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The problem with Treasury yields



I'm always on the lookout for valuation discrepancies, and these two charts highlight the biggest potential discrepancy that I'm aware of today: Treasury yields are very low given the strength of the economy and the level of inflation. Stock prices are rising because the economy is proving to be somewhat stronger than expected. Inflation is not dead—it's been rising for the past year—and it now is close to where it's been for the past decade, around 2-3%. Yet bond yields are near all-time lows and are priced to the expectation that the economy will be chronically weak and inflation will move towards zero. 

There are of course three valid explanations for why Treasury yields are so low despite the improvement in the economy and the outlook for 2-3% inflation (i.e., the market is not entirely crazy): 1) the Fed keeps insisting that it will keep short-term rates near zero for the next three years, 2) the Fed, via its "Operation Twist," is actively attempting to keep Treasury note and bond yields low, and 3) the world is willing to pay very high prices for the safety of Treasuries given the threat of Eurozone sovereign defaults and the potential demise of the Euro. 

However, those rationales could evaporate very quickly, if a) the Fed becomes convinced that the economy is doing better than expected and there is little risk of inflation being too low, and b) the Eurozone survives a Greek default without any significant collateral damage. I think there is a reasonable chance we could see both of those developments within a reasonable time frame. Thus I view Treasuries as very risky investments, while equities remain relatively attractive, underpinned by relatively low PEs and strong corporate profits.

UPDATE: There appears to be some confusion regarding the market's expectation of future inflation, and I should have made that clear in my initial post. The best measure of expected inflation that I know of is that which is derived from the pricing of TIPS and Treasuries. And the Fed agrees, having annointed the 5-yr, 5-yr forward inflation expectation implied in TIPS and Treasury prices as the "best" measure of the market's inflation expectations. I show that in the chart below, with the current reading being about 2.5%. On a longer-term basis, the expectation for average CPI inflation over the next 10 years is about 2.25%. Both of these expectations are very close to what inflation has averaged in the past 5 and 10 years, so there is nothing unusual in today's expectations for the future. 


You can see the same pattern in this chart as in the charts above: 10-yr yields are trading substantially below the level that has prevailed in the past, given current inflation expectations. No matter how you look at it, Treasury yields appear to be artificially depressed. And from my perspective, the pressures for higher yields are building daily. 

PPI inflation of 3.5% points to higher yields ahead



January Producer Price Inflation was lower than expected, but the core version was higher than expected. Nothing scary here, thank goodness, but on balance, inflation at the producer level is running at a rate around 3.5% per year. As the second chart shows, this is roughly the level of inflation that we have seen for the past 8 years, and it is about twice the rate that we enjoyed throughout most of the 80s and 90s. We likely are still in a somewhat higher, more volatile inflation environment than we saw during the Greenspan era. Given the weakness in the dollar and the strength of gold and commodity prices, and the Bernanke Fed's continued emphasis on being accommodative, I still believe that the risks to inflation in coming years are on the high side.


Treasury yields remain very low relative to the current level of PPI inflation. This creates incentives for firms to borrow and invest in raw materials, since the after-tax cost of borrowing has been much lower than the rate by which commodity prices have risen over time. It also makes it less likely that the Fed is going to be able to keep Treasury yields as low as they would like. With the economy showing clear signs of picking up, and inflation still alive and well, there is increasing pressure on Treasury yields to rise. I find it very difficult to believe that the Fed will be able to keep its "promise" to keep short-term rates close to zero for the next three years. When the Fed backs off of that promise, that should provide a further boost to confidence as yields rise to more normal levels.

Housing starts are up 46% from their low


It would be hard to argue that residential construction, measured by housing starts, is not in full recovery mode. January starts were much higher than expected (699K vs. 675K), and December starts were revised up almost 5%. From the low in April '09, starts are now up by 46%. This is a recovery, and it started almost a year ago, though it has somehow managed to fly under the radar of the consensus view that the economy is very weak. The level of starts is still miserably low, of course, but we are seeing very impressive changes on the margin in this indicator. This is very good news, because it shows that builders are more confident in the future because they see a looming shortage of housing after years of extremely deep construction cutbacks. This further suggests that the underlying fundamentals of the housing market are much sounder than most believe have been led to believe. On the margin, the problem is no longer a glut of homes for sale, but a shortage of homes relative to the number of households in a position to buy them. This is very good news.

