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Inflation expectations are alive, well, and rising


I'm watching the yield curve and TIPS' implied inflation expectations carefully these days. As I've noted several times in the past several weeks, the pronounced steepening of the yield curve at the long end (blue line in this chart) has correlated pretty well with a significant increase in the market's future inflation expectations (red line). Forward-looking inflation expectations have increased from 2% a year at the end of August to almost 3% today. The only time in the past 5 years that we have had a similar-size increase in inflation expectations over a short period was early last year, when the market began to realize that the economy was not falling into a depression/deflation abyss.

The Fed is pulling down Treasury yields out to 10 years, but the Fed has no control over yields beyond that. The increased (and record-setting) spread between 10 and 30 years reflects a market that is balking. The prospect of another round of quantitative easing has convinced the market that inflation is headed higher, much as the Fed now seems to want. Investors are shunning long-term bonds because they are increasingly worried about long-term inflation risks.

This is not good, of course, and that's why the dollar is down since the end of August, and gold is up. Stocks are not getting hit, however, but I think that can be explained if you assume (as I do) that stocks have been depressed for a long time over the risks of a double-dip recession, deflation, and a punishing increase in future tax burdens. The double-dip has so far failed to show up, QE2 all but erases the possibilities of deflation, and the November elections increasingly promise to result in a reduction in government spending and future tax burdens. The combination of all three means that future after-tax cash flows are now expected to be stronger than the market had been thinking. That's why stocks are rallying even though the inflation fundamentals are deteriorating.

UPDATE: Of course, the more inflation expectations rise, the less likely we are to see the Fed proceed with its QE2 program. We've already heard more than one Fed governor say that QE2 is not yet a done deal. I still think there's an outside chance that the Fed does little or nothing in the way of QE2 after next months' FOMC meeting. Though that might be a disappointment to the market at first, any selloff should be viewed as a buying opportunity. It's never a bad thing for the Fed to do the right thing.

Leading indicators still positive


The Leading Indicators (weekly hours (manufacturing), weekly jobless claims, manufacturers' new orders, vendor performance, building permits, stock prices, M2, yield curve slope, and consumer expectations) continue to reflect an economy that is likely growing—no sign at all of a double-dip here.

Claims are stable, may be improving



On a seasonally adjusted basis, claims last week fell to a level below the average so far this year (top chart). Actual claims (second chart) have not yet experienced the increase that is typical for this time of the year, but it is too early to tell whether this is a big deal or not. The next few weeks should tell the tale. If actual claims fail to increase as expected, then the adjusted number will start declining and that would be good news to a market that is still priced to very slow growth.

My growth expectations remain unchanged from my prediction at the end of 2008: 3-4% real growth on average. I think this number is reasonable, because I expect employment to increase about 1% a year (a number that is pretty meager in fact, and less than what we have seen so far this year in the private sector), and I expect the productivity of all those working to increase by about 2% a year (and that is less than the 3% average over the past two years, less than the 2% average over the past several decades, and less that the 3.7% rate we've had over the past year). Growth in the labor force plus growth in productivity gives you real growth, and my assumptions are actually quite conservative. Growth of 3-4% is consistent with an unemployment rate that remains painfully high for some time to come, and with a recovery that is painfully slow.

If Congress can extend the Bush tax cuts after the election, and if the electorate delivers a clear mandate for change (i.e., less spending, and less government intervention in the economy), then most likely I would raise my growth forecast for next year.

Pity the Chinese


The Chinese own about $1 trillion worth of Treasury securities, whose average yield is now probably in the range of 1-1.5%, and they are being forced to take a beating on those holdings. They are in a real bind, because they are being pressured to appreciate their currency by U.S. politicians who are sadly ignorant of how global trade and capital flows work, and by the Federal Reserve, the architect of the ongoing loss of the dollar's value. In the past four months, China's central bank has allowed the yuan to appreciate over 8% against the dollar in an attempt to alleviate those pressures.

China's reasons for doing this are twofold: to appease U.S. policymakers who are arguing for a much more dramatic appreciation of the yuan, and to minimize the inflationary impact of being tied to a weak and falling dollar. Pegging its currency to the dollar is the cornerstone of China's monetary policy, and if the dollar weakens, then the yuan also weakens, and this is equivalent to a monetary ease which will sooner or later show up as higher Chinese inflation. In fact, China's CPI has already risen, on a year over year basis, from a low of -1.8% in July '09 to 3.5% as of August '10. The weakening of the dollar, which has carried the yuan down with it, is the proximate cause of this reflation.

Revaluing one's currency doesn't come cheap, however, especially when the currency you are revaluing against is also the currency in which the majority of your reserve assets are denominated. The appreciation of the yuan over the past four months has effectively wiped out a little over 3 year's worth of interest on their dollar security holdings. Further yuan appreciation, which seems likely, will wipe out even more of the value of China's foreign bond holdings. They are truly caught between a rock and a hard place.

This reminds me of the massive losses that Japan suffered as result of the appreciation of the yen, which rose from 250/$ in 1985 to 80/$ at its peak in 1995. This 200% yuan appreciation destroyed fully two-thirds of the value of the countless billions of dollar assets that Japanese savers had accumulated. Recall that Japan was a major export engine at the time, its aging population had a high savings rate, and the destination of choice for those savings—which were larger than could be accommodated by Japan's own economy—was the U.S.

