Main menu

Eurozone update: it's not as bad as many think

With markets swooning yet again over eurozone fears, it's time to revisit spreads and yields for a look at just how likely a default or disaster is likely to be, according to market pricing. As should be apparent, the fears are much worse than the facts.

First, a look at 2-yr sovereign yields, which are a decent barometer for the likelihood of a near-term default. What stands out in this chart is how much things have improved in Portugal and Ireland. It was almost exactly one year ago that yields on Irish and Portuguese debt exploded skywards. Since then they have settled back down quite a bit, with Ireland now trading through Spain and approaching Italy. Who would have thought there could be such a dramatic change in Ireland's fortunes? (It helps that Ireland has been serious about reining in government spending while keeping tax rates as low as possible.) Portugal was thought to be a basket case sure to follow in Greece's footsteps, but Portuguese debt spreads now trade within the realm of high-yield corporate debt: 5-yr Portuguese CDS spreads are about 800, with the average high-yield spread being 580.

Another thing to focus on is the amount of outstanding debt in each of these countries. At $900 billion, Spain's debt is a serious chunk of change. Spanish debt is trading between 70 and 90 cents on the dollar, so the market has already priced in something like a 20% default. If Spain goes all the way over the cliff, its debt might suffer a 70% haircut in a worst case scenario (Greek debt has suffered a loss of about 85%), which would mean wiping out an additional $450 billion of debt. But: would that be enough to bring on the end of the world as we know it? Considering that there is something like $50 trillion of debt in the world, so even a disastrous Spanish default would be only a drop in the bucket.

And as I argued a year ago, the money that the Spanish government borrowed was long ago wasted. Whether the government ends up defaulting on its debt or not, serious losses have already been incurred because the money was effectively squandered. In a true economic sense, the losses are water under the bridge. All that remains to be seen is who will be stuck with writing off the losses on their balance sheet. So the angst over potential debt defaults is overdone, and the reality of a default is likely to be much less awful than most people imagine.

Eurozone 2-yr swap spreads are now back to where they were about a year ago, and down significantly from the highs of late last year. This represents a substantial improvement in the health of the Eurozone financial markets and banks' liquidity. This is not at all consistent with fears that a Spanish default could bring down the eurozone banking industry. Moreover, euro basis swap spreads are closing in on relatively healthy territory, suggesting that Eurozone banks have reasonably good access to dollar liquidity. Spreads are still elevated, to be sure, but nothing here is even close to suggesting a near-term collapse. Meanwhile, U.S. swap spreads remain low, with financial markets in the U.S. clearly avoiding any Eurozone contagion.

Finally, although the euro has been falling in the past year, it is hardly a catastrophic decline. As the first chart shows, the euro is now equal to its average against the dollar since the euro's inception. And according to my estimate of purchasing power parity, the euro is still somewhat overvalued against the dollar. This is not what you would expect to see if the eurozone were on the verge of disaster.

Let's end discrimination

When I was in sixth grade, back in the mid-1950s, I was taught that the color of one's skin didn't make any difference, that we were all the same. It made sense to me, and I brought up my own children to understand the same. At some point in the future, I explained, all the races and all the ethnicities would be commingled—it is inevitable given the ease of travel in modern society. Yet here we are, over 50 years later, still taking census counts of how many of us are white, brown, black, or whatever. We keep insisting on identifying our racial origins, and classifying ourselves by language, religion, and sex, but to what end? If we are going to stop the discrimination, we need to stop the counting and the classifying. Aren't we all just Americans? Free to pursue our own vision of happiness?

The Democrats are hell-bent on raising taxes on "the rich" but not the middle class, even though higher taxes on the rich would only amount to a fraction of our current $1.2 trillion deficit, and even though the hardest-working of the middle class would likely aspire to be rich some day. The Republicans want to avoid raising taxes on anyone, arguing that this might endanger the fragile recovery. Unfortunately, both parties are missing the more important point: using the tax code to discriminate between one person and another is just plain wrong.

