Main menu

Swap spread update

Time to once again to revisit swap spreads, which in the past have proven to be excellent leading indicators of major changes in the economy and financial markets. U.S. swap spreads have been trading at very benign levels for over a year now, suggesting that our financial markets are healthy, liquidity is back, and systemic risk is very low—all the conditions you would want to see for an ongoing recovery. The change on the margin that is interesting is coming from Europe, where swap spreads have been trending down all year, after rising last year over concerns that sovereign defaults (e.g., Greece, Ireland) could cause havoc among European banks and that in turn could translate into bad news for the economy. The level of euro swaps is still a bit elevated, but swaps are now low enough to suggest that sovereign debt restructurings (which increasingly look inevitable) do not pose a significant risk to the European banking system or to the economy.

Producer inflation continues to heat up

(This is a repeat of yesterday's post which seems to have disappeared)

Inflation at the producer level continues to move higher, whether or not you include food and energy. Over the past six months, producer prices are up at a double-digit rate: 11.5% annualized. Core prices are up at a 3.1% annualized rate over the same period.

Compare these numbers to what we saw during the 10-yr period ending Dec., 2003, in which core producer price inflation averaged just 1% per year, and the headline PPI averaged 1.6% per year. That same period saw the headline CPI average 2.4% per year, and that was the lowest level of inflation in a 10-yr period that we had seen since the 1960s. Not coincidentally, the Fed was following a relatively restrictive monetary policy during that period, during which time the real Federal funds rate averaged 2.4% per year (today it is -2%), the dollar was generally appreciating, and commodity prices were for the most part unchanged.

The recent decline in oil prices undoubtedly will result in a decline in the headline PPI in the months to come (thank goodness, otherwise we'd be talking about double-digit year over year producer inflation), but it won't necessarily cause the core PPI to decline. Indeed, as I've noted before, it is noteworthy that core prices have been picking up of late even as oil prices have soared: if the Fed were tight enough to keep inflation at bay, then a big rise in oil prices would have resulted in a decline on average in non-oil prices. The fact that both headline and core PPI inflation have been picking up for the past 18 months is good evidence that monetary policy is indeed accommodative.

Easy money works first at the commodity and producer level, and eventually makes its way to the consumer level. By the time easy money shows up in the consumer price index, it's been out in the wild for many months and even years. And by that time it's almost too late to do anything about it. Gold and commodity price speculators for years have been anticipating the rise in inflation that is now underway. The only question now is whether inflation will prove to be as high as the runup in gold and commodity prices is assuming. Unfortunately I don't know the answer to that question. But I do know that deflation risk at this point is just about zero, and that nominal GDP is going to be picking up significantly in the years to come, and that is going to prove to be fertile ground for cash flows for all sorts of companies. That should be good news for equity investors, for holders of corporate and emerging market debt, and for owners of real estate.

Making claims out of thin air (cont.)

(This is a repeat of yesterday's post which seems to have been lost)

Last week I argued that the huge and unexpected rise in unemployment claims was most likely due to seasonal adjustment factors. Further, I predicted that if this were true then we would see claims fall back down in subsequent weeks. Today's number (which showed a decline of 40K) is right on track in confirming that diagnosis and prediction.

The top chart shows seasonally adjusted claims, while the bottom chart shows the raw, unadjusted data. In the raw data, we see there has been no meaningful rise in claims. The expected seasonal adjustment factors that would indicate a decline in the raw data didn't happen. Seasonal events don't always happen the way the seasonal adjustment factors expect, and this was one of those times. Expect to see further declines in the seasonally adjusted claims number in coming weeks.

Rising inflation points to rising bond yields

In April the CPI registered a 3.2% rise over the past 12 months, a 5.1% annualized rise over the past six months, and a 6.2% annualized rise over the past 3 months. The bond market and the Fed appear to be ignoring that, in the belief that it is mainly due to energy prices, and those have already cooled in recent weeks, so perhaps this is only a transitory rise in inflation.

