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Federal budget numbers continue to impress

Bringing with them the close of FY 2012, September budget figures were encouraging. The deficit fell to just under $1.1 trillion, thanks to increased revenues—up 6.4% from the prior fiscal year—and a reduction in spending—down 1.7% from the previous fiscal year. These numbers reinforce the trend we have seen since the current recovery began: spending growth has been minimal, but revenues have continued to expand as the economy has grown and jobs have increased. 


The above chart shows the 12-mo. rolling sum of federal spending and revenues. Note that spending is almost unchanged since the recession ended, whereas revenues have risen significantly, and without the help of any tax hike. In fact, revenues have increased despite tax rate decreases, since there has been a partial payroll tax (FICA) holiday in effect for most of the past two years.


This next chart shows the same numbers as the first, only relative to GDP. Here we seen a welcome decline in spending, and only a meager increase in revenues.


The federal deficit as a % of GDP has declined significantly from its 10.5% high in late 2009 to what is now about 7%. This is very good news, since deficits above 9% of GDP can quickly become destabilizing.

If these trends continue, the deficit will continue to decline without any need for higher taxes.

The sad part of the story is that the federal deficit, which has totaled almost $5 trillion since the end of 2008, has effectively absorbed almost all of the after-tax profits (which have set all-time records) of U.S. corporations over the same period. Corporations have worked extremely hard to be productive and profitable, only to have the fruits of their labors in large part squandered by profligate government spending, which for the most part consisted of transfer payments (not to mention countless billions lavished on "green" industries that have since gone bankrupt). This is the simplest answer to the question: "why has this recovery been so weak?" If the fruits of the economy's labors are not spent and invested wisely, there is little reason to expect living standards to rise.

In this light, the reduction in the burden of government in recent years is a welcome development. The sum of what has happened is hugely disappointing, but the change on the margin is positive.

Consumer confidence becomes less pessimistic


According to the University of Michigan survey, consumer confidence has risen to a post-recession high—it's even higher now than it was before the last recession hit, and it was much stronger than expected (83.1 vs. 78). While it's nice to see that consumers are finally realizing that things have improved a lot since last year—when many worried that the Eurozone crisis would end up dragging the U.S. economy into another recession—I don't think the current reading is yet consistent with "optimism." In that regard, I note that confidence is still below the levels that prevailed in the 2001 recession and its 9/11 aftermath. I think the current reading is consistent with everything else I see, which is that the market is reluctantly acknowledging that the future hasn't turned out to be nearly as bad as had been feared. What we see is a lessening of pessimism, not rising optimism.

Labor market conditions just keep on improving


Seasonally adjusted initial claims for unemployment last week were much lower than expected (339K vs. 370K), mainly because on an unadjusted basis, actual claims failed to rise as much as they usually do in the first week of October. Compared to last year at this time, actual claims are down 19%. Layoffs are undeniably declining. Conditions in the labor market just keep on improving.


The number of people receiving unemployment insurance has dropped 20% in the past year. So far this year, 2.26 million people have dropped off the unemployment compensation rolls. We are talking about some serious changes on the margin here. Every week, more and more people have an increased incentive to find and accept a job, even though the pay might be miserable compared to their last job. This isn't pleasant for many, but it is one way that the economy "heals."


And with this ongoing improvement in labor market conditions, equities move higher. The market is rallying not because optimism is rising, but because of the improvement on the margin in the economy. Put another way, the market is up because the economy is not down, and in fact is getting a little better. Slow improvement, but improvement. The market has been braced for deterioration, and instead we get modest improvement. This is enough to push risk assets higher, and Treasury prices lower; 30-yr Treasury yields are up 70 bps since last November.

UPDATE: Reader "Bike" notes correctly that last week's data was missing the results from one large state, and that likely accounts for a good portion of the decline in claims. I missed that fact. I think, however, that the downward trend in claims is most likely still intact.

TIPS point to very weak economic growth

TIPS are complex securities that only reveal their true message upon careful consideration of a variety of factors. A casual glance at the fact that every TIPS issue out to 20 years' maturity is trading at a negative real yield—with 5-yr TIPS trading at -1.62%—would lead one to think that demand for TIPS must be intense, and that therefore, the market's desire for a hedge against inflation (which TIPS are designed to be) must also be intense, and that therefore the bond market must be extremely worried about inflation. But that would be wrong.


The chart above compares the real yield on 5-yr TIPS with the nominal yield on 5-yr Treasuries. The difference between the two is the market's expected annual rate of inflation over the next 5 years. While inflation expectations have indeed risen of late, they are not greatly different from what they have been over the past 15 years. There is no real inflation message to be found here; inflation expectations are up, but they aren't unusual.


The true message of TIPS can be found in the chart above. The negative real yield on TIPS is not a message about inflation expectations, it's a message about real growth expectations. When the real yield on TIPS is negative, as it is today, it's because the bond market holds very dim expectations for real growth in the years to come. This chart suggests that the bond market is calling for growth to be essentially zero over the next two years. That's just my interpretation, of course, but if the market expected real growth to be improving, then it wouldn't also expect the Fed to be on hold, and short-term rates to be close to zero, for the next several years, as it now does.

This reiterates the point I've been making for a long time: the market has very pessimistic assumptions about the future of economic growth. Therefore, if growth fails to be as weak as expected, then optimists will be rewarded. The bar for growth and optimism is set very low these days. I think the economy can beat those dismal expectations, which is why I remain optimistic.

The higher education bubble continues to inflate

Just as the housing crisis was fueled by government demands that banks make it easier for buyers to get a mortgage (e.g., no down payments, floating interest rates, interest-only mortgages, stated income), now we have the emerging student loan/higher education crisis that is being fueled by government demands that students have easier access to credit to finance their education. I'm not the first to discover this, of course, as it's been actively discussed for years. But I will offer a few charts which shed some light on the subject.



In the first chart, we see that student loans started growing explosively in early 2009, after being essentially unchanged for the previous eight years. All of the increase in student loans since the end of 2008, $385 billion, was issued by the federal government, which has now essentially co-opted the entire student lending industry. Private lending in the student loan market has not increased at all over this this same period. The government has taken over and the mandate is to increase loans no matter what. Student loans are the only part of consumer credit that has expanded post-recession. Consumers in aggregate are deleveraging, but students are leveraging up, and many in a big way. As a percent of consumer credit, student loans are exploding skywards: up from 4% at the end of 2008 to 18% today.

This will inevitably end in tears for taxpayers, as well as for the students who have taken on onerous levels of debt. Colleges and universities will also suffer, since federal largesse in the form of a flood of new loans has enabled education costs to reach levels that are way out of line with the rest of the economy. Sooner or later, when the student loan plug is finally pulled, colleges and universities will find themselves forced to undergo the same painful restructuring and cost-cutting that has devastated the residential construction sector for the past six years.

Calafia beach sunset

An incredible sunset last night (taken with my iPhone 5):