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Reading the bond and stock market tea leaves


Today's deeply disappointing GDP report has helped 10-yr Treasury yields to their lowest level of the year, and there's little doubt that the problems Congress is having over increasing the debt limit are contributing to the market's malaise. As my chart suggests, the current level of 10-yr yields is indicative of a market that expects a recession. The last time yields were this low or lower the market was last summer, when concerns about a double-dip recession were rampant.

10-yr yields are strongly influenced by the market's expectation of the future path of the Fed funds rate, and with the economy so weak and expectations for future growth so dismal, the market is now expecting the Fed to keep rates near zero throughout this year and most of next year; in fact, the market currently doesn't see much chance of any meaningful Fed tightening until the first half of 2013.


Are the bond and stock markets out of synch? Bonds are priced to a recession, but the S&P 500 is only 5% below its recent highs, and over 20% above last summer's lows.



These two charts help explain what's going on. As a result of the recent revision to the past several years of GDP, corporate profits were revised to be much higher than before. First-quarter after-tax profits (which are based on corporate tax filings from the IRS) are now reported to be running at an annualized rate of almost $1.45 trillion, compared to the $1.26 trillion previous estimate. Relative to GDP, corporate profits are now at a new all-time high. Even though the recovery that began two years ago has been downright dismal, corporate profits have surged by almost 50% to record-setting highs.


Using NIPA profits as a proxy for all corporate earnings and the S&P 500 index as a proxy for the value of corporate equities, I've constructed the chart above. This shows that PE ratios have rarely been so low in the past 50 years. The market may be depressed by the economic outlook, but it's hard to ignore $1.5 trillion of corporate profits. If anything is sustaining the level of equity prices today, it's profits, not optimism. As a result, for those who believe that the debt limit will be raised and fiscal policy will improve—even marginally—current valuations represent real bargains.

GDP: less growth, more inflation


As this chart from Calculated Risk shows, today's historical revisions to GDP subtracted a lot—a little more than $200 billion—from real GDP. The recession now looks worse than before, and the recovery looks weaker. Real GDP has still not recovered to its 2007 high. Although growth in 2010 was revised upwards, growth this year has proved to be much weaker than previously thought. On a minor note, my original forecast in late 2009 that GDP would grow by 3-4% in 2010 has now been vindicated, since according to today's revisions, GDP expanded by 3.1% in 2010. But so far, first-half 2011 growth (0.8%) is much slower than the 3-4% I expected last December.



Much of what was subtracted from real GDP was added to inflation (i.e., nominal GDP didn't change very much, but its composition did). The first of the above two charts shows quarterly annualized changes in the GDP deflator before today's revision, and the second shows them after the revision, including the second quarter number. Previously, we had two quarters of deflation, with six quarters of inflation that was either very close to zero or negative. Now we see only one quarter of deflation, and only two that were close to zero or negative. For the first half of this year the GDP deflator has risen at a 2.6% annualized rate. The CPI rose at a 3.8% rate over the same period, so between the two we have clear signs of accelerating inflation.


This has to be a very surprising and even shocking result for establishment economists as well as for the Fed. As the above chart shows, real GDP is now over 12% below its long-term trend. This huge "output gap" should have been extremely deflationary, according to traditional Keynesian analysis, but that hasn't been the case at all. The Fed has been in a near-panic for the past three years, believing that the extreme weakness (aka "resource slack") of the economy posed the very real threat of a debilitating deflation, but deflation has proved to be only a fleeting phenomenon. If current trends continue, the Fed is soon going to be worrying about too much inflation, not too little. 

Once again these developments underscore supply-siders' belief that growth can only come from hard work and risk-taking. Monetary policy can't create growth out of thin air, and neither can fiscal "stimulus" spending. The swimming pool analogy is very apt: fiscal spending "stimulus" is akin to taking water out of the deep end of a pool and pouring it into the shallow end—it achieves nothing and is simply a waste of effort. Real growth only occurs when people work more and/or someone figures out how to make the same amount of work produce more output.

If there is a silver lining to this gloomy GDP cloud, it is that fiscal and monetary policy "stimulus" have now been soundly discredited. Congress does not have the power to pull spending levers in order to speed up the economy, and the Fed can't speed up the economy by keeping interest rates at artificially low levels. In fact, fiscal and monetary policy errors of the sort we have lived with in recent years only serve to weaken the economy. Too much debt-financed spending only wastes the economy's scarce resources, while simultaneously boosting expected tax burdens. This in turn reduces the after-tax rewards to hard work and risk-taking, which explains why corporations have been so slow to invest their growing stockpiles of cash. Too much easy money only boosts speculative activity (which shows up as higher commodity and gold prices) while undermining the dollar and reducing investment.

