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Auto sales point to ongoing economic recovery


Total auto sales in September were about 2% stronger than expected. Abstracting from the disruption in the data caused by the ridiculous "cash for clunkers" program last year, and the typical month-to-month volatility in this series, auto sales are up at a 16% annual rate from their Feb. '09 low. That's a pretty impressive rebound. The level of sales is of course still dismally low, but the change on the margin is quite positive. This is fully consistent with an economy that is recovering. With employment, incomes, and confidence rising, I see no reason why this can't continue for the foreseeable future.

ISM indices continue to point to moderate growth




The September ISM manufacturing index was a tiny bit weaker than expected (54.5 vs. 54.4), but remains firmly in a range that in the past has coincided with 3-4% economic growth, as my first chart suggests. While this rate of growth is above the economy's long-term average of 3%, it nevertheless represents a fairly moderate recovery from a recession that was unusually deep. That's been the case for awhile, so in a sense today's report didn't change the outlook at all.

The export orders component (second chart) has weakened in recent months, but it too remains at levels that are consistent with economic growth, and it is far above any level that might suggest a double-dip recession.

The prices paid index jumped in September, and for my money it is signaling the existence of widespread and ongoing price pressures, something that is totally inconsistent with the Fed's and the market's preoccupation with how all the economic "slack" out there is deflationary. If the economy were even remotely on the cusp of a general and pernicious decline in the price level, you would think that some hint of that would be evident in this survey. But no, fully 70% of the ISM members reported paying higher, not lower, prices in September.


Finally, although the employment component of the ISM index dipped in September, it remains extraordinarily high. Since 1980, this index has only been higher in 14 out of 369 months. This suggests that the manufacturing sector continues to add jobs at a fairly impressive rate.

Adding it all up, the ISM report paints a solid picture of an economy that remains on a moderate growth track. Plus, it casts serious doubt on whether it makes sense for anyone—especially the Fed—to worry about deflation.

Oil is likely to remain somewhat expensive


Changing the subject, here's an updated version of an interesting chart I haven't shown for a long time. It compares the real price of crude oil with the total number of oil and gas drilling rigs operated worldwide (including offshore rigs). Not surprisingly, drilling activity responds to changes in the real price of crude with a lag. What stands out for the recent period is that while crude prices in real terms are back to the levels of the early 1980s, there are still far fewer rigs operating today than there were back then. Rig counts are still rising, however, so maybe the industry will eventually catch up. But the relatively low level of exploration activity today may help explain why crude prices are still quite high from an historical perspective. This further suggests that crude prices could remain in their current range of $70-80/bbl for quite some time.


This second chart is a reminder that the relatively high price of oil in real terms is much less burdensome for the economy today than it was in the early 1980s. That's because, thanks to conservation efforts and improved technology, the U.S. economy today uses about half as much oil per unit of output as it did in the early 1980s.

Caveat: I'm not an expert on the oil and gas market by any stretch; I'm just making some informed guesses based on a simple analysis of historical patterns.

The claims situation is slowly improving


Claims fell more than expected in the latest week, to a level (453K) that is a bit below the average for the year to date (465K). It's now clear that the unexpected swings in the index that occurred in July and August were the result of faulty seasonal factors (i.e., the actual numbers didn't behave as the seasonals had expected). The underlying trend in the labor market has been large unchanged this year, and that is a move towards very gradual improvement.


This chart shows the actual, unadjusted claims number, which has been clearly trending down all year. Importantly, it is now below the levels that prevailed at this time two years ago. Normally, actual claims would be moving higher at this time of the year, but so far that hasn't happened.


As this last chart shows, the biggest change in the claims situation has been the significant decline over the course of the year in the number of persons receiving unemployment insurance. That number has fallen by 3.75 million since the high at the beginning of this year. It's likely that at least some portion of this decline has occurred because some people are finding jobs. According to the household survey, some 1.8 million new private sector jobs were created in the first 8 months of this year. The improvements in claims to date suggests that next week's jobs number could hold some more pleasant surprises for the market.

