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Household balance sheets continue to improve


The Fed has released its Flow of Funds data for the first quarter, and there are several notable developments, as summarized in the chart above. For starters, households have been deleveraging since 2007 (reducing net debt by almost $1 trillion), yet the economy has failed to implode as the doomsters were predicting. Financial assets have made a full recovery back to their 2007 high, thanks mainly to a $1 trillion addition to savings deposits and a rally in the equity and corporate bond markets. The value of households' real estate holdings has recovered to 2010 levels, but is still down over $6 trillion from the 2006 highs. Finally, despite all the turmoil of the past decade (housing market collapse, financial market collapse, worst recession in generations, slowest recovery in generations), households' net worth has risen at an annualized rate of just over 4% since 1997, almost double the rate of inflation.

This is a testament to the resilience and inherent dynamism of the U.S. economy. We have managed to weather almost unimaginable storms; most households have endured wrenching and painful adjustments; nevertheless, things are getting back to where they should be, slowly but surely, thanks to hard work and savings. A good deal of this progress has come despite the headwinds of excessive government spending and regulation, despite extreme gyrations in monetary policy, and despite the huge growth in federal borrowing which has raised fears of a significant increase in future tax burdens. If monetary and fiscal policy can get back to a more stable, sustainable and predictable path in the future, and I think they can, then the outlook will brighten even more. (See John Taylor's excellent summary of what needs to be done here.)

Continued progress on the claims front


Weekly claims for unemployment came in as expected, and they were almost exactly what they have been averaging so far this year, so there hasn't been much progress in this area for awhile. But considering all the hand-wringing about the U.S. getting a case of recession contagion from the Eurozone, it's very good news: no sign at all of any deterioration in the U.S. economy as of last week. The good news here is that there's no bad news.


Meanwhile, there continues to be significant progress in the number of people receiving unemployment insurance: 1.26 million fewer people today are "on the dole" than were a year ago, and that's an impressive decline of 18.3%. And it's ongoing, especially since more and more people are going to be exhausting their "emergency claims" benefits in the months to come. This represent a positive change on the margin in the incentives that people have to find and accept a new job, and changes in incentives can be powerful factors affecting the evolution of the economy.

What TIPS tell us about the outlook for growth

I've asserted several times in the past that the real yield on TIPS is a good proxy for the market's outlook for real economic growth, but I've never done a good job demonstrating that with charts. So I had an inspiration and came up with the following set of charts which I think does a reasonably good job. As I said last month, the extremely low (actually negative) level of real yields on TIPS tells us that the bond market is very pessimistic about the prospects for economic growth. Here are some ways to understand why that is so, and in the process to gain an understanding of just how cheap equities might be.


The chart above compares the 2-year annualized real growth of GDP to the real yield on 5-yr TIPS. What I'm trying to show here is that there is a correlation, albeit not very tight, between the level of real yields and the general strength of the economy. In the late 1990s and early 2000s, real yields on TIPS were fabulously high, as was optimism about growth. I remember thinking at the time that the markets were priced to the expectation that the economy would grow at 4-5% for a long time. Since then, the economy suffered two recessions, and is still in the midst of the most disappointing "recovery" in modern times. Not surprisingly, the real yield on TIPS is as low as its ever been. Most TIPS yields are in fact negative, which means that investors are willing to lock in a negative real yield on default-free TIPS just for the privilege of knowing they won't lose any more than that, presumably because they expect that real yields could be even more negative on risky assets. The chart is suggesting that TIPS are priced to the expectation that real economic growth will be zero at best for the next two years, and that would undoubtedly lead to some very negative real returns on equities and corporate bonds.


I've showed this next chart many times over the past several years, always remarking that since the earnings yield on equities has been higher than the yield on BAA corporate bonds, this means the market is extremely pessimistic. Investors would rather accept a lower, fixed rate on corporate debt in order to have first dibs on earnings (which the market suspects will be in short supply in the future), rather than enjoy a higher earnings yield and the potential price appreciation that comes with being an equity owner.


This last chart ties real yields on 5-yr TIPS to the earnings yield on equities. The real yield on TIPS is inverted, in order to show that a lower real yield (and as the first chart suggests, a lower expectation for real economic growth) goes hand in hand with a higher earnings yield on equities. Real yields are very low and equity earnings yields are very high for the same reason: the market is very fearful that a recession and/or a period of prolonged economic stagnation awaits us. The market is unwilling to believe that the record-high level of corporate profits will last. The market is priced to the expectation that the economy will be very weak and profits will collapse. While that may prove to be the case (the market is sometimes, but not always, right), it is nevertheless a very pessimistic way of looking at things. I think it reflects the mood of investors that have been "once burned and now twice shy." I think emotions are running high and valuations may therefore be unreasonably low.

