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Panic is slowly fading.



The first chart above is a closeup look at the Vix/10-yr ratio, and the second chart shows the longer-term picture of the same. The market is still nervous (the Vix is still substantially above where it would be in normal times) and holds out little hope for a healthy economy (the 10-yr yield is still at levels that were associated with the Depression), but those sentiments are slowly giving way to the fact that the financial fundamentals in Europe are improving and there are quite a few indicators that show the U.S. economy is improving as well.

The Vix/10-yr ratio was priced to a global catastrophe at its peak in early October, and markets are breathing a tentative sigh of relief that so far nothing all that bad has happened. This year is off to a good start, if only because it's not proving to be as terrible as expected.

The bond/equity disconnect


Over the past several years, bond yields have correlated pretty well with equity prices—yields rise and fall along with the ups and downs of the stock market. Higher stock prices reflect increased optimism (or less pessimism) about the future, and bond yields move in synch because a more healthy economy increases the odds of higher inflation and a tighter Fed. Most of the time the correlation between stocks and bond yields has been 0.6 to 0.8, interrupted with a few relatively brief periods of negative correlation, as can be seen in the two charts below. Over the past few months, we have once again entered one of those periods where the correlation has gone to zero. Equity prices are up, but bond yields remain very low and relatively stable. As the above chart suggests, either bond yields should be at least 100 bps higher, or equity prices should be a lot lower.



In my view, this disconnect reflects a buildup of tension in the market—something is likely to break pretty soon. Bond yields have been depressed because risk-averse investors have been seeking shelter from a potential Eurozone collapse that might trigger another global recession/depression/deflation. But equity prices have been rising because in the meantime, while the world waits for the Eurozone to implode (and we've been waiting for at least 18 months now), the U.S. economy continues to improve. Bonds are the doomsday trade, while equities are more realistic about what's happening right now.

I can think of an alternate explanation, but it's not very convincing. Maybe bond yields are low because the market is absolutely convinced that no matter what happens to the economy, inflation is going to be very low for a very long time, and central banks, and particularly the Fed, are going to remain at or close to their "zero bound" for as far as the eye can see. To counter this explanation, I note that break-even spreads on TIPS reflect inflation expectations to be in a 2.0- 2.7% range, which is pretty close to the average rate of CPI inflation over the past two decades (2.5%), and during that time 30-yr bond yields have averaged 5.5%. In other words, I find no evidence to suggest that bond yields today are priced to deflationary concerns, so their low levels therefore more likely reflect an intense risk aversion on the part of investors.

In any event, it's unusual and I think unnatural for capital markets to be so schizophrenic. The assumptions driving bonds and stocks should ordinarily reflect the same world view, but these days they don't seem to.

My money is on bonds catching up to stocks—bond yields are more likely to rise than stock prices are to fall. What could trigger this? Maybe the Fed bows to the same realities that are driving equity prices higher, and informs us that with the economy doing better on the margin, the Fed mostly likely won't have to keep yields at zero for the next several years as the market currently believes it will. Or maybe Greece finally executes its default, but the world does not come to an end (after all, a huge default has been fully priced in for a very long time, so it should not prove surprising or disruptive when it finally happens). Or maybe the simple passage of time without anything disastrous occurring will do the trick—markets can't stay priced to disaster forever if a disaster doesn't occur.

Meaningful improvement in Eurozone fundamentals

Here's a quick recap of important indicators of financial market health, which all register substantial improvement, especially in the Eurozone. Even though a Greek default is a virtual certainty (Greek 2-yr yields today are 180%), these indicators suggest that the risk of contagion to other countries has dropped significantly, and the Eurozone financial system is not destined to collapse any time soon. 


2-yr swap spreads are an excellent indicator of financial market liquidity and systemic risk. Spreads are down meaningfully in the Eurozone, albeit still quite elevated. U.S. spreads are now back to a level that is consistent with "normal" conditions.


Euro basis swaps reflect the difficulty that Eurozone banks are having in obtaining dollar liquidity. Funding pressures have eased significantly in the past month, leading the way to reduced swap spreads, also a measure of counterparty risk. Eurozone financial markets are exiting the danger zone when liquidity dries up and trading freezes.


