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A CPI Christmas present


The November CPI report was uneventful, but if anything it's a nice Christmas present because it shows that inflation is not the problem that so many—including me—have worried about, at least for now. Most measures of inflation in fact have been relatively tame in recent months, showing inflation to be running at about a 2% annual rate, which is nothing at all to be concerned about.


The first chart above shows the year over year change in inflation, while the second shows the 6-mo. annualized rate of inflation. Using more recent data, this second chart highlights the relatively tame nature of current inflation.


Falling energy prices have been a big part of the reason inflation has been so tame. This chart shows the CPI ex-energy, but even that is only running at 2.4% over the past six months.



Natural gas prices have fallen significantly, thanks to huge new discoveries and production in the U.S. As Mark Perry notes, in looking at the CPI report, natural gas is "the only item that has fallen in price over the last 12 months (-1.3% vs. a 19.7% increase in gasoline)." If anything is disruptive, this is, because (as the second chart above shows) natural gas has now become incredibly cheap relative to oil. This is going to transform energy-intensive industries and enrich the lives of everyone.

I'm not letting down my inflation guard, however, but for the time being my level of concern has eased, and that adds to my belief that the outlook for the economy is better than most people think.

Exports remain strong


I first noted that outbound container traffic was a good leading indicator of goods exports in an April 2009 post. Container traffic data comes out in a much timelier fashion than goods exports, and it turned up months before we learned that exports had indeed started to recover; that proved to be an excellent end-of-recession indicator. With today's release of November container traffic data from the Port of Los Angeles—up 15% from a year ago—it looks like goods exports are still enjoying robust growth. That's excellent news for the U.S. economy, and it also suggests that the economies of our trading partners are improving as well.

PPI update


The November PPI was in line with expectations, and didn't show anything unusual. As the chart above shows, the pace of headline PPI inflation has moderated a bit—it's up at only a 3% annualized pace over the past three months—but core PPI inflation has picked up a bit.


With this chart of the actual producer price index, I'm trying to show the bigger picture. The y-axis is plotted on a logarithmic scale so that rates of growth become easier to appreciate. Note the huge 9% annualized growth in the 1970s, followed by the 1.7% annualized growth in the 1980s and 1990s; that's a dramatic statement about just how inflationary monetary policy was in the 1970s and how well Volcker and Greenspan were able to arrest that inflation. In the past 8 years, however, the pace has picked up again, with inflation posting a 3.7% annualized growth rate, double the rate of the preceding two decades. Inflation is far from being a menace, but it has definitely picked up. The Bernanke Fed can not claim to have done a very good job delivering price stability.


The chart above shows the same pattern, only it focuses on intermediate goods, and uses a 10-yr rolling annualized return. Inflation has clearly picked up in the past 8 years, and I note that this same measure is up 15% over the past year. Moving further up the production pipeline, the PPI crude materials measure of inflation has risen at a breathtaking 9.6% annualized pace over the past 10 years, which translates into a 150% increase in prices. From this I conclude that it's premature to view the moderation of the overall PPI in recent months as a precursor to a more moderate inflation regime.


Some encouraging developments

Sometimes it is difficult to see signs of improvement in the aggregate data until a trend is clearly underway. Changes on the margin can be hard to detect, and nothing is for sure until things are clear, but of course by then it may be too late to get on board. Here are some charts of relatively obscure developments that are looking very good on the margin. 


This chart compares the yield on 2-yr Spanish (white line) and Italian (orange line) bonds. The outlook for Spain has improved dramatically in the past three weeks, with yields plunging from 6.1% to 3.7%, thanks to what looks like an emerging political consensus that supports austerity measures. Things have even improved for Italy, with yields falling from 7.7% to 5.5%. Italy may not have the austerity consensus that Spain does, but Italy's deficit is less than 5% of GDP, so the fundamentals have never been even close to awful. As a caveat to this otherwise good news, I note that 2-yr Eurozone swap spreads are still hovering around 110 bps, and that is very high. There has been some piecemeal improvement in the Eurozone, but not enough to make a significant difference to the overall level of systemic risk facing the banking industry. But a few more bits of good news like this could mark a tipping point of sorts.


