Rabu, 09 Oktober 2013

Tracking important market prices

Last week I argued that the lack of government-provided statistics was not really a problem, since there are lots of real-time, market-based prices out there that speak volumes about the state of the economy. Here's an expanded list, with up-to-date charts, of the indicators I think are the most important to watch.  On balance, I don't detect anything going on that's particularly disturbing or encouraging, which means the economy is probably continuing to expand at a relatively slow pace.

1-mo. T-bill yield:

Yields on 1-mo. T-bills have jumped this month by about 25 bps, whereas yields on bills maturing in 3 and 6 months remain quite low. This reflects a modest degree of concern that the current government shutdown and debt ceiling debate may remain deadlocked and result in a temporary "default" on federal debt. If the risk of default were major and lasting, yields on all maturities would have spiked, but that is not the case, at least so far. This is akin to a tiny ripple on the pond of risk.

2-yr swap spreads:

2-yr swap spreads are about the best leading indicator of systemic risk that I'm aware of. (For more detail on what swap spreads are, see here.) Today, swap spreads in the U.S. are about as low as they have ever been, while swap spreads in the Eurozone remain somewhat elevated. This reflects almost a complete absence of any degree of risk in the financial and economic fundamentals in the U.S., and a modest degree of risk in the Eurozone economy. Conditions have not changed materially in the past year.

5-yr TIPS real yield:

As the first of the above charts shows, real yields on TIPS tend to track the real growth of the U.S. economy. Real yields have moved substantially higher in the past six months, and that is a good indication that the market believes the economic fundamentals of the U.S. economy have improved. But real yields are still quite low, suggesting that the market now expects the U.S. economy to grow at a sub-par rate whereas before the market was concerned about the potential for a double-dip recession. As the second chart shows, real yields have dropped about 50 bps from their recent high, reflecting a) some disappointment with the economy and b) less likelihood of a near-term Fed tapering. Under the new leadership of Janet Yellen, the Fed is probably less likely to taper and less likely to tighten aggressively. Real yields would have to decline further before I would worry that economic fundamentals were deterioriating.

Breakeven inflation spreads:

The above chart shows the market's implied inflation expectations for the 5-year period beginning in 5 years, which are derived from the yields of 5- and 10-yr TIPS and Treasuries. This is the Fed's preferred measure of forward-looking inflation. As the chart shows, inflation expectations today are almost exactly the same as the average of the past four years. Nothing much going on here—inflation is likely to remain subdued for the foreseeable future.

Gold vs. real yields:

The price of gold has been remarkably well correlated with the inverse of 5-yr TIPS yields (which is equivalent to saying that gold has been positively correlated with TIPS prices). I've argued that this is a sign that the world's demand for safe assets is beginning to decline. Not much has changed here in the past month or so, but this remains one of the more intriguing relationships I follow, especially since the demand for money and safe assets has been extraordinarily strong for the past 5 years. Strong money demand has led to a major decline in the velocity of M2, and has all but compelled the Fed to adopt its Quantitative Easing policy. As I've argued before, the primary function of QE is not to "print money," but to swap newly created bank reserves (functionally equivalent to T-bills) for bonds. Since there is no evidence of any increase in inflation as a result of the Fed's QE efforts, we can infer that the Fed's provision of bank reserves was likely just enough to satisfy the world's demand for safe assets. When the supply of money equals the demand for money, there are no inflationary consequences.

Gold vs commodity prices:

Gold and industrial commodity prices have tended to move together over long periods. The most striking thing in the chart above, in my opinion, is the degree to which gold "overshot" the rise in commodity prices coming out of the Great Recession. I think this reflected very strong demand for safe assets, very deep concerns over the potential for QE to be inflationary, very deep concerns about the long-term value of the dollar, and deep-seated concerns about global financial stability. But since these fears have not been realized, gold has begun to fall back in line with commodity prices, which have been relatively stable for the past few years. Not much has happened to gold in recent months, but if the world continues to avoid a disaster then I would expect gold prices to move lower. Relatively stable commodity prices tell me that there are no material changes in the strength of the global economy.

Dollar vs. other currencies:

As the first of the two charts above shows, the inflation-adjusted value of the dollar relative to a trade weighted basket of currencies is still unusually weak. However, the dollar has managed to increase somewhat in the past two years, which I take as a sign that the U.S. economy has done somewhat better than expected (or perhaps it's better to say "not as badly as expected"). The second chart looks at the nominal value of the dollar vs. major currencies for the year to date, and here we see that the dollar has only recently found a bit of support after declining from last summer's highs. There's not much love out there for the dollar, but neither is the dollar disastrously weak. On the bright side, there's a lot of room for improvement in the dollar if the outlook for the U.S. economy were to improve.

Baltic Dry Index:

This measure of shipping costs for bulk commodities has staged a remarkable comeback in the past four months. While it's difficult to draw firm conclusions from this (the index can be affected not only by demand for commodities but by changes in available shipping capacity), I think it's safe to say that global economic activity is not deteriorating, and may even be firming.

Credit default swap spreads:

CDS spreads are a very liquid proxy for the default risk of corporate bonds. That spreads are still very close to their lowest levels since the recession is a sign that the market detects no deterioration in the economic outlook. Spreads are still meaningfully higher than their pre-recession lows, however, which signals that the market is still relatively risk averse.

Vix Index:

The Vix index has jumped of late, a clear sign of increased market jitters. But from a longer-term perspective, it is still relatively low. The market is obviously concerned about the ramifications of the current government shutdown, but not terribly so. This is a contributing factor to the general mood of risk aversion that pervades most market indicators.

S&P 500 Index:

The first of the above two charts shows the PE ratio of the S&P 500 index. It's up from the lows of 2010, but is not unusually high. In fact, PE multiples today are almost exactly in line with long-term averages. I think this shows that the market is at the very least not overvalued. Indeed, since corporate profits currently are at record levels in both nominal terms and relative to GDP, I think this shows a remarkable lack of optimism. In other words, I take this as a sign that the market is still relatively risk averse, and that explains why the demand for safe assets is still relatively strong.

The second chart shows the index itself, which has been on an uptrend ever since March, 2009. Prices are near all-time highs, but valuations are still relatively subdued. There is still lots of upside potential if the market should start to feel less concerned about monetary and fiscal policy, and/or should the economic fundamentals improve.

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