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Industrial production slows in the US, picks up in Europe

U.S. industrial production was a bit disappointing in July, and from the chart above we can see that production growth has been slowing for the past few months. But that slowing is more than offset, from a global perspective, by a surge in German industrial production and some gradual improvement in Eurozone industrial production. The Eurozone appears to be coming out of its 2-year recession, and that is good news for Europeans and for the world.

Claims continue to fall, but the market continues to worry for naught

Weekly claims for unemployment continue to fall, now reaching a new post-recession low of 320K, which by the way was less than the expected 335K (the chart above shows the 4-week moving average).

Can there be any doubt that the economic fundamentals continue to improve? That there is no sign of recession or incipient economic weakness? After more than four years of improvement, it's amazing to me that there can still be so many who moan and groan about how this recovery is so awful. Yes, we should and could have had a lot more people working now, but that doesn't negate the fact that things have been improving relentlessly for over four years.

Claims are rapidly approaching the lowest level that we have ever seen relative to the size of the workforce. What's not to like? Oh, yeah: recessions almost always follow low levels of claims. But it might be years still before another recession hits. Every recession in my lifetime has been the by-product of a tightening of monetary policy. The market is in fits these days not because the Fed is tightening, but because the Fed is nearing the point at which it will begin to ease less. Tapering—buying fewer bonds each month—is still accommodative policy, it's just policy that on the margin is becoming less accommodative.

We are still years away from the time when monetary policy will become tight—as defined by real short-term rates that approach 3-4%, and a yield curve that becomes flat or inverted. The above chart makes it clear that the economy faces absolutely no threat from monetary policy at this juncture.

Tracking the demand for safe assets

Caution, risk aversion, and a lack of confidence have characterized much of the current recovery. So it is not surprising that the demand for money and safe assets has been strong, just as the public's desire to deleverage has been strong (deleveraging is equivalent to wanting more money and less debt). Savings deposits, despite their near-zero yield, have grown at double-digit rates since 2008. T-bill yields are virtually zero, a sign of extremely strong demand for safe assets. The real yields on TIPS plunged deep into negative territory, as the demand for these default-free and inflation-immune assets proved so strong that investors were willing to accept a guaranteed negative real rate of return. Bond mutual funds have enjoyed exceptionally strong inflows for most of the past four years, while equity mutual funds have suffered massive withdrawals. Household financial asset burdens have declined significantly as households have deleveraged. Gold, the preferred asset for those seeking refuge from inflation, geopolitical risk, and the just-plain-jitters, rose to extraordinary heights over more than a decade, doubtless fueled in part by speculators with access to money at historically low interest rates.

Despite the persistence of doubts and fears, the economy and the financial markets have staged a "reluctant recovery," as I described last November.

The latest source of fear is the approaching tapering and eventual reversal of the Fed's Quantitative Easing. Those who believe that QE has been the essential fuel for our (tepid) recovery and the stock market's rather spectacular gains over the past 4+ years worry that the absence of Fed purchases, followed—at some uncertain point in the future—by the reversal of QE (i.e., the sale by the Fed of the trillions of bonds and MBS it now owns) will surely doom this economy. They reason that the Fed's bond purchases have artificially depressed interest rates, and that this in turn has helped boost the economy—so therefore a reversal of QE will depress the economy.

But as I pointed out in a recent post, "the real point of QE was not to lower bond yields, but to create bank reserves for a world that desperately wanted them." For most of the past four or five years, the world's demand for safe assets has been so strong that there was a relative scarcity of traditional vehicles (the primary one being T-bills). Enter bank reserves, which, thanks to the Fed's decision in 2008 to pay interest on reserves, became functionally equivalent to T-bills, but with a superior yield. In just under five years, banks have accumulated almost $2 trillion of "excess" bank reserves, above and beyond the level required to collateralize their deposits. No one has forced them to accumulate these reserves, and no one has forbade them from using those reserves to massively expand their lending. Yet that is what has happened: the accumulation of reserves for no purpose other than to accumulate safe assets with a positive yield. Clearly, there has been intense demand for bank reserves on the part of banks, arguably because they were functionally equivalent to T-bills, the ultimate safe asset, and because banks were not willing to greatly expand their lending activities—just as the private sector has also been working hard to reduce its debt burdens.