The Vix index today fell to its lowest level since the August eruption of bad news from the Eurozone. I've called this "panic exhaustion," but it could also be the result of the simple passage of time, since that gives markets an opportunity to brace for bad news. Markets do not stand idle when challenges and risk present themselves. Given time, those with too much risk exposure can lighten up, while others with more risk appetite can marshall their resources, and that in turn improves the market's fundamentals. I see this decline in underlying risk as a very healthy development, a precursor of real fundamental changes in the outlook.


As the chart above shows, a decline in the Vix suggests that we could see some improvement in equity prices going forward.


The ongoing decline in weekly claims for unemployment is also pointing to higher equity prices. An improving U.S. economy goes a long way to negating the Eurozone headwinds.


Weekly claims continue to improve



The news from the weekly unemployment claims front just keeps getting better, as claims for the recent week came in substantially below expectations (366K vs 390K). Claims are very timely data, and they paint a picture of a jobs market that has been improving almost continuously for the past two years. There is absolutely no sign here of the double-dip recession that ECRI insists is imminent, because a sustained rise in seasonally adjusted claims has marked the beginning of every recession in the past 40 years.

On a seasonally adjusted basis, declining claims at this time of the year means that layoffs are not rising as much as they have in prior years. Layoffs typically rise beginning in October and reaching a peak in early January. This year they have also risen, but by much less than they would have in a typical year. This means that businesses have really gotten lean and mean—minimizing seasonal hiring and relying more on working existing employees harder, and that is one reason corporate profits continue to impress. This also means that as the economy continues to pick up, it becomes more likely that the pace of hiring will not only continue at its recent 1.5% annual pace, but increase and gradually bring down the unemployment rate. Nothing is likely to happen fast, however, so I doubt there will be substantial improvement before next year's elections, which means that a sluggish and disappointing recovery is almost certainly going to be one of the election's major themes.


Bond yields are out of whack




The bond market is out of whack, because bond yields are not consistent with the inflation expectations embedded in bond prices.

The top chart compares yields on 10-yr Treasuries to the year over year changes in the Core CPI. Normally, the two should move at least in the same direction, and at approximately the same level, since over time the rate of inflation is the major determinant of bond yields. Instead, they have moved sharply in opposite directions over the past 6 months or so. Ok, you say, but maybe the decline in bond yields is simply the market saying that inflation will be much lower in the years to come?

If that were the case, then the second chart would look very different. As it is, it plots the market's 5-yr, 5-yr forward expected annual rate of inflation, based on the relative prices of 5- and 10-yr TIPS and Treasuries. This is the sensitive, forward-looking measure of inflation expectations that the Fed considers to be the most important and most reliable. Inflation expectations by this measure are about where they've been for the past 10 years (between 2 and 2.5%), so there's nothing unusual here. And if you consider the third chart, which compares 10-yr Treasuries to 10-yr TIPS, the message is the same: inflation expectations are nothing out of the ordinary, and very much in line with what we have seen over the past decade.

So the problem is that the current level of 10-yr bond yields is priced as if inflation were headed to zero, when a broader look at the TIPS and Treasury market reveals that inflation expectations are somewhere in the neighborhood of 2-2.5%.

The only reasonable explanation for this divergence, as far as I can tell, is that the level of Treasury yields is artificially depressed. TIPS and Treasuries of similar maturities, when taken together, are priced to normal inflation expectations, but in isolation their yields are too low to be consistent with their implied inflation expectations.

