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Jobs: steady as she goes

The only remarkable thing about the July jobs report was its consistency. The trends that have been in place for the past several years—2% annual gains in private sector employment, a slow decline in public sector employment, very slow growth in the labor force, and a low labor force participation rate—all remain in place. Thus, we're left with an economy that is likely to continue to grow at a disappointingly slow pace. The Fed's Quantitative Easing strategy has yielded no meaningful change in the economy's ability to create jobs, but that is not surprising since there is no reason to think that it should. With the economy growing at a steady and unremarkable pace, and with systemic risk declining, there is little reason for the Fed not to begin to taper its bond purchases within the next several months. Bond purchases only serve to feed the world's appetite for safe-haven assets, and with each month that goes by with no signs of economic deterioration, that appetite is slowly but steadily ebbing.


Both surveys of the jobs market show the same thing: relatively steady private sector jobs growth for the past three and a half years.


The private sector has been generating new jobs at roughly a 2% annual pace for the past three years. That's almost exactly the rate of jobs growth that we saw in the years leading up to the Great Recession.


The decline in public sector employment has been welcome, since it had become bloated, but that decline shows increasing signs of coming to an end. The private sector is the source of most of the economy's growth, and it has been doing OK, but private sector employment is still below its pre-recession peak.


The labor force is still growing at a relatively slow pace, and it is significantly below its long-term trend. Many millions of workers have "dropped out" for a variety of reasons, and that is the source of the ongoing decline in the unemployment rate.

No signs of deflation in the dollar, gold, or commodities

The dollar is weak but improving on the margin, while gold prices and commodities are soft and declining on the margin, but still relatively high from an historical perspective. I think this points to a gradually improving outlook for the U.S. economy (e.g., double-dip inflation fears have now been replaced by a view that the economy can probably sustain modest growth of 2 or maybe 3%), and an ebbing of speculative pressures that had pushed gold and commodities to lofty levels. From a long-term perspective this is all positive. I don't see a reason to worry about deflation at this juncture.


The Fed's calculation of the dollar's inflation-adjusted value against a large basket of currencies and against major currencies is arguably the best measure of the dollar's effective strength vis a vis other currencies. As the chart above shows, as of the end of June the dollar was still quite weak from a long-term historical perspective, but it had risen on the margin in recent years.


Gold and commodities are in many ways the mirror image of the dollar's strength. Both reached very high levels from an historical perspective a few years ago, at the same time the dollar plunged to new all-time lows. Since then, gold has declined and commodity prices have eased, at the same time the dollar has recovered a bit.


The chart above shows the CRB Spot Commodity Index, arguably the best measure of non-energy, non-gold commodity prices, and its 5-year moving average (purple line). Although commodity prices are down from their 2011 highs, they are still above their 5-yr moving average. I show this on the theory that it takes perhaps 5 years for the world to adjust to commodity prices, so any important deviations from the 5-yr average creates problems, either for producers (unexpectedly weak prices) or consumers (unexpectedly strong prices). I note that the last time the U.S. came perilously close to a general deflation was in the late 1990s and early 2000s, and that happened to be a period during which commodity prices were exceptionally weak, both historically and relative to their 5-yr moving average. That's not the case today, so I think that argues against the risk of deflation.


As above chart shows, 5-yr TIPS and Treasury yields are priced to the expectation that inflation over the next 5 years will average about 2%. That is substantially higher than expected inflation was back in the late 1990s and early 2000s, and it is very close to the 2.1% average we have seen since TIPS were first introduced in 1997. In other words, there are no signs of deflation fears in the bond market.

The most likely explanation for what is happening to gold and commodity prices is that they are coming off of speculation-induced highs, not that they are now signaling deflation risk. An ebbing of speculative pressures such as these actually augurs well for the long-term outlook for the economy, since it means that investment decisions are increasingly based not on speculation, but on the economic merits of each decision.

