Main menu

Earnings yields tower over bond yields


With yields on 10-yr Treasuries falling to 2.7%, a level which is reminiscent of the depression and deflation of the 1930s, I thought it fitting to once again compare the earnings yields on equities with the yield on 10-yr Treasuries. Rarely have equities yielded so much more than Treasuries. The current situation is very similar to what we saw in the late 1970s and early 80s, just before Treasury yields exploded to the upside and equities began a rally that would extend for many years.

Faced with the choice between equities yielding 6.8% and Treasury bonds yielding 2.7%, a rational investor would choose bonds (and I note that bond funds are receiving strong net inflows, while equity funds are experiencing net outflows) only if he thought that equity yields were only temporarily high, and corporate earnings were about to collapse (ignoring the fact that S&P 500 earnings per share have risen at a 45% annual rate in the past six months, and are now back to the levels of July 2008). Thus, the gap between stock and bond yields is a good indication of the tremendous amount of fear, uncertainty and doubt that plagues the market these days. The stock market is priced to something a lot worse than a double-dip recession.

Since I don't see a double-dip on the horizon and I continue to believe that the economy can grow 3-4% for the foreseeable future, then I conclude that equities are extraordinarily cheap.

No shortage of liquidity, rather an excess of spending



As this chart demonstrates, over the past 15 years the M2 measure of money supply has grown about 6% per year annualized. That's a bit more than the 5.5% annualized growth in nominal GDP over the same period. Thus, there is more money per unit of GDP out there today than there was 15 years ago, and if you'll recall, the economy boomed from the end of 1995 through early 2000 when M2 growth averaged 6% per year.

Note also that the relatively slow M2 growth that we've seen since March of last year has been almost entirely a "payback" for very rapid growth during the depths of the 2008-09 recession.

I think the cause of today's relatively slow M2 growth (up 2.5% in the past year, and up at an annualized rate of 3.4% in the past six months and 5.5% in the past three months) is that the demand for money has declined (and money velocity has therefore increased). Slow M2 growth does not reflect tight monetary policy, it reflects a drop in the demand for money. So M2 is saying very little, if anything, about the economy's ability to grow or about whether the Fed is not being accommodative enough to allow the economy to expand.

It is much more likely that today's disappointing economic growth is the result of anti-growth fiscal policy, rather than restrictive monetary policy. It may seem paradoxical, but $1 trillion of government "stimulus" spending only harms the economy because a) government spends money less efficiently than the private sector (i.e., it would have been better to not borrow all that money and instead to cut marginal tax rates), and b) the huge increase in government spending that has occurred creates expectations (and fears) of huge increases in future tax burdens. Moreover, a larger public sector inevitably brings with it more regulations that help smother private sector initiative.

The death of Keynesian theory


(click to enlarge)

This wonderful piece of satire comes from an enlightened client report from Sprott Asset Management (HT: Zero Hedge).

Container traffic update


July shipments of loaded outbound containers increased at the Port of Long Beach, but fell at the Port of Los Angeles. After a strong rebound early last year, both ports have seen an irregular upward trend in outbound container shipments that appears consistent with the gains in goods exports (blue line in the above chart). Data from the past few months seems to show somewhat of a slowdown in activity, consistent with slower growth reported for second quarter GDP and a slowdown in export activity in general.

Meanwhile, though export growth seemed rather lackluster in recent months, both ports reported a surge in import activity in July. Total container traffic at Long Beach rose a very impressive 36% from July of last year, while Los Angeles reported a 27% gain. Taken together, I see this news as supportive of the view that the U.S. economy continues to grow.

A surge in Asian imports in July boosted container traffic through the Port of Los Angeles, the largest in the U.S., to its highest level in almost two years.
Los Angeles reported its strongest month since August 2008 as imports climbed 21%. Nearby Long Beach had its busiest month since October 2008 as imports rose 33%. Both ports account for around 40% of U.S. inbound container traffic.

Japan: What deflation? What depression?