This is a highly unusual circumstance that can only have highly unusual roots. I think those roots are most likely to be found in the Eurozone. Such is the fear that the PIIGS defaults will destroy the Eurozone banking system and ultimately lead to a global depression and a financial market collapse, that investors are willing to pay exorbitant prices for Treasuries in view of their safe-haven status. The risk-free status of Treasuries seems paramount, far more important than possible concerns about inflation.

If there is a message here for investors, it's that fear has reached extraordinary levels, artificially inflating the prices of Treasuries. And it's not a stretch to go from that conclusion to the belief that fear is also artificially depressing the prices of equities.

Current prices can hold only if we really are on the cusp of a major collapse. To be bearish you have to believe that the collapse will be unlike anything we have ever seen before, or maybe even worse.

The message of gold


Gold is down 18% from its summer highs. The euro has dropped 12% against the dollar since April, while the yen has risen almost 10%. These all sound like big numbers for such a small time span, but the chart above shows that they are mere ripples in a very large pond.

The big story here is that all currencies have depreciated massively in terms of gold over the past decade. Some (like the yen) by less, some (like the dollar and the euro), by much more. In yen, gold is worth less today than it was at its early 1980 peak (one third less, to be exact); in dollars, gold is worth 90% more.

The relative worth of currencies tells us a lot about the underlying inflation fundamentals of each. As this chart shows, the dollar has fallen massively relative to the yen since 1978, with the yen soaring from 240/dollar to 78. This fact alone dictates that the dollar has suffered from much more inflation than Japan. So its not surprising that since 1978, U.S. consumer prices have risen 264%, while Japanese consumer prices have risen only 50%. Since the dollar has fallen 30% against the DM over that same period, it makes sense that German consumer prices have risen by 40% less than U.S. consumer prices (115% vs. 264%).

Gold is a good reference point to compare the relative behaviors of currencies (A Gold Polaris, as the late Jude Wanniski put it), and arguably, it also tells us about the market's future expectations for how currencies and their purchasing power are likely to behave. Since gold has risen significantly against all currencies in the past several years, that tells us that the market is expecting inflation in all countries to rise in coming years. Since gold has risen the least in terms of yen, that implies that the market expects the yen to suffer from much less inflation than most other currencies.

As I see it, the huge rise in gold in dollar terms in the past decade was the market's way of worrying that U.S. monetary policy was adrift, no longer tied to something like a Taylor Rule, and instead more focused on promoting growth and bailing out banks and debtors at the expense of sacrificing purchasing power. The dollar's rise against the euro since last April, while both have fallen relative to gold, is the market's way of saying that the Eurozone sovereign debt crisis is changing the outlook for ECB monetary policy: the ECB has become a less reliable advocate for low inflation and is now instead more likely to succumb to pleas to bail out the southern European nations by running the printing presses faster.

Meanwhile, the dollar of late has benefited at the expense of the euro not only because the ECB seems to be losing its independence, but also because the U.S. economy is gradually decoupling from the problems of the Eurozone. U.S. growth has been gradually picking up (though still painfully slow), while the Eurozone economy has been slowing down; U.S. stocks have outperformed Eurozone stocks by 25% over the past year. But I hasten to add that the price of gold today is still pointing to the very real risk that the U.S. government will resort to the printing press to help address the looming problem of out-of-control spending and soaring debt burdens.

How to explain the fact that gold prices have fallen 13% in dollar terms, 16% in yen terms, and 11% in euro terms since gold hit its all-time highs last September? I'm going to guess that the across-the-board selloff in gold may be an indication that the market was priced to Armageddon last September—a global depression and massive monetary and fiscal policy uncertainty—and is now seeing that while things are still bad, the end-of-the-world-as-we-know-it is not inevitable (e.g., the U.S. economy is slowly improving, the political winds are moving in the direction of less profligacy, even in Europe). Others might say we are simply seeing the forced unwinding of massive and leveraged gold speculation, but I think there is a fundamental explanation in addition to a technical one.

