Kamis, 03 Mei 2012

Still no sign of a recession

Although recent data have not reflected any unexpected economic strength, it is also the case that to date there is no evidence that the economy is sinking into another recession. That's very important, because the level of Treasury yields and the level of equity PE ratios strongly suggests that the market continues to worry about a weak economy. If the economy simply avoids a recession and continues to grow at a moderate pace of 2-3%, the market is going to eventually reprice to more optimistic expectations of the future—Treasury yields and equity prices are going to rise.

In April, publicly announced corporate layoffs, as tallied by Challenger, Gray & Christmas (love that name!), remained at extremely low levels. No sign here of any deterioration.

The April ISM Service Sector report was weaker than expected, but this index has been unusually volatile in recent years, and it remains above 50, suggesting that the sector is growing, but only modestly. It would be nice to see it higher, but at the current level it is not consistent with recessionary conditions. The employment subindex also weakened in April, but remains at a relatively high level, pointing with more emphasis to continued growth. On balance, today's service sector report is perfectly consistent with an economy that is growing slowly but not experiencing any serious problems.

As the above two charts show, systemic risk in the U.S. (as reflected in swap spreads) is low, and systemic risk in Europe, while still relatively high, looks to be improving on the margin (note the continued improvement in Euro basis swap spreads, which reflects healthier liquidity conditions in the Eurozone banking sector). Conditions in the Eurozone are far from healthy, but on the margin they are getting better.

The only reason that the world is holding 2-yr Treasuries yielding 0.26% and 10-yr Treasuries yielding 1.9% is that the market collectively is very fearful that the U.S. economy will follow the Eurozone into another recession, and that the Fed will therefore need to keep short-term interest rates at or close to zero for as far as the eye can see (well, at least for another two years). If the market were to be convinced that the economy would grow by at least 2-3% for the next several years, it is my contention that Treasury yields would be significantly higher than they are today, because continued growth would remove the need for any additional Fed easing and accelerate the need for an eventual tightening. Equity prices likely would be much higher as well, since corporate profits today are at record levels, but PE ratios are below average.

Readers can infer that I am not in agreement with the conventional wisdom that says that Fed purchases of a significant portion of the Treasuries issued in the past year or so to fund the federal government's $1.3 trillion annual deficits are responsible for the depressed level of Treasury yields. The Fed could purchase all of the current year's deficit (although they are highly unlikely to make any net new purchases unless the economy sharply deteriorates) but that would still leave over $9 trillion of Treasuries in the hands of investors, institutions, and central banks around the world. And it would still leave many tens of trillions of MBS and corporate bonds that are priced at relatively low spreads to today's extremely low Treasury yields. The Fed is no longer making net new purchases of Treasuries, and they won't buy more unless the economy deteriorates significantly. So today's extremely low level of Treasury yields means the world is content to hold tens of trillions of high quality bonds with historically low yields, because the world is very concerned that the future looks bleak.

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