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Systemic risk remains low, so equities continue to rise


I must have showed this chart at least a dozen times since late 2008, but it's still worth showing again. The story here is that a big cause of the recession was fear: fear of an international banking collapse, widespread bankruptcies, a global depression, and just plain fear that the world was coming to an end. So it made sense to think that if and when fear subsided, then the world and the global economy would sooner or later get back on the path of growth, asset prices would recover, and that's what has been happening ever since.

In the chart above, we see that the Vix index, a good measure of the fear and uncertainty priced into the equity market, has been fairly low for over a year now, and equity prices have been slowly but surely recovering. The Vix is still somewhat elevated, to be sure, since it was as low as 10 back in late 2006 and early 2007, so the market is not entirely fearless. Ditto for credit spreads (below), which have come down a lot from their recession highs, but remain meaningfully higher than their pre-recession lows. Both indicators of fear, doubt, and uncertainty show that the market is still infused with a degree of caution, which further suggests that asset prices are not over-priced.



The upward blip in unemployment claims a few weeks ago gave the market pause, but as the chart above suggests, investors appear to understand that the rise was due to statistical noise rather than any actual weakening of the economy. In the next few weeks the 4-week moving average of claims should move back down to 400K or less, putting it back on track with a slowly rising stock market.


Swap spreads (above) tell a similar story. As a leading indicator of financial and economic risk, swap spreads in the U.S. are telling us that there is no reason to expect any calamity: economic and financial fundamentals are healthy, liquidity is abundant, and default risk is low. Europe is where systemic risk still lingers, in the form of looming sovereign debt defaults/restructurings. Still, the level of swap spreads in Europe is low enough to suggest that whatever problems Europe faces are unlikely to be calamitous—painful, to be sure, but unlikely to cause any significant disruption to the Eurozone economies. The market has seen the likelihood of a Greek default, it has been priced in (see chart below, which shows 2-yr Greek government yields at almost 25%, a level which indicates a very high likelihood of default), and it is unlikely to be earth shattering when it happens (German 2-yr yields are a mere 2%).


Meanwhile, life goes on, and some sectors of the stock market are at new, all-time highs, such as the relatively pedestrian consumer staples sector, shown below.


The Fed's role in all this (so far) has been to help the market deal with and overcome its lingering fears. Short-term interest rates have been set close to zero for more than two years, in part to accommodate the market's huge appetite for risk-free cash and cash equivalents. The world has been content to accumulate cash and cash equivalents paying little or no interest, as shown in the chart below. If a zero short-term interest rate were way below the market clearing rate, then the demand for M2 (i.e., the demand for cash and cash equivalents) would have collapsed, and nominal GDP would have exploded, but it has not (at least so far).


But there are increasing signs that we are transitioning out of the fear phase of this business cycle. As I've pointed out before, bank loans to small and medium-sized businesses have been growing this year, a sure sign of rising confidence. As banks lend more, they increase their deposits, and that increases the amount of required bank reserves, as we see in the next chart. Required reserves have increased at strong double-digit rates so far this year.


All of these developments are significant, and they all act to reinforce each other; rising confidence displaces fear, rising confidence boosts asset prices, and rising confidence and stronger markets fuel more investment, which in turn feeds back into more jobs, more production, and rising profits. This process is unlikely to be easily derailed, and it has a lot more room to run.

Making claims out of thin air (cont.)

Two weeks ago I argued that the large and unexpected rise in unemployment claims that occurred in April was likely the result of faulty seasonal adjustment factors—which expected a decline in unadjusted claims that failed to materialize—and predicted that claims would retreat in coming weeks. Fortunately, that's exactly what has happened.



The top chart shows the seasonally adjusted series, while the bottom chart shows the unadjusted data. Now that the seasonal dust has largely settled, we see that the supposed rise in claims was a statistical artifact that had nothing to do with what was going on in the economy. Case closed.

Why Google is selling bonds

Yesterday Google decided to sell $3 billion worth of bonds, despite having $37 billion in cash. Greg Mankiw wonders why they would do this when the yield curve is very steep by historical standards. One of his readers suggests that it is because most of Google's cash is held offshore, and would be subject to a punishing tax rate of 35% if repatriated; Google is essentially betting that the corporate tax rate will be lower in the future, at which time they can repatriate the cash and pay back the bonds and come out ahead.

