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2-yr Treasury yields fall to record low

As this chart illustrates, 2-yr Treasury yields today fell to a record low 0.33%. Bond market math tells us that this means the market expects the Fed funds rate to average 0.33% over the next two years (today it stands at 0.1%). According to the pricing of Fed funds futures, the market is expecting the Fed to remain on hold for at least another year, and then to raise its target rate only modestly beginning some time later next year and reaching 0.8% in two years' time.

This is the most pessimistic outlook for future interest rates hikes in modern history. Looked at another way, since Fed policy is strongly influenced by the health of the economy, the bond market is assuming that the outlook for growth over the next few years is dismal at best. By inference, the equity market must also be assuming similarly dismal prospects for future cash flows.

However, I find it very difficult to share the market's conviction that growth will be extraordinarily weak and inflation will be tame for the next several years. There are tensions building up in the market that could be resolved rather explosively (and positively) in coming months if the economy picks up as I expect.

How can the outlook for growth be so dismal when corporate profits are at record levels, both nominally and relative to GDP? When retail sales are up almost 8% in the past year? When private sector jobs are growing at the rate of almost 2% per year? When U.S. exports are growing at almost 20% per year? When business investment (capex) is increasing at a 10% annual rate? When commodity prices are only 5% off of their all-time highs? When households' net worth has increased over $9 trillion in the past two years? When financial market conditions are relatively healthy, liquidity is abundant, and the yield curve is extremely steep? (I've covered all these points in recent posts.)

My guess is that the market is ignoring all these positive fundamentals and instead is paralyzed by the mounting risk of a PIGS sovereign debt default, and by the ballooning size of the federal budget deficit. The Keynesian instincts which permeate the market's thinking are predicting economic disaster as a result of forced fiscal tightening. Budget deficits are going to have to be slashed, and to a Keynesian that means contraction.

But as Steve Hanke reminds us in today's WSJ, contractionary fiscal policy—and even budget surpluses—can coexist with a very strong economy. Moreover, it's a fact that despite the huge fiscal "stimulus" of recent years we have had the weakest recovery in modern times. Indeed, it just makes sense that as the government consumes less and less of an economy's scarce resources, that allows the private sector to blossom and expand.

The only thing we might have to fear about the coming fiscal "contraction" in the U.S. is that politicians try to replace excessive borrowing with higher taxes, thus avoiding a huge cut in spending. But a significant hike in tax rates at a time when growth is meager is going to be a very tough sell. And as Milton Friedman long ago taught us, the true burden of government is measured by spending, not borrowing or taxes. The only sensible—and the best—solution is to cut back government spending. There is no reason to think that would reduce growth, and every reason to think it could lead to stronger growth.

With 2-yr yields and confidence in the future at record lows, the potential rewards to being optimistic have almost never been better.

Inflation expectations are heating up

Sometimes you have to really dig into the entrails of the bond market to find important information. What this chart illustrates is that the changing shape of the yield is reflecting a rise in the market's near-term inflation expectations. One part of the yield curve that stands out is the spread between 10- and 30-yr Treasury yields; this has widened from a low of 102 bps in April to 130 bps today. At the same time, the 5-yr, 5-yr forward breakeven inflation rate embedded in the TIPS market (a sensitive measure of near-term inflation expectations that the Fed pays particular attention to) has risen from 2.4% to 2.9%.

Rising inflation expectations can also be seen in the above chart, which measures the spread between 5- and 10-yr Treasury yields. This spread is now as wide as it has ever been. This is a direct reflection of the Treasury market's fear that inflation is going to be higher in the second half of the next decade than in the first half.

The last time all of these measures of inflation expectations rose in tandem was in the Sept-Oct '10 period, as the market began to fear that QE2 (which began in November) would be inflationary, and the economy began emerging from its April-August '10 slowdown.

Consider the factors which have been driving the steepening of key parts of the Treasury curve. To begin with, the economy's sluggish growth of late, coupled with the market's lack of confidence that growth will improve in the future, have created the expectation that the Fed will keep short-term interest rates extremely low for at least the next year. The Fed of course has helped foster these expectations with its repeated use of the "extended period" language, and its ongoing concerns about weak growth, high unemployment, and deflation risks. Currently, the market does not see any appreciable chance of a Fed tightening until the third quarter of next year, according to Fed funds futures contracts. If the market's expectations are realized, the Fed funds rate will have been 0.25% or less for fully three and a half years—which would mark a truly unprecedented period of accommodative monetary policy.

