Friday, December 30, 2016

Predictions for 2017



First, a look at how last year's predictions turned out:




Here's what I see in my crystal ball for 2017:










Thursday, December 29, 2016

Commercial real estate still booming

According to the folks at the CoStar Group, the commercial real estate market is registering annual price gains of more than 8%, as the rally in prices that began some six years ago continues to impress.

The chart above includes the latest (as of November) Co-Star data. Note that both measures of commercial real estate prices are at new nominal highs and have been increasing at annual rates of 8-10% for a number of years.

Moodys publishes a similar index (second chart above). As both charts show, prices have reached new all-time highs.

As the chart above shows, commercial real estate has been outperforming the residential market in the current cycle, whereas it lagged during the great housing market boom of the early 2000s. But both are performing quite well.

If anything, the action in the commercial real estate market would appear to be at odds with the very low rates of inflation and sub-par rates of growth that we have seen in the current business cycle expansion. My take is that this is evidence, at least in the past year or so, of rising optimism as well as declining demand for money, and both are precursors, in this age of Quantitative Easing, of rising inflation, as I've explained many times before. However, the bond market is still showing modest inflation expectations (e.g., 1.9-2.0%) for the foreseeable future, so it may be premature to sound a rising inflation call. Especially given the impressive strength of the dollar.

As a reminder, real estate is likely to benefit from a strong economy as well as rising inflation.

Friday, December 23, 2016

The Fed doesn't control bond yields

For years I've been saying that the Fed can't control bond yields, but the myth that the Fed can manipulate yields (e.g., by buying lots of 10-yr Treasuries and/or by buying lots of MBS) persists. Experience tells us that the Fed can only control short-term rates, and even then it is questionable whether the Fed can move rates up or down by more than the market is ready for at any given time. Recall the bond market tantrum earlier this year when the Fed hinted that it might raise rates several times during the course of the year, and the Fed then quickly backed off, raising rates only once (recently). Bond yields are effectively set by market forces, and are heavily influenced by the market's perception of the future of Fed policy, the expected level of inflation, and the outlook for economic growth.

Here are some charts which compare the history of the Fed's purchases of Treasuries and MBS and their corresponding yields. You can judge for yourself whether the Fed has managed to manipulate those yields with its Quantitative Easing programs.

The chart above shows what happened to 10-yr Treasury yields during the Fed's three Quantitative Easing programs. In each period, despite massive bond purchases, the yield on 10-yr Treasuries rose. Ironically, the Fed justified QE by saying it would depress yields, and that in turn would stimulate the economy. What I think really happened to cause yields to rise despite Fed bond purchases was that the Fed's QE efforts supplied badly-needed bank reserves to the system, and that satisfied the market's thirst for safe assets; that in turn resulted in healthier market liquidity, which in turn caused the market to become somewhat more optimistic about future growth, which in turn caused the market to anticipate higher short-term interest rate guidance from the Fed in the future.

The chart above compares the magnitude of the Fed's Treasury purchases with the level of 10-yr yields. It stands to reason that the Fed could potentially manipulate the bond market only if it buys or sells a quantity of bonds that is significant relative to the outstanding supply of those bonds. Thus the rationale for the blue line, which is the ratio of the Fed's holdings of Treasuries relative to the total marketable supply of Treasuries. Several things jump out: 1) during 2008, as Fed holdings of Treasuries were plunging, yields were falling, and 2) in 2013, as Fed holdings of Treasuries was surging as part of QE3, Treasury yields surged (both in contrast to what the Fed promised QE would do), and 3) the Fed currently holds about 18% of outstanding Treasury debt, and that is about the same amount it held at the end of 2004 and less than the 20% of Treasury debt it held at the end of 2002, yet yields today are much lower than they were back then. Tough to see any convincing or enduring correlation between these lines.

The chart above compares the magnitude of the Fed's MBS purchases with the level of MBS yields. Here we see that despite huge MBS purchases in 2009, MBS yields were relatively unchanged. More recently, with Fed holdings of MBS holding relatively steady, yields have surged. No convincing causality or correlation that I can see between these two lines.

