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Claims continue to improve

Weekly claims for unemployment continue to decline, and at a fairly impressive pace. This is undeniable evidence of ongoing improvement in the economy. It's something to cheer tonight as we toast the end of a bad year. It was a dreadful year for the millions of people who lost their jobs. But it ended up being a whole lot less bad than the great majority of people imagined it would be. That's the good news.

A V-shaped recovery for inflation expectations

The green line in the top chart is the market's breakeven inflation rate for TIPS, and it's pretty clear that the action in the last year has described a classic V-shaped recovery (in inflation expectations). One year ago the TIPS market was priced to zero inflation, now it's priced to inflation of almost 2.5%, which was the prevailing level prior to last year's financial crisis. To get to this point, Treasury yields have surged, while the real yields on TIPS have plunged. If the economy continues to improve and the Fed continues to drag its feet on whether to tighten or not, we can expect to see more of the same in the coming year: rising Treasury yields and flat to lower TIPS yields. More interesting, perhaps, is that a continuation of this past year's trends will quickly lead us to uncharted inflation-expectations territory.

I've said many times here that the bond market is not a very good predictor of inflation, mainly because there are many times in the past when the bond market has been very slow to figure out the implications of the Fed's monetary policy. But it is true that the bond market sooner or later does figure things out, if only belatedly. I think we're seeing another instance of that right now.

The second chart looks at the valuation of TIPS on a stand-alone basis, irrespective of what the market's inflation expectations are. Here we seen that TIPS have recovered some value of late, thanks to a modest rise in real yields, but they are still somewhat expensive by my estimation.

What this all means is that the market is figuring out that monetary policy has an inflationary bias. As a result, people are much more willing to buy TIPS than Treasuries. People are willing to pay a premium, if you will, for the inflation protection you get with TIPS. Bernanke & Co. should be following this development very closely. If I could get close to one of the Fed governors, I bet I would see a bit of sweat forming on his brow.

Higher interest rates are not a big concern

In my predictions for 2010 I say that 10-year Treasury yields should rise significantly, ending up higher than 4.5% by the end of next year. Predicting sharply higher bond yields brings with it a prediction of higher mortgage rates, and that apparently makes a lot of folks very nervous about the housing market. I post this updated chart of mortgage rates to calm those fears. Even if 10-yr T-bond yields rose to 5%, that would probably result in 30-yr fixed mortgage rates of about 6.75% (conforming) and 7% or so (jumbo). In the great scheme of things, these are not very scary, and would amount to simply rolling back the clock to the late 1990s, when the housing boom was already underway.

It's also important to note that we won't be seeing 5% Treasury yields until and unless the economy is doing appreciably better, and/or inflation is picking up. More inflation and stronger growth would imply higher incomes, and that, despite higher interest rates, would combine to keep housing more affordable for most folks than it has been for a long time. Higher rates would also give an impetus to buyers sitting on the fence: "buy now before rates go higher."

Other folks worry that banks aren't lending. It certainly looks more difficult to get a loan today than it was just a few years ago. But at the same time, the Fed has already provided the banks with all they could possibly need to ramp up lending. In time they undoubtedly will, since the spread between banks' cost of funds and what they can charge consumers is huge, and the yield curve is very steep. Moreover, I'm not willing to underestimate the ability of this country's finance whizzes to figure out new ways of lending. We're in a period of great creative destruction, and innovation is more likely than stagnation at times like these.

Is Fed tightening a threat to growth? No. Interest rates are ridiculously low right now. So low, in fact, that they make a lot of people nervous about the future: How will the Fed exit its quantitative easing strategy; how high might inflation go; what if China stops buying our debt? These concerns weigh heavily on the dollar, which is very close to its all-time lows. That in turn makes global investors think twice about putting their money to work in the U.S. The uncertainty surrounding monetary policy and the problems this poses for investment is a major headwind for the economy right now. Markets would be much happier, and growth fundamentals much stronger, if the Fed were to surprise people by snugging up monetary policy tomorrow. Doing the right thing is always better than continuing to make a mistake.

So I'm not worried about higher interest rates. In fact, I welcome them and hope they come sooner rather than later. No economy that I'm aware of has ever been able to fool its way to stronger growth and higher living standards by debasing its currency.