A decent manufacturing report trumps QE

A much stronger-than-expected manufacturing report (54.5 vs. 52) from the Institute for Supply Management, indicating that U.S. manufacturing activity in July was picking up, has proved once again that the perceived health of the economy is a more powerful determinant of interest rates than the Fed's monthly purchases of $85 worth of Treasuries and MBS. 10-yr Treasury yields are now over 100 bps higher than they were when the Fed initiated its QE3 campaign almost a year ago—in which time it has purchased enough bonds to finance the entire federal deficit—because the market now sees that the economy is on a stronger footing, even though expectations for growth remain very unimpressive. A year ago the market thought the U.S. economy faced a serious risk of many years of dismal growth or even another recession; today the market likely believes that the economy can sustain growth of 2-3%, a rate of growth that would still qualify this recovery as being the weakest ever.

This is a very important assertion, since it casts serious doubt on the assumption that many observers have made that the Fed has been artificially lowering interest rates and in the process distorting the capital markets and artificially stimulating the economy. As I've asserted for a long time, the Fed's QE program has been designed not to stimulate the economy but to accommodate the world's intense demand for money and cash equivalents. And not only has monetary policy not been stimulative, but fiscal policy has been acting like a headwind to growth, since its emphasis has been on redistribution, huge new regulatory burdens (e.g., Dodd-Frank, Obamacare), and higher taxes. In short, what we are seeing is that the economy has been growing in spite of monetary and fiscal policy, not because of it. The recovery, as meager as it has been, is nevertheless a genuine recovery which could be much stronger if fiscal policy were to get out of the way of the private sector. Which it in fact is, though much remains to be done for the outlook to brighten significantly.
  

As the chart above shows, the July level of the ISM manufacturing report is consistent with GDP growth of 3-4%, which is substantially better than what we have seen over the past year or so.


The export orders subcomponent of the ISM index suggests that overseas economies continue to expand. If the world is increasing its purchases of U.S. goods, that helps sustain our growth.


The prices paid index continues to point to little or no inflationary pressures, confirming that monetary policy has not been stimulative—it's simply been accommodative of strong demand for money.


The employment index last quarter had dipped to zero-growth levels, but has now rebounded, suggesting that manufacturers feel more optimistic about the future.


Although the Eurozone has yet to pull out of its two-year recession, manufacturing activity is no longer contracting, as suggested by the July Markit survey of manufacturing. It would appear from this chart that both the U.S. and the Eurozone are enjoying a modicum of improving conditions. 


The ongoing rise in global equity markets is thus supported by an improving economic outlook. Very good news, even though global equities have yet to regain their former highs set almost six years ago.

The problem with Obama

... is that "he does not understand rudimentary economics," writes Richard Epstein in an excellent article titled "Obama's Middle Class Malaise." Here are some excerpts, but read the whole thing for a concise and sober explanation of what ails the U.S. economy from a policy perspective:

The President, who has never worked a day in the private sector, has no systematic view of the way in which businesses operate or economies grow. He never starts a discussion by asking how the basic laws of supply and demand operate, and shows no faith that markets are the best mechanism for bringing these two forces into equilibrium.
Unfortunately, our President rules out deregulation or lower taxes as a way to unleash productive forces in the country. Indeed, he is unable to grasp the simple point that the only engine of economic prosperity is an active market in which all parties benefit from voluntary exchange. Both taxes and regulation disrupt those exchanges, causing fewer exchanges to take place—and those which do occur have generated smaller gains than they should. The two-fold attraction of markets is that they foster better incentives for production as they lower administrative costs. Their comparative flexibility means that they have a capacity for self-correction that is lacking in a top-down regulatory framework that limits wages, prices, and the other conditions of voluntary exchange.
[Obama] constantly thinks of his greatest regulatory failures as his great successes. No other president has “saved the auto industry,” albeit by a corrupt bankruptcy process, or “taken on a broken health care system,” only to introduce a set of unworkable mandates that are already falling apart, or “investing in new technologies,” which tries to pick winners and ends up with losers like Solyndra. The great advances in energy have come from private developments, most notably fracking, and not from the vagaries of wind and solar energy, which no one has yet figured out how to store for future use when needed.
So long as the President is trapped in his intellectual wonderland that puts redistribution first and regards deregulation and lower taxation as off limits, we as a nation will be trapped in the uneasy recovery that will continue to dog us no matter who is chosen to head the Federal Reserve.

Housing prices firm



Both Case Shiller and Radar Logic report strong gains in housing prices a few months ago. Home prices are up about 10% year over year.