Still more improvement in the labor market


First-time claims for unemployment continued their descent last week, dropping to a mere 348K. It is now absolutely clear that there has been substantial improvement in the labor market. At last week's level, the ratio of claims to payrolls (what I term "workforce disruption" is now lower than at any time prior to 1997. We've rarely seen claims at such a low level relative to the size of the workforce. This must mean that firms have done just about all the cost-cutting that they are going to do. If firms have to change course because of something unexpected, it is much more likely to be in the direction of more hiring, not less, because they are already prepared for bad news. In other words, they are now vulnerable to an unexpected improvement in the economy. This is good.

Paul Ryan for President

I don't know that there is any politician in Washington that has a better grasp of the facts and  what is going on in this country than Paul Ryan. It's a real shame he declined entreaties to run for President, because we really need someone like him, someone who appreciates why government must be scaled back, not only because it is spending and redistributing way too much, but also because it is encroaching on our precious liberties as individuals. This is not just partisan politics—I'm a fiscal conservative and a social liberal and don't fit the traditional mold of either Republicans or Democrats—it's about what's best for freedom, free markets, and prosperity for all. I don't know of any other way that is more conducive to a strong and prosperous economy, one that provides the highest standard of living to the most people.

There are way too many politicians of both parties that are guilty of pursuing policies that threaten our future, and I'm compelled to make that case on this blog, since I cherish free markets and individual liberty. I'm also compelled to criticize Obama's attempts to divide this country into have and have-nots, which I view as nothing but a transparent attempt to divide and conquer in the name of Big Government, which in the end is the biggest threat we face today.

Following are some excerpts from Ryan's opening statement today, as Chairman of the House Budget Committee introducing testimony from Acting OMB Director Jeff Zients regarding President Obama's recent budget proposal. To my knowledge Ryan makes not a single error or misrepresentation of the facts. We have a serious problem with deficit spending and runaway entitlement programs that can't be fixed by higher taxes, and Obama, the Senate Democrats and too many Republicans are studiously avoiding any meaningful solutions.

I’d like to thank our witness today, Mr. Zients. Unfortunately, you are in the position of having to defend a budget that essentially dodges the most difficult challenges our country faces.
The New York Times has reported that this budget is, quote, “more a platform for the president’s re-election campaign than a legislative proposal.” After a careful review, it’s hard to disagree. The Associated Press has reported – accurately in my view – that this budget, quote, “[takes] a pass on reining in government growth.” Instead, it leaves the drivers of our debt – namely, the unsustainable growth of entitlement spending – quote, “largely unchecked.” It takes a pass on real reform, even though the looming bankruptcy of these programs threatens to end the guarantee of security they provide for our nation’s seniors.
Jack Lew, your former boss, claimed that the reason Senate Democrats haven’t passed a budget in over 1,000 days is that the Republicans have threatened to filibuster. This is simply false. As Mr. Lew surely knows, budget resolutions cannot be filibustered. They can be passed with a simple majority.
The real source of dysfunction in the Senate comes from members of the President’s own party, who have been unwilling – for almost three years now – to go on record in support of his budgets, or to pass budgets of their own.
More to the point, it wasn’t so long ago that the President’s party held total control of the White House and both branches of Congress – during which time his agenda was enacted in near totality:
* massive new spending and taxes
* the creation of new, open-ended entitlements
* a regulatory onslaught that hurt the economy
* and trillions of dollars in new debt.
We were – and we remain – eager to work with the President to stop spending money we don’t have… to reform government programs that aren’t delivering on their promises… and to enact pro-growth policies that raise revenue by getting our economy moving again.
Yet, instead of working with us, the President has demonized our ideas to save and strengthen health and retirement security programs. And he continues to insist on taking more money from hardworking Americans – not to reduce the debt, but to fuel his ever-higher spending.

$4 gasoline isn't a big threat to the economy




As the top two charts show, oil and gasoline prices are very close to all-time highs. Arab Light crude is closing in on $120/bbl, driven by increasing mideast tensions, and that's only $26 off its all-time high of mid-2008. As the bottom chart shows, the nationwide average price of regular gasoline is now over $3.50/gallon, and it could be headed once again to its all-time high of $4.00. (Here in So. California, we're already paying over $4/gallon at most stations, and I've seen prices as high as $4.50.) Gasoline prices at the pump are just following the pattern of crude oil and wholesale gasoline prices.

Do rising oil and gasoline prices pose a threat to the economy? I know it's painful for many folks to have to shell out upwards of $100 to fill up the tank, but I doubt this will bring the economy to its knees.


This next chart is one reason why $4 gasoline is not a big threat. Thanks to conservation and technology, the U.S. economy today requires less than half as much oil to generate a unit of output than it did in the 1970s.


