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Fear subsides, prices rise



The Vix index (implied equity volatility) has fallen to its lowest level since the onset of the panic selloff in equities which began last May (which in turn was driven by the belief that the economy was on the cusp of a double-dip recession). Equities have not completely recovered from that episode, however, but they look to be in the process of doing so, and a declining level of fear is one important driver of the rally. As the top chart shows, the implied volatility of T-bonds, as measured by the MOVE index, fell dramatically this week. This is also helping equities, and let me explain why.

It would appear that the market has reached an almost unanimous opinion that the Fed will implement a second round of quantitative easing early next month, this time with the objective being to pull down 10-yr Treasury yields and keep them down for a considerable period. I think this is foolish and unnecessary, as I argued in yesterday's post, but those concerns are irrelevant for now. If one believes that the Fed will do all in its power to suppress 10-yr Treasury yields in an effort to avoid deflation and to spur the economy, then it makes sense that the implied volatility of Treasury options should fall to very low levels. After all, isn't the Fed going to practically guarantee that yields won't rise? And since they can't fall a whole lot more than they already have, this means that we are now (supposedly) at the beginning of a long period of low and stable yields (though I'm not necessarily agreeing with this). So options become very cheap, because uncertainty has all but vanished.

As I argued yesterday, the important thing about the Fed's promise to do anything it takes to avoid deflation (and maybe even to push inflation up) is that this all but eliminates the risk of deflation if done in convincing fashion. Deflation fears have been lingering for quite some time now, but now they are vanishing. When you take deflation risk off the table, suddenly the expected future value of all cash flows goes up: that's why the stock market is going up.

At this point it is probably not even necessary for the Fed to proceed with QE2. Promising in convincing fashion that they would do it if necessary is enough. And the market is now convinced. That automatically brightens the future, even though it leaves alive the concern that they will push inflation too high.

Private sector jobs are growing at a moderate pace, but the public sector is shrinking




The September employment report issued today was pretty much in line with expectations, which is actually somewhat unusual. It did, however, shed some new light on the economy's recovery. For one, it confirmed that employment in the private sector is growing, at an annualized rate of about 1.2–1.5% over the past six months. This is neither spectacular nor horrible; in fact, it is only a bit less than the average pace of job growth in the previous recovery. And it is still the case, as I have noted previously, that the household survey is leading the establishment survey, which is typical in most recoveries because the household survey is better able to pick up jobs created by small startups. The household survey shows that the private sector has created about 1.7 million jobs year-to-date, while the establishment survey pegs the number at 900K.


The most startling thing in this report was news that the public sector is shedding jobs like never before (third chart). With most of the census workers gone, we now see that public sector jobs are shrinking at a significant rate (1.7% annualized since the end of last year). This spells bad news for those who are losing their jobs, but it's good news for the economy, since it means the reversal of the trend towards ever-greater government bloat that has been a drag on growth for years. It also means that state and local governments are biting the bullet and cutting costs, and that is something that simply must be done. So, to the extent that a shrinking public sector is resulting on a drag on growth (which is not really significant, since there has only been a net decline in public sector emploment of some 250K year to date), this is not really bad news, it's a necessary adjustment, and it is freeing up resources which will ultimately be put to better use by the private sector.

Adding it all up, the private sector is doing a decent job of creating new jobs, and the public sector is undertaking the difficult task of trimming bloated budgets. Given the headwinds coming from fiscal and monetary policy, this is not at all a bad combination of events.

We don't need QE2



Top chart: Adjusted bank reserves. Bottom chart: M2

The investing world has worked itself into a frenzy of anticipation over the arrival of a second wave of Quantitative Easing from the Fed, which is supposedly going to be announced at the FOMC meeting in early November. The idea behind QE2, as it's called, is that the economy needs to be force-fed more money in order to pump up growth; $1 trillion of added reserves in late 2008 didn't help much, so we need a lot more.

