Main menu

Growth, not Greece, is fueling the market


On the margin, the news about Greece has been positive, with the government agreeing to austerity measures in order to receive financial assistance. But the market continues to believe that a default (or restructuring) is highly likely, as the above chart shows. Yields on 2-yr Greek government debt have declined marginally, but they are still high enough to equate to a high probability of a significant loss of principal. This can also be appreciated by looking at the price of credit default swaps on Greece, which as of yesterday traded at 2100 bps.


So while the Greek situation looks less dire, it still promises to be painful for many, and the fundamental problem (i.e., grossly inflated public sector spending) is far from being resolved.  Markets understand this. So the impetus to the rally in U.S. equities is likely mostly due to news which suggests the economy is pulling out of its recent slump. A resumption of stronger growth in the $15 trillion U.S. economy easily trumps whether or not Greek bond holders lose a few hundred billion.

Climbing walls of worry


With the passing of the supply-chain disruptions, with the easing of energy prices, and with the progress of the Greek bailout, the market has managed to climb one more wall of worry in its quest to reattain pre-recession levels.

Construction still weak


Construction spending in May continued to slide slowly downhill, though there are signs that the residential market may be hitting bottom. Regardless, with construction spending now only about 2% of GDP, whatever weakness remains in this sector has become almost irrelevant for the overall economy. But an eventual recovery in this sector would be significant.

ISM survey beats expectations


The Institute for Supply Management's June survey produced better-than-expected results, adding to the market's growing perception that the economy's recent slowdown was probably limited to the knock-off effects of the Japanese tsunami and the April spike in energy prices, and not the start of a double-dip recession. Progress towards a Greek bailout has also helped sentiment, but since a bailout only buys time and in the meantime weakens the eurozone economy (by pouring good money after bad, and failing so far to result in any meaningful reduction in Greek public sector spending), I don't think that's as powerful an impetus as the more numerous signs of an easing in supply-chain disruptions and a moderation in energy prices.


The export orders subcomponent was the only area that showed further deterioration, but trade often lags.


The prices paid index fell further, reflecting the recent decline in energy and commodity prices, and this represents a source of relief to many manufacturers. Still, it remains quite elevated, suggesting that inflationary pressures continue to percolate throughout the economy.


The employment index rose, and remains one of the brightest spots in the manufacturing universe. Firms haven't been this eager to hire since late 1983, when the economy was just embarking on a boom. Very impressive.

Inflation expectations are heating up (cont.)


This chart compares my calculation of the 5-yr, 5-yr forward inflation expectations embedded in the pricing of Treasuries and TIPS (i.e., the market's expectation of what the 5-yr forward average rate of CPI inflation will be five years in the future) with the actual, year-over-year rate of inflation according to the CPI. By this measure, inflation expectations were only briefly higher than they are today in August 1997. (Note that forward inflation expectations have naturally been much less volatile than actual inflation, since the forward measure is based on what the market expects inflation to average over a 5-yr period.)

While it's clear that inflation expectations have been heating up considerably in the past few years (from almost zero at the end of 2008 to now almost 3%), it's also true that inflation expectations might still be considered to be "anchored" in the sense that they are not outside the range of what actual inflation has been over the past few decades.

So far, the market data support both those who worry that inflation is heating up, and those who believe that inflation is still firmly under control. Thus, reasonable men can continue to disagree on this subject.

As one of those who worries that inflation is likely to continue to heat up, and potentially sustain a higher level than what we have seen in recent decades, I cite the evidence of a very weak dollar, very strong gold and commodity prices, a very steep yield curve, and a super-abundance of bank reserves which have the potential to create a significant expansion in the money supply. Those who are not worried about inflation cite the economy's weak growth and large output gap (which according to Phillips Curve theory creates significant deflationary pressures), the relatively subdued 6% growth in the M2 money supply, and the significant decline in real estate prices.

I would add that on the margin, the evidence lends more support to those who worry than to those who don't. Both actual and expected inflation have been rising this year, much as the market-based evidence (e.g., the dollar, gold, commodities, yield curve) has been predicting, and contrary to what the Phillips Curve theory of inflation has been predicting.

