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Eurozone continues to make progress



Here's a quick update on some key measures of systemic risk in the Eurozone. Swap spreads in Europe have been declining all year, and although they remain somewhat elevated, they tell us that the ECB has managed to restore a good deal of liquidity to the banking system. Liquid markets are essential to an economic recovery. U.S. swap spreads remain very low, a testament to how much the U.S. economy has avoided Eurozone contagion.


The Eurozone has yet to solve its underlying problem (excessive spending), but as this chart of 2-yr sovereign yields shows, the risk of large and potentially disruptive defaults has receded significantly.

The economy continues to avoid another recession

Second quarter GDP was undeniably weak (1.5% at an annualized pace), but the more important news is that the economy continues to grow. With the market priced to dismal expectations (e.g., 10-yr Treasury yields at 1.4%, PE ratios below average despite record-setting profits, real yields on TIPS deep in negative territory) all it takes to cheer the market is evidence that the economy continues to grow and continues to avoid a recession.


GDP was upwardly revised a bit over the past three and a half years, but as the chart above shows, the economy is still about 12% smaller than it could have been if we extrapolate from the growth trend over the past 50 years. That 12% "output gap" translates into roughly a $2 trillion shortfall in national income—that's an awful lot of money and jobs that have gone missing. This is a real national tragedy, that we have experienced such a weak recovery. If there is a silver lining to this dark cloud, it is that we now know that running up annual deficits of well over $1 trillion per year (equivalent to a whopping 9% of GDP each year on average) for the past three years hasn't managed to help the economy at all. Indeed, it's likely that the deficits are to blame for most of the underperformance, because they served mainly to redistribute income and finance a lot of wasteful and unproductive spending (e.g., Solyndra et. al.). In other words, the government spending multiplier is probably negative; we would have been much better off without all that "spending."




One other important piece of news is that despite the economy's unprecedented (in modern times) output gap, inflation remains positive, and still close to the upper bound of the Fed's target range. Keynesian theory has thus suffered a double body blow in this recovery: government spending is not necessarily stimulative, and weak growth is not necessarily deflationary.


Indeed, even as economic growth has slowed this year, from a 4.1% annualized rate in Q4/11 to 1.5% in  Q2/12, forward-looking inflation expectations (as shown in the chart above, which plots the implied 5-yr, 5-yr forward inflation expectations embedded in TIPS and Treasury prices) have been rising, albeit modestly.

Capex remains flat


New orders for capital goods, a good proxy for business investment, have been flat for the past year. This is somewhat discouraging, since it points to a lack of confidence on the part of businesses, and it portends reduced productivity growth in the future. But it's not necessarily a precursor to a recession. If anything, it simply reflects the well-known fact that the economy has been growing very slowly for the past few years, and it suggests that growth is likely to remain disappointingly slow for the rest of the year. No surprise.

Even though the lack of robust growth and the still-high unemployment rate are deeply disappointing, it remains the case—as I have been pointing out continuously for the past three and a half years—that the economy has been doing better than expected. The only thing that moves markets is the unexpected; if the market expects a recession but instead the economy grows a measly 1-2%, that is a positive. I've argued repeatedly that the market has been priced to very weak and even recessionary conditions, as reflected, for example, in the extremely low level of Treasury yields and the below-average level of PE ratios at a time when corporate profits have been extremely strong. So if the economy continues to grow slowly and avoids a recession, then equity prices are likely to continue to move higher.

Claims update: still positive



Weekly unemployment claims have been erratic in recent weeks, a sure sign of seasonal adjustment problems. It now looks like the typical auto industry layoffs that occur in July have been fewer than expected, so in a few weeks we should see the true underlying trend reassert itself, and it will likely prove to be still downwards. Although the number of people receiving unemployment insurance (second chart above) has ticked up in recent weeks, on a year over year basis (which eliminates seasonal variations) it has been declining at about a 15% rate for most of this year.

On the margin, these timely indicators of the health of the economy continue to be positive. As the chart below suggests, the gradual improvement in the level of weekly claims has been helping to guide the equity market higher.


