Wednesday, July 30, 2014

A Brief Note On The Second Quarter

  • Both nominal and real growth remain subdued.
  • There are no signs of acceleration.
  • The bond market has over-reacted.

On a YoY basis, RGDP is growing at 2.4% and NGDP is growing at 4%, far below the growth rates of the Clinton and Bush years. The low level of real growth reflects the low level of nominal growth, because you are not going to have 4% real growth along with 4% nominal growth. Nominal growth should be at least 6.5% if we ever wish to see 4% real growth again. The core problem is that the Fed’s 2% inflation target is much too low; and the FOMC has tolerated below-target inflation since the Crash.

Given that the economy has been stalled for the past four years, and given that the Fed is in the process of withdrawing stimulus, there is no reason to expect higher growth or inflation. Bond yields are unlikely to rise substantially against such a backdrop, and today’s selloff will prove to be a blip.

Investment Conclusion
The economy is not accelerating at a pace that should raise bond yields. Low bond yields sustain the wide equity premium (5.4% according to Aswath Damodaran).

Sunday, July 27, 2014

Janet Yellen: The Manchurian Candidate?

  • Both the Right and Left see Yellen as a radical departure from her predecessors.
  • But she is just another Bernanke and she won’t upset the apple cart.
  • We can expect to see nothing radical coming out of the FOMC in the foreseeable future.
Janet Yellen has recently been getting a lot of attention in the media from both the Right and the Left.
On the Left, the New Yorker recently published a profile by Nicholas Lemann which painted Yellen and her economist husband in liberal if not leftist colors: “Yellen is notable not only for being the first female Fed chair but also for being the most liberal since Marriner Eccles.” Lemann reports that Yellen’s Nobel Prize winning husband, George Akerlof, called the Bush Administration “the worst government the U.S. has ever had in its more than 200 years of history”.
Lemann, who does not appear to be a close student of economics (“Economic management sounds technical, but it also has the quality of a powerful fable”), gets a bit confused when trying to make the case that there are “liberal” and “conservative” monetary policies. He tries to paint Milton Friedman as a conservative and Yellen as a liberal, when in fact they are both monetarists. Lemann is groping for the monetarist vs Austrian dichotomy, but he doesn’t have command of the scholastic nomenclature. In any case, he paints the Democrat Yellen as being to the left of the Republican Bernanke, and says that this has profound policy implications.
On the Right, Peter Schiff (a conservative hard-money pundit) recently published a column in which he takes the Lemann interview and runs with it. His column is a broad-ranging indictment of the new chairman as a dangerous liberal, leftist and inflationist: “She is very different from any of her predecessors in the job. Put simply, she is likely the most dovish and politically leftist Fed Chair in the Central Bank's history...She does not seem to see the Fed's mission as primarily to maintain the value of the dollar, promote stable financial markets, or to fight inflation. Rather she sees it as a tool to promote progressive social policy and to essentially pick up where formal Federal social programs leave off.”
Schiff deplores QE, saying that it “has prevented the government from having to raise taxes sharply or cut the programs she believes are so vital to economic health”, while “pushing up prices for basic necessities such as food, energy, and shelter”. He says that, as a liberal, Yellen focuses exclusively on employment: “Yellen clearly sees jobs as her top priority. Any hope that she will put these priorities aside and move forcefully to fight inflation when it officially flares up should be abandoned.” He expects her to pursue radically stimulative policies.
Obviously, a big part of the problem here is that not a lot of pundits understand monetarism (or Keynesianism). There is a strong desire to cast the FOMC as a battleground between the right and the left, much like the Supreme Court where there are “Democratic” and “Republican” justices. This analysis founders, of course on the fact that many “Republican” economists are monetarists, such as Friedman, Greenspan, Bernanke and many others, and that Republican presidents have nominated many monetarists to the Board of Governors.
The sad fact is that, despite the hopes of the Left and the fears of the Right, Yellen is another Bernanke, a radical monetarist who abandons all of his core beliefs the day he first sits down in the chairman’s seat. Lemann is wrong that Yellen will speed up growth, and Schiff is wrong that she will cause inflation. I hope that both of their predictions prove true, but I’ll bet two-to-one against it.
Bernanke had the best shot we will ever see of implementing radical reflationary policies, and he failed. He recanted almost everything he had preached as an academic about price-level targeting and the need to do whatever is necessary to oppose deflationary forces. If Bernanke couldn’t do it, in face of the Great Recession, there is no way that Yellen is going to do it.
That is because the #1 job of the Fed chair is not to grow the economy, but to maintain consensus in the committee and credibility on Capitol Hill. If Yellen were to form a growth caucus on the FOMC and ram through policies intended to get the economy moving again, the GOP would would pass legislation which would remove policy discretion and perhaps even the employment mandate. Such bills have already been introduced. This may happen even if Yellen stays on the reservation, but the probability would rise exponentially if she allowed inflation to hit 4%, which is now defined as hyperinflation.
Yellen and the monetarists know that, were they to incite such legislation, the future policy consequences could be dire. So they won’t. Instead we will see the end of QE, continued interest on excess reserves, and increasing pressure to “normalize" the Fed’s “bloated” balance sheet, despite the fact that money growth has been declining for the past two years, inflation has been below target and--most recently--both nominal and real growth have been negative.
Investment Conclusion
Because the Fed will not pursue reflationary policies, inflation, inflation expectations and bond yields will remain very low, while the wide equity premium will persist until stock prices go materially higher.

