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Eurozone improvements

Eurozone 2-yr swap spreads have plunged by 65 bps so far this year, and are now almost back to the levels that preceded last year's flare-up of Eurozone default worries. This tells us that the ECB has been successful in its attempts to inject needed liquidity to the financial system. The risk of major bank defaults has been sharply reduced, and that in turn brightens the outlook for the Eurozone economy. Problems still exist, of course, but the atmosphere of crisis and panic has all but disappeared. Liquid markets have an amazing ability to sort out problems, by allowing participants to distribute risk to those more willing and able to bear the risk. 

5-yr credit default swaps are an excellent indicator of the credit risk of major borrowers. As this chart shows, default risk has dropped considerably over the past year. Spain, Ireland, and Italy are now considered to be better credits than the average junk bond. They are still risky, of course, but at these levels the risks are manageable and attractive to many institutional investors hungry for yields.

The best personal computer in the world

This is my new MacBook Pro with Retina Display. I'm showing it off because it is without a doubt the best personal computer in the world right now. Lightning fast processor, solid state drive, gorgeous design, highest-quality build, and about one-third lighter than its predecessor. But what sets it apart from all the others is the display. It's like looking at a high-quality magazine with a page that's more than twice the size of the new iPad: type is crystal clear, and photos are as good as the best printer could ever deliver. You can't see the pixels: looking at any other screen, everything looks blurry.

After taking it out of the box it took me about 3 minutes to set up, and then an hour and a half to transfer 175 GB of files from my old MacBook Pro. Once the transfer finished, all my applications and files were just where they should be, and everything worked just fine.

2.6GHz quad-core Intel Core i7
Turbo Boost up to 3.6GHz
8GB 1600MHz memory
512GB flash storage
Intel HD Graphics 4000
NVIDIA GeForce GT 650M with 1GB of GDDR5 memory
Built-in battery (7 hours) 
Weight: 2 kg  
Retina display; 15.4-inch (diagonal) LED-backlit display with IPS technology; 2880-by-1800 resolution at 220 pixels per inch
Some will say that its $2800 price tag is outrageously expensive. I think it's staggerlingly cheap, since I remember my very first Mac, which I bought in 1987. It too cost about $2800, but it had a very tiny black and white screen, only 1 MB of RAM, and only 20 MB of hard drive storage. Back then a computer like this one would have been impossible to even contemplate, and you couldn't create it for all the money in the world. Everything is relative, of course, and today there are plenty of cheaper laptops that get the job done. But this one does just about anything you can imagine (even running Windows programs alongside Mac programs) in grand style. Some day all computers will have displays like this—we've been waiting decades for them, and they're finally here.

TIPS update: very weak growth, higher inflation

Time to check in on the TIPS market to see what it is telling us. By looking at the assumptions embedded in TIPS and Treasury yields, we see that the market is expecting exceptionally weak growth and/or recession for the next several years, but also higher inflation than we have currently. This is a rather amazing development, since the bond market traditionally has tended to associate weak growth with low and/or falling inflation. This tells me that the bond market is correctly evaluating the consequences of today's expansive monetary policy and oppressive fiscal policy.

To begin with, the real yield on TIPS today is very close to an all-time low. In fact, real yields on TIPS are negative all the way out to 15 years' maturity. The chart above shows the real yield on 10-yr TIPS, and I have overlaid my view of how attractive or unattractive real yields happen to be. With real yields as low as they are today, investors in most TIPS are guaranteed by the US government to lose some portion of their purchasing power every year. Looked at another way, with yields super-low, prices are super-high, and that implies very strong demand for TIPS. And very strong demand for something means that it is not very attractive from an investor's point of view.

This chart compares the real yield on 10-yr TIPS to the nominal yield on 10-yr Treasuries. The difference between the two is the market's "break-even" or implied annual inflation rate over the next 10 years. Here we see that both TIPS and Treasuries enjoy exceptionally strong demand, because their yields are both very close to all-time lows. However, the market's expected rate of inflation is about average: 2.3% for the next 10 years, which is only slightly less than the 2.4% annualized CPI over the past 10 years. From this we can deduce that although TIPS are very expensive—trading very close to all-time high prices—it's not because investors fear inflation. Inflation expectations today are quite normal.