To make a long story short, the Fed's massive QE efforts boil down to a simple transmogrification of Treasury notes, Treasury bonds, and MBS into bank reserves, an exercise that proved necessary to accommodate the world's strong and rising demand for safe assets.

It follows therefore that the "tapering" and the eventual unwinding of QE will be necessary to compensate for the declining demand for safe assets, and not a threat to the financial system. The Fed will stop buying and eventually—in a year or so—start selling bonds as the economic fundamentals improve. When they finally do begin to reverse QE, they will be selling bonds at higher interest rates than we have today (e.g., 10-yr Treasury yields of 4% or so) when the demand for them will be stronger. Indeed, if the Fed does not reduce the supply of bank reserves as the demand for them declines, they will risk igniting what could prove to be a very uncomfortable rise in inflation. That is the risk to worry about—that the Fed fails to reverse to QE in a timely fashion—not the reversal of QE.

The tide of risk-aversion seems to be turning. I have argued before that this process, which includes the return of confidence (lack of confidence breeds demand for safe assets, so the return of confidence should go hand in hand with a decline in the demand for safe assets), is already underway, though still in its early stages.

Confidence, though still relatively low, is rising. Savings deposit inflows, though still heady, are slowing. The price of uncertainty has declined to near-normal levels. Real yields, though still low, have jumped. Gold, still quite expensive, has suffered a 30% decline. Equity funds are beginning to see inflows instead of outflows, and bond funds are beginning to suffer outflows. All of these market-based indicators are consistent with a decline in risk aversion which goes hand in hand with a decline in the demand for safe assets. If these trends continue, the Fed will have a clear path—indeed, a mandate—to first taper, then reverse, its Quantitative Easing program.

What follows is a series of charts which track the return of confidence, the decline in the demand for safe assets, and the beginnings of a trend toward taking on more risk. All of these suggest that a tapering of QE is appropriate.

Consumer confidence has been rising irregularly for the past several years, but it is still depressed from an historical perspective. There are still plenty of concerns out there, but they are slowly fading.

U.S. banks have been the recipients of $3 trillion in savings deposit inflows since the onset of the financial crisis in 2008. The growth rate of savings deposits was 10-15% per year from 2009 through last year, but that has now cooled off to a 9% rate. That's still fast, but no longer galloping. The evolution of savings deposits—which pay almost no interest currently—bears close watching. Banks have funneled most of their deposit inflows into bank reserves. A tapering of Fed bond purchases should dovetail nicely with a slowing in the growth of deposit inflows and a lessening of banks' desire to accumulate reserves.

The Vix index measures the implied volatility of equity options, and is thus a proxy for the market's level of uncertainty, fear and doubt. (You pay more for an option when you are uncertain, because owning options limits your downside risk.) Currently, the Vix is close to levels that might be considered "normal." As I interpret this, the market is now relatively confident in the outlook for the U.S. economy; not necessarily excited or optimistic about the outlook, but just reasonably confident that not much is going to change: more slow growth ahead, but much less risk of a another recession. (The Vix has jumped to 14.5 today as the market worries that QE tapering is rapidly approaching.)

Gold has tracked commodity prices pretty well for the past several decades, although it has been much more volatile (note that the scale of the right y-axis is almost twice as large as the one on the left). Gold surged ahead of commodities in 2009, as the world worried about another recession, Eurozone defaults, and the potential for QE to trigger a collapse of the dollar and a surge of inflation. In other words, gold surged as fears and speculation mounted, and as confidence declined. The recent 30% decline in gold prices marks a significant change in this dynamic.

Real yields on 5-yr TIPS have a strong tendency to track the market's expectations for real economic growth. When real yields fell to -1.8%, that was a clear sign that the bond market was very fearful that U.S. economic growth would stagnate, and that another recession was a disturbing possibility. The jump in real yields in recent months is an excellent sign that the market is becoming less pessimistic about the prospects for economic growth, and less anxious to pay a huge premium for the relative safety of short- and intermediate-maturity TIPS.

