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Mortgage rate update

Mortgage rates continue to be very close to their all-time lows. Low mortgage rates plus lower home prices plus higher real incomes add up to make housing much more affordable—according to the National Assoc. of Realtors' index of affordability shown here—than at any time in the past 20 years (with the exception of early last year, when mortgage rates were briefly lower than they are today).

Claims update

Weekly unemployment claims are still pretty high from an historical perspective, but I note that they were this high or higher more than a year after the last two recessions. The "healing" of the job market (defined as the reduction in the number of people being laid off) has proceeded at a much faster pace this time around. That's most likely due to the severity of this recession, of course, but it's a positive spin that gets easily overlooked.

The inconvenient financial realities of healthcare reform

As Cato's Michael Cannon details in a policy analysis published today, the healthcare reform bills currently under consideration in Congress contain provisions that would "penalize work and reward Americans who refuse to purchased health insurance." Not only do they promise to be a fiscal disaster, but they will also do significant harm to the incentives of low- and middle-income single workers and families. A must read for all who want to understand what these bills really entail. Excerpts:

... mandates and subsidies would impose effective marginal tax rates on low-wage workers that would average between 53 and 74 percent— and even reach as high as 82 percent—over broad ranges of earned income. By comparison, the wealthiest Americans would face tax rates no higher than 47.9 percent.

Over smaller ranges of earned income, the legislation would impose effective marginal tax rates that exceed 100 percent. Families of four would see effective marginal tax rates as high as 174 percent under the Senate bill and 159 percent under the House bill. Under the Senate bill, adults starting at $14,560 who earn an additional $560 would see their total income fall by $200 due to higher taxes and reduced subsidies. Under the House bill, families of four starting at $43,670 who earn an additional $1,100 would see their total income fall by $870.

In addition, middle-income workers could save as much as $8,000 per year by dropping coverage and purchasing health insurance only when sick. Indeed, the legislation effectively removes any penalty on such behavior by forcing insurers to sell health insurance to the uninsured at standard premiums when they fall ill. The legislation would thus encourage "adverse selection"—an unstable situation that would drive insurance premiums, government spending, and taxes even higher.

Conclusion: The health care bills that President Barack Obama is shepherding through Congress contain new taxes and new government subsidies, both of which would touch low- and middle- income Americans. The complexity of those tax-and-subsidy schemes makes it difficult for voters to discern whether they would be a net beneficiary or a net payer.

... low- and middle-income exchange participants would face often alarmingly high effective marginal tax rates. Even if such workers would receive subsidies under the House or Senate bill, they nevertheless would keep less of every additional dollar of income than they do today. Many would see their tax bills rise even as their real incomes fell. Those perverse incentives would set a low-wage trap for millions of Americans, discouraging them from climbing the economic ladder and encouraging them to remain dependent on taxpayers. Meanwhile, the legislation’s insurance regulations would encourage Americans not to purchase coverage—the opposite of the legislation’s intended effect.
In my view, the healthcare reform under consideration is so reckless and over the top that I can't believe it will ever see the light of day.

Why zero rates are not driving the equity rally

I've been asserting for some time now that the equity market rally has nothing to do with the Fed's zero interest rate policy or with fiscal stimulus. Indeed, I think the rally continues despite the Fed's too-easy monetary policy and despite the terribly misguided fiscal stimulus policies coming out of Washington. Those are some mighty controversial assertions, given that there appears to be a multitude of observers who assert just the opposite—that the rally is a bubble, that the economy's strength is ephemeral, that the recovery is unsustainable, and that things are simply so bad that they can never get put right. For more than a year I've pointed out my rationale for, and the evidence of, a genuine recovery developing, but it can't hurt to put it all down in one place, and it might convince some of the skeptics.

But before I begin, let me say that the Fed's quantitative easing/zero interest rate policy was likely instrumental in averting a financial meltdown a year ago, and so the policy should get credit for setting the stage for recovery. Without a functioning banking system, a recovery probably would have been impossible. To be sure, the banking system is still not back to "normal" and many small businesses are having difficulty accessing credit. But that doesn't make a recovery impossible, nor does it ensure the demise of the current recovery; it only slows things down.

