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Commodity update





Here are two more charts to add to my commodity reflation recap post on Wednesday. The first chart is the Journal of Commerce index of 18 industrial commodities; the second chart is the textile subset of this same index. I think it's quite interesting that textile prices—hardly the stuff (cotton, burlap, and polyester) one might think would be the subject of commodity speculators—are at a new all-time high. This bolsters my view that the rally in commodity prices is a good indicator of global growth, and of growth that belies the cautious growth forecasts that I'm seeing from most sources. Accommodative monetary policies are also playing a role, but for now it would appear to be a secondary role.

Note: I've reindexed the values of both indices so their Nov. '01 values are equal to 100. I chose that date because that was when the great commodity price rally of the 2000s began.

Exports still looking strong



Here's an updated version of a chart I've been showing for awhile, which suggests that outbound container shipments from the ports of Los Angeles and Long Beach are a good leading indicator for U.S. goods exports. The most recent news shows that container shipments are still going strong. Mark Perry has a related post, in which he notes that "Container counts at the LA Port have increased in six out of the last eight months, and reached the highest total level since last November."

Bill yields return to zero



Yields on 3-mo. T-bills have gone to zero, once again. The last time this happened was in December of last year. At that time, the world was in full panic mode, with markets braced for a double-deep depression and years of deflation. The stock market was about 20% lower than it is today, credit and swap spreads were on the moon, the Vix index was almost double what it is today, and 10-yr Treasury yields were approaching 2%.

So now that the signs of panic have receded hugely, why are bill yields again approaching zero? It could be year-end pressures, as portfolio managers unwind risky positions and build up cash so their year-end statements reflect some prudence. Or it could be that, as I've mentioned in recent posts on TIPS, the market is capitulating to the idea that the Fed is going to keep the funds rate near zero all throughout the coming year. Alternatively, it could be that the prospect of the Fed being on hold for a prolonged period is awakening inflation expectations; if you're a bond manager afraid that bond yields may be rising in the future, you'll want to sell bonds and park the money in cash and TIPS. The facts seem to support this last explanation best, since the yield curve is unusually steep and breakeven inflation expectations have risen meaningfully as bill yields have collapsed.

So I'm tempted to say that the best explanation for why bills are trading near zero is that the bond market is feeling very uncomfortable with the idea of one more year of zero rates from the Fed. I sympathize with that feeling, since I find it very hard to believe that the Fed will actually deliver on its promise to keep rates at zero for a very long time. I see too many positive developments in the economy on the margin, and I see too many signs of rising inflation pressures on the margin. I think the Fed could and should raise rates much sooner than most people suspect.

In any event, bill yields approaching zero are one way the market has of telling you to watch out for surprises that could be lurking behind the next corner.

TIPS valuation update (2)



This post is a follow up to my post yesterday on TIPS valuations. The purpose of this chart is to show that real yields on TIPS are largely determined/driven by changing expectations for Fed monetary policy. The red line represents the real yield on 5-year TIPS, and the blue line is the market's one-year forward expectation for 3-mo. Libor (as determined by the fourth eurodollar futures contract), minus the current year over year change in the Core PCE deflator. Thus the blue line is a proxy for what the market expects the real Fed funds rate to be in one year.

It is expectations of future Fed tightening or easing that drive TIPS yields, and the logic is simple. If you expect the Fed to be reducing the real Fed funds rate in the future, then your desire to own TIPS increases, because an easier monetary policy increases the risk of rising inflation, and thus increases the demand for TIPS. In the past month or so, the market has sharply reduced its expectation of where the Fed funds rate will be at the end of next year, and this has almost exactly corresponded to a sharp decline in the yield on TIPS. At the same time (though not shown on this chart) the market's 5-year, 5-year forward expectation of inflation has risen sharply. It all ties together.

As a thought experiment, assume that the Fed were to raise the funds rate unexpectedly tomorrow. This would likely cause the market to shift upwards its expectation for the level of the funds rate in one year. According to my model, that would in turn result in a sharp increase in the yield on TIPS, as well as a decline in the market's breakeven inflation expectations. The implications for the Treasury market would be a rise in both nominal and real yields, but with real yields rising more than nominal yields.

