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Federal budget update: modest improvement


With today's release of May federal budget data, we see the continuation of a healthy trend: federal revenues have increased by 10.7% in the past year, while spending has increased by only 4.4%. Revenues are outpacing spending, believe it or not, and that's happening without any increase in tax rates. As a result, the 12-mo. rolling sum of the federal budget deficit has declined from $1.36 trillion to $1.29 trillion over the past year. It's still monumentally large, of course, but at least it is shrinking modestly instead of increasing further.

Revenues almost always pick up as the economy recovers, and this business cycle is no exception. Indeed, the pickup this time has been more robust than what followed in the wake of the 2001 recession. Growth creates more jobs, more income, and more profits, and these in turn are what generate higher revenues.

The lesson for politicians is simple: we can fix the budget deficit by reining in the growth of spending and reducing the burden of government, and by pursuing policies that help the economy grow. As today's WSJ editorial notes, Texas is living proof that smaller government and a freer economy can work miracles: "37% of all net new American jobs since the recovery began were created in Texas."

Credit spread update



Bearish sentiment is surging. Investors are nervous, and the prices of risky assets are down. The above charts show the impact of investors' concerns on credit spreads. While it's no fun to suffer losses on stocks and corporate bonds, what we've seen so far is in the nature of a correction, not a collapse. Credit spreads are higher and the prices of corporate bonds are lower, but it would take a lot of bad news to push spreads significantly higher. Higher spreads equate to a higher yield, and that provides investors with a cushion against further losses. Plus, as these charts show, spreads already are quite elevated relative to where they have been during times of relative calm. Translation: the market is priced for some pretty ugly news, so it makes sense to be bearish only if you are truly very concerned that the outlook is going to continue to unravel, and in a big way.


As this chart of 2-yr swap spreads suggests, the level of systemic risk is quite low in the U.S. and only moderately elevated in the Eurozone. This presents a big challenge to the bears, since U.S. swap spreads are too low to be consistent with further economic and financial market deterioration.

UPDATE: As the next chart shows, this stock market correction has been unusual since the magnitude of the selloff has not been matched by a similarly large rise in the Vix index. Combined with the low level of U.S. swap spreads this suggests that there is a lack of meaningful drivers for the selloff, and thus it may be overdone.

Why low interest rates hurt the economy

I've argued for quite some time that the Fed's easy money/quantitative easing strategy has been counterproductive. It's weakened the dollar, and helped to push up gold and commodity and commodities, thus rewarding speculators and discouraging investment. It has also weakened investment by creating tremendous uncertainty about the endgame to QE2 (e.g., can the Fed unwind this policy in time to avoid a big surge in inflation?).

Raghuram Rajan explains it like this: artificially low interest rates are a tax on savers and a subsidy to spenders, and anytime the government distorts market prices it creates unforeseen consequences that can make the situation worse. Here's an excerpt from his article "Money Magic," but read the whole thing.


More than any other policy action, monetary policy suffers from the sense that there is a free lunch to be had. Yet the interest rate is a price for the savings that are transferred to spenders. To the extent that the Fed manages to push this price down ... , it taxes the producers of savings and subsidizes the spenders of savings. Clearly, no government considers pushing down the price of any real good an effective way to stimulate the economy – any gain to consumers is a loss to producers, and the loss typically will outweigh the gain if the market price is a fair one. So why are savings different?

Clearly, someone is paying a price for ultra-low interest rates: the patient and uncomplaining saver. Interestingly, if traditional spenders such as firms and young households are unwilling or unable to take advantage of low interest rates, low rates could even hurt overall spending, because savers like retirees receive lower financial incomes and curtail spending.

I've also argued that an early and unexpected move by the fed to tighten monetary policy (say, by raising the Fed funds rate to at least 1% and announcing that more hikes are coming, much as the ECB has done) would actually help the economy by a) strengthening the dollar, b) punishing speculators, c) encouraging investors, and d) reducing the risk of an inflationary policy mistake, thus boosting confidence. I'm sure Rajan would agree, since higher interest rates also would reduce the current distortions to saving and investment.

HT: Greg Mankiw

Household balance sheets continue to improve


Household balance sheets continue to improve, according to the Q1/11 figures just released by the Fed. Net worth has yet to recover to its former highs, but financial asset holdings are recording strong gains, thanks to increased savings and rising equity and corporate bond prices. Thanks also are due to deleveraging: households have paid down about $0.5 trillion in debt over the past four years, though defaulted mortgages likely figure prominently in that total. Real estate remains depressed, but the rate of decline of housing values has clearly fallen over the past year or so. Recovery, repricing, and deleveraging are all proceeding at a moderate pace, and there is probably another year or two to go before we get back to the peak net worth of 2007, but the progress is nevertheless salutary.