Fixed rate mortgages hit another all-time low


30-yr fixed rate mortgages have never been cheaper. The latest data show that the nationwide average for conforming, 30-yr fixed rate mortgages is 3.99%, and the rate for jumbo mortgages is 4.28%, both at new all-time lows. Plus, the spread between conforming and jumbo rates is now down to just 30 bps, which in turn is the average spread during times of relative market calm. It doesn't get much better than this for homebuyers.

Anecdotally, I was talking with a prominent realtor friend the other day and remarking about how incredibly affordable housing has become. She agreed, but noted that the problem as she sees it is that most people are just plain terrified of buying a house these days. That's one very good reason why houses are so cheap.


This chart comes from Mark Perry, and is the best one I've seen when it comes to housing affordability.

The dollar is still very weak



Since the end of April, just before the Eurozone sovereign debt crisis started heating up, the dollar has risen against other major currencies by about 10% (see top chart above). A stronger dollar is always good news, in my opinion, since the strength of the dollar is a significant part of our standard of living and reflects importantly on the overall health and viability of our economy. But most of the dollar's gains this year have come at the expense of the confidence-weakened euro, and that's hardly a ringing endorsement of the dollar. As the second chart above shows, the real value of the dollar (adjusted for relative inflation differentials) is still very low from an historical perspective; by my estimates, the dollar today is only about 7.5% above its recent all-time low against a large basket of currencies.




Measuring the value of the dollar against other commodities is certainly a useful exercise, but it also helps to know how the dollar is faring against things (e.g., gold, commodities, energy, real estate). On that score the dollar also is not doing very well. As the first two charts above show, the dollar has lost considerable ground against gold, commodities and oil, though it recently has recovered a portion of what it lost in the past 10 years. Relative to real estate (third chart), the dollar has done much better, only losing a fraction of its value against home prices, and hardly any of its value against commercial real estate prices. The fourth chart shows the real price of gold, which is still shy of the peak it briefly reached in early 1980.

Overall, the dollar looks pretty weak, with the notable exception of real property. That suggests that if you're looking for some way to hedge against a further decline of the dollar's value, buying real estate (and possibly leveraging it with a record-low fixed rate mortgage) might be the best candidate.


Selling the dollar against other currencies is a risky proposition, given that it is close to its all-time lows, and as the second chart at the top suggests, there is likely to be some support at these levels. The chart above suggests that the dollar is very undervalued relative to the Aussie dollar, and that is a reflection of how important commodity prices—which are close to record highs against the dollar—are to the Australian economy. If commodities were to weaken further, the Aussie dollar would probably follow suit.

Retail sales growth remains impressive



November retail sales rose a bit less than expected, but growth since the recovery got underway has been fairly impressive. Nominal retail sales are now at a record high, 5.5% above their pre-recession high, despite the fact that non-farm employment is still 6.3 million below its pre-recession high. Even after adjusting for inflation—which has not exactly been quiescent—real retail sales are only about 1.5% below their prior high while employment is 4.5% below its prior high. Today's workforce is a lot more productive than it was just a few years ago, and consumer confidence and willingness to spend has apparently not been much affected by the sluggish recovery.

Mark Perry adds some color: "Retail spending in November was 6.7% higher than the year-earlier level, and spending in every category except department stores (-3.0%) registered annual gains last month, with especially strong gains in auto sales (+7.5%), miscellaneous stores (+7.7%), gasoline stations (12.9%) and nonstore retailers (+13.9%). Excluding gasoline sales, retail sales increased by 6% on an annual basis."

Federal finances update


The above chart summarizes the current state of Federal finances over the most recent 12-month period ending November. The good news is that for the past two years, revenues have been slightly outpacing spending—hard to believe, I know, but nevertheless true. The bad news is that the gap between spending and revenues is still enormous.