With this next chart I try to show how the real yield on 5-yr TIPS tends to track the economy's real growth rate over time. In the late 1990s, economic growth rates were very strong, and TIPS yields were extraordinarily high. That made perfect sense, because the real yield on TIPS had to be competitive with the real return on other securities, and other securities were delivering fabulous real returns because the economy was so strong. Today it's just the opposite. Real yields are low because the market expects economic growth to be very weak; as this chart suggests, the real growth expectations driving 5-yr TIPS are likely somewhere in the neighborhood of 0-1% on average over the next 5 years. There is so much fear about the future out there in the market that investors are happy to lock in a guaranteed loss of purchasing power with TIPS because they believe that the return on alternative investments will be much worse, and that is what one would expect if the economy were indeed to grow less than 1% per year over the next five years.

This next chart shows my calculation of the 5-yr, 5-yr forward expected inflation rate embedded in TIPS and Treasury prices (Bloomberg's calculation of this rate today is 2.74%, mine is 2.67%). Think of this as what the market's 5-yr inflation expectations will be, five years from now. Since the 10-yr expected rate is 2.3% and the expectation for the second half of the next 10 years is 2.7%, that means the market expects inflation to average just under 2.0% over next five years.

Contrast the situation today (super-low real and nominal yields) with conditions at the end of 2008 (low nominal yields, relatively high real yields). Back then, the market feared deflation more than anything else (the 5-yr, 5-yr forward expected inflation rate was less than 0.5%), and demand for TIPS was very weak. But today, the market fears very weak growth more than anything else, which is why both TIPS and Treasury yields are extremely low. On the margin, the market has been worrying more and more, over most of the past year, that inflation could creep up at some point in the future, even as the market has been worrying that the economy will be weaker.

To be in a situation where market expectations call for very weak growth for as far as the eye can see, while at the same time expecting somewhat higher inflation is remarkable, because it refutes the traditional Phillips Curve mentality that says inflation goes up only when the economy is very strong, and goes down when it is very weak. This is one more blow to Keynesian-type thinking, and I say good riddance.

In my view, the bond market is correctly evaluating the implications of today's very accommodative monetary policy coupled with today's very oppressive fiscal policy, and concluding that on the present track, we are heading towards a very weak economy with somewhat higher inflation.

Just because the deficit is still huge as a percent of GDP does not mean fiscal policy is expansionary. On the contrary, as Milton Friedman always taught us, it is the level of government spending more than anything else that is the important fiscal variable to watch. Whether a given level of spending is financed by borrowing or by taxes is not as important as whether the government is commandeering too much of the economy's resources. With federal spending currently running about 23.5% of GDP (12% higher than the 40-year average of 20.9%), I think spending (the bulk of which is transfer payments from the most productive members of society to the less productive) is too high and it is acting as a headwind to the economy's ability to grow. The government is wasting a significant portion of the economy's resources that could be better utilized by the private sector, in addition to creating perverse incentives.

All of the above adds up to one more reason why I continue to insist that the market is priced to very pessimistic assumptions, e.g., the Fed is going to make an inflationary mistake and there is very little chance that our bloated federal government will become less oppressive. If you agree with the market, then you stay in cash on the sidelines, and/or you buy TIPS and Treasuries in case things turn out to be even worse. If you think there is a chance that things could improve even just a little bit, then you avoid cash, Treasuries, and TIPS, and you invest in just about anything else: stocks, corporate bonds, and real estate. I exclude gold and commodities from this list, because I think they are priced to a very big inflationary mistake on the part of the Fed. If the Fed manages to keep inflation below 3-4% for the foreseeable future, then I would expect to see gold prices decline significantly, and that would imply very little, if any, upside potential for commodities.