The global yield plunge


As this chart shows, refinancing activity has been very strong and on the rise since early last year. I should know, as we are just finishing our second refi in the past 12 months. With a new 30-yr mortgage, our monthly payments will now be almost 30% less than they were a year ago. That frees up cash for all sorts of things, and if rates ever go back up, I'll feel like I've won the lottery. And if they should continue to fall, well then, I'll just refinance again. I keep thinking that someday I'll look back and congratulate myself for locking in a historically cheap rate (and tax deductible too!) on 30-yr money. There might never be another opportunity to borrow money at a fixed, after-tax cost of only 2-3%.

The other side to this coin is that the person lending me the money has seen a big reduction in his interest income. Actually, there is a massive amount of money all over the world that is being forced into lending at lower and lower interest rates. Most mortgages can be refinanced relatively easily when rates fall, but when rates rise, mortgages turn into long-maturity bonds because homeowners have a disincentive to move or refinance. Lenders thus see their MBS holdings behave like short-term deposits when rates fall, and like long-term bonds when rates rise—it's a painful experience.


And it's not just in the U.S. that yields have collapsed. As the first chart above shows, 10-yr sovereign yields in the U.S. and Germany are rapidly approaching the super-low level of Japanese yields. Who would have believed this could happen? I've been dead wrong on my prediction several years ago that Treasury yields would be much higher than they are today. And it's not because inflation has dropped or that deflation threatens; inflation expectations embedded in TIPS and Treasury prices are firmly in the range of 2 - 2.5%, which is very much in line with what inflation has been over the past 10-15 years.


The yield on 10-yr Treasuries, which is the principle driver of fixed mortgage rates, is down not because the Fed has engaged in quantitative easing or "operation twist," but because yields everywhere are falling.


The world's major central banks are the proximate driving force behind the global yield plunge. As the chart above shows, they have pegged short-term rates to near-zero for over three years, and no one even hints at raising rates anytime soon. Why? Because markets and central bankers all believe that global growth is going to be very disappointing, and easy money is believed to be the only policy lever that might work to stimulate growth. Fiscal "stimulus" spending has been tried and it has failed. But never mind: as Treasury Secretary Geithner made clear in a speech today, "The economy is not growing fast enough. Unemployment is very high. There's a huge amount of damage left in the housing market. Americans are living with the scars of this crisis. The institutions with authority should be doing everything they can to try to make economic growth stronger ..."

Central banks can influence bond yields by the manner in which they target short-term interest rates and future expectations of short-term interest rates: if they say, as they have done for years now, that short-term rates will be kept low indefinitely in order to combat pervasive economic weakness, then yields all across the maturity spectrum will experience a strong gravitational pull downwards. The only thing that can push rates up is faster growth and/or a reversal of demands for policy stimulus.

What the history of low rates and disappointingly slow growth should tell us, however, is that easy money (e.g., very low short-term interest rates) doesn't stimulate growth. How are low interest rates going to create jobs, when fiscal deficits are gobbling up a gigantic amount of the global economy's resources? (One easy illustration of this is the billions of dollars that the U.S. government has poured into "green" industries that have yet to produce anything profitably.) In the U.S., our federal deficit has effectively absorbed every dime of total after-tax corporate profits for the last several years. Keeping interest rates low only facilitates government borrowing, while at the same time transferring wealth from savers to borrowers.

It's become a vicious circle of sorts: government spends more than it takes in and borrows the difference; excessive spending weakens the economy because much of it takes the form of transfer payments and inefficient spending; the weak economy prompts central banks to keep rates low; and lower rates facilitate more wasteful borrowing. Meanwhile, savers accept the lower rates because they have no confidence that things will improve; witness the huge, $2.3 trillion increase in savings deposits in the U.S. in the past four years that pay almost nothing.

