Main menu

Equities rise with inflation expectations

As a follow up to my post yesterday, the chart below provides strong support for my belief that equities are responding more to inflation expectations than they are to real growth expectations. That is consistent with the monetarist view that the Fed has very little control over real growth—you can't print your way to prosperity.

The chart compares the S&P 500 to the market's forward-looking inflation expectations, the 5-yr, 5-yr forward implied inflation rate embedded in TIPS and Treasury prices.

Equities benefit from QE3 because it is likely to boost nominal GDP growth, but not necessarily real growth. Inflation is now much more likely than deflation, and future cash flows are likely to be better than expected.

This is all good news for now, but lurking in the shadows is the issue of how the Fed is going to reverse its quantitative easing in the future, and whether they can do it in a timely fashion to avoid inflation going too high.

Meanwhile, it's good to see Treasury bond yields and equities on the rise. Higher yields are symptomatic of an improved outlook.

Quick updates

The August budget numbers continue to show that tax revenues are rising much faster than spending. Over the past three years, federal government spending has risen at a very modest 1.6% annualized rate, although it has picked up a bit of late: over the past six months, spending has increased at a 5.2% annualized rate. But overall, the slow pace of spending growth in recent years is a godsend, as it has allowed government spending as a % of GDP to decline from 25.2% of GDP to now "only" 23.5%. Spending is still too high, and threatens to rise further as Obamacare kicks in and entitlement programs continue to expand. Tax revenues, on the other had, are up 5.3% over the past year and have risen at a 4% annualized pace over the past three years. If these trends continue, the budget will eventually balance and spending will shrink to an acceptable level relative to GDP. To date, the deficit over the past 12 months has been $1.26 trillion, which is down from a high of $1.48 trillion in early 2010. Thank goodness for small favors.

The number of people "on the dole" continues to decline, and that is also a good thing from a macro perspective. 18.4% fewer people are receiving unemployment insurance today than there were one year ago. This is helping to moderate federal spending, and it is creating positive incentives to find and accept jobs.

Fed stimulates inflation expectations

I didn't think they would do it (QE3), but they did. It wasn't necessary, but I presume that the FOMC was under tremendous political pressure to "do something!" So the Fed will be buying $40 billion of MBS per month for the foreseeable future, and they will also continue "Operation Twist." Their objective is to stimulate the economy, primarily by artificially suppressing mortgage rates, which in turn they hope will stimulate the housing market and thus contribute to a stronger economy. Unfortunately, to judge by key market-based indicators, all they have achieved so far is to stimulate inflation expectations.

The chart above shows 10-yr Treasury yields (the main reference point for mortgage rates) in orange, and the yield on current coupon Fannie Mae collateral (the benchmark yield for mortgage rates) in white. In the past two months, Treasury yields have risen while mortgage yields have not fallen. The spread has narrowed in favor of mortgage rates, but the level of mortgage yields has not changed. If inflation expectations continue to increase, Treasury yields and mortgage rates will rise. The Fed can't stimulate without causing Treasury yields to rise, and if they rise further, mortgage rates will have no choice but to rise as well. Rising mortgage rates will be an excellent indicator that the Fed has succeeded in stimulating the housing market. Rates could rise by a lot before they became a burden on the housing market.

The chart above shows the market's forward-looking inflation expectation (i.e., the expected average annual inflation rate over the 5-yr period beginning five years from now). This has now reached 2.85%, up from a low of 2.0% a year ago. 

This same result (higher inflation expectations) can be observed in the spread between 10-yr TIPS and 10-yr Treasuries. The average annual expected rate of inflation over the next 10 years is now 2.48%. Not unusually high, but it's clear that the market is figuring that QE3 increases the odds of higher inflation in the future. Not dangerously higher inflation, but the risks of deflation have now almost vanished, and that is presumably a good thing.

 The gold market is also treating the Fed's move as a signal for higher inflation.

How about the stock market—is it discounting stronger growth, or higher inflation? That's a tough question to answer, but my reading of the market tea leaves suggests that the stock market views QE3 as a sign of stronger nominal growth: businesses are more likely to see improvement in their cash flows in coming years. Whether than improvement comes from more inflation or more growth or both, matters little at this point. Stronger nominal growth means less likelihood of defaults, better profits on average (at least in nominal terms), and less risk of a recession or depression. On balance, the odds have shifted in favor of those who have a claim on future corporate cash flows, so stocks look more attractive. I don't think the market is yet discounting stronger real growth. Let's get nominal growth up and then we'll worry about how much of that increased nominal growth is real and how much is inflation.

I worry more about the risk that the Fed has made an exit strategy from QE more difficult, and thus I worry more about inflation rising in the years ahead. But so far, those fears are somewhat offset by a reduced risk of recession and/or deflation. It's unfortunate the Fed had to come to this, but it's premature to say it's the end of the world.

