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Oil prices reach a post-recession high


This chart shows the spot price of Arab Light Crude, and I feature it because oil prices have moved to new post-recession high ground in the past few weeks, after having been range-bound for most of the recovery. As with the story behind commodity prices, I think there are two things driving higher oil prices: 1) accommodative monetary policy from almost every central bank in the world that is weakening the purchasing power of currencies, and 2) an ongoing and probably-strengthening global economic recovery that is causing the demand for commodities and energy to exceed the expectations of commodity producers.


This chart shows the price of Arab Light Crude in constant dollars (using the PCE deflator). In real terms, oil today is not only at a post-recession high, but also higher than it was in the early 1980s. I've argued before that this is not necessarily an ominous development, since U.S. consumption of oil per unit of output has fallen by more than half since the early 1980s. In other words, we are much less reliant on oil to run the economy, so higher prices are less harmful than they were before.


The chart below compares the real price of crude (using the CPI) to the worldwide drilling rig count. Not surprisingly, higher prices are providing an extra incentive to producers to increase drilling and exploration activity, and that should eventually bring more supply to the market, thus capping the rise in prices.


The last chart compares the price of crude to the price of gold, and it shows that crude prices are roughly in line with the gold prices from an historical perspective. The ramifications of this are many, however, and I'll have to leave that for later.

Green lights for a stronger recovery



The first chart shows the level of the Index of Leading Indicators, while the bottom chart shows the year-over-year change in the index. Two things stand out: One, the index is moving higher and showing absolutely no sign of any economic slowdown. Two, as the top chart suggests, the growth in the index over the past several decades has been impressive, and not at all like the stagnant conditions which prevailed during the great equity bear market of 1965-82. In other words, the index is a big green light for continued expansion and prosperity.

With the sea change in the direction of fiscal policy that began with the November elections and which has been confirmed now with the extension of the Bush tax cuts for everyone and for capital, plus the defeat of the last-gasp-of-the-big-spenders Omnibus spending bill yesterday, the private sector has a very good chance of generating a stronger recovery in the years to come. The private sector has been oppressed for years by increased regulatory burdens; investors and businesses have been reluctant to invest given the threat of a massive increase in tax burdens; and the huge increase in inefficient government spending and transfer payments has been a drag on overall productivity. Looking ahead, all of these headwinds should be reversing, or at least slowing down dramatically.

This amounts to a giant Christmas present for investors in equities and corporate debt. At the same time, it is a death knell for investors in Treasury notes and bonds, since they have been priced to a very gloomy economic growth outlook.

Exports continue to grow


October exports were quite strong, as I noted in a recent post, and now comes news from the ports of Los Angeles and Long Beach that November loaded outbound container shipments were strong as well. This suggests that November trade statistics will be strong as well. With strength evident in exports, retail sales, and manufacturing, fourth quarter GDP could come in as strong as 4-5%. Mark Perry has some more color on the activity at the Port of Los Angeles here.

Housing has become almost irrelevant


Housing starts have been essentially flat for about two years, and have plumbed the lowest level of residential construction activity relative to GDP (slightly over 2%) ever recorded. If construction activity were to decline further, it most likely would have happened by now—no construction company CEO by now could possibly have ignored all the signs of distress and overbuilding and excess housing inventories. Even if activity were to decline further, it would have a de minimis impact on the overall economy. Conclusion: for all practical purposes, housing can only get better, since it can't get much worse. When will the improvement come? It doesn't really matter, since even a 10 or 20% jump in housing starts would have a minimal impact on the economy. Housing will likely turn up well after everything else has turned up, and most things have been turning up for almost a year and a half. Housing is going to be bringing up the rear this time around, for the first time ever. This is a very different business cycle, because it was the only one that was precipitated by a housing crash following a housing boom of epic proportions.