This idea deserves to be buried alongside the corpse of Keynesian economics. Government spending can't boost growth because government spends money very inefficiently (especially when the spending program is designed by Pelosi, Reid & Co., and consists mainly of transfer payments and payoffs to unions). Government spending also needs to be paid for, and the funds that are borrowed to finance the spending represent funds that are removed from the pool of capital available to finance private sector initiatives. Similarly, quantitative easing can't boost growth for the simple reason that growth only comes from initiatives that boost productivity and/or increase the total number of people working. Printing money ultimately results only in higher prices, not a bigger economy.

The only justification for quantitative easing is as an offset to a dramatic increase in money demand. That was indeed the case in late 2008. The financial crisis shocked people all over the world into suddenly wanting to hold more money, and the dollar was the favored recipient of that new-found attraction for money. The Fed needed to supply a lot of extra money to the system, otherwise we would have likely fallen into a serious deflation.

But since the economy is now largely out of the woods and money demand is slowly declining, more quantitative easing is not only unnecessary but also potentially dangerous. The gold market is telling us that investors all over the world are growing increasingly concerned that central banks are making serious inflationary errors; gold is up because their demand for money has been seriously undermined. More of the same could accelerate the process of declining money demand, and that would be like adding fuel to the inflationary fires that have already been kindled.

Putting aside the theoretical arguments, let's look at the two charts above. What they are telling us is that the Fed's provision of reserves to the banking system has been declining since the end of February, while the amount of money sloshing around the economy (M2) has been increasing. Bank reserves have fallen by $170 billion, while M2 has increased by $270 billion. M2 is currently increasing at an annualized rate of over 6%. The increase in M2 has absorbed some of the excess reserves in the system, and the Fed's balance sheet has shrunk a bit, resulting in a $228 billion decline in excess reserves since February. Conclusion: the Fed's is effectively reducing the amount of money it is supplying to the banking system, but banks nevertheless are using some of their excess reserves to create new money, and all measures of money are now growing at healthy rates. And all of this is happening as the equity market rallies.

Things are getting better on all fronts, and that means the Fed shouldn't try to fix something that isn't broken by ramping up another quantitative easing program.

As I've said many times in the past, "there is no shortage of money." Whatever problems the economy may have, a lack of money is not one of them.

Weekly claims improve modestly and slowly



Top chart: seasonally-adjusted weekly claims. Bottom chart: non-seasonally-adjusted claims.

For yet another week, actual first-time claims for unemployment failed to increase as expected by the seasonal adjustment factors. Adjusted claims are now 4% lower (445K) than their year-to-date average (464K). The economy is not shedding jobs as it has in the past around this time of the year.


This next chart uses non-seasonally-adjusted figures in order to show exactly how many people are receiving unemployment benefits. The total continues to be boosted significantly by Congress' willingness to extend benefits up to two years via "emergency" claims.

Taken together, we see a picture of slow, and very modest improvement in the jobs market.

The bond market is bracing for the return of inflation




Lots of important action in the bond market these days. 10-yr Treasury yields have plunged to a mere 2.36%. Recall that they hit a generational low of 2.05% at the end of 2008, when the entire world was terrified of impending economic death and destruction. Are yields today telling us that doom is just around the corner? Absolutely not. This time around things are very, very different.

The plunge in yields today is all about the much-anticipated Quantitative Easing II that is expected to be launched in four weeks, and which could result in the Fed becoming the largest holder of Treasury securities in the world (mostly of maturities 10 years and in). Expectations have been enhanced because the Bank of Japan yesterday announced it would be joining the QE party with bond purchases of its own.

The market apparently figures that Treasury yields inside of 10 years are going to be very low for a very long time. Those who were short Treasuries have thrown in the towel. After all, it costs money to be short, and having to pay out carry for years on a short position is not a very comforting prospect.