The trade picture looks good


What does it mean when U.S. exports of goods and services rise at more than a 20% annual growth rate, and the gap between imports and exports narrows compared to what it was in the heydays of 2004-2006? It means that foreigners are less willing to buy our bonds, and less willing to lend us money. We keep importing lots of stuff, for which we pay them, and they therefore have to buy lots of stuff from us. But nowadays they are buying less of our financial assets and more of our goods and services. That's the way it works: for every dollar foreigners earn from selling something to us, they have to spend a dollar on something here in the U.S., whether it be stocks, bonds, real estate, loans, movies, or consulting services. If they decide to buy fewer bonds and otherwise lend us less money, they have to buy more of something else. So the narrowing of the trade gap per se really doesn't mean very much.

What's important is that our exports are growing at strong double-digit rates, because that means the export sector of our economy is picking up some of the slack from the moribund construction and financial sectors. It's also nice to see that imports are growing at double-digit rates, because that means that consumers are getting back on their feet. All told, the trade picture is looking good.

Claims: much ado about nothing



Seasonal factors are most likely still distorting the reported unemployment claims numbers. The problem lies with auto plant layoffs, which have come earlier this year than is usual—they usually happen in July, a period I've highlighted in the top chart which shows unadjusted claims. With auto layoffs coming at a time when they weren't expected, the seasonal adjustment factors treat that as if it were a genuine rise in the number of unemployment claims, and that's why we got a spike in the adjusted data (bottom chart) in April and May. But there will be payback for this mistake come July, if I'm right. When the actual number of layoffs doesn't rise as much as the seasonals expect, the adjusted numbers will show a surprising decline; something similar happened last year, when adjusted claims experienced a sudden dip in July. So in a few weeks we should expect to see some "unexpected" declines in the number of unemployment claims, and that will likely come as a positive shock to the market. Unfortunately, it's all much ado about nothing.

I note also that unadjusted claims have been relatively low and stable for the past 3-4 months. There haven't been any big things happening in the real world.


As this last chart shows, on an unadjusted basis the number of people collecting unemployment insurance has been declining steadily all year. The labor market is slowly improving, not deteriorating. The progress is disappointingly slow, but it's progress nonetheless.

Why is Obama siding with Argentina over the Falkland Islands?

I'm married to an Argentine, we lived in Argentina for four years in the late 1970s, and I've followed Argentina closely ever since. As a citizen of the U.S. and as a fierce critic of Argentina's Kirchner administration—and most of the many failed Argentine administrations during my lifetime—it's quite disheartening, to say the least, to learn that the Obama administration is taking the side of Argentina against the U.K. in the issue of the sovereignty of the Falkland Islands. Nile Gardiner of The Telegraph sums it up:

President Obama was effusive in his praise for the Special Relationship when he visited London recently, but his administration continues to slap Britain in the face over the highly sensitive Falklands issue. Washington signed on to a “draft declaration on the question of the Malvinas Islands” passed by unanimous consent by the General Assembly of the Organisation of American States (OAS) at its meeting in San Salvador yesterday, an issue which had been heavily pushed by Argentina. In doing so, the United States sided not only with Buenos Aires, but also with a number of anti-American regimes including Hugo Chavez’s Venezuela and Daniel Ortega’s Nicaragua.
The declaration calls for Argentina and Great Britain to enter into negotiations over the sovereignty of the Falklands, a position which London has long viewed as completely unacceptable. It also comes in the wake of increasing aggression by the Kirchner regime in the past 18 months, including threats to blockade British shipping in the South Atlantic.
Secretary of State Hillary Clinton made it clear in a joint press conference with Cristina Kirchner in Buenos Aires in March 2010 that the Obama administration fully backs Argentina’s calls for negotiations over the Falkands, handing her Argentine counterpart a significant propaganda coup. The State Department has also insultingly referred to the Islands in the past as the Malvinas, the Argentine name for them.
It is hugely disappointing that the Obama administration has chosen once again to side not only with the increasingly authoritarian regime in Argentina, but also with an array of despots in Latin America against British interests.

Regrettably, the U.S. has long neglected its friends and neighbors to the south, but this is not the time, nor the issue, to start getting chummy. The only reason Argentina is interested in the Falklands is for its potentially huge oil reserves. The people who live on the islands have been Brits for their entire lives and would be crazy to prefer the rule of the corrupt, despotic, and thieving Argentine government.