Despite the fact that the U.S. economy has more than doubled in size since 1979, our oil consumption has hardly risen at all. Cars are much more efficient these days, and more and more of our economy gets transacted through the internet, where marginal costs are almost nil.


As this chart shows, the average consumer today spends only about 6% of his income on energy (most of which comes from petroleum products), and that is almost 30% less than what he spent at the end of 1983, when the economy had just finished its first of what would prove to be seven years of very rapid growth and oil was very close to its (then) all-time highs. Simply put, we use a lot less energy today to power our economy, so the fact that energy is relatively expensive is much less important. (Actually, it's because energy is so expensive that we use a lot less of it.)


Meanwhile, plunging natural gas prices (thanks to new drilling technologies) help take the sting out of rising crude oil prices.

So, even though gasoline pump prices are making headlines and causing much irritation among consumers, there is little reason to think that this puts the economy at risk.

The U.S. economy is definitely picking up

Today was a solid "good news" day for the U.S. economy: more evidence that the housing market has turned up, strong manufacturing production, and a strong NY manufacturing survey. With numbers like this and upside momentum building, the economy is very likely to post stronger growth numbers this year. We'll still be struggling with a gigantic output gap, but the gap should be closing. The public will likely perceive some improvement by the time of the November elections, but I suspect it won't be enough to make a significant difference to the outcome. We are on the road to recovery, but policy blunders along the way have amounted to significant headwinds—we could have been in far better shape if things had been done differently. It's a testament to the inherent dynamism of the US economy that we are doing as well as we are. In my decades of experience, I've learned that one should never underestimate the ability of the U.S. economy to grow, even when faced with significant hurdles.


This index of homebuilders' sentiment is still at miserably low levels, but the improvement in recent months is striking. Things have really improved on the margin, and that is what is most important—not the level, but the change on the margin. This also suggests that housing starts, which rose 25% last year, are likely to continue to pick up.


I know there are still plenty of analysts reminding us that banks have a huge supply of REO that they are going to dump on the market any day now, warning that this will lead to another housing slump. But as this chart shows, the supply of unsold homes has declined significantly in the past year. It's a combination of sales picking up and slower growth in new homes being put up for sale. I see this as a strong sign that the market is clearing; in fact, it's been clearing for several years now (we're over 5 years into this housing downturn) and there isn't a person alive in the U.S. that doesn't know that housing prices have been weak and there are still plenty of foreclosures in the pipeline. Buyers are responding to lower prices, even as there are many still sitting on the sidelines waiting for things to pick up. Problem is, the pickup is usually not visible to most folks until it's well underway. Once it makes headlines, you get a buying stampede as prices and interest rates start to rise. In any event, if sentiment starts to improve, then new buying can easily outweigh whatever new supply the banks might dump on the market. The ingredients for improving sentiment are out there: incredibly low mortgage rates, prices that are an order of magnitude lower than they were 5 years ago, and an improving economy.


There are still lots of vacant homes for sale, and I'm sure everyone has seen several in his or her neighborhood. But on the margin, there are fewer and fewer. That's real improvement.


Since early October, when stocks slumped over fears that a Eurozone financial meltdown would trigger a double-dip recession in the U.S., this index of the stocks of major homebuilders is up 67%. (The S&P homebuilders' index is at a new post-recession high.) Altogether, this is substantial improvement on the margin and there is plenty of upside left.


January industrial production was up by less than expected, but revisions to prior months boosted the index to a new high, and weakness was concentrated in the utility sector, where good weather reduced the demand for electricity. As this chart shows, industrial output in the U.S. economy has diverged substantially from that of the Eurozone economy. We are not dependent on Europe for our growth, and despite all their financial misery and fears, the fundamentals of the U.S. economy have continued to improve. No reason this can't continue. Rather than us fearing that Europe might drag us down in the future, the Europeans are likely cheering the fact that a stronger U.S. economy will provide fundamental support for their own economy. Growth is infectious.



Abstracting from utility output, U.S. manufacturing production—led by the auto sector—has been very strong: up at a 8.6% annualized rate in the past three months, and up at a 6.7% annualized rate in the past six months. (Mark Perry has a nice table showing the breakdown by sector.) It doesn't get much better than this.


Finally, the February Empire State Manufacturing Survey came in very strong, reinforcing the message of the January manufacturing production number.

I haven't seen any news lately from the folks at ECRI, but I imagine they must have abandoned by now their September '11 call for an imminent and inevitable recession.