The interesting part of the bond market action, however, is in the TIPS market, where yields have plunged by much more than Treasury yields, and in the long end of the Treasury curve, where the spread between 10 and 30-yr Treasuries has widened to its steepest level ever. Since the end of August, when QE2 expectations started to heat up, 10-yr Treasury yields have declined by 10 bps, whereas 10-yr TIPS real yields have dropped by 50 bps. That's a 40 bps increase in annual inflation expectations over the next 10 years. Using the more sensitive measure of inflation expectations—the 5-yr, 5-yr forward breakeven rate—inflation expectations have jumped almost 50 bps since the end of August (see top chart). The spread between 10- and 30-yr Treasuries has shot up to a record-breaking high of 127 bps, up from 105 bps at the end of August.

Note in the second chart above how the drop in Treasury yields in late 2008 reflected deflationary fears (with inflation expected to average zero over the subsequent 10 years), whereas the current drop reflects inflationary fears.

So the market is saying that it has little doubt that the Fed will ramp up its quantitative easing efforts, and almost no doubt that this will prove inflationary in the years to come. The plunging dollar and the soaring price of gold fully support this interpretation.

This is the best evidence you can find that deflation risk has evaporated. The question now is not how low inflation will be, it's how high it will be in the years to come.

As I've been arguing for a long time, when you take deflation risk off the table, you automatically brighten the economic outlook, even though inflation is not typically good for economic growth. I think that explains, in part, why stocks have rallied over 10% since the end of August. The other reason stocks are up is that the prospects for a Republican landslide have improved, and with them, the chances of an extension of the all the Bush tax cuts have risen considerably. Just the idea that Republicans now stand a good chance of "stopping all the bad stuff," as John Boehner recently put it, is reason for cheer considering how gloomy the prospects have been since early last year.

So once again I'm left with this thought: if the prospects for the economy are improving and inflation expectations are rising, why in the world would the Fed proceed with QE2, when it would only complicate things in the long run? This is really important stuff, and I get the feeling that Bernanke & Co. have not yet thought through all the ramifications of what they are planning, nor have they paid sufficient attention to market-based signals.

UPDATE: I'm bringing this up from the comments section since it adds useful info to the post:

The only question now is how high inflation rises. Many worry it's going to rise by an awful lot. I'm not sure yet. Gold has not yet broken new high ground in real terms, and the dollar has not yet set a new all-time low in real terms. So maybe things won't be catastrophic. The Fed certainly doesn't want a catastrophe, and I've learned it never pays to underestimate the Fed's ability to get what it wants. I'm playing this by ear right now.

I note, meanwhile, that real yields on 10-yr TIPS are now at a record low. When you combine that with gold at a record nominal high and the dollar at a record low, you realize that in order to buy protection against lots of inflation you have to pay a pretty stiff price. There is no obvious place to hide.

Count on the IMF to get things wrong

Here's a blurb from the WSJ that summarizes a gloom-and-doom pronouncement from the IMF today:

WASHINGTON—Global growth will slow more sharply than expected in 2011 as advanced economies slash their budgets amid the continuing sovereign debt crisis, the International Monetary Fund said Wednesday.
The downside risks remain elevated in the face of a fragile economic recovery, the IMF said in its World Economic Outlook. "The financial sector is still vulnerable to shocks and growth appears to be slowing as policy stimulus wanes," predominantly in advanced economies, the IMF said. 
"Simultaneously addressing both budgetary and competitiveness problems in a deteriorating external environment is likely to take a heavy toll on growth," the IMF said.
In short, the IMF is saying that efforts to restore fiscal discipline will undermine global growth prospects. Which is funny, because here I have been thinking that it was fiscal profligacy that got us into so much trouble to begin with. How is it that doing the wrong thing—spending way more than you have on non-productive things—can be good for your economy, but doing the right thing—spending within your means and reducing tax burdens—can be bad?

Here's how I would rewrite this:

Global growth will pick up more than expected in 2011, as advanced economies cut back on wasteful "stimulus" spending and the sovereign debt crisis recedes.
Downside risks are likely to decline, as reduced financing demands by major governments will leave more funds available for use by the private sector to create jobs.
Simultaneously addressing competitiveness problems by reducing wasteful government spending and reducing tax burdens will boost global growth prospects. 