Reading the bond market tea leaves: gloomy growth expectations


The chart above is my way of interpreting what the level of 10-yr Treasury yields means. The recent four-month decline in yields is telling us that the market has become very pessimistic about the prospects for economic growth. It's a mini replay of the six-month decline in yields that occurred last year (April-October), which coincided with the widespread belief that the U.S. economy was headed for a double-dip recession.

Contrary to popular opinion, the level of 10-yr Treasury yields has very little to do with the Fed's quantitative easing initiatives. There are still many people who think that the Fed's QE2 program has helped the economy by lowering the level of long-term yields, and/or by pumping up the money supply, and this was precisely the justification advanced by the Fed for adopting QE2 in the first place. The evidence, however, does not support this contention.

To begin with, there is no evidence that 10-yr Treasury yields have been depressed by Fed purchases of notes and bonds. On the contrary. That became obvious when 10-yr yields started rising at almost the same time that the Fed began implementing its QE2 program early last November. If Fed purchases of significant amounts of Treasury notes and bonds had any impact on the market, it was the exact opposite of what one might have expected. Moreover, yields have been declining for the past four months, even as the end of QE2 approaches in a few weeks. If Fed purchases had depressed yields, you would have thought the market would now be bracing for rising yields, but that is clearly not the case.

Second, there is no evidence that the Fed's QE2 program has had any impact on the amount of money in the economy. If QE2 hasn't favorably impacted yields, and has had no noticeable impact on the amount of money in the economy, how can it have had any impact on the economy?


As the above chart shows, there is no evidence whatsoever that the Fed's quantitative easing—which involved the purchase of $1.6 trillion worth of agency and Treasury debt—has had any impact on the amount or growth rate of M2, arguably the best measure of the money supply. The M2 money supply has grown on average by about 6% per year for the past 16 years. Despite the supposedly massive money-creating impact of QE2, M2 has grown at only a 4.9% annual rate over the period during which QE2 has been in effect. As I've explained before, the net effect of quantitative easing has been to swap T-bill equivalents for notes and bonds, thus effectively shortening the maturity of government debt and satisfying, in the process, the market's apparently voracious demand for safe-haven cash. There has been no unusual amount of money printing.

The reality is that yields are not determined by Fed purchases, they are driven by the market's expectation of growth and inflation fundamentals. 

Stronger growth and higher inflation lead the market to expect more Fed tightening in the future, and the expectation of higher short-term rates in the future translates directly into higher 10-yr yields today. Conversely, when the market loses confidence in the economy's ability to grow, as it did from April '10 through October '10 (when a double-dip recession was widely anticipated), and from February '11 to this day, then 10-yr yields decline because the market expects the Fed to keep short-term rates low for longer.


You can see this dynamic clearly in the above chart. The white line is the yield on 10-yr Treasuries, and the orange line is the expected Fed funds rate one year in the future, and there is a strong correlation between the two (over 0.8). 10-yr yields rise when the market adjusts upward its expectation for the future path of short-term interest rates, and vice versa. (An efficient market sets 10-yr Treasury yields to equal the average expected return on cash invested at the Fed funds rate over the next 10 years.) Fed expectations, in turn, are driven by the market's perception of how weak or strong the economy is, since the Fed's Phillips Curve mentality has a strong tendency to want to tighten when the economy is strong and ease when the economy is weak. 

The simple conclusion is that the recent decline in yields is a reflection of the market's increasingly pessimistic view of the prospects for economic growth. Pessimism has been fueled by the supply disruptions that have rippled outwards from the Japanese tsunami, and by the vagaries of seasonal adjustment factors for weekly unemployment claims, which have made it look like the labor market was deteriorating when in fact it was not. In addition, the market seems to have become overly concerned by what has amounted to only a minor correction in commodity prices.

With the market priced to a relatively high degree of pessimism, it is thus very vulnerable to any news which contradicts the expectation of deterioration. Bearing in mind that corporate profits remain very strong, that swap spreads remain very low, and that commodity prices remain very high, I think the market is going to be surprised to find out that the economy has not in fact deteriorated to the extent that is currently priced in. It's not that I'm wildly optimistic about the future, it's just that I am not as pessimistic as the market. 