Looked at another way, if the economy ends up doing anything better than a recession, then valuations will most likely improve. You don't need to be a raging optimist to like the market, you just need to be less pessimistic than the market.

More on forward inflation expectations


Contrary to a recent post on Zero Hedge which notes that 5-yr, 5-yr forward inflation expectations according to Bloomberg's calculations have turned negative for the first time ever, I have updated my chart using Bloomberg's calculations of this variable (USGG5Y5Y Index, for those interested). Rather than falling to unprecedented lows, forward inflation expectations have now risen to their highest level since last August. My own calculations of this rate confirm Bloomberg's numbers, so I'm at a loss as to how ZH got the story backwards.

In any event, as I noted in a previous post, it is very interesting that forward inflation expectations are rising at a time when 10-yr Treasury yields have plunged. Moreover, it's very interesting that this has happened while gold has fallen, commodities have fallen, and the dollar has risen. It suggests that the driving force behind collapsing Treasury yields (and this includes the sovereign debt of the UK, Germany, and Japan as well) is a budding global panic over the likelihood of a global recession, accompanied by fears that this will all end with currency debasement (particularly of the Greek variety) and thus higher inflation. Investors apparently have an insatiable appetite for risk-free, yield-bearing assets, because they fear that everything else will be negative, while at the same time reasoning that eventually (some years in the future) governments will resort to even more monetary stimulus that will reignite inflation. It's a curious state of affairs, to say the least.


Jon Hilsenrath's story that broke late today has contributed to the rising inflation fears today, since he reports that the Fed is once again considering another round of easing. I'm still having difficulty understanding how more Fed easing could solve the problem of insolvent PIIGS, and I note in this regard that 2-yr Eurozone swap spreads are not signaling any sudden or acute shortage of liquidity. Furthermore, it seems to me that another round of QE would only exacerbate what appears to be an acute shortage of high-quality sovereign debt (e.g., Treasury notes and bonds, plus the bonds of the UK, German, and Japanese governments, all of which are trading at extremely low yields).

What this suggests, of course, is that monetary policy easing is the wrong response to the problem at hand. We don't have a shortage of liquidity, we have a failure of policymakers to understand that in order to improve the health of the world economy, we need to shrink Big Government just about everywhere. More liquidity injections may be necessary to keep banks functioning and markets liquid, but for now they can't fix the underlying problem which is more spending than private sectors can afford to bear.

On the bright side, Scott Walker's solid victory in today's Wisconsin election is one more marker on the long road to smaller government, and that's good news.

U.S. vs. Eurozone update

As I mentioned in yesterday's post, which explained why the problems that plague the U.S. economy have little to do with a lack of Fed easing, " the Eurozone is the epicenter of the world's growth and financial concerns." We have yet to see any clear signs of a significant weakening of the U.S. economy, but there is no lack of such signs in the Eurozone.


This chart compares the Institute for Supply Management's survey of the manufacturing sector for the U.S. and for the Eurozone. Note how the Eurozone was doing somewhat better than the U.S. prior to the 2008 recession, but how severely the Eurozone has underperformed since. See more on this underperformance here, where I argue that this underperformance is a good proxy for the losses that have resulted from lending to countries (e.g., the PIIGS) that don't have the ability to service their debts. It's very likely that the Eurozone (with the notable exception of Germany) has been in a recession for most of the past year.


This chart compares the ISM indices for the Service Sector in the U.S. and in the Eurozone. Here we see the same pattern as with the manufacturing sector; the sovereign debt crisis is impacting everything in the Eurozone, while the U.S. continues with its relatively sluggish recovery. (As Robert Barro so ably notes in yesterday's WSJ, this "recovery" is arguably not a recovery at all, since real growth over the past year or so has been below the economy's 3% potential, thus leading to an ever-widening gap between where the economy is today and where it could be if economic conditions and policies were better.)


So most Eurozone economies probably have been in a recession for awhile, and maybe that has contributed somewhat to the slow growth of the U.S. economy. But the U.S. economy is still not even flirting with a recession based on the ISM indices, and although jobs growth is disappointing it is still positive. As the chart above suggests, we would have to see the ISM manufacturing index fall below 47 (it's currently at 53.5) before we could see recessionary conditions. The service sector index does not yet have enough data to make a similar comparison, but the current U.S. service sector reading is 53.4, which is enough above the 50 level to suggest continued expansion.