Thoughts on quantitative easing


Ever since the Aug 10th FOMC statement—in which the Fed announced it would be buying longer-term Treasury securities with the proceeds of its maturing or prepaid Agency and MBS holdings—there has been a very interesting and tight correlation between the slope of the Treasury yield curve from 10 to 30 years and the market's own inflation expectations. This is shown in the above chart, with the red line representing the 5-yr, 5-yr forward inflation expectations embedded in TIPS securities, and the blue line representing the slope of the Treasury yield curve from 10 to 30 years.

What stands out is that the slope of the longer end of the yield curve is now a good proxy for the market's inflation expectations. That is at it should be, of course, since the higher inflation expectations, the greater the premium that investors should demand to own 30-yr bonds instead of 10-yr bonds. But it hasn't been that way for some time. And as the next chart shows, the slope of the 2-10 portion of the yield curve has been trending down all year even as inflation expectations have perked up. Plus, the flattening of the 2-10 portion of the curve has occurred under very unusual circumstances. (Typically, the curve flattens when the Fed pushes up short-term rates, and it steepens when the Fed lowers rates. For some time now, the Fed has kept short-term rates steady at very low levels, while longer-term rates have been falling.)


So the behavior of the yield curve is telling us something important, namely that the Fed's purchases of (and intention to continue purchasing) longer-term Treasury notes is having an impact. The Fed is artificially depressing yields out to 10 years, and that's not surprising because that's what they are aiming for. The Fed believes that lower long-term yields will be stimulative for the economy.

Whether the Fed's purchases of bonds will prove to be a stimulus for the economy remains to be seen, of course. Since early August, lower 5-yr and 10-yr Treasury yields have not resulted in any significant decline in mortgage rates, for example, because the spread between Treasuries and mortgage rates has simply widened. This is not unusual at all, it is simply the market saying that it doesn't believe lower Treasury yields are permanent, and/or it doesn't think that buying mortgages at lower yields is likely to prove profitable. And even if the Fed were able to drive mortgage rates to artificially low levels, I think it's questionable at best whether this would prove to be a stimulus for the economy.

Artificially low borrowing costs are part of the reason we're in the mess we're in. Cheap credit, among other things, helped fuel the housing boom, which eventually went bust. Flooding the system with money could help bail out underwater homeowners by pushing up home prices, but only at the cost of another round of reflation (perhaps housing prices, or in some other area of the economy, who knows?). Plus, it's hard to convince people to borrow these days, when so many are still smarting from having borrowed too much some years ago.

But I suppose that if the Fed tried hard enough for long enough, it would soon become apparent to intelligent people that taking out a whopping big mortgage was a good way to become rich. Borrow now at a super-low fixed rate for 30 years, buy a bigger home or some other tangible asset, then sit back and wait for the price level to rise and reduce the cost of repaying your loan. If enough people decide to borrow more, that translates into a reduction in the demand for money, and that has the effect of increasing the amount of money in the system relative to the prices of goods and services. It shouldn't be hard to see how that would in turn result in a higher price level for just about everything. It won't, however, result in any material change in the economy's ability to grow, since growth only occurs when the productivity of labor rises—when we collectively produce more for a given amount of effort.

I think the bond market is already thinking along these lines, and that is why the long end of the yield curve is steepening. The Fed may be able to depress 10-yr yields by promising to keep the funds rate at zero for an extended period of time, but there is no way the Fed can convince investors to buy 30-yr bonds a ridiculously low yields. Savvy investors are figuring this out: quantitative easing is going to push up inflation, so the thing to do is to shun long-term bonds (or borrow at long-term rates), and buy tangible assets or other currencies. Did I mention that gold and other currencies are already rising? And that's why the steepening of the long end of the curve is indeed a good sign that quantitative easing is going to lift inflation.

Along the way to higher inflation—which could take years to show up—this Fed exercise in quantitative easing may have at least one salutary effect, and that will be to vanquish the widespread fears of deflation. Convincing people that holding onto cash yielding zero is a bad idea is one way of boosting the velocity of money, and that is in turn a way of boosting the economy, if only because velocity has been very depressed. People have been hoarding money since the financial crisis erupted, and the hoarding continues to this day. That has depressed growth in the economy, which is another way of saying that fear of the future and risk aversion are not compatible with healthy growth.