It's wrong to discriminate on the basis of race, color, ethnicity, or religion, and it's just as wrong to discriminate on the basis of one's income or capital gains. It's wrong to discriminate on the basis of whether a couple is married or not, or whether they have children or not, or whether they rent or own their home, or whether they make more than $250,000 or not. We need to greatly simplify our tax code by not discriminating on the basis of anything. We need to make sure that everyone has an equal opportunity to succeed, but we need to stop punishing those that do and stop rewarding those who don't.

If the tax code distributes favors to every favored interest group, at the expense of any minority group, we only end up being a nation of special interests pitted against each other.

The more we discriminate on the basis of anything, the more incentive our politicians have to pander to special interest groups, and the more divided we become. This will be the death of us if we don't stop it.

Claims update

Weekly claims jumped last week, but only on a seasonally-adjusted basis. This confirms widespread suspicions that faulty seasonal adjustment factors (i.e., reality not conforming to assumptions, with the focus here being on the timing of scheduled auto industry layoffs) were behind the huge drop in claims the week before. What we are left with is a modest uptick in claims that is of the sort that happen now and then, and it probably has something to do with the fact that economic growth slowed in the second quarter.

Meanwhile, the number of people receiving unemployment insurance continues to decline: there were 15.8% fewer people on the dole last week than there were a year ago. This could well be the more important number to focus on, since it means that there are more and more people losing their unemployment benefits and thus gaining a new-found motivation to look for and accept employment—perhaps a less-than-ideal job, but a job nonetheless. Changes on the margin like this can be good for the economy down the road.

Housing starts up over 40% in past 18 months

This chart provides good evidence that housing starts have turned up in a big way. Since Dec. '10 (which I've marked with a green line), starts are up 41%, or at a 25.7% annualized rate. Of course, the level of starts is still miserably low (they fluctuated between 1 and 2 million from 1968 until the current recession), but the gain in the past year or so has been signficiant. The recovery in residential construction is upon us, and it is for real.

The Fed has no reason to ease further

This morning, markets were a little disappointed that Fed Chairman Bernanke failed to pledge more monetary ease, despite increasing evidence that economic growth has slowed in recent months. As I see it, there is no reason for the Fed to do anything, so Bernanke did the right thing. There is nothing wrong with inflation or inflation expectations, so there is no need for the Fed to do anything different at this point.

June Consumer Price Inflation came in as expected. Although the headline number has fallen at a 0.8% annualized pace in the past three months, the core CPI continues to register inflation that is comfortably at or above the upper end of the Fed's target. The chart above shows the 6-mo. annualized pace of core inflation, and also highlights the times when the Fed began to undertake a significant quantitative easing policy. Clearly, a substantial decline in core inflation encouraged the Fed to act, in an effort to forestall deflation, which has been Bernanke's Public Enemy #1 for years. With core inflation now running at a 2.4% pace over the past six months, the threat of deflation is nonexistent, so there is no reason for further monetary ease. And as my earlier posts today noted, the housing market is continuing to improve and industrial production continues to expand. Where's the problem that warrants still more expansive monetary policy?

This next chart shows the nominal yield on 5-yr Treasuries, the real yield on 5-yr TIPS, and the difference between the two, which is the market's expectation for the average annual gain in the CPI over the next 5 years (i.e., "break-even inflation"). Note that near-term inflation expectations by this measure have been fluctuating between 1.5% and 2.5% for the past 30 months, with the current number being 1.8%. This is consistent with the view that the market expects the headline CPI to pick up over the next year or so, and that is particularly likely now that energy prices have stopped declining.

The chart above shows the Fed's preferred measure of inflation expectations: the 5-yr, 5-yr forward break-even inflation rate. The preceding chart shows that the market expects inflation to average 1.8% from mid-2012 through mid-2017, and the chart above shows that the market expects inflation to average 2.6% from mid-2017 to mid-2022. Again, no sign of any deflation threat here, and every reason to think that inflation will be on target, so no need for the Fed to do anything.

TIPS spreads such as I've posted here are important and reliable gauges to market inflation expectations, and they are rationally linked to the facts on the ground. They deserve attention.

