Employment update

The unemployment rate, now 10.2%, is just about as high as it's ever been since the Depression (see top chart). Job losses keep mounting, and so far it's another jobless recovery. In fact, jobs haven't grown at all for about 10 years. It's painful, and it's miserable. It's terribly unfortunate that the Obama administration dumped so much "stimulus" money down a black hole earlier this year, when cuts in marginal tax rates could have unleashed the power of the private sector instead of redistributing a trillion dollars from the haves to the have-nots. 

But things could be a lot worse, as the second chart shows. That's the so-called "Misery Index" that was invented in the late 1970s to capture the dual problem back then of very high unemployment and very high inflation. Today we're fortunate that inflation is still relatively low. We worry that inflation might rise in the future, but for now that remains tomorrow's problem.

Most of the changes on the margin that I see are quite positive. Despite the lack of jobs, it is still the case that the pace of job losses is slowing. We're well past the worst part of the recession and in the early stages of a recovery. Financial markets have undergone tremendous healing. The private sector has already reorganized itself to become extremely productive: the productivity of the workforce surged at an 8.1% annual pace in the six months ended September, and productivity is likely still improving. Businesses are becoming more profitable. There is plenty of cash out there. Confidence is returning. The velocity of money is picking up. Global economic activity is rebounding. It is only a matter of time before we see net job gains. It still pays to be optimistic, but one needs to be patient. 

TIPS valuation update

This comes in response to a reader's question. TIPS are a bit of a challenge to value, since they have several potentially valuable characteristics: 1) the real yield paid to the investor, 2) the future inflation adjustment paid to the investor, and 3) the change in the market price that may occur (which is determined by the change in the real yield). This chart focuses on the first characteristic, the real yield to maturity of 10-year TIPS, which is a decent proxy for where the TIPS market happens to be. (Right now, short-maturity real yields are about 1%, while long-maturity yields are 2.4%.)

The colored valuation bands on this chart are my creation. I think that on the basis of their current real yield, TIPS are not undervalued, and are actually a bit overvalued.

To step back for a minute, it is important to note that TIPS offer the only real yield that is guaranteed by the U.S. government; it is the coupon paid on TIPS whose face value is adjusted daily (prorata) for changes in the CPI two months earlier. No other security promises a guaranteed return above the rate of inflation. As such, the real yield on TIPS is extremely unlikely to rise beyond the 4-5% level, whereas the nominal yield on Treasuries can theoretically rise without limit. Why? Because the world's investors could not possibly turn down the opportunity to make a 5% guaranteed real yield for 10 years—no asset class could compete with that. Real yields could conceivably fall below zero, however, but I think that would only happen in a scenario in which inflation rose dramatically (into double digit levels) and demand for TIPS proved to be extremely strong. At that point an investor would effectively be giving up some of his inflation adjustment for the privilege of being protected against raging inflation.

As for the second characteristic, TIPS look to me to be cheap relative to Treasuries. That's because the difference between the yield on TIPS and Treasuries of similar maturity (which equates to the market's expectation of future inflation) is only a bit over 2%. The market expects the CPI to average about 2.1% over the next 10 years, whereas it averaged about 2.5% over the past 10 years. I think there's a good chance that inflation will be more than 2.5% on average going forward, so that means that the Treasury market, internally, is undervaluing TIPS. This in turn means that you should prefer TIPS to Treasuries.

As for the third characteristic, I think the likelihood of price gains relative to current prices is low. The one significant risk faced by TIPS investors today, in fact, is that their market price is likely to fall when the Fed starts tightening policy, and especially if they tighten policy sooner than expected.

To sum up, I don't think you are going to make a killing by buying TIPS today, unless inflation truly skyrockets. TIPS are best thought of as a guaranteed way to keep money safe from inflation while also earning a modest real yield. If you currently own Treasuries, you might be wise to trade them in for TIPS. If you currently hold cash as a hedge against risk in general, you might be wise to hold TIPS instead.

Weekly claims update

Claims continue to slowly decline. Weekly claims for unemployment have declined by about 23,000 per month, on average, since peaking at the end of March. If progress slows a bit going forward, as it usually does in the first year after the end of a recession, then claims might reach 400,000 per month in about six months. Coming out of the 2001 recession, that was the point at which the unemployment rate began to decline. So politicians could be very nervous for many more months, since we are not likely to see any significant improvement in the unemployment rate until the second quarter of next year at the earliest, if these trends continue.