The Economy and Bond Market Radar (July 30, 2012)

Sunday, July 29th, 2012

The Economy and Bond Market Radar (July 30, 2012)

After hitting a new low on Tuesday, Treasury yields bounced back sharply on Friday as ECB president Mario Draghi vowed to do whatever it takes to save the euro. This news sparked a “risk on” rally driving risky assets higher and bond prices lower. Yields on Spanish 10-year government bonds reversed course and dropped sharply on the news as it appears the likelihood of a sovereign default has diminished.

Strengths

• In addition to the ECB news discussed above, there was a front page story in the Wall Street Journal earlier this week that was widely believed to be leaked from the Fed to prep the market for potential Fed policy actions as soon as next week. Monetary policy-makers are taking action around the globe.
• Second quarter GDP grew 1.5 percent. While this is a slow level of absolute growth, it modestly beat expectations.
• Several homebuilding companies reported earnings this week which indicated orders in the second quarter were very robust.

Weaknesses

• June durable goods orders ex-transportation fell 1.1 percent, indicating broad-based weakness.
• The U.K. economy contracted by 0.7 percent in the second quarter, while Mexico’s economy shrank by 0.36 percent in May.
• Markit’s July eurozone manufacturing Purchasing Managers Index (PMI) fell to the lowest level since June 2009. The more traditional PMI reports will be released next week, but the indications obviously look weak.

Opportunity

• The Fed and ECB are both talking about additional monetary stimulus. Interest rates are likely to remain very low for the foreseeable future.

Threat

• Europe remains a wildcard with the markets shifting focus on a weekly basis.

Tags: Bond Market, Bond Prices, Durable Goods Orders, Ecb President, Fed Policy, Government Bonds, Homebuilding Companies, Mario Draghi, Market Radar, Markit, Monetary Policy, Pmi, Policy Actions, Purchasing Managers Index, Quarter Gdp, Risky Assets, Shifting Focus, Stimulus, Treasury Yields, Wall Street Journal
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Does Quantitative Easing Benefit the 99% or the 1%?

Sunday, April 29th, 2012

Forget Competing Theories … What Do the Facts Say about Quantitative Easing?

Paul Krugman says that QE, expansive monetary policy and inflation help the little guy (the 99%) and hurt the big banks (the 1%).

Of course, followers of the Austrian school of economics dispute this argument – and say that it is only the big boys who benefit from easy money.

As hedge fund manager Mark Spitznagel argues in the Wall Street Journal, in an article entitled “How the Fed Favors The 1%”:

The relentless expansion of credit by the Fed creates artificial disparities based on political privilege and economic power. [We have repeatedly pointed out that Fed policy increases inequality.]David Hume, the 18th-century Scottish philosopher, pointed out that when money is inserted into the economy (from a government printing press or, as in Hume’s time, the importation of gold and silver), it is not distributed evenly but “confined to the coffers of a few persons, who immediately seek to employ it to advantage.”

In the 20th century, the economists of the Austrian school built upon this fact as their central monetary tenet. Ludwig von Mises and his students demonstrated how an increase in money supply is beneficial to those who get it first and is detrimental to those who get it last. Monetary inflation is a process, not a static effect. To think of it only in terms of aggregate price levels (which is all Fed Chairman Ben Bernanke seems capable of) is to ignore this pernicious process and the imbalance and economic dislocation that it creates.

As Mises protégé Murray Rothbard explained, monetary inflation is akin to counterfeiting, which necessitates that some benefit and others don’t. After all, if everyone counterfeited in proportion to their wealth, there would be no real economic benefit to anyone. [Remember, even Keynes himself - and Ben Bernanake - said that inflation is a stealth tax.] Similarly, the expansion of credit is uneven in the economy, which results in wealth redistribution. To borrow a visual from another Mises student, Friedrich von Hayek, the Fed’s money creation does not flow evenly like water into a tank, but rather oozes like honey into a saucer, dolloping one area first and only then very slowly dribbling to the rest.

