Main menu

Storm hits Calafia Beach

I took this shot of a waterspout that formed about 2 hours ago off Cotton's Point (Trestles Beach as the surfers call it), just a mile south of Calafia Beach, just in advance of the brunt of the storm that hit a few minutes later. Amazing. Yes, there are tornados in Southern California, only they are mostly made of water.

Bank lending continues to accelerate

Bank lending to small and medium-sized business is still accelerating. The six-month annualized rate of growth is now at 15.4%, a post-recession high. The 13.6% year over year growth of C&I Loans is also at a post-recession high. This is undeniably a sign of increasing optimism among both banks and businesses, and that in turn is a good sign that the economy is still growing.

Meanwhile, the annual growth in savings deposits at U.S. banks has been running at double-digit levels since April '09. Clearly, the demand for safe-haven cash remains very strong, even as the economic fundamentals continue to improve. I suspect that much of the increase in savings deposits in the past 9 months comes from Europe, since that is where legitimate concerns about the future of economic growth still reside. As confirmation of this, 2-year swap spreads in Europe are still elevated, while U.S. swap spreads are still in "normal" territory.

So these charts continue to reflect the disconnect between improving conditions in the U.S. and still-precarious conditions in Europe.

Reading the Treasury tea leaves

The purpose of these two charts is to show that the bond market is not always right when it comes to inflation. From a long-term perspective (e.g., 50 years), the yield on risk-free Treasuries of 10 years' maturity or more has averaged about 2.5 percentage points above inflation. This is rational, because while Treasuries are default-free, tying one's money up for a multi-year period puts the investor at risk of receiving a return that fails to maintain the purchasing power of his funds. So moving out the Treasury yield curve should give an investor some modest expected real return, and 2.5% sounds about right. But over shorter time frames, it doesn't always work this way.

The top chart compares the yield on 30-yr Treasuries to the Core CPI, and the bottom chart compares the same yield to the PCE deflator, which is a broader and somewhat more volatile measure of inflation than is the core CPI. Both charts are set up to show that when yields and inflation converge, that is equivalent to a 2.5 percentage point expected real rate of return. In other words, when the two lines are on top of each other, bonds are arguably fairly valued.

But bonds are not always fairly valued, as should be obvious. Bond yields were way below where they should have been in the 1970s, mainly because investors were slow to raise their expectations for inflation as actual inflation exceeded expectations. By the early 1980s, however, everyone knew inflation was a big problem and so the yield on long bonds rose to levels that exceeded inflation by a substantial margin. (I was lucky enough to realize this at the time, and bought 30-year Treasury strips yielding over 11% for my IRA account which I sold 10 years later for a 300% profit.) Then, as inflation gradually subsided over the course of the 80s and 90s, bond yields slowly declined as well, until they reached something close to fair value by the early 2000s. Since then—a period that began around the time when the Fed started easing in earnest in 2002—bond yields have been at or below fair value more often than not, and especially in the past year. Over the course of the past year, inflation has settled in around 2-2.5%, but long bond yields have dipped to 3%, and 10-yr Treasury yields today are only 2%.

Buying Treasury bonds at today's yields is not a very attractive proposition, since recent inflation and inflation expectations are higher than most of the Treasury yield curve. For example, the CPI has averaged 2.7% per year for the past two years; the 5-yr, 5-yr forward inflation expectation embedded in the Treasury yield curve is 2.6% today, and has averaged 2.6% over the past year; and the 10-yr expected inflation rate embedded in TIPS is 2.3%. So if inflation comes in around expectations, buying the long bond today at 3.15% gives you an expected real return of just over 0.5% per year, whereas buying the 10-yr Treasury today gives you a negative expected real return.

With Treasury yields this low relative to inflation, it only seems reasonable to conclude that the market is willing to pay a premium for the safety of Treasuries, and that premium in turn is motivated by deep concerns over the economy's ability to grow. Investors are content to accept the likelihood of a negative real rate of return in exchange for protection against default, and paying a premium for protection against default only makes sense if you are really concerned that a weak economy is going to significantly increase the risk of defaults.

This is why I see today's Treasury yields as a very good indicator that the market is still dominated by fear, rather than by optimism. I think the economy is very unlikely to deteriorate significantly, but neither do I see it being very strong. But since the market is dominated by fears of weakness, my view makes me effectively an optimist.

Last week's increase in claims is not significant

Weekly claims for unemployment jumped "unexpectedly," but I don't think this leads to the conclusion that the labor market is suddenly deteriorating. As the second of these two charts shows, weekly volatility in this series is the norm. As the first shows, when comparing the recent week to the same week a year ago, the pattern of unadjusted claims is the same. Unadjusted claims this year were almost 9% below where they were a year ago, and that is in keeping with the pattern we've been seeing for the past two months. Given that Good Friday was involved in one of these numbers, it's likely that today's reported increase in claims was an artifact of the seasonal adjustment process.