2-yr yields on sovereign debt are a good measure of the market's estimation of default probabilities. Greek yields have soared, but all other countries have seen meaningful declines in the past few months. Italian 2-yr yields have fallen by half since their peak in late November. This is rather impressive.

The cost of obtaining insurance against Eurozone defaults has not declined as much as 2-yr yields, but the CDS contracts represented here cover a 5-yr period. The combination of only marginal improvement in CDS plus significant improvement in 2-yr yields means that while the market realizes that defaults are not likely in the near term, they remain a risk over a longer time horizon. Efforts to restore liquidity and confidence to Eurozone markets have been reasonably successful, but investors have yet to see any meaningful steps on the part of the PIIGS governments to address their fundamental problem, which is bloated, deficit-financed government spending.


The decline in systemic risk in the Eurozone is one reason that the U.S. equity market has been able to move higher in recent weeks, and the implied volatility of equity options has dropped to a 5 1/2 month low. As risk declines, risky asset prices rise.

Effective tax rates are highly progressive

There's a lot of chatter these days about whether the rich pay a high enough tax rate. Warren Buffett comes to mind, as do the recent attempts to shame Mitt Romney for paying only 15% of his AGI in tax.

Confusion arises only if we look at part of the picture. For example, everyone who is employed pays social security tax and personal income tax. But only those with investment income pay capital gains and dividends tax. And in order for investors to receive capital gains and dividend income, the companies they have invested in—with after-tax dollars—need to pay a corporate income tax. Consider, for example (and I'm simplifying), a worst-case scenario person who is self-employed, whose income puts him in the top Federal and California income tax bracket, and who has substantial income from investments. He pays 35% federal income tax, 9% state income tax, a 15% social security tax, and a 2% medicare tax. Any income he receives from his investments—which were originally made with after-tax dollars—is effectively what the companies he owns have earned after paying a 35% corporate income tax, and on top of that he must pay 15% of what is distributed to him—he might be paying an effective tax on his total investment income of as much as 45%. Depending on how the numbers stack up, this unfortunate person could be paying an enormous effective tax rate—well over 50%—on his total income.

When Warren Buffet says he only pays a 15% effective tax on his income, that's because his income mainly comes from capital gains and dividends, and he is completely ignoring the fact that the companies he owns must pay a corporate income tax of as much as 35% before he can receive those gains and dividends.

Fortunately, we do have access to facts that do not distort or color the picture. The chart below uses the numbers as crunched by the Congressional Budget Office. The effective total tax rate shown is the ratio of total federal taxes (income, social security, corporate, excise) divided by comprehensive household income. As Greg Mankiw notes, our tax system is highly progressive: "the rich face average tax rates more than twice those of the middle class, and about seven times those of the lowest quintile." And these effective tax rates include all the benefits of whatever deductions may have been available to individuals and companies along the way.


Greg Mankiw also has a nice summary of how progressive our tax system actually is:

1. The U.S. personal income tax is generally progressive, and substantially so. Click here to see the numbers. The average tax rate for tax returns with over $1 million in income is 25 percent. The average tax rate for returns with income between $50,000 and $75,000 is 7 percent.
2. It is arguably better to use an average tax rate that is all-inclusive. That is, we should include not only personal income taxes but also payroll and corporate income taxes. CBO analysts regularly do that. They find a substantially progressive tax system, as I have pointed out before.
3. If we added transfer payments (which are essentially negative taxes), we would find an even more progressive fiscal system. Those data are harder to come by, as data on transfers are rarely integrated with data on taxes.
4. It make little sense to aggregate payroll taxes with personal income taxes and ignore corporate income taxes.

Inflation remains relatively tame


The headline Consumer Price Index in December was flat, compared to expectations of a 0.1% increase. On a year-over-year basis, the CPI has fallen from a high of 3.9% to 2.4% in the past three months. As this chart shows, all of that decline was due to energy prices, which have been relatively flat to down for the past three months (oil was up but gasoline prices have fallen and natural gas prices have dropped significantly). The CPI ex-energy has continued to pick up.