This recession turned into a profound recession right after the failure of Lehman Brothers in September '08. A worldwide panic ensued, in which the demand for money and risk-free assets rose astronomically and spending collapsed. If the Fed had not responded with an equally astronomical injection of bank reserves to the system, the financial panic would not only have led to a steep recession, but also to what would likely have been a painful deflation. The Fed did the right thing, but it took them awhile to figure it out. (The need for quantitative easing has long since passed, I think, but that is the subject of a separate debate.)

What follows is a recap of why I think the rally is genuine and not just the result of fiscal or monetary stimulus:

Printing money can never create growth. The only way an economy can grow at a rate faster than its population growth is if it can utilize existing resources in a more productive fashion; it it can produce more from a given amount of labor, capital, and resources. Gains in productivity, in turn, only result from great effort: from investment, from risk-taking, from saving, and from working harder and smarter. In an inflationary environment brought on by easy money, people tend to favor speculative activities (e.g. investments that pay off if prices rise, such as commodity speculation and real estate purchases) over productive activities (e.g., new plant and equipment, worker training, computers, infrastructure). In the extreme—something I learned from the years I lived and worked in Argentina in the late 1970s—an inflationary environment makes planning and productive investment virtually impossible. Everything becomes reduced to price speculation and survival. Look at the record of any country that has experienced high and rising inflation and you will find very little, if any, real growth. Alas, generations of Fed governors have failed to learn this lesson, and Mr. Bernanke in particular continues to believe that the Fed can fine-tune economic growth by raising and lowering the Federal funds rate.

Monetary policy that is too accommodative can actually be anti-growth. When monetary policy over-supplies money to an economy, the result is not growth but rising prices. Monetary policy that is too easy creates great uncertainty: how far will the currency fall? how much will prices rise? what is the end game? how high will interest rates have to go to stop the inflation? how bad will the next recession be? Already we see these questions being asked by fearful investors. Uncertainty is an investment killer, and if you shut down investment you all but guarantee that future growth will be disappointing.
Zero interest rates do not stimulate an economy, but they are symptomatic of great fears that the economy is in trouble. The main reason the Fed has kept short-term rates at zero for more than a year is that it is terribly afraid that the economy is weak and vulnerable. The Fed's insistence on this tenuous outlook has convinced the bond market to feel the same way, and that is evident in the fact that credit spreads are still historically wide, expectations of rate hikes over the next two years are still very modest, and the dollar is still very weak. Investors' demand for safe assets like T-bills and money market funds would not be as strong as it is today if zero rates had convinced everyone that a durable recovery was underway. Money velocity is still very low compared to where it was prior to the recession, which means that the demand for money is still very high—and again, that is symptomatic of great fears about the durability of the recovery.

Keynesian fiscal stimulus is almost always counterproductive. This is a corollary to some of the above points about monetary policy. If more government spending produced a stronger and more productive economy, then socialism and communism would be the dominant form of economic organization in the world. Instead we see that the most dynamic economies are those that have the most freedom and the smallest government presence. China might be a major exception, except for the fact that its double-digit growth is arguably the result of moving from a very socialist economy to a quasi-free market economy. From my supply-side perspective, fiscal stimulus of the spending variety (such as we have now) is an obvious anti-growth factor, since it creates immediate expectations of higher future tax burdens, and that in turn dampens the urge to invest and take risk. It's highly likely that the outlook for growth in the number of small businesses—the major source of new jobs in our economy—is dismal right now because people are fearful of how much their tax burdens are going to rise. Every day we hear about some new proposal to "tax the rich" to pay for all the new spending and healthcare initiatives.

There have been many signs of improvement in the economy for a long time. I've been highlighting a long and growing list of "green shoots" and "V-signs" since November 2008, well before the fiscal and monetary stimulus had a chance to work. The earliest signs of recovery were a significant narrowing of swap spreads in Nov. '08, followed by a narrowing of credit spreads in Dec. '08 and Mar. '09. In April '09 we saw a big jump in copper prices, and I reiterated my call for the recession to end by mid-year. In May '09 we saw rising commodity prices, rising emerging market equities, rising shipping rates, falling weekly unemployment claims, and higher Japanese industrial production. In June '09 we saw a big jump in the ISM manufacturing index. In July we saw the beginnings of declining spreads for ABS and CMBX securities, impressive gains in industrial metals prices, and a big decline in corporate layoff announcements. It was also clear by then that currency and M2 growth had slowed, signaling a rebound in money velocity that would propel spending. The list goes on, and you can find everything in my prior posts.