But as this chart shows, the core CPI (ex food & energy) is up 1.3% over the past 12 months. Moreover, it is up at an annualized rate of 1.8% in the past six months, and a 2.1% annualized rate in the past three months. It's not so easy to dismiss the recent rise in inflation as transitory. If we just look at the CPI ex-energy, it is up 1.6% in the past 12 months, and has risen at an annualized rate of 2.3% in the past six months and 2.9% in the past three months. Inflation is heating up, no matter how you slice and dice the numbers, and the pickup appears to be broad-based.

This chart also suggests that the bond market is on shaky ground, since inflation is the most important determinant of yields. The core CPI will almost certainly approach 2% on a year over year basis in coming months, and could well exceed that level before the year is out. The last time the core CPI was 2%, bond yields were substantially higher than they are today. The bond market is ignoring the rise in inflation for now, in the belief that economic weakness makes it only a temporary phenomenon, but that belief is going to be tested in coming months. From my perspective, I see no reason for core inflation to decline, so I think there is a good chance that Treasury yields are going to rise.

Full disclosure: I am long TBT at the time of this writing.

Dramatic improvement in commercial real estate

Real estate markets are still very depressed, of course, but they are doing a whole lot better than people expected just a year ago. That's the message of this chart, which plots the price of a basket of commercial real estate-backed securities rated AA and issued back in October '07. Last summer these securities were trading around 35 cents on the dollar, which meant that investors expected a massive wave of defaults to occur. Today they are trading at 63 cents on the dollar, which means that default expectations have collapsed relative to what they were last year. This improvement also means that banks, institutional investors and corporations who have held these securities and were forced to write them down in the wake of the crash because they were "impaired," have now realized substantial gains that have not yet flowed through to their balance sheets (they had to realize the loss when the securities were declared impaired, but they won't have to realize the gains until they are sold).

Retail sales look quite strong

Retail sales are growing strongly, up 7.6% in the past year, and up at 9.9% annualized rated over the past six months. Rising gasoline prices have contributed to this strong growth, of course, but even excluding autos and gasoline, sales are up at a 6.2% annualized pace in the past six months.

It's interesting therefore to compare the recent period of strong gasoline price rises with what happened to retail sales the last time we had a huge spike in oil and gasoline prices. The chart above does just that: the white line being retail sales, and the orange line oil prices. Note that in late 2007 and early 2008 retail sales hardly budged despite soaring oil prices, whereas over the past two years both oil prices and retail sales have soared. Things are certainly different this time around. The rise in retail sales of late owes its strength not only to higher prices, but also to more jobs, rising confidence, easy money, and a global recovery.

Federal finances are still in awful shape

These charts sum up the problem of the federal budget nicely: Congress is simply spending way too much money.

From the top two charts we see that federal revenues are growing nicely, even rebounding faster now than they did coming out of the 2001 recession, and without the help of higher tax rates (actually, thanks to not raising rates). This would normally have resulted in a shrinkage of the deficit, but that's not happening since spending has surged. It is now becoming obvious that with the help of Bush in 2008 and a massive assist from Obama, Pelosi, and Reid in 2009, federal spending as a % of GDP has effectively grown by fully 25% (i.e., from 20% to 25% of GDP).

Instead of shrinking as it normally would be at this stage of the business cycle, the deficit is growing, and it's almost 10% of GDP. That's a huge number, much bigger than any we have seen since WWII. Very few developed countries have run deficits this large in modern times (think Italy and Japan), and no country with a deficit this large has enjoyed much in the way of prosperity.

Indeed, it would appear that very large deficits that are the result of too much spending are actually one of the causes of poor economic performance, as illustrated in the fourth chart. The more money the government spends, the higher the unemployment rate goes. It's not too hard to understand, really, since the bulk of the increase in government spending has been in the form of transfer payments, which, by redistributing income from those with lots to those with not so much, create perverse incentives: penalizing the hard-working while rewarding the non-working. More government spending and more transfers of wealth also squander the economy's resources, since the money would be much better spent if those earning the money were allowed to decide how to spend and invest the money, rather than letting politicians make the decisions. HT to Brian Wesbury, whose book It's Not as Bad as You Think first tipped me to the remarkable relationship between government spending and the unemployment rate.