With policy so easy for so long, the risks of an unwelcome rise in inflation become too big to ignore. No wonder the price of gold has doubled, to $1500/oz., since late 2008, and the dollar has dropped by 15%. No wonder the front part of the yield curve has never been so steep.

Even if real growth continues to disappoint, the economy still shows every sign of continuing to grow. I don't see why GDP can't post at least 3% growth for the foreseeable future, but that would of course leave the economy about 10% below its potential growth, and that in turn implies the unemployment rate will remain quite high for some time. And if inflation accelerates further—the year-over-year GDP deflator has already picked up from 0.2% in Sep. '09 to 1.6% in Mar. '11, and the CPI has gone from -2% in July '09 to 3.4% in May '11—then we will see a significant pickup in nominal GDP going forward.

Even with sluggish growth, a pickup in inflation and accelerating nominal GDP growth should be good news for equities, corporate bonds, and real estate. Rising nominal GDP provides a good foundation for further growth in corporate cash flows and profits, and increased cash flows plus higher inflation should eventually be good for real estate, especially since it has fallen so much in the past 5 years. (Normally I would include gold and commodity prices in the list of things likely to benefit from accelerating inflation, but they appear to have already anticipated a lot of that.)

Capital spending still strong

Capital goods orders (a good proxy for business investment) in May broke out of their early-year slowdown, rising 3.5% above the previously reported level for April. They rose at a strong 10.3% annualized rate in the past six months, and are up a solid 10.5% in the past year. This is a key reason to remain optimistic about economic growth, since business investment today is the seedcorn for future growth.

Since hitting a post-recession low in April '09, capital goods orders have surged 39% are now only 3.4% below their pre-recession high. This has been an excellent recovery from the standpoint of business investment, but still disappointing from a long-term perspective. Consider that the level of investment today hasn't increased from where it was in the year 2000, while the economy has grown almost 20% over the past 11 years. There is still a lot of catching up to do. When business investment fails over the years to keep pace with the growth of the economy, that can only mean a slower rate of growth going forward. Investment is needed to raise worker productivity, and productivity—which has averaged about 2% a year for the past several decades—is a major source of growth, which averaged about 3% a year until several years ago.

The lagging pace of business investment over the past decade is also disappointing when you consider that corporate profits after tax have more than doubled in the same period. After-tax corporate profits now stand at 8.4% of GDP, just 20 bps below their highest level ever. Corporations have been piling up massive amounts of cash on their balance sheets in recent years, but it's important to remember that all the money saved by people and business in any given year is always spent by someone else. As it turns out, our federal government has effectively borrowed and spent every dime that businesses have saved since the recovery started. The federal deficit has totaled $2.55 trillion since the recovery started, while total after-tax corporate profits have been $2.06 trillion over the same period.

With businesses unwilling—for whatever reason—to reinvest surging profits, the federal government has stepped in to fill the gap. But since government spending (a portion of which is euphemistically termed investment) is almost certainly less efficient and less productive than private sector investment, the source of our lagging growth (with an output gap I estimate to be almost 10%) becomes obvious. As a country, we have squandered trillions of dollars by allowing the federal government to greatly expand its control over the economy's scarce resources. Federal spending as a % of GDP has grown by an explosive 24% since the end of 2007.

Housing price trends

Everyone knows that housing prices are falling, right? This chart, however, is intriguing because it suggests that's not necessarily true. The chart comes from the RadarLogic survey of prices in 25 metropolitan areas, and, like the Case Shiller home price index, it has a substantial built-in lag of about 3 months. The price reflects the average cost per square foot of homes sold (not seasonally adjusted), and the most recent price comes from the average of sales in the 28-day period ending April 21st. There is some seasonality in the data (prices tend to rise in the second quarter of every year), so the best way to compare the trend in home prices is using a year over year comparison. On that basis, home prices are down about 5%. Compared to two years ago, however, prices are down only 3%. The comparable Case Shiller price index shows prices down only 1.4% in the two years ending March '11.

Cheaper gasoline on the way

The top chart compares crude oil (orange) and wholesale gasoline prices (white), and the inference I draw is that crude prices are leading gasoline prices on the way down. Today's $91 crude price suggests that wholesale gasoline prices should fall to at $2.70/gal or less. The bottom chart compares wholesale gasoline (white) and regular gasoline prices at the pump (orange); the tight correlation between the two suggests that if wholesale gasoline prices fall to $2.70, then prices at the pump should fall to $3.40 or less, compared to today's $3.61 average nationwide price for regular. That would result in a 15% net decline in gasoline prices from April's highs, which in turn would reverse most of the bulge in oil prices that started last February.