More evidence of a housing recovery

Sales of new homes in July were a bit stronger than expected (373K vs. 365K), and they were up 36% from last year's low. That's pretty impressive, even if the current sales rate is still miserably slow. The signs on the margin of genuine improvement in the housing market abound. After 6 years of a wrenching adjustment, this market is back on its feet and improving.

Claims data shows no sign of recession

Real-time, market-driven data such as Treasury yields and swap spreads are arguably the best things to watch for clues to the economy's health; they can't be manipulated, they embody the collective wisdom of millions of market participants, they aren't subject to faulty seasonal adjustment, and they are never revised after the fact. The next best thing are weekly statistics (high-frequency data), with initial claims for unemployment being arguably the best. Claims data comes with a 1-2 week lag, and sometimes is subject to faulty seasonal adjustment, so it's not perfect, but it is very timely compared to many other statistics.

As these two charts show, as of a week ago there was no sign whatsoever of any deterioration in the labor market. On an adjusted basis, weekly claims have been relatively flat so far this year; on an unadjusted basis, claims last week were 10% below their year-ago level. If the economy were healthier, claims would be lower—we would be seeing numbers in the 300-350 range, instead of the 350-390 range that has prevailed this year. But that's not a huge difference. If the economy were tipping into recession, we would be seeing claims rising, but that's not the case at all.

Meanwhile, the number of people receiving unemployment insurance benefits continues to decline: down 17% in the past year, or 1.1 million fewer people. This means that there is an ongoing improvement in the incentives that the unemployed have to find and accept jobs. Unemployment insurance is a nice "safety net," but the truth is that getting a weekly check for not working reduces one's incentive to find another job, especially if the new job pays less than the old job. Unfortunately, recessions happen when the economy's resources are no longer being efficiently utilized—when resources such as labor have to be shifted from one are to another, or adjust to new pricing realities. In short, unemployment claims retard the recovery process because people naturally resist taking a new job for less pay than they received before. So it's good to see the ongoing decline in the number of people receiving claims.

Claims data shows no sign of recession and is consistent with an economy that continues to grow, albeit slowly.

Why a QE3 won't be good for bonds

Today the bond market got excited because the minutes of the July FOMC meeting reflected strong support for another round of Quantitative Easing should the economy fail to improve. 10-yr Treasury yields fell over 10 bps on the day, in apparent anticipation of more Fed purchases of Treasuries. This type of knee-jerk reaction is bound to end in tears, however.

As the above chart of 10-yr Treasury yields shows, the bond market's enthusiasm for past episodes of quantitative easing was short-lived. The first phase of QE1 was announced Nov. 25, 2008, and it consisted of up to $100 billion in Agency securities and $500 billion of MBS. In the early stages of QE1, 10-yr yields declined almost 100 bps, but only for 5-6 weeks. (I think Fed purchases were overwhelmed by the widespread fears of a global financial collapse.) By late January, when the Fed announced the purchase of more Agency and MBS debt, and the expectation of the purchase of long-term Treasuries, yields had jumped back up. On March 18, 2009, the FOMC formally announced the expansion of the program to total $1.25 trillion of MBS and $300 billion of longer-term Treasuries. Despite these massive and unprecedented purchases, 10-yr Treasury yields marched steadily higher, and didn't peak until the end of QE1 in late March, 2010. Yes, that's right: yields rose until the time the Fed stopped purchasing bonds.

The idea of QE2 was first floated by Bernanke in late August 2010, when 10-yr yields were around 2.65%. By the time QE 2 became official, with the FOMC announcement of Novermber 3, 2010, 10-yr yields had fallen by a about 15 bps, to 2.5%. As QE 2 was implemented over the next six months, with the Fed purchasing an additional $600 billion of Treasuries, not only did yields fail to decline, they actually rose by 100 bps.

In short, the anticipation and the reality of two major rounds of Fed purchases of MBS and Treasuries only served to depress yields temporarily. The major impact of QE1 and QE2 was to drive yields higher, even though the Fed justified its efforts by asserting that Quantitative Easing would drive yields lower, and that in turn would stimulate the economy. Furthermore, this short history of aggressive Fed intervention provides no evidence whatsoever to support the notion that the Fed has artificially depressed Treasury yields. If anything, two rounds of QE only pushed rates up.

