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Headed down to the end of the world

Shortly, we'll be on our way to the far ends of South America, so blogging will be sporadic and most likely quite different. Two years ago we went to Argentina about this same time of the year, and I think I arrived there about a week after the market hit its fearsome low in March 2009. This time the trip will be far less burdened by concerns for the future of the country and the health of our investments.

We'll be spending a day in Buenos Aires, then 8 days in southern Patagonia: El Calafate (in the heart of Argentina's glacier district; El Chaltén, at the foot of spectacular Mt. Fitz Roy; and Chile's Torres del Paine national park. We return for a few more days in Buenos Aires, followed by some time in Tucumán, where we will be attending a wedding and getting reacquainted with family and friends. On our way back we'll stop in Chaco, in the northeastern part of Argentina, to check in on a Grameen-style bank that we helped establish some years ago. I hope to have time to post photos and commentary along the way, as this should be a welcome respite for all.

Bank loans to small businesses are rising


Commercial and Industrial Loans are a good measure of bank lending to small and medium-sized businesses, the ones that don't have easy access to the huge corporate bond market. After two years of a severe contraction, in which C&I loans shrunk by 25% ($400 billion), a rebound is finally underway. Over the past three months, loans have risen at a 6.1% annualized pace, after zero growth for most of the second half of last year. It's still small potatoes in the great scheme of things, but it nevertheless marks an important inflection point. Instead of shunning new lending, banks are now expanding their balance sheets; instead of deleveraging, businesses are now in the mood to borrow.

It should be clear from this chart that recoveries are not dependent on an increase in bank lending. Indeed, most recoveries in their initial stages are characterized by deleveraging, as companies shore up their balance sheets in preparation for renewed growth. So the message of the recent increase in C&I loans is not that the recovery is finally getting underway, it's that business balance sheets are healthier, business excecutives are more confident in the future, and banks are once again in the mood to lend. All of this will help sustain the recovery in the years to come.

Jobs growth continues to slowly improve


The February jobs situation improved from January, but wasn't what could be called robust (as I was hoping). The private sector added 222K jobs, according to the establishment survey, and 162K according to the household survey. The latter survey has been noisy in recent months, but the former has been more stable. For now I think the establishment survey is doing a better job of tracking the situation, and it shows that jobs over the past six months have increased at a 1.6% annual rate, which is the fastest pace of growth since July '06. Since the low last February, the establishment survey says the economy has created a little over 1.5 million new private sector jobs, while the household survey counts 1.8 million. Things are getting better, but they have a long way to go before you could say they were great. Judging from all the other numbers we are seeing, I continue to think that we will see continued improvement here—it is just a matter of time.



Despite the relatively tepid pace of jobs growth, the unemployment rate has declined. This is mainly due to the fact that the labor force has not grown at all in the past three years (a rising number of people employed divided by a shrinking total labor force gives you a lower unemployment rate), whereas it has typically grown about 1% per year. This likely reflects things such as discouraged workers giving up on their job search, and baby boomers deciding to retire early. What it implies is that once the economy starts moving forward in a more energetic fashion, many of those who "dropped out" may decide to get back in, thus boosting the size of the labor force and slowing the decline in the unemployment rate. 


Public sector jobs continued to decline in February. Although this is tough on those who are being laid off, it is a good sign for the economy as a whole, since one of the biggest problems that state and local governments face is a bloated workforce. Government at all levels has grown too big too fast, and must be reined in if the private sector is to have a chance to unleash its dynamism. If the public sector consumes fewer resources, and there are fewer bureaucrats to meddle with things, the private sector will benefit.


As a followup to my post the other day, it turns out that the ADP estimate of private sector job growth was spot-on. The past few months of BLS data were revised higher, moving closer to the ADP numbers, and the February number was almost identical for the two surveys.

Europe braces for an ECB tightening


Short-term interest rates in Europe are rising, in anticipation of a decision by the ECB to start raising interest rates. ECB President Trichet today surprised the world by suggesting the ECB may raise rates at its next meeting, in response to evidence of rising inflation pressures. German 2-yr yields, priced to the market's expectation for the average of the ECB's target policy rate over the next two years, jumped over 20 bps today and have risen almost 100 bps so far this year; they are now 100 bps above 2-yr Treasury yields. As the chart below shows, the ECB already has the distinction of being the "tightest" major central bank in the world, with its target rate of 1%. (It would be perhaps better to say that the ECB is the "least easy" of the major central banks.) If they are the first to tighten, and it would appear likely, this will be a very important development.