The recent surge in bond yields has almost nothing to do with Fed policy, and very little to do with increased inflation expectations. It's mostly about an improving outlook for growth assuming that Trump is able to reduce the tax and regulatory burdens that have been holding back growth for the past decade.

Wednesday, December 21, 2016


It's likely that close to half the population of the U.S. is still fearful of what Donald Trump will do once he becomes the most powerful man on earth. But to judge from the reaction of the stock and bond markets, the other half is ecstatic. Since November 4th, when expert opinion held that Hillary Clinton was almost sure to win, 1) the value of the U.S. stock market has increased by just over $2 trillion, according to Bloomberg, 2) the expected real growth rate of the U.S. economy has increased by roughly 0.5% per year according to the bond market, which translates into an additional $1 trillion per year in national income, and 3) the global purchasing power of U.S. residents has increased by about 6% according to the foreign exchange markets. You might call those gains Trump-Trillions.

The chart above shows the value of the U.S. stock market (in trillions of dollars).

The chart above shows the real yield on 5-yr TIPS, which is a good proxy for the market's economic growth expectations. About two-thirds of the 80 bps increase in 5-yr Treasury yields since the election has been due to an increase in real yields.

The chart above shows the trade-weighted value of the dollar vis a vis other major currencies, which is up about 6% since the election.

In a sign that the world's general level of discomfort has eased measurably, gold is down over 13% since the election.

The question now becomes whether the market has gotten ahead of itself. According to Mohamed El-Erian, the market has "priced in no policy mistakes ... no market accidents ... [and] ignored all sorts of political issues." I'm not sure I'd put it the same way, but it's undoubtedly the case that the market has priced in good things that have not yet happened, and that leaves the market vulnerable to disappointments. Further gains over the six months or so will probably require concrete achievements, not to mention a pickup in corporate profits and an actual reduction in tax and regulatory burdens.

Over the long haul, I think there's still lots of upside potential. To support that assertion, I offer the following chart, which suggests that the real yield on 5-yr TIPS would have to increase significantly if the market were to price in a booming economy with 4-5% real growth rates.

Tuesday, December 20, 2016

Chemical activity still strong

Here's another update of an indicator I've been highlighting for the past several months. The American Chemistry Council's Chemical Activity Barometer (see chart above) hit a new all-time high this month, rounding out a significant pickup in the second half of this year, and suggesting that the economy will register stronger growth in the months to come.

As the chart above shows, the year over year gain in the 3-mo. moving average of the CAB has tended to lead a similar gain in industrial production, which has been weak for some time now.

HT: Calculated Risk, which has been covering this issue in greater detail for some time now.

Wednesday, December 14, 2016

The Fed didn't tighten today

The Fed increased its target short-term interest rate today to 0.75%, but that doesn't represent a tightening of monetary policy. It would be more correct to say that today monetary policy became slightly less accommodative. Neither the market nor the economy has anything to fear from today's Fed action. Financial markets today enjoy plentiful liquidity conditions, and confidence in general in rising.  Interest rates have adjusted upwards slightly to reflect this. Remember: higher interest rates don't threaten growth; interest rates are higher because growth expectations are somewhat stronger. This is all good news. Today's modest decline in equity prices is more a buying opportunity than a warning sign.

The chart above compares the current real short-term rate (red) with the market's expectation for what the average real short-term rate will be over the next 5 years (blue). The current real short-term rate is about -1%, and that rate is expected to average about zero over the next 5 years. There is no way this represents a tightening of monetary policy for the foreseeable future. And since the real yield curve is still positively sloped (i.e., the blue line is higher than the red line), that is yet another indication that monetary policy is not tight, nor is it even beginning to get tight. The time to worry is when the red line approaches and exceeds the blue line (as happened prior to the past two recessions), because that is the market's way of saying the Fed is tight enough to threaten growth.