Wednesday, July 16, 2014

Bond Yields Don’t Rise When The Fed Tightens Prematurely

  • Many pundits are predicting stronger growth and higher bond yields.
  • They are misreading the monetary data.
  • The FOMC is withdrawing stimulus in the face of slowing growth.
  • The outlook is for low money growth, low inflation, low nominal growth and low bond yields.
  • This is bullish for both stocks and bonds.

There is a growing chorus among the economic pundits that the economy is picking up steam, that monetary policy should “normalize”, and that bond yields “will have to normalize”. This consensus is not supported by the data.
Nominal growth, inflation and bond yields are artifacts of monetary policy. Monetary policy today is restrictive and becoming more so. If the quantity equation holds, then we won’t be seeing any pickup in nominal growth that could justify higher bond yields. Anyone who thinks that the first quarter growth numbers were caused by “winter” isn’t looking at current monetary policy. (This may come as a shock to Al Gore, but the government still seasonally adjusts the quarterly GDP data.)
The bottom line for the economic outlook is that the Fed is withdrawing stimulus in the face of falling growth. This is not a monetarist Fed; it is a hawkish Fed. While the FOMC is not as Austrian* as the ECB, the Austrian hawks on the FOMC have an effective veto over any policies intended to stimulate inflation and nominal growth--due to the institutional priority placed on consensus and “credibility”.
Despite the fact that both Bernanke and Yellen are dovish monetarists, the policy mix that we are seeing today and can expect to see in the future is Austrian Lite, which is a compromise between monetarism and Austrianism. We are going to get a continuation of low inflation, low nominal growth, and low bond yields. We will not see again the high levels of nominal and real growth that we saw during the Greenspan years. That is, not unless there is a radical change in the composition of the FOMC.
There is nothing to stop the Fed from raising the funds rate, since this is within its complete control. But the impact of a rate hike in a weak economy is deflation and lower bond yields. A higher funds rate will not raise bond yields; it will just flatten the curve and create a recession.
What is the policy stance of the FOMC today? Judging by its actions, as opposed to its palaver, the policy stance is to target an inflation rate below 2%, to grow the money supply in the mid-single digits, and to tolerate abysmal levels of nominal and real growth. In other words, Austrianism Lite. The policy is restrictive; the brakes are on. This is not monetarism.
Bush and Obama appointed dovish monetarists to the chairmanship, hoping for good growth and low unemployment. But the minute a dovish academic walks into the Eccles Building, he stops being an economist and becomes a consensus-seeking, controversy-avoiding "manager". The monetarists are institutionally captured, no matter what they truly believe about economics. The real job of the Fed chair is institutional credibility and continuity, not growth or other humanitarian desiderata. The last thing that a Fed chairman wants to be called is "controversial". This is analogous to the job of the chief justice: retain credibility and respect.
The post-crash FOMC has not completely ignored its full employment mandate, but mainly pays it lip service. It’s slogan (like that of the ECB and the pre-Abe BoJ) is “We’re doing all that we can do and monetary policy is not a panacea”. They are “creating the conditions” for recovery, but take no responsibility for making it actually happen. They are defying the quantity equation. I can only wish that Milton Friedman were still around to be able to explain to Bernanke and Yellen that the pace of nominal growth is within the control of the Fed. Friedman did not put the quantity equation on his license plate because he didn’t believe in it.
So today we have 6% money growth, falling velocity and dangerously low nominal growth. In the face of that data, the Fed has decided to end its balance sheet expansion. The FOMC has declared victory and now plans to do nothing further.  So why in the world should we expect nominal growth and bond yields rise in such circumstances?  Let’s look at what the bond market thinks: 10-year yields have fallen from 3.0% to 2.6% this year. That does not suggest that the bond market expects a pickup in nominal growth let alone higher yields. Why would falling bond yields lead people to expect higher bond yields? Why would falling growth lead people to expect accelerating growth? It’s as if the data didn’t exist.
Investment Conclusion
We are living in a “new era” of slow money growth, low inflation, low nominal growth and low bond yields. Since low bond yields support high stock PE multiples, this news is bullish for both stocks and bonds, but stocks will continue to outperform bonds (because the equity premium is so high).
*Austrianism is the belief that the optimal policy of the monetary authority is price stability, rather than moderate nominal growth or full employment. (Paul Ryan, Rand Paul and Paul Gigot are Austrians.) Austrians reject the quantity equation (money growth = nominal growth) as simplistic and meaningless. They believe that if the central bank delivers price stability, the economy will grow at its “natural” pace and that growth should not be stimulated with "monetary steroids". They believe that recessions naturally occur and naturally correct without fiscal or monetary stimulus, and they recommend supply-side measures such as regulatory reform and lower taxes. This philosophy (once espoused by Herbert Hoover and his gang) has created 12% unemployment in the Eurozone, a shrinking nominal economy in Japan for two decades, and U6 unemployment in the US of 12% five years after the Crash.