There's a lot of unfounded talk going around these days about how deflation has killed the Japanese economy, as good friend Don Luskin pointed out to me the other day. This chart shows the year over year growth in Japan's Nationwide CPI. Since Mar. 1993, Japan's price level hasn't budged: inflation has netted out to zero. That's over 17 years of price stability. From the very peak in Japan's inflation, which was in late 1998, Japan has "suffered" an average annual decline (i.e., deflation) in its price level of 0.4%. It's hard to see how this might be the killer deflation scourge that it's made out to be.

And as for "killer," it turns out that Japan's economy hasn't been killed at all. From the end of 1998 through the first quarter of this year—the period during which the Japanese price level fell 0.4% per year on average—Japan's economy expanded by almost 10%, for an average annualized growth rate of 0.8% per year. By comparison, the U.S. economy grew 25%, or 2.0% per year on average over the same period. The U.S. economy sure trumps the Japanese economy, but not if you consider that our population is younger and has grown at a faster rate than Japan's.

From the end of 1998 to June of this year, Japan's labor force actually shrunk by 3.1%, or about 2 million workers. That means that on a per worker basis, Japanese output expanded by about 13%. By comparison, the U.S. labor force grew by 10.8%, or about 15 million workers over the same period. That translates into a 13% expansion per worker, almost exactly the same as in Japan!

Where Japan has really suffered, of course, is in its stock market. The Nikkei 225 peaked at 39,000 at the end of 1989, and today stands at a mere 9,200, for a decline of almost 75%. The S&P 500, in contrast, has risen over 400% during the same period.

Thoughts on TIPS and gold as inflation hedges



TIPS (Treasury Inflation Protected Securities, the original acronym) are complex bonds that are difficult to evaluate. I first recommended TIPS in October 2008 ("TIPS are a steal"), and pounded the table to buy them for the next several months. I have been consistently a fan of TIPS (though more recently only for as a substitute for cash) ever since. If you take TIP as a proxy for the TIPS market, TIPS have enjoyed price appreciation of some 18% since their low in November '08, plus interest (in the form of their real coupon) of about 5%, for a total return of roughly 24%. That's not as good as equities, but then TIPS are default-free bonds that pay guaranteed interest while equities are full of risk.

As the chart above shows, the real yield on TIPS is now as low as it's ever been, which means that TIPS prices are at or near their all-time highs (the market price of TIPS varies inversely to their real yield). As my chart also suggests, TIPS are in "expensive" territory based on their real yield. Is now the time to sell?

If you are trader holding TIPS and not particularly concerned about the future of inflation or downside risk to the economy, then now is an excellent time to sell TIPS. Real yields might fall a bit further, but I think they are reaching their limit. Real yields are low because nominal yields are low, and both are low because the market is terribly concerned about the risk of a significant slowdown in the U.S. economy. Low Treasury and TIPS yields are a direct reflection of a deep pessimism that pervades both the stock and the bond markets. I don't share the market's pessimism, so I'm willing to think that the decline in yields has just about run its course.

If you are a long-term investor holding TIPS, then you should understand that TIPS are quite unlikely to enjoy any price appreciation from here. TIPS returns will be driven entirely by the change in the CPI going forward, and the risk of some price depreciation in the future is not negligible. As the next chart shows, TIPS are priced (relative to Treasuries) to the assumption that the CPI is going to rise 1.8% per year on average for the foreseeable future. (That's the breakeven or expected inflation rate.) Thus, the market is saying that a TIPS holder is likely to earn 1.8% per year from inflation, plus a 1% coupon, for a total return of 2.8% per year, minus any price depreciation that happens to occur.

That's not a particularly exciting prospect. TIPS are going to deliver exciting returns ONLY if inflation turns out to be significantly higher than the market expects, and they could deliver disappointing returns if inflation doesn't change much, if real yields rise because TIPS fall out of favor, and/or the economy picks up and Treasury yields in general rise.

So TIPS are now a pure bet on inflation. Inflation has to pick up meaningfully for an investment in TIPS to do better than Treasury bonds. If it doesn't, you're going to either make a pittance or you're going to lose some money.