Gold's decline from the stratospheric heights of $1900/oz. has tracked pretty well with the rise in real yields on TIPS. Both are clear indicators of a decline in the demand for safe assets.

It's probably too early to say that the tide has turned here, but net equity flows in the past seven months have been positive.

The PE ratio of the S&P 500 is about average, having risen from decidedly below-average levels in the past few years. This shows that investors' confidence in the future of corporate profits has improved, although it is still relatively subdued considering that interest rates are still at very low levels from an historical perspective.

Bond funds have seen major outflows in recent months, eclipsing anything seen in the past several years. The demand for the relative safety of bonds has definitely weakened.

The nation's major home builders haven't been this confident about the future of their industry for over 7 years.

U.S. households have been working very hard to reduce their financial burdens and improve the health of their balance sheets (aka deleveraging). As a result, financial burdens (monthly payments relative to disposable income) are as low today as they have been for over 30 years. Risk aversion has been significant in recent years, but it's now possible that households are ready to start taking on more risk.

All things considered, it looks to me like the market is over-reacting to the prospect of a tapering of Fed bond purchases. When it does begin tapering, the Fed will be responding in a responsible fashion to the world's declining demand for safe assets. This is not something to fear, it's something to cheer.

Why QE was a successful failure

Taken at face value, the most massive expansion of a major central bank's balance sheet in history, in which almost $2.5 trillion was added to the U.S. monetary base for the purpose of artificially lowering long-term interest rates in order to stimulate the economy, was a failure. Why? Because 10-yr Treasury yields are no lower today than they were when QE1 was first announced in late November, 2008, and 30-yr Treasury yields are actually a bit higher, and because real GDP has grown at a 1.6% annualized pace over the same period, making this the weakest recovery on record. These facts say that the Fed was incapable of bringing down interest rates, and did absolutely nothing to boost the economy.

The first round of Quantitative Easing involved the purchase of about $1.3 trillion of MBS, $0.3 trillion of Treasuries, and $0.1 trillion of Agency debt. Over the course of 17 months, Fed purchases essentially doubled the monetary base. With the addition of QE 2 and QE 3, the Fed has effectively quadruped the size of the monetary base compared to what it was at the end of the third quarter 2008. The last five years of U.S. monetary history were absolutely unprecedented in both size and scope, and for that reason alone there has been much confusion as to what was really happening. Was the Fed crazy? Did they want to destroy the dollar and bring on hyperinflation? Was the economy so weak that gargantuan amounts of monetary stimulus failed to move the economic needle?

The chart above shows the periods during which each QE program was in effect. In addition, it shows the 15-month period during which the Fed attempted, via what it called "Operation Twist," to bring down long-term rates by selling short-term securities and buying long-term securities. Note how 10-yr yields ended up higher at the end of each round of QE, and how they were unchanged at the conclusion of Operation Twist. There is absolutely no evidence here that quantitative easing has lowered interest rates.

Part of the Fed's balance sheet expansion, almost $400 billion, was necessary to allow the expansion of currency in circulation, which has grown at an 8% annualized pace since the third quarter of 2008. Since the Fed only issues currency on demand, this expansion is not considered to be "stimulative." This is what the Fed needed to do to accommodate the very strong worldwide demand for U.S. currency during a time of financial market and economic turmoil. Most of the remainder of the reserves created by QE is being held today in the form of "excess reserves." Banks have apparently been content to accumulate a massive amount of reserves (which are not money and are held on the Fed's books) because they are functionally equivalent (and in a sense superior) to T-bills. Reserves are virtually as safe as T-bills, since the Fed can't default, and they carry what is presumed to be a floating interest rate. Reserves currently pay an interest rate of 0.25%, which is more than the 0.05% rate of interest that can be had on actual T-bills.

It's hard to believe, but the net result of the Fed's Treasury bond purchases was to restore the Fed's holding of marketable Treasuries to about the same percentage as it held prior to 2008. This obscures the fact, however, that most of the decline in the Fed's holdings of Treasuries in early 2008 was the result of the Fed's sale of most of its T-bill holdings, which in turn was necessary given the world's voracious demand for safe assets at the time; bills were in desperately short supply at the time.