Thursday, July 3, 2014

Ignore The June Employment Data

  • The June employment numbers are noise.
  • Employment growth remains slow.
  • There is little risk of an inflation shock.

How should we interpret the strong employment growth figures for June? Does it suggest that the economy is accelerating, or even overheating? My answer is no to both. Employment growth remains slow, and the economy is not overheating.

Between 2003 and 2008, total employment grew from 130 million to 138 million. Over the next two years the economy shed 8 million jobs and employment returned to 130 million. Since 2010, the economy has added back the 8 million jobs that were lost in the recession, and we are just above where we were six years ago. It has been a long and painful recovery, which reflects poorly on the stewardship of the FOMC (which consistently ignores its full employment mandate).

Since the Crash, employment on a YoY basis has been growing at between 1.5% and 2.0%. The June number, on a YoY basis, remains within range at 1.8%. On an annualized basis, monthly employment growth during the recovery has averaged below 2%, with a range between 0.6% and 3.3%. The June growth number was 2.5%, well within range. There is thus not a lot of information content in the June number; I see it as noise, just like the shrinkage of the economy in 1Q14.

The economy and employment (nominal) continue to be stuck in second gear, growing far below the levels achieved before the Crash. I attribute this to the combination of sluggish money growth (~6%) and the slow recovery of the credit cycle. For the economy to accelerate to escape velocity will require faster money growth (9%) and much stronger housing activity. In other words, the economy has not yet recovered from the trauma of 2008.

There is still substantial slack in the labor market. The participation rate has not recovered at all. The broad measure of unemployment (U6) is at 12%, far above the 8% level before the Crash. Ten million workers have no jobs. Therefore, I would be very surprised if the June employment number has any effect on monetary policy. The Fed has not yet achieved full employment, nominal growth remains very slow, and capacity is not constrained. What would change the Fed’s mind would be a sustained rise in core inflation, but I don’t expect this given the economy’s weakness and the slack in the labor market. (The employment cost index grew at a 0.6% annual rate in 1Q14.)

Investment Conclusion
The big drop in nominal GDP in 1Q14, and the big spike in employment in June are both noise. Nothing has changed: inflation remains low and the Fed is unlikely to tighten in the foreseeable future. For the capital market, this means that there is very little risk of an inflation spike that would cause stock and bond prices to decline. We are living in a new world of permanently slow growth and low interest rates.