I could say the same thing about gold, however, but in spades. Consider that gold has soared 370% since its early 2001 low (next chart). If gold is up because central banks all over the world are in accommodation mode, then gold is anticipating lots of inflation down the road. If you buy gold today, you NEED lots of inflation to show up, and you NEED central banks to remain super-accommodative, otherwise gold could collapse. If gold is up because of geopolitical risks or other types of raw fear, then you NEED things to never get better, otherwise gold could collapse.


TIPS and gold are two classic inflation hedges, but with very different characteristics. Gold is like a highly leveraged play on inflation, but TIPS have limited downside risk. Gold might drop by 60% or more. But TIPS have no default risk and, more importantly, the real yield on TIPS almost certainly has an upper limit (unlike the yield on nominal bonds, which can theoretically rise without limit). I say that because the real yield on TIPS is a U.S. government-guaranteed real yield—a risk-free real yield. At the end of the day, the only yield or return on an investment that really counts is its real (after-inflation) yield. If you could buy TIPS with a real yield of, say, 4% or more, would there be any investment in the world that could match that on a risk/reward basis? I seriously doubt it. If real yields on TIPS rise, at some point they will become absolutely compelling investments relative to the universe of other investments, and my guess is that the upper limit is around 4%.

If real yields were to rise from 1% to 4%, this would equate to a drop in price for TIP of 20-25%; that would be offset by their 1% real coupon plus whatever inflation happens to be. Thus, the downside risk to TIPS in a worst-case scenario (barring a U.S. government default, in which case all bets are off) would be a mark-to-market loss of 20-25% that could be reduced if one were willing to hold TIPS to maturity. (TIPS traded briefly above the 4% yield level in 2001, but that was when the TIPS market was still in its infancy, they were not well understood, and equities were all the rage because people thought the economy would grow 4-5% per year forever.)

To summarize: TIPS make sense only for long-term investors who are concerned about the risk of rising inflation and are willing to suffer some losses if that doesn't happen, and TIPS are a much less risky hedge against rising inflation than gold.

Full disclosure: I am still long TIP and TIPS at the time of this writing.

Market pessimism is distorting the facts


It's a sign of the market's deep-seated pessimism that an observer can look at this chart of weekly unemployment claims and say, as this morning's Bloomberg story put it: "More Americans filed applications for unemployment insurance last week, signaling firings stepped up as the economy slowed. Initial jobless claims rose by 2,000 to 484,000 ... the highest level since mid February." Or consider this headline from Drudge: "Jobless claims jump to highest since Feb."

If every little rise in claims signaled a slowing in the economy, and every little drop a pickup, then the economy has been on a super roller coaster this year, surging ahead and then braking, then surging, etc. The truth is that the fluctuations in this series so far this year have minimal in nature. Look at the longer-term chart below for perspective—claims this year have been remarkably stable. Where are the articles reporting this? "Jobless claims over the past 8 months have moved in a very narrow range, far below the levels of this same period one year ago, signaling an economy that likely is growing at a relatively moderate and stable pace."

Pulse of Commerce Index points to continued growth


This index (I'm showing the seasonally-adjusted, 3-mo. moving average version of the index) of real-time diesel fuel consumption by many thousands of trucks criss-crossing the country correlates strongly to industrial production and almost as strongly to GDP. July data is included in this chart, and it suggests we might see a somewhat stronger-than-expected industrial production report next week. In any event, the index has been climbing steadily for more than a year, and is showing no sign of any slowdown in the pace of economic growth.

This is a fairly new index and I have only been following it for the past several months, but it looks pretty decent. You can see more details and versions of the index here.

HT to John Sturges for alerting me to today's July release.

July budget numbers show revenues improving

Over the past 10 months, and on a rolling 12-month basis, the federal budget deficit has actually shrunk from $1.6 trillion to just over $1.3 trillion. As this chart shows, that's due to a combination of reduced expenditures and increasing revenues. Expenditures are still off the charts on an historical basis and relative to GDP, and that's bad, but the increase in revenues is a very welcome sign that the economy is on the mend. It's quite typical for revenues to decline in the wake of recessions, and then to come back once a decent recovery gets underway, and this time is no exception. Rising revenues mean that incomes and profits are up, and that only happens when the economy expands.


