Thursday, April 12, 2018

Reading the yield curve's message

If you haven't already heard that an inverted Treasury yield curve is a good predictor of recessions, then either you haven't been reading this blog for long or you haven't been reading much in the financial press of late. (For background, see some earlier posts of mine on the subject here and here.) The subject has become the focus of attention in recent months because the yield curve has been flattening, which in turn has sparked concerns that the risk of recession is rising. These concerns are misplaced, as I explain below.

Chart #1


The top portion of Chart #1 is the standard way to display the status of the Treasury yield curve. It represents the difference between the two lines on the bottom portion: the difference or "spread" between 10-yr and 2-yr Treasury yields. The spread is effectively a measure of the slope of the yield curve, which indeed is relatively flat compared to where it was several years ago. But it's not flat nor is it inverted; it is still positively-sloped, and that means the market believes the Fed is justified in saying it plans to increase rates modestly over the next year or so. The relative flatness of the yield curve is not saying that the Fed is tightening too much or threatening growth, it's best characterized as the market's way of saying that economic growth expectations are neither exciting nor worrisome. I explain this a bit more below.

Chart #2

Chart #2 is another way of looking at the yield curve—a better way, since it gives us some important additional information. The red line in Chart #2 is similar to the blue line in Chart #1, but the blue line in Chart #2 is the important addition: it shows the real, inflation-adjusted Fed funds rate, which is the overnight rate that the Fed targets. The Fed these days has absolute control over the nominal funds rate, while the rest of the nominal yield curve is essentially a projection of what the market thinks the funds rate will average over time. Any yield curve analysis worth its salt should measure not only the slope of the Treasury curve, but also consider the level of the real Fed funds rate.

The Fed doesn't just target the funds rate. What it really targets—but rarely talks about—is the real funds rate. Borrowing money at 5% when inflation is 1% is one thing, but borrowing money at 5% when inflation is 10% is quite another (the former means borrowing is expensive, the latter means borrowing money is a good way to make money). Real borrowing costs are what truly affect behavior. When money is very expensive—when real borrowing costs are high—people are discouraged from borrowing and spending and are encouraged to save money; eventually, if real rates are forced too high, economic activity suffers. That's been the proximate cause of every one of the recessions in the past 60 years.

One thing that stands out in Chart #2 is that the real funds rate has been negative for the past decade. Doomsayers think this means the Fed has been flooding the world with money, and the sky will soon be falling. Monetarists reason that, since we have seen neither a collapse of the dollar nor soaring inflation over the past decade, this can only mean one thing: the demand for short-term financial assets has been incredibly strong for many years (another way of saying that the market has been very risk averse for most of the past decade), and, moreover, the Fed hasn't artificially depressed interest rates, nor has it flooded the market with money no one wanted. The Fed has kept rates low because the demand for money has been strong. See this post (The Fed is not "printing money") from five years ago for more background.

Chart #2 actually has two messages: 1) an inverted yield curve is a good leading indicator of a recession, and 2) very high real short-term interest rates are also a good leading indicator of a recession. When both those conditions hold, that's when you need to worry about a recession. Today we're not even close to having to worry. Despite the Fed having raised its target funds rate six times in the past 18 months (from 0.25% to today's 1.75%), the real funds rate is still in negative territory (-0.18% as of March 31 by my calculations), because inflation over the past year has been almost 2%. The Fed has raised its target for the real funds rate because the market has grown less risk-averse and economic growth expectations have improved somewhat. The Fed hasn't "tightened" in the sense that it is trying to slow things down. The Fed is just following the market.

Chart #3

Chart #3 is important because it gives us information about the slope of the real, inflation-adjusted yield curve. Real yields are just as important, if not more so, than nominal yields. The blue line, the real funds rate, is ground zero for the real yield curve, while the red line, the real yield on 5-yr TIPS, is the market's estimate for what the real Fed funds rate will average over the next 5 years. Today, the front end of the real yield curve is positively sloped (i.e., the spread between the two lines is positive), and it has actually been steepening since last summer. The message: the market agrees with the Fed that short-term interest rates, in real terms, will need to rise in coming years. Not by a whole lot, but by enough to rule out the notion that the market and/or the Fed are nervous about the health of the economy. The time to worry is when the real yield curve becomes negatively-sloped, as happened before each of the past two recessions (i.e., when the blue line exceeds the red line, because that means the Fed has tightened too much).

