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Bond yields are ignoring the good economic news


The Bond Vigilantes blog caught my eye this morning, with an excellent post and chart which inspired this version above. What this chart shows is that (up until last summer, that is) bond yields have been strongly influenced by the market's understanding of how weak or strong the economy. The white line is the Citi Economic Surprise Index, which tracks how actual economic news releases compare to expectations. The index has moved up strongly since last summer, as almost every economic indicator has come in stronger than expected (with the weekly claims report this morning the latest example). In the past, a stronger-than-expected economy such as we've seen in recent months would have led to a substantial rise in Treasury yields (10-yr yields are shown in orange). But not now, most likely because (and here I agree with the Bond Vigilantes) the market is terrified of PIIGS defaults. The news in the U.S. has clearly gotten better, but the news coming out of the Eurozone has been pretty awful, and Treasuries end up being the beneficiary of the world's intense demand for safe-haven assets.

The Fed and others might argue that Operation Twist (the Fed's current program of selling short maturity bonds and buying longer maturity bonds) is responsible for holding down 10-yr yields, but I don't buy that. The Fed can control the level of short- and intermediate-term yields, but not long-term yields. Thought experiment: if the news in Europe suddenly took a turn for the better (e.g., PIIGS governments took genuine steps to curtail spending), wouldn't you expect 10-yr yields to rocket higher?

The bond market is likely a tightly coiled spring, with yields compressed by fears of Eurozone defaults and a possible collapse of the Eurozone financial system. 2-yr Eurozone swap spreads confirm this, as they are still trading at nosebleed levels of 115 bps. To push yields down further would require these fears to be realized by a succession of truly awful events (and that's where I disagree with the Bond Vigilantes).

More good news

Third quarter GDP today was revised down by a few billion dollars, but that's old news. The more recent news provides more evidence that fourth quarter growth will be stronger, and the U.S. economy continues to beat the market's rather dismal expectations. 


Seasonally adjusted unemployment claims once again surprised the market by coming in lower than expected (364K vs. 380K). This is the best reading we've seen since the recovery got underway, and at the rate we're going we should see further declines in claims in the weeks ahead. Businesses have pared costs and employees to the bone, so they are likely to fire a lot fewer people than usual as the holiday season winds down.


The ongoing decline in claims is an excellent indicator that the outlook for the U.S. economy is improving, so we should also see the equity market forge ahead to higher levels, as this chart suggests.


The ongoing decline in implied equity volatility (the Vix index) also argues for higher equity prices. With the news showing that the U.S. economy is not only not deteriorating but actually improving, despite the anguish in the Eurozone regarding PIIGS defaults, this removes an important source of uncertainty, and less uncertainty is almost always good for equity markets.


I'm usually reluctant to place much stock in the Conference Board's Leading Indicators, but they do not even remotely suggest that the U.S. economy is in trouble. Fourth quarter real GDP growth is now looking to be in the 3-4% range.


Consumer confidence usually lags reality, so the somewhat stronger-than-expected increase in the December Michigan Consumer Confidence survey reported this morning is simply confirmation that things haven't turned out as bad as most people were expecting. Confidence has picked up of late, but it is still at extremely low levels from an historical perspective. That's the recurring theme we've been seeing since last summer: markets and consumers were braced for a serious deterioration in the economic outlook, yet the economy has actually managed to improve somewhat. But the market is still climbing walls of worry, since on balance the market is not yet even slightly optimistic about the future. After all, we have yet to see the fallout of the Greek default which will almost certainly happen soon.

Chart of the day: implied equity volatility tumbles


This chart of the implied volatility of equity index options is sending a powerful message: the market's level of fear and uncertainty has declined significantly in recent weeks and months. We can only guess at the reasons for this, but the improved outlook is not just a function of today's massive ECB refinancing operation or yesterday's strong housing starts.

I would argue that there is a whole host of developments that have brought more clarity and calm to the markets. Economic data have so far failed to reveal any economic collapse, despite the continued high level of stress in Eurozone financial markets (2-yr swap spreads are still in nosebleed territory at 115 bps). Markets have had 20 months to prepare for a Eurozone default, panicky investors have had plenty of time to take refuge, over-extended banks have had plenty of time to hedge themselves, and risk-loving hedge funds and distressed debt investors have had plenty of time to marshall their forces in eager anticipation of panic-driven sales. The U.S. economy shows every sign of continuing to grow, albeit at a disappointingly slow rate. Corporate profits continue to be very strong. Central banks have embraced their role as lenders of last resort, and liquidity in most parts of the world remains abundant. Profligate government spending is meeting strong resistance almost everywhere.