This next chart compares the above numbers to nominal GDP:


This last chart focuses on the difference between these two lines:

Our Botswana safari

Our trip to Africa last month included a fascinating four-night safari experience. It began with a charter flight to a tiny airstrip in the Khwai River floodplain, located in the Okavango Delta region of Botswana. It was winter there, and the dry season, so we had no mosquitos to worry about.


We were met by folks from Kazuma Trails, a safari outfitter based in Victoria Falls and run by the wonderfully enthusiastic David Carson. On the 45 minute drive to our campsite, we were stunned to see animals at almost every turn: giraffes, baboons, elephants, hippos, impalas, and even some lions taking a nap in the brush. We saw a lot more animals on later excursions. I won't bore you with too many animal shots, as I think it's more interesting to shed light on the safari experience itself






This was billed as a "luxury" safari, and that was an understatement. Each couple had a spacious tent with an adjoining bathroom which included a bush shower and a toilet (under which was a four-foot hole in the ground). On request, the staff was quick to fetch a bucket of warm water for the shower, a true luxury for a camper. The main part of the tent featured two beds with fresh pillows and comforters, a small wardrobe, and nightstands with battery-powered lights.


Lunch and dinner were served with elegant place settings, delicious food, and wine. David's staff numbered at least 10, and there were 22 of us. The cook was a magician, cooking for over 30 people using what you see in this picture (the metal box serving as the oven). We had fresh bread, casseroles, curries, pot pies, salads, desserts and pasta, to name just a few of the many dishes this man conjured up from his humble kitchen.


We had three guides each time we ventured out of the campsite: David, Spokes, and Rod (see below). Rod slept on top of his jeep every night with a rifle by his side, in case any animals wandering through the campsite decided to make a fuss. We were visited at night by elephants, hyenas, and at least one lion. Staff urged us to stay in the tents no matter how awful the cries were at night. Fortunately, no mishaps occurred.


One morning we left camp at the crack of dawn to follow some lion tracks, and before too long found him. He was a young lion making a walking circuit of the area, marking his territory. To our amazement, he completely ignored our presence. At one point, if I had leaned out of the jeep I could have almost touched him as he passed by. David explained that predators' brains are simply not programmed to see people inside a jeep as potential prey. As long as you stay inside the jeep and inside your tent at night, you're OK. But venture out and you're history. That may be so, I thought to myself as the lion walked straight toward me, but what if there's a first time and I'm the victim?



Although things looked pretty dry, there was actually a lot more water than usual for this time of the year. The jeeps regularly had to ford ominous streams, and once we got stuck in deep mud. One highlight of the trip was careening around the bush in the dark, with David swinging a flashlight too and fro, lighting up the eyes of hyenas and wild dogs closing in on a recent kill, David insisting "Can you smell the stomach?"


Another highlight was running across a family of cheetahs taking a nap in the brush. About 200-300 yards behind them we could see a fairly large here of impalas—Africa's "meals on wheels"—grazing contentedly. The cheetahs apparently preferred to rest rather than hunt.


Finally, some profound thanks are due to our good friends Lowell and Linda Rice, who spent the past 18 months planning and organizing this amazing trip. Here's a shot of them I took in Cape Town, looking south toward the Cape of Good Hope. We can only hope we have the chance to do another trip as rewarding as this was.

Understanding China's property boom

A fellow supply-sider, Michael Kurtz (head of China research for Macquarie Securities) has written an excellent article in the Asian WSJ: "The Price of China's Property Boom." He explains the reasons behind China's property boom and how it all might work out. It's not necessarily a disaster—and it's all very rational. The good news is that it could lead to some much-needed reforms. Here's an excerpt, but do read the whole thing:

China's citizens, raised with an awareness of their country's heartbreakingly tumultuous history of messy dynastic successions, invasions and expropriation, have come to value tangibility as an attribute. A housing unit is solid and intrinsically valuable, although not portable. By comparison, from the Chinese perspective a share of stock is merely a claim on a distant and impersonal management's promise of a future that may never materialize. 

So a well-off middle-income Chinese family with savings to deploy may rationally choose to put their savings into even an empty housing unit. Without an annual property tax, the carrying cost of a vacant unit is effectively zero. This also reduces incentives to seek rental yield as an offset to carrying costs, one reason why empty units are so prevalent. Presumptive capital gains seem to be satisfactory for most investor-owners. 