The Fed doesn’t expand the money supply by uniformly dropping cash from helicopters over the hapless masses. Rather, it directs capital transfers to the largest banks (whether by overpaying them for their financial assets or by lending to them on the cheap), minimizes their borrowing costs, and lowers their reserve requirements. All of these actions result in immediate handouts to the financial elite first, with the hope that they will subsequently unleash this fresh capital onto the unsuspecting markets, raising demand and prices wherever they do.”

***

The Fed is transferring immense wealth from the middle class to the most affluent, from the least privileged to the most privileged. This coercive redistribution has been a far more egregious source of disparity than the president’s presumption of tax unfairness ….

***

Before we start down the path of arguing about the merits of redistributing wealth to benefit the many, why not first stop redistributing it to the most privileged?”

And Ben Bernanke himself said in 1988 that quantitative easing doesn’t work. As Ed Yardley notes:

Two economists, Seth B. Carpenter and Selva Demiralp, recently posted a discussion paper on the Federal Reserve Board’s website, titled “Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?” [Here's the link.]

[The study states:] “In the absence of a multiplier, open market operations, which simply change reserve balances, do not directly affect lending behavior at the aggregate level. Put differently, if the quantity of reserves is relevant for the transmission of monetary policy, a different mechanism must be found. The argument against the textbook money multiplier is not new. For example, Bernanke and Blinder (1988) and Kashyap and Stein (1995) note that the bank lending channel is not operative if banks have access to external sources of funding. The appendix illustrates these relationships with a simple model. This paper provides institutional and empirical evidence that the money multiplier and the associated narrow bank lending channel are not relevant for analyzing the United States.”

Did you catch that? Bernanke knew back in 1988 that quantitative easing doesn’t work. Yet, in recent years, he has been one of the biggest proponents of the notion that if all else fails to revive economic growth and avert deflation, QE will work.

Indeed, Fed policy itself has killed the money multiplier by paying interest on excess reserves. And a large percentage of the bailout money went to foreign banks (and see this). And so did most of money from the second round of quantitative easing.

Forget Theory … What Do the Facts Show?

But let’s forget ivory the tower theories of either neo-Keynesians like Krugman or Austrians … and look at the evidence.

Initially:

[The] Treasury Department encouraged banks to use the bailout money to buy their competitors, and pushed through an amendment to the tax laws which rewards mergers in the banking industry.

Similarly, former Secretary of Labor Robert Reich points out that quantitative easing won’t help the economy, but will simply fuel a new round of mergers and acquisitions:

A debate is being played out in the Fed about whether it should return to so-called “quantitative easing” — buying more mortgage-backed securities, Treasury bills, and other bonds — in order to lower the cost of capital still further.

Pages: 1 2 3 4

Tags: 18th Century Scottish Philosopher, Aggregate Price, Austrian School Of Economics, Ben Bernanke, David Hume, Economic Benefit, Economic Dislocation, Fed Chairman, Fed Policy, Government Printing Press, Hedge Fund Manager, Ludwig Von Mises, Monetary Inflation, Money Supply, Murray Rothbard, Paul Krugman, Relentless Expansion, Spitznagel, Stealth Tax, Wall Street Journal
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Fed Policy: Bernanke Is Warming Up His Helicopter

Wednesday, March 28th, 2012

This article originally appeared in the Daily Capitalist.

Economists cling to statistical data like barnacles in order to have some kind of anchor to explain what is going on in the world. They will try to cram the square data peg into the round holes of economic ”laws” rather than abandon them when they are obviously wrong. Which is not a very satisfactory way to explain things. You might begin to think the data you measure is just coincidentally correlative for the period measured if it falls apart at some point. Instead of trying to stretch the data into what you think it should be, then maybe you might think that you’ve got it all wrong.

Chairman Ben Bernanke is not letting a data inconsistency get in the way of his prior conclusions about unemployment. In his speech today, he says that he’s not sure why we have such high rates of unemployment, some may be just cyclical, some may be structural, but whatever it is the Fed will be available to print money to “support demand and for the recovery.” Somehow QE1 and QE2 were not enough.