Inflation is not dead, deflation is not a threat, and so far inflation has not been the problem I thought it would be. Thank goodness.

Housing starts rose 25% last year


December housing starts were less than expected (657K vs. 680K), and were 70% below their early-2006 peak; a pessimist would say that's pretty grim. But an optimist like me is quick to note that last year housing starts rose by a very impressive 25%. The big housing bust that began in early 2006 likely ended about a year ago—5 long years of terrible destruction for the residential construction industry. But it's over, finally.

For all those who have been saying that we'll never get a decent recovery until the housing market starts improving, your time to turn optimistic about the future has come.

For all those who say that those on the right of the political spectrum are hoping for a lousy economy so that Obama can be forced out, I want to emphasize once again that I think the economy is improving not because of anything Washington is doing but rather in spite of all the things that Washington has been doing to try to help. As I said in my forecast for 2012, "Left to its own devices, and given enough time to adjust to adversity, the U.S. economy is perfectly capable of growing—and that is what is happening now. No reason this can't continue." This is an organic recovery, if you will. The U.S. economy is by nature dynamic; it never pays to underestimate it. The economy will probably be doing a little better come November, but I suspect that Obama will find it difficult to turn that to his advantage. Unemployment is still going to be high, the deficit will still be gigantic, gasoline prices will be high, the dollar will still be relatively weak, and government's presence in our midst will still be oppressive.

Claims continue to fall


First-time claims for unemployment last week fell by a surprisingly large amount, and were significantly less than expected (352K vs. 384K). Nevertheless, at this time of the year, when layoffs are just coming off their annual peak, the seasonal factors are very large so we have to take this news with a few grains of salt. Still, it's clear that employers by now have done the bulk of the cost-cutting and cutbacks that they needed to do, so the next phase of the economy's expansion will see more emphasis on new jobs rather than getting rid of jobs. That process is underway, but only gradually. Things could improve more convincingly as the year wears on and employers get more comfortable with the likely future direction of fiscal and monetary policy.


Thoughts on producer inflation


Once again the headline measure of Producer Price Inflation came in below expectations (-0.1% vs. +0.1%), with the result that on a year-over-year basis, this measure of inflation has been declining for the past 5 months. Unfortunately, that good news is fully offset by higher-than-expected core PPI inflation. And unless oil prices spike again, these trends are likely to continue. I note, for example, that the headline PPI is up a cumulative 40% over the past 10 years, while the core PPI is up only 20%; this divergence is bound to narrow over time, with the core measure catching up to the headline measure as higher energy prices slowly filter down to other prices.

One thing that should stand out here is that PPI inflation over the past 10 years (with a compound growth rate of 3.4% per year) has been and continues to be higher than it was in the previous 10 years (when the compound growth rate was 1.2% per year). And what has changed in the past decade? Monetary policy was undeniably tight in the 1990s, but the Fed has been working overtime to be accommodative for most of the past 10 years. That same message can be found in the dollar, which rose throughout the 1990s and early 2000s and has been falling for the past 10 years. It works like this: monetary policy impacts the value of a currency, and a declining currency eventually results in higher inflation.


Another thing that doesn't receive as much attention as it should is that Treasury yields have been lower than the rate of PPI inflation for most of the past four years. We haven't seen such low real interest rates since the highly inflationary 1970s, when the Fed was chronically "behind the curve," repeatedly failing to raise interest rates enough to constrain the high inflation that was triggered by the collapse of the dollar early in the decade.

Low real interest rates, a weak dollar, and an accommodative Fed are a combination that augurs for inflation that continues to surprise on the upside for the foreseeable future. In fact, that's been the case (higher than expected inflation) ever since the end of the last recession. Recall that at the end of 2008 the expected 5-yr, 5-yr forward annual CPI inflation rate embedded in TIPS prices was 0.5%. Instead, the CPI has averaged 2.1% a year over the past 3 years.