With such demand distortions entrenched, and particularly assuming inflation remains a factor, China would not appear to be an oversupplied market. The modest price pullbacks of May-June have enticed buyers back out of the woodwork in recent weeks. Centaline Property in Shanghai estimates that even at China's now-reduced monthly transaction volumes (half of where they were in late-2009), the primary residential market has only three to four months of outstanding supply, well below the long-term average of seven to eight months. 

Those same demand distortions, though, also portend at least three difficult eventual transitions for China's property market in the not-distant future: interest rate reform, which over time would increase returns to bank savings and reduce property's relative attractions; capital account liberalization, which would broaden Chinese households' access to the world of cross-border investment alternatives; and the introduction of value-based property ownership taxes to reduce local governments' reliance on land-sale revenues, which would impose a carrying cost for empty housing.

Tricky as these reforms may prove, each is central to the economic restructuring and efficiency improvement Beijing hopes to pull off in the next few years, meaning difficult decisions and trade-offs lie ahead. The true risk may be that by having allowed a potential property overhang to come into existence, Chinese policy makers paint themselves into a corner where essential reforms such as financial liberalization and fiscal restructuring seem too dicey to implement. If so, China may be able to keep its firm property market, but at the cost of postponing progress beyond a capital-wasting bank-SOE complex ill-suited to China's economic future.
UPDATE: This is very encouraging news, as it would directly address one of the sources of China's property boom (artificially low deposit rates):


China should target a rise in banks' deposit interest rate ceiling, rather than hiking the benchmark interest rates, to pull real deposit rates out of negative territory, a senior government economist said in remarks published on Friday.
'We must give the market a signal that we are pulling it (the real deposit rate) to a positive level,' Xia Bin, an adviser to the cabinet and the central bank, told the official People's Daily overseas edition.
China puts a lid on banks' deposit rates and a floor under lending rates, but the negative real deposit rates at banks have created an incentive for savers to seek other investment opportunities.

The good news behind the June trade deficit




The trade deficit increased in June because the growth rate of exports has slowed. The market is interpreting that to be bad news, but it isn't.

To begin with, there's nothing wrong with a trade deficit. In fact, many healthy economies have trade deficits. A trade deficit is the flip side of a capital inflow—you can't have one without the other—and capital inflows are a measure of foreign investor's confidence in your economy.

Treasury is selling over $100 billion a month of T-bills and T-bonds, and foreigners are buying a good portion of that debt. That leaves foreigners with less money to spend on our exports. Our export growth has declined, but our sales of T-bonds to foreigners have risen. Since nobody is holding a gun to foreigners' heads and demanding that they purchase our debt (and low interest rates suggest they are quite happy to do so), one is forced to concede that foreigners have made a decision (to buy our bonds instead of our debt) that is in their best interest. If they didn't feel good about doing that, they could shun our debt, which might make interest rates rise, but they would be left with more cash to buy our exports.

The only bad thing about our trade deficit is that it's likely driven at least in part by our federal government's voracious need to finance its spending habits, which in turn means that we are likely squandering some of our capital inflows since they could be put to better use if they were available to the private sector rather than being gobbled up and spit out as transfer payments.

Meanwhile, the very strong growth in imports, which has been running at a 20+% pace for the past nine months, is a excellent sign that U.S. consumers are feeling much better about spending money (incomes are up, confidence is slowly returning, money hidden under mattresses is being spent), and that is unequivocally a good thing.


This last chart compares imports and exports to consumption. What it shows is that imports have represented about about 20-25% of our total consumption expenditures for the past decade or so—imports on average have grown at about the same pace as consumption. Meanwhile, our exports have grown faster than consumption, and exports are now only a shade below their all-time high relative to consumption. This means that our exports are financing a greater share of our consumption than at almost any time in history, and that represents a healthy diversification for our economy.

Another observation: the U.S. economy is now more than twice as integrated into the global economy than it was back in 1980, because our imports and exports have more than doubled in size relative to consumption. It's hard to see how this could be a bad thing.

