Friday, November 21, 2014

Why the global gloom?

One popular meme these days is "the global economy is slowing down." China's economy has slowed from double digit growth rates to 7%, Japan has suffered two quarters of negative GDP growth, and the Eurozone economy has grown by less than 1% in the past year. The U.S. economy has barely managed to exceed 2% annual growth for the past five years, and people worry about the future since the Fed seems almost certain to begin raising interest rates within the next 3-6 months. Industrial commodity prices are down almost 10% in the past six months, and oil prices have plunged almost 30% since last June—all (supposedly) signs of weaker demand. Moreover, high-yield credit spreads have risen over 140 bps since June, reflecting a loss of confidence in the future of corporate profits. 

To make matters worse, policymakers seem to have run out of options. Short-term interest rates are near the zero bound in Europe, Japan, and the U.S. Quantitative easing hasn't done much at all to stimulate the U.S. economy, and it's unlikely to be a miracle cure for the Eurozone economy. The Bank of Japan has managed to ease by enough to push the yen down by almost one-third against the dollar, but a hike in Japan's sales tax seems to have swamped any stimulus from stronger exports. Genuine stimulus (e.g., tax reform, tax cuts, and reduced regulatory burdens) is being discussed almost everywhere, but it's not likely to happen any time soon.

A lot of people are probably thinking "If policy can't stimulate, and demand is weakening on the margin, it's time to really start worrying."

I'm not so sure it's time to run for cover. 


One of the most remarkable turnarounds in the global economy in recent years is shown in the chart above. In the past two years, the yen has plunged against the dollar, and the value of Japanese equities has doubled, both in seeming lockstep. Even in dollar terms, the Nikkei 225 is up over 30% in the past two years. It's hard to deny that something big is going on here, even though the Japanese economy shrunk in the six months ending September.

Have you noticed that no one seems to be talking about the "wealth effect" anymore? That's the theory that says an increase in stock prices and/or housing prices can induce consumers to spend more because they have become wealthier. That increased spending has the effect of strengthening the economy, or so the theory goes. That's never made much sense to supply-siders, however. You can't spend your way to prosperity. Prosperity only comes as a result of more work, more investment, and/or more risk taking. The "wealth effect" theory assumes that stock prices just happen, or that they can be pushed up by easy money. In turn, higher stock prices cause more spending, which grows the economy and validates the higher stock prices.

Not so, in supply side theory. The stock market, like the bond market, is difficult to fool. Easy money doesn't just magically raise stock prices, and higher stock prices don't then stimulate the economy. More likely, stock prices rise as a result of improving economic and financial market fundamentals. Higher stock prices discount rising future earnings. Stock prices are the barometer of the economy's future health, not a by-product of easy money.


So consider the implications of the chart above. It shows that the market capitalization of the world's equity markets has increased over $40 trillion dollars since March 2009, and in the past two years the value of global equities is up about 30%. That's a huge, and welcome increase. Does it mean that consumers are going to be spending double and triple as much because stock prices have almost tripled? No. It means that the expected future cash flows of corporations all over the globe have increased significantly. Consumers likely will be spending more in the future, but only because corporations will be making more and better stuff, hiring more workers, building new plant and equipment, and booking rising profits. The stock market is often able to look across the valley of despair and see a better future on the other side. It's likely that that's the case today.


As the chart above shows, U.S. equities have greatly outpaced their Eurozone counterparts in the past four years. Well, yes, we know that the U.S. economy has been much stronger and more dynamic than the Eurozone economy—that's not a surprise. But conditions in the Eurozone have nevertheless improved. In the two years since Japan's equity market suddenly came to life, U.S. equities are up almost 50%, and Eurozone stocks are up a little over 30%. In dollar terms, Eurozone equities are up about 20%. That's not chickenfeed.

It's hard to get pessimistic about the future when the world's stock markets are becoming more and more optimistic. Of course, it's hard to see significant improvements anywhere right now, but in my experience it sometimes takes awhile before the average person realizes the extent to which economic conditions have actually improved. For now, the world's stock markets are seeing better times ahead, and investors seem to be getting the message.

Despite all the gloom out there, and despite all the disappointment, there is reason to be optimistic. If we've learned anything in the current recovery it's that 1) fiscal stimulus (e.g., the ARRA) doesn't work and 2) monetary stimulus (e.g., QE and zero interest rates) don't work either. Government policymakers cannot conjure up prosperity by spending more money or cutting interest rates. What's needed is for government to get out of the way and boost incentives for the private sector to jump-start the economy. That means lowering marginal tax rates, simplifying tax codes, eliminating subsidies, and reducing regulatory burdens.

This is not rocket science. The entire world has witnessed massive, almost laboratory-type experiments in fiscal and monetary stimulus fail to deliver the promised results. There's nothing left to try except what is most likely to work. Politicians need to hand the reins over to the private sector and market forces and step aside. The world's stock markets seem to be saying that this is a real possibility that may come to fruition within the foreseeable future.