Just because the Eurozone is in a recession does not doom the U.S. economy to a similar fate.

Why a recession is not likely, and the Fed has no reason to ease further

The world seems obsessed with the idea of a Eurozone collapse sparking a global recession. Capital is fleeing Eurozone banks, and seeking out the safety of the dollar, the yen, and Treasuries. It's difficult to know today what the ultimate outcome of the current Eurozone turmoil will be, and whether and by how much that will impact the U.S. economy. Should the Fed be launching another round of easing to ward off these risks?

A quick look at key market-based indicators of risk suggests that a U.S. recession is not very likely, and that there is little or no need for the Fed to do anything at this point.

10-yr Treasury yields have plunged to an all-time low of 1.5%, but 10-yr TIPS break-even rates show no sign of unusually low inflation expectations, and 5-yr, 5-yr forward inflation expectations derived from TIPS and Treasuries have actually been rising for the past 9 months and currently stand at 2.6%. This suggests that the decline in nominal yields is being driven not by declining inflation expectations—which in turn would be what we might expect if there were a need for the Fed to ease—but by sharply declining expectations for real growth. See my earlier post for more details on this theme.

Foreigners' insatiable demand for safe-haven assets that also offer a guaranteed yield is most likely the driving force behind the unprecedented low in Treasury yields, because it's hard to find evidence that the outlook for the U.S. economy is that dire. Plus, the decline in 10-yr yields began in earnest about the same time that the Eurozone financial crisis began heating up last summer, and 10-yr yields have closely tracked the decline in Eurozone equities.


The strong correlation between European economic conditions and 10-yr Treasury yields can be seen in the above chart (10-yr Treasury yields in white, and the Euro Stoxx equity index in orange). In contrast, U.S. equities have been trending higher for the past two years even as Eurozone equities have moved back to their 2009 lows. Clearly, the Eurozone is the epicenter of the world's growth and financial concerns.


I've shown this chart many times in the past several years, and it continues to be useful, because it strongly suggests that the U.S. economy is not currently at risk of a recession. What it shows is that every recession in the past 50+ years has been preceded by 1) a pronounced rise in the real Federal funds rate, and 2) by a flat or inverted Treasury yield curve. In other words, tight monetary policy has been the proximate cause of every recession in the past 50 years. Currently, we are very far from seeing either of those two conditions prevail, thus the likelihood of a near-term recession is very low.

The logic behind this chart is fairly simple. The blue line represents the real Federal funds rate, which is one of the best ways of determining whether monetary policy is tight or loose—the Fed itself uses this as a gauge of how easy or accommodative policy is. The higher the real funds rate, the tighter monetary policy is, and very tight monetary policy is main tool the Fed uses to slow economic growth and reduce inflation pressures. To judge from this chart, whenever the real funds rate exceeds 3% it's time to start worrying about a recession. Today, however, the real funds rate is -1.6%, and it has rarely been lower.

The red line measures the slope of the Treasury yield curve from 1 to 10 years' maturity, and this is another way of gauging how easy or tight monetary policy is. A steep yield curve is the result of the bond market anticipating a future tightening of monetary policy. The steeper the curve, the more the market expects the Fed to tighten in the future; by the same logic, a very steep yield curve is an indicator that the Fed is very accommodative, and can't remain that accommodative for very long before it will have to start raising rates. A flat or inverted curve, on the other hand, means that the Fed is so tight that the market expects they will have to soon begin easing, because the market senses that the economy is suffering from high real yields and beginning to slow down. Currently, the yield curve is neither extremely steep, nor flat, nor inverted. This further suggests that the Fed is not as easy as the extremely low level of the real funds rate would suggest, but they are still easy.

That is, what has happened over the past year is that the Fed has become "less easy."


Since early last summer, just before the Eurozone crisis started heating up for a second time, the yield curve by this measure has flattened by almost 150 bps; and since mid-March, it has flattened by almost 100 bps, with almost all of the flattening coming from a decline in 10-yr yields. The chart above shows the steepness of the curve in a slightly different perspective, and here it should be obvious that despite the significant recent flattening of the curve, it is still a long way from being flat or inverted. In other words, the Fed is less easy than it was a year ago, but still easy.