The chart above shows that the prices of gold and 5-yr TIPS continue to track each other (using the inverse of the real yield on TIPS as a proxy for their price). This is significant, because it says that the market is willing to pay less for the protection of TIPS and gold, and that in turn is equivalent to saying that the market is regaining confidence in the future. Gold is still quite expensive (my calculations say that the long-term average price of gold in today's dollars is somewhere in the neighborhood of $500-600 per ounce), and real yields are still very low, so it's still the case that the market is on the defensive, and risk aversion is still evident.

Swap spreads are almost exactly at a level which is "normal." That means that liquidity conditions are very healthy, and it further suggests that the outlook for growth is also healthy. No one is being starved of liquidity as a result of the Fed's "tightening" of monetary policy. In the past, prior to IOER, the Fed tightened by reducing the availability of bank reserves, which tends to shrink the amount of money in the financial system. But that is not the case today. All the Fed has done is to change the appeal of holding cash equivalents—by making them somewhat more attractive on the margin. That is a prudent move, because the recent rise in the equity market tells us that the market is becoming more optimistic on the margin about the future, and more optimism would imply less demand for cash equivalents. The Fed needs to respond to rising optimism by making bank reserves more attractive; otherwise banks might be tempted to lend too much, and that could give us higher-than-expected inflation.

As the chart above shows, credit spreads are still relatively low. That's another way of saying that the Fed's move today presents no threat to economic growth. Markets are comfortable with the Fed's move, and generally agree with the Fed's assessment that the economic outlook has improved somewhat and that higher real rates are justified.

Monday, December 12, 2016

Animal spirits are perking up

Over the weekend we had dinner with friends in north San Diego County. His firm provides consulting services to other firms that are in the initial stages of planning residential and commercial projects in the area—projects that won't be finished for 2-3 years. "Last summer was the worst summer we have ever had," he lamented. New business all but dried up. But days after the November election new business began pouring in. He's busier now than ever before.

This squares with what I have been thinking for the last six months or so: faced with the extreme uncertainties surrounding the election, decision makers would be compelled to put new projects on hold, thus weakening the economy. But now that Trump has won and it appears likely that he is going to advocate for reduced tax and regulatory burdens, decision makers are much more willing to pull the trigger on major project decisions. If "animal spirits" are perking up even before tax and regulatory burdens have been cut, imagine what might happen if and when they actually are.

This is only anecdotal evidence, to be sure. But I'm pretty sure that next year promises to be a much better one for the economy.

UPDATE (11/13/16): The NFID Small Business Optimism Index jumped almost 4% in November, thus providing some corroboration for what I learned from my friend.

Sunday, December 11, 2016

Richer than ever

Last Friday the Fed released its Q3/16 estimate of the balance sheets of U.S. households. Collectively, our net worth reached a new high in nominal, real, and per capita terms. We are living in the weakest recovery ever, and things could and should be a lot better, but it is still the case that today we are better off than ever before.

As of September 30, 2016, the net worth of U.S. households (including that of Non-Profit Organizations, which exist for the benefit of all) reached a staggering $90.2 trillion. To put that in perspective, it's about one third more than the value of all global equity markets, which were worth $66 trillion at the end of September, according to Bloomberg. I note that household liabilities have increased by only $300 billion since their 2008 peak; the value of real estate holdings is up about 5% from that of the "bubble" high of 2006 (10 years ago!); and financial asset holdings have soared since pre-crash levels, thanks to significant gains in savings deposits, bonds, and equities.

In real terms, household net worth has grown at a 3.6% annualized rate for the past 65 years.

On a real per capita basis (i.e., after adjusting for inflation and population growth), the net worth of the average person living in the U.S. has reached a new all-time high of $278K, up from $62K in 1950. This measure of wealth has been rising, on average, about 2.4% per year since records were first kept beginning in 1951. By this metric, life in the U.S. has been getting better and better for generations.

The ongoing accumulation of wealth is not a house of cards built on a bulging debt bubble either, regardless of what you might hear from the scaremongers. As the chart above shows, the typical household has cut its leverage by over 30% (from 22% to 15%) since early 2009. Households have been prudently and impressively strengthening their balance sheets over the past seven years by saving and investing more and by sharply reducing the use of debt financing. 