Regardless, inflation hedges just became more attractive. Seems to me that the cheapest inflation hedge right now is real estate, while the most expensive asset is Treasuries. So: buying real estate using 30-yr fixed mortgage debt (equivalent to shorting Treasuries) looks like an incredibly attractive proposition. With the banking system set to accumulate even more excess reserves, it seems inevitable that banks will want to increase their lending. At the same time, the demand for inflation hedges like real estate should be picking up, and with it the demand for more lending and thus more monetary expansion. Whether this will be good for the economy or just good for the real estate market and inflation hedges in general is a question that will be answered in the next year or two. For now it looks like inflation hedges are the better bet.

The business of the federal government is redistribution

This post builds on an excellent post by Mark Perry. Money quote: "... the federal government has become an entitlements machine. As a day-to-day operation, it devotes more attention and resources to the public transfer of money, goods and services to individual citizens than to any other objective, spending more than for all other ends combined."

Mark's charts show the composition of federal spending and taxes as a share of total spending and total taxes; mine show them as a % of GDP. Note the relatively low level of defense spending today, even though it includes all the costs of foreign wars. Defense spending is dwarfed by transfer payments.

Bond market despair

This chart shows the yield on 2-yr Treasuries, currently 0.25%. It's about as low as it's ever been, and that means that the bond market holds out very little hope for any meaningful growth in the U.S. economy for the next several years. To understand why that is the case, consider simply that the 2-yr Treasury yield is equivalent to the market's expectation for what the Federal funds rate—currently 0.16%—will average over the next two years. Market arbitrage ensures that this is so, because investors on average must be indifferent to holding cash at an overnight rate for the next two years (earning whatever the Fed funds rate adds up to), or investing in a 2-yr Treasury note and locking in the current rate for the next two years.

Expectations are running high that the Fed will engage in another round of quantitative easing given the weak growth in jobs and the generally weak nature of the U.S. economy. But even strong expectations of QE3 have failed to increase the market's confidence in the future. What they have done, however, is to increase future inflation expectations, as seen in the chart below:

The 5-yr, 5-yr forward implied inflation expectation embedded in TIPS and Treasury prices has reached 2.8%, up from 2.0% about one year ago.

In other words, the bond market believes the economy will remain very weak despite more quantitative easing, and that inflation will tend to rise nonetheless.  The bond market vigilantes are saying that more Fed ease won't help the economy, but it could hurt via higher inflation. The gold market agrees, having sent gold prices up 8% in the past few weeks. All of this should give the Fed pause. We already have $1.5 trillion of excess reserves; adding more won't make the economy stronger.

The dangers of crony capitalism

The Koch brothers are routinely vilified by the left, but they are shining examples of how hard work and informed risk taking have made the U.S. a rich and prosperous nation. They didn't build an empire by being stupid, and they didn't build it by cozying up to government; on the contrary, they built it themselves.

Some years ago I had the great privilege of visiting Koch Industries' headquarters, improbably located in the middle of a corn field outside of Wichita. After spending two hours matching wits with some senior finance people, I came away inspired. This was one of the most intense and gratifying meetings of my career, mainly because the competitive energies of this dynamic organization were palpable, and the people were driven to excel. I've been in similar situations in numerous large corporations in my life, and these folks ranked among the very best I've encountered.

In an article in today's WSJ entitled "Corporate Cronyism Harms America," Charles Koch discusses the problems that arise when businesses seek profits from government, rather than from the free market, and when government is only too happy to oblige. This philosophy ought to transcend partisan politics since it is just simple common sense. Some excerpts follow, but for a great education, do read the whole thing:

Businesses have failed to make the case that government policy—not business greed—has caused many of our current problems. To understand the dreadful condition of our economy, look no further than mandates such as the Fannie Mae and Freddie Mac "affordable housing" quotas, directives such as the Community Reinvestment Act, and the Federal Reserve's artificial, below-market interest-rate policy.
Far too many businesses have been all too eager to lobby for maintaining and increasing subsidies and mandates paid by taxpayers and consumers. This growing partnership between business and government is a destructive force, undermining not just our economy and our political system, but the very foundations of our culture.
The role of business is to provide products and services that make people's lives better—while using fewer resources—and to act lawfully and with integrity. Businesses that do this through voluntary exchanges not only benefit through increased profits, they bring better and more competitively priced goods and services to market. This creates a win-win situation for customers and companies alike.
Trouble begins whenever businesses take their eyes off the needs and wants of consumers—and instead cast longing glances on government and the favors it can bestow. When currying favor with Washington is seen as a much easier way to make money, businesses inevitably begin to compete with rivals in securing government largess, rather than in winning customers.
To end cronyism we must end government's ability to dole out favors and rig the market. Far too many well-connected businesses are feeding at the federal trough. By addressing corporate welfare as well as other forms of welfare, we would add a whole new level of understanding to the notion of entitlement reform.