The world's major central banks—with the notable exception of the Bank of Japan—tend to move together, as the chart above suggests. An early move by the ECB to raise rates will thus put pressure on the Fed to follow suit. Is this something to worry about? No. The prospect of higher rates has not deterred European stocks from rising, and it has given a substantial boost to the Euro, as indeed it should. Currency markets love tight-fisted central banks. The dollar, in contrast, is at its weakest level ever, thanks in large part to the Fed's repeated promises to keep rates close to zero for a very long time.

European yield curves are still very steep, and the real ECB target rate is approximately zero. This means that the ECB could (and is likely to) raise rates by hundreds of basis points over the next several years before policy becomes tight enough to threaten growth. In the meantime, it bolsters confidence in the Euro, and strengthens the outlook for the Eurozone economies. I note also that 2-yr Euro swap spreads fell today on the ECB news, and are now at a 10-month low—another sign that this is a welcome development.

Commodities continue to rise, inflation can't be far behind



These charts represent the two major components of the CRB Spot Commodity Index. They contain no oil or energy-related commodities—just basic inputs to a lot of manufacturing processes and very run-of-the-mill types of food. They are both rising strongly and are posting new all-time highs almost every day. As I've pointed out many times before, it cannot be a coincidence that almost all commodity prices began their current run (which was briefly interrupted by the financial crisis in 2008) in 2001, which also marked the beginnings of the Fed's Great Easing. That easing was followed shortly thereafter (Mar. '02) by a major dollar decline; since then the dollar has lost 25% of its value, and is now at an all-time low in inflation-adjusted terms against a large basket of trade-weighted currencies. Easy Fed, weak dollar, strong commodity prices: they all fit, and in that order. The natural consequence of this, if left unchecked for too long, will be rising inflation.

QE2 has achieved its objective


Inflation expectations are once again stirring in the bond market. This chart shows the nominal yield on 5-yr Treasuries, the real yield on 5-yr TIPS, and the difference between the two, which is the market's "breakeven" or expected inflation rate over the next 5 years. Expected inflation is now only 20 bps shy of its all-time high, which was reached in early 2005 as the CPI was in the process of ramping up from a low of 1.1% in 2002 to an eventual high of 5.6% in 2008. (It doesn't make sense to exclude energy prices from this analysis, since TIPS are adjusted by using the change in the entire CPI index.)


This next chart shows the same analysis, using 10-yr TIPS and 10-yr Treasuries. Again we see inflation expectation rising in recent months. It's probably not a coincidence that inflation expectations have been on the rise ever since the Fed first floated the idea of QE2 in late August of last year. 5-yr inflation expectations have risen from a low of 1.2% in late August to a current 2.6%. That's significant.

To be sure, inflation expectations today are not out of line with the experience of the past few decades. TIPS are priced to the expectation that the CPI will average about 2.5% for the foreseeable future, whereas the CPI has averaged 2.6% over the past 20 years. But what stands out is that there now is no longer any trace of deflation sentiment left in the bond market. QE2 has wiped out deflation fears. This may have helped the economy improve, since it eliminated the fear of deflation and thus improved confidence on the margin.

I think there is a good case to be made that QE2 should be retired, because it has served its purpose. There is no need for the Fed to wait to see the employment numbers improve—that's like driving by looking in the rear-view mirror. The Fed should be forward-looking, and all the forward-looking indicators suggest that the economy is clearly on the mend. Easy money won't make the recovery any more solid from this point on. Easy money that overstays its welcome will only begin to generate real inflation fears, and that can sap confidence and weaken the economy just as deflation fears did. We already see all the portents of a significant rise in inflation: a very weak dollar, and soaring gold, oil, and commodity prices. Those prices will be validated if the Fed continues with QE2 for too long, and that would likely lock in a permanent upward shift in the general price level.

Service sector activity is picking up


The February ISM service sector surveys were stronger than expected, and this marks yet one more in an impressive series of indicators that are all pointing to a meaningful acceleration in economic activity. This recovery is real, it has legs, and it is still in its early stages. The manufacturing surveys reported earlier this week were very strong, and now we see the much larger service sector also registering significant improvement. New hiring is on the way.