As this last chart shows, our federal deficit problem is very unlikely to be solved by raising tax rates. Tax revenues have never exceeded 21% of GDP, even when top tax rates were 90% in 1944. The most important lesson from this chart is that federal tax revenues were about 17% of GDP when top tax rates were about 70% in the mid-1970s, yet federal revenues were even higher, at 18% of GDP in 2006, when top tax rates were only 35%. A lower tax rate is always preferable to a higher tax rate, if both end up collecting the same share of incomes, because lower marginal rates create fewer distortions and reduce the incentive to evade taxes. Income tax revenues are depressed today not because tax rates are too low, but because the unemployment rate is very high and there are 8 million people who lost their jobs a few years ago and haven't gotten them back (and are not paying taxes).

Bottom line: the budget problem must be fixed, and it must be fixed by slashing government spending as a % of GDP. That's not as hard as it sounds, since as I've pointed out several times before, simply freezing spending at current nominal levels would likely result in a balanced budget in about 5 years.

Prices work

This chart shows the news that has sent the commodity markets into another tailspin. According to the DoE, total stocks of crude oil (excluding the Strategic Petroleum Reserve) have surged this year, and recent increases have been much more than the market was expecting. Prices work. The high and rising prices of crude oil and gasoline have apparently conspired to increase supplies while also reducing demand, thus boosting inventories. In retrospect, it seems that prices were too high, so now they have to fall some. This is how markets balance supply and demand.

Impressive growth in exports

In one of the economy's more impressive comeback stories, U.S. March exports reached a new all-time high, after growing at a 15% annual rate for most of the past year. Exports now equal almost 13% of GDP, and that's up a staggering amount since the mid-1980s, when they were only about 5% of GDP. Moreover, exports have grown faster than imports since 2004, cutting the trade gap almost in half, from 5.9% of GDP to today's 3.0%. Mark Perry has some interesting facts on the fastest-growing area of exports—manufacturing—here.

This may be a good place to note that if the Chinese and other major holders of U.S. debt wish to second-guess their decision to park significant sums of money in our economy, then the withdrawal of that money from our economy can only happen via a significant—and further—increase in our exports of goods and services. After all, the large trade gap that the U.S. has experienced for the past 20 years occurred thanks to an equally large capital inflow; foreigners decided that they wanted to save and invest a portion of their export earnings in our economy, rather than buy our goods and services. So any new capital outflows must be matched by an equal increase in the purchase of our goods and services.

Used car prices continue to soar

It's a good thing there's no inflation, otherwise used car prices might be on the moon by now.

According to the Manheim index, used car prices have risen almost 5% in the past year, and almost 19% in the past two years. The reason? "Restricted supplies and strong retail demand."

Fed expectations are what is hurting the dollar

2-yr sovereign yields can be thought of as the market's best guess for the average short-term monetary policy rate over the next two years. Today's 0.6% yield on 2-yr Treasuries therefore means that the market is expecting the Fed funds rate to average 0.6% over the next two years: rising from today's 0.1% to 1.5% two years from now, with the first tightening not coming until until March of next year. 2-yr German yields, in contrast, stand at 1.7% today, which implies that the European Central Bank's target rate is expected to rise from today's 1.25% to a little over 2% two years from now.

The blue line in this next chart represents the difference between the yield on 2-yr Treasuries and 2-yr German bonds. The spread is currently negative, meaning that U.S. yields are trading substantially lower than German yields, and that in turn means that the market is expecting the ECB to be materially tighter than the Fed over the next two years. The fact that the red line (the value of the dollar against other major currencies) is fairly tightly correlated (0.81) to this spread strongly suggests that the Fed's accommodative monetary policy stance is largely responsible for the dollar's weakness; the Fed is expected to be much easier than other central banks, and that reduces the world's desire to own dollars (who wants to own a currency that is going to be in oversupply for the next two years?). By this logic, if the Fed were to tighten sooner and by more than the market currently expects, that would most likely result in a stronger dollar. Similarly, a decision by the Fed to postpone tightening would likely weaken the dollar.