Thursday, November 20, 2014

How well do TIPS predict inflation?

Yesterday's post focused on the market's current inflation expectations for the next 5 and 10 years, as embedded in the pricing of TIPS and Treasuries. It concluded that inflation expectations are not unreasonable, and they are in line with past inflation and what is reasonable to expect going forward. This post focuses on how well the bond market's inflation-forecasting skills have proven to be.

Conclusion: the bond market has more often than not tended to underestimate future inflation. For the first 12 years of the existence of TIPS, 5-yr breakeven inflation rates were lower than inflation turned out to be about two thirds of the time, and there have been some sizable errors at times.

Introduction for neophytes: "TIPS" is an acronym for Treasury Inflation Protected Securities. TIPS were introduced in early 1997. They are a unique type of bond, because they pay a fixed, "real" rate of interest plus a rate that is equal to whatever inflation happens to be. The effective interest rate a TIPS investor receives thus has a real component (known in advance) and an inflation component, and both are guaranteed by the U.S. government. In practice, TIPS work like this (in simplified fashion): they are issued with a par value of $100, and that value is subsequently increased by the rate of consumer price inflation. They are also issued with a fixed coupon that is paid on the inflation-adjusted principal. Say you buy some 5-yr TIPS on January 1st with a fixed coupon of 2% and a par value of $100. At the end of the year it turns out that the CPI has increased by 3%. You would then end up with a total return of a little over 5%: the principal value of your TIPS would be 102 at the end of the year, and you would be paid a coupon of 3% on that value: 1.02 * 1.03 = 1.0506, or 5.06%. The market price (not the par value) of TIPS once they are issued varies inversely with their real yield: if real yields increase, the market price declines, and vice versa.

If you compare 5-yr TIPS to 5-yr Treasuries, you can easily determine the bond market's expected, or "breakeven" inflation rate. (Breakeven is the technical term, since that is the inflation rate that would make the return on holding 5-yr TIPS equal to the return on holding 5-yr Treasuries to maturity.) You simply subtract the real yield on 5-yr TIPS from the nominal yield on 5-yr Treasuries.


The chart above compares the trailing 5-yr annualized rate of CPI inflation (red line) with the 5-yr breakeven inflation rate (i.e., the expected annualized rate of inflation over the subsequent 5 years) as predicted by 5-yr TIPS and Treasuries (blue line). Think of the blue line today as the market's inflation forecast made 5 years ago.

For example: 5-yr TIPS first started trading in July 1997, when the breakeven or expected inflation rate for the next 5 years was 2.3%. The starting value for the blue line is thus 2.3% in July 2002, five years after their first issuance. In their first month of trading, the 5-yr breakeven inflation rate embedded in TIPS prices turned out to be exactly right, since the CPI rose at an annualized rate of 2.3% for the 5 years ending July 2002.

As you can see from the chart, the blue line was almost always lower than the red line from 2002 through 2009. That means that the breakeven or expected inflation rate embedded in the pricing of TIPS and Treasuries was almost always lower than actual inflation turned out to be, and by a considerable amount, during the 7-yr period from 1997 through 2004. But from late 2004 through late 2007 (2009 through 2012 on the chart), the expected inflation rate tended to be somewhat higher than actual inflation, and the errors were of much smaller magnitude.

Since mid-2008 (mid-2013 on the chart), the bond market's expected rate of inflation proved again to be much higher than actual rate of inflation. In general terms, TIPS have under-estimated inflation for 8 of their first 12 years of trading, and over-estimated inflation for four of the first 12 years.

I note also that there have been times in the past where Treasuries and TIPS have egregiously under-estimated inflation. In late 1998, for example, (late 2003 on the chart) the expected rate of inflation over the next 5 years was about 0.6%, but actual inflation turned out to be about 2.5%. In late 2001, the expected rate of inflation was about 0.8%, but actual inflation turned out to be about 2.6%. In late 2009, the expected rate of inflation was about -0.4%, but actual inflation over the subsequent 5 years turned out to be 2%.

I think there's a reasonable explanation for why the bond market has at times underestimated future inflation by a considerable amount. 1998, 2001, and 2009 were all times of great distress in the markets: the Russian default and LT Capital debacle in 1998, the recession of 2001, and the financial crisis of 2009. During times of great uncertainty, Treasury prices have been bid up to unrealistically high levels due to the market's craving for certainty; this pushed Treasury yields down relative to TIPS yields.

Today, 5-yr TIPS and Treasuries are predicting that inflation over the next 5 years is going to be about 1.6% per year (the last datapoint for the blue line). Since 1966, inflation over any rolling 5-yr period has only been that low or lower for seven months—from April 2013 through October 2013—and that period was dominated by the negative rates of inflation we saw in 2009.

In short, the U.S. bond market currently is expecting inflation to be historically low for the next five years. Since TIPS were first issued in 1997, the bond market has had a strong tendency to underestimate future inflation, especially during periods of rising inflation and during periods of financial market stress. Although the current expected rate of inflation is consistent with what we have seen in recent years and consistent with the significant decline in energy prices over the past six months, the market is arguably still afflicted with a substantial amount of risk aversion, as I've noted repeatedly. And it would appear that the bond market does not see hardly any chance that the Fed commits an inflationary error as it unwinds QE and moves away from zero-bound interest rates.

