Monday, October 20, 2014

Reading the bond market tea leaves

Nominal 10-yr Treasury yields have fallen from 2.6% in mid-September to as low as 1.9% last week, followed by a rise to today's 2.2%. The decline mainly reflects a moderation of inflation expectations which in turn are being driven by a 20+% decline in oil prices since June. Real yields on 5-yr TIPS—which I believe closely track the market's real GDP expectations—have gyrated in the past month or so because the bond market has been worried about the "contagion" risk that the U.S. economy faces because of slower growth in the Eurozone and Asian economies, and a "Black Swan" outbreak of Ebola. These fears have subsided of late, mainly because of no new cases of Ebola.


The chart above shows the nominal yield on 5-yr Treasuries and the real yield on 5-yr TIPS, and the difference between the two, which is the bond market's implied inflation expectation for the next five years. The bond market's current expectation for the average change in the CPI over the next five years is 1.6%, which is somewhat lower than the 1.9% long-term average 5-year inflation expectation since TIPS were introduced in 1997. But it's not even close to the deflation expectations that gripped the market towards the end of 2007. Inflation expectations are down because oil prices are down over 20% in the past three months. That has already resulted in a slowing in headline consumer price inflation: the CPI rose at an annualized rate of only 0.6% over the past three months. Meanwhile the core CPI is running just under 2%.


As the bond market sees it, inflation is going to be a little lower in the next few years than it has been in the past few years, thanks to lower energy prices. But over the next 10 years, as the chart above shows, the bond market is expecting the CPI to average 1.9%. That's somewhat lower than the 2.3% annualized rate of CPI inflation over the past 10 years, but it hardly smacks of deflation fears. We've seen levels this many times in the past. Inflation expectations appear to be "well anchored."


The chart above shows the 5-yr, 5-yr forward measure of bond market inflation expectations (i.e., what the market believes inflation will average from 2019 through 2024), which is currently about 2.3%. Note again the absence of anything suggesting deflation. This expectation is fully in line with historical experience.

Putting this all together, we find that the bond market is expecting inflation to be a little below 2% for the next several years, followed by a modest pickup to just over 2% in subsequent years. On average, the bond market sees inflation in the next 10 years being only moderately less than it has been in the past 10 years. There's nothing unusual about any of this.

What is unusual is the bond market's apparent conviction that the massive expansion of the Fed's balance sheet, which has resulted in the creation of $2.7 trillion of excess reserves in the banking system, will not result in any unusual increase in inflation. It's hard to argue with the market, but at the same time it requires a leap of faith of sorts to believe that banks will not want to greatly increase their lending activities to take better advantage of their huge holdings of excess reserves, which currently pay only 0.25% (and by so doing, create an excess of money relative to the demand for it—the classical source of higher inflation). It's theoretically possible for the Fed to increase the interest rate it pays on reserves by enough to keep banks content with holding $2.7 trillion of idle reserves, but we're all in uncharted waters on this subject.

One reason the bond market does not find it difficult to ignore the risk of rising inflation is the chronic weakness of the U.S. economy. This remains by far the weakest recovery ever. Weak growth has been strongly associated with low inflation risk ever since the invention of the Phillips Curve, which postulated that inflation was a by-product of strong resource utilization, particularly labor. High unemployment, a hallmark of recessions and weak economies, was thought to lead to low inflation, and vice versa. The Fed repeats this mantra all the time: the economy is likely to continue to have lots of slack, and that will keep downward pressure on inflation, so they probably won't have to raise rates much for a very long time.

I've preferred to view the absence of inflation as a phenomenon associated with strong risk aversion—not weak growth. Banks—and most everyone in fact— have been extremely risk averse in the current recovery. The demand for money and safe assets like bank reserves has been very strong. Banks have thus been content to accumulate excess reserves, and businesses and consumers have preferred to deleverage rather than leverage up, and banks have taken in mountains of savings deposits. But risk aversion is on the decline, and bank lending is picking up on the margin.


Confidence is picking up, but it is still well below its former peak, as the chart above shows. But if confidence continues to build, then the dynamics of the bond market and inflation could change meaningfully. Banks would feel more comfortable lending, and businesses and consumers more comfortable borrowing. Businesses might feel more comfortable expanding too. All of this would be consistent with a decline in the demand for money and safe assets at the same time as bank lending and the amount of money in the economy increase. That is how we could get to higher inflation: it only takes a return of confidence.