Another reason stocks are not overpriced

One very long-running theme on this blog has been that equities are not overpriced, overvalued, or otherwise in a valuation bubble. Here's another chart that supports that theme, and even suggests equities could be undervalued.

To appreciate the chart, you need to understand and agree with a few assumptions. For one, the S&P 500 index is a good proxy for the value of all corporate equities. Two, equity prices can be thought of as the discounted present value of future after-tax profits. Three, the 10-yr Treasury yield is a reasonable interest rate to use when discounting future cash flows. Four, nominal GDP is a good proxy for corporate cash flows. The blue line in the chart represents the value of equities as a % of nominal GDP, and the red line is the yield on 10-yr Treasuries.

The basic implication of the assumptions is that the ratio of corporate equities to nominal GDP should vary inversely with interest rates. If interest rates rise, then equity values should decline relative to nominal GDP (since they are being discounted at a higher rate), and vice versa. If interest rates are relatively stable, then the ratio of equity prices to nominal GDP should be relatively stable over time.

Looking at the chart, it's clear that equity values relative to GDP did indeed decline from the 1960s through the early 1980s as interest rates rose. Subsequently, equity valuations rose as interest rates fell. Equity valuations way overshot in the late 1990s and early 2000s, and we now know that was indeed a "bubble." Since then, equity valuations appear to have undershot; interest rates today are about where they were in the 1960s, but equity valuations today are about 25% below the levels of the 1960s.

A reasonable person could argue that interest rates likely are being artificially depressed these days by Fed policy, and that the market is wise to this and therefore is using a higher interest rate than the 10-yr Treasury yield to discount future cash flows. Yet even if that were true, and the market were implicitly assuming, say, a 7% discount rate, it would still be the case that equities are not overvalued at current levels, using this model.

Commodity update -- only a mild correction

With all the recent hoopla about the big plunge in commodity prices, you would think they dropped a lot. But as these two charts—which are the two sub-components of the CRB Spot Commodity Index—show, the commodity price correction has been relatively modest.

Even the decline in copper prices, a favorite of speculators and thus subject to more volatility during selloffs, looks relatively modest when put into the proper perspective, as this chart attempts to do.

Ditto for crude oil prices.

Imported goods prices rise as the dollar falls

This morning the BLS reported that April imported goods prices were 11.1% higher than a year ago. Excluding petroleum, import prices were up 4.3% year over year. So it's not just oil prices that are moving up, it's all prices. And the common denominator behind all imported goods prices is the dollar, whose value has been declining since 2002.

The two charts above tell the story. The top chart shows an index (nsa) of all imported goods prices ex-petroleum. The bottom chart is a popular measure of the dollar's value against other currencies. Note how the two lines tend to move in opposite directions: the rising value of the dollar from 1995 through 2002 corresponded to a decline in imported goods prices; while the falling dollar from 2002 on has seen a substantial rise in imported goods prices.

This simply illustrates the obvious fact that a weak currency inevitable results in more inflation. If the dollar were to continue to decline, then imported goods prices would continue to rise and eventually all prices would rise.

More signs of jobs growth

The April Monster Employment Index release was full of good news, which I've summarized in the chart above.

Annual growth rate at 9 percent in April, marking the 15th consecutive month of year-over- year growth 
Index climbs 7 percent (9 points) month-over-month
27 of the 28 metro markets showed positive annual growth in April
Mining, quarrying, oil and gas extraction continues to lead the Index on an annual basis; 
Manufacturing reaches highest levels of demand since late 2008, driving growth in manufacturing hubs such as Detroit and Cleveland

The core foundation areas of the economy – wholesale trade, retail trade and transportation – continue to show upward momentum that would suggest positive job gains as we progress on a path of recovery.

Financial conditions have turned healthy

A reminder that financial conditions are looking pretty healthy these days (the more the index is above zero the better), and that is always supportive of growth. Index components: TED spread, CP/Bill spread, Libor/OIS spread, investment grade corporate bond spread, muni spreads, swap spreads, high-yield spreads, agency spreads, equity prices, and the VIX index. It's also a reminder of how far we've come in the past two years.