Wednesday, July 2, 2014

The Equity Risk Premium Is Still High

  • The stock market remains attractively valued.
  • The equity risk premium remains high by historical standards.
  • The size of the premium reflects the low yields on offer in the bond market.

At the beginning of each month, Professor Aswath Damodaran at NYU publishes his estimate of the implied equity risk premium as of the first day of the month. His estimates go back to 1961. Today he published his estimate for July 1, 2014, which is 5.4%. How should we interpret this number?

The 53-year range for Damodaran’s ERP is 2.0% to 7.7%, and the eyeball median is between 3% and 4%. Since the Crash, the range has been between 4.4% and 7.7% (the all-time high, set in March 2009 and again in October 2011) . The current number is the highest it has been since last October.

My personal view is that when the ERP is above 4%, the stock market offers an adequate risk premium, and when it is below 4% it is less compelling and more risky. The all-time low was set in 1999 at 2.0 %. The stock market was highly overvalued at that time, and it took 15 years for the real S&P 500 index to return to its 1999 high.

Fernando Duarte and Carlo Rosa at the New York Fed published a paper on the ERP in January: “The Equity Risk premium: A Consensus of Models”. The authors concluded that:
  • There is broad agreement across models that the ERP has reached historical heights [as of mid-2013] even when the models are substantially different from each other and use more than one hundred different economic variables. [Note: today’s ERP is only slightly below the level in mid-2013.]
  • The ERP is high at all foreseeable horizons because Treasury yields are unusually low at all maturities.  In other words, the term structure of equity premia is high and flat because the term structure of interest rates is low and flat.  Current and expected future dividend and earnings growth play only a minor role.
  • A high ERP caused by low bond yields indicates that a stock market correction is likely to occur only when bond yields start to rise.
  • We should no longer rely on traditional indicators of the ERP like the price- dividend or price-earnings ratios, which all but ignore the term structure of risk-free rates.
  • The current high levels of the ERP are unusual in that we are not currently in a recession and we have just experienced an extended period of high stock returns. During previous periods, the ERP has always decreased during periods of sustained high realized returns. It is unusual for the ERP to be at its present level in the current stage of the business cycle, especially when expectations are that it will continue to rise over the next three years.
  • Our analysis provides evidence that is consistent with a bond-driven ERP: expected excess stock returns are high not because stocks are expected to have high returns, but because bond yields are exceptionally low.

The key take-away from their paper is that the stock market offers an attractive risk/return relationship not because of expected earnings growth, but instead because low interest rates justify a high PE ratio. A simple way to look at it is to compare the PE of the 10-year Treasury bond with that of the S&P 500. The current PE for the bond market is 40x, while the PE for the stock market is 20x--even though corporate earnings grow and bond interest doesn’t.

One might argue that both stocks and bonds are overvalued, perhaps due to the zero funds rate and quantitative easing. However, I see no evidence that bond yields are artificially low. Bond yields are historically low because inflation expectations are historically low. Despite “unprecedented monetary stimulus”, both expected and observed inflation have remained low.

Admittedly, the bond and stock markets are vulnerable to an inflation shock, but I don’t expect one. Money growth remains in the mid-single digits, velocity continues to decline, overall credit growth is modest, and nominal growth is at a recessionary level. Higher oil prices are deflationary, not inflationary.

I am aware of the argument that “true” inflation is much higher than reported, but this requires a level of paranoia that is neurotic and not analytic. Inflation is low, which is why the prices of gold and silver have been falling for almost three years. Not only is price inflation low, but also wage growth is currently flat.
Investment Conclusion
The stock market has offered investors a historically high risk premium since the Crash. While the current premium is below the all-time highs following the Crash, it remains elevated at all horizons and does not depend upon expected earnings growth. Higher inflation and bond yields would reduce the premium, but I see the risk of an inflation shock as low. Consequently I believe that the stock market remains attractively valued at current prices.

Friday, June 13, 2014

A Brief Note On The War In The Middle East

The United States is fighting a cold war with Iran. US policy has been to aid Iran’s enemies (the Gulf States, Israel) and to hurt Iran's friends (Syria, Hizbollah). So, when Sunni insurgents revolted against the Assad regime in Syria, the US provided them with covert assistance. These Sunni insurgents are the same people who are now invading western Iraq and are menacing Baghdad.