If there is a single message here, it is that we are not on the cusp of the-end-of-the-world-as-we-know-it. Given how fearful the market has been, that's very good news.

Housing update



There were large revisions to the past few years' data on existing home sales, but the net result was a substantial reduction in the inventory of homes for sale. (See today's excellent posts on Calculated Risk for a detailed discussion of this.) The current inventory is now back down to levels last seen in 2005, and that brightens the outlook for the housing sector. Even the shadow inventory of homes (those with serious delinquencies and very likely to be foreclosed and sold) has declined, though it remains substantial. And even though the current sales rate is still far below what we saw in the heydays of the housing boom, the month's supply of inventory (second chart above) is now substantially lower than the levels that prevailed throughout the 1980s, and that, in turn, diminishes the threat of the shadow inventory.

In sum, the housing market has undergone a gigantic and very painful adjustment, but the market is clearing, and the overhang of unsold homes now is on a par with what we have seen before and survived. Moreover, financing costs are at record-low levels, and the economy continues to grow and incomes continue to rise. Therefore I don't think it is likely that the existing and shadow inventory of homes for sale implies a further wrenching adjustment. I continue to believe that we have seen the worst for the housing market.

Fear subsides, prices rise


As this chart shows, the Vix index has dropped to a new post-Greece-is-likely-to-default, and the-end-of-the-world-as-we-know-it-is-nigh low. Ostensibly, today's good news on housing starts is the trigger for the S&P 500's 3% advance. But the good news has been accumulating for awhile now (e.g., jobs growth, car sales, exports, inventories, bank lending, retail sales, capex, corporate profits), even as the stress in the Eurozone financial system approaches the extremes of late 2008.


Call it panic exhaustion: it's tough to continue to worry about the end of the world being right around the corner when the fundamentals continue to show improvement. And it's tough to worry that a Eurozone default will be a surprise or catch anyone off guard now that the world has had 20 months to prepare for it and markets have already marked down $1 trillion worth of sovereign debt. It's tough even to worry that a major sovereign default will bring down the global economy, since defaults are a zero-sum game that don't destroy demand. The bad thing about defaults is what led up to the defaults: all that deficit-financed spending that was squandered on transfer payments and faux-stimulus policies.


What's pushing the market up is the growing realization that despite all the concerns out there, the global economy is not hanging by a thread. On the margin, fears are declining. In part, that's because billions of people continue to go to work every day, and corporations continue to rake in record profits. It's also the case that, despite their best efforts to muck things up with "stimulus" policies that only work to restrain growth and increase uncertainty, governments and central banks are rapidly approaching the point where they can do no more harm. Keynesian stimulus policies have been almost completely discredited. Monetary policies have reached the "zero bound." Quantitative easing has been so massive already that adding a few more hundreds of billions to bank reserves can't possibly make any difference, except to further weaken currencies and boost destructive speculation. Meanwhile, the fundamentals that lead to real growth—the private sector's dynamism and willingness to work and invest—have been slowly and quietly improving behind the scenes, despite all the headwinds and roadblocks that governments have thrown in their way.

To prevent capital flight, don't try to stop it


Argentina's central bank has been hemorrhaging reserves this year in its attempt to keep the paso from falling more rapidly against the dollar. Money is fleeing Argentina—possibly as much as $20 billion dollars so far this year—because people don't trust the government and don't trust the currency. The peso is becoming overvalued, the government is understating inflation, and the government is trying accomplish by force that which can only be achieved by trust. The government is actively trying to prevent people from taking money out of the country. In the latest move, sniffer dogs are being deployed at border crossings to detect bundles of dollar bills.

The more the government tries to stem capital flight, the more there will be. Capital only stays in places where it is welcome and free to leave. Argentina instead punishes capital with steeply progressive tax rates, by hiking export taxes and limiting access to cheap and essential imports, and now by limiting how much Argentines can spend when they want to travel abroad. It is almost impossible for a government to prevent capital flight by force; there is no shortage of ways that fearful citizens and corporations can manage to circumvent capital controls—and the more a government tries to stop it, the more fearful and resourceful people become. We've seen this movie many times in the past, and it always ends with a tragedy. If there is one thing certain about Argentina's future, it is that there will be yet another major devaluation and the inevitable recession that follows. The only question is when. At this rate the timetable is accelerating. Very sad.