I'm not condoning a QE2, however. I am hopeful, in fact, that it will not prove necessary, and I think that will become obvious as more signs of economic growth show up in coming months.

Online job demand points to rising employment


This chart comes from The Conference Board, and it shows the relationship between the level of employment (red line) and an index of online help-wanted ads (blue line). Over the relatively short sample period available, ads seem to do a good job of leading employment, which in turn suggests that we should be seeing further job gains in the months ahead.

HT: Mark Perry, who notes that "the 4,296,100 job vacancies in September were the highest level since November 2008, almost two years ago." This is a fairly impressive and positive sign in my view.

Let's follow the lead of Sweden

Sweden? Yes, Sweden, where conservatives have demonstrated that supply-side theories do work as advertised: "when you tax something less, you get more of it." Read the whole story in "Swedish conservatives bucked the recession by lowering taxes." Some excerpts follow:

This week Fredrik Reinfeldt is celebrating the first re-election in history of his party, the Moderaterna. He is also celebrating the success of an extraordinary experiment. His response to the recession was to cut taxes, a move his critics said the country could not afford. The European Commission warned him it would end in tears. But instead, the lower taxes were a spur to growth and Sweden now has the fastest-growing economy in the Western world.
When elected four years ago, leading a four-party coalition, Reinfeldt had a striking slogan. 'We are the new workers' party,' he said, meaning he would cut taxes for those in employment, but not for those on benefits. When faced with protests about how the poorest would be paying a higher marginal tax rate, he appealed to voters' innate sense of fairness - and resentment at the high level of welfare dependency. At every stage, his ministers would explain the basics of low-tax economics. Cut tax on wages, and you increase the incentive to work. 'This will increase employment,' Reinfeldt said. 'Permanently.'
Tax on low-paid jobs fell sharpest. Nursing assistants, for example, saw their tax bill drop by a fifth. The aim was to make work compete more aggressively with Sweden's famously generous welfare state.
Like most of Europe, [in response to the recession] Sweden launched a stimulus, but Reinfeldt set aside two thirds of his for a tax cut. Corporation tax fell from 28 per cent to 26.3 per cent, taxes on jobs were cut further still while income tax thresholds were raised. Determined not to let a crisis go to waste, he declared the tax cuts permanent.

HT: Don Luskin

Tech and consumer stocks have recovered nicely


The world is so gloomy that I thought it would be nice to show some good news. As this chart shows, both tech sector and consumer sector stocks have almost fully recovered to their pre-recession highs. Consumer staples are only 5% below their late-2007 (and all-time) high, while tech stocks are less than 3% below their late-2007 high.

The tech sector is still well below its very-inflated 2000 high, but its recovery to date from the 2002 lows is extremely impressive. It just goes to show that this economy is quite dynamic, and able to bounce back from even the worst of news.

Confidence remains low, and that's good for investors


The September reading from this measure of confidence fell, and that spooked the market temporarily this mornign. In my view, this is old news, and it simply validates what I have been saying for a long time: the market is priced to very pessimistic assumptions. Optimism is hard to come by, and consumers especially are still quite concerned about what's going on in Washington and the lack of a meaningful recovery. But when the majority of people are very worried, that gives optimists some attractive odds to bet against the prevailing mood. If there is just a little bit of improvement going forward, this could be good for prices of risky assets. Investors should worry when confidence is high, as it was before every recession in the past.

The housing market has adjusted to new realities



The top chart shows inflation-adjusted prices for homes in 10 major metropolitan areas since 1987, while the bottom chart shows prices in 20 major metropolitan areas since 2000 (and is also seasonally-adjusted). Both show that real home prices have fallen by one-third since the peak in 2006, and both show that prices stopped falling over one year ago.

Because of the lags in the way this index is constructed, the latest datapoint (July) tells us only about the average of prices in the second quarter of this year, and that's admittedly old news. But it's impressive that prices have remained firm for over one year after a significant decline. This is the way you would expect an overbuilt market to work: prices have to decline to a new clearing level that allows excess inventory to be worked off. That has happened.