Friday, December 9, 2016

China's problem is too much money

The Chinese yuan has fallen from a high 6 per dollar three years ago to 6.91 today, and China's foreign exchange reserves have fallen from a high of $3.99 trillion in mid-2014 to $$3.05 trillion as of the end of November. Yet despite the almost 25% decline in China's forex reserves (a key component of China's monetary base), the amount of money in China continues to grow, and has increased over 10% in the past year. There is something wrong with this picture.

A declining yuan alongside declining forex reserves is powerful evidence of significant capital flight. Investors, individuals, and corporations apparently wish to reduce their exposure to the Chinese economy, and that's why the demand for yuan is falling. This problem won't be solved until the dollar value of the Chinese money supply declines by enough to match the decline in the demand for yuan. That can be accomplished by 1) shrinking the monetary base and the money supply, 2) devaluing the yuan vis a vis the dollar, and/or 3) inflating the Chinese price level. Alternatively, China could take steps to boost confidence in the yuan (e.g., by allowing the monetary base to shrink) or boost the demand for yuan (e.g., anything that improves China's long-term economic growth potential).

China's forex reserves are declining because the central bank is selling its foreign assets (mostly held in dollar securities), in an effort to try to support the currency; in effect the central bank is accommodating capital flight. The fact that the currency continues to decline suggests that forex sales have not been sufficient to stem the decline. It's not too hard to see why: the central bank is not allowing the decline in reserves to shrink the monetary base, and indeed, the amount of yuan in circulation continues to rise. Ordinarily, capital flight that is accommodated by central bank sales of forex would result in a shrinkage in the money supply, and that shrinkage would eventually bring the supply of yuan back into line with the declining demand for yuan.

To make matters worse, the ongoing increase in the amount of yuan in China, despite the decline in the demand for same, means the central bank is selling dollar assets and buying Chinese assets, thus “degrading” the quality of the yuan and allowing the oversupply of yuan to continue. The central bank is not allowing capital flight to shrink the monetary base. Replacing dollar assets with yuan-denominated assets in the monetary base is eroding the effective quality of the yuan, and that does little or nothing to maintain confidence in the yuan.

China is not taking adequate steps to address the decline in the demand for yuan. This means that the problem of capital flight and the decline in the value of the yuan will continue, despite China's best efforts to physically stem capital flight. It also means that Chinese inflation is likely to rise. Unless properly addressed, these problems will persist, and they will further weaken the Chinese economy. That is not good for China or for the world. It's difficult to see how exactly this will play out, and what impact it could have on the U.S. economy. 

A crisis is not likely imminent, however, since China still sits on a virtual mountain of forex reserves, and the dollar value of Shanghai Composite Index is up over 15% since January. But as John Cochrane muses, and today's WSJ op-ed points out, there are disturbing things going on that bear watching.

At the very least, this makes Trump's demand that China boost the value of its currency vis a vis the dollar a virtual impossibility.

The chart above summarizes the central facts. As it suggests, the persistence of capital flight is forcing the central bank to devalue the yuan. 

Despite the yuan's decline in recent years, it is still very strong against a basket of trade-weighted, inflation-adjusted currencies. 

Wednesday, December 7, 2016

Walls of worry update

Here's an update of one of my favorite charts. I show it in honor of another decisive market move to new all-time highs that has been accompanied, not surprisingly, by a significant decline in the market's level of fear and a meaningful rise in interest rates, which in turn reflects a more confident growth outlook.

Tuesday, December 6, 2016

The outlook for interest rates

10-yr Treasury yields have jumped 100 bps in the past 5 months, 30-yr fixed-rate mortgages are up almost 70 bps since August (to 4.0%), and the bond market is convinced that the Fed will raise short-term interest rates to 0.75% at its meeting next week. A good part of the rise in 10-yr yields since their all-time low back in early July was due to an improvement in the economy's fundamentals (GDP growth in the third quarter was 3.2%, up from 1.4% in the second quarter), whereas a little over half of the rise in yields has occurred since Trump's surprise election victory. A further breakdown of the rise in yields reveals that about half was due to stronger growth expectations (real TIPS yields are up about 50 bps), and half was due to higher inflation expectations (which are now up to 1.9-2.0% for the next 5 and 10 years).