HT: David Gordon

Housing starts are recovering


November housing starts beat expectations by almost 8% (685K vs. 635K). Not only that, but they are up 30% so far this year, and up 43% from their all-time low, April 2009. They say that housing cycles typically last 5 years, but this one has been the worst ever and has lasted almost 6 years. Thus, there is every reason to believe that we have indeed seen the bottom in housing and that a recovery is now underway. They also say that an upturn in residential construction is an essential part of a larger economic recovery; if so, then maybe the recovery skeptics will finally have to change their tune.

Unvarnished good news, and the harbinger of much more good news to come. The collapse in housing starts has allowed a huge reduction in the excess inventory of homes, bringing supply back in line with demand. As the economy slowly improves, new family formations advance, and more people working want new and better homes, the nation could find itself with a shortage of housing before too long and much higher prices and interest rates to boot. This is a recovery that can feed on itself, and its still in its infancy.


This index of homebuilders' stocks has almost doubled from its late-2008 lows, and has the potential to double and even triple from here if housing starts regain their former altitude.

Bank lending continues to rise


Commercial & Industrial Loans (a good proxy for bank lending to small and medium-sized businesses) are up 9.6% in the past year, or $116 billion.

Remodeling activity is very strong


As this chart shows, remodeling activity has surged this year (source). I should know, since we have done quite a bit of it ourselves this year and last. Plus, some contractor friends—particularly one that specializes in energy retrofitting—tell me that business is doing very well.

As Calculated Risk notes: "The BuildFax Residential Remodeling Index increased for the twenty-fourth straight month in October to 147.6, a new high for the index. This was up from 141.4 in September, and up 39% year-over-year from 105.8 in October 2010. This is based on the number of properties pulling residential construction permits in a given month."

Not everything is in the dumps, as you might expect if you only looked at the stock market, PE ratios, and 10-yr Treasury yields.

M2 update



The first chart shows the history of M2—arguably the best and broadest measure of "spendable" money—over the past 17 years. As should be obvious, there is no shortage of money; M2 has been growing by more than 6% a year for a very long time. The second chart narrows the focus to the past 5 years. On this scale, two "bulges" in M2 growth stand out, and they correlate nicely with periods of financial panic which caused the public's desire to hold "money" to rise. The late 2008 bulge gradually disappeared as the recession ended and the confidence returned. The current bulge also looks to be gradually fading, which could be a welcome sign that fear of a Eurozone financial collapse is beginning to abate.


Almost all (80%) of the latest "bulge" in M2 has come in savings deposits at large commercial banks, and this category is by far the largest component of M2 (see above chart). The Fed cannot force-feed money into savings deposits; people park money in banks only because they want to hold it, and that is especially true now that the interest rate on savings deposits is virtually nil. In other words, exceptional M2 growth in recent years has been almost exclusively a demand phenomenon, rather than a supply phenomenon: it's not that the Fed is running the printing presses in order to push prices up, it's that the demand for money has surged to unprecedented levels, and the Fed has been willing to accommodate this with generous supplies of bank reserves. Exceptional M2 growth has not sparked a big rise in inflation, because it has been the result of increased money demand. This may well change in the future, of course. If the demand for money begins to decline and the Fed does not act in a timely fashion to withdraw bank reserves from the system, then we could have an inflationary problem. This is one of the fears the weighs heavily on markets, and is likely one of the reasons that the price of gold has doubled since 2008.


This chart tracks money demand (the ratio of M2 to GDP). Since the onset of the 2008 recession and subsequent financial panic, the public's demand for money balances has soared in unprecedented fashion, and to an all-time high. The M2/GDP ratio has increased almost 20% since the end of 2007; i.e., money growth has exceeded nominal GDP growth by 20% in the past four years. If the increased demand for M2 in recent years were to reverse without there being an offsetting decline in the amount of M2, this could eventually fuel an extra 20% increase in nominal GDP, and much of that could come in the form of higher inflation.

In fact, money demand has most likely already fallen from its peak, because annualized M2 growth in the most recent 3-mo. period has been only 2.6%, while nominal Q4/11 GDP growth is likely to be at least 5% (e.g., real growth of 3-4% and inflation of 1-2%). If the Eurozone crisis manages to morph into a non-catastrophic problem, then confidence will slowly return, money will come out of hiding and be spent (e.g., be withdrawn from savings deposits), and economic activity will almost certainly pick up. We could be in the very early stages of this process already.