In his speech Bernanke tries to explain why Okun’s law (a correlation between GDP and employment/unemployment) is still valid yet doesn’t explain the current situation. Perhaps GDP “growth” Bernanke sees is really a figment of money steroids, something the Fed has unleashed, and that unemployment is still high because of long-term capital/savings destruction caused by QE and ZIRP.

If you look at the rate of employment to the working population, you might wonder why it crashed so disproportionately to past cycles:

The blue line is the ratio of employment to population; the red line shows population growth. The population is still growing but the ratio fell off a cliff. The ratio of employed to population is back to 1977 levels. This is not something Chairman Bernanke wishes to hear or believe. He would rather adhere to the outdated ideas of the mainstream rather than question the dogma.

This is apropos of a conference sponsored by the Fed last Friday on, among other topics, the efficacy of quantitative easing. The conclusion coming from a Fed conference should be pretty obvious: QE is successful. The paper presented by economist Mark Gertler of NYU, a close collaborator with the former Professor Bernanke, concludes that QE works and he has an econometric model to prove it. What he does is look at what he considers to be the proper data and concludes that there is cause and effect and then he builds a mathematical model around this and believes it works. If his interpretation of the data is incorrect then the model is incorrect.

Here is a portion, out of context, of Gertler’s model:

Etcetera. You would have to be an econometrician to understand this. But it is just a way to disguise false ideology by cloaking it in mathematical formula. See Hayek and Mises on this topic. Because the formula “works” doesn’t mean it is right. Believe what you want to believe.

I think this is mostly an ad hoc ergo propter hoc (A happened and then B happened, thus A caused B) kind of analysis and that his conclusions are based on incorrect theory and fail to explain anything. But it doesn’t matter if he’s right or wrong for our purposes because Bernanke and most of the people at the Fed believe it. We can thus be assured that the Fed will unleash another round of QE when the economy stagnates (as I have forecast that it will).

It matters if he’s right or wrong for our purposes as investors though, because QE distorts the entire economy, gives an illusion of growth, destroys capital, causes more unemployment, and leaves the economy structurally impaired for a considerable time. One of the nasty little side-effects of QE that is most recognizable to investors and consumers is price inflation. It is probably higher than it is reported but it would grow much higher with more money printing. It destroys your wealth. It is possible, as we found out in the 1970s that you can have economic stagnation and high inflation at the same time.

What we are seeing now in the data is an effect from QE1 and QE2 and Operation Twist. It cannot last and it won’t because you can’t create wealth out of thin air as they are attempting to do.

Bernanke’s speech is another example of Mr. Bernanke’s admission that he does not understand the fundamentals underlying our economic problems. Otherwise Fed policies he unleashed would have cured the problem long ago.

Just last Thursday in an econ class at George Washington University he said the Fed’s low-interest-rate policies in the early 2000s didn’t cause the housing boom and bust:

“There’s no consensus on this,” Mr. Bernanke told a class of college students at George Washington University. “But the evidence I’ve seen suggests that monetary policy did not play an important role in raising house prices during the upswing.”

The housing boom-bust must have been caused by “irrational exuberance” which was Alan Greenspan’s “animal spirits” Keynesian explanation for the Dotcom bubble. Greenspan has also denied that he caused the housing bubble.

What can one say about this? There is actually very good evidence that the Fed’s easy money policy was the fountainhead of the bubble. But readers of the Daily Capitalist are well aware of that.

These speeches are further confirmations of disastrous Fed monetary policies that won’t end until the Fed raises interest rates and stops printing money. I’m betting on stagnation, more QE, and higher price inflation.