The end of the weekly claims seasonal problem




For most of this year, the weekly unemployment claims have been jerked around by seasonal adjustment factors that didn't quite match the typical seasonal variations that occur. As a result, claims were under-reported in late February and March, and over-reported in April. I've been blogging about this for a long time. Now I think this little sideshow is finally coming to an end.

The top chart shows the seasonally-adjusted data, while the bottom chart shows the actual data. Note that in actual data claims have been relatively low and flat since February, with a modest spike in July (which is typical in July because auto manufacturers usually lay off workers as they retool their assembly lines). In the adjusted data, there is a huge spike in April which does not show up at all in the raw data. This was largely the result of earlier-than-expected auto layoffs. The seasonal factors expected the actual data to be weak in April, but instead it was higher than usual, so that turned into a large rise in the adjusted data.

In any event, the predictable seasonal events are now in the past, and we won't have another until later this year when workers hired to prepare for the Christmas season start getting laid off. What's happened so far this year is that all the confusion created as a result of volatile claims numbers has been much ado about almost nothing. Despite the headlines, claims have been fairly stable for most of the year; the economy is neither accelerating nor decelerating. It's steady (and slow) as she goes, although I think there is reason to expect activity to pick up somewhat in the months to come.

Nobody is proposing actual spending cuts

When the history of the Great Debt Limit Debate is written, one of the key villains will be the definition of "cut." For everyone who lives outside the halls of Congress, "cut" means to reduce. But inside Congress, "cut" means to spend less than your baseline projection of future spending. Since spending always tends to rise by at least the growth of nominal GDP, which has averaged about 5.5% for the past 30 years, the baseline that everyone compares their budget proposals to tends to project increased spending of about 5-6% per year.

Over the past 12 months the federal government has spent $3.56 trillion. A typical baseline would project spending to increase about 5.5% a year, reaching some $6 trillion a year by 2021 (budget scoring generally focuses on what happens over the next 10 years). That would equate to total expenditures of $48.4 trillion over the next decade. So when one party proposes to "cut" spending by, say, $4 trillion, what they really mean is that they propose to spend $44.4 trillion over the next 10 years instead of $48.4 trillion. The $4 trillion "cut" they are proposing actually works out to a 4% annual increase in spending, instead of a 5.5% annual increase in spending.

So even the most radical of "cuts" that are being proposed today would still allow government spending to increase by 4% a year. How hard or draconian is that?

I suspect the great majority of Americans would be stunned to realize that if we allowed government spending to increase by only 2% a year, then we could probably balance the budget in about 7 years, without any need to increase tax rates or actually cut anybody's spending. No real cuts and no real tax hikes are needed to balance the budget within a reasonable time frame. Why is there so much sound and fury surrounding this debate?

(My calculations assume that tax revenues as a percent of GDP rise naturally to about 18% of GDP over the next 7 years, which is close to the long-term average and the same level that was achieved a few years after the Bush tax cuts. Tax revenue as a % of GDP always rises during the expansion phase of a business cycle, and we know that the current level of tax rates can generate 18% of GDP if the economy is healthy.)

UPDATE: Prompted by reader "William" as to why it seems so hard for Congress to do something simple like cutting the growth rate of spending to 2% instead of 5.5%, I offer this explanation: The problem with cutting the growth rate of spending is that CBO scores this as a "cut", and the "cut" that would result from a 2% growth rate in spending would be on the order of $8.6 trillion. My guess is that no congressman or senator would want to be labeled as the guy who "cut" such a gigantic amount of spending. Think of all the kids who would starve, the old folks who would die from lack of medicine, etc. In short, it would be too easy for political opponents to brand the cutter as an evil madman, when in fact he was just trying to be reasonably prudent.

A suggestion for Boehner and Reid

Fellows, at this point there is no way anyone is going to come up with a serious reform of our dysfunctional federal government before August 2nd, and I don't even want you to try. You can't change the course of our government with a deadline approaching and with false accusations and hyperbole polluting the airwaves. I hope you don't attempt something like what happened with Obamacare, where a 2,000 page bill was put together in the wee hours of the morning and nobody had a chance to read the fine print before it was passed. This is a debate that needs to be conducted in the open air, with plenty of time and discussion. It's not going to happen this week.