Labor market conditions continue to improve



The labor market is showing enduring signs of improvement. It's not that lots of people are getting hired, however. It's that not many are being fired given the time of year. The top chart shows new, seasonally adjusted claims for unemployment, while the bottom chart shows the raw, nonseasonally adjusted numbers. From the latter, the degree of improvement is noticeable. Currently, layoffs are running only slightly higher than they were at the same time of the year in the growth years of 2004-2007. That suggests that businesses are running a very tight ship, so that any improvement in underlying conditions, coupled with improved confidence in the future, could quickly translate into significant new hiring activity next year. And of course there is that mountain of cash that has accumulated on corporate balance sheets that is just waiting for something to do.

How the bond market vigilantes work



The controversy over QE2 continues, but the real action is in the bond market, where bond yields and inflation expectations are moving up daily, if not hourly.

Before QE2 was even a possibility, yields and inflation expectations were declining from May through August. The fuel for this move was the belief that sovereign defaults in Europe would spread contagion through the global economy that could result in a double-dip recession in the U.S. Weaker growth, in turn, would intensify deflation pressures, thus making 10-yr Treasuries an attractive hedge. So everyone piled into 10-yr Treasury bonds, driving their yield down from 4.0% to 2.5%.

Then the Fed floated the idea of QE2 at the end of August, and everything started changing. Traders began speculating that Fed purchases would create downward pressure on the Treasury yield curve out to 10 years. The market began to front-run the Fed, by buying bonds that the Fed was expected to purchase. By October, the market had driven 10-yr yields down to an extremely low 2.4%.

Meanwhile, speculators were also figuring that QE2 could have inflationary consequences. Normally this would have pushed up yields all across the curve, but savvy traders focused their efforts on the long end, because they knew they would be fighting the Fed if they bought the intermediate part of the curve. So the 30-yr bond came under intense selling pressure, and 30-yr yields soared relative to 10-yr yields, taking the 10-30 spread to by far its steepest level ever: 160 bps. For investors making a yield curve play, a popular strategy was to buy 10-yr Treasuries and sell 30-yr Treasuries in a duration-neutral fashion.

The latest twist in this tale began in November, when the FOMC executed the first of its planned $600 billion in purchases of intermediate Treasuries. Two forces were at work: On the one hand, you had a trader's natural impulse to "buy the rumor, sell the fact." The market had been buying 10-yr Treasuries in advance of QE2, and that had been profitable, so now was the time to start unwinding the trade. On the other hand, you had a tremendous hue and cry coming out against QE2. Criticism of the Fed, and dissension with the ranks of the FOMC hadn't been so intense for as long as I can remember. Maybe QE2 would be shut down or cut short? All the more reason to start reversing the trades that had been put into place leading up to November. So the 10-30 part of the curve flattened with a vengeance, and the 2-10 part of the curve steepened dramatically.

Today the steepness of the various segments of the yield curve has returned to the levels that prevailed earlier this year, before sovereign defaults, double-dip recessions, and QE2 arrived on the scene.

What are we likely to see going forward? Two factors are going to figure large in coming months: QE2 and the strength of the recovery. QE2 is likely to continue to fuel inflation concerns, driving inflation expectations higher. Meanwhile, the economy is likely to strengthen at least moderately, with the extension of the Bush tax cuts adding to the forward momentum that has been building for the past several months. The combination of those two forces will very likely result in higher 10-yr yields, and a steeper 2-10 curve, because rising inflation expectations and a stronger economy not only increase the likelihood that QE2 will be curtailed or aborted, but more importantly, they demand a higher level of Treasury yields.


If the market comes to believe that the economy will grow at a more normal rate next year, then by my estimation (laid out in the above chart) 10-yr yields need to be at least 4%. If in addition to that, inflation expectations continue to rise, then we're talking yields of 5% or so.

I think many observers are misinterpreting the rise in yields, thinking that the market is reacting in horror to the prospect that extending the Bush tax cuts will mean an even-bigger federal deficit. They fail to appreciate that federal revenues are already rising at 10% annual pace, and that this is sufficient, if combined with some spending restraint on the part of the new Congress, to reduce the deficit substantially in coming years. Extending the tax cuts won't affect this picture at all; it will most likely increase the economy's ability to generate jobs, expand the tax base, and lift tax revenues.