Federal budget update

Today's release of March federal budget numbers was mixed. Three broad themes remain in place: 1) annual outlays have grown very little since the recovery started (only $90 billion), thanks to Congressional gridlock; 2) revenue growth has slowed over the past year, thanks to the payroll tax cut and only moderate growth in jobs; and 3) the budget deficit continues to decline relative to GDP (from a high of 10.4% in late '09 to 8% now), thanks mainly to increased tax revenues and stagnant spending. If Congress can continue to hold the line on spending, and if the economy continues to grow, the budget deficit will slowly fade away as a pressing problem—but of course this could take many years.

I can't resist posting an updated version of this chart, even though every time I do, it creates a storm of controversy. Students of the business cycle know that a recession typically leads to increased spending (e.g., automatic stabilizers such as unemployment benefits and food stamps kick in), so it is natural for spending to increase relative to GDP (blue line in the above chart), at the same time that the unemployment rate increases (red line). Similarly, recoveries reduce unemployment and that takes some pressure off of spending. But the most recent recession was an outlier, since it featured a surge in spending the likes of which we haven't seen since WW II. This time around, spending wasn't just driven by an increase in unemployment benefits and automatic stabilizers, it was also driven by Washington's attempt to seriously boost spending on things that were supposed to strengthen the economy. But as we now know, a trillion dollars of "stimulus" spending failed to boost the economy and failed to bring down the unemployment rate as its proponents had argued.

My point here (which is difficult to prove, I know) is that "stimulus" spending actually ended up weakening the economy, and that is why the level of spending relative to GDP is still very high and the unemployment rate is still very high. When the government redirects a significant amount of the economy's resources in the name of "stimulus," what it is actually doing is hobbling the economy by taking money from those who are more productive and giving it to those who are less productive. Transfer payments have surged, unemployment benefits have been extended in unprecedented fashion, and "stimulus" funds have been wasted on "make-work" projects. None of this helps create jobs, and in fact the incentives for new job creation have only declined, due to increased regulatory burdens and the fear that huge increases in future tax burdens will be required to reduce the bulging federal debt.

The implication here is that since deficit-financed spending increases can weaken an economy, reductions in spending relative to GDP can strengthen an economy. We're on that virtuous path to some extent, and that is why the unemployment rate is slowly declining. But it would be far better if we—and the Europeans—could make a more vigorous effort to reduce spending relative to GDP. That's the kind of "austerity" that leads to a stronger economy.

UPDATE: It occurs to me that there is another reason for why the huge increase in spending vs. GDP in recent years has corresponded so tightly to the unemployment rate. The unprecedented expansion of unemployment benefits and the equally unprecedented increase in food stamp benefits in recent years has undoubtedly played a role in reducing the labor force participation rate (many people may have decided to stop seeking employment in order to enjoy extended/emergency unemployment benefits and food stamps), and the reduction in size and lack of growth in recent years of the labor force has been an important contributor to the decline in the unemployment rate. I don't have facts or figures to back this up, but it does seem intuitive.

Europe needs spending cuts, not tax increases

With Spanish and Italian yields surging, and with Spanish equities yesterday hitting a new post-March 2009 low, the Eurozone crisis appears to be entering yet another panic phase.

The basic problem is that while the ECB's recent efforts to provide sufficient liquidity to the banking system have improved conditions dramatically, the underlying problem facing the Eurozone has not yet been addressed: How exactly are the PIIGS countries going to implement the severe austerity measures that investors are begging for; how are they going to address their huge deficit spending problem? 

As I mentioned in a post last week, the problem with austerity is not so much the proposed cuts to government spending, but the proposed increases in taxes: 

It's tax austerity that is creating the problem: Spain's desire to raise taxes in order to help reduce its fiscal deficit—at a time when the economy is struggling and unemployment over 20%—is likely to harm the economy and aggravate the deficit, rather than reduce it. Raising taxes is the problem because that is basically an attempt to validate a level of spending that is already way too high; furthermore, it asks the weakened private sector to carry an additional burden and spares the bloated public sector from needed adjustment.

With a HT to Greg Mankiw, there is serious academic research by Alessina and Giovacci to back up my claim:

The accumulated evidence from over 40 years of fiscal adjustments across the OECD speaks loud and clear:
First, adjustments achieved through spending cuts are less recessionary than those achieved through tax increases.
Second, spending-based consolidations accompanied by the right polices tend to be less recessionary or even have a positive impact on growth.
These accompanying policies include easy money policy, liberalisation of goods and labour markets, and other structural reforms.
There remains a lot of work to be done on identifying the appropriate accompanying policies and understanding the channels through which they help spending-based stabilisations, but the fact is there, as shown for instance in a recent paper by Roberto Perotti (2011).
Third, only spending-based adjustments have eventually led to a permanent consolidation of the budget, as measured by the stabilisation – if not the reduction – of debt-to-GDP ratios.

