in general, and/or 2) since TIPS are the safest and surest way to protect against inflation (TIPS pay a coupon equal to their real yield plus the rate of CPI inflation), and since the Fed is pledging to keep short-term rates very low for a long time, the Fed is effectively putting an artificially low cap on the level of all real yields, which forces investors to pay artificially high prices—and receive artificially low real yields in exchange—for inflation hedges. I'm inclined to think that both forces are working at present.

Chart #7

Chart #7 has been featured regularly for a long time. The market's level of fear (red line) is elevated but not excessively so, which allows equity prices to drift irregularly higher, hitting air pockets of panic along the way. Over the 3+ year period shown in the chart, an investment in the S&P 500 has produced an annualized total return of about 15% per year (including reinvested dividends). Not bad, considering all the air pockets and potholes along the way! 

Of course that also suggests that one should keep their hopes for the future from running wild. Stocks can't go up like this forever. 

UPDATE: (Feb 25th) As Chart #8 shows, capital goods orders (the precursor of future productivity gains and thus an excellent leading indicator of economic growth) have surged in recent months, far exceeding expectations and breaking out of a prolonged slump. This is perhaps the most optimistic chart in my basket.

Chart #8


Benjamin Cole said...

Another great wrap-up by Scott Grannis.

However I think Grannis is beginning to lie about his age, which is forgivable.

"Inflation is expected to average almost 2.5% per year for the next 5 years. We've seen something like this before, but nothing much worse than that"--SG

Right, I don't remember disco either.

Andrew said...

30 year TIPs, which had been negative for months have risen sharply and within the last week turned slightly positive.

Previous to this year, they had never been much below 0.25%.

Roy said...

"copper prices are exploding to the upside even as gold prices hold relatively steady. The world is rebuilding and speculators are jumping on the commodity price bandwagon. The dollar is somewhat weak, but I think the chart tells us that a weaker dollar is not telling the whole story."

Indeed. There's one country that consumes about 50% of global copper supply. This is following significant regulation to support supply-side. The USA only consumes a small part of the global copper supply.

It's also true for various other commodities.

Then, there's a feedback loop, where the rising prices beget rising prices due to everyone expecting higher inflation.

"And a multi-trillion dollar "stimulus" plan is going to do just the opposite of stimulating the economy."

I guess you see that that way because you are ideologically strictly supply-side (regardless of circumstances.)

Well, it might make you happy to hear that Biden is also working on the supply-side, with executive action taken today. Look it up.

"The government simply cannot spend money more efficiently than letting people spend their own money."

People don't have money (due to money flowing to external supply and various distorted local regulations) --> government gives people money --> people spend money --> real economy grows including supporting external supply.

I think that 100% we will see good, real growth, the question is about the value of the USD.

randalltee said...

"The government simply cannot spend money more efficiently than letting people spend their own money." -SG

So true and Wesbury would be proud!

Salmo Truttra said...

Reflation or inflation? I think the latter. During the U.S. Golden Era in Capitalism (which was not optimized as there were 2 recessions, Aug 1957–April 1958 and Apr 1960–Feb 1961 ), the annual compounded rate of increase in our means-of-payment money supply was about 2 PER CENT. And during this same period, 1955-1964, the rate of inflation, based on the Consumer Price Index, increased at an annual rate of 1.4 PER CENT. Unemployment averaged 5.4 PER CENT.

The fact is that during the U.S. Golden Era in Capitalism private-sector debt dominated, while public sector debt, *real net Federal debt* remained absolutely unchanged. The economy was financed in 2/3 by an increase in savings that was invested (or by velocity). Today, almost all economic activity is diametrically opposed, i.e., financed by new money.

From 1954-1966, the 12-year annualized rate-of-change in R-gDp was 5.5% (the real output of goods and services).

Things ended in 1965. That's when the commercial banks, DFIs, began to outbid the non-banks, NBFIs, for loan-funds (resulting in disintermediation of the thrifts).
That's when William McChesney Martin Jr. re-established stair-step case functioning (and cascading), interest rate pegs (like during WWII), thereby abandoned the FOMC’s net free, or net borrowed, reserve targeting position approach in favor of the Federal Funds “bracket racket”.

I.e., the Fed once again, began targeting interest rates and accommodating the banksters and their customers whenever the banks saw an advantage in expanding loans, thereby usurping the Fed's "open market power" (in 1955 rhetoric, refilling the “punch-bowl”, at first coinciding with the rise in chronic monetary inflation and in anticipated inflation and stagflation, and eventually and inevitably secular strangulation).