I think it is also extremely important to acknowledge the role of public policy in the equity market rally. In the first few months of last year, the market was struck dumb by the realization that Obama's agenda consisted of a rapid and massive expansion of government spending and control over the economy (e.g., fiscal "pump-priming", income redistribution, cap and trade, nationalization of healthcare, banks and auto companies, stronger and more pervasive unions). As soon as this agenda began meeting serious pushback in early March, the equity market began to recover. Since then, the prospects for a rollback of expansive government and a major shift in political power as a result of the Nov. '10 elections have combined to infuse the market with a measure of optimism, where before there was only doom and gloom.

In sum, although zero interest rates played an important role in ending the recession, they have not been the driving force of the recovery which started some six months ago. This recovery is being driven by the activities that drive all recoveries: people adjust to new circumstances, with an innate desire to avoid poverty and seek prosperity; prices adjust until markets clear; workers shift from declining to rising sectors of the economy; people work harder; companies tighten their belts and restructure; confidence recovers; risk-taking resumes. I think these changes are well underway, and the equity market is keenly aware of this. Thus the equity rally is based on solid fundamentals.

To think that politicians or Fed governors can wave a magic wand and turn a recession into a recovery is just silly. Recoveries are made the old-fashioned way: with lots of hard work. This hard work is already paying off, and the results are not going to vanish the day the Fed abandons its zero-interest rate policy. The sooner the Fed raises rates, the better in my book.

Fiscal policy update

There's a wealth of information in these charts, and they speak volumes. I'll just highlight a few things:

The federal deficit increased marginally in the 12 months ended December, according to figures released today by Treasury, as revenues declined by more than outlays. Federal revenues as a % of GDP haven't been this low since 1943, even though the top marginal tax rate back then was 88%, and today it is 35%. Tax rates are thus not the major determinant of revenues—the health of the economy is. As a supply-sider, I believe the economy would be healthier today, and revenues would be higher as a result, if Congress and the Obama administration had focused their stimulus efforts on lowering marginal tax rates for individuals and businesses, rather than massively redistributing income and ramping up make-work projects.

Federal spending as a % of GDP hasn't been this high since World War II. If Obama's spending plans aren't cut back, spending is destined to remain at a level of GDP that we have only experienced during wartime. This would be a truly unprecedented (to use O's favorite word) expansion of the government's control of the economy. As Milton Friedman taught us long ago, it's not really the federal deficit that is bad for the economy, it's the level of government spending. The more government spends, and the more it takes out of one person's pocket and puts into another's, the less efficient the economy becomes. Roughly two-thirds of the $3.5 trillion spent last year by the federal government was entitlement spending. That's about $200 billion every month that the federal government collects from some people and hands out to others.

If these trends continue—permanently higher spending that focuses primarily on income redistribution—it is not clear at all that tax receipts can be raised sufficiently by raising tax rates. Our economy has never generated a level of of federal revenues sufficient to finance current spending projections, no matter how high tax rates have been.

As the bottom two charts show, we saw a huge reduction in top marginal rates since the mid-1960s, but tax revenues as a percent of national income have remained basically unchanged (with the exception of the recent recession).

I don't see impending disaster in these charts or in the numbers. But I do see that we are entering uncharted waters, and that the unprecedented expansion of the size and scope of the federal government, and its increasing focus on income redistribution, raise very troubling prospects. While these concern me greatly, I do believe that it is possible to reverse these trends, and I note some major shifts in the politicial winds this past year that are encouraging in that regard. Things look very grim, but I think the changes on the margin going forward will prove to be positive.

$2 trillion a month adds up

The market capitalization of the world's equity markets has risen 85% over the past 10 months. That works out to just over $2 trillion per month. It's still 22% shy of the all-time high, but from the looks of things, we'll get there, which means another $14 trillion of value is waiting to be captured.