If nominal Treasury yields were artificially depressed, because they are the object of global investors' affection and the object of the Fed's quantitative easing efforts, then the spread between TIPS and Treasuries should be artificially depressed as well. But on the contrary, we see that the spread (the break-even inflation rate) is behaving quite normally; the market has bid up TIPS prices in line with rising Treasury prices. That is very important, since it means that the decline in both real and nominal yields is not driven by declining inflation expectations, but by declining growth expectations. Once again, we see that current conditions do not point to any need for the Fed to take further action. Today's problems are not about inflation or monetary policy, they are about growth, and monetary policy has no power to conjure growth out of thin air as long as there exists no risk of deflation.

This next chart confirms this, since it shows that real yields on TIPS have declined in line with the slowing growth of the U.S. economy. As I see it, the current level of 5-yr TIPS yields is saying that the market is expecting real growth in the U.S. over the next few years to be close to zero. If we do indeed experience zero growth in coming years, then there will be lots of companies that are struggling to survive, and that will pose real problems for equities and corporate bonds. In order to avoid likely losses, investors are willing to sacrifice 1.2% of their future purchasing power (which is what a real yield of -1.2% on 5-yr TIPS implies) in order to enjoy the no-default-risk safety of TIPS. That is rational.

The future growth of the U.S. economy is now in the hands of our politicians in Washington, who need to remove barriers to growth, reduce the size and scope of government, and reform the tax code by broadening the tax base and keeping tax rates as low and as flat as possible.

Industrial production continues to increase

June Industrial Production was close to expectations and rose to a new post-recovery high. Manufacturing Production (which excludes utilities from Industrial Production) posted a 0.7% gain which largely offset earlier weakness. While neither series shows very impressive growth in recent months, neither is there any sign here of a decline or impending recession. Economies aren't like businesses, which can go into decline if they fail to thrive. Economic growth can slow, as it has in recent months, but that does not mean it must eventually decline. As the bottom chart above shows, manufacturing growth has slowed down a number of times in the past without there being a subsequent recession. And despite the recent slowdown, year-over-year gains are still reasonably healthy: 4.7% for Industrial Production and 5.6% for Manufacturing Production.

UPDATE: As reader "brodero" notes, production of business equipment, a good indicator of business confidence and likely a leading indicator of future productivity gains, is up at strong, double-digit rates over the past 3, 6, and 12 months (13.7%, 14.7%, and 12.7%, respectively). This is a very healthy sign.

Still more evidence of a housing recovery

Many observers of the housing market keep insisting that we have yet to see the bottom, arguing that 1) there is still a ton of foreclosed homes in banks' inventories, 2) there are still millions of delinquent mortgages, many of which will likely end up being foreclosed, 3) it is still difficult for buyers to qualify for financing, 4) unemployment is still very high, 5) consumer confidence is still low, and 5) the Fed is artificially propping up the market by depressing the Treasury yields that drive mortgage rates.

I am not arguing that these facts are untrue; the housing market is still very clearly depressed. But I do think the evidence of improvement is becoming quite clear. In the past year we have passed an important inflection point in the housing market: instead of deteriorating further, conditions are now improving on the margin, even though they are still far from being healthy.

This chart shows the results of the NAHB/Wells Fargo monthly survey of home builders' perceptions of current single-family home sales and sales expectations for the next six months. The survey also asks them to rate the traffic of prospective buyers, and then seasonally adjusts the results. A reading of 50 indicates that more builders view conditions as good than poor. So the July reading of 35, which significantly beat expectations of 30, indicates that conditions are still far from "good," but definitely getting less "poor." This is a very important and positive change on the margin, even if overall conditions are still not very good.

This chart shows an index of the price of major homebuilders' stocks. It is up 68% from last year's low, and up 166% from its 2009 recession low. The market, always forward-looking, says we saw the worst of the housing market a long time ago, and is confirming the view that conditions in the housing market, while still depressed, are improving on the margin.

Meanwhile, the Radar Logic measure of home prices, which reflects the average cost per square foot of homes sold in 25 metropolitan areas with a 63-day lag, now shows that prices on May 15th were unchanged from a year ago. Before prices start rising, they have to stop falling.