Commodity reflation recap

As this collection of charts shows, there's an awful lot of upward price action out there in the world. Two things can explain this: a global revival of demand, and a global monetary reflation. Most importantly, the information revealed by these real-time, market-determined prices is directly contradictory to the pervasive concerns about the durability and breadth of the current recovery and the effectiveness of monetary policy. All of these charts reflect prices as of today or yesterday, and they are all at or very near their highs for the year, and not very far from reattaining their previous all-time highs that were set last year.












Bond market volatility returns to "normal" levels



This chart highlights the attainment of yet another "milestone" in the market's recovery from last year's panic recession. This is the MOVE index as calculated by Merrill Lynch: a weighted average of the implied volatilities of 1-month options on 2, 5, 10, and 30-year Treasuries. The implied volatility of the bond market has now subsided to levels not seen since 2007, and it is even lower today than its average since 1990. (The Vix index of implied equity volatility is still above its lows of 2008, in contrast.)

Skeptics would be quick to note that today's low bond market volatility owes much to the Fed's insistence on keeping short-term interest rates low for a long time. Yet they have been saying much the same thing for the balance of this year, and that did not keep bond market volatility from skyrocketing.

When I combine today's relatively low level of bond market volatility with the observation that the market's expectation for 3-mo. Libor at the end of next year has fallen from 1.77% to 1.2% in just the past month, and that credit spreads remain well above normal levels, I conclude that the bond market has finally capitulated to the Fed's way of seeing things. That view of the world says that a) the economy is going to be very sluggish and could easily slip into at least a mild recession within the next year or so, and b) inflation is going to remain relatively low.

Since the bond market belongs to the same capital market in which equities reside and trade, it is hard to escape the corollary to the above conclusion: stocks are nowhere near "bubble" territory and in fact are still cheap if one believes that the economy can grow at some reasonable rate (3-4% being quite modest given the depth of the latest recession) and avoid another recession.

TIPS valuation update



TIPS continue to rise in price (which is shown in this chart as a decline in their real yield to maturity), as demand for their inflation protection increases. This has been the salient feature of the bond market since the beginning of last month: real yields have declined across the board, and they have declined relative to nominal yields of comparable maturity.



This rise in inflation concerns is a somewhat belated response to the revival in inflation itself, as this second chart shows. The year over year decline in the CPI which started late last year, and has dominated the headlines, has masked the 2.7% annualized rise in the index for the year to date, and the 3.5% annualized rise over the past six months. Inflation is alive and well, despite the enormous amount of "slack" in the economy that, according to the Fed's inflation model, should be producing active deflation by now.

The inflation implied by the difference between real yields on TIPS and the nominal yield on Treasuries has risen significantly from its low of late last year (when the market expected CPI inflation to average almost zero over the next 10 years), to now 2.2% over the next 10 years. The 5-year, 5-year forward inflation expectation has risen from 0.7% to 2.7% over the course of this year. By either of these measures, however, TIPS are still priced to future inflation being equal to or less than what it has been so far this year, and well within the range of where it has been in the past 5 or 10 years. In other words, the bond market has not yet begun to price in any increase in inflation beyond the ordinary, despite the enormous expansion of the Fed's balance sheet in the past year, and the Fed's repeated assurances that they will keep short-term interest rates very low for a very long time.

So, while the first chart suggests that TIPS on a standalone basis are relatively expensive at current levels of real yields, they are a risk/reward bargain compared to Treasuries.

Global equity recovery continues



Good news like this just doesn't get enough attention. The capitalization of global equity markets has risen 78% from the lows of last March, and now stands at $45.6 trillion. We've filled a huge valuation hole that was precipitated by the collapse of Lehman last year, and the next step is to get things back closer to where they were before the financial panic of last year. I remain confident we'll get there.