If there is any unpleasant news, it is that both the manufacturing and the service sector surveys are reporting rising prices. This is good in one sense, since it means that demand is picking up, but it also reflects higher commodity prices—which likely reflect the impact of a very weak dollar and thus portend rising inflation pressures.

Layoffs are declining rapidly, new hiring to follow


Weekly claims have been "unexpectedly" strong (i.e., low) for quite some time now, and they just keep driving. The improvement is impressive. As with the Challenger tally of corporate layoffs, the story is simple: businesses have done most of the cost-cutting they are going to do. They are lean and mean, and ready to hire. And it's almost certain that they will be hiring in increasing numbers, because there are multiple signs that consumers are recovering their confidence, businesses are recovering their confidence, and financial markets have healed.


There are still just over 8 million people receiving unemployment insurance, however. This represents an army of workers available for hire—an army that has been sitting idle for the past two years. Generous and repeated extensions of the eligibility period for receiving unemployment compensation have likely slowed the reabsorption of a goodly portion of these people into the workforce, since it lets them hold out for the perfect job rather than taking whatever is available or learning some new skill or trade. This is not going to change dramatically any time soon, but I suspect that if anything does change soon, it will be employers who decide to step up their hiring efforts in order to meet rising demand. We should be seeing a significant pickup in new hirings before too long.

Swap spread update


Long-time readers know that I assign great importance to swap spreads. They have been excellent, forward-looking indicators of important financial and economic fundamentals. For example, note in the chart above how spreads rose well in advance of the onset of the 2008-9 recession, and how they fell well in advance of the end of the recession in mid-2009.

U.S. swap spreads have been very low and stable for over a year now, and despite the turmoil in the Middle East, soaring oil and gasoline prices, the declining dollar, hand-wringing over the Fed's QE2 program, and trillion-dollar deficits for as far as the eye can see, swaps haven't budged (well, except for a brief scare last April-May when the prospect of Eurozone sovereign defaults threatened and many started predicting a double-dip recession). That tells me that our financial market is on sound footing; there is no threat to the banking system or the economy on the horizon, liquidity is back where it should be, the economy doesn't suffer from any liquidity shortage, and confidence in the future has been reestablished. Low and stable swap spreads mean that systemic risk is very low. Whatever problems we face today are likely to resolved without significant economic or financial market disruption. And yes, that implies that the trouble in the Middle East and $100 oil prices are not likely to topple the still-might US economy.

The picture isn't so bright in Europe, however, with swap spreads still at levels that reflect unusualy systemic stress (e.g., the likelihood of some unpleasant things happening like a Greek default or debt restructuring). Things haven't heated up enough in Europe to disturb stock markets or the value of the Euro, though, but perhaps swaps are telling us that will be the next shoe to drop. In any event, with swaps elevated, I would approach Europe with caution.

Corporate layoff activity remains low


The Challenger, Gray & Christmas tally of announced corporate layoffs in February came in a bit higher than expected, but that is well within the range of random noise for this series. Nothing here to suggest any change in the fundamentals of the job market. The important thing is that corporations have most likely completed most or all of their downsizing, and are thus primed for a new cycle of hiring.

ADP points to stronger job growth


ADP is guessing that the change in February private sector jobs to be reported this Friday is going to be 217K. They have over-estimated the actual number for the past two months—are they going to make the same mistake again? I'm an optimist, given all the good numbers we're seeing, so I think they might even be underestimating the number this time. The market is expecting 200K new private sector jobs this Friday, and I think we could see more than that.

Car sales continue very strong


The level of auto sales is still relatively low, but the growth rate—up at 19.7% annualized rate over the past two years—is truly impressive. February sales came in much stronger than expected, and I doubt there was anyone in the world who imagined, back in Feb. '09, that auto sales would be growing 20% per year for the next two years. This kind of growth is having ripple effects all up and down the economy. It shows that consumers have regained a good deal of their confidence and their financial health; that financing is available; that automakers are going to be ramping up production and hiring plans; that dealers will be feeling better; and of course GDP will be stronger.


It's also impressive that used car prices continue to rise, and are now at a new all-time high. The car market has come roaring back to life. This recovery has legs.