Meanwhile there are many trillions of dollars sitting in money market funds around the world, owned by investors—mainly institutional—who would prefer to earn essentially nothing on their money in order to keep it safe. To prefer a safe zero interest rate to the market's potential to continue growing is to be incredibly concerned about the future. It has also been a terribly expensive proposition in the past 10 months, since anyone sitting on cash has underperformed the market by a significant amount.

The longer this goes on, the harder it is to invest that cash. I'm hearing a familiar refrain these days from the managers of large institutional funds that have significant cash holdings: "We're waiting for the next big correction to get invested." Ah, OK, good luck.

China looks good

China's central bank today announced it was raising its required reserve ratio from 15.5% to 16.0%. Is this a reason to fear that the Chinese boom may turn into a bust? Hardly.

China's monetary policy is largely determined by the Federal Reserve, because China pegs its currency to the U.S. dollar. However, the Chinese have been reluctant to be completely at the mercy of Bernanke and Greenspan's whims. As the next chart shows, they allowed the yuan to appreciate against the dollar from 2005 through 2008, largely in response to the fact that the dollar became seriously weak over that same period. Why stay pegged to a collapsing currency? Better to float the yuan higher.

Allowing the yuan to appreciate was equivalent to a tightening monetary policy that in effect helped counteract the extremely easy monetary policy coming from the Fed during that period. To complement this tightening the Chinese central bank also raised its required reserve ratio from 6.0% in 2003 to 17.5% in mid-2008. The Chinese, like the Australians, are proactively tightening monetary policy, and the Fed should be following their example. This is not bad news for China, it is good news. Sound monetary policy is an essential ingredient to strong growth. And to judge from the top chart, China is back on track to more double-digit growth.

This is not deflation

I still see plenty of people worrying about deflation, but they need to look at charts like this and chill. Deflation is when all prices fall. When housing prices fall and rents fall and stores offer incredible bargains, that is not deflation; it's a change in relative prices. Firms that suddenly find that demand for their goods and services has collapsed must lower their prices if they are to stay in business. Meanwhile, the prices of virtually all commodities are going up. These two charts are just a sampling of what I could show, but both of these happen to show prices up over 100% from the lows of late 2008 and early 2009. You might say that lower housing prices are freeing up money that is instead being spent on higher energy costs.

Foreign trade in a V-shaped recovery

As the first chart shows, foreign trade has yet to return to the peak levels of 2008; indeed, we are still well short of reattaining those levels. But as the second chart shows, the rebound from the bottom has seen the fastest rate of growth in exports in decades. Imports are up at a 37% annualized rate in the six months ended in November, which marks by far the fastest pace of growth in imports in many decades. Exports boost our economy, but they are also a good proxy for the health of global economies. Imports "subtract" from GDP growth, but their strength is a direct reflection of the strength of domestic demand, which in turn is a good proxy for the general health of our economy. By either measure, things are turning around impressively.

This was a severe recession, but the rebound must surely be categorized as "V-shaped."

Equity rally update

I'm updating these charts because they have been very impressive for a long time and bear watching very closely. Implied volatility in equity options continues to trend down, helping equity prices to trend up, something I have been noting since late 2008. The recent strength in the dollar (note that the red line in the second chart moves inversely to dollar strength) has not derailed the rise in equities, contrary to the very popular view that the equity rally is just part of a larger "carry trade" that only works if the Fed keeps rates low and the dollar declines.

This rally is built on solid economic fundamentals, in short. But I see so many analysts arguing that this is all a house of cards that is set to collapse for any number of reasons (e.g., huge commercial real estate vacancies, a second wave of home mortgage defaults, an inflating credit bubble, the winding down of fiscal stimulus, rising tax rates, soaring Treasury yields, etc.) So many people are worrying these days about all the things the might go wrong, yet so few people seem to worry about all the things that might go right. This is how major bull markets always work: the market climbs a wall of worry, and ignores the fundamental drivers of the recovery.

Reading the bond market tea leaves

This chart compares the real Fed funds rate (using the Core PCE deflator as a measure of inflation to minimize the distortions of volatile energy prices) with the slope of the yield curve (using the spread between 1-year and 10-year Treasury yields). Note that these two series tend to move in opposite directions, and in lockstep. The easier the Fed gets, the steeper the yield curve gets, and vice versa. The yield curve is at an all-time steep because the Fed has almost never been easier. A steep yield curve is the market's way of saying that sooner or later the Fed will have to raise short-term rates by a lot.