Chicago PMI -- another V-sign

The Chicago Purchasing Managers' Index has risen rather dramatically this past year, joining the rapidly growing list of signs and symptoms of a V-shaped recovery. I've been arguing for a long time that this recovery would be V-shaped, that once the financial markets got back on their feet and confidence started returning, the recovery would feed on itself--a virtuous cycle, if you will.

It's very hard to derail a process such as this. I know that the recovery skeptics point to all sorts of dreadful things that await us as the housing market experiences another wave of defaults and commercial real estate struggles with high vacancy rates and its own wave of defaults, and as the nation struggles with high unemployment and trillion-dollar deficits. But all of those become less dreadful if the underlying economy is picking up. And in any event, defaults don't kill growth, they merely transfer wealth. Housing price declines don't kill growth either; rather, they allow new owners to buy a home they otherwise couldn't afford. High unemployment doesn't kill growth, it is a manifestation of slow or weak growth: an effect, not a cause. Deficits don't kill growth either, but they do slow down the recovery since they are caused mainly by massive government transfer payments which don't produce much in the way of productive activity, if any.

Predictions for 2010

Following the tradition I started one year ago, in which my predictions for 2009 proved amazingly accurate, here’s what I think will happen to the economy and the markets in 2010. Caveat: last year’s accuracy provides no assurance whatsoever that this year’s predictions will be accurate or profitable.

Inflation: Inflation hit a low ebb one year ago, and has been trending slowly higher since. I think inflation will continue to trend slowly higher, because all of the key leading indicators of inflation are still saying that monetary policy is accommodative: the dollar is weak, gold is strong, the yield curve is very steep, commodities are strong, breakeven inflation rates on TIPS are rising, and credit spreads are declining. I don’t see significant inflation on the horizon, but I do believe that inflation will exceed the breakeven expectations implied in the pricing of TIPS, which are currently in the neighborhood of 2-2.5%.

Growth: Thanks to a return to more normal financial market conditions, an abundance of signs that economic fundamentals are improving on the margin, and the growing pushback that is emerging against Obama’s hard-left agenda (an important development that has helped the market for most of this year), I believe the economy will grow 3-4% over the course of the year. While this represents an above-average growth rate from an historical perspective, it will be a distinctly sub-par recovery given the depth of the recession which ended about six months ago. I think the main reason for sub-par performance will be the misguided and bloated Keynesian stimulus policies enacted earlier this year, coupled with a significant increase in government regulatory burdens and government spending (mostly in the form of transfer payments), and huge federal borrowing requirements. (Not surprisingly, this puts me at odds with most Keynesian forecasters, who generally believe that the winding down of stimulus spending will cause the economy to slump in the second half of the year. Where they see slower stimulus spending hurting the economy, I see stimulus spending acting all along as a obstacle to recovery.) If the economy manages to exceed 3-4% growth, it will likely be due to the fact that corporations and individuals have a strong incentive to accelerate the receipt of income this coming year, in order to avoid the higher tax rates that are slated to take effect at the beginning of 2011.

Fed: The market currently expects the Fed to begin raising short-term interest rates in June, and the current year-end expected Fed Funds rate is approximately 1.0%. Given my relatively optimistic outlook for the economy, and my belief that inflation is likely to trend higher, I think the Fed will end up raising rates sooner and/or somewhat more aggressively than the market currently expects.

Housing: Residential construction activity is likely to slowly but gradually improve over the course of the year. Housing prices on average are likely to post modest gains as well, thanks to improving economic activity, rising incomes, relatively low interest rates, and accommodative monetary policy. Prices could dip briefly as a result of increased foreclosure activity in the first half, but this should prove to be only a temporary setback. Rising mortgage rates, since they will still be relatively low from an historical perspective, should do more to encourage a "buy it now" mentality than to discourage would-be buyers who will see that in many areas homes are more affordable than ever.

Interest rates: Interest rates on Treasury bills, notes and bonds should rise significantly over the course of the year, with 10-yr T-bond yields exceeding 4.5%. The impetus for higher rates will be a stronger-than-expected economy, and higher-than-expected inflation. Higher rates will not threaten the recovery, however, since they will occur largely as a result of the recovery. Moreover, even though I see the Fed tightening sooner than expected, I nevertheless expect them to be “behind the curve” throughout the year, much as occurred with monetary policy in the 1970s (i.e., the Fed will wait too long to raise rates and is unlikely to raise them by enough to quickly dampen inflation pressures). There is very little risk that Fed policy will be anywhere near tight enough next year to threaten the economy.