The stock market appears to be getting a little spooked by the rise in yields as well, thinking that higher yields will shut down the forces of growth. But that's not how things work. Treasury yields are rising because the economy's prospects are improving, and yields are still quite low from an historical perspective. We've seen very strong growth coexist just fine with much higher yields than we have today. It's also the case that while rising Treasury yields make it more expensive for the government to borrow money, they don't necessarily cause corporate borrowing costs to increase. Credit spreads are still quite generous and they can compress further.

There is nothing here that would derail the forces of growth. The only thing of real concern is that Fed policy may eventually unleash the inflation genie that to date has been quite restrained. That could trigger a new round of Fed tightening that would eventually be bad for the economy, but those are concerns we're unlikely to have to worry about for at least the next year or two.

What the FOMC statement didn't say


Today's FOMC statement was unsurprising, and the decision to leave policy unchanged was as expected. The statement reiterated the view that the economy was growing at a disappointing rate, and that "measures of underlying inflation have continued to trend downward."

But the most important part of the statement was what wasn't said. Nowhere was there any mention of the fact that 10-yr Treasury yields have jumped over 100 bps in the past two months (see above chart), while 80% of that rise is due to an increase in the real yield on 10-yr TIPS—a sign that the rise in yields is mostly due to an increase in real growth expectations. Plus, there was not a single reference to the stock market, which is now up almost 12% year to date, and up almost 20% since the Fed first floated the idea of QE2 (see chart below of the S&P 500). The rise in bond yields and the rise in equity prices are classic indicators of a big increase in the market's expectation for future growth. Why couldn't the Fed at least acknowledge this?


Another glaring omission was the failure to mention the fact that the dollar is very weak from an historical and inflation-adjusted perspective (see chart below). The dollar's historical weakness is reflected, not surprisingly, in gold prices which are now at historical highs. A very weak dollar is almost proof-positive that there is an over-supply of dollars in the world. And we still need more quantitative easing?


If the Fed persists in ignoring the market's signals, they will end up making another mistake. It's very unfortunate, since past mistakes (e.g., tightening too much in the late 1990s, then easing too much in the early 2000s) have given us a roller-coaster stock market, huge gyrations in interest rates, and a massive housing boom and bust. Monetary mistakes coupled with fiscal policy mistakes (e.g., last year's $1 trillion of "stimulus" that turned out not to be stimulative at all) have been the bane of the U.S. economy for over a decade now, and it's high time our policymakers learned how to pay attention to the market and how to understand what makes the economy tick.

I'm amazed that the FOMC has managed to ignore the market-based indicators for so long. But I find it hard to believe that this state of affairs can continue for much longer. The bond market vigilantes have only just begun to raise the alarm, and sooner or later the Fed will be forced to take note. The Tea Partiers have already beat our politicians over the head, and that's begun to bring positive change to Washington. Despite the miserable state of affairs, there is still room for optimism.

Retail sales make a comeback


After upward revisions to previously reported data (another reason why government statistics can never be as reliable as market-based indicators such as commodity prices, which have been pointing to relatively strong growth since last July), retail sales are now seen to have surged at a 12% annual rate in the past five months, and they are up 7.7% in the past year. November sales were only 0.3% below their all-time of late 2007. At this rate, December could be the best Christmas ever, and fourth quarter GDP could be substantially stronger than third quarter.

This should put to rest any lingering talk of a double-dip recession, of course. And with the rising confidence that will come with an extension of the Bush tax cuts, the question now becomes how much stronger the economy will be next year.

Producer price inflation still alive and well


The November producer price index rose a bit more than expected, but as the above chart shows, over the past few years there hasn't been much change in the level of inflation according to this measure. Abstracting from the huge volatility of oil prices in 2008, producer prices have been rising at about a 3.5% rate for the past 6-7 years on average, while core prices (ex-food and energy) have been rising a little over 1% a year for the past two years. I note that even though this recovery has been sluggish, unemployment has been unusually high, and there has been an extraordinary amount of "slack" or idle resources, inflation has bounced back faster in the current recovery than it did following the 2001 recession. That's just more proof that inflation doesn't respond to the strength or weakness of the economy as the Fed's Phillips Curve Theory of Inflation suggests.


