Main menu

Consumer price inflation still moderate

Inflation according to the CPI remains moderate: no surprises. As the chart above shows, inflation is running in the 2-3% range, regardless of whether or not you include the contribution of energy prices. This level of inflation is very close to what we have seen over the past decade. For reference, on an annualized basis, the CPI is up 2.5% over the past two years; 2.4% over the past three years; 2.3% over the past 5 years; and 2.5% over the past 10 years.

There is nothing alarming about this level of inflation in any sense. No sign of a big inflation increase, and no threat of deflation either. The Fed has absolutely no need to engage in any further quantitative easing or easing of any variety. The Fed's next move will likely be to increase rates, but the timing of that move is unfortunately still shrouded in mystery. Recent action in the bond market (e.g., a 20 bps rise in 2-yr Treasury yields, and a 40 bps rise in 5-yr yields) suggests that the Fed will begin tightening sooner than was expected just a few months ago. I think it's reasonable to assume that we will see more of this action in the months to come.

Manufacturing production is very strong

February industrial production was unchanged from January, but this masks the fact that January production was revised up by 0.4% and February's weakness was concentrated in utilities and mining. Manufacturing production is where the strength lies, and this is shown in the charts above. Over the past six months, manufacturing production is up at a strong, 7.4% annualized rate. US factories are simply churning out a lot of stuff, and there is no sign at all of weakness on this score.

TIPS update--not very attractive

The top chart shows the nominal yield on 10-yr Treasuries, the real yield on 10-yr TIPS, and the difference between the two, which is the market's expected average annual inflation rate over the next 10 years. The bottom chart focuses on the real yield on 10-yr TIPS, and overlays my estimate of how intrinsically valuable TIPS happen to be at different levels of real yields. The lower the real yield, the less intrinsically valuable TIPS are, because TIPS are a unique asset since they pay a government-guaranteed real yield—nothing else can make that claim. (TIPS are Treasury bonds whose principal is adjusted by the CPI, and whose coupon is therefore a real yield.) TIPS are very expensive today because they actually have a negative real yield. TIPS would be attractive relative to Treasuries if inflation proves to be higher than expected, but with a guaranteed real yield that is negative, TIPS are not necessarily attractive at all in an absolute sense.

The long-term story told in the top chart is that ever since TIPS were first issued in 1997, nominal and real yields have been in decline, but the difference between the two hasn't changed much on balance. Inflation expectations have moved up and down, but current inflation expectations are not greatly different from the inflation we've actually experienced over the past decade: current inflation expectations are 2.38% for the next 10 years, while the CPI has averaged 2.48% over the past 10 years.

So the only thing that has really changed is real yields, which have declined from 3% to zero. The decline in real yields has brought with it a decline in nominal yields, since inflation expectations haven't changed much. I think real yields have declined mainly because the economy has run out of gas, and that has depressed the market's expectations for real returns across a variety of assets. Think of TIPS as defining the zero-risk real rate of return for various maturities of assets in real, inflation-adjusted space. 10-yr TIPS today are saying that if you want to lock up your money for 10 years with no possibility of default, then you must accept a slightly negative real rate of return. All other long-term assets offer a higher expected real return, along with the risk of principal loss. Put another way, 10-yr TIPS are telling us that the market believes that other, risky assets on balance don't have the potential to deliver much more than, say, a 1% real rate of return or slightly better. The expected real return of all assets has declined along with the decline in TIPS real yields, and that can only mean that the market does not expect much real growth from the U.S. economy. In short, the real yield on TIPS is inextricably linked to the market's expectations for economic growth.

The economy's poor performance in recent years is directly reflected in the growing gap between real GDP growth and its 3% long-term growth trend, which has widened since 2006, when real yields were about 2.5%. The Fed, via its quantitative easing policies and its "operation twist," has encouraged nominal yields to fall, in the hopes that lower long-term yields would help spark stronger growth. But since monetary policy cannot create growth out of thin air, the Fed's efforts cannot raise growth expectations, and they cannot—by extension—push real yields higher. If anything, aggressive monetary ease likely reduces growth expectations, since easy money increases the incentives to speculative (i.e., non-productive) activities.