But price increases are slowing on the margin, as shown in the first chart above. The second chart above compares the Radar Logic house price series for 2011, 2012, and 2013. Note that this year, prices fell in late April and early May, when the usual seasonal pattern is for them to rise. No doubt the housing market has gotten a case of the same jitters that affected the bond market in recent months after the Fed began discussing an early end to its bond-buying. New mortgage applications for home purchases have dropped about 10% in the past few months.


As the chart above shows, 30-yr fixed rate mortgages have jumped almost 1 full point in recent months. I doubt this will kill the housing market, but it seems likely to put a damper on home buying enthusiasm for awhile.


Meanwhile, on an inflation-adjusted basis, prices today are about the same as they were back in 2009; the recent price increases have merely offset the impact of inflation in the past four years.

What we see here so far is more in the nature of a stabilization and consolidation of the housing market which will eventually lead to a stronger recovery over time.

Stocks track truck tonnage



It's not surprising: the inflation-adjusted value of U.S. equities has closely tracked the amount of tonnage carried by U.S. trucking services, according to data compiled by the American Trucking Association. Truck tonnage is a reasonable proxy for the size of the economy, so it makes sense that as the economy expands the value of U.S. businesses should rise. At times stocks appear to overshoot or undershoot truck tonnage, but that is likely due to the vagaries of human emotion which tend to magnify the ups and downs of the business cycle.

With truck tonnage up almost 6% in the year ending June 2013, the expansion of the U.S. economy may actually be greater than suggested by the GDP statistics, which, when released later this week, will probably show that the economy grew by about 2% over the same period. GDP growth statistics may be registering a bit on the low side due to the relatively dramatic shrinkage of the public sector during the past four years. Regardless, the ongoing physical expansion of the economy reflected in rising truck tonnage is encouraging.

The recovery is real; it is not a figment of Fed policy or the result of fiscal "pump-priming."

Newest tongue twister: "stocks track truck tonnage"

Credit spread update: still looking good

Credit spreads typically are good coincident and leading, market-based indicators of the health of the U.S. economy. Although they are still somewhat higher than they have been in the past—during times of normal growth and relatively tranquil conditions—they show almost no sign of concern and are consistent with an economic expansion that is ongoing.


Swap spreads—proxies for AA bank credit risk and highly liquid—have been the best leading indicators of trouble ahead. The chart above provides a long-term history of 2-yr swap spreads. (See here for a more detailed explanation of swap spreads.) Swap spreads have risen in advance of every recent recession, and have declined meaningfully in advance of every recent recovery. Currently they are about as low as they have ever been. This is symptomatic of very healthy liquidity conditions in U.S. financial markets, generally low default risk, accommodative monetary policy, and very low systemic risk.



The first of the above charts focuses on the past six years, and compares U.S. swap spreads to their Eurozone counterparts. Eurozone swap spreads are still somewhat elevated, but that is not surprising given the ongoing problems with sovereign default risk in the Eurozone. It is comforting to see that Eurozone swap spreads have been relatively stable for most of the past year. This has proven to be a good leading indicator of economic conditions in Europe, which are improving, as shown in the second chart (note that swap spreads are inverted, to show that declining spreads point to improving conditions); Eurozone manufacturing is pulling out of its two-year slump and the Eurozone economy may therefore soon be emerging from recession.


Credit default swap spreads are highly liquid, generic indicators of corporate default risk. They are now very close to post-recession lows, although still higher than their pre-recession lows. This suggests some ongoing concerns, but that is not surprising given that the U.S. economy is still mired in a disappointingly slow recovery. On the bright side, however, generally low and stable credit spreads show that the corporate sector is generally quite healthy.


As the above chart shows, swap spreads were good leading indicators of junk bond spreads before and during the recession. With swap spreads very low and stable, high yield spreads should at least be relatively stable and likely have room to fall further.


This last chart gives a long-term look at credit spreads for the investment grade and high-yield corporate bond sectors. Spreads are still relatively attractive compared to their historical lows, and they have been largely unaffected by the recent 100 bps rise in 10-yr Treasury yields. This is the bond market's way of saying that higher Treasury yields pose little or no threat to the economy.