Scott Grannis said...

Re 30-yr TIPS real yield: It has indeed jumped recently, but going back in history we see it was much, much higher than it is today. In 2001 it was 3.5%; from 2006 through 2009 it was 2.0%; from 2014-2018 it was 1.0%; today it is a mere 0.2%. This speaks to a significant secular slowdown in real economic growth in the U.S. The market is having trouble seeing much if any economic growth on the long-term horizon. Quite pessimistic.

steve said...

Wow, rising bond yields AND falling stock prices. NOT good. There's about a 50/50 chance this could be the start of a legit bear market. Buy the dip, sell or just hold'm? Virtually the one year anniversary of my selling my entire mortgage portfolio only to buy back a month later. May do the same soon...

Ataraxia said...

Rising bond yields due to inflation expectations only? Hope not.

Scott Grannis said...

Re rising yields and inflation expectations: Today (Feb 25) both nominal and real yields rose by about the same about, which means that inflation expectations were unchanged. Thus the rise in yields is due to improving expectations for the US economy's health. That's good. It should be a problem for the stock market. What we are seeing is probably a temporary, knee-jerk reaction to higher yields, which have often been bad for the economy. That's not a problem right now. Higher yields are actually a healthy development if they keep the stock market from becoming overly-confident.

Scott Grannis said...

meant to say (above) that "It should not be a problem for the stock market"

Scott Grannis said...

Re Benjamin Cole's comment earlier. My comment carried with it the assumption that we were only considering the period of time covered by the chart., and not the inflationary 1970s and early 80s. I was there and I remember it vividly.

Ataraxia said...

Thanks so much for clarifying Scott. It will be interesting to see if this time rising yields are durable and accompany a healthy dose of growth (or at least growth) + inflation.

Scott Grannis said...

Re Benjamin Cole's comment earlier. My comment carried with it the assumption that we were only considering the period of time covered by the chart., and not the inflationary 1970s and early 80s. I was there and I remember it vividly.

Benjamin Cole said...

Scott Grannis knows disco.

One interesting aspect of the late 1970s-early 1980s has been that (older) US economists have forever been a predicting a return to that era's inflation rates.

I would like to return to that era too, but for reasons that have to do with mirror balls and the Bee Gees.

A little inflation would be a small price indeed.

K T Cat said...

A couple of us know disco. :-)

It looks different to me this time. We never had $1.9T, 5,000 page stimulus bills before to go along with $30T in government debt. This is wartime spending without the war. It might be interesting to compare it with 1944 instead of 1978.

What concerns me is not just the $15 minimum wage, which probably won't make it through, but whatever else might in those 5,000 pages. You could hide quite a bit of economic engineering in there.

El Gringo said...

I agree that - looking at yield curve - we are a ways off from a recession, but where we are at on that truck tonnage chart sure does look like 2006.

Grechster said...

Scott, I'd love to get your take on something that I've been watching for a while and that was written up in a WSJ article today: Breakevens are in backwardation. That is, five year breakevens are higher than tens or thirties.

I would think this hints at the idea that talk of Weimar are quite misplaced. But I'd love to get your take.

HDX said...

Paul Singer of Elliot Capital Management joined a growing list of hedge fund managers (many of whom are long time democratic party donors) in saying that Biden's $1.9 trillion pork spending will invariably lead to rampant INFLATION.

I would add (not sure if Singer agrees) that it is a supreme a$$h-le move to send billions of USA taxpayer money to transvestites in Afghanistan (that is not a joke), while denying money to restaurants in the USA that were closed by illegal covid edicts from governors like Cuomo and Newsome.... when Cuomo wasn't killing elderly in nursing homes.

The USA acts like a banana republic, we have socialists "running" things, are legal system has become a means to attack political opponents while ignoring illegal activity by the party in power, and we spend like socialists... same garbage in, same garbage out.

Biden has also managed to anger Saudi Arabia and Israel, both at the same time. The Egyptians remember that cluster f#ck speech by Obama and the Muslim Brotherhood -- they already don't trust Biden. And lets not forget the Obama regime killed its own ambassador to Libya so they could steal Qaddafi's weapons and ship them to "moderate" terrorists in Syria.

Biden also managed to alienate the pipe-fitters union by unilaterally canceling the XL pipeline to benefit Warren Buffett's train cars. Welders and pipefitters have more layoffs to come, as Biden also wants to cut off lending to shale oil companies... capping USA energy independence while p!ssing off the Saudis at the same time.