Article of the Day

A brilliant essay by Prof. Paul Rahe, in which he lays bare American Catholicism’s Pact With the Devil. In the process of exposing how the church came to support liberal ideals such as an expanding welfare state, while tolerating liberal ideals such as abortion, he highlights the most disturbing thing about ObamaCare's recent ruling that health insurance providers must offer contraceptives and abortifacients to all, regardless of one's religious beliefs. It's not just that the government has now crossed the line between church and state—which is bad enough—it's that an expanding and more powerful government eventually tramples the individual liberties of all.

Excerpts (but do read the whole thing since it is profoundly interesting):


In the 1930s, the majority of the bishops, priests, and nuns sold their souls to the devil, and they did so with the best of intentions. In their concern for the suffering of those out of work and destitute, they wholeheartedly embraced the New Deal ... [and] welcomed Social Security. They did not stop to ponder whether public provision in this regard would subvert the moral principle that children are responsible for the well-being of their parents. They did not stop to consider whether this measure would reduce the incentives for procreation and nourish the temptation to think of sexual intercourse as an indoor sport. They did not stop to think.
In the process, the leaders of the American Catholic Church fell prey to a conceit that had long before ensnared a great many mainstream Protestants in the United States – the notion that public provision is somehow akin to charity – and so they fostered state paternalism and undermined what they professed to teach: that charity is an individual responsibility and that it is appropriate that the laity join together under the leadership of the Church to alleviate the suffering of the poor. In its place, they helped establish the Machiavellian principle that underpins modern liberalism – the notion that it is our Christian duty to confiscate other people’s money and redistribute it.
At every turn in American politics since that time, you will find the hierarchy assisting the Democratic Party and promoting the growth of the administrative entitlements state. At no point have its members evidenced any concern for sustaining limited government and protecting the rights of individuals. It did not cross the minds of these prelates that the liberty of conscience which they had grown to cherish is part of a larger package – that the paternalistic state, which recognizes no legitimate limits on its power and scope, that they had embraced would someday turn on the Church and seek to dictate whom it chose to teach its doctrines and how, more generally, it would conduct its affairs.

Federal budget update; fiscal austerity is not bad for growth


Note how flat spending has been since the end of the recession. Up only 3.7%! Of course, spending rose 23% during the recession, so this is only a modest payback. But it is at least a significant step in the right direction. Hard to believe that we are going to see any major spending initiatives get approved this year. Obama is proposing much more spending, but it's likely to be passed. The increase in revenues post-recession has faded, however. But from the low in revenues in late 2009, we have seen an increase of 14% despite net reductions in tax rates (e.g., the payroll tax holiday).


Federal spending has been very elevated as a % of GDP, well above its post-war average of about 19%, and federal revenues as a % of GDP have been well below its post-war average of about 17%. The increased spending mostly represents a big increase in federal transfer payments (e.g., income redistribution), while the shortfall in revenues can be traced largely to the fact that there are 5 million fewer workers today than there were prior to the recession. Also, the payroll tax "holiday" that has been in effect for over a year now, and that has reduced revenues meaningfully. Unfortunately, that type of tax cut has very little impact on growth, since most consumers view it as only temporary. Tax cuts need to be permanent and across the board to have a decent stimulative effect on growth.


We are still looking at trillion-dollar deficits for as far as the eye can see, but there has been some improvement on the margin in recent years. From a high of $1.48 trillion in early 2010, the deficit has declined by 17%.


As for this last chart, let me say at the outset that it is highly controversial. I don't want to assert here that there is any causal relation between the level of government spending and the unemployment rate. Nor do I want to assert that the official unemployment rate is an accurate reflection of the true state of the labor market. Both assertions could be debated by reasonable people. However, whatever measure of unemployment you prefer, it is nevertheless the case that there has been some improvement in recent years, at the same time as the level of government spending relative to GDP has declined. 

What I do think makes sense and is important to note is that the chart shows that spending can decline relative to GDP (by growing very slowly or not at all), and that is not inconsistent with an improving and growing economy and reduced unemployment. This runs directly counter to the prevaling Keynesian wisdom, which holds that a reduction in government spending (i.e., fiscal austerity) will result in a weaker economy and must therefore be avoided. By not spending more as the economy grows, the government effectively allows the private sector to keep more of what it makes. Since the private sector spends money more efficiently (and less corruptly) than the public sector, shrinking the public sector (even just in relative terms) goes hand in hand with stronger growth. That's just plain common sense. 

Can we confidently predict that more fiscal austerity would translate into stronger growth? No. But neither can we confidently predict that fiscal austerity would result in slower growth. I see this chart as supportive of the case for fiscal austerity, and destructive of the case for continued stimulus. It shows that we can cut back on the growth of spending and avoid increasing taxes without damaging the economy.