So why not just concede that you have reached an impasse, and that the only sensible thing to do is to increase the debt limit by enough to buy us time for more discussion. In fact, the issues you need to resolve are exactly the issues we should all be discussing next year as a national election approaches. Let's extend and continue these discussions, but let's remove the threat of default that is just making things worse.

Capex update: moderate growth


New orders for capital goods fell slightly in June, but the more stable 3-mo. moving average rose 0.3% (this series is notorious for its monthly and quarterly volatility), and is up at a 9% annualized rate over the past six months. Nevertheless, there has been a slowdown in the past year, compared to the rapid growth of the first half of 2010, and this is consistent with a lot of other indicators of moderating activity, and with the slower reported growth of the first and (most likely) second quarters of this year. So there's not much new or helpful information in this series.

Housing price update


This first chart shows the latest data for two different but remarkably similar indices of home prices. The Case Shiller index tracks the sale price of the same houses over time, and reports the average price of homes sold, and the Radar Logic index tracks the average cost per square foot of homes sold. While both are showing that prices have slipped a bit in the past year, prices today (actually, the latest data report the average of the three months ended in May) are almost identical to what they where in the early part of 2009. Thus, we have had two years of relative price stability in the housing market. 


After adjusting for inflation, however, housing prices have fallen about 5% in the past two years. Real home prices are now about 39% below their 2006 peak. That's a significant price adjustment.


We can look at prices over a longer period thanks to the Case Shiller data which covers 10 major metropolitan areas (the top chart cover 20). This third chart is also adjusted for inflation.  
Those looking for further significant declines in housing prices might like this chart, since it suggests that prices could fall back to their 1997 lows, which would imply a 32% decline from today's levels. That would be painful indeed.


On the other hand, this chart of real median existing home prices shows that prices today are about the same as they were in the late 1970s, and that prices haven't even increased in real terms by 1% a year over the past 40 years. (It seems reasonable that real home prices should tend to increase by at least some small amount over time, to reflect rising real incomes and a rising standard of living).

In my opinion, what all these charts show is that there is good reason to think that the "bubble" in housing prices that formed in the mid-2000s has disappeared, and that prices today are reasonable, give or take a little, compared to long-term historical trends. There is no compelling historical reason, in other words, to think that prices need to drop significantly from current levels. Moreover, new home construction has been far below the rate of new housing formations for several years now, so we know that the excess inventory of homes has declined significantly. Whatever slack is left in the housing market could quickly become used up by a combination of 1) moderate economic growth, 2) rising incomes, 3) rising inflation, and 4) new household formations. And of course with mortgage rates near record lows, the effective cost of a home today is quite low by historical standards, perhaps as low as it's ever been.

I continue to believe that we've seen the worst of the housing market, and that the next shoe to drop will be the surprising news that prices are starting to rise and residential construction is starting to improve.

Thinking twice about a possible Treasury downgrade

I was probably too cavalier this morning in my dismissal of the risks of a Treasury downgrade. In discussions over lunch today with my most excellent former colleagues, Steve and Ken, I came to appreciate the deep concerns that hover over the institutional bond market community. My point this morning was that a downgrade of US Treasury debt is essentially a downgrade of all debt—since Treasuries are the bedrock upon which all debt is priced—so a downgrade doesn't really mean much.

Their point, however, is that a downgrade of Treasury debt has huge and little-understood implications for many large institutional bond portfolios. To understand why, consider the case of a billion dollar bond portfolio that is currently underweight Treasuries, overweight MBS and corporate bonds, and skewed to lower-quality debt given the steepness of the credit curve. Given the steepness of the yield curve and the still-generous level of corporate spreads, overweighting MBS and corporates has been a very profitable strategy in recent years and promises to continue to be so. Moreover, such a strategy recognizes that Treasuries are very fully valued (and quite possibly overvalued), and thus minimizes a portfolio's exposure to rising Treasury yields. If a manager is even modestly optimistic on the economy's prospects, and if he believes that the Fed's accommodative monetary policy stance should, by making liquidity relatively abundant, result in relatively low default rates and facilitate economic growth, then positioning this portfolio at the low end of his client's acceptable credit quality range makes a lot of sense. (And isn't the Fed trying to encourage people to take on more risk?) In short, there are many good reasons for large, diversified, institutional portfolios to be structured today with a relatively low average credit quality.