The issue going forward is whether we need another significant decline to allow what is presumed to be a "new wave" of foreclosures to be sold. Put me in the skeptical column, because a) the housing market has had almost 5 years to adjust to new realities, b) prices have adjusted very significantly, c) prices have been stable for over a year, d) mortgage rates have declined by one-third since their peak in 2006, which further reduces the effective cost of buying a home by a substantial amount, e) new home construction has plunged by two-thirds, which contributes mightily to work off the excess inventory of homes, and f) the economy has recovered and we are now seeing job and income gains. That adds up to a giant amount of price and inventory adjustment, and enough time for all sorts of things to be dealt with. Why would we need more?

The housing market is clearing and has apparently stabilized. It's time to worry about other things, such as what will happen to taxes beginning next year.

The market is priced to pessimistic assumptions


I haven't shown this chart for awhile, and in the meantime yields have fallen when I thought they would have risen. The colored "valuation zones" that I've added to the chart of 10-yr Treasury yields represent my guesstimate of the expectations/assumptions that underlie a given level of yield. Real investors determine the yield on 10-yr Treasuries, and they take into consideration a number of variables in coming to their decision to buy them. Chief among those is their outlook for economic growth and inflation, since those are the two variables that factor the most into the future course of the Fed funds rate. And the expected future course of the funds rate is ultimately the thing that most determines the level of the 10-yr Treasury yield. If the market expects growth to be very weak and inflation to be very low, the market will not expect the Fed to raise short-term interest rates for a long time. If the Fed stays on hold for many years, then a 10-yr Treasury yield of 2.5% looks very attractive relative to the expected return on staying in cash and earning almost nothing. That is the situation we find ourselves in today.

This is not to say, of course, that the market is always correct. I think one key to successful investing is identifying first what the market's assumptions are, and then deciding whether those assumptions could be wrong, and whether market pricing offers the investor attractive odds to "bet against" the market.

I knew that the market was expecting depression and deflation when yields fell to almost 2.0% at the end of 2009. That's because at the end of 2008, TIPS spreads were reflecting deflationary expectations, and corporate bond spreads were consistent with the assumption that as many as 50% of the companies in the U.S. would be out of business within the next several years. I had numerous posts in the fourth quarter of 2008 which expanded on the abysmal valuations and assumptions that were priced into the market at the time.


Today the market is revisiting the yield levels that we last saw near the end of 2008. There are some important differences this time around, however, which bear noting. For one, corporate credit spreads are an order of magnitude lower than they were in late 2008, which implies that the market currently is not expecting a depression, but rather something like a "double-dip" recession or a long period of agonizingly slow growth. Second, the implied volatility of equity and T-bond options is not nearly as high today as it was in late 2008, which suggests that the level of fear, doubt and uncertainty is much less. In a sense, the market seems more sure today that the economy will be very weak for a long time, whereas back then the market was terrified that we were headed over the edge of an abyss.


In my view, this means that the odds the market is offering to bet against it are not nearly as attractive today as they were in late 2008. Back then, you could make a fortune just betting that we weren't headed for the end of the world as we know it. Today, you need some amount of growth (which I'm guessing is 1-2% per year) and some positive inflation in order to make money.

Still, it seems to me that 10-yr Treasury yields are very low relative to the outlook implied by credit spreads and implied volatility. There is a disconnect, in other words, between Treasury yields and other key indicators of market valuation. Whether this makes Treasuries a bubble or not, I'm not sure. All I know is that if the economy grows 2% or more and inflation picks up just a little, it's not clear to me that the Fed will remain on hold indefinitely. That would challenge the market's current assumptions, and at the very least some holders of 10-yr Treasuries would likely get nervous and sell.

In order to like the idea of holding 10-yr Treasuries in your portfolio, in other words, you need to be quite sure that the economy is going nowhere for a long time, and that there are some lingering deflationary pressures out there which haven't been addressed by the Fed's $1 trillion injection of reserves into the banking system, or by the dollar's pervasive weakness against other currencies, commodity prices, and gold.

