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Treasury yield curve is now steeper than ever before



Today the spread between 2- and 30-yr Treasuries reached a new all-time high of 398 bps. This is an unequivocal indication that the Fed's effective policy stance is ultra-accommodative. The yield curve almost always steepens a lot coming out of recessions, because the Fed typically shifts to easing mode as the economy enters a recession, and then reaches full-bore easing in an attempt to help the economy dig out of its recession hole. This cycle has been no different from many others, with the main difference being that the funds rate has never been at or close to zero before.

A very steep yield curve such as we have today is also the direct result of the bond market's expectation that short-term interest rates will not remain at or near zero forever—starting sometime around the end of this year, the market expects the Fed to begin hiking rates, reaching 4% within 5 years' time. That too is typical as business cycles mature.

And as the top chart suggests, a steepening of the yield curve is also strongly indicative of rising inflation expectations. The only mystery about recent market action this year is the failure of 5-yr, 5-yr forward inflation expectations to rise in line with the ongoing steepening of the curve. It may be the case that intermediate TIPS breakeven spreads are being distorted by the Fed's ongoing Treasury purchases. Higher inflation expectations over the next 5 years would require higher nominal yields—but those are being held down by Fed purchases—and/or lower TIPS yields—but those are already negative out to 5 years. The path of least resistance for now would appear to be a further decline of short-term TIPS yields into negative territory (i.e., a further increase in the prices of short-maturity TIPS), a prospect that nevertheless must be daunting for many investors to contemplate. But with the ongoing rise in commodity prices, investors may eventually conclude that accepting a negative real yield is the price one must pay for inflation protection.

The news is still positive

A quick roundup of today's good news:


The December Leading Indicator (above) rose much more than expected (+1.0% vs. +0.6%). It has been rising steadily, and at a healthy clip, ever since March 2009, with the exception of a flattish period from Mar-Aug of this year. That period included the Euro sovereign debt default scare, the US economy's "soft patch," and an apparent slowdown in the housing market. Those problems are now in the past, and fiscal policy is now pointed in a much more optimistic direction, leaving open the strong possibility, in my view, that we could see an acceleration in U.S. economic growth this year.


Weekly unemployment claims jumped unexpectedly last week, but settled back down this week, leaving us with a significant and convincing decline in the 4-week moving average over the past several months. The labor market is definitely improving. As an anecdotal aside, my cousin landed a decent, full-time job yesterday after a relentless, at-times-heartbreaking, two-year search.


China's economy grew about 10% last year. For years, it seems, markets have been on tenterhooks over the possibility that China's economic growth bubble might burst, bringing the rest of the global economy down with it. Yet the Chinese growth engine just keeps on chugging. It's amazing what can happen when a government unleashes market forces in an economy that was formerly highly regulated and suppressed. The minor amount of "tightening" that has been applied by the central bank in recent months is unlikely to make much of a difference here, since at best it offsets the dollar's weakness (which in turn is a function of the Fed's quantitative easing).

 
Existing home sales surged 12.3% in December, and have rebounded hugely from last summer's terrifying (at the time) weakness. The lion's share of the volatility in home resales in recent years can be attributed to government incentive programs which have come and gone. That's apparent when you consider that the average level of existing home sales over the past three years is unchanged from what it was in early 2008. Meanwhile, the inventory of unsold homes has fallen by 20%, from 4.5 million in mid-2008 to 3.5 million. These are not scary numbers at all, and are fully consistent with a market that has found a new equilibrium.


The January Philly Fed business outlook survey was a tiny bit lower than expected (19.3 vs. 20.8), but remains at a healthy level, providing further confirmation that the "soft patch" that troubled market participants last summer was just temporary.

Commodities take a 40-yr round trip



The top chart is the nominal version of the CRB Spot Commodity Index, while the bottom chart is the real, inflation-adjusted version of the same index. According to the PCE deflator, inflation has totaled 385% since the beginning of 1970, and according to this commodity index (which includes no energy), commodity prices have risen a total of 370%. That means that in real terms, commodity prices today have just about returned to where they started in 1970. (For the record: during the 1960s, inflation was about 25%, but commodity prices rose only 15%, so real commodity prices today are about 10% below where they were in 1960.)

To make things more interesting, on the second chart I have added some colored backgrounds to highlight how different monetary policy regimes have impacted real commodity prices. Monetary policy was notoriously easy in the 1970s. Money was cheap to borrow (real interest rates were generally low), so speculators had a field day buying and hoarding commodities, and selling the dollar. Beginning in late 1979, when Paul Volcker took over the Fed, monetary policy shifted to inflation-fighting mode and ignored any signs of economic weakness. Real interest rates were generally high for the next two decades, and inflation fell from double digits to a mere 2%. Speculators had a hard time surviving those years, since commodity prices went nowhere but borrowing costs were high. Unable to speculate on inflation-fueled price rises, investors were forced to make money the old-fashioned way by buying and creating productive assets. Since 2002 we have seen the Fed shift to an overtly accommodative monetary policy stance. Real borrowing costs have been generally low, speculators have thrived, the dollar has again collapsed, and commodity prices have soared.

The parallels between the 1970s and the past 8 years are many: a weak dollar, soaring commodity, gold, and energy prices, real interest rates that are generally low, and a Fed pays more attention to the economy than it does to sensitive asset prices. The only thing that makes the period since 2002 different from the 1970s is that inflation hasn't risen in recent years (although the CPI did rise to 5.6% in mid-2008). Will we continue to see very low inflation? I sincerely doubt it. History may not repeat itself exactly, but there is sure a lot of rhymin' going on.