Another reason the Fed needs to raise real rates is to boost the attractiveness of the $2 trillion of excess bank reserves held by the banking system. Failing to do so would decrease banks' desire to hold excess reserves, and that in turn would lead to excessive lending, too much money, a weaker dollar, and rising inflation.

Chart #4

Chart #5

Chart #4 uses real and nominal 5-yr yields to give us information about the market's inflation expectations. Despite the Fed having kept real short rates negative for 10 years, inflation expectations today are no different from what they have been in the past. As Chart #5 shows, the CPI ex-energy has been on a 2% growth path for the past 15 years, and inflation expectations today, based on 5-yr TIPS and Treasury yields, are about 2.1%. That is effectively proof that the Fed has not been printing money or distorting markets. In monetarist parlance, the Fed has managed to keep the supply of money pretty much in line with the demand for money, though not completely, because inflation has averaged about 1.6% per year for the past 10 years.

Chart #6

Chart #6 shows that real yields on TIPS also provide us with information about the market's GDP growth expectations. The level of real yields tends to track the level of real growth, and that is not surprising at all. A stronger economy implies higher real returns, and real yields should therefore rise in a faster-growing economy. Conversely, as economic growth weakens, as it did following 2000, real yields should fall. Currently, real yields of about 0.5% on 5-yr TIPS tell us that the market expects the economy is likely to grow about 2-2.5% per year, according to my reading of the bond market tea leaves.

If last year's tax reform results in a significant increase in economic growth, as I expect it will, then the Fed is going to have to guide real yields significantly higher as well. And that of course means significantly higher nominal yields, assuming inflation expectations remain "contained."

But for the time being, today's yield curve holds no threatening messages for the economy, and I think the market intuitively understands this.

What's worrisome today is not the yield curve, but the threat of a possible trade war with China and the ongoing tensions in the Middle East. The volatility that we are seeing is the result of the turbulence one would expect when headwinds (trade war risk, Middle East tensions) collide with tailwinds (last year's tax reform). For now, the market's judgment is that the two opposing forces effectively neutralize each other, with the result that growth is expected to be unimpressive, while inflation is expected to remain in the neighborhood of 2%.

Friday, April 6, 2018

Despite a weak March, jobs growth still improving

The March private sector employment report was a big miss on the downside (102K vs. 188K), but the trend rate of growth in private sector jobs continues to improve. The monthly jobs numbers are notoriously volatile and subject to significant revision after the fact, so one month's number cannot possibly be significant. For years I've focused on the 6- and 12-month rate of growth in private sector jobs, and by those measures conditions in the labor market continue to improve, after hitting a low last September. Here are the relevant charts:

Chart #1

Chart #2

Charts #1 shows the nominal monthly change in private sector jobs, while Chart #2 shows the 6- and 12-month rate of growth of private sector jobs. Big swings such as we have seen in recent months are pretty much the norm, so any attempt to characterize the underlying dynamics of the jobs market must rely on at least several months. Over the last six months, private sector jobs have increased on average by 213K, which translates into a 2.0% annualized rate of growth. Over the past 12 months, private sector jobs have increased on average by 187K, for a 1.8% rate of growth. This represents a significant improvement since the low point in September of last year, when private sector jobs rose at a 1.6% rate over the previous 6 and 12 months. We're making progress, albeit slowly.

Chart #3

Another bright spot is the recent pickup in the year over year growth of the labor force (the number of people of working age who are employed or looking for work). This hit a low of 0.4% last October and now stands at 1%, which is close to its average in recent decades. Background: over the long haul, the labor force tends to grow by about 1% per year, and productivity tends to average about 2%: the combination of the two, 3%, gives you the long-range average rate of growth of the economy. The current recovery, the weakest on record, has seen annualized growth rate in the labor force of just 0.5% and annualized productivity growth of only 1.0%.

Chart #4


Chart #4 shows the size of the labor force, which for many years increased by a little over 1% per year. If that growth trend had persisted, there would have been another 12 million or so either working or looking for work, and the unemployment rate—currently 4.1%—would currently be a lot higher.