I would like to suggest yet another reason. First, I would note that the bonds Google is selling are of relatively short maturity: $1 billion of 3-yr bonds, $1 billion of 5-yr bonds, and $1 billion of 10-yr bonds. That gives you an average maturity of just over 5 years. To simplify the analysis, Google is effectively selling something like $3 billion of 5-yr bonds. Thanks to its AA- credit rating, Google is able to borrow at a rate that is about 50 bps on average above what the U.S. Treasury would pay for similar maturity bonds. That's not a terribly low spread, and the yield curve is relatively steep, but it is a relatively low spread over extremely low 5-yr Treasury yields, as the chart below demonstrates.


In short, Google is borrowing $3 billion at a yield that is just about the lowest yield in modern U.S. history. The Federal Reserve has been trying very hard to convince the world to borrow dollars, and Google is simply taking its advice. If corporate tax rates decline in the next year or so—a bet that looks more attractive almost every day—and if the economy improves and interest rates rise, Google will have executed a very profitable trifecta: it could repatriate its cash at a lower tax rate and buy back its bonds at a discount. And even if none of this works out, Google's cost of borrowing $3 billion will only be about 2.3%, which in an historical context is not very much. And if the dollar continues to depreciate, then borrowing dollars today in order to keep cash abroad will also prove to be a profitable strategy.

Gasoline price relief coming soon


Gasoline prices at the pump have only just begun to decline. This chart from Bloomberg, which shows gasoline futures prices (white line) and gasoline prices at the pump, according to the Auto Club (orange line), suggests that pump prices should fall to $3.50-3.60/gallon once the dust settles, based on the decline in gasoline futures prices that has already occurred.


This next chart compares gasoline futures prices (white line) to crude oil futures prices (orange line). The action to date suggests that gasoline futures prices could decline a bit more, given the decline in crude which has already occurred. This strengthens the case made above for a substantial decline in gas prices at the pump.

In very short order, the reversal of energy prices has removed a potential stumbling block to continued economic growth, and that is good news.

More Kudos to Paul Ryan

There's at least one person in Washington who has a grasp of our fiscal problems, and a comprehensive and sensible approach to fixing them: Paul Ryan. Here, some excerpts from his speech today to the Economic Club of Chicago:

...the unsustainable trajectory of government spending is accelerating the nation toward a ruinous debt crisis.
This crisis has been decades in the making. Republican administrations, including the last one, have failed to control spending. Democratic administrations, including the present one, have not been honest about the cost of the tax burden required to fund their expansive vision of government. And Congresses controlled by both parties have failed to confront our growing entitlement crisis. There is plenty of blame to go around.
This trajectory is catastrophic. By the end of the decade, we will be spending 20 percent of our tax revenue simply paying interest on the debt – and that’s according to optimistic projections. If ratings agencies such as S&P move from downgrading our outlook to downgrading our credit, then interest rates will rise even higher, and debt service will cost trillions more.
This course is not sustainable. That isn’t an opinion; it’s a mathematical certainty. If we continue down our current path, we are walking right into the most preventable crisis in our nation’s history. Stable government finances are essential to a growing economy, and economic growth is essential to balancing the budget.
... chasing ever-higher spending with ever-higher tax rates will decrease the number of makers in society and increase the number of takers. Able-bodied Americans will be discouraged from working and lulled into lives of complacency and dependency.
... when it becomes obvious that taxing the rich doesn’t generate nearly enough revenue to cover Washington’s empty promises – austerity will be the only course left. A debt-fueled economic crisis will force massive tax increases on everyone and indiscriminate cuts on current beneficiaries – without giving them time to prepare or adjust. And, given the expansive growth of government, many of these critical decisions will fall to bureaucrats we didn’t elect. 
First, we have to stop spending money we don’t have, and ultimately that means getting health care costs under control.
Second, we have to restore common sense to the regulatory environment, so that regulations are fair, transparent, and do not inflict undue uncertainty on America’s employers.
Third, we have to keep taxes low and end the year-by-year approach to tax rates, so that job creators have incentives to invest in America; and
Fourth, we have to refocus the Federal Reserve on price stability, instead of using monetary stimulus to bail out Washington’s failures, because businesses and families need sound money.
There is widespread, bipartisan agreement that the open-ended, fee-for-service structure of Medicare is a key driver of health-care cost inflation. 
The disagreement isn’t really about the problem. It’s about the solution to controlling costs in Medicare. And if I could sum up that disagreement in a couple of sentences, I would say this: Our plan is to give seniors the power to deny business to inefficient providers. Their plan is to give government the power to deny care to seniors.
We have to broaden the tax base, so corporations cannot game the system. The House-passed budget calls for scaling back or eliminating loopholes and carve-outs in the tax code that are distorting economic incentives. 
We do this, not to raise taxes, but to create space for lower tax rates and a level playing field for innovation and investment. America’s corporate tax rate is the highest in the developed world. Our businesses need a tax system that is more competitive.
A simpler, fairer tax code is needed for the individual side, too. Individuals, families, and employers spend over six billion hours and over $160 billion per year figuring out how to pay their taxes. It’s time to clear out the tangle of credits and deductions and lower tax rates to promote growth.