Reading the bond market tea leaves


This chart illustrates some enduring truths about monetary policy, Treasury yields, and the health of the economy, so it's worth revisiting from time to time. Right now it's sending a strong message: monetary policy is very accommodative, and poses virtually no risk to the economy. This unfortunately undermines at least some of the rationale behind the Fed's quantitative easing strategy (i.e., the economy needs help). Moreover, it also suggests that easy money today could be setting us up for rising inflation tomorrow, and that in turn could lead to another round of monetary tightening and the recession that would likely follow—though it could take several years for the unpleasant implications of this chart to surface.

The blue line represents the real Federal funds rate, using the PCE Core deflator as a measure of inflation (that being also the Fed's preferred inflation measure). The real funds rate is arguably the best measure of how "tight" or "loose" monetary policy is: a high real rate discourages borrowing by making it very expensive, while a low real rate encourages borrowing by making it cheap. When borrowing becomes intolerably expensive, the public's demand for money rises (rising money demand being the opposite of rising demand for borrowed money), and eventually collides with the Fed's efforts to make money scarce (by tightening monetary conditions). An effective shortage of money thus develops that typically results in a recession.

Based on this chart, one could argue that every post-war recession was caused by tight money. And in almost every case of very tight money, there was also a pronounced rise in inflation which created the need for monetary tightening. The late 1990s was the notable exception, since the Fed tightened aggressively even though the PCE Core rate of inflation never exceeded 2% from mid-1997 through mid-2001, gold and commodity prices fell, and the dollar rose.

The red line reflects the difference between the yield on 10-yr Treasuries and the yield on 1-yr Treasuries, what's known as the slope of the yield curve. Bond market math tells us that the yield on 10-yr Treasuries is the market's best guess as to the average of the Federal funds rate over the next 10 years. Investors in aggregate are necessarily ambivalent between keeping money in cash for the next 10 years or buying a 10-yr Treasury bond today—both strategies are expected to yield the same total return over time, because a steep yield curve means that the market expects the yield on cash to rise over time as the Fed tightens policy.

The fact that the red and blue lines move inversely most of the time confirms that the slope of the yield curve is a good indicator of how easy or how tight monetary policy is. When the Fed is very easy, the yield curve is usually very steep, because the bond market anticipates that the Fed will eventually have to raise rates significantly. Similarly, when the Fed is very tight, the yield curve becomes either flat or inverted, which is the bond market's way of saying that tight money today will be followed by easier money tomorrow. In short, monetary policy can't remain at extremes of tightness or looseness forever, and the slope of the yield curve is the bond market's way of saying how obviously easy or tight monetary policy is at any point in time.

So, when the blue line is very high (i.e., when the Fed is very tight) and the red line is very low (i.e., when the yield curve is flat or inverted) that almost always signals a recession ahead, because it means that money is becoming exceedingly scarce. Conversely, as is the case today, a low red line and a high blue line are typically indicators of a business cycle that is still in its early stages, and money is in relatively abundant supply. The unusually weak level of the dollar today confirms that dollars are relatively plentiful, and the high level of gold and commodity prices says the same thing.

The bad news here is that the Fed is likely repeating the errors of the 1970s, when monetary policy was on a roller-coaster ride and money was at times very cheap. Very cheap money in the 1970s helped fuel inflation, and today's cheap money is likely to do the same.

The good news is that deflation risk is non-existent; the economy is not starved for money; and there is every reason to expect the economy to continue to expand for the foreseeable future. Plus, there is still time for the Fed to reverse course before inflation becomes too high or too ingrained.

More signs of a housing market bottom


The Bloomberg index of major home builders' stocks is once again at a post-recession high, up almost 150% from its March 2009 low. That low occurred right around the time that home prices, according to the Case Shiller index, hit bottom (considering the 2-3 mo. lag built into the Case Shiller index). I also note that the home builders' index peaked in mid-2005, about 6 months before home prices peaked.

Today, many are arguing that home prices are set up to decline to new low levels—given an expected surge in foreclosed homes being dumped on the market—but equity investors are either ignoring that news or (more likely) seeing signs of improvement in the housing market. Since housing starts have been basically flat and at very low levels for almost two years, I think the picture that emerges is one in which the coming supply of foreclosed homes is effectively offset by the combination of a multi-year dearth of new construction and the ongoing increase in new household formations. In short, after a wrenching 5-yr period of adjustment, the housing market has found a new equilibrium, and the equity market is "looking across the valley" of bad news to an impending recovery in home prices.

One more commodity chart


This index of commodity prices contains a decent amount of crude oil and products, in addition to a variety of other industrial commodities. Since crude prices are still about one-third less than their mid-2008 highs, it is remarkable that this index is now at a new all-time high. That is a testament to the pervasiveness with which commodity prices have risen across the board.

Note that 100 on the chart marks the mid-Nov. '01 low for most commodities. And recall that over the course of 2001, the Fed dropped its funds rate target from 6% to 1.75%—a substantial easing move that was exceeded in magnitude only in 1982 and 2008. Easy money—which has been with us for most of the past 9 years—provided the spark which subsequently drove commodity prices to a 200% gain.