Pulse of Commerce Index shows modest improvement


According to the folks at UCLA who publish the Pulse of Commerce Index, it "has now declined in four of the first five months of 2011, and in eight of the past twelve months." That sounds pretty gloomy, but when you look at the 3-mo. moving average of the index (blue line in above chart), there has been steady improvement over the past six months. The source of differing interpretations of this data is the relatively high level of volatility in the index over the past year, so this may be one of those situations where a moving average makes a lot of sense. To be sure, the growth rate of the moving average has slowed over the past year, but we already knew that the economy has slowed, so there's really nothing new here.

Putting used car prices in perspective


According to the folks at Manheim Consulting, used car prices have soared by 30% since the end of 2008. That sounds like quite a lot, but the real story is that used car prices have only barely kept up with inflation over the past eight years.

The chart above compares the nominal value of the Manheim Index (blue line) with the inflation-adjusted (real) value (red line). Since 1995, the consumer price index has risen by about 50%, but used car prices have risen by a little less than 30%. So real used car prices have fallen almost 20% since 1995. Most of that decline occurred during the 2000 to 2003 period, which was a time when the Fed's extremely tight monetary policy of the late 1990s began to take hold (recall that the dollar was soaring and commodity and gold prices were plunging in the late 1990s/early 2000s). Deflation was a real threat back then, and used car prices were deflating both in real and nominal terms.

The recent gain in used car prices, when looked at in constant-dollar terms, has been just a reversal of the huge drop that occurred during the recession. On balance, real used car prices haven't changed at all since 2003, and they are still almost 20% below where they were in 1999.

Credit card delinquencies and chargeoffs continue to decline



These charts show the latest data from the Fed through the end of the first quarter. Both show positive trends in consumer finances, with credit card delinquency rates and chargeoff rates falling significantly from their recession highs. Delinquency rates are now well below their 20-year average (3.8% vs. 4.6%). Chargeoff rates are still well above average, but they normally lag delinquency rates, so we should expect to see continued and significant improvement there. The message: consumers are deleveraging, getting back to work (albeit slowly), earning more, and recovering their financial health; the economy is continuing to recover, and though it may seem agonizingly slow, it is nevertheless progress.

Freight update: growth and inflation


Here's an obscure but potentially useful indicator of industrial shipping activity from Cass Information Systems. Both freight expenditures and shipping volumes have increased significantly in the past year, but the rate of increase in shipments has fallen in recent months, likely reflecting the "soft patch" in other data that we have already seen. Rising fuel costs likely account for much of the increase in expenditures. I don't think this adds much to our current understanding of the economy, but it does provide concrete evidence that the economy is indeed expanding and deflation risk is de minimis. No amount of money printing can account for the 9.6% increase in the volume of industrial freight shipments over the past year (only genuine growth can drive that), but the 29% rise in shipping expenditures probably has a lot to do with easy money and the weak dollar.

Freight shipment volumes remained essentially flat in May, down .2% from April levels, but up 9.6% compared to 2010. At the same time, transportation expenditures continued to climb, rising 1.7% over the previous month and up 29% from May 2010.

Healthy financial market conditions point to a stronger economy


This chart illustrates swap spreads' ability to forecast financial and economic conditions. Swap spreads (see my primer on swaps here) are excellent barometers of systemic and financial makret risk. They rise when financial market participants see rising counterparty risk, and that risk in turn is a function of general liquidity conditions, monetary policy, and the health of the economy. Swaps represent a highly liquid market which is extremely sensitive to underlying fundamentals, and as such they can and do tend to lead developments in other markets, such as corporate bonds and equities. For example, when financial conditions deteriorate, sources of funding become more expensive and/or dry up, investment declines, and economic growth eventually suffers.

Swap spreads started rising in mid-2007, well before the economy entered a recession, and well before the financial market crisis of late 2008. They peaked in early October '08, and then fell precipitously in late 2008/early 2009, thanks largely to the Fed's quantitative easing program, which (belatedly) succeeded in meeting the world's intense demand for safety and liquidity that followed in the wake of the collapse of Lehman Bros. With financial market conditions vastly improved going into 2009, it didn't take long for the equity market to reach a low in early March, and for the economy to begin to recover in July '09.


Swap spreads have now been low and stable since last August, signaling the complete normalization of financial market conditions. This normalization can also be seen in the above chart, which plots Bloomberg's index of a variety of financial indicators. I would also note that there has been a noticeable improvement in Commercial & Industrial Loans (bank loans to small and medium-sized companies) since the end of last year, and this is yet another example of how a normalization of financial market conditions eventually translates into an improved economy. When financial conditions are healthy, this opens the door to increased investment, and that is what fuels economic growth.