The real Fed funds rate is a decent proxy for how easy or tight monetary policy is. High real rates are a sign of tight monetary policy, while low real rates signal easy policy. When interest rates are very high relative to inflation, it becomes very expensive to borrow and speculate. High real rates therefore increase the public's demand for money (rising money demand equates to a reduced desire to borrow), and this tends to make money scarce relative to goods and services. That in turn tends to depress the price of goods and services, which is another way of saying that tight money tends to reduce inflation. When real rates get very high, they can be the catalyst for a recession, since the economy becomes effectively starved for liquidity. Note that every recession in this chart was preceeded by at least a year or two of very high real rates. Similarly, every recovery was kicked off by a huge decline in real rates.

Short-term interest rates are clearly low enough in both real and nominal terms to kick off a recovery. This chart tells us there is no reason at all to expect the economy to face any difficulties in the foreseeable future. Instead, there is every reason to expect both a recovery and rising inflation.

Current monetary policy is about as easy as it has ever been; policy was easier only briefly in the mid-1970s. Easy money in the 1970s was what gave us rising inflation, but it wasn't all that bad for growth—contrary to popular perceptions—since the economy grew at a rate (3.3% per year from Mar. '70 to Mar. '80) that was actually faster than what we have experienced over the past 30 years (2.7% per year).

Monetary conditions today are designed specifically to reduce the public's demand for money, since it was an explosion of money demand in late 2008 (for precautionary purposes) that brought the U.S. economy to its knees. By paying essentially a zero rate on overnight money, the Fed wants people to feel free to borrow (i.e., to be short) as much money as they want. Reduced demand for money makes money more abundant relative to goods and services, and that tends to increase the price of goods and services. Thus, the Fed is trying very hard to counter the price-depressing excess capacity that exists in the economy by making money abundant. Recovery skeptics would do well to consider that the Fed has the unique capacity of always, eventually, getting what it wants.

While there are indeed many prices that are soft these days, all the evidence I see suggests that inflation is slowly rising despite all the supposed slack that exists in the economy. Consider: housing prices on average have been rising since last March, commodity prices are soaring, gold is soaring, and the dollar has fallen and is very weak (meaning all prices outside the U.S. are up). Inflation expectations, not surprisingly, are up as well: they were essentially zero at the end of 2008, and the 5-year, 5-year forward inflation expectation built into TIPS prices is now almost 3%.

The steepness of the yield curve is a good proxy for several things: economic growth, inflation, and the future of Fed policy. Today the curve is steeper than it has ever been. At 0.94%, today's 2-year Treasury yield is the market's best guess for what the Fed funds rate will average over the next two years. The eurodollar futures market tells us that the consensus expectation for 3-mo. Libor at the end of this year is 1.2%, which is consistent with a Fed funds rate of about 0.9%, and that is also consistent with what Fed funds futures are telling us. So the Fed is expected to raise short term rates a little bit this year, and just a little bit more next year (to just over 2%). This will happen only if the economy remains very weak and inflation remains very subdued.

I see a potential disconnect here. On the one hand the market is priced to a Fed response that only makes sense if economic growth is dismal (i.e., 2% or less) and inflation is very low (2% or less). Yet the Fed is virtually as easy today as it was in the 1970s, when we had plenty of inflation as a result and the economy managed to post pretty decent growth.

This brings me back to the message of credit and swap spreads, which I have addressed many times in the past. Although spreads have contracted significantly, they are still at levels which are consistent with dismal economic conditions.

So again I say that I see no signs in this market of exuberance or excessive optimism. I see a market that is terrified that growth is going to falter. I see a Fed and a bond market that share an abiding faith that a weak economy will prevent an eruption of inflation. I see virtually no sign (except in the steepness of the yield curve) that the economy has any chance of growing by a significant amount (say, 3-4% or more).

Bottom line: if you think there is a decent chance that the economy can grow by 3-4% or more (which would only equate to a very tepid recovery given the depth of the recent recession), then you need to be long risk assets and short Treasury bonds, since the market does not share your optimism in the slightest.