Tags: Barnacles, Ben Bernanke, Correlation, Correlative, Data Inconsistency, Dogma, Economic Laws, Economists, Employment Unemployment, Fed Policy, Figment, GDP Growth, Long Term Capital, Outdated Ideas, Population Growth, Qe, Red Line, Statistical Data, Steroids, Zirp
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Goldman’s Economists Score 7 Out Of 10 For 2011 (Retrospective)

Thursday, December 22nd, 2011

Since the 2012 Outlooks have now slowed to a drip, its appears retrospectives are the stocking-filler of choice for the week. Goldman’s economist group reflects on their ’10 Questions for 2011′, released at the end of December 2010, and finds they were correct seven times. The tricky thing about judging the ‘score’ is the magnitude of the error – or more importantly the magnitude of the question’s impact on trading views. Jan Hatzius and his team have had their moments this year, for better or worse, in economic sickness or health but they have largely been accurate at predicting Fed policy (or should we say ‘directing/suggesting’ Fed policy), but were significantly off (along with emajority of the Birinyi-ruler-based extrapolators from the sell-side) on growth (high) expectations and inflation (low) expectations. Nevertheless, the lessons learned from over-estimating the speed of healing from the credit crisis and the disin- / de-flationary effects of a large output gap (which BARCAP would argue is not as wide) when inflation is already low and inflation expectations well anchored are critical for not making the same overly-optimistic mistake into 2012.

US Daily: A Retrospective on “10 Questions for 2011″

Today’s comment reviews the 10 key questions for 2011 that we posed a year ago, our answers at the time, and what actually happened.

It has been a mixed year. On the positive side, our views on Fed policy have proven accurate. On the negative side, we were too high on growth and too low on inflation. Adverse supply shocks, including the upheaval in the Middle East and the Japanese earthquake in March, explain part of these misses. But we also overestimated both the speed of healing from the credit crisis and the disinflationary effects of a large output gap when inflation is already low and inflation expectations are well-anchored.

In the last US Economics Analyst of 2010, published on December 31, we posed “10 Questions for 2011.” In today’s comment, we review each of the questions, our answers at the time, and what actually happened.

Question 1: Will we finally see a “real” economic recovery?

Our answer: Yes.

Verdict: Incorrect. Ultimately, 2011 felt much like 2010. A strong performance in the winter was followed by a sharp slowdown in the spring, renewed recession worries in the summer, and some signs of reacceleration in the fall. From the perspective of our forecasts, the main difference was that we predicted the slowdown of 2010 but failed to predict the slowdown of 2011. In fact, we thought that growth would accelerate to a 3.5%-4% annualized pace in the course of 2011.

However, real GDP grew just 1.2% in the first three quarters of 2011 and our current activity indicator (CAI)–an alternative measure of growth that takes into account a broader range of data–grew 1.9% in the first eleven months of 2011. Depending on which of the two measures we use, this implies that growth has fallen short of our forecast by 2 to 2-1/2 percentage points.

What explains this miss? We see three factors:

1. Adverse supply shocks account for a 3/4-point miss. We estimate that the nearly 30% increase in seasonally adjusted gasoline prices between November and April–largely due to increased supply worries in the wake of the “Arab spring”–shaved 1-1/2 percentage points from real disposable income growth in the first half of the year. With little change in the saving rate at the time, most of the real income hit fed through into weaker consumer spending growth. In turn, with little change in net trade, most of the consumption hit fed through into real GDP. (Note that this implies a real GDP hit of about 1 percentage point, since the level of consumption is about two-thirds that of GDP.) The supply-chain disruptions following the East Japan earthquake of March 2011 also weighed on growth for a while. For the first three quarters of 2011, we believe that adverse supply shocks may have subtracted 3/4 percentage point from growth.

 

2. Fiscal retrenchment accounts for a 1/2-point miss. When Congress extended the 2001-2003 tax cuts for another two years and passed the temporary fiscal measures–especially the payroll tax cut–at the end of 2010, we thought that this meant a roughly neutral fiscal stance in 2011, with slight net stimulus from the federal government offset by slight net restraint from state and local governments. However, we now believe that fiscal policy has subtracted about 1/2 percentage point from growth in 2011 so far. The official GDP data show that a reduction in government spending, concentrated in the state and local sector, has subtracted 1/2 percentage point from growth; meanwhile, there seems to have been little change in overall tax rates after accounting for income, payroll, and sales taxes. Overall, this suggests that fiscal policy subtracted 1/2 points more from growth than we expected.

