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Fed expectations reveal very pessimistic market psychology




I'm now back to civilization, and I find that the world is obsessed with whether tomorrow the Fed's FOMC is going to announce a new attempt to further ease monetary policy in order to rescue an economy that is apparently on life support and threatening to succumb to deflation. In any event, I'm happy to see that my one-month absence coincided with a pretty nice rally in the equity market—as happened when I went to Argentina for three weeks in mid-March last year—so perhaps I should plan more of these getaways in the future!

It's been my thesis for a long time that the equity market was trading at very cheap levels, mainly because the market was plagued by doubts and uncertainties of all sorts: would there be a double-dip recession? what about the soaring federal deficit? would tax rates be hiked massively? what about the burden of a new healthcare system and its attendant regulations and new taxes? how will the Fed avoid the inflationary consequence of a $1.3 trillion expansion of its balance sheet? These concerns have manifested themselves in credit spreads that have been chronically high (though tending to fall); in implied volatility that has been chronically high (though also tending to fall); in Treasury yields that have been exceptionally low (10-yr Treasury yields traded below 3% only briefly at the end of 2008 and before that only during the depression/deflation of the late 1930s—see chart below); and in equity yields (the inverse of PE ratios) that have been below average.



One other indicator that signals the depths to which the market's expectations for the future of the economy have sunk is the real yield on 5-yr TIPS, which today is trading just below zero for only the second time in history (the first being in March of '08 when the market first began to get concerned that the subprime mortgage market crisis could tip the economy into recession). You can think of real yields on 5-yr TIPS as a good proxy for the market's expectation for real GDP growth, mainly because there should be some reasonable connection between the risk-free real yield an investor can earn on TIPS over the next 5 years and the real yield on cash flows tied to the economy's performance via generic equity exposure. For example, if expectations for economic growth were healthy (e.g., 4-5% real GDP for the next several years), then an investor would be foolish to put his money in 5-yr TIPS that promised a zero real return. Cheerfully buying 5-yr TIPS with a guaranteed real yield of zero only makes sense if one has very grave doubts about whether the economy can generate any real growth at all in the coming years.

You can also think of the real yield on 5-yr TIPS as a good proxy for the market's expectation of the future stance of monetary policy. That's what the chart at the top of this past attempts to illustrate. The blue line is a proxy for what the market expects the real Fed funds rate to be one year from now (which I calculate by subtracting the year over year change in the core PCE deflator from the yield on eurodollar futures contracts—a good proxy for the expected funds rate—maturing one year in the future. The red line is simply the real yield on 5-yr TIPS. There's a remarkably good fit between these two lines, mainly because the front part of nominal and real Treasury curves are driven by expectations of future Fed policy. In short, what the Fed is expected to do exerts a powerful influence on the nominal and real Treasury curve.

That future 3-mo. real Libor rates are expected to be negative for the next year only makes sense if the market expects the economy to be miserably weak, and/or for inflation to be very low or even negative over the next year, since both conditions would almost certainly force the Fed to keep policy in an extremely accommodative mode. So it's not surprising that many are calling for tomorrow's FOMC announcement to include some new version of quantitative easing (QE2 as it's called), or perhaps some firm commitment to a very long period of zero interest rates.

My point here is that if you are worried about buying risky assets because you are deeply concerned that the economy is going nowhere fast and deflation is lurking around every corner, then rest assured you have plenty of company. Indeed, I would venture to say that for a bearish bet on the economy to pay off, you would need to see an actual recession set in and/or the CPI to be negative for the next few years at least. The market is priced to very bad news, so for the market to be disappointed, the news is going to have to be very bad indeed.

While I agree that there are plenty of reasons to be concerned about the future, I just don't believe things are going to be worse than the miserable conditions the market currently expects. I see modest 3-4% real growth ahead, and a gradual rise in inflation. I believe this to be the case because financial fundamentals (e.g., swap and credit spreads, implied volatility, the upward slope of the yield curve, corporate profits, gold, and commodity prices) either show absolutely no sign of deterioration or at the very least point to a future in which economic conditions gradually improve and/or deflation is nonexistent. I also believe the future will be better than expected because I have learned over the decades that it is very risky to underestimate the resilience and dynamism of the U.S. economy.

And finally, I think there is good reason to be optimistic because of the sea change in the mood of the electorate, which augurs strongly for a rightward shift in fiscal policy as the November elections approach. Not being a Keynesian, I firmly believe that we can keep taxes low (and even cut corporate taxes), and cut government spending, without causing any long-term harm to the economy. In fact, I think that the combination of low taxes and reduced government intervention would prove to be a powerful tonic for both investor confidence and the economy. For proof, just look at what Canada has achieved in the past few decades—it's summarized nicely in "Canada, Land of Smaller Government" in today's WSJ. Excerpts:

America's northern neighbor has transformed itself economically over the last 20 years. ... change really began to take off in 1993. A socialist-leaning government in Saskatchewan started by reducing spending and moving towards a balanced budget. 
This was followed by historic reforms by the Conservatives in Alberta, who relied on spending reductions to balance their budget quickly. All government spending peaked at 53% of Canadian GDP in 1992 and fell steadily to just under 40% by 2008. 
Canadian taxes have also come down at the federal and provincial level. They were reduced with the stated goal of improving incentives for work effort, savings, investment and entrepreneurship. Beginning in 2001 under a Liberal government, even the politically sensitive federal corporate income tax rate has been reduced. It is now 18%, down from 28%, and the plan is to reduce it to 15% in 2012. The U.S. federal rate is 35%. Canada has also reduced capital gains taxes twice (the rate is now 14.5%), cut the national sales tax to 5% from 7%, increased contribution limits to the Canadian equivalent of 401(k)s, and created new accounts similar to Roth IRAs. 
Most strikingly, Canada is emerging more quickly from the recession than almost any industrialized country. It's unemployment rate, which peaked at 9% in August 2009, has already fallen to 7.9%. Americans can learn much by looking north.

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