So now there is a regional Sunni-Shi'a war in Syria/Iraq, in which US is supporting both sides: the Sunni jihadis in Syria and the Iran-aligned Shi'a in Iraq. US policy is to bring peace to the region by providing arms and assistance to both sides in this bloody war.

Now I understand the Nobel peace prize.

Friday, June 6, 2014

Draghi’s Latest Announcement Is A Big Nothing

  • Another "growth package" from the ECB
  • No effective policy to spur money growth
  • Eurozone inflation and growth remain out of reach

On Thursday, the ECB governing council announced a range of window-dressing measures intended to make it appear that the ECB understands monetary policy. None of the announced measures will do anything to raise nominal growth to the level required to achieve a material reduction in unemployment. Europe’s problem is the combination of a deflationary monetary policy, a contractionary fiscal policy, and ongoing credit contraction caused by the unending banking crisis. It is noteworthy that the euro rose following Draghi’s presser, indicating that the market has no confidence in the achievement of 2% inflation.

Here are the current data (YoY change) for the eurozone:
Monetary base: minus 14%
M1: 6%
M2: 2.5%
M3: 0.9%
Credit: minus 3%
NGDP: 1.8%
RGDP: minus 0.3%
CPI: 0.7%
Unemployment rate: 12%
Source: FRED

When I was in college I was taught that, according to the Quantity Theory, the monetary authority determined the rate of nominal growth: MV = PT, where MV is velocity-adjusted money growth, and PT is nominal growth. I was also taught that in a depression fiscal stimulus accompanied by reflationary monetary policy can stimulate aggregate demand. I subsequently learned from Ben Bernanke, John Taylor and others that when interest rates are already very low, monetary policy can still stimulate demand by lowering the real interest rate (by raising inflation expectations). What I was taught appears to be unknown in the dark reaches of the Continent.

How can we explain Mario Draghi’s puzzlement at the fact that when  contractionary monetary and fiscal policies are pursued, and the real interest is far above the Taylor Rule, sustained growth does not occur? Does he truly believe that structural reforms alone will produce growth and inflation? Show me an economics textbook, in any language other than German,  which says that the way to achieve nominal growth is to hold money growth at zero while pursuing structural reforms.

De minimis money growth produces de minimis nominal growth, which is what the ECB appears to be targeting (channeling the pre-Abe BoJ). The ECB evidently defines its mandate as zero inflation, which it believes is the foundation of its “credibility”. An analogy is the 1930-33 Fed, which maintained its “credibility” by defending $20 gold in the face of 25% unemployment and a 1/3 decline in NGDP. Starvation is the best proof of central bank credibility.

Draghi desires both credibility and prosperity, which are incompatible. Either the ECB sacrifices its credibility, or else the European depression will continue.

Friday, May 23, 2014

The FOMC Is Plotting "Normalization"

>The Fed intends to “normalize” monetary policy and reduce the size of its balance sheet.

>There would appear to be no opposition on the FOMC to this objective.

>The doves have flown the coop.

>The outlook is for low bond yields and high equity multiples.

The big topic in monetary policy circles these days is the impending normalization of monetary policy: how to unwind QE and bring  the size of the Fed’s balance sheet back to a normal, pre-Crash level.

This is from the FOMC’s April minutes: “Participants generally agreed that starting to consider the options for normalization at this meeting was prudent, as it would help the Committee to make decisions about approaches to policy normalization and to communicate its plans to the public well before the first steps in normalizing policy become appropriate.”

Professor Alan Blinder, a former Fed governor, wrote in the WSJ this week: “The FOMC will have to figure out how and when to exit from two main policies: its near-zero interest rates and its bloated balance sheet.”

In this discussion, the debate is between those who want to normalize now, and those who want to normalize later. There is no debate about why the Fed should normalize policy; normalization as a compelling policy desideratum is just a given. In other words, normalization is being prioritized over less important  policy goals such as growth and employment.

The performance of the economy, and the ability of the economy to provide remunerative employment to the American labor force, are to be subordinated to a technical objective for “good housekeeping” reasons. The Fed’s balance sheet is “bloated”, and that is unattractive.