The failure of Keynesian pump-priming


I've showed this before, but it's worthwhile repeating. The chart above makes a bold and striking statement: the more the government spends, in relation to the size of the economy, the higher the rate of unemployment; and the less the government spends, the lower the rate of unemployment. That's not the same as saying that rising government spending causes the unemployment rate to rise, since it's very true that rising unemployment forces the government to spend more (e.g., for unemployment benefits and other assistance to those losing their jobs), and rising unemployment goes hand in hand with a weaker economy, and that tends to push government spending higher in relation to GDP. So I want to be careful with the causation/correlation argument here.

But the experience of the past several years has been remarkable in that there is no question but that three years ago the government embarked on a major campaign to stimulate the economy via a massive increase in government spending. The big rise in spending as a % of GDP in the past three years was mostly driven by a forced increase in spending, and only partially by the fact that automatic stabilizers (e.g., unemployment insurance, food stamps) kick in as the economy weakens. And it is clear that this virtually unprecedented spending boost coincided with the biggest and fastest rise in the unemployment rate, and the deepest recession and slowest recovery in many decades.

At the very least this is prima facie evidence that Keynesian pump priming doesn't work, and it's potentially strong evidence that a big dose of pump priming not only doesn't work, it makes things worse. Furthermore, it's evidence that a significant reduction in government spending as a % of GDP does not prevent a significant strengthening of the economy: consider the 1993-2000 period in the above chart, when both spending and the unemployment rate experienced significant declines.

Spending is the elephant in the living room, and it needs to be cut back sharply. Government spending doesn't add to demand, it wastes resources. When the government spends more than it takes in, that money has to come from somewhere. And when government spends money it does so much less efficiently than the private sector. Moreover, deficit-financed spending takes just as many resources out of the economy as tax-financed spending. The only difference between the two is that when the government borrows to finance its spending the private sector at least has the hope of recovering the money some day, whereas with higher tax rates there is no hope of recovery. Plus, higher tax rates impact future decisions adversely, since they reduce the after-tax rewards to saving and investing and thus reduce future living standards by depressing investment activity.

The debate in Washington over spending cuts vs. higher tax rates is extremely important to the future of the economy. This has nothing to do with partisanship, and everything to do with basic common sense and the facts presented in the chart above. Since more government spending has hurt the economy, less government spending should help the economy.


UPDATE: I can see from a number of comments that readers are not getting my point. As I noted above, there is of course a natural tendency for spending as a % of GDP to rise during recessions (automatic stabilizers kick in, increasing spending, while the recession reduces GDP), but what is unique about this recession and recovery is the huge increase in spending (e.g., TARP, ARRA, cash for clunkers, emergency unemployment benefits) that occurred. Without the additional "stimulus" spending, the blue line in the chart above would have increased to 21-22% of GDP, but the additional spending came on top of that. Clearly, an unprecedented amount of spending has done nothing to improve the health of the economy, and most likely has hurt it.

UPDATE: Cato's Chris Edwards has nice article explaining more in detail why federal spending doesn't work.

Next week's unemployment claims could be exciting



The top chart shows unadjusted weekly unemployment claims, while the bottom chart shows the seasonally adjusted numbers. Note in the top chart that there is an upward "blip" in the middle of each year (actually it occurs in the first part of every July). This surge in unemployment claims comes from the annual summer closing of auto plants. The seasonal factors take this into account by subtracting from the actual number, so if actual claims rise by the typical amount, then the seasonally adjusted number is flat. This year is likely to be different, since the auto plant closures happened for the most part a few months ago. So if the actual claims numbers don't rise by as much as expected beginning next week, then the seasonal factors will give us a seasonally adjusted decline which could last through the latter part of July.

