The good and bad news about unemployment claims

Unemployment claims continue to tell us that the economic fundamentals are gradually improving. On an unadjusted basis, the number of first-time claims is down almost 10% from a year ago. There is still no sign at all of a deterioration in the jobs market, and this all but rules out a recession. Claims keep falling, and the number of jobs keeps rising, and those are hallmarks of recovery. On an unadjusted basis, the number of people currently "on the dole" is down over 17% from a year ago. More and more people have an incentive to find and accept a job, and that is a very positive change on the margin.

Unfortunately, as the above chart shows, the portion of the labor force that is receiving unemployment compensation is still extremely high from an historical perspective. Congress was never more generous in its willingness to extend unemployment benefits in this business cycle, and the recovery was by far the worst in modern times. Could there be a connection between those two facts? Yes. When