In short, the market is priced to some fairly pessimistic assumptions. I'm by nature an optimist, believing that free markets are a breeding ground for industrious people and new ideas that in turn lead to productivity gains and continually rising living standards. I'm also very encouraged by the sea change in the mood of the electorate—as reflected best in the astonishing appearance and rise of the Tea Party—and what this means for the future course of fiscal policy. Washington has been doing just about everything wrong for the past several years, and now there is reason to think that policy may get back on a more sensible and growth-generating track.

The deleveraging fallacy

Paul Krugman speaks for the bears when he argues that "when everyone tries to pay down debt at the same time, the result is a depressed economy and falling inflation, which cause the ratio of debt to income to rise if anything." I think his logic is flawed, just as the logic is flawed behind the assumption that an increase in outstanding debt leads to an increase in total demand.

The fallacy here is that borrowing increases demand, while deleveraging reduces demand. It's simply not true, except in the case that the lender happens to be a bank that is using its reserves to increase the money supply. Even then, an increase in the money supply cannot result in a real increase in demand, otherwise we could print our way to prosperity. Dumping money into the economy only increases prices.

If A borrows $100 from B and spends the money, there has been no increase in demand because B now has less money to spend. Similarly, if A repays his $100 loan to B, then A has less money to spend and B has more. When the private sector creates credit, it is not creating new money or new demand, it is only shifting money from one pocket to another. Now it's true that increased credit may result in a more efficient economy (though not necessarily), and that may result in a net increase in demand, but on the margin when one person lends to another, demand is shifted from one person to another, but no additional demand is created.

As supply-side theory tells us, new demand is created by new supply. Global demand cannot increase at all unless global production rises. Otherwise we could all get rich just by spending more, or as the late Jude Wanniski was fond of saying, "we could spend our way to prosperity." It just can't happen.

So deleveraging needn't result in a weak or depressed economy.

Mark Perry has a nice post today that is effectively a corollary to the above, recalling Milton Friedman's point that deficit spending is also powerless to stimulate an economy.

Household financial obligations have eased considerably

According to a recent release by the Fed, households' financial burdens continued to decline in the second quarter of this year. From their peak in Q3/07, total household financial obligations as a % of disposable income have declined by fully 10%. And as this chart shows, debt and financial burdens today are about where they have been for the past 25 years on average.

Pessimists will argue that bankruptcy and foreclosure have been the drivers of reduced financial burdens, but while that may be true for a portion of the population, I think it is also the case that many people have been working hard to pay down debt in the past several years, while at the same time disposable personal income has been rising. In that regard, I note that disposable income (the denominator of the ratios in the chart) has increased on average about 3% per year per capita, and 4% per year in nominal terms, over the past 5 years. Thus, it's likely that most folks have seen their disposable income rise by more than their debt and financial obligations in recent years.

It's hard to see how this chart could be construed in a negative way. At the very least, we can say that consumers today are no more at risk from too much debt than they have been for the past several decades.

Commodities reach new all-time highs


It's official: the CRB Spot Commodities Index today reached a new all-time high (485), eclipsing the previous high (481) set in July 2008. This can be interpreted in many ways, of course, but let me state the obvious: this is not a symptom of deflation, and this is not a precursor of a double-dip recession. This is unambiguously symptomatic of growth and accommodative monetary policy.

What is amazing to me is that the Fed and so many commentators persist in wringing their hands over the possibility of deflation and a weakening of economic growth when commodity prices continue to move to all-time highs almost every day. I have yet to see anyone come up with a coherent explanation as to how we can be on the verge of deflation and recession when commodity prices are making new highs almost daily.

Commodity prices are measured in virtual real-time. They lie at the intersection of supply and demand across markets around the world. They tell us at the very least that economic activity is not contracting, it is expanding; that the price level is not declining, it is more likely increasing. Commodity prices are not subject to faulty seasonal adjustments, and they are not subject to revision. They are the here and now, and they are booming. And they are being led by gold, which is also at new all-time nominal highs.