The coming decline in seasonally adjusted claims should provide some support for the emerging notion that the economy may be picking up somewhat, now that gasoline prices have come back down and the disruption that followed in the wake of the Japanese tsunami begins to ease. In reality, of course, the market hasn't suffered as much as the April rise in adjusted claims suggested—it's simply been in a soft patch; claims have been essentially flat for the past 4-5 months. The market is already sensing improvement, in any event, and that is what is pushing equity prices and Treasury yields higher. July could see some more excitement. 

The bond market hits a welcome downdraft


Just five days after I posted that "with 2-yr yields and confidence in the future at record lows, the potential rewards to being optimistic have almost never been better," bang: Treasury yields have shot higher, reducing the price of 10-yr Treasury bonds by 2.1% while wiping out two thirds of a year's worth of coupon yield, and equities are up over 3%.

The most visible trigger for this remarkable turnaround is progress towards avoiding a Greek default, but I suspect there are other factors at work as well. I note that the breakeven inflation rate on 5-yr TIPS has jumped by 21 bps in the past five days, as nominal yields have risen 34 bps and real yields have risen by only 12 bps; this signals that half of the rise in nominal yields is due to rising inflation fears, while the other half is due to stronger growth expectations. I note also that crude oil futures are up almost 5% in the past five days, and the Vix index has dropped almost 18%. All of this leads me to the conclusion that, as I suspected, the market was depressed more by fear than by fundamentals.


What it all boils down to is this: Treasury yields are a good barometer of the market's growth expectations, and the market's Phillips Curve logic makes growth and inflation expectations move hand in hand. Yields have been trading at very low levels, suggesting that the market had become deeply pessimistic about growth. Higher yields are thus an excellent sign that the outlook for the economy is improving. Higher yields faster, please.

Mid-year forecast review

My predictions for 2011 are experiencing mixed results so far, but I think I've been more right than wrong.

The economy will grow by 4% or more in 2011. Wrong. First quarter growth was only 1.9%, and while I expect that second quarter growth will be in the 3-4% range, growth in the first half of the year will likely be only 3% or so. One reason for the growth slowdown was the supply-chain disruptions that followed in the wake of the Japanese tsunami, but those disruptions are already easing and paving the way for a pickup in growth in the second half. I expect growth will be in the range of 3-4% for the year as a whole, only slightly less than I expected late last year. Importantly, although my growth expectation amounts to only a modest recovery, I think I am more optimistic than the market. To judge by the very low levels of Treasury yields, I believe the market is expecting growth of 2-3% at best.

Inflation will trend slowly higher. Correct. All measures of inflation have turned up this year. On a six-month annualized basis, the CPI has moved up from 3.1% to 5.1%; the core CPI from 0.8% to 2.1%; the PPI from 5.9% to 10.8%; the core PPI from 0.9% to 3.5%; the PCE deflator from 1.9% to 3.9%; the core PCE deflator from 0.4% to 2.0%. On a year-over-year basis, the GDP deflator has moved up from 1.2% to 1.6%. I think it is worth noting here that even though the economy was weaker than I thought, and disappointingly weak even from the market's rather gloomy expectations, there has been a very clear trend towards higher inflation. This runs directly counter to the Phillips Curve theory, which predicts that a very weak economy and a large output gap generates deflationary pressures. I continue to think we'll see somewhat higher inflation over the next year.

The Fed will raise rates sooner than the market expects. Too early to call, but probably wrong. I called for the Fed to raise rates before the end of the year, but currently the market is assigning almost a zero probability of that happening. Unless the economy stages a very impressive recovery in the next several months, I doubt the Fed will hike rates before the end of the year.

The housing market will be showing signs of life by the end of the year. Too early to call. As I have noted in recent posts, there are some signs that housing is bottoming, but it is too early to point to anything concrete. I still think we will see some signs of improvement in housing before the year is out.

Interest rates on Treasuries should be higher. Wrong. T-bill yields have fallen from 0.1% to 0.03%; 5-yr Treasury yields have fallen from 2.0% to 1.6%; 10-yr Treasury yields fallen from 3.3% to 3.0%. However, 30-yr yields are unchanged at 4.3%. I continue to believe that Treasury yields will move higher this year, and that they offer very unattractive valuations.