We can also see evidence of less-easy monetary policy in the 15% decline in gold prices since last summer, in the 11% rise in the dollar, and in the 16% decline in the CRB Spot Commodity Index. (See the respective charts above.) If the Fed were really tight, commodities would be far lower than they are today; as it is, they are still significantly above the extremely low levels of 2001. Furthermore, the dollar would be much stronger that it is today, since it is still very close to historic lows and far below the highs of early 2002. All of these sensitive indicators of monetary policy have behaved in a manner consistent with monetary policy becoming less easy and dollars becoming less abundant.


2-yr swap spreads (above chart) are a good way of measuring how tight monetary policy is. When policy is very tight, dollars are in short supply and swap spreads tend to rise because systemic risk is rising and the economy is slowing; rising swap spreads are like the canary in the coal mine, warning that dangerous conditions are approaching. Although swap spreads have increased a little of late, they are still within what might be termed the safe zone—nowhere near high enough to indicate a serious problem. Again, this is consistent with monetary policy that has become less easy, but is still far from being too tight.


Credit default swap spreads can sometimes, but not always, be a measure of how tight monetary policy is. If policy is very tight, then dollars become scarce, the economy slows, and deflation risk rises, and all of those conditions increase default risk. In the chart above, we see that default risk has indeed risen of late, and currently is at a level that preceded the last recession. But taken in the context of other indicators which suggest that monetary policy is less easy but still "easy," I think it's safe to say that the cause of the rise in CDS spreads has very little to do with U.S. monetary policy and everything to do with the problems in the Eurozone. The market is legitimately concerned about the risk of Eurozone contagion, but so far there are no signs of recessionary forces building inside the U.S. economy.

How has the Fed become less easy if they haven't announced such a change in policy? That's easy: the Fed has become less easy inadvertently, because they have not responded to an increase in dollar demand from global investors. As a result, dollars have become somewhat less abundant in the past year. Not in short supply, simply less abundant. On the margin, there has been the equivalent of a modest tightening of monetary policy, but not by enough to threaten the economy. This is a very important distinction.

What this means is that the Fed should not feel greatly pressured to implement a third round of quantitative easing. The problems the world is facing are not because the Fed is too tight (like they were in 2008, when they failed to ease in response to a huge increase in the demand for dollar liquidity, which in turn led to a 25% plunge in gold and an unprecedented surge in swap spreads), but because of the trauma facing the Eurozone countries. There is very little the Fed can or should do to address that issue; it's simply not our problem.

This is not to say that there is zero risk of a recession, but rather to say that to date there are very few signs that a U.S. recession is imminent or even likely, and almost no indication that the Fed needs to initiate another round of quantitative easing.

Check out JC Penney

I'm the typical guy when it comes to shopping: I hate it. I only go to stores that I know and like, and then only when I need something. My favorite store is Nordstrom, but I only buy things that are on sale, since I can't bear to pay $100 for a shirt that must cost them less than $10. For decades, I have gone to JC Penney only every other year, when I needed new socks and underwear.

So a few months ago, before our recent trip to Argentina, I went to JC Penney for some socks and underwear, and I was amazed at what I saw.

About a year ago I remember reading that Ron Johnson, the guy who spearheaded Apple's hugely successful retail stores many years ago, had left Apple to become CEO of JC Penney. His goal: rethink JCP's entire retail strategy. The stock jumped on the news, but then settled back down. Last January, JC Penney announced their new strategy: low prices every day, plus new brands and better selection. This boosted the stock from $35 to to $43, but then it settled back down again. Three weeks ago, JCP plunged from $34 to $26 on news that the new strategy has not produced the desired results. The company reported a first-quarter loss and suspended dividends.


Tim Travis does a good job of summarizing the rationale for buying JCP at these levels. The Street, however, is very disappointed, with many arguing that a strategy of everyday low prices just won't work—too many people are addicted to sales. In any event, I hasten to add that just about all I know about the stock can be found in this post.

What really gets me excited is that I have visited a JC Penney store about five times in the past month or so, and every time I've bought things I wasn't even looking for. This is not the store I remember, not at all. The prices (all rounded to nearest dollar, which makes me feel like they aren't trying to fool me) are extremely reasonable and in many cases unbelievably cheap. The quality is excellent, and they have the latest fashions, with lots of name-brand merchandise.

If you haven't already, I strongly recommend you visit a JC Penney store and check things out for yourself. I can't believe that great stuff for low everyday prices won't eventually be a winning formula. And for those that like sales, they have a special every month on a certain collection of things. Today I bought Father's Day stuff (all on sale: two shirts and a pair of shorts) for myself, and was stunned when I saw the total: $49, including tax. My wife thought they were fantastic. I'll be wearing them to a BBQ tonight.

I am going to be looking closely at taking a position in JCP.