When inflation exceeds expectations and real interest rates are uncommonly low for several years running, this has distorting effects on economic activity. Since borrowing costs have been unexpectedly low and the returns to commodity investing have been unexpectedly high, it's not surprising that the mining and related sectors have been on fire, and commodity producers like Australia and Canada are at the top of their game. I wish I knew how much longer this will go on, but one thing is for sure: central banks are setting up the global economy for an inevitable and sharp correction in commodity prices and a return to rising borrowing costs.

More signs of improvement

The U.S. economy continues to struggle with high unemployment, only moderate jobs growth, and an oppressive level of government spending and regulation, but the outlook is nevertheless improving, as several indicators released today show.


The most surprising news was the stronger-than-expected rise in the NAHB Housing Market Index of homebuilder sentiment. It was also gratifying to me since a year ago I predicted that by the end of last year the housing market would be showing signs of life, and my prediction for this year calls for continued gradual improvement. My sense of the market's sentiment is that most people see housing construction and prices either flat or down this year, so gradual improvement coming off a multi-year and extremely low bottom are quite a surprise. Today's index reading is the best we have seen in four and a half years. Sentiment can play an important role in the housing market, so the increasing signs of a bottom could create a "buy it now before the price goes up" mentality, especially since houses have never been more affordable than they are today.


This chart shows an index of new mortgage application activity. It's been choppy of late, but an uptrend from the lows of summer 2010 is in place I believe, and this is consistent with the rise in the homebuilders sentiment index (top chart) and the increase in construction activity in the past year.



December industrial production increased 0.4%, and production is up at a 4.8% annualized pace over the past six months. The charts above show how manufacturing production continues to improve, rising at a 5.2% annualized pace over the past six months and 4% over the past year. The manufacturing sector has yet to recover its pre-recession high, which is unfortunate, but progress is being made, and that's what is important on the margin.

See how your DNA works

Time out from econ and finance for an amazing animation from Drew Berry that allows you to see how DNA works inside your cells. I can't figure out how to uncrop the video, so going directly to the TED talk might be your best approach.







Money demand is the key monetary variable


The most remarkable development on the monetary front in recent years has been the unprecedented surge in money demand, as shown in this chart. (I'm measuring money demand as the ratio of M2 to nominal GDP.) Think of money demand as the ratio of your liquid, cash, readily spendable assets (M2) to your income (GDP). From the end of 2007 to the end of 2011, money demand surged by 21%: that is, the M2 money supply increased 21% more than nominal GDP.


Virtually all of the increased demand for money occurred in the savings deposit category (the largest component of M2), which increased by just over $2 trillion from Dec. '07 through Dec. '11. In general terms, and roughly speaking, households and firms increased their savings deposits relative to their incomes by $2 trillion over the past four years. It's not hard to understand why, either. The flight to cash and safety was driven by the recession that developed over the course 2008, the collapse of U.S. housing prices, and the near-collapse of the global financial system in late 2008. Then we had the Eurozone sovereign debt default scare which began last year and which threatened to create another global financial panic and economic collapse. In short, firms and households have been hit with one panic after another, and not surprisingly have become extremely risk-averse in the process. Nearly everyone has been setting aside cash and building up savings deposits for a rainy day.



The huge increase in money demand doesn't show up as an extraordinary increase in M2, however, as the two charts above suggest. M2 is growing a bit more than its long-term average (6% per year), and that outsized growth can be easily traced to the financial panic of 2008-2009 and the PIIGS default panic that hit last year. But the extra M2 growth has come at a time when nominal GDP has experienced a significant deceleration, which is why the ratio of M2 to GDP has increased so dramatically.

The Fed has had to accommodate this huge increase in risk aversion and money demand by hugely expanding bank reserves. Bank reserves have increased almost $1.5 trillion since the Lehman crisis hit, and most of those reserves sit on the Fed's balance sheet as excess reserves, parked there by banks that are also very risk averse and unwilling to make the massive loans that those reserves would ordinarily allow. If the Fed had not taken extraordinary action to expand the monetary base by $1.8 trillion ($1.5 trillion of new bank reserves plus $250 billion of new currency), today we would probably still be engulfed in the global depression and deflation that so many were expecting at the end of 2008.