This way of thinking is nonsense. First of all, how does anyone know what the optimal size of the Fed’s balance sheet is without reference to desired macro policy outcomes? Is there an optimal balance sheet independent of desired policy outcomes? Of course not. Who in the world cares how big or small the Fed’s balance sheet is?

Second, the bigger the Fed’s balance sheet, the smaller the national debt which is good for our nation’s credit. Federal debt held by the Fed is extinguished unless and until the Fed sells it back to the public. Why would the Fed want to sell it back to the public when it doesn’t need to, and when doing so might be contractionary?

Thirdly, if the Fed’s balance sheet is indeed bloated and must be reduced for some reason, why not simply have the Fed forgive most of its holdings of Federal debt? Since the Fed is owned by the Treasury, the forgiveness of the Treasury’s debt would be “eliminated in consolidation” as the accountants say: a meaningless book entry. Oh, but that would reduce the Fed’s “capital”, the ignorant would argue, entirely missing the fact that the Fed prints dollars and doesn’t need a penny of capital, and that the goodwill value of the license to print money is infinite, and thus the Fed cannot be insolvent in dollar terms.

But to return to Planet Earth: Only a fool would subordinate the Fed’s statutory mandates to the shibboleth of “balance sheet normalization”. QE had the effect of creating massive excess reserves. In the event that at some point these excess reserves started leaking into the money supply (which looks doubtful), the Fed has many tools to limit the impact, such as increasing required reserves or open market operations.

The bottom line is that there are no longer any doves on the FOMC.  They are all Austrians now, to paraphrase Richard Nixon. The doves have all capitulated to the siren song of normalization. Like the Fed of the Hoover years, technical concerns will subordinate such trivial matters as growth and employment: above all, the Fed must keep a tidy balance sheet. The fact that every prediction made by the hawks since the Crash has proven false does not diminish the allure of their comfortable useless conventional wisdom.

Investment Conclusion:

Monetary policy will continue to tighten. Growth and inflation will remain low. Bond yields will continue to reflect a low real interest rate and low inflation expectations. Equity multiples will continued to be supported by low bond yields.

Thursday, May 15, 2014

Why Bond Yields Are Falling

  • Bond yields have been falling since January
  • This has nothing to do with monetary stimulus
  • Falling yields are a signal of declining inflation and growth expectations
  • Stocks are the only option for today’s investor
As usual, the financial media is deeply confused about the relationship between monetary policy and bond yields. Bond yields are falling, and the public demands an explanation! Today’s WSJ gives it a stab:
“Bond yields are – once again — plunging worldwide. The reason for this revived buying among fixed-income investors is that central banks are – once again – signaling their intent to ease monetary conditions in yet another bid to kick-start sluggish economies and forestall a downward spiral in prices, or deflation. The prospect that central banks will continue to inject money into the world's bond markets...has acted as a green light for the world's bond buyers.”
Bond yields are declining because central banks are pursuing inflationary policies. Wasn’t it just yesterday that we were being told that quantitative easing would cause hyperinflation and double-digit bond yields? Now we are supposed to believe that monetary stimulus causes bond yields to fall. Inflation is deflationary.
A second myth being retailed now is that central banks have been providing monetary stimulus since the Crash:
"The global economy hasn't fired up despite all the heavy monetary stimulus,'' said Mary Ann Hurley, vice president of trading at D.A. Davidson & Co...“We continue to stay in this ultra-loose monetary-policy environment" which supports bond prices, said Jason Brady, head of fixed income at Thornburg Investment Management. (in today’s WSJ)
It should by now be evident to any market participant who has taken Monetary Policy 101 that there has been no “heavy monetary stimulus” and that we are not in an “ultra-loose monetary policy environment”. There are a number of ways to judge a central bank’s policy stance, and almost all of them indicate that none of the major central banks (aside from the PBoC) has been providing “massive stimulus”. These measures include money growth, inflation, nominal growth, real growth, expected inflation and bond yields. For the Fed, the ECB, the BoE and the BoJ, all of these indices have been flashing “TOO SLOW” since the Crash. Fitful efforts at QE have failed to move any of the dials.
Falling bond yields are not about the prospects for more stimulus. They are instead a signal of the market’s loss of faith in the ability of the central banks to provide adequate monetary stimulus. The market looks into the future and sees very low money growth, declining velocity, less than 2% inflation, 3% nominal growth and 1% real growth. Such an outlook justifies a 10-year yield of 2.5%.
And by the way, we are not in a “new era”--we are in an old era called the mid-20th century, when bond yields remained below 3% for twenty years, from 1935 to 1956. Of course, this is all new to the baby boomers, who can only remember the inflationary era after the breakup of Bretton Woods. We will need to erase those inflationary memories and reacquaint ourselves with our parent’s era when 3% bond yields were considered high, and a 2.5% yield was considered normal. There is nothing “extreme” about low inflation and low interest rates.
What About Stocks?
Declining bond yields are bullish for stock prices. The 10-year yield has declined from 3% in January to 2.5% today. Stated differently, the PE on the 10-year bond has risen from 34 to 40. This raises the equity premium which makes equities more attractive, and justifies a higher multiple. Today, the forward multiple for the S&P is 15.8x which represents an earnings yield of 7%, which is certainly more attractive than 2.5%.