If higher crude and gasoline prices contributed to the economy's slowdown in the first quarter, which seems likely, then the reversal in prices over the past two months should help support the economy this summer.

P.S. And all of these price declines so far have happened without any assistance from government policies. It's been a natural market reaction to the combination of a rise in price and a rise in crude inventories. Today's announcement by the IEA that it will be releasing crude inventories into the market will likely have only a minimal impact compared to the larger fundamentals that are driving the market.

Livestock prices reach new highs

Just when you thought that commodity prices were correcting and the Asian economies were slowing down and inflation—according to today's FOMC release—was set to decline in coming months, I bring to your attention the fact that the CRB Livestock index (a subcomponent of the CRB Foodstuffs Index, which in turn is a major subcomponent of the CRB Spot Commodity Index) has been setting new all-time highs in the past week. This measure of livestock prices has soared 138% since March 2009. Are speculators hoarding hides, hogs, lard, steers, and tallow? Or is global demand robust and the dollar very weak? My money's on the latter.


Today the FOMC announced the end of its incremental quantitative easing efforts. The Fed won't undertake a QE3, but it will keep in place—for now—the extra $1.6 trillion of reserves that it has supplied to the banking system via its purchases of Treasury and agency debt. There will be no tightening of monetary policy, and there will be no further easing: monetary policy will remain plenty easy as it is.

The market reacted to the news with what amounts to a yawn, which is good. 10-yr Treasury yields were unchanged on the day, after having declined some 60 bps since February; stocks fell marginally today, and are down only about 5% from their recent highs. The decline in Treasury yields and stock prices reflects a market that has soured on the economy's growth prospects, but not a market that is fearful that a Fed on hold—with interest rates close to zero—poses any significant threat.

The contrast between the two charts above underscores a reality that is not widely understood or appreciated. The Fed has injected a massive amount of bank reserves into the financial system, but this has not resulted in any unusual growth in the broad M2 money supply. The extra reserves have not been used by the banking system to make new loans, because banks have instead preferred to hold those extra reserves in order to bolster their balance sheets. Without any meaningful increase in the amount of money sloshing around the financial system, there is no meaningful risk that inflation will soar to frightening levels.

In short, although the numbers are theoretically terrifying ($1.5 trillion of extra bank reserves could potentially result in a doubling of the M2 money supply and a huge increase in inflation), the reality is that nothing much has happened.

That's not to say that nothing unseemly will happen, of course. It's quite troubling that the dollar is just about as weak as it has ever been, and $1500 gold is makes a powerful statement to the effect that the world is seriously worried about the future of the dollar.

But despite all the lingering bad news, it's reassuring to know that there is no shortage of important measures of economic health that are in good shape or materially improving. Corporate profits are very strong; the economy has created over 2 million private sector jobs since the recession low; swap spreads are very low; the implied volatility of equity options is only moderately elevated; the yield curve is very steep (thus ruling out any monetary policy threat to growth); commodity prices are very strong (thus ruling out any material slowdown in global demand); the US Congress is debating how much to cut spending, rather than how much to increase spending; oil prices are down one-third from their 2008 recession-provoking highs; exports are growing at strong double-digit rates; the number of people collecting unemployment insurance has dropped by 5 million since early 2010; federal revenues are growing at a 10% annual rate; households' net worth has risen by over $9 trillion in the past two years; and the level of swap and credit spreads shows no signs of being artificially depressed (thus virtually ruling out excessive optimism or Fed-induced asset price distortions).

When you put the latest concerns about the potential fallout from a Greek default (which is virtually assured and has been known and expected for months) against the backdrop of these positive and powerful fundamentals, the world doesn't look like a very scary place.

Spread update

With all the concerns about the U.S. economy being in a soft patch (and possibly entering a double-dip recession), and Europe being plagued by imminent PIGS defaults, credit spreads have understandably widened of late. But as the chart above shows, this widening has been rather tame when viewed from an historical perspective. Furthermore, the widening of spreads has occurred mainly as a result of declining Treasury yields; yields on high-yield debt haven't fallen as much as Treasury yields have. (The widely-followed HYG ETF is down only about 3% from its recent highs.) I note, moreover, that spreads remain quite elevated relative to their lows since 1997. Investment grade spreads today are almost as wide as they were during the 2001 recession, and high-yield spreads are more than twice as high today as they were in mid-2007.

The best explanation for why spreads have only widened marginally, despite the long list of concerns which currently weigh on the market, is that the market has been priced to a lot of bad news for some time now. Put another way, valuations in the corporate debt market have been and continue to be depressed.