So why did massive bond purchases not only fail to drive bond prices higher and yields lower, but produce exactly the opposite of the Fed's intended result?

The short explanation is that QE1 and QE2 pushed yields higher because they were just what the markets and the world needed. The first two rounds of quantitative easing helped address deep-seated issues that were creating a scarcity of dollar liquidity, which in turn was holding back the economy and threatening deflation. Note in the chart above how QE1 and QE2 followed periods in which core inflation fell to very low levels—a sign of a shortage of money—and the Fed was very determined to avoid the threat of deflation. The demand for money was intense, and the Fed's aggressive provision of bank reserves satisfied that demand. (Bank reserves, since they now pay interest, are functionally equivalent in the eyes of banks to 3-mo. T-bills, universally regarded as the world's safest and most liquid asset.) Quantitative easing provided much-needed liquidity to the economy and to the markets, and it was a stronger economy and the reduced risk of deflation that in turn boosted yields.

But will QE3 work the same way? 10-yr yields are down almost 150 bps since the end of QE2. Some of that decline could be due to Operation Twist (which involved the sale of short-term Treasuries and the purchase of longer-term Treasuries), but I think it's more likely that yields have declined because economic growth has slowed. However, today core inflation is not unusually low, and inflation expectations, such as the 5-yr, 5-yr forward breakeven rate embedded in TIPS and Treasury prices, have been rising for most of the past year, currently standing at 2.75%.

Conditions today are quite different from what they were leading into QE1 and QE2. The economy is weak, as before, but this time the threat of deflation is quite remote. Swap spreads are very low and credit spreads are relatively low, which suggests that the economy is not suffering from a shortage of liquidity. Although gold and commodity prices are off their highs of last year, they are still way above the levels of 10 years ago, when deflation fears first surfaced, and far above the lows of late 2008 when deflation was a again a real threat. If anything, commodity prices have risen so much more than the general price level in the past 10 years that they are probably contributing to inflation.

So if the Fed proceeds with QE3 later this year, it won't be because the economy is suffering from a shortage of liquidity, or because deflation is a real threat. It will simply be because the Fed thinks—or hopes—that additional purchases of bonds will help strengthen the economy. Long-time readers of this blog will know that I don't believe that monetary stimulus can result in stronger growth. Monetary policy can remove barriers to growth, as we have seen with QE1 and QE2, but it can't create growth out of thin air. So if we do see a QE3, then this time I think its effects will be mainly to push inflation higher. And of course, higher inflation is very likely to drive bond yields higher.

So if we do get QE3, don't expect bond yields to decline—expect them to rise.

Apple becomes the most valuable company of all time

My first post on the subject of Apple vs. Microsoft was in October '08, when I predicted that AAPL would surpass MSFT in market cap within a few years (AAPL was trading around 100 then). Well, they did that in mid-2010, and now they have achieved yet another milestone: Apple's market cap ($621 billion as of this writing) now exceeds Microsoft's all-time high, which at the time (late 1999) was the highest market cap ever achieved. Apple is now the most valuable company of all time. This has got to be the greatest David vs. Goliath corporate story of all time. The chart tells it all.

I have made numerous posts on Apple over the years, always of the bullish variety. I remain bullish on AAPL, but have cut the size of my position for reasons of prudence and diversification. Obviously, AAPL can't continue to post such outsized gains forever. But I don't see why it can't continue to grow, especially since Apple's share of the PC market is still relatively small. Morever, although Apple has a very healthy share of the global smartphone market, smartphones still represent only a relatively small share of the global mobile phone market. There is lots of room to grow, and Apple still has the best products in its class and can still claim the mantle of world's most innovative company. New products are in the pipeline and it will be very exciting to see whether and how Apple can revolutionize TV as we know it.

I'm looking forward to upgrading to an iPhone 5 next month, and will be receiving a new MacBook Pro with Retina Display later this week.