And here's the key point: "... we should stop focusing fiscal policy discussions on the size of austerity programmes. A relatively small tax-based adjustment could be more recessionary than a larger one based upon spending cuts. Likewise, a small spending-based adjustment could be more effective at stabilising debt-to-GDP ratios than a larger tax-based adjustment."

If the economists and politicians of Europe are not brain-dead or totally ignorant of the facts behind successful fiscal adjustments, they will do the right thing and focus their efforts on spending cuts rather than tax increases. Doing the right thing is always the sensible thing, and in this case, the only thing that has a chance of working. Doing the wrong thing at this point is almost unthinkable.

How hard can this be? I refuse to believe that there will be massive Eurozone defaults and subsequent financial and economic chaos spreading throughout the world. The solution to today's problem is far easier and less painful than the consequences of failing to find a solution.

And by the way, the U.S. needs exactly the same kind of solution.

The threat of higher gasoline prices is receding

According to AAA, the nationwide average price of regular gasoline is $3.93/gal. (In California we are paying well over that, with prices for premium approaching $5/gal.) As the chart above shows, gasoline prices today are about as high as they have ever been. Does this pose a threat to our struggling economy? While it's undoubtedly a problem, I think it's more in the nature of a headwind rather than a big recession threat.

The chart above compares the nationwide average price of regular gasoline (orange line) with the price of nearby wholesale gasoline futures prices (white line). Note how well these two series track each other, but especially note that the orange line tends to lag the white line a bit. That makes sense, since future prices operate in real time and wholesale prices necessarily lead retail prices. Note also how wholesale prices have rolled over in the past week, and are basically unchanged over the past month. Pump prices have only recently gone flat. So the price of gasoline futures today suggests that pump prices will probably decline to $3.80-3.85 in the next few weeks.

The first of the above two charts focuses on recent trends in crude oil prices, using the NYMEX futures contract. Here we see that prices today are about 30% less than their peak in mid-2008. (Arab Light Crude currently has been trading at an unusually wide 20% premium to U.S. crude for the past nine months or so, and I'm guessing that mid-east tensions account explain a lot of that.) The second chart shows the inflation-adjusted price of Arab Light over the past 40 years. On this basis crude is about 15% below its mid-2008 level.

The chart above compares the price of Light Sweet Crude to the wholesale price of gasoline. They track each other closely—as they must—but it should be clear that gasoline prices today are quite high relative to crude prices. This is probably a function of a shortage of refinery capacity. It's going to be difficult for gasoline prices to move higher unless crude prices increase by a lot. Meanwhile, market arbitrage is going to tend to bring gasoline prices down relative to crude prices. And since pump prices are high relative to wholesale prices, and wholesale prices are high relative to crude prices, it is reasonable to think that pump prices are at least unlikely to rise further, absent a significant increase in crude prices, and could well decline.

From a longer-term perspective, these charts show that, thanks to the greatly increased energy efficiency of the U.S. economy (last year the U.S. consumed 18.84 million barrels of oil per day, the same as in 1978, despite the fact that the size of the U.S. economy has increased by 130% since 1978), the average person is spending only 6% of his disposable income on energy, or about one-third less than in 1980. They also show how spikes in the price of oil lead to a substantial reduction in U.S. oil consumption, thanks mainly to technology gains and ongoing conservation and energy efficiency efforts. Since gasoline prices are very high in both nominal and real terms, it is thus reasonable to expect that gasoline demand will be soft for the foreseeable future, while the demand for more energy-efficient vehicles will remain strong.

This chart shows how drilling and exploration activity respond to the real price of crude, which is perfectly rational; crude prices have jumped since the end of the recession, and this has led to a surge in drilling and exploration activity all over the world. Combine this with the prior two charts and you see how expensive gasoline is the "cure" for high gasoline prices, since high prices lead to reduced demand and increased oil drilling and exploration. Prices are definitely high in real terms today, so gasoline demand is likely to be soft, even as drilling activity continues to pick up. And with prices at the pump somewhat high relative to wholesale prices to crude prices, we are unlikely to see pump prices rise much further, if at all, in the near term. Finally, gasoline prices at this level do not represent an unusual burden on consumers' pocketbooks in historical and relative terms.

Expensive gasoline is a problem, but market forces are working to alleviate the problem, and consumers are less dependent on energy prices in general than they have been in the past. So the current spike in gasoline prices is not necessarily an economy killer.

UPDATE: The following two charts show how incredibly cheap natural gas has become in the U.S. This undoubtedly alleviates to a meaningful degree the problem of expensive gasoline.