MBS spreads are likely to widen. Correct. Spreads on current coupon Fannie Mae collateral have widened by about 10 bps so far this year. I continue to believe that mortgage spreads will widen as investors worry about extension risk in a rising interest rate environment.

Credit spreads are likely to decline gradually. Correct. Investment grade spreads have narrowed by about 15 bps, and high-yield spreads have tightened by about 50 bps. Even though growth has been disappointingly slow, corporate profits have been strong, and easy money and rising inflation have improved the outlook for corporate cash flows and reduced the risk of default. I continue to believe that corporate bonds offer attractive valuations.

Equity prices are likely to register gains of 10-15%. Correct. The total return on the S&P 500 year to date is 4%, and on the Dow 6.5%. Importantly, despite lots of volatility along the way, the return on equities has been substantially higher than the miniscule return on cash. I continue to believe that equities offer attractive valuations.

Commodity prices will continue to work their way higher. Correct. Despite a sharp selloff in the past two months, the CRB Spot Commodity Index is up over 5% so far this year, the JOC Index is up 1%, and Arab light crude is up 20%. I continue to believe that commodity prices will move higher with time, as the economy is likely to pick up and monetary policy remains very accommodative.

Emerging market economies are likely to do somewhat better than industrialized economies. Correct. Most emerging market economies are enjoying stronger growth than most industrialized economies. However, most emerging market equities are underperforming those of industrialized economies, as global growth has slowed somewhat. Emerging market debt has generally performed quite well, however. I continue to believe that emerging market equities and debt offer attractive valuations, since these economies tend to thrive in an environment of easy money, rising commodity prices, fiscal policy reform, and ongoing globalization.

Gold will probably move higher. Correct. Gold is up 5.5% so far this year. I continue to believe that gold can move higher, given the likelihood that monetary policy will remain very accommodative, but the potential for extreme volatility (especially on the downside) makes gold an unattractive investment for all but the most ardent speculators.


The dollar is likely to move higher against most major currencies, and hold relatively steady against emerging market and commodity currencies. Wrong. The dollar is down about 5% relative to major currencies so far this year, and it is also down against most emerging and commodity currencies. I continue to believe, however, that the dollar has significant upside potential, given that it has never been weaker and I think the outlook for the U.S. is likely to improve. 

Housing prices update



The top chart compares the Case Shiller Home Price Index with the RadarLogic Home Price Index. Rarely do you see two indices such as these that use different methodologies to measure complex phenomena track so closely. The bottom chart is a closeup look at the RadarLogic index. What both indices show is what looks to me like a bottoming process that has been taking place over the past two years. Yes, prices are still slipping on a year over year basis, but how much more do they have to fall to clear the market if real home prices are already 39% below their peak, and mortgage rates are at historically low levels? Not much more, is my guess.


Monetary policy is growth-friendly, but we are suffering from a surfeit of stimulus


This chart is very much worth a periodic review, since it illustrates the strong link between monetary policy and the health of the economy.

Note that prior to every recession since 1960, the real Fed funds rate (using the PCE Core deflator, the Fed's preferred measure of inflation) has risen substantially. In all but one case, the real funds rate exceeded 4% prior to every recession. The last recession was the only exception to that rule, since the real funds rate only rose to 3%. The level of the real funds rate is a good measure of how tight the Fed is; the higher the tighter. When real interest rates become very high, it is a sign that the Fed is restricting the flow of liquidity to the economy, and money becomes scarce and therefore very expensive to borrow. (They usually do this in response to a rise in inflation.) High real borrowing costs begin to snuff out risky initiatives, and increase the demand for money. People begin to prefer letting cash sit in money market funds rather than putting money at risk. Speculative activities become very expensive; it's more rewarding to own a bond than it is to be long gold or commodities. When enough of that happens, economic activity begins to weaken, and those with high debt burdens get crushed.

Also note that prior to every recession, the slope of the yield curve from 1 to 10 years was either flat or negative. A flat or inverted yield curve is a classic sign of tight money, because it is the bond market's way of saying that the Fed is so tight that it will almost certainly have to lower rates in the future. The combination of a high real funds rate and an inverted curve is thus an excellent sign that the Fed has put a big squeeze on the economy and a recession is thus very likely.