Chart #5

The Labor Force Participation Rate has been steady—and quite low—for the past several years, but with a hint of improvement. (This is the labor force—those working and looking for work—divided by the working age population.) This rate is going to have to increase in coming years if the economy is to grow by more than 3%. Which means that a good portion of the 12 million or so that have "dropped out" of the labor force are going to have to decide to get back in the game. There are hints that this improvement has begun, but progress is still slow. What will entice millions of folks to get off the sidelines and back to work? Better-paying jobs. Where will the extra money to pay higher salaries come from? From increased corporate profits, which are baked in the cake thanks to the recent tax reform, and which will increase the nation's capital stock as corporate investment improves. With more capital deployed in the economy, labor will become relatively scarce and thus more valuable—and better-paid.

Chart #6 

Chart #6 is another bright spot, since it shows that there has been zero change in the level of public sector employment since the end of 2007. (Note that the y-axis for both series shows a similar scale increase, namely 20%.) This means the relative size of the public sector workforce has shrunk by almost 10% over the past decade. That is a very good thing, since the private sector is much more productive. 

Monday, April 2, 2018

ISM optimism

The monthly surveys of the Institute for Supply Management are very timely (though not real-time) indicators of the health of the manufacturing and service sector industries, and that's a good reason to pay attention to each release on the first of the month. They aren't perfect, but when they register strong levels it is almost always the case that the economy is doing well. I dedicate this post to today's manufacturing sector release, which was uniformly positive. That's comforting, given the backdrop of tariff wars.

It's obvious that the market is more concerned about the threat of a tariff war, as evidenced by today's renewed decline in stock prices, than it is bolstered by the strong ISM surveys. Trump has mandated tariff hikes targeted to China, and China is now retaliating with its own tariffs on selected US goods. This way lies misery, and the real losers will be consumers in both China and the US, who will be saddled with higher prices for a wide range of products. We can only hope that these are negotiating tactics on both sides, and that in the final analysis trade between the US and China will become more fair and more free. If not, we will have a mess on our hands and Trump's presidency will end in ignominy. Can he really be so stupid as to carry this tariff war to its disastrous conclusion? Thank goodness he has Larry Kudlow at his side to warn him of this danger.

Chart #1

Chart #1 compares the overall ISM manufacturing index to quarterly GDP growth. The two don't track perfectly, but as I look at the chart it strongly suggests that Q1/18 GDP growth is very likely to exceed current estimates, which, according to the current output of the Atlanta and NY Fed's models, is likely to be just under 3%. I'd wager that if the ISM index remains at or near these levels for several more months, we are very likely to see some stronger-than-expected GDP numbers before too long.

Chart #2

Chart #2 tracks export orders. Although the March reading dropped from the very high level of the February reading, this survey still suggests that overseas economies are doing well, and US exporters are enjoying strong demand.

Chart #3

Chart #3 shows that a significant number of ISM respondents are experiencing rising prices. This could be a harbinger of higher inflation ahead, but it could only be a sign of generally strong global conditions.

Chart #4

Chart #4 shows that a meaningful number of manufacturing firms are planning to increase their hiring activity in the months to come. That in turn reflects a decent level of optimism on the part of industry executives.

Chart #5

Chart #5 compares the US manufacturing index to a similar index/survey of Eurozone manufacturing firms. Both have been quite strong of late, but conditions in the Eurozone appear to have softened a bit in recent months. Eurozone stock markets have been underperforming their US counterparts for many years, however, so somewhat weaker conditions in Europe are not "new" news.

UPDATE: Today's release of the ISM Service Sector surveys (4/4/18) adds to the growing list of indicators which point to stronger US GDP growth:

Chart #6

Chart #7 compares the monthly changes in private sector employment as calculated by the Bureau of Labor Statistics and ADP. We are seeing here preliminary signs of an increase in the trend rate of growth in private sector employment. I think there is a decent chance that Friday's jobs report will be somewhat stronger than the market is currently expecting (+190K).

Chart #7

The market is obviously torn between the good news, reflected in part by the above charts, and the bad news, which is a budding tariff war with China. Comparing the two, I'm inclined to say that "a bird in the hand (i.e., stronger US GDP growth) is worth two in the bush (i.e., the possibility of a trade war with China)." Tariffs are for the moment only in the threat stage, still months away from actually being imposed, whereas it is becoming more clear that the US economy is gaining upward momentum.