But here's the catch: If Treasuries are downgraded, then a portfolio's average credit quality, assuming it holds at least some Treasuries, will fall. Even if the portfolio holds MBS and no Treasuries, one could argue that a downgrade of Treasuries perforce implies a downgrade of current-issue MBS, since their AAA rating depends crucially on the assumption that the implied Treasury guarantee of principal is bullet-proof. In short, if you downgrade Treasuries you downgrade just about everything, as I was arguing this morning.

But if you downgrade Treasuries and MBS, you need to understand that the average credit quality of our diversified, billion dollar portfolio will fall, and meaningfully. If a portfolio is currently at the low end of its acceptable average quality, a downgrade of Treasuries and MBS could quickly put it in violation of its credit quality guidelines. The solution to this problem illustrates the quandary that the bond market is very concerned about: The only way to bring the average quality of our billion dollar portfolio portfolio back up to its minimum required level, if Treasuries are downgraded, is to sell the cheapest bonds (e.g., the low-quality corporates) and buy the most expensive bonds (e.g., Treasuries). How would you like to call your billion dollar client and explain to him that as a result of the downgrade of Treasury bonds, of which you held very little or none because you think they are overvalued, you now have to buy more? And that in order to buy more Treasury bonds you have to sell the bonds that yesterday you thought were the cheapest and most attractive?

When this example is multiplied over the hundreds of billions and even trillions of dollars of diversified bond portfolios with strict quality guidelines, you suddenly realize that the bond market might theoretically be forced to dump massive quantities of low-quality bonds (thus raising the borrowing costs of hosts of struggling companies) in order to buy equally massive quantities of Treasury bonds (thus keeping Treasury yields very low), should Treasuries be downgraded. To drive home the absurdity of this, consider that the worse the deficit situation of the US becomes, the more our billion dollar bond portfolio would have to invest in Treasuries. This may sound surprising and even counterintuitive to bureaucrats, rating agencies, and the layman, but it would be eminently in keeping with The Law of Unintended Consequences, which is always lurking in the background, waiting to make fools of those who live by rigid rules and not by logic.

Memo to the bond market: it's past time to make quality guidelines more flexible.

The debt limit will be raised

There's a lot of political posturing going on in Washington, but by the end of the week we are almost certain to see an increase in the debt limit, because neither party can afford to fail on that issue. What is not clear, however, are three things: 1) how much the limit will be raised (will it be a short-term fix, or a fix that will take us beyond next year's elections?), 2) how much spending will be cut (spending will definitely be cut), and 3) whether taxes will increase. On the latter point, I see almost no chance that tax rates will increase; if higher revenues are part of the deal, the money will come as the result of cleaning up the tax code (eliminating deductions), and from a stronger economy. The economy is not strong enough to sustain tax rate increases, and everybody knows that.

So by the time the dust settles later this week, there's a very good chance that we will see Washington take action to fix our biggest problem, which is too much spending. The debt limit debate has served a good purpose, which has been to focus the public's mind on the huge growth in government spending that has left us with a staggering burden of debt in just a few short years. It's about time. Fiscal policy was on an unsustainable course, and now it looks like a  course correction is imminent. The problem won't be completely solved, of course, because it will take years to fix. But next year's elections will give the people ample time and opportunity to think about our priorities. I suspect that the ongoing popularity of the Tea Party reflects a widespread and growing belief that government has become too large and must be cut back. If that's the case, then there is plenty of room for optimism.

Whether US debt is downgraded or not is almost a side-show compared to the bigger, long-term issue of the size of government. A downgrade doesn't seem very likely, but if it were to occur it would just add to the pressure to cut spending, a process that is already underway.

But all this is hardly news, and I only point out the obvious. A quick glance at the bond market, where 10-yr Treasuries are trading at 3%, is enough to know that the market is not at all concerned about the possibility that the US might actually default on its debt obligations.

UPDATE: This quotation from Thomas Babington Macaulay seems to fit perfectly the emerging mood of the people:

Our rulers will best promote the improvement of the nation by strictly confining themselves to their own legitimate duties, by leaving capital to find its most lucrative course, commodities their fair price, industry and intelligence their natural reward, idleness and folly their natural punishment, by maintaining peace, by defending property, by diminishing the price of law, and by observing strict economy in every department of the state. Let the Government do this: the People will assuredly do the rest.

HT: Don Boudreaux