Today the situation is the exact opposite of a monetary squeeze. The real funds rate is almost as low as it's ever been, and it has been negative for more than 3 years now. This is typical of the early stages of a recovery. Recessions are provoked by a severe tightening of monetary policy, and once the economy has stalled the Fed reverses course and steps on the monetary gas. Their aim is to make money very cheap to borrow, and to weaken the demand for money. As the demand for money weakens, the velocity of money increases—people start spending the money they hoarded going into the recession, and this helps pull the economy out of its slump. We're now on the upslope of the monetary policy roller-coaster.


This recovery has been unusually slow to gain traction, and one reason is that the demand for money remains very high. M2 velocity has been very low (because money demand—the inverse of money velocity—has been very strong) since late 2008. Money demand has been so strong, in fact, that banks have been unwilling to use their mountain of reserves to make new loans, and the economy has been unwilling—in aggregate—to borrow more money, preferring instead to deleverage. Banks prefer to hold on to their reserve "cash" instead of spending it on new loans.

But this is not to say that the economy will be spinning its wheels forever. One thing we know almost for sure is that the economy is not suffering from a lack of liquidity right now, and liquidity shortages are what have precipitated every recession in the past. It would be highly unusual and surprising to see a double-dip recession any time soon.

What is more likely is that the economy will continue to grow, albeit slowly.

Why slowly? I have been arguing since early 2009 that we are suffering from a surfeit of stimulus. Fiscal policy is supposedly very stimulative, with federal spending having increased by fully 25% relative to the rest of the economy, generating gigantic deficits that have never been seen in postwar U.S. But excessive government spending coupled with increased regulatory burdens (e.g., Dodd-Frank) and huge deficits actually act to depress the economy in several ways. To begin with, when the government appropriates a big new chunk of economic activity by increasing its spending (and transfer payments), this wastes the economy's scarce resources and creates perverse incentives (e.g., by rewarding the idle and punishing the ones working hard). Second, new regulatory burdens dampen animal spirits by raising the cost of doing business. Third, huge deficits create the very rational expectation of huge new tax burdens, further increasing the cost of business. When you make businesses more costly to run, you should expect to see fewer new businesses. And when you increase tax rates on the margin, this reduces the reward to risk-taking and work, so you should expect to see fewer new businesses and fewer people offering their services to the labor market.

Furthermore, the hugely expansive position of the Federal Reserve—with its absolutely unprecedented and off-the-charts purchase of $1.6 trillion of government and agency debt—has most likely weakened the dollar and helped push up commodity prices. There remains great uncertainty about how and whether the Fed will be able to tighten policy in time to avoid an unpleasant rise in inflation—which is already on the rise. Monetary policy fears go a long way to explaining the strong speculative urges that have driven gold and commodity prices to new highs in recent years. And monetary uncertainty has undoubtedly contributed to dampen investor confidence in the future.

So to summarize: the chart at the top says we have every reason to expect the economy to continue to grow, but a surfeit of monetary and fiscal stimulus amounts to a significant headwind to growth. Memo to Washington: please stop the stimulus, it's really hurting!

Truck tonnage confirms growth pause


Truck tonnage fell in May, most likely due to supply-chain interruptions and higher oil prices. Calculated Risk has more details. I offer this updated chart to show how closely the stock market, not surprisingly, tends to follow the ups and downs of the physical economy. I also note that truck tonnage is a very real indicator of economic growth, and can't be artificially elevated by cheap money or misguided stimulus programs.

Trucking serves as a barometer of the U.S. economy, representing 67.2% of tonnage carried by all modes of domestic freight transportation, including manufactured and retail goods.

It's reasonable to expect that supply-chain disruptions are now fading, and that, combined with a 20% drop in crude oil prices over the past two months, should allow somewhat stronger growth to resume in coming months.

Inflation heats up (cont.)