Lower interest rates aren't going to stimulate the economy. They are better thought of as barometers for how weak the economy is perceived to be. This is not going to change in any meaningful way until policymakers—with the prodding of markets—realize that the way to get out of this vicious circle is to cut back on the size and scope of government. The sound and fury coming out of the Eurozone these days is all about this: governments and their constituencies fighting the efforts of markets to impose healthy fiscal discipline. The only countries where yields are rising are the ones (e.g., Spain) where markets see that spending and borrowing are on a collision course that can only end in tears. Fortunately, the bond market vigilantes have driven Spanish yields up to levels that will make it very difficult for the government to avoid the inevitable cuts in spending. This is how it should be.

The message of TIPS: extremely weak growth ahead


If you had been stranded on a desert island for the past 10 years and the first thing you saw upon returning to civilization was the chart above, you would most likely figure that dollar inflation must be very high. Why? Because with the real yield on TIPS at its lowest level ever, and firmly in negative territory, you would know that the price of TIPS was at a record high level; and from there it would follow that if investors were willing to pay an unprecedented price for TIPS, then the inflation protection afforded by TIPS must be in very high demand, and therefore inflation must be very high and/or threatening to be very high.

But you would be wrong.



As these two charts show, the expected rate of inflation that is priced into TIPS and Treasuries is relatively low and very normal. The top chart shows the break-even expected rate of inflation over the next 10 years, and it is the difference between the nominal yield on 10-yr Treasuries and the real yield on 10-yr TIPS. The bottom chart shows the 5-yr, 5-yr forward expected rate of inflation, as derived from the pricing of 5- and 10-yr Treasuries and TIPS, and as calculated by Bloomberg. This measure is also the Fed's preferred measure of inflation expectations, and it reflects what investors expect inflation to average over the period 2017 through 2022. The 10-yr expected rate of inflation is now 2.12%, and the forward expected inflation rate is 2.65%. Both compare very favorably to past inflation: the CPI has risen at a compound rate of 2.6% over the past 2 years, 2.0% over the past 5 years, and 2.4% over the past 10 years. Nothing unusual at all about these numbers.

So if the real yield on 10-yr TIPS is at amazingly low levels, but inflation expectations are very normal, what then does the top chart tell us? Actually, it tells us nothing, since to fully understand the message of TIPS pricing you have to also know the price of Treasuries of comparable maturity. That's what the second and third charts in the post show. If TIPS are extremely expensive, but inflation expectations are normal, then the real message is that interest rates in general (both real and nominal) are extremely low. And why are interest rates in general extremely low? The only logical answer is that investors believe that the outlook for the future is very weak growth and average inflation for as far as the eye can see. Very weak growth, as in the weakest growth we've seen on average in my lifetime.


So TIPS aren't really saying anything unusual about the outlook for inflation, but they are saying that the outlook for growth is dismal. Investors are buying TIPS with the full knowledge that they are going to give up purchasing power (as a direct consequence of negative real yields) in the future in exchange for the default-free nature of TIPS (with the exception of TIPS maturing more than 20 years from now, since those real yields are still marginally positive, as seen in the chart above). You buy TIPS today because you figure you would rather lose purchasing for sure, rather than risk losing even more by buying virtually anything else, or even by just holding on to cash or currency.

The message of TIPS is that the market has an extremely pessimistic outlook for the future: pessimism rules. Which of course means that you don't have to be very optimistic about the future to be a bull these days.

UPDATE: I should add that I continue to expect the economy to grow, albeit at a relatively slow pace. Although this would leave the unemployment rate very high, and jobs growth relatively low, I believe my outlook places me well to the optimistic side of the dismal expectations built into current market prices.

Plus, my comment from below bears repeating here: "If the high prices of TIPS reflected huge demand for inflation protection, then Treasury prices would have to be much lower, and the spread between TIPS and Treasury yields would have to be much higher. In other words, we would have to see relatively high inflation expectations if the demand for inflation protection were relatively high. But that's not the case.

Moreover, the extremely low level of all interest rates, coupled with inflation expectations that are simply average, can only be intrepreted to mean that the bond market is effectively expectating economic growth to be extraordinarily weak for as far as the eye can see. Rates are low because the economy is expected to be very weak, and the market rationally expects that very weak growth will force the Fed to keep rates very low for a long time.