 

3. A longer “hangover” may account for the remaining 1-point miss. The preceding two points explain perhaps 1-1/4 points of disappointment, but this still leaves approximately another 1 percentage point. An obvious candidate explanation is the European crisis, which has intensified beyond most people’s expectations (including ours) this year. But we think that this explains only a small part of the miss. Instead, a more plausible story is that the “healing” in private domestic demand has simply progressed more slowly than we had expected at the end of last year, when measures of underlying final demand had started to pick up at a fairly impressive speed. In other words, the “hangover” from the bubble seems to be lasting even longer than we thought.

Question 2: Will the housing market recover meaningfully?

Our answer: No.

Verdict: Correct. Although housing starts and home sales did rise slightly through 2011, the increase has fallen short of what we would call “meaningful.” Moreover, house prices have fallen on net, and some measures show a reacceleration in the pace of decline in recent months. We expect a somewhat better performance in 2012, with starts and sales growing more noticeably and home prices stabilizing late in the year.

Question 3: Will the trade deficit shrink substantially?

Our answer: No.

Verdict: Correct. The trade deficit has been essentially unchanged in 2011, as both exports and imports have grown at impressive 10%+ rates through the year. We expect more of the same in 2012.

Question 4: Will the unemployment rate fall?

Our answer: Yes.

Verdict: Correct (but partly for the wrong reasons). The unemployment rate fell from 9.8% in November 2010 to 8.6% in November 2011, which is actually somewhat below the 9% we expected a year ago. The larger-than-expected decline occurred despite weaker-than-expected GDP growth, as the labor force participation rate fell by another 1/2 percentage point to 64.0%, the lowest since 1983. Going forward, we expect the unemployment rate to move sideways to higher as growth stays sluggish and participation stabilizes.

Question 5: Will inflation move back toward 2%?

Our answer: No.

Verdict: Incorrect. Both core and headline PCE inflation rose significantly in 2011 and now stand at 1.7% and 2.7%, respectively. Part of our error was due to the bigger-than-expected increase in the prices of oil and other commodities, as well as the surge in automobile prices following the Japan earthquake. But we also underestimated the upward pressure on rents in an environment of still high but gradually declining excess supply of housing; in particular, our expectation that excess supply in the owner-occupied sector would also hold down rents in the renter-occupied sector (via an arbitrage relationship between the two sectors) proved incorrect. More broadly, we probably overestimated the disinflationary effects of a large output gap at a time when inflation is already very low and inflation expectations are well-anchored. All that said, inflation now does seem to be slowing again, and we see the core PCE deflator back at 1.3% by the end of 2012.

Question 6: Will profit margins rise further?

Our answer: Yes.

Verdict: Correct. When measured as after-tax profits as a share of GDP, profit margins rose from 6.8% in the third quarter of 2010 to 7.3% in the third quarter of 2011. When measured as S&P 500 earnings per share in percent of revenue per share, margins rose from 8.3% to 9.0%. Going forward, we expect margins to flatten out both on a top-down and bottom-up basis.

Question 7: Will QE2 end on schedule, i.e., in June 2011 with total holdings of $600bn?

Our answer: Yes.

Verdict: Correct. Fed officials did stop the program on schedule at $600bn. Since then, they have embarked on “operation twist,” whose effects on financial conditions are similar to QE in our view, and we expect them to return to QE in the first half of 2012.

Question 8: Will Fed officials start to “exit” from their current policy stance by raising the funds rate or shrinking their balance sheet?

Our answer: No.

Verdict: Correct. Despite some hawkish signals early in the year, Fed officials ultimately embraced a “lower for longer” view and are currently indicating no rate hikes until “at least mid-2013.” With the short-term rate discussion settled for the time being, we moved to a view of further easing in August, which occurred in September via “operation twist.”

Question 9: Will the 10-year Treasury note yield end 2011 above the current level of 3.4%?