MBS spreads: Since the Fed plans to cease its purchases of MBS by March, this could push MBS spreads wider over the next few months. Regardless, MBS spreads are likely to widen over the course of the year. The main impetus for wider MBS spreads next year is likely to come from an across-the-board increase in the extension risk of MBS as Treasury yields rise.

Credit spreads: Credit spreads are likely to decline gradually over the course of the year. Easy money and a strengthening economy add up to a perfect environment for spread tightening. Easy money that leads to higher inflation and improved cash flows is a boon to borrowers, especially the most indebted ones, and that means lenders will be rewarded by lower than expected default rates. High-yield bonds and emerging market debt should be the biggest beneficiaries of tighter spreads.

Equities: Equity prices are likely to experience a few dips along the way, but they should be at least 10-20% higher by the end of the year. The onset of Fed tightening may provoke a temporary selloff, but in the end a Fed tightening is just what the economy and the markets really need to build confidence in the dollar and in the future of the economy. The main impetus to higher equity prices will be an improving economy and improving corporate profits.

Commodities: Commodity prices will continue to work their way higher over the course of the year, buoyed by an ongoing improvement in global growth conditions and accommodative monetary policy.

Gold: Gold prices are likely to spike one more time to a new high this coming year. Gold speculators will be encouraged to see that the Fed is “behind the curve” and reluctant to tighten boldly and aggressively. However, gold is a highly speculative investment at these levels, and not for the faint of heart. In the long run, gold's downside potential now greatly exceeds its upside potential.

The dollar is near enough to its all-time lows, both in nominal and in real terms, that it is likely to rise at least modestly against most major currencies, and it should be able to hold near its current levels against most emerging market and commodity currencies. The dollar will find support from Fed tightening, and from the growing realization that the economy is getting stronger despite all the concerns about the disturbing trends in fiscal policy and the ongoing defaults in the residential and commercial real estate markets.

Purely anecdotal—but impressive nonetheless (2)

About two months ago I posted some very optimistic comments from a friend who runs a well-known construction and remodelling business in the Inland Empire, and who had seen an impressive upturn in new business in recent months. Now comes this from my son who has been working in a store in the heart of Waikiki Beach for the past several years. He's been very down on the state of business for well over a year, but suddenly things have improved:

Just wanted to let you know that the past week has been amazing out here in Waikiki. Tons of people from all over the world (Japan, Australia, South America, Canadians, and strangely, Americans) have been spending $ as if it were burning a hole in their pockets. We haven't seen it like this in two years, maybe three. Sales have quadrupled. People are saying that it should continue at least through mid- January. It's amazing.

Commodities still going strong

A quick look at commodity prices says that the growth story is still strong. These two indices of industrial commodity prices today are both at new highs for the year. This is undoubtedly a reflection of an ongoing and significant rebound in global activity. As such, it supports an optimistic view of the future of U.S. growth prospects. Last year was a horrible year, but with action like this, the memory is fading fast.

Fear, uncertainty and doubt are way down

This chart plots the implied volatility of equity and T-bond options, and thus is a good proxy for the level of fear, uncertainty and doubt (FUD) that inhabits the market. The market has effectively breathed a huge sigh of relief this past year. Implied volatility hasn't yet returned to levels that would be consistent with tranquil economic and financial conditions, but it's coming into view.

Part of this improvement is due to the shifting winds of politics; a good portion of Obama's destructive policy agenda (e.g., cap and trade, card check) has been derailed, while others (healthcare) have received considerable push-back from members of his own party. In fact, the hard-left policy agenda he has been pushing increasing appears to be out of sync with the desires of the electorate. Back in early March the market looking with great fear and trembling at the prospects of a fiscal train wreck culminating in a sweeping expansion of government powers and awesome tax increases; the worst-case scenario which seemed likely then is much less likely now.

Part of the improvement can be chalked up to emergency measures on the part of Treasury and the Fed which helped restore confidence in the banking system and averted a debilitating deflation. This in turn provided the necessary backdrop for the economy to pursue its own process of recovery.

I view this improvement in financial conditions as one of the key economic fundamentals supporting an optimistic outlook for growth in the coming year. Markets abhor FUD and risk in general, and that explains why economies generally have great difficulty posting healthy growth when conditions are highly uncertain. The greatly reduced level of perceived risk that is evident in this chart should translate directly into improved growth conditions, since it means reduced transaction costs, lower borrowing costs, and greatly reduced systemic risk.