BUT, when viewed from a different perspective, the Fed's balance sheet expansion was a success, since (with the benefit of hindsight) it served to accommodate the world's enormous demand for safe assets. In effect, the Fed's monetary expansion was equal to the world's increased demand for safe assets. Without all that QE, there would have been a serious shortage of safe money in the world, and that could have been deflationary and/or contractionary.

As the chart above shows, there has been no acceleration of inflation since the Fed began its aggressive balance sheet expansion. Indeed, many have worried that inflation in recent years has been too low. To borrow from Milton Friedman's classic description of inflation, we can argue from the evidence (inflation, or the lack thereof) that the Fed's supply of money was not greater than the world's demand for money. It was pretty close to being just about right.

If there is any revelation here, it is that the real point of QE was not to lower bond yields, but to create bank reserves for a world that desperately wanted them. It also follows, I would argue, that the Fed has little or no power to directly influence bond yields. Bond yields are determined by the market's desire to hold the outstanding stock of bonds, which is measured in the tens of trillions, since a good portion of the global bond market trades relative to Treasuries. The Fed's bond purchases have been paltry in comparison to the size of global bond market. Since Fed purchases have little or no impact on bond yields (or the economy), then it follows that the cessation of such purchases should have little or no impact either. Tapering is not something to fear.

Finally, this analysis suggests that bond yields are up over the past year not because the Fed is considering tapering its purchases, but because the market is less eager to hold bonds at extremely yields. The world's declining demand for bonds, in turn, is likely related to the market's growing perception that the U.S. economy rests on a more solid foundation these days—that the economy is more likely to be able to sustain growth in the future. As fears decline, the demand for safe assets declines as well, and this can be seen in the 25% decline in the price of gold over the past nine months and in the 130 bps rise in real yields on 5-yr TIPS.

In this sense, the rise of bond yields and the apparent "failure" of QE is actually a testament to the Fed's success. Bond yields are up because the world is leaving behind the fear and loathing that kept bond yields depressed for the past several years, and the Fed—through its aggressive provision of bank reserves—can take a good deal of credit for vanquishing the fears which have contributed to keep economic growth rates disappointingly slow.

Quantitative Easing: the financial world's biggest, most spectacular, and most successful "failure."

More background on many of the points touched on in this post can be found here, here, here, and here.

Federal budget progress continues

In today's WSJ, Steve Moore echoes my thoughts from last month on the incredible shrinking federal budget deficit. Yes, "The biggest underreported story out of Washington this year is ... the federal budget ... shrinking ... much more than anyone in either party expected." And with the July numbers released today, the story hasn't changed, although the 12-month deficit inched up from $694 to $722 billion. The progress is mostly due to a pronounced slowdown (and even a recent shrinking) of federal spending. At the same time, a growing economy, rising incomes and corporate profits have boosted revenues to new highs. 

Spending has dropped almost 4% over the past year, while revenues are up almost 13%. As the second chart above shows, revenues have been higher than their year-ago level every month for the past several years; this is not just the front-loading of incomes that happened last December in order to beat higher expected tax rates—this is ongoing and likely to continue. It's the sort of thing that happens in every recovery. But we've never seen a slowdown in spending since WW II. That is big news.

The budget deficit is now down to only 4.2% of GDP. Just a few years ago we were all worried that the runaway budget deficit would be the ruin of us all. Now the deficit is back down to levels that are easily manageable. To be sure, entitlement spending promises to reverse this in coming years, but for now things are under control and entitlements are not cast in stone.

This is very good news because it all but eliminates the rationale for higher tax rates, and it has resulted in a serious shrinkage of the relative size of the federal government, from a high of 24.4% of GDP in 2009 to only 20.7% today. That's a whopping 15% reduction in the size and burden of government in just under four years. This gives the private sector some badly-needed breathing room, and that's a good reason to expect somewhat stronger economic growth in the years to come.