Our answer: Yes.

Verdict: Incorrect. Despite our bullish call at the front end of the yield curve, we predicted an increase in rates at the longer end (albeit a moderate one that was below the forwards at the time of our “10 Questions” note). At least part of this was due to the worse-than-expected domestic growth performance and the greater “flight to quality” in the wake of the intensifying European crisis.

Question 10: Will the state and local budget crisis derail the recovery?

Our answer: No.

Verdict: Correct. The widespread fears about state and local finances at the end of 2010 did not materialize. Municipal governments have not defaulted in large numbers, and municipal bonds outperformed most other sectors of the fixed income market in 2011. While continued fiscal tightening was responsible for much of the improvement, the negative impact on GDP growth from state and local spending has actually diminished a bit in the last few quarters and should continue to do so in 2012.

Tags: Birinyi, Credit Crisis, Disin, Drip, Economist Group, Fed Policy, Gap, Goldman, High Expectations, Inflation Expectations, Japanese Earthquake, Low Expectations, Outlooks, Output Gap, Retrospective, Ruler, Seven Times, Supply Shocks, Upheaval, Us Economics
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Jim Grant Discusses Central Banks’ Money Printing, and the Farmland Bubble

Tuesday, November 15th, 2011

Here is an interesting video on Bloomberg with Jim Grant regarding the European Central Bank’s response to the sovereign-debt crisis, ECB policy, Fed policy, central bank printing, and farmland.

Link if video does not play: ECB’s Response to Debt Crisis, Money Printing

Grant notes that farmland in Iowa is going for $17,000 an acre far above the rental value of the land. Grant does not use the term bubble, but does suggest this is the wrong time to buy.

Bubble is the correct term.

Mike “Mish” Shedlock

http://globaleconomicanalysis.blogspot.com

Tags: Acre, Blogspot, Bloomberg, Central Banks, Debt Crisis, European Central Bank, Farmland, Fed Policy, Grant Money, Jim Grant, Land Grant, Mish Shedlock, Money Grant, Money Printing, Sovereign Debt, Wrong Time
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Stephen Roach – U.S. Did Not Learn from Japan

Thursday, September 22nd, 2011

via Trader Mark, Fund My Mutual Fund

Morgan Stanley’s Stephen Roach, seen by some as a nearly perma bear, but by others as very realistic visited CNBC this morning, and offers his latest views on what is happening.  Essentially, as written in these pages a few years ago, the U.S. is going through a Japan-lite crisis.  Much of it due to Fed policy.  Half the discussion on that topic, and about half on China.

13 minute video

Here is a link to a follow up discussion on Europe – 4 minutes.

Tags: China, Cnbc, Europe, Fed Policy, Japan, Morgan Stanley, Mutual Fund, Stephen Roach
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King of the Mountain (Arnott)

Sunday, September 18th, 2011

King of the Mountain (Arnott)

by Robert Arnott, Research Affiliates, (RAFI)

Most of us remember playing “king of the mountain” as children. The goal, often accompanied by a certain measure of roughhousing, was to summit a little hill and stay at the top while others vied to push us off and take our place.

King of the Mountain is not merely a child’s game. The U.S. stock market has been straddling a surprisingly precarious “mountain” in asset valuation for nearly two decades, resisting efforts to push us back below historical norms of valuation levels except for brief periods in 2002 and 2009.

We’ve written about the challenges over the past two years. In 2009, we described the coming “3-D Hurricane’s” soaring deficits and debts, in which we expect the post-baby-boom generations to pay down debts that we (1) promised to ourselves, (2) failed to prefund, and (3) failed to consult the generations that will be expected to honor these debts. In 2010, we addressed the consequence of soaring debt burdens in most of the developed world, as compared with the generally well-managed debt burdens of our primary external creditors in the developing world. In this issue, we explore the challenges to our lofty perch in the equity markets. Specifically, we examine the potential consequences of understated inflation and toolow real interest rates, paired with a Fed policy that seems intent on further boosting inflation and eroding real interest rates.