All of this suggests that we are likely to see continued improvement in the economy as the year unfolds. That improvement, in turn, should provide strong support for a continued rally in the equity and corporate bond markets. The "soft patch" of the last few months is thus most likely related to bad weather and the disruptive impact of the Japanese tsunami. Brian Wesbury fleshes out that story here.

Apple announcements: "it just works"

I've been an Apple fan and user since 1987; I've owned probably a dozen Macs over the years, and today, between my wife and I, we have two iMacs, one MacBook Pro, two iPhones, one iPad, and two Airport Extremes. I've subscribed to Apple's MobileMe service for several years, and during that time we have finally consolidated our Address Book and Calendars—whereas before I tried to keep contacts and calendars up to date on my computer while she relied on a paper calendar and a phonebook list, and our information inevitably became hopelessly jumbled and out of synch. Thanks to MobileMe, which (used to) cost $100/yr (but is now free), all of our Apple devices now display the same up-to-date contact and calendar info. We can make a change on any of our devices and the change shows up on all the others within minutes or even seconds. All automatic; it just works.

Today Apple announced that it is providing this same service for free to anyone who buys an Apple device. Plus, it is extending this service to provide automatic synching of all your iBooks, music, and new photos (up to 1000 for 30 days), and automatic backup and synching of all your documents (with free storage up to 5 GB). Moreover, Apple has taken key elements of its mobile iOS and will add them to the Mac OS, in the planned Fall release of OS X Lion, which will cost only $29. The Apple Mac/iPod/iPhone/iPad ecosystem was already huge and growing, and now it is even more integrated and accessible than before.

Over the years Apple has been THE personal computing innovator. Apple was the first to introduce a mass-market graphical interface, the first to abandon the floppy disk, the first to offer WiFi on its entire product line, the first to introduce a computer without a hard drive or CD/DVD slot, the first to introduce Thunderbolt connections, and the first to introduce FireWire connectors. Today, Apple announced that mobile devices such as iPhones and iPads will no longer need to connect to a computer—they can be set up and updated wirelessly, wherever you happen to be. Apple has cut the computer-mobile device umbilical cord, and at the same time Apple has eliminated the need for CDs and DVDs altogether. You can now purchase and download software, books, magazines, and music wirelessly, even OS updates, for all your computers and mobile devices, all from a central location. Buy it on one and use it on them all (up to 10 for music)! And one more thing: Apple is now incorporating Twitter into its mobile and desktop software.

Apple is not only offering a broad range of digital devices (iPods, iPhones, iPads, laptops, and desktops), but it is now going to tie all those devices together seamlessly, for free. This is a powerful combination, since the whole Apple experience is much greater than the sum of the parts. You will no longer need a computer (Apple or PC) to use an iPhone, but if you have an iPhone, you will be much more inclined to make your next computer or laptop an Apple, if you haven't already—or to make your next smartphone an iPhone, if you haven't already. Apple will even make it easier to switch from a Windows computer to a Mac, with a Windows Transfer application.

The market appears to have been disappointed that Apple failed to introduce new hardware at today's WWDC conference. But that doesn't preclude the possibility that we may see a new iPhone in a few months' times, or a refreshed Air laptop. And it shouldn't overshadow the importance of what Apple did announce, which was significant progress towards the seamless integration of our digital lives—with the sole exception of movies, which could be another piece of the puzzle to be added at a later date (what else is there that wasn't included?). Books, music, documents, photos, messages, calendars, contacts, applications, backups, all synchronized and backed up to the Cloud automatically and available on any and all your Apple devices with a simple one-time setup, and for free. This works for me, and I suspect it will work for plenty of other folks as well. Today Apple has given new meaning to Cloud computing—a nebulous concept until now.

Investors might want to take note of the fact that (according to Bloomberg) AAPL today is selling for a trailing PE of 16.1, and a forward PE of only 13.7. This, despite having grown revenues at a 42% annual rate over the past five years, and there being every reason to expect revenues to continue to grow at impressive rates in the future.

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

Unemployment rate recap


This is in response to a reader's request for a long-term look at the unemployment rate and recessions. I think that no matter how you slice it, the recovery (in terms of jobs and the unemployment rate) has been slower this time around than following any other recession. This has been a deep recession (people are now referring to it as "The Great Recession") and a painfully slow recovery. Calculated Risk has a nice chart which makes the point clearly:


See also Mark Perry's post on the subject of recessions and recoveries.