More very strong manufacturing reports


The February ISM survey of manufacturers was strong across the board, exceeding expectations. This first chart of employment is almost "off the chart" strong, since it is by far the strongest reading since 1973: almost two-thirds of firms surveyed reported plans to increase hiring.


As this next chart shows, more firms are seeing increased demand from abroad. The weak dollar is undoubtedly contributing to the general strength in exports that we've see for awhile, but this also reflects the fact that global growth is strong, and that provides a healthy backdrop for just about everything.


The prices paid component of the ISM survey moved higher, as 82% of the firms surveyed reported paying higher prices. This could simply reflect the rising cost of energy, as the chart above suggests, but it more likely reflects broad-based rises in most commodity prices as well. Those who look for inflation at the consumer level to remain subdued, in the face of an avalanche of price hikes at the producer level, believe that firms will simply absorb higher input costs into their profit margins and not pass along price hikes to their customers. I don't know about you, but yesterday I received a notice from my health insurance carrier and from my phone/internet/TV provider that they are raising the price for their services. I expect to see more such notices over the course of the year.


Add it all up and you get a very strong ISM index. As this chart suggests, the strength of the manufacturing sector is consistent with overall GDP growth well in excess of what we have seen in recent quarters. I would be very surprised if Q1 and Q2 growth were not at least 4%, based on this chart and the growing number of indicators reflecting improvement (e.g., truck tonnage, plus my two dozen bullish charts).

The big problem with healthcare? It's not a market


I've showed this chart before, but this version includes recently-released data as of 2009.

Markets function well when they are free of outside intervention, when transactions costs are low, and when both parties to transactions have good information on which to base their buy/sell decisions. That is most certainly not the case for the healthcare market, and that's why it's a mess.

Thanks to a distortion introduced to our tax code in the early days of WWII, only employers can deduct the cost of healthcare insurance. To circumvent war-time wage and price controls which were preventing employers from attracting badly-needed workers, the government agreed to allow companies to give workers tax-free health insurance; companies could deduct the cost of the insurance, and it wasn't considered income to the workers. Workers thus received an important tax-free benefit which has since grown enormously in size and importance.

This significant feature of the tax code has finally taken us to its logical conclusion: whereas consumer paid for most of their own healthcare prior to 1940, they now get almost all of their healthcare paid for by someone else, since this is highly tax-efficient.  Along the way, of course, politicians have created a baker's dozen of federal and state programs designed to pay other people's healthcare costs.

The system as it stands today works best for employees when the insurance offered by employers and government agencies covers as much healthcare as possible, thus maximizing the tax benefit. That's the reason why low-deductible policies with prescription drug coverage are so popular. If employees were paying for their own healthcare, many would undoubtedly choose higher-deductible policies.

As the chart shows, consumers now pay only 12% of total healthcare costs out-of-pocket. The rest is paid by private health insurance companies (32%), medicare (20%), medicaid (15%) and other private and government programs. The 12% that is still paid out of pocket consists mostly of payments by individuals not covered by employer policies or government programs (whether voluntarily or not), and co-pays and deductibles by individuals that are covered.

It stands to reason that when people don't pay the bill for the services they receive, they are very unlikely to take price into consideration when making a healthcare decision. Why shop around if everything is paid for by someone else? And when politicians set the reimbursement rates for medicare, there is a huge potential for error and fraud. And when insurance companies and government agencies pay most of the bills, even for small things like a vial of 30 pills, back-office costs begin to add up. Furthermore, those who aren't employed by a company that offers healthcare insurance face an immediate "tax wedge" since they must pay for their own insurance with pre-tax dollars, thus inflating the cost relative to someone who is covered by an employer. That extra cost figures importantly in many people's decision to not buy insurance. Add it all up and you have every reason to think that the market for healthcare is not going to be a well-functioning or efficient market. It's not really a market at all, and that's why it's such a mess.

The biggest single way to fix the healthcare market would therefore be to change the tax code. Either let everyone or no one deduct the cost of healthcare insurance. If there were no tax-efficiency reasons for employers to offer healthcare insurance, most would eventually drop the program (it's a headache) and just let employees decide how to spend the money. (Think of the parallel between this and the big shift away from defined-benefit plans in favor of defined-contribution plans) That would put consumers back in charge and I would bet any amount of money that all sorts of healthcare innovations would be unleashed—as healthcare insurers and providers were forced to compete directly for customers—that would eventually result in a more efficient, less-costly, and more satisfying healthcare experience for everyone.