Tuesday, May 6, 2014

Bond Yields Fall As Fed Tapers Purchases--Markets Perplexed!

  • Bond yields are falling despite the Fed’s decision to taper QE

  • This is because QE has not affected the economy
  • Falling bond yields are not bearish for stocks

Since the FOMC began to taper its bond purchases at the beginning of this year, the 10-year Treasury yield has declined by 40 basis points from 3.0% to 2.6%. This has caused puzzlement in the financial commentariat:
The demand for Treasury bonds is all the more remarkable because the Federal Reserve is ending the Treasury-bond-buying program it has used to keep interest rates low. That normally would reduce Treasury demand and push yields higher. Instead, Treasury prices have risen and yields declined.” (WSJ, 05 May 14)

This amazing phenomenon does not come as news to readers of my blog. I have been calling attention to the tightening of monetary policy for the past two years. The fact that the Fed has given up on QE is a signal of even greater tightening, which is entirely consistent with falling bond yields. Today’s bond market is looking at a very subdued horizon:
  • 6.0% money growth, the impact of which is further diminished by declining velocity;
  • 1.2% inflation, which is 40% below the Fed’s target;
  • 3.7% nominal growth, which is inadequate to sustain anything like 4% real growth--which was in fact zero (QtQ) in the first quarter;
  • A complete absence of any discussion at the FOMC of taking concrete steps to accelerate money growth.

We are also told that falling bond yields are a bearish signal for stock prices:
“One sign of the current worry is the strength of U.S. Treasury-bond prices. In times of economic optimism, investors normally buy risky assets like stocks, not safe Treasury bonds.” (WSJ, 05 May 14)

It is true that the depressed economic outlook is bearish for the rate of corporate earnings growth, but this does not translate into a bearish outlook for equity prices. That is because, ceteris paribus, declining bond yields increase the relative premium being paid to stockholders. Damodaran at NYU calculates the equity risk premium at 5.1% as of May 1st. This compares with an all-time high of 7% during the Crash and an all-time low of 2% in 1998. The current level is considerably above the historical mean. Stocks offer a relatively attractive prospective return in a world of ultra-low interest rates.

The ERP is elevated because bond yields are very low, not because of the outlook for earnings growth. The threat to current stock multiples is not low earnings growth, but instead higher bond yields. Given the current subdued outlook for growth and inflation, I see little reason to expect higher bond yields anytime soon.

There is a widely-held view that bond prices have been artificially supported by QE, and that the end of QE should herald lower bond prices--that financial markets have been artificially supported by “massive monetary stimulus”. The empirical evidence suggests that bond prices were not inflated by the Fed, and that the withdrawal of QE will not result in lower bond (or stock) prices.

My view has been that, because QE has failed to increase money growth, inflation and nominal growth, it has not raised bond prices. This is because inflation expectations have declined during QE, which should not have occurred during a period of “massive money printing”. Pre-crash, 10-year inflation expectations were above 2.5%; today, they are 2.2%--despite a quadrupling of the Fed’s balance sheet. The tapering of QE is a signal that nothing more will be done to raise inflation expectations, hence the rise in bond prices. QE was nothing but a sideshow: a huge distraction from the Fed’s continuing failure to get control of money growth.