The bond market could be right about the future of inflation, but it's making some pretty heroic assumptions, and past experience suggests it's probably underestimating future inflation today.

Wednesday, November 19, 2014

Inflation expectations are just fine

The minutes of the October 2014 FOMC meeting released today showed that policy makers "should remain attentive to evidence of a possible downward shift in longer-term inflation expectations." Members also worried that "if such an outcome [a downward shift of inflation expectations] occurred, it would be even more worrisome if growth faltered."

The charts that follow illustrate the market's inflation expectations as implied by the pricing of TIPS and Treasury notes and bonds. They all show that although inflation expectations have declined somewhat of late, they are not unusually low. It's notable that inflation and inflation expectations have remained solidly above 1-1.5% for the past 5 years, despite this being the slowest recovery on record—that suggests that the Fed's concern about slow growth leading to deflation are overblown. It's also notable that inflation hasn't been a lot higher despite the Fed's unprecedented experiment with massive Quantitative Easing—that suggests that the Fed hasn't really been printing money, but rather just supplying the world with risk-free assets (i.e., bank reserves) that have been in high demand.


The chart above compares the nominal yield on 5-yr Treasuries with the real yield on 5-yr TIPS. The difference between the two (the green line on the chart) is the market's expected average annual inflation rate (CPI) over the next 5 years, which is currently about 1.6% That is lower than the 2.3% average inflation rate we've had over the past 10 years, but it is consistent with the fact that oil prices have fallen by about 30% in recent months and CPI inflation ex-energy has been running 1.5-2% for the past few years. With big declines in gasoline prices we should expect to see headline inflation fall somewhat. Moreover, there's no reason for the Fed to worry about a somewhat lower rate of inflation that is the by-product of falling energy prices, since cheaper energy should bolster economic growth.

In short, I don't see anything to be concerned about on the inflation or monetary policy front at the present time.


The chart above shows the 10-yr version of the first chart, and the green line represents the market's expected average annual CPI inflation rate over the next 10 years, which is currently about 1.8%. That too is consistent with our inflation experience in recent years and the behavior of energy prices.


The chart above effectively links the first two. It shows the implied forward-looking inflation rate five years from now (i.e., what the average annual inflation rate is expected to be from 2019 through 2024). For years 1-5, as the first chart shows, inflation is expected to be about 1.6% a year. For years 6-10, as the second chart shows, inflation is expected to be faster, about 2.2% per year. Over the next 10 years, inflation is expected to average 1.8%. That's just fine in my book, although I'd be a little happier if inflation were closer to zero. Low and stable inflation is nirvana for supply-siders, since it fosters confidence, facilitates long-term planning (which in turn boosts investment and productivity gains), and minimizes the world's need to spend time and money looking for inflation hedges. Why the Fed is so fixated on inflation being 2% instead of 1% is a mystery that can only be explained (possibly) by the Fed bowing to the current "wisdom" that low inflation exposes the economy to the "risk" of deflation. It may be politically expedient to extoll the risks of deflation, but there is no practical reason to do so. Deflation doesn't lead to slow growth, and deflation is not incompatible with strong growth.

Nothing mysterious or scary about these numbers, in any event.


So what about falling commodity and gold prices? As I see it, commodities and gold are still trading well above the levels of 10-15 years ago. (see chart above) The next two charts look at gold and commodities in real terms, which I think is more relevant when considering whether commodity prices are likely to contribute to inflation or not.


As the chart above shows, in real terms gold is still about double what it has averaged over the past century. Today's gold prices therefore reflect a substantial premium, which in my mind means that the market still worries a lot about the possibility of the Fed making an inflationary error in the future, and the possibility of geopolitical turmoil. Gold, in other words, is still priced to a substantial risk of something going wrong. But since gold has fallen from $1900 to $1200 in the past few years, it means that the market's concerns have been alleviated to some degree. That's good. It's not a harbinger of deflation, it's a sign that the risk of high inflation has gone down.


As the chart above shows, in real terms commodity prices today are about 10% below their 45-year average. They were really cheap in 2002, and that was a time when the dollar was very strong, gold was very weak, and deflation was a definite possibility. Today, commodity prices are only somewhat lower, relative to other things, than they have been for many decades. In my view, this means commodity prices today aren't likely to impact overall inflation by much, if any.

All things considered, the near-term outlook for inflation is not worrisome at all. But I still worry that the Fed could be slow to raise short-term rates and/or withdraw excess reserves in a timely fashion should inflation begin to accelerate. In short, for now things look OK, but I still think the risk of higher inflation down the road is more worrisome than the risk of deflation.

All of this suggests that the Fed is unlikely to do anything that would shock the markets in the foreseeable future (e.g., the next 3-6 months).