As a corollary, a good portion of the money that is currently being spent by government agencies on healthcare could be turned over to consumers in the form of a voucher. We need to let consumers make the decisions about how to spend the money, not bureaucrats.

UPDATE: For a thorough analysis and review of what's necessary to fix healthcare, see John Cochrane's essay "After the ACA: Freeing the market for healthcare." It's very long, but also very excellent. A must-read for anyone.

Thoughts on the yield curve





These charts tell the long-term story of Treasury yields. Yields today are very low by historical standards, but the yield curve is almost as steep as it's ever been. Yields today are low because inflation is low, and because the Fed—and the bond market—are very concerned about the health of the economy and the risk that a lot of economic "slack" might produce deflationary pressures.

To avoid deflation and to give the economy a boost, the Fed has promised to keep short-term interest rates very low for a long time. The market currently expects the Fed funds rate to remain at 0.25% for at least the rest of this year. Since the yield on 10-yr Treasuries is driven in large part by the expected future path of short-term rates (i.e., the current 10-yr yield of 3.4% implies that the Fed funds rate will average 3.4% over the next 10 years, with the funds rate projected to rise to about 4.25% within 10 years), the Fed's promise to keep short-term rates low for an extended period is putting downward pressure on 2- and 10-yr Treasury yields. But the 10-yr yield is not completely constrained by the Fed's promises—if the bond market were convinced that the Fed was making a big mistake by keeping short-term yields low-for-long, then it would be free to jack up future expected rates.

Regardless, it would appear that 10-yr yields of 3.4% today are fairly valued if inflation stays in a 1-2% range. In other words, there is no evidence here that the fed has grossly distorted the yield on Treasury notes or bonds, since they currently yield about 2% more than inflation, and that is in line with historical observations. And the almost-unprecedented steepness of the 2-10 curve suggests that the market is not giving the Fed much benefit of the doubt: the amount of eventual tightening that is priced in is also almost without precedent. I take this as evidence that the Fed is not unduly distorting yields, and that it is guiding policy more or less in line with current market thinking. Long-time Fed-watchers know that the Fed and the bond market are always engaged in an intricate and complicated dance, where one leads the other and vice-versa. The feedback goes in both directions, and there is no sign that anything is obviously amiss right now.

But if inflation rises and/or the Fed decides to raise rates sooner than expected because the economy is exceeding expectations, then 10-yr Treasury yields will face inexorable pressure to rise. That is the big "if" that is hanging over markets today.

Truck tonnage shows impressive gains


I'm a little late to the Truck Tonnage party (see Mark Perry's latest post on the subject here, and Calculated Risk's post here), but I do have this interesting chart to add to the discussion. Truck tonnage (seasonally adjusted) has now almost completely recovered to its pre-recession highs, after a strong 3.8% gain in January. Say what you will about the Fed inflating asset prices, but when the millions of trucks out there are actually hauling increased amounts of stuff around the country, that's a pretty good indication that economic activity is definitely picking up.

As this chart shows, the stock market has done a pretty good job of tracking truck tonnage over the decades, though it tends to "overshoot" now and then as psychology at times blinds investors to the underlying fundamentals. My read of this plus many other indicators I've highlighted here is that there is a genuine upturn in the economy underway, and the stock market is in the early stages of catching on. With trucking activity poised to reach new all-time highs this year, there is no reason not to expect the equity market to also register new all-time highs.

More strong news from the manufacturing sector


I don't usually pay much attention to the regional components of the ISM surveys (they don't always correlate well to the national survey), but this one is hard to ignore. The Chicago Purchasing Managers Index has soared in recent months, well ahead of expectations. It hasn't been this strong since the boom days of the 1980s, and it's well above the levels recorded during the boom in the second half of 2003, when the economy grew at a 5.2% annual rate. Where there's smoke there's fire, as they say. Although not as strong as Chicago's number, the Dallas Fed and Milwaukee manufacturing surveys for February handily beat expectations. The economy is almost surely accelerating.