Why the end of QE2 is good news

What is likely to happen when the Fed's QE2 program is finished next month? Here are two competing theories and possible scenarios (for related discussion see today's WSJ article on the subject):

Weaker growth, lower Treasury yields. QE2 was a successful program, providing needed stimulus to the economy and vanquishing deflation fears. That is why 10-yr Treasury yields started rising as soon as the program started in early November. The end of QE2 therefore will hurt the economy by withdrawing needed stimulus; a weaker economy, in turn, will increase the demand for safe-haven Treasuries, driving yields lower. This explains the recent decline in 10-yr Treasury yields, since the market is already pricing in the expectation of a weaker economy, disregarding stronger economy news such as the greater-than-expected increase in April jobs.

Stronger growth, higher Treasury yields. QE2 never provided direct stimulus to the economy, since it never resulted in any meaningful addition to the amount of money in the economy. And since the end of QE2 will not result in the withdrawal of any of the bank reserve injections, nor shrink the Fed's balance sheet, it should have no direct effect on the economy. QE2 was indirectly helpful, however, since it effectively vanquished deflation fears and this helped boost investor confidence. That helps explain why equities started rising shortly after the idea of QE2 was first floated in late August, and the subsequent rise in Treasury yields was the market's natural reaction to news that the economy was indeed improving. To the extent that QE2 increased the market's uncertainty about the outlook for inflation and weakened the dollar, however, it was a drag on the recovery, which has been modest by historical standards. Treasury yields are relatively low today because the market is ignoring signs of strength (e.g., faster jobs growth) and worrying instead about possible threats to growth in the future, some of which likely have been exacerbated by QE2 (e.g., higher oil prices, weaker dollar).

My sympathies lie with the second scenario, because I don't believe that Washington has the ability to create or fine-tune growth through standard Keynesian measures. Fiscal "stimulus" which relies on more government spending and transfer payments can never create growth, since it destroys incentives and makes the economy less efficient, and stimulative monetary policy can only create inflation (i.e., you can't print your way to prosperity).

The above chart is my way of interpreting the significance of different levels of 10-yr Treasury yields. I've never believed that Fed purchases of Treasuries were artificially suppressing yields. Instead, yields are driven mainly by inflation and growth fundamentals. Growth expectations feed into inflation expectations, since both the market and the Fed believe in the Phillips Curve theory of inflation, which holds that very weak growth is potentially deflationary, while very strong growth in potentially inflationary. Today's yields are symptomatic of a market that expects very weak growth.

This next chart shows a decent correlation between 10-yr Treasury yields and the year over year change in the core CPI. With core and headline inflation rates now trending upwards (the 6-mo. annualized change in the core CPI is 1.4%, and the headline CPI is 4.7%), we have likely seen the lows in Treasury yields. Yields are only as low as they are today because the market is very concerned that the economy is at risk from a cessation of QE2, from high oil prices, from a renewed bout of housing weakness, and from the fiscal austerity measures that will be necessary to deal with our out-of-control federal budget.

The market is ignoring signs of rising inflation and rising prices because it believes that they will eventually be trumped by very weak growth. This assumption, however, is likely to be put to the test by the end of this year, since I believe that we will see the economy tending to grow a bit faster and inflation tending to increase.

Meanwhile, the end of QE2 won't change the Fed's balance sheet, but it will mean we no longer have to worry about the Fed compounding any inflationary errors that it may have been making with QE2. And if the Fed ends QE2 because it is worried about the dollar and rising inflation and not overly concerned about the economy's supposed weakness, then that should bolster confidence and strengthen the dollar, and that in turn should be an impetus to growth. Likewise, if Congress manages to put in place policies that lead to a reduction in the size of our bloated government, that is likely to boost confidence and increase economic efficiency over time, thus leading to stronger growth.

In short, instead of worrying about the end of monetary "stimulus" and fiscal "stimulus," we should be cheering. Misguided stimulus is bad; ending it is therefore good. The economy is struggling under the weight of too much "stimulus," and it needs a break.