So it would appear that interest rates are well on their way to normalizing, right? Well, not exactly. According to the implied pricing of the Treasury curve, the bond market is expecting only a gradual rise in note and bond yields over the next several years—less, in fact, than what has occurred in the past 5 months. Whether this is reasonable or not is the issue confronting investors today. If rates end up rising by more or by less than the market currently anticipates, that could have a big impact on interest-sensitive sectors such as utilities and real estate, both of which have already been hit by the recent and unexpected rise in rates.

The chart above compares the current level of the Treasury yield curve (blue line), with the bond market's implied forward yields (i.e., the future yield which is implied by current yields) over the next 2 and 3 years. Most of the eventual rise of yields is expected to occur over the next year, with the Fed expected to raise short term rates another two or maybe three times (to at most 1.5%) over the next 12 months. Beyond that, the market sees the Fed's target rate rising to at most 2% by the end of 2019, and possibly 2.25% by the end of 2020. 5-yr Treasury yields are expected to rise from 1.84% currently to 2.6% by the end of next year, and 2.8% by the end of 2019. 10-yr yields are expected to rise from 2.4% currently to 2.7% by the end of next year, and 3.1% by the end of 2019. The market expects that it will take at least 7 years for 10-yr yields to rise by 100 bps from where they stand currently.

Now let's put these rates in context. As the chart above shows, 5-yr Treasury yields not too long ago were as high as 5%, at a time when core CPI inflation was funning at 2.5-3% and real GDP growth was 2.5-3%. If that was "normal," then today's 1.8% 5-yr yields should be almost 200 bps higher, given the current level of core CPI inflation.

The current level of real and nominal 5-yr Treasury yields (see chart above) tell us that the market is expecting CPI inflation to average about 1.9% per year over the next 5 years. It's unusual, to say the least, for nominal 5-yr yields (currently 1.8%) to be less than the expected future inflation rate over the next 5 years. "Normally," nominal 5-yr yields are 1 or 2 percentage points above expected inflation. Inflation expectations seem reasonable (the core CPI has increased almost 2% per year over the past 10 years), but the level of nominal and real yields seems unusually low, despite their recent jump. This suggests that the market is still priced to miserably low growth expectations. Which further suggests that if Trump's economic plan ends up providing the economy with a significant boost, it's fair to say the market will be quite surprised, and yields will move significantly higher.

The charts above show how the recent move up in 10-yr Treasury yields has affected 30-yr fixed mortgage rates, which are up about 70 bps from their recent, all-time lows. Mortgage rates are still very low from an historical perspective. They were much higher when the housing market was booming in the early 2000s.

Even with the recent jumps in interest rates, and the Fed's almost certain hike in short-term rates next week, it appears that interest rates are still very low and not expected to rise much more in coming years. If you believe there is a decent chance that Trump's economic policies could get the economy back on a healthier growth track, then you need to be very worried about further unexpected rises in interest rates.

While higher-than-expected increases in 5- and 10-yr Treasury yields would definitely be bad news for bond investors, they would not necessarily be bad news for interest-sensitive sectors of the economy. That's primarily due to the fact that higher-than-expected interest rates would most likely come hand in hand with stronger-than expected growth and possibly higher-than-expected inflation. The negative impact of higher than expected rates on the real estate market, however, could be substantially mitigated by the positive effects of stronger growth and higher inflation. It's not obvious, in other words, whether real estate investors should be worried about higher interest rates. Ditto for the utility sector, where prices have already discounted further hikes in interest rates, but not a further strengthening of the economy.

The key thing to keep in mind is this: if interest rates rise by more than expected, it will almost surely be because growth and/or inflation prove to be stronger than expected. Higher interest rates aren't a threat to growth, because stronger growth will boost interest rates.