The problem with healthcare

If you could only use one chart to illustrate the fundamental problem with healthcare in the U.S. today, this would be it.

As of the most recent data (2007), consumers paid for only 12% of their healthcare expenses out of their own pocket. Back in the days before WW II, consumers paid for the vast majority of their healthcare expenses out of pocket. That began to change in the early 1950s, when the government agreed to allow companies to circumvent existing war-time wage controls by giving their workers tax-free health insurance; companies could deduct the cost of the insurance, while it wasn't considered income to the workers. This significant feature of the tax code has finally taken us to its logical conclusion: consumers now get almost all of their healthcare paid for by an employer, since this is highly tax-efficient. The 12% that is still paid out of pocket likely consists mostly of payments by individuals not covered by employer policies, and co-pays by individuals that are covered.

Since the vast majority of healthcare expenditures are not paid for by those receiving healthcare services (but rather by a third party insurer or the government), there exists little or no incentive for consumers to shop around. There is a notorious lack of price transparency in the healthcare market, and costs have risen inexorably at a rate much higher than inflation.

To understand why this is all quite predictable (and thus easily avoidable and easily corrected), consider the following:

Suppose the government created a new category of nontaxable compensation for employees that would allow employers to offer "food insurance" to their employees. Employers could deduct the cost of the food insurance, and employees would enjoy a considerable tax-free benefit. Eventually just about every employer would offer a plan that might look something like this: for a co-pay of $15 everytime you visit the supermarket, you could walk out the door with almost anything you wanted, provided it fit into a shopping cart. Those with special needs (e.g., birthday parties, anniversaries, large families) could petition their insurance company for an exemption to this restriction, and insurance policies would undoubtedly carry lifetime food allowance limits that would cover the reasonable needs of just about everyone.

What do you suppose would happen to the cost of food? Would filet mignon be in scarce supply relative to hamburger meat? Would anyone buy lettuce by the head, or would it all be sold chopped up in bags and ready to eat? Would stores bother to put prices on the cans and boxes of food? Would stores bother to advertise the fact that their prices were lower? How much more food would be thrown out uneaten by U.S. households? Would food become more available or less? Would everyone become outraged over how much it cost to buy food insurance policies?

To fix most of what is wrong with healthcare, we simply need to fix the tax code. Either allow everyone to deduct the cost of healthcare, or no one. That would quickly restore the proper incentives to consumers, since almost everyone would end up paying for healthcare insurance out of their own pocket or choosing not to buy policies.

HT: Coyote Blog

Treasury bond yields rise, and that's good

Yields on 10-year Treasury bonds are a handy barometer of the market's economic optimism. Yields plunged late last year to 2%—a level not seen since the Great Depression—as the market came to fear that the economy was headed for a severe depression and deflation. Yields are now headed back 4%, which—in my view—is a level consistent with an economy that is only capable of managing meager growth with very low inflation. Yields would have to go well over 4% and approach 5% before I would say that the market's expectation of our economic future was anything close to "normal."

So the market is still gloomy, but not catatonic as it was a year ago. Rising bond yields reflect improving sentiment on the margin, and that goes hand in hand with the Fed moving sooner, rather than later, to reverse its quantitative easing and push short-term interest rates higher. This is not a threat to the economy, this is a natural consequence of the economy doing better than expected. The Fed would need to raise short-term rates to at least 5% before anyone could argue that money was tight enough to threaten the economy. Historically, it has taken one or more years of a real Fed funds rate of 4% or more before the economy succumbs to tight money and slides into a recession.

And since the yield curve today is as steep as its ever been, we know the market is already prepared for significantly higher short-term interest rates over the next few years. The real problem would be if the Fed failed to raise rates in a timely fashion, since that would likely result in higher inflation and eventually another round of tight money and a protracted recession.

Asian V-signs

Japanese industrial production suffered the most in last year's downturn, so it's not surprising that it has also rebounded the most this year, rising fully 27% from its Feb. '09 lows. This is an important sign of the strength of the global recovery, which this time around is helping pull the U.S. economy out of its slump (the U.S. is typically the engine of global recovery). Sending the same message of a strong global economic rebound, the Hang Seng equity index is up 89% from its March low and 49% year to date, and most Asian stock markets have turned in performances that handily beat the S&P 500's 25% return year to date.