This next chart puts things in a long-term perspective. It shows the producer price index on a semi-log scale, so the slope of the line becomes the inflation rate. I've indicated different inflation regimes on the chart, beginning with the early 1960s when inflation was as low, subdued and steady as it has ever been (and it's not a coincidence that the U.S. was on a strict gold standard at the time).

Inflation has quickened somewhat since 2004, which not coincidentally was when the Fed first started getting serious about easing policy to pump up the economy and to avoid deflation, but it is still far below the hectic pace of he late 1970s (thank goodness). Easy money hasn't done much for economic growth—and there's no reason to think it should, since a nation can't print itself to prosperity—but it has given us a faster pace of price increases at the producer level. Sooner or later this should give us a quickening of inflation at the consumer level. Put another way, the ongoing rise in commodity prices—industrial commodity prices have risen a total of almost 12% a year for the past 9 years—must at some point translate into higher prices for many consumer items.

Notable comebacks






The S&P 500 index is still about 20% below its 2007 all-time high, but as these charts show, there are a lot of key financial indicators which are at or very near all-time highs. Copper is now at an all-time high, as are a variety of industrial commodity prices (first two charts). The CBOE index of technology stocks is at a post-2000 high, while the S&P 500 consumer staples index is with just a few percentage points of an all-time high (third chart). The VIX index of implied equity option volatility is almost back to its pre-crash lows (fourth chart), and it shows how the decline in fear and uncertainty has helped stocks in general to recover. The Dow Transports index is within shouting distance of new all-time highs (fifth chart). Finally, 5-yr swap spreads (six chart) long ago made a complete recovery (swap spreads are very good leading indicators of economic and financial market health, as I have noted many times since late 2008), and swap spreads continue to suggest that the economy too will make a complete recovery sooner or later.

These recoveries stand in sharp contrast to the still-depressed levels of financial and homebuilders stocks, which is another way of saying that the 2008-9 recession's wrath was concentrated in just a few sectors of the economy (next two charts, respectively). The devastation in housing and banking was so great that it will take many years to fully recover, but this is no reason to be pessimistic about the economy's medium-term prospects.




At this point it seems quite likely that Congress will pass legislation which extends the Bush tax cuts for all taxpayers, and that will remove one more barrier to an eventual, full recovery because it reduces uncertainty and it improves the incentives to work, risk-taking, and investment. It also marks a sea-change in Washington's attitude towards the private sector, and that is a very welcome return to policies that are more likely to foster rather than retard growth. It highlights the fact that higher tax rates are not the remedy for our budget ills, so it will put inexorable pressure on Congress to rein in spending. As I noted in a post last week, continued economic recovery will boost tax revenues automatically, without the need for higher tax rates, so simply holding the line on spending is quite capable of balancing the federal budget within 5 years. The future is hardly grim, and there is plenty of reason to think that the economy and the country can get back on a prosperity track before too long.

Two years ago, the prospect of a full economic and financial market comeback was so remote as to be almost unthinkable. Now, it's just a question of how much longer it will take. That's probably the biggest comeback I can think of.

UPDATE: One more chart (below) that shows the impressive comeback in retail sales, now truly just inches from a new record high.

The fatal flaws of ObamaCare (cont.)

Last month I updated a series of posts outlining the six fatal flaws of ObamaCare. One of the fatal flaws was the unconstitutionality of mandating that people buy health insurance just because they are alive. Today this was confirmed by U.S. District Judge Henry Hudson in Richmond VA, who found that the minimum essential coverage provision of the act "exceeds the constitutional boundaries of congressional power."

While this is certainly cause for cheer among those who cherish individual liberty, there are still quite a few hurdles left before the law is definitively struck down for constitutional reasons. Another important ruling is expected this week in similar case in Florida, where 20 states have joined an effort to have the statute thrown out.

Another issue that remains to be clarified is whether nullifying the individual mandate would essentially render the law inoperable, because it would make it impossible to mandate that insurance companies refuse insurance to those with pre-existing conditions. Last week the White House conceded that it would. Randy Barnett has a nice discussion on this issue here.