If the economy starts to pick up—exceeding the current dismal expectations of market participants—and the GDP gap starts to narrow, then we should see higher nominal yields, because the market will begin (as it has in recent days) to ratchet higher its expectations for Fed tightening. Real yields are likely to rise as well as economic growth expectations improve. If inflation expectations increase alongside a pickup in growth expectations, then the rise in nominal yields should exceed the rise in real yields.

The price of TIPS is thus quite vulnerable to any unexpected strengthening of the U.S. economy, regardless of whether inflation proves higher than expected or not. A TIPS investor would benefit directly from higher inflation, but at the same time suffer a decline in the value of TIPS. So TIPS are not a very "clean" or cheap inflation hedge, since the gains from higher inflation would likely be eroded by the loss from higher real yields.

To sum up: TIPS are only attractive to an investor who believes 1) that inflation will prove to be higher than expected, and 2) that economic growth will continue to be disappointing.

Liquidity conditions continue to improve in Europe

The Eurozone is not yet out of the woods, since the fundamental problem of bloated government spending has not been fixed, but liquidity conditions in the Eurozone financial markets continue to improve, as the chart above attests. Without liquidity, financial markets become frozen and can't carry out their role as a shock absorber for the real economy. Liquid markets, however, can deal with seemingly intractable problems, and that is a necessary condition for a long-term solution to Eurozone problems. So far, so good.

Yields and inflation expectations rise in bow to healthier economy

2-yr Treasury yields (see chart above) have jumped to their highest level since last summer, as the bond market finally absorbs the emerging reality of a healthier-than-expected economy (or perhaps I should say a less-weak-than-expected economy?). The bond market is now estimating that the Fed will not keep short-term rates at 25 bps for the next two years; Fed funds futures and eurodollar futures contracts now expect one or two "tightenings" before the end of next year. That's still a very modest change in expectations, but it is likely only the beginning. If the economy maintains its recent momentum, the Fed could be forced to begin raising rates before the end of this year, and even that would mean the Fed would be reacting to events reacting than being proactive.

A behind-the-curve Fed is also being priced into the Treasury market, as the spread between 10-yr TIPS and 10-yr Treasuries (the market's expected, long-term inflation rate) has widened from a low of 1.71% last September to today's 2.37% (see chart above). The longer the Fed delays in responding to the new reality of an economy that is no longer fragile and in desperate need of ultra-accommodative monetary policy, the higher inflation expectations are likely to be.

It is with great interest, therefore, that I see that the price of gold has declined by 14% since last September, even as the bond market's inflation expectations have risen. There are several ways of interpreting this. This could be a classic case of "buy the rumor, sell the fact." The gold market has been expecting higher inflation for a very long time, and now that the case for higher inflation is beginning to solidify, prescient gold investors are taking their profits and looking for the next long-term speculation. Or it could reflect the market's realization that since the economy is doing better-than-feared (e.g., Greece defaulted, but the world didn't end), then the case for extreme monetization and hyperinflation has weakened, and thus it no longer makes sense to pay a huge price for a gold hedge. (I note in that regard that over the past century, the average price of gold in today's dollars has been about $500/oz.) I'm inclined towards the latter explanation, because it's still a matter of speculation whether the Fed will in fact end up allowing inflation to rise significantly. In other words, I'm still willing to give the Fed the benefit of the doubt, even as I become more convinced—along with the bond market—that inflation is likely to be higher than expected.

Fear has been overcome, but confidence is still lacking

The Vix index is now down to 15, which is relatively low. It was as low as 11.2 in March 2007, before we knew that the housing market was unraveling. During "good times," the Vix likes to be a in a 10-15 range. So based on the today's Vix level, we can assume that the market has largely gotten over the fear that the Eurozone sovereign debt crisis would plunge the world into another Recession. As fear has subsided, equity prices have risen, and we're slowly approaching pre-recession levels for the S&P 500—another 14% and we'll be at new all-time highs for this broad measure of equity prices.