Today's FOMC announcement adds marginally to inflation risk, and might help the housing market


The FOMC today announced that it will reinvest principal payments on its mortgage holdings into longer term Treasury securities. What that means is that bank reserves will remain constant: the line on the above chart will not slowly decline as we had been told it would earlier. The Fed will effectively reduce its trillion-plus holdings of mortgage-backed securities over time, but now it will replace them with Treasury holdings instead of allowing principal repayments to reduce the size of its balance sheet. This will result in a lengthening of the maturity and duration of the Fed's security holdings in a manner that could be likened to another "operation twist," in which the Fed attempts to flatten the yield curve by selling shorter-term securities and buying longer-term securities. In fact, it has already had that effect, and it has helped bring down fixed mortgage rates to new all-time lows.



The first of the two charts above reflects the degree to which the Fed's policy intentions have affected the yield curve. The spread between 2-yr and 10-yr Treasuries has narrowed by almost 70 bps since hitting an all-time high earlier this year. The second chart shows that the spread between 10-yr Treasuries and MBS has not changed materially, so the decline in MBS rates is almost entirely due to the decline in 10-yr Treasury yields. By insisting that it will not tighten policy for a long time, and that meanwhile it will make no effort to reduce the size of its balance sheet, the Fed has managed to bring about a significant decline in intermediate interest rates, with the result that borrowing costs for homeowners have been reduced substantially.

We can't know how much stimulus this will provide to the economy (probably very little if any), but it should be a positive on the margin for the housing industry, since the Fed has so far succeeded in lowering mortgage rates, and that has the immediate impact of making current housing prices more affordable for the marginal buyer.

Since the vast majority of the reserves that the Fed created in the latter part of 2008 have been sitting idle on the Fed's books (banks haven't used the reserves to create new money), the Fed's announcement today was almost a non-event. Whether excess reserves (currently about $1 trillion) remain unchanged or decline slowly (as the market previously expected) will not have any practical impact, per se, on the amount of money sloshing around the economy, nor will it make any difference to banks' willingness to lend. But by lowering borrowing costs for homebuyers, the Fed's actions might increase the public's demand for loans (thereby having the effect of reducing the demand for money), and this could increase the inflationary impact of monetary policy. Confirming this, I note that the values of the dollar and gold changed meaningfully on the news (the dollar weakened and gold rose, signaling an effective increase in the supply of dollars relative to the demand for dollars), the spread between Treasury and TIPS yields widened marginally (signaling a modest rise in inflation expectations), and the 10-30 spread has widened to its highest level in history (signaling an increase in long-term inflation risk).

From my supply-side perspective, the FOMC announcement was disappointing. Instead of standing firm in defense of the dollar and in favor of low and stable inflation, the Fed has (once again) bowed to political pressures by giving priority to the economy and attempting to manipulate the yield curve in support of the housing market.

Does this make me less bullish on equities? Yes, but not by much. Today's announcement does not mark any significant change to the way the Fed has been conducting monetary policy over the past 22 months. But it does push forward the day when the Fed eventually moves to tighten policy, and that is a negative for the economy since it reduces confidence in the dollar and inhibits productive investment. Nevertheless, we are only talking about small changes on the margin to the policy outlook; monetary policy has been part of the problem for some time, and now we know it will remain part of the problem for somewhat longer. The bigger problem right now is fiscal policy, and the Fed made no attempt whatsoever to address that, which is unfortunate.

Temp jobs are increasing at a very healthy rate


This index of the number of people employed in temporary and contract work shows very healthy gains over the past year. Comparing the most recent week to the same week a year ago, staffing is up an impressive 27%. I believe this confirms my view that the economy continues to expand and employment is rising, albeit not by as much as people (and politicians) would like to see.

HT: Mark Perry, who manages to dig up all sorts of nice indicators like this.

Thoughts on monetary policy and productivity


Using the latest productivity numbers (productivity was down slightly in Q2/10, after having risen very strongly for the previous five quarters) and the latest GDP revisions, I've updated this chart that has been a long-time favorite of mine. The blue line represents the running 2-yr annualized growth rate in nonfarm productivity (this smooths out the typically volatile quarter-to-quarter changes), while the red line represents the year over year inflation rate as measured by the GDP deflator, which in turn is the broadest measure of inflation available.