And confidence might turn more positive before too long. Republicans look set to take control of the Senate in a few weeks, according to the latest pricing in the Iowa Electronic Markets. As the chart above shows, the probability that Democrats lose control of the Senate has risen to 92%. It's not unreasonable to think that Congress will attempt to pass more business- and growth-friendly legislation before too long (e.g., lower and flatter tax rates for corporations, scaling back Dodd-Frank, lower marginal tax rates for individuals in exchange for fewer deductions, and market-style reforms to Obamacare). Would Obama want to take a strong stand and veto everything, even as his popularity has collapsed and faced with yet another big electoral defeat for his party? Would Democrats refuse to override his veto considering so many of them these days are trying to distance themselves from his growing list of failures? I doubt it. A friendlier tailwind from Washington would reinforce the trend to rising confidence and could push economic growth up a notch or two.

It could also push inflation higher as well, if the Fed waits too long to ratchet up short-term interest rates. Start worrying if the mood of the country improves and the Fed is slow to react.

Thursday, October 16, 2014

Still no signs of deflation

Fears of deflation are all the rage these days. Phrases like this can be found everywhere: Europe is "perilously close" to deflation, major economies face the "specter" of deflation, Eurozone "deflation threat" looms, the clear and present "danger" of deflation, the risk of deflation fuels global fears, etc.

It's completely overblown. Deflation is not like a black hole that sucks economies in once they cross the zero price change event horizon. Just because Europe's CPI increase is approaching zero doesn't mean the Eurozone economy is going to collapse or that something urgent needs to be done. Japan's problems over the years are commonly attributed to deflation, but that ignores completely the fact that Japan's fiscal policies have been abysmally bad for decades (e.g., way too much government spending). Deflation doesn't necessarily lead to recession or even slow growth. The U.S. economy boomed in the late 19th Century despite years (or actually because of) years of deflation; falling prices dramatically increased consumers' purchasing power and fueled a huge rise in living standards. Deflation is often necessary for an economy to adjust to external shocks.


In any event, although a decline in producer prices in September captured the headlines yesterday, there is no evidence at all that producer prices are falling. Producer prices are notoriously volatile from month to month, and the often decline in one month only to rise the next month. As the chart above shows, over the past year producer prices are up 2%, and they are probably trending higher at a 1.5% annual rate.


Take out falling energy prices, and you find that core producer prices—shown in the chart above—show absolutely no sign of declining.

Forget about the deflation bogeyman. Deflation is not a threat and it's not happening in any event.

Industrial production is quite strong

September gains in U.S. industrial production far surpassed expectations (+1.0% vs. +0.4%). Gains in the past year are well over 4%, which marks an acceleration relative to the first three years of the current growth cycle, when gains averaged about 3% per year. This stands in stark contrast to the emerging weakness in the Eurozone economy, where industrial production is flat to down a bit over the past year. The U.S. economy is emerging as an island of strength in a sea of slowing growth. Markets worry that the rest of the world will drag the U.S. down, but it doesn't have to be that way.


U.S. industrial production has grown by leaps and bounds compared to the Eurozone. The one bright spot in Europe is the U.K., where industrial production is up 2.5% in the year ended August. Japan's industrial production is down over 5% year to date.


Manufacturing production in the U.S. is up a solid 3.7% over the past year, and the production of business equipment is up by an even stronger 4.6%. These are real gains that point to at least a modest acceleration in overall GDP growth. This is terrific news.



By far the strongest sector of the U.S. economy is mining, shown in the first of the two charts above, which in turn is being led by the surge in crude oil production, shown in the second chart. The output of the mining sector is up over 40% since the end of 2009. This is nothing short of spectacular. Yet it's my impression that these gains have been given short shrift by most analysts. Oil and hydrocarbons in general are not favorites of the politically correct crowd—it's somehow sort of "dirty." But as Mark Perry and I've been saying for years, it's hard to over-estimate just how much the fracking revolution is impacting the overall economy.


Surging U.S. oil production, in combination with slowing growth in Asian economies, is finally working to push oil prices down. Crude prices have plunged 25% year to date! The U.S. economy is going to benefit broadly from a huge reduction in the real cost of energy, the first "lucky break" we've had since the Great Recession. Again, it's hard to underestimate the ripple effects of these very positive developments.

The only thing that poses a serious downside risk to the U.S. economy at this point is a widespread Ebola outbreak. If it weren't for that, we'd have clear sailing for the foreseeable future.