The Valuation Mountain

First, let’s look at how real interest rates and inflation affect valuation multiples. Some years ago, Marty Leibowitz and Anthony Bova pointed out a “hill” in valuation multiples.1 When real interest rates—which we define as 10-year Treasury bond yields less the trailing three-year average Consumer Price Index—are midrange, suggesting solid economic growth, the stock market sports a robust P/E ratio, often well above 20 times earnings.2 When real interest rates are either negative (reflecting a desire to aggressively stimulate the economy) or unusually high (reflecting a desire to rein in an overheated economy), the average P/E ratio plummets below 11.

The real-rates valuation hill is illustrated in Figure 1. It’s quite a lofty hill. Over the past 140 years, whenever real short-term interest rates have been in their 3–4% “sweet spot,” the market has exhibited a price 21 times 10- year smoothed real earnings. At real interest rates that are either lofty (above 6% in real terms) or negative, the average P/E ratio

tumbles to 11. If we limit ourselves to more recent results—over the past 50 years—we find that the peak is a little bit taller, with more tolerance for slightly lower real rates. But the shape of the curve changes remarkably little. It’s also very interesting to note that this valuation hill accounts for some 40% of the variation in P/E ratios. Real interest rates really matter to equity valuations.

It turns out that there’s another valuation hill, related to the rate of inflation. Of course, inflation generally moves in opposition to real rates: when inflation rises, often real rates fall, until the Fed decides to do something about it. In some ways, this second hill is even more powerful than the real rates hill. As we can see in Figure 2, the peak is taller, with typical P/E ratios of over 23 whenever inflation is 2–3%. However, high inflation is far more damaging to P/E ratios than high real interest rates: When trailing three-year inflation is above 6%, the P/E ratio plunges to an average of 9.4 times average 10-year real earnings.

Because real interest rates and the rate of inflation are negatively correlated, the two hills combine to create an impressive three-dimensional mountain, formed by plotting P/E ratios against both real interest rates and inflation (see Figure 3). Of course, there are some scenarios that either never happened or almost never will.

When real rates are 3–5% (moderately high) and inflation is 1–3% (reasonably benign), the average P/E ratio is 26. But it’s a sharp peak. When real rates are a bit lower (1–3%), the average P/E ratio drops to 19, a drop of more than 25%. When real rates are high (above 5%), the average P/E ratio nearly halves to 14. When inflation is a bit stronger, the average P/E ratio drops to 20; when inflation is a bit weaker, the average P/E ratio drops to 17.

The linkages are strong. The correlation between the indicated P/E ratio drawn from this valuation mountain and the actual Shiller P/E ratio is 68%. To be sure, this is an in-sample comparison, but even after adjusting for overlapping samples, we get a t-statistic of over 7 for this comparison—a strong confirmation of the validity of the data. The bottom line: over half of the variability in P/E ratios over the past 140 years can be explained by real interest rates and the rates of inflation.

Tags: 10 Year Treasury, Anthony Bova, Asset Valuation, Baby Boom, Bonds, Consumer Price Index, Debt Burdens, Developing World, External Creditors, Fed Policy, King Of The Mountain, Leibowitz, Lofty Perch, Outlook, Prefund, Rafi, Research Affiliates, Robert Arnott, Treasury Bond Yields, U S Stock Market, Valuation Levels, Year Treasury Bond
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Fed Policy – No Theory, No Evidence, No Transmission Mechanism (Hussman)

Monday, September 12th, 2011

Fed Policy – No Theory, No Evidence, No Transmission Mechanism

by John P. Hussman, Ph.D., Hussman Funds

On Friday, the yield on 1-year Greek debt surged above 90%, while Wall Street still has barely blinked, evidently convinced by the bailout mentality of the past three years that governments will simply make the problem go away with public funds. One thing is certain – public funds will indeed be used to address this problem. But it is also nearly certain that those funds will be used to recapitalize European financial institutions (ideally, restructured ones) following a major default of Greek debt. The reason for this is simple. With Greek debt now beyond 144% of GDP and on track toward 180% by year-end, neither a further extension of credit to Greece, nor a modest writedown of its debt, would be sufficient to restore Greece’s ability to service that debt over time.