This chart contrasts total federal revenues with the portion that comes from individual income tax receipts. Here we see that the biggest source or rising tax revenues has been income taxes, since they have risen at a much faster rate. One reason for the sluggish growth in total revenues, of course, is the cut in social security withholding rates that has been in place for the past year and is quite likely to be continued. The chart also highlights the fact that since the Bush tax cuts were first instituted in mid-2003, income tax receipts are now substantially higher—36% higher (almost $300 billion on an annual basis)—than they were when tax rates were higher. Once again, we see here concrete evidence that Art Laffer's vision (and his famous curve) was anything but crazy: lower tax rates can promote stronger growth, and thus result in higher tax revenues. If it weren't for the 20080-9 recession, which had everything to do with a collapse of the housing bubble and a 6 million decline in the number of private sector jobs, and almost nothing to do with low tax rates, both the economy and tax revenues would now be considerably higher.


The state of federal finances remains abysmal, but nevertheless it is the case that the deficit as a % of GDP has declined from a high of 10.4% at the end of 2009 to 8.1% today. In nominal terms, it peaked at $1.48 trillion in Feb. '10, and in the most recent 12 months is now $1.25 trillion. If current trends continue—which is unlikely unless our major entitlement programs are reformed—then the U.S. could escape the fate that has engulfed the PIIGS countries, where deficits are above 9% of GDP.


This chart (inspired by Brian Wesbury) again bears repeating, since it lends support to claims by the anti-Keynesians (of which I am one) that the biggest factor that has worked to slow economic growth in recent years is the huge increase in federal spending. Instead of "stimulating" the economy, enormous increases—in both nominal and relative terms—in federal spending have ended up "stimulating" the unemployment rate more than anything else. The reason? The public sector spends money much less efficiently than the private sector. And when you consider that over 70% of federal spending takes the form of "payments to individuals" (i.e., transfer payments, see chart below), and that this has been the most rapidly growing portion of total spending, and you understand Milton Friedman's assertion that you don't spend other people's money on yourself nearly as carefully and efficiently as you spend your own money on yourself, then it becomes easier to understand. The vast bulk of government spending these days boils down to transferring money from those who are working and producing the most, to those that are working and producing the least, and that is not a prescription for a strongly growing economy.


While depressing to contemplate how large and inefficient our federal government has become, it is nevertheless the case that spending vs. GDP is slowly declining and the economy is slowly improving. If Congress can see fit to further curtail the growth of federal spending in the years to come, then the future should be much brighter.

The PIIGS crisis is fading in importance

Even as the likelihood of major Eurozone sovereign defaults continues to rise, there are signs that the the denouement of the Eurozone sovereign debt crisis may not be nearly as bad as everyone has been led to believe. This is a theme I've been developing since last July ("Carmageddon, free markets and the PIIGS crisis"), and have updated several times since (Panic exhaustion?, Eurozone panic update, Panic exhaustion revisited). The idea is simple: when markets are given ample time and warning, they are very good at making the necessary adjustments to accommodate the arrival of bad news. As I discuss below, markets have already written off $1 trillion of PIIGS debt, and the sky has not fallen, nor have markets or global economic activity collapsed. In fact, economic life goes on, the U.S. and many other economies continue to grow, and many equity markets have moved substantially higher in recent months. We've had so much "panic" for so long that it's simply fading away.


The PIIGS debt crisis first surfaced in April of last year, which means that markets have now had about 20 months to adjust. That is completely different from the situation surrounding the Lehman bankruptcy and the subsequent financial meltdown of late 2008, because back then there was almost no advance warning of what was coming; the news sparked a classic rush for the exits, in which panic selling drove prices to absurdly low levels, thus making the panic and confusion even worse. The subprime mortgage collapse was also completely different from the PIIGS crisis, because back then the market found it almost impossible to value the thousands of often obscure and arcane mortgage-backed securities that were tied to many millions of homes whose prices were tumbling at different rates all over the country. With the PIIGS crisis, we are dealing with only a handful of borrowers who have issued fairly straightforward debt securities.