Thursday, December 1, 2016

Manufacturing and inflation get a lift

Both inflation and real growth are getting a modest lift these days. Recent economic data continue to support the notion that economic activity has firmed a bit in the second half of the year, after being weak in the first half. The improvement is modest, but nevertheless encouraging, especially since there are signs that overseas activity is picking up as well. The market is also pricing in a modest pickup in inflation, with expectations now centering around 2% over the next 5 and 10 years.

As the chart above suggests, he November ISM manufacturing report is consistent with an economy that is growing at a modest 2-3% pace.

It's encouraging that Eurozone manufacturing surveys point to some improvement in the second half there as well.

Industrial metals prices have surged almost 45% year to date, and that is very impressive. Some of the upward impetus could be speculative in nature, a bet that a Trump administration ramp up infrastructure spending in a big way. The hoopla surrounding the ARRA infrastructure spending bonanza was way overblown, but this time could be different. Instead of relying on local governments to identify "shovel-ready" projects, Trump may instead rely more on tax incentives and private sector funding, and that could mean an infrastructure push that could be more efficient and more productive. Caterpillar stock, up 60% since January, is sending the same message. However, I note that prices have been increasing all year, well in advance of any expectation that Trump might win.

This year has seen a remarkable divergence between the value of the dollar and industrial commodity prices. They normally move inversely (e.g., a stronger dollar coinciding with weaker commodity prices), but this year both the dollar and commodity prices have moved up (resulting in the divergence shown in the chart above). When prices move inversely it is a sign that the change in commodity prices has a monetary component (e.g., tight money is pushing the dollar up and deflating commodity prices). Now that they are moving together it could be that the rise in commodity prices is mostly being driven by improving economic fundamentals both here and abroad: prices are rising because demand is outstripping supply. The dollar has its own reasons for rising: the Fed is clearly in a mood to raise rates, while most other central banks are still on the sidelines. More recently, the dollar has gotten a boost from speculation that a Trump administration will be more growth-friendly.

Traditionally, a stronger dollar has spelled bad news for emerging market economies. That's because a stronger dollar has usually coincided with weaker commodity prices, and commodities are very important to emerging market economies. But this time emerging market economies have been taking a beating of late, even though commodity prices have been rising. Perhaps there is too much pessimism? Might it be the case that a stronger dollar and an improving U.S. economy and rising commodities will act like a rising tide that lifts all economies, particular those in the Western hemisphere?

The yen has fallen almost 13% against the dollar in just the past 3 months, and Japanese stocks have reversed to the upside. The strong inverse correlation between the value of the yen and the stock market is still in place. It's unusual for a weaker currency to be good for a country's stocks, but the case of Japan looks different from that of most countries. A weaker yen may be a sign that deflationary pressures—which have weighed heavily and uniquely on Japan's economy for many years—are being replaced by some much-needed reflation.

The U.S. stock market has outperformed the Eurozone stock market for many years now, and nothing seems to have changed of late. The outlook for the U.S. economy is still brighter than it is for the Eurozone economy.

Inflation expectations, as derived from the prices of TIPS and Treasuries, have moved meaningfully higher in the past three months. The chart above shows how this has played out with 5-yr TIPS and 5-yr Treasuries. Nominal yields have risen much more than real yields, with the breakeven spread (equivalent to the expected average annual rise in the CPI over the next 5 years) rising from a low of 1.3% in early August to now 1.9%. 10-yr inflation expectations are now 2.0%. At the very least this means that deflation worries are a thing of the past.

Caution: if this process continues (i.e., if inflation expectations continue to rise), it will mean that the Fed is falling behind the inflation curve and will therefore need to speed up its normalization of short-term interest rates. As I've warned for years, the Fed's biggest nightmare is the return of confidence, and confidence is definitely picking up these days. With rising confidence and less risk aversion, the pubic's demand for all the money that has been created in the past 8 years will begin to decline, unless the Fed takes offsetting measures to boost money demand by raising short-term interest rates.

UPDATE: As seen in the chart below, the Chemical Activity Barometer is still rising impressively, up 4% in the year ending November. Such a move has tended to foreshadow a pickup in industrial production, which has been flat for quite awhile.