The personal consumption deflator in May came in as expected at 0.2%, but the core version was a bit higher than expected at 0.3%. As this chart of the six-month annualized rate of change of each series shows, inflation is definitely picking up on the margin, regardless of how it's measured. So far this year the core PCE deflator is up at a 2.3% annualized pace. It's notable that both core and headline inflation are moving higher at the same time, since this confirms that monetary policy is definitely accommodative. If policy were tight, then higher oil prices would be pressuring other prices to decline, and we would be seeing core inflation falling while headline inflation was rising.

Inflation is now high enough to justify the Fed's decision to forego QE3, and high enough to begin to justify the concerns of those who worry that the Fed may have been too easy for too long. Deflation is dead, of that we can be sure.

UPDATE: The bond market responds to the news by steepening, sending sensitive, forward-looking inflation expectations higher.

The 10% gap


This chart compares the actual path of real GDP to a trend line that equates to 3.1% annual growth. About two-thirds of the trend growth rate is due to increased productivity, while one-third is due to growth in the number of people working. Recessions typically cause GDP to fall below its trend growth rate, and recoveries typically result in faster-than-trend growth. This behavior of GDP was described by Milton Friedman and I've discussed it before.

Actual GDP is now about 10% below where it could be if the underlying trends in productivity and population growth remain unchanged. The shortfall is now equal to about $1.5 trillion of lost income per year, and that is the true cost of this very weak recovery that we are experiencing. It's also a good measure of the degree to which unemployment and underemployment impinge on the lives of many millions of our citizens.

For all the terrible cost this latest recession and meager recovery have exacted, there is a bright side: the amount of un- and under-utilized resources in the economy is huge, and just waiting to be tapped. If Washington can steer a better fiscal and monetary policy course (e.g., shrinking the size and burden of government, lowering and flattening tax rates, broadening the tax base, and tightening monetary policy) then there is a staggering amount of growth that could be unleashed in coming years. In short, if government can get out of the way of the private sector, the future could be quite rosy.

Why can't we cut our way to prosperity?



In his weekly radio address today, President Obama said, in regard to the upcoming talks he will be having with Congressional leaders over reviving the stalled budget negotiations, "we can't simply cut our way to prosperity."

He might do well to consider the record of the Clinton administration. As these charts show, federal spending as a % of GDP fell 4 percentage points—from 22% to 18%—during the 1993-2000 period, thanks mainly to 8 years of very low spending growth: 3.1% on average. During that same period, real GDP grew at an annualized rate of 3.8% per year, well above its long-term 3.1% per year average, and the unemployment rate fell from 7.4% to 3.9%.

During that same period, rising prosperity resulted in a surge of federal tax receipts, which rose from 17% of GDP to 20%, as revenue growth averaged 7.8% per year. The combination of very slow spending growth and a strong economy reduced the budget deficit from 5% of GDP to a surplus of 2.5% of GDP. And thanks to the combination of strong growth and tight monetary policy, the dollar rose 20% during this period, further boosting confidence and investment.

The hallmarks of policy during the 1993-2000 period are exactly what we need today: 1) sharply curtailed spending growth and 2) tighter monetary policy. It's not a coincidence that explosive spending growth and easy money have given us the slowest recovery on record. Moral of the story: you can't simply spend your way to prosperity.

UPDATE: To expand on this most important of themes: You can't spend or print your way to prosperity; prosperity comes only from hard work and productive investments. Government doesn't know how to do either very well, since it lacks the profit motive, and politicians have the luxury of spending other peoples' money instead of their own. Printing money doesn't create prosperity because it only fosters speculation and destroys confidence in the value of a currency. The worst thing about policies of the past several years (including the Bush administration) has been the reliance on policies (e.g., lots of government spending and easy money) that don't make any sense, but which sound good because they supposedly put the politicians and the bureaucrats in charge of pulling the economy out of a slump that they themselves (of course) were responsible for creating. The Keynesian belief that politicians and bureaucrats can pull spending and money levers and thus turn around the economy have once again been totally discredited. How long will it take before we as a country learn this lesson?