All this chaos and destruction in less than 30 days. Makes me long for the idiot who just tweeted dumb stuff but didn't go through with it.

John said...

According to a Reuters poll of economists, there is major support for the $1.9 trillion stimulus, given the circumstances and low borrowing costs.

Grechster said...

There a many compelling signs that would undermine the "runaway inflation" thesis...

1) Gold is not rising. In fact, it just made an eleven month low.
2) Breakevens on ten year bonds are lower than breakevens on fives.
3) While the yield curve has steepened, the 10-30 has flattened.
4) Velocity remains in the tank. It's hard to get significant inflation if this doesn't go up. And while that could change, the Fed retains a major regulator on it as it has the ability to raise rates on IOER thereby mitigating a dangerous increase in inflation.

Yields could well move up from here. I just don't see runaway inflation.

Grechster said...

Oops. Gold only made an 8.5 month low. Point still holds, though.

Benjamin Cole said...

I never liked gold as an indicator, is it seems to require an astrologer to make predictions on price movements.

By the way, if you own the currency known as Bitcoin, the world is in rapid deflation. Bitcoin is a currency backed by nothing. Nothing!

So what makes lumps of metal, or Bitcoin, or an Andy Warhol painting, valuable?

By the way, silver was a monetary metal long before gold. But people no longer rhapsodize about silver.

HDX said...

It is some seriously flawed circular logic to acknowledge the Fed is manipulating Treasury note prices (and yields) keeping interest rates across the curve artificially low -- and then to cite those same manipulated rates as "proof" that inflation is somehow subdued.

Market interest rates may or may not tell us something. Fed manipulated interest rates tell us the Fed is manipulating interest rates, and that is all they say.

Johnny Bee Dawg said...

Fed cant control rates "all along the curve", and they never could. Market prices are still the best information we have.
They can do a decent job of controlling short rates, but once short rates IN THE MARKET start rising, the Fed will follow. When they get out of sync with market signals, bad things happen. Fed always follows, not leads. Almost everyone disagrees with that.

"Breakevens on 10 year bonds are lower than breakevens on 5 year bonds"....IMO, that indicates RE-flation from artificial COVID disruptions rather than IN-flation worries from monetary policy. For now. That is how I am playing it, anyway, until proven wrong by markets.

Im fine with RE-flation, and can make money in that. So far, Im not reading the market configurations outlined in Scott's post as IN-flation indicators. Yet.
Everybody is calling for inflation, so we shall see if it pans out. "Everybody" is usually not right.

With the new socialist policies piling up, we could end up fighting DEflation again after COVID disruptions are gone.
Nobody is predicting that.

10% stock correction could get everybody's minds right again!

Johnny Bee Dawg said...

BTW, great observations above by Benjamin Cole RE: Bitcoin, Gold, silver and Warhol!

Non-rich buddy of mine has an entire series of young Warhol drawings he bought decades ago for very little money. VERY little.
Its astounding what he is offered now.

Speaking of Warhol....I used to like that "Andy Warhol" Bowie song on Hunky Dory.
As I recall, David Bowie issued over $50 million in bonds that paid interest based on future royalties of his catalog.
David was a pioneer of a unique type of "inflation adjusted" bonds. I may be off, but I think he did that about the same time TIPS began.
Bowie and investors both profited.
Pretty clever. He used the upfront money to buy the rest of his song rights and his net worth improved a lot.

randy said...

"So what makes lumps of metal, or Bitcoin, or an Andy Warhol painting, valuable?"

Greater fools.

I was sorry to hear an advertisement recently targeting retail / small investors for some kind of vehicle for "investing" in "art". Leaches.

I'm a so-so fan of Warhol. It's interesting stuff, iconic even. But like most post-modern art - it's pretty easy for the mind to wonder if decent middle school-ers artwork could easily be passed off as some meaningful work. But, Warhol was creative and an innovator.

The Warhol museum in Pittsburgh is certainly worthy. I was most drawn to his photography - particularly the celebrities. The photos really seemed to capture something.

The art that blows me away is early 20th century Americans - George Bellows, Edward Hopper, William Glackens...

Johnny Bee Dawg said...

Jay Powell, with his near perfect record of smashing markets, today, just with the sound of his voice!

I hope Surbhi Sharma will be able to weigh in.

Fred said...

All he said was that inflation might pick up temporarily. What is he supposed to say?: "There will never be inflation and we will forever be in a deflationary death spiral no matter how much money we print or spend." If what he said today is enough to tank the market we are in worse shape than I thought.