Remember the book "Rising Sun," by Michael Crichton? His thesis was that the U.S. was monumentally stupid to allow the Japanese to buy so much of our real estate and so much of our industry. As a resident of Los Angeles, I recall that Japan's purchases of a number of downtown office towers occurred almost precisely at the peak of real estate prices in the early 1990s. Prices then proceeded to drop by one-third, at the same time the dollar fell from 130 yen to the low 80s—real estate bought in the early 1990s lost over one-half its value when translated back into yen. Japan's savers lost a fortune, thanks to the Bank of Japan's extremely tight monetary policy. And as it turns out, Japan never acquired the nefarious control over U.S. industry that Crichton warned about in his book. On the contrary, we took them to the cleaners. We bought their cheap cars and cheap electronics; they invested their export earnings in the U.S., only to see a huge portion of those savings wiped out by the weak dollar/strong yen.

And so it is with the Chinese. They sell us mountains of cheap goods, then turn around and invest most of the proceeds (equivalent to our trade deficit with China) in U.S. Treasury securities. We get the goods, and we get to keep the money. Then we devalue the dollar, and they lose on their investment. Why we would want them to stop doing this is beyond me, though if I were a Chinese citizen, I would be furious with my government for directing such massive quantities of my country's export earnings to Treasuries. The central bank of China has no need to further increase its already-massive reserves; instead, the government should be relaxing capital constraints, allowing Chinese citizens more freedom to save and invest abroad in the types of vehicles with which they feel most comfortable. China's workforce is aging daily, and like Japan a few decades ago, China's economy cannot accommodate all the savings of the Chinese people—they are essentially forced to save overseas.

Contrary to what you read in the press—which mistakenly believes that our large trade deficit with China is something we need to worry about—China is the one that needs to worry, not us.

UPDATE: I highly recommend John Cochrane's WSJ article, "Geithner's Global Central Planning." Key quote: "The Chinese government's accumulation of U.S. debt represents a tragic investment decision, not a currency-manipulation effort." The article is an elegant ridicule of all those who think they can spot and treat a global trade or currency "imbalance." It should be required reading for all students of economics.

Residential construction is in an upward trend


September housing starts exceeded expectations, and data from prior months were revised upwards. The pattern is becoming clearer with the passage of time: residential construction bottomed about 18 months ago, and the upward trend in this volatile series since early last year works out to a 14% annualized growth rate, which by itself is actually pretty impressive. For all the woes that still surround the industry, it remains the case that we have seen the worst and conditions are now improving, albeit erratically. We'll very likely to see substantial improvement over the next several years at least, given the depths to which activity sunk in 2008. I would note, of course, that residential construction now represents such a small part of GDP (about 2.5%) that the ups and downs of housing starts are going to have a very small impact on the overall economy no matter what direction the trend ends up heading.

Industrial production does not support the case for QE2



The September industrial production and capacity utilization releases came in a bit below expectations, but in the context of rising commodity prices and improving financial market health (e.g., very low swap spreads, generally declining credit spreads, declining implied volatility of equity and bond options) I consider this to be a blip and not the beginnings of a double-dip recession.

As the top chart shows, most major economies are experiencing a gradual recovery in industrial production, with a bit of weakness apparent in the summer months. Despite this weakness, U.S. industrial production over the past six months has risen at an annualized rate of 5%, and Eurozone industrial production is up at an impressive 9.6% pace over the same period. We've still got a ways to go before recovering to the peak levels of 2008, but we're making progress, and that's the most important thing.

I'm most interested in the second chart, since that gives some insight into the future course of monetary policy. As this chart suggests, monetary policy has a strong tendency to follow the health of the manufacturing sector, which in turn is a decent proxy for the health of the overall economy. When the economy weakens, the Fed almost always eases (by reducing the real Federal funds rate), and when the economy strengthens, the Fed tightens (by raising the real funds rate).

The 2008-2009 recession saw industrial production fall to extremely low levels, but that has been followed by a decent recovery. The Fed eased as much as it could in response, though they were limited by the so-called "zero bound." Regardless, the economy appears to have recovered enough, according to my reading of this chart, to obviate the need for further easing. If the Fed just kept policy on hold while the economy continued to gain ground, that would probably be sufficient stimulus.

One of the glaring flaws behind the supposed need for a second round of quantitative easing (QE2) is that there is no evidence at all that the economy is being held back by a lack of liquidity—the Fed can't fix something that's not broken. All measures of the money supply are growing at healthy rates and are at all-time high nominal levels; swap spreads are unusually low; credit spreads are in a declining trend; and equity prices are rising. Furthermore, there is little reason to think that a further (and likely quite modest) decline in Treasury yields or mortgage rates would provide significant stimulus to the economy. After all, mortgage rates are already at all-time lows, and housing affordability is better today than at almost any time in the past 30 years.

The great majority of the excess reserves that were added by QE1 are still sitting on deposit at the Fed. Increasing bank reserves by purchasing additional Treasury and/or MBS would likely only increase further the amount of idle reserves, while putting only modest downward pressure on interest rates. The more the Fed tries to stimulate via the purchases of bonds, the more the market will worry that monetary stimulus will lead to higher inflation, and that in turn will reduce the market's willingness to hold bonds. So the Fed can try to bring down interest rates further, but they are going to be fighting mounting headwinds that are working to drive interest rates higher.

If QE2 (or talk thereof) is good for anything, it is to throw lots of very cold water on deflation fears. With the dollar at extremely low levels, gold prices over $1300, and commodity prices setting new all-time highs, the likelihood of deflation is already de minimis in my view. But the market still worries (albeit less so every day) about deflation, and so does the Fed. Eliminating deflation fears would thus change the expected distribution of cash flow risk by effectively eliminating much of the downside risk, and that argues strongly for rising equity prices, since equity prices are the discounted present value of future cash flows. And by the same logic, eliminating deflation risk should lead to a gradual improvement in confidence and therefore a continued economic recovery.

In short, the Fed has probably done all it needs to do already.