New applications for mortgages jump


This chart shows the Mortgage Bankers' Association purchase index, which includes all mortgage applications for the purchase of a single-family home. Since its low of last July, the index is up over 20%—a good sign that the housing market is firming rather than headed for another cliff. Purchase activity is still very depressed from a recent historical standpoint, of course, but on the margin it is moving in a positive direction. As the next chart shows, activity today is roughly the same as it was in 1997, just before the big housing boom got started.

The Challenger report suggests a healthy jobs market


According to the folks at Challenger, Gray & Christmas, announced corporate layoffs last month remained at close to the lowest level registered in the past 11 years. By now it's obvious that Corporate America has all but finished its downsizing. So the next shoe to drop will be a renewed interest in hiring. Signs of this are already evident in the strong rise in temp hires, as noted in yesterday's post. And according to Challenger, announced hiring plans last month were among the largest they have recorded in the past six years (bottom chart). And don't forget that through August we saw 1.8 million new jobs created year to date according to the household survey of employment. This Friday's jobs numbers should shed further light on the subject, and I expect it to be favorable.

Quantitative easing is working


The steepness of the long end of the Treasury yield curve reached another all-time high today of 126 bps. 10-yr Treasury yields have fallen to their lows for the year, but investors in longer maturities are balking—the steepening of the curve is coming mainly from rising yields on 30-yr Treasury bonds, which are up 20 bps since the end of August. That's a sign that the Fed's quantitative easing program is working.

The Fed can pin the 10-yr Treasury yield at artificially low levels, but easy money can't make an economy grow, except to the extent that the prospect of inflation causes people to invest money they would rather just keep in cash. Shoveling money into the economy mostly results in higher prices, and there is growing evidence that this is occurring.


Against a basket of major currencies, the dollar is down 12% from its June highs, and down 6.5% from its late August level, when the Fed first started to float its QE2 program. Measured against a broad basket of currencies and adjusted for inflation, the dollar is once again at its all-time low level by my estimation (above chart). A weaker dollar, of course, means that prices outside the U.S. are rising. Pinning interest rates at an artificially low level is akin to supplying dollars that no one wants, and so we see that the dollar's value is declining.


Gold is up $25/oz. today, reaching another all-time high and also confirming that the world is awash in dollars. Most commodity prices are rising as well, and oil today is up to $83/bbl.

If there is anything good about these signs of reflation, it's this: rising prices throw very cold water on the notion that the U.S. economy is at risk of deflation. And if you can dismiss the risk of deflation, then the future brightens considerably, and risk-aversion makes much less sense. Investors who are parking cash in zero-interest accounts are forced to reevaluate their convictions and concerns. The calculus increasingly favors taking on some risk, and this is one of the things the Fed is hoping for. As a result, we're getting a modest boost to growth, and increasing signs that inflation may perk up in the future.

The next shoe to drop will be the realization that an improving economy with rising prices means that more quantitative easing is not really necessary. This may short-circuit the Fed's widely telegraphed plan to launch QE2 a month from now, but that would hardly be bad news.

ASA Staffing Index continues very strong


The strength of this index, which measures temporary and contract employment, is quite impressive. Compared to the same week a year ago, demand for temp workers is up 25%. This reflects some underlying vigor in the economy that is hard to ignore or explain away. I'm beginning to suspect that the jobs number will be surprisingly strong this Friday. And given today's 2% equity rally, the market may be suspecting the same thing.

HT: Mark Perry

Service sector indices not particularly strong




This morning the market was apparently impressed by the higher-than-expected reading on the ISM service sector composite index (and also impressed by Japan's latest attempt to fight deflation by lowering interest rates further). I don't share those views. I've been following the business activity index, and as the first chart shows, it has not been very strong of late, and came in still weaker today. Last month I thought it was just one of those random variations, but now it looks more like the service sector is just plodding along, not growing by any impressive amount. That view is confirmed by the employment index (third chart), which is just barely above 50—signaling very modest growth in employment, if any.