This chart shows the price of the current Greek 2-yr bond, which has fallen from almost 100 at the beginning of last year to a mere 26.625 today. The $470 billion of outstanding Greek debt is now trading at about 20-25 cents on the dollar, which means that the market has effectively written off about $350 billion of Greek debt. In other words, if Greece tomorrow were to restructure its debt and impose a 75% haircut on its creditors, nothing much would happen because markets have already priced in that eventuality.


After Greece, where a major default is almost a certainty, the next-most-likely-to-default country is Portugal, with about $220 billion of outstanding debt. The chart above shows the price of the current Portuguese 2-yr bond, which has fallen from 110 early last year to 85.2 today. Portuguese government bonds are now trading at 50-60 cents on the dollar on average, which means that the market has already written off some $100 billion.


Continuing with Ireland, 2-yr Irish bonds have fallen from 106 to 96, and the $150 outstanding of Irish debt is trading at about 80-85 cents on the dollar, for a write-down of  roughly $25 billion. 


Continuing with Italy, 2-yr Italian bonds have fallen from 100 to 94, while the value of the $2.1 trillion of outstanding Italian debt is trading at 85-90 cents on the dollar, for a write-down of roughly $260 billion.

Finally, the $870 billion outstanding value of Spanish debt is trading at about 95 cents on the dollar, for a write down of roughly $40 billion.

Now let's look at what has happened while global bond markets have been busy shaving $1 trillion off the value of sovereign PIIGS debt.


The S&P 500 index is up 10% from the end of 2009, and about as much since the peak of the sovereign debt crisis and double-dip recession fears of early October. 


The Vix index (a good proxy for the market's degree of fear) is still at levels which indicate serious concern, but we see in this chart that the market has weathered two storms of volatility (in the 2nd quarter of last year, and in the past several months) and panic "exhaustion" appears to be setting in, with the Vix trading at 27 today after hitting a peak of 48 last August. Even though a major Greek default has never been more likely nor as large as it is today.


The VIX/10-yr ratio is a good proxy for the market's level of fear and despair. While still extremely elevated from an historical perspective, it has declined from near-Lehman levels to 13.5 today. This chart also reminds us that periods of fear, panic, and despair occur every so often, but eventually they fade away and economic life goes on.


This chart shows how strongly the equity market has been influenced by fear in recent years. But as markets adjust to expectations of PIIGS defaults, fear subsides, and equity prices rise. 


This chart compares the level of 2-yr swap spreads—a good proxy for systemic risk and financial market health—in the U.S. and the Eurozone. The message here is that although the Eurozone banking system is still in the grips of a very serious crisis of confidence (the likelihood of bank failures and thus counterparty risk is very high), the U.S. banking system has gradually decoupled from the problems in Europe over the past few years. Systemic risk in the U.S. is a little elevated, but not seriously by any means. This suggests that even though the Eurozone may yet experience some wrenching bank defaults, and the fallout may well be very economically disruptive to the Eurozone economies, it shouldn't prove too unsettling for the U.S.

As I mentioned in a post last month ("Putting PIIGS debt into context"), the value of liquid, global debt and equity markets is about $110 trillion, and this total can vary up and down by trillions of dollars every day. So the loss of $1 trillion in PIIGS debt is not a big deal from a macro perspective, and I think the charts I've shown here reinforce the point that the reality of a major PIIGS default—should it occur—is likely to be much less catastrophic than the headlines would have you believe. Meanwhile, there is still no reason to give up hope that the PIIGS countries (save, perhaps, Greece) will eventually realize that the best solution to their problems (e.g., fostering more private sector growth by shrinking the size of their governments and lowering and flattening their tax structures) is also the easiest. Major defaults, restructurings, and/or devaluations all have devastating and lasting consequences, but reversing the trend to ever-more-burdensome government is a great solution for the majority of the population.