Update: here's an alternative proposal that isn't quite as well thought out:

HT: Steve Grannis

On the bond market's inflation forecasting abilities


How good is the bond market at anticipating inflation? Thanks to the advent of TIPS (Treasury Inflation-Protected Securities), we can now begin to answer that question in scientific fashion.

The chart above compares the actual rate of Consumer Price Inflation, using a rolling 10-yr annualized basis, to the market's expectation of what the CPI will average over the next 10 years (as embodied in the difference between the nominal yield on 10-yr Treasuries and the real yield on 10-yr TIPS). For example, in early 1999, the expected rate of inflation over the next 10 years (blue line) was a little less than 1% a year. Ten years later, in early 2009, the actual (annualized) rate of inflation over the previous ten years was 2.6%. Thus the bond market in 1999 underestimated future inflation by 1.6% a year, which adds up to a 17% cumulative miss.

Further, as the chart also shows, the bond market underestimated future inflation consistently from early 1997 through April 2001. In April 2001 the expected rate of 10-yr inflation was 2% per year, and we now know that the CPI has registered an annualized rate of increase of 2.7% over the 10-yr period ending April 2011.


On a less scientific basis, we can infer from this next chart that the bond market tended to underestimate inflation throughout most of the 1970s (because inflation exceeded 10-yr yields on average), and clearly overestimated inflation from the early 1980s until a few years ago (because yields greatly exceeded inflation).

In summary, inflation expectations embodied in TIPS pricing are not to be dismissed, but they need to be taken with a few grains of salt; the bond market is not infallible, and it has made some significant misses over the years in its estimates of future inflation. Regardless, I would note that since last August, when the Fed first floated the idea of QE2, 10-yr inflation expectations have risen from 1.5% to 2.4%, and the year over year change in the CPI has risen from 1.1% to 3.2%. Inflation and inflation expectations have moved significantly higher in the past year, even as they have declined modestly in the past month. Furthermore, the current real interest rate promised by 10-yr TIPS (the difference between current yields and current inflation) has narrowed quite a bit in recent years, thus offering investors who are looking for a real rate of return on 10-yr Treasuries a much smaller margin of error.

If I had to hazard a guess as to whether the bond market is more likely to over- or underestimate inflation in coming years, I would go for the latter. I base that on the Fed's clearly accommodative monetary stance, its avowed desire to push inflation higher, the historically low level of 10-yr Treasury yields, and the bond market's record of underestimating inflation during times of monetary accommodation (accompanied importantly by a very weak dollar and rising gold and commodity prices) as happened in the 1970s.

I refer readers to several of Mark Perry's posts in the past week for a reasoned but opposing viewpoint.

Bank lending update


The significant increase in bank lending to small and medium-sized businesses (otherwise known as Commercial & Industrial Loans, and shown in this chart) is not getting the attention it deserves, so I continue to revisit this series each week. C&I Loans have posted a 10.7% annualized gain over the past 3 months, and have jumped over $50 billion from last September's low. Those are impressive gains on the margin, but still only a drop in the bucket of total bank credit (about $9.1 trillion) and the M2 money supply (about $9 trillion). Nevertheless, this series continues to demonstrate that in aggregate, banks are increasingly more willing to lend, and businesses increasingly more willing to borrow, and that adds up to an increase in confidence overall, which is an essential ingredient if the economy is to continue expanding.