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More signs of gradual improvement in the economy

The slow melt-up in equity prices since early last October has not been a sign of increasing optimism, it's been a sign of decreasing pessimism—brought on by the accumulation of data points which have shown the economy to not be as weak as everyone had feared. The economy has improved a bit in recent months, but it's nothing to get hugely excited about. As the chart above shows, the ISM manufacturing index—which came in weaker than expected but does not point to any significant weakness—is telling us that the economy is probably growing at a 3-4% rate in the current quarter, a little bit faster that the 3% rate of the fourth quarter. I think this observation is very consistent with other news in recent months.

The biggest improvement in the various ISM sub-indices came from the export sector, where the survey now shows substantially better-than-average activity. This is encouraging from two perspectives: for one, it reflects continuing growth in U.S. export activity, which contributes to GDP; and two, it reflects a relatively healthy global economy that is eager for U.S. goods and services, and a healthy global economy in turn provides a good backdrop for ongoing U.S. growth.

The employment index remains unspectacular, pointing to only modest improvement.

Treasury yields have been very gradually drifting higher this year. But even at today's 3.18% yield, 30-yr Treasuries are priced to a very gloomy outlook for U.S. growth. Now, with no indication from Bernanke yesterday that T-notes and T-bonds will receive another round of QE support, there is little to keep yields from rising further. Even if the economy just ekes out 3-4% growth for the rest of this year, that will be a lot more than would be consistent with bond yields at current levels. Higher Treasury yields should be viewed as a sign of a healthier (or not as sick as expected) economy. Three cheers for lower Treasury prices!

U.S. swap spreads are back down to levels that are quite normal, while Eurozone swap spreads are still elevated but showing signs of gradual improvement. Liquidity and confidence are slowly returning to the Eurozone, even though the fundamental problem of too much bloated government spending remains to be resolved. Liquid markets are essential to helping economies adjust to unexpected difficulties, and that process is underway in Europe. Europe is not out of the woods yet, but the risk of a meltdown is declining meaningfully. Once again, this paints a picture of the future turning out to be less awful than expected; markets are "melting up" because the economy is not melting down.

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