It was only in June (see Greek Yields: “Certain Default, But Not Yet” ) that we published a schedule showing the probability of default implied by Greek yields, with several lines showing the probability of default depending on the expected date of default and the assumed “recovery rate” (the percentage of face value that bond investors could expect to recover in the event of default). That wistfully optimistic chart is reprinted below.

Amésos: Adv (Greek): Immediately, forthwith, straightaway.

As I noted in June, “At the point that a near-term default becomes likely, we would expect to see one-year yields spiking toward 40% and 3-month yields pushing past 100% at an annual rate (essentially pricing near-term bills toward the anticipated recovery rate). This temporarily reassuring situation, unfortunately, strongly contrasts with the longer-term outlook for Greek debt. Even assuming a 60% recovery rate (that is, assuming a default would wipe out 40% of the Greek debt burden), the implied probability of a Greek default within the next two years is effectively 100%. The only way you get a lower probability is to assume a far lower recovery rate.”

Tags: Bailout, Bond Investors, Bonds, Commodities, Debt Burden, Face Value, Fed Policy, Financial Institutions, GDP, Governments, Greece, Hussman Funds, Implied Probability, Mentality, Outlook, Term Bills, Term Outlook, Transmission Mechanism, Wall Street, Year End
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Canadian Inflation Quickens (BCA)

Thursday, June 30th, 2011

The quickening of inflation is serving as a warning that the Bank of Canada has to do something to curb pressure with normal monetary policy measures in the coming months, says BCA Research, in its Daily Insight on Canada. Also prefaced is that this development should translate into a stronger Loonie.

Canada’s CPI experienced a greater-than-forecast month-over-month increase of 0.7% during May. Although this monthly increase was led by by food and energy, the core rate CPI rose by a strong 0.5% month-over-month. The underlying rate of inflation as measured by the Bank of Canada accelerated to 1.8% annualized, and this was far greater than the 1.4% forecast made by BoC in the latest Monetary Policy Report. As a result of worries over U.S. growth, Europe’s debt crisis, and hard landing fears in China, interest rate futures had all but discounted the need for higher policy interest rates for the next year ahead.

Despite those worries, it appears the Canadian economy is indicating that a tightening of monetary policy is required.

Housing is showing signs of bubbling, and there is pressure on the labour front, says BCA.

Yesterday’s CPI report contained warnings that spare capacity within the Canadian economy is nearly used up. Notwithstanding external economic shock, the monetary tightening cycle should be resumed later this year. So long as U.S. Fed policy stands down, spreads between short term interest rates will widen, making conditions favourable for the Canadian dollar and Canadian bonds will underperform its counterpart U.S. treasuries, assuming currency is hedged.

Source: BCA Research

Tags: Bank Of Canada, Boc, Canadian, Canadian Bonds, Canadian Economy, Canadian Inflation, Canadian Market, China Interest, Core Rate, Cpi Report, Debt Crisis, Economic Shock, Fed Policy, Interest Rate Futures, Labour Front, Loonie, Monetary Policy Report, Policy Interest, Policy Measures, Rate Of Inflation, Treasuries, Underlying Rate Of Inflation
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PIMCO’s Paul McCulley on Rising Market Risk, Investment Strategy, Fed Policy

Monday, May 9th, 2011

This week on Wealthtrack, Consuelo Mack talks to Paul McCulley. The recently retired Fed watcher and head of short-term trading at bond giant PIMCO is speaking out about Fed policy, building market risks and investment strategy.

Note: The transcript of this interview is not available yet, but will be posted here as soon as it arrives.

Source: Wealthtrack, May 6, 2011.

Tags: Consuelo Mack, Fed Policy, Giant, Investment Policy, Investment Strategy, Market Risk, Paul McCulley, PIMCO, Risk Investment, Risk Strategy, S Paul, Strategy Note, Wealthtrack
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