What the chart purports to show is that there is a strong tendency for productivity and inflation to move inversely. Periods of declining and low inflation tend to be periods during which productivity is rising and generally strong—with the 1995-2003 period being a classic example. Periods of rising and high inflation tend to be periods during which productivity is volatile and generally low—with the 1970s being the classic example.

This relationship holds, I believe, because low inflation tends to focus people's attention on productive investments at the same time it promotes confidence by delivering stability, while high inflation tends to encourage speculative investments and discourage investment because it increases uncertainty. If prices are generally stable, for example, then it is difficult to make money by buying commodities, and the only real game in town is making money the hard way, by working harder and doing things more efficiently. If on the other hand prices are rising, then it becomes easier to make money by speculating in commodities, and it becomes very difficult to work more efficiently or to take on long-term investments because one loses confidence in the future. During the 4 years I lived in Argentina the inflation rate was well over 100% per year, and I can personally vouch for the fact that investment horizons shrink dramatically as inflation rises, and the business of life eventually becomes reduced to survival rather than planning and saving for the future.

I note that the chart is suggesting (still early to call this for sure, but it's tempting nonetheless) that we could be entering a new period of rising inflation and declining productivity. That's essentially the scenario I've been calling for since early last year—rising inflation and a subpar recovery.

How would this work? Easy money is likely to give us rising inflation, while oppressive government (e.g., the 25% increase in federal spending relative to GDP that Obama's budget is projecting) is likely to give us declining productivity.

I raise this issue because it is timely, with all the talk these days focused on the economy's presumed "loss of momentum" in the past several months. Most observers want the Fed to take steps to make money cheaper and for a longer period, in the belief that the economy is being starved for liquidity and the banking system is failing to pump out loans. From my perspective the Fed is not the culprit, if indeed the economy is losing momentum and slowing down. The Fed's easy money has helped commodity prices rise impressively, and the trillion dollars of bank reserves that are currently sitting idle at the Fed send shivers up the spine of investors and businesses everywhere, as we worry about the endgame of this unprecedented experiment in quantitative easing. I think easy money is part of the problem, not the solution. The op-ed in today's WSJ, "The False Fed Savior," agrees with me.

Monetarists, classical economists, and supply-siders all believe that monetary policy is essentially powerless to create growth out of thin air. You can't print your way to prosperity, since pumping unwanted money into the economy only creates inflation, not growth. In the same vein, monetary policy is a very poor tool for fine-tuning economic growth. Monetary policy tends to be a blunt instrument: the Fed tightens policy in order to fight inflation, and eventually policy becomes so tight that the economy falls into a recession—that's been the story of every post-war recession with the possible exception of the last recession. Monetary policy can become an obstacle or impediment to growth if it is incorrectly managed, but it can't call up growth from the ether. Good monetary policy can facilitate growth because it inspires confidence and that results in more investment and risk-taking, while bad monetary policy can kill growth because it creates uncertainty and that can shut down investment.

So I would like to see the Fed address its limitations today, rather than launch some new QE2 program. Ideally, the Fed should point the finger at Congress, since fiscal policy has been and promises to be a huge obstacle to progress. Only a more business-friendly and investor-friendly shift in fiscal policy can brighten the outlook for growth. The Fed can't and shouldn't try to do more than it has already.

Record-low mortgage rates don't signal a weak housing market


I haven't featured this chart in over a month, and meanwhile 30-yr fixed rate mortgages have been hitting new all-time lows (both conforming and fixed!). This is a big story that deserves attention.

As some readers have reminded me at various times, Milton Friedman once observed that low interest rates are an excellent indicator that inflation is low, so they wonder why I keep predicting that inflation will rise. My response has been that while low inflation does indeed lead to low interest rates, and vice versa, the two don't necessarily move in lock step. Often it takes a period of high interest rates (the result of Fed tightening) before inflation moves down and interest rates eventually follow. The early 1980s would be a great example of this. Similarly, it often takes a period of low interest rates (the result of Fed ease) before inflation pressures rise and interest rates eventually follow. The 1970s were a good example of how low interest rates can lead to higher inflation and higher rates. I think we've been in the latter kind of period for some time now. Remember, Milton also observed that the lags between monetary policy can be long and variable.