The market has climbed a huge "fear" wall of worry, but it is not very confident at all about the future of the U.S. economy. We can see that in the still very-depressed level of Treasury yields.

The two charts above make it absolutely clear just how depressed Treasury yields are today. Not only are 10-yr Treasury yields almost as low as they have ever been, they are as low as they were in the depths of the Great Depression. And if that's not enough to convince you, I note that U.S. yields have almost converged to Japanese yields, which have been trading at extremely low levels for more than a decade, thanks to modest growth and zero to negative inflation. According to these charts, it's not unreasonable to think that the bond market believes that the outlook for the US economy is one of Japanese-style growth stagnation coupled with extremely low inflation.

So the message from the prices of stocks and bonds is that although the market sees little chance of another major recession, the outlook for the economy remains dismal. I believe that 10-yr yields would have to rise to at least 3 or 4% before one could argue that the market was optimistic about the future. For now, pessimism continues to rule the day.


This chart summarizes the advances in both the Vix index (which has declined significantly) and the 10-yr Treasury yield (which to date has risen only modestly). Risk has dropped a lot, but confidence in the future remains very weak, and that is why the Vix/10-yr ratio remains quite elevated from an historical perspective. There is very little about this market that smacks of optimism. The main message is that fear and pessimism have declined, but that we are still a long way from seeing the market as being overly optimistic.

How much longer will the Fed worry about the economy?

February retail sales were much stronger than expected, and as this chart shows, they have been rising strongly for the past three years. Over the past year, sales are up 6.5% in nominal terms, and about 4% in real terms. I think this is strong evidence that the economy is no longer fragile and in need of super-accommodative monetary policy. But when will the Fed finally wake up to this reality? It could be sooner than most folks think.

2-yr Treasury yields (shown in the chart above) are effectively the market's best guess for what the Fed funds rate is going to average over the next two years. From the lows of last September, when the world thought that the Eurozone sovereign debt crisis was sure to plunge the global economy into another deep recession, 2-yr Treasury yields are up almost 20 bps. That equates to almost two Fed tightenings over the next 2 years; not all that much, but this is evidence that the bond market is beginning to realize that the funds rate is not going to be pegged at 0.25% for the next 2 years as the Fed has been promising.

The long end of the Treasury curve is also beginning to have doubts about just how much more the Fed needs to do to pump up the economy. 30-yr yields are up about 50 bps from their all-time lows of early last October. If the market became convinced that the economy was in a sustainable expansion, yields would be much higher still—at least 4%. If anything is fragile it's not the economy, it's the health of the Treasury market, which is still trading at very low yields that only make sense if the economy is at real risk. 

The scale of the universe

Don't miss this fascinating and truly amazing visual representation of the size of the universe from the smallest (planck length) to the largest (visible universe).

HT: Gordon

Federal budget update

February budget numbers released today were mixed. Revenue growth has slowed meaningfully over the past year, with the rolling 12-month revenue total rising at only a 1.7% annualized rate in the past six months. That partly reflects the payroll tax cut that began last year, but it also reflects the economy's huge output gap and only modest growth in jobs. On the other hand, there has been very little increase in spending since the end of the recession (a mere $60 billion), and that's good because otherwise the budget deficit would be truly frightening. Here's a little-known and under-appreciated fact: virtually all of the reduction in the budget deficit has come from increased tax revenues. Revenues have increased in spite of the payroll tax cut, and without any increase in tax rates; revenues are up because the economy has grown.

About a year ago I began noting that if spending could be frozen, the budget could be balanced within 7 years or so without any tax hikes. Amazingly, we seem to be following that virtuous path, thanks to a growing economy and Congressional gridlock. As a % of GDP, the federal budget has declined from a high of of 10.4% at the end of 2009 to 8% today. In nominal terms, the deficit has fallen from a high of $1.47 trillion to $1.24 trillion. Imagine if the next Congress actually figures out how to cut spending in nominal terms! Fiscal reform is not a pipe dream, and it is slowly happening without any apparent help from Washington.

Things could be a lot worse.