The prices paid index (second chart), however, continues to come in with an unambiguous result: a clear majority of businesses report paying higher prices. Deflation is not an issue.

In any event, I don't see signs anywhere of a double-dip recession. The economy is not growing very fast (I still think 3-4% growth is likely, even though that represents a very meager recovery), but neither is it deteriorating by any meaningful amount. Importantly, the larger economic backdrop continues to look healthy: commodity prices remain very strong, global trade continues to expand, and emerging market economies are doing very well.

The biggest problems the U.S. economy faces are 1) very misguided fiscal policy ("stimulus" that doesn't stimulate, and which leaves dreadful debt burdens in its wake, plus massive expansions of government regulatory authority which stifle private sector initiative), and 2) very disconcerting monetary policy (desperate attempts on the part of the Fed to pump up the money supply and weaken the public's demand for dollars). If policymakers would only stop trying to "do something," the economy is perfectly capable of mounting a robust recovery on its own. I remain hopeful that this will be one of the big messages that voters send to Washington next month. The traditional entrepreneurial spirits that have given us strong economic growth in the past are being held down by bad policies, but they have not been snuffed out.

Profits outlook--still bright




With the end of the third quarter behind us, it's time to update what we know or can infer about corporate profits and stock market valuations.

The top chart compares trailing, after-tax, 12-month profits (earnings per share) as reported by the S&P 500 (blue line) for September, with the annualized (Q2/10) after-tax profits of all corporations (red line) as reported in the National Income and Profit Accounts and adjusted for Inventory Valuation and Capital Consumption Allowances. The former is a relatively narrow-focused measure of profits, whereas the latter is very broad-based. NIPA profits hit a new all-time high as of June 30, 2010, whereas S&P profits at the end of Sept. '10 were still 15% below their August '07 high.

Despite their differences (apples to oranges, as skeptics would immediately notice), there is some remarkable similarity in the long-term behavior of these two measures of profits: both have increased by about the same amount over the past 50 years, and both show similar cyclical fluctuations. Plus, NIPA profits not only tend to lead reported profits, they are also much less volatile—despite being quarterly annualized numbers. Reported profits on a trailing basis are naturally lagging in comparison, but you would think they also would be less volatile as a result; that they are in fact more volatile suggests that reported profits are a less accurate indicator of profits on average than are NIPA profits. I note further that NIPA profits are based on information submitted by companies to the IRS, and as my good friend Art Laffer—who has been touting the NIPA profits number for decades—notes, no company is likely to overstate its profits on their IRS tax return. Key takeaway: The top chart has been and continues to suggest that reported profits are likely to keep increasing for the foreseeable future.

The second chart looks at PE ratios using S&P 500 reported profits. Here we see that PE ratios are somewhat below average. The third chart makes a similar case, but using NIPA profits and a normalized value of the S&P 500 as a proxy for the average value of US corporations. Here we see that PE ratios are quite low from an historical perspective. About as low, in fact, as they were at the onset of the great bull market of the 1980s.


This next chart compares the yield on long-term BAA corporate bonds (blue line) with the earnings per share (i.e., earnings yield) of the S&P 500 (red line). As I noted last month, earnings yields are now noticeably higher than corporate bond yields, another indication that equity valuations are relatively cheap. After-tax earnings on the S&P 500 stocks now represent a "yield" of just under 7%, which happens to be the average of the past 50 years. Corporate bond yields, in contrast, are currently 5.7%, which is 300 bps less than their average of the past 50 years. If it weren't for the market's obvious expectation that earnings are very unlikely to maintain current levels, much less increase, stocks would be considered an incredible bargain by historical standards.

If the NIPA profits are correctly predicting a continued and substantial rise in reported profits, then I have to believe that that the equity market has some very substantial upside potential, as either of the trend lines in the last chart are also suggesting.

Shipping update



Time for another update on shipping rates. The Harpex Index continues to rise, while the Baltic Index seems to be moving somewhere just below the middle of the wide range it has established in the past seven years. Neither index appears to be screaming inflation, nor does either point to anything like a double-dip recession.