What this all means is that there is approximately $2 trillion that has been set aside by households and firms for a rainy day. It's a massive dam of liquidity that has been held back by fear. Should that rainy day fail to materialize (e.g., should Eurozone defaults fail to plunge the global economy into a depression, and should the U.S. economy continue to slowly improve), then there is the potential for a $2 trillion flood of liquidity to released. It's not likely to happen overnight, but over the next several years we could see that liquidity being gradually shifted into more equity exposure, more consumption, and higher prices in general. And the key to that gigantic potential shift is money demand, which has been driven by fear. If and when fear fades and confidence in the future returns, there is huge potential for changes on a number of fronts.

More importantly, I believe this process is already getting underway, as shown in a variety of indicators: a significant pickup in Commercial & Industrial Loans (increased borrowing is the flip side of reduced demand for money), today's big increase in the Empire State Manufacturing Index, the 6.5% increase in retail sales over the past year, the reversal of euro basis swaps, the decline in weekly claims, the pickup in hiring, the decline in the Vix Index, the 24% increase in housing starts in the past 12 months, and the big increase in the Citi Economic Surprise Index, to name just a few.

New York Manufacturing Index very impressive



I usually don't pay much attention to regional Fed manufacturing surveys, but today's Empire State survey caught my eye, and Mark Perry's comments were compelling. This chart shows the six-month outlook for general business conditions, and it has brightened significantly in the past two months, about on par with the improvement we saw just prior to the economy's emergence from the 2008-9 recession. Add this to the growing list of improving economic fundamentals in the U.S. economy, contrast that to the still-gloomy assumptions priced into equity markets and Treasury yields, and you begin to understand why the equity market is moving grudgingly higher, as I explained in greater detail last week.

Credit spread update


Credit spreads are still elevated, as the top chart of 5-yr generic credit default swaps shows. In fact, today they are higher than they were at the beginning of the last recession. At the very least this reflects a market that is very concerned about the possibility of another recession, and any student of early warning indicators knows that spreads at this level are a classic sign of a recession that is either underway or just about to start. Normally I pay a lot of attention to the level of credit spreads, but now—and I hate to say "this time is different"—is one of those rare times when the signal deserves to be ignored.


The next two charts help explain why things are very different today. The first chart above shows spreads on 5-yr A1-rate industrial company bonds and 5-yr swap spreads (equivalent to AA bank credit risk). Swap spreads aren't particularly high, and aren't signaling any grave concerns, but industrial spreads are at or near levels that have preceded recessions in the past. The second chart above shows the components of industrial spreads: industrial yields and Treasury yields. What should be immediately obvious is that spreads have widened over the past year even as industrial yields have collapsed. It was very different in 2008, when spreads and yields soared at the same time. The key difference today is that Treasury yields are at all-time lows, driven by the world's desperate attempt to find a safe asset. Industrial companies have never had it so good—they've never been able to sell debt at yields below 2%. Firms are not being starved of credit, as usually happens when spreads widen; investors are eager to buy corporate paper because it yields almost twice as much as Treasury debt, which pays almost nothing.

In short, spreads are elevated not because corporate default risk is rising, but because Treasury yields have collapsed.

But couldn't the collapse in Treasury yields be the market's way of saying the end of the world is just around the corner, and that default risk is indeed therefore quite high? If you think that Eurozone defaults are imminent, that they will bring down the Eurozone financial system, and that in turn will precipitate a major global economic collapse and depression, then yes, you will interpret the current elevated level of credit spreads as a bad sign. But if you think a catastrophe can be averted, then spreads today are not a warning, they are an opportunity.

There's not much value in high-quality corporate bond yields, however, as the chart above shows. Earning a coupon of less than 2% on a high quality industrial bond is not going to make you rich, and the bond itself is subject to some price risk if Treasury yields ever move up from today's rock-bottom levels. High-yield (junk) debt is much more attractive, however, since yields are averaging a little over 8%. This gives you some decent protection against defaults and rising Treasury yields.