Industrial production and commodity prices








Supply-siders try whenever possible to look at market-based indicators of what is happening in the real world, rather than indicators that come from government statistics offices. Government statistics can be misleading, they can lag reality by months, they can be revised after the fact, and they can be subject to distortions and incorrect adjustments. Market-based indicators, however, are real-time, and they reflect the combined actions and wisdom of hundreds of millions of people all over the world. If I want to know what is happening today, on the margin, I would always prefer to look to market prices rather than government statistics.

So these two charts are quite different in that the top chart comes from government offices whereas the bottom chart comes from the market. But as I think should be evident, they tell approximately the same story. The top chart shows the path of industrial production in most of the industrialized world, while the bottom chart shows an index of spot industrial commodities. The message: stronger production tends to correlate with higher prices and vice versa. Both prices and production are rising on the margin, so this reflects a positive picture of growth around the world.

The differences in these charts are also instructive. Note that industrial production has fallen so severely, even despite this year's rebound, that is has effectively wiped out most or all of the gains of the past 10 years. Yet commodity prices have almost doubled over the past 10 years. I take this to be a sign that accommodative monetary policy has been an important source of commodity price gains, and that is a portent of price inflation that could find its way into prices throughout the global economy in coming years.


The other message of these charts is that all central banks are probably guilty of pursuing overly-accommodative monetary policies. All currencies have lost significant value relative to gold and commodity prices in recent years. Rising commodity prices are telling us that the global economy is rebounding and that inflationary pressures are percolating. It's past time that central banks started taking their feet off the monetary accelerator, particularly the Fed, since the dollar has fallen much more than other currencies.

It's not as bad as you think



While recovering from what was most likely a case of the H1N1 virus (which wasn't as bad as I had feared), I've spent some time with good friend and fellow supply-sider Brian Wesbury's new book It's Not as Bad as You Think. He and I share an innate optimism regarding the future of the U.S. economy, even though we both agree that fiscal and monetary policies present serious headwinds to progress. Our optimism is driven by a belief that capitalism, free markets, and people's desire to better their lot in life add up to a force that can drive progress in spite of the roadblocks set up by misguided politicians and policymakers. His book is well laid out and easy to get through, and he brings a lot of common sense to bear on all the problems leading up to last year's panic recession, and how things are likely to sort themselves out going forward. I should add that he also does a terrific job of explaining the key differences between how supply-siders view the world and how most of the other economists in the world (the Keynesians) do. It's a refreshing antidote to what you see in the press these days.

Dollar approaches critical levels





The dollar continues to trade lower, and is now only a few percentage points above its all-time lows against other currencies, both nominally and in inflation-adjusted terms, as shown in these two charts above.

Bernanke's speech this morning provided no comfort for dollar bulls, since once again he all but guaranteed that monetary policy would extraordinarily accommodative for a long time, while also remaining relatively downbeat on the prospects for the U.S. economy. He promised the dollar would remain a strong currency, however, and he noted that the Fed was watching the dollar's value, but he utterly failed to say how the dollar might rise from all-time lows to a level that might be considered strong. He also failed to comment on the significance of gold reaching another all-time high of $1140/oz., and what that says about the dollar's value and the Fed's stewardship of the currency.

A dispassionate observer would undoubtedly conclude from all this that the fundamentals couldn't be much worse for the dollar than they are today: weak economic growth prospects, astoundingly profligate fiscal policy, massively accommodative monetary policy, and an almost total absence of any official concern for the value of the dollar. But the same observer would also note that the dollar's value today is largely consistent with these fundamentals.

So where does that leave us? When the fundamentals are awful and the pricing is awful, then awful things must happen, otherwise the market is going to have to rethink its position. I think that as the dollar approaches its all-time lows the situation is increasingly ripe for some big shocks to consensus thinking. Perhaps the economy isn't as weak as everyone seems to think. Perhaps the Fed won't have to keep short-term rates at zero for another year.

Meanwhile, dollar weakness continues to go hand in hand with equity market strength, as this chart, which I have been showing repeatedly, shows. My theory for why a weak dollar is good for the stock market is that the dollar's weakness is a reflection of a rebound in money velocity, and that in turn is fueling an expansion of economic activity worldwide. There is at least one silver lining to the dollar's otherwise miserable condition.