My sense is that the market looks at today's rates that are very low and falling, adds in Milton's observation about low rates and low inflation, and infers that inflation may actually be at risk of being so low as to threaten deflation. I think there's a decent chance the market may not be reading things correctly, and may be failing to learn the lessons of the past.

In any event, it is also the case that low interest rates can be a sign of a chronically weak economy, such as Japan has suffered for decades. When investment opportunities are scarce, it doesn't take much of an interest rate incentive to balance savings flows with investment demands for cash. This could be the reason for why mortgage rates are so low and why so many continue to worry housing prices have not yet hit bottom: low mortgage rates could be signaling that there is a shortage of mortgage borrowers relative to the number of investors willing to buy MBS—thus, the demand for housing could fail to absorb all the housing supply that is due to hit the market over the next year or so as foreclosures allegedly pick up.

One needs to keep in mind, however, that there is as yet no indication that the housing market is not clearing or will soon fail to clear. (By clearing I mean that sellers are able to find buyers at some price.) According to the NAR, the monthly supply of unsold homes in the U.S. has fallen from a recession high of just over 11 months to now just under 9 months. Sales volume is up in many markets, particularly in California and Florida, and the Case-Shiller index of home prices in 20 major markets shows that prices have been flat to slightly up since early last year.

The housing market is clearing, and has been clearing for over a year. Between declining mortgage rates and declining housing prices and a recovering economy, the market has found a price that equates buyers and sellers. The ongoing decline in mortgage rates is obviating the need for lower home prices. Think of it this way: the bond market, thanks to its conviction that the economy is going to be very weak for the foreseeable future, has been acting as a great shock absorber for the housing market by bringing mortgage rates down to all-time historic lows. In this view, low mortgage rates could be signaling simply that the market is very pessimistic about the economy, not that there is a shortage of homebuyers. Higher rates wouldn't jeopardize the economy or the housing market, since they would signal rising confidence, stronger growth expectations, and the prospect of rising incomes and rising home prices. Higher rates would also be a sign of rising inflation expectations, and that would only add fuel to housing demand.

So I don't see any reason to think that the recovery is fragile or that the housing market is on the verge of another collapse. Instead, I see lots of signs that investors are very concerned about the future of the economy, and I find little or no evidence in my list of key indicators for a reason to share those concerns.

Unemployment claims do not suggest a double-dip



Still catching up on recent developments. Just recently I saw someone claiming that the recent uptick in weekly unemployment claims could be a good indicator of a coming double-dip recession. What? In fact, recently I've seen so many articles and comments from people searching for a double-dip under every rock and around every corner that I am simply amazed. It's become something of an obsession. From my perspective I haven't seen anything yet that would make me concerned about the possibility of a double-dip.

The chart above looks at the 4-week average of claims. I fail to see anything that could be interpreted even remotely as a deterioration in the jobs market. Claims have been essentially flat all year. Sure, it would be better if claims were falling, but holding steady for seven months doesn't point to any weakening of the jobs market.

This next chart compares claims to the number of people working, which is arguably a better way to judge the health of the labor market. While the line has ticked up just a bit in the past few months, it is hardly of a magnitude that is unusual for two series which are not well correlated. There have been many such upticks—and many of them much larger—in recent decades that have not been followed by recession. The bears need to get a grip.

Recent commodity correction is over



As this chart shows, the commodity correction that started last May has now been completely reversed. This index of non-energy-related spot commodity prices is now at a post-recession high, and it is only 7% below its all-time high, registered in mid-2008.

This means that a) monetary policy is accommodative and inflation risks are not negligible, and/or b) global economic growth is at least strong enough to keep the U.S. economy from suffering a double-dip recession. In other words, the market is overly concerned about the health of the U.S. economy. As a corollary, it also means that should the Fed fail to announce some form of further monetary ease at the conclusion of tomorrow's FOMC meeting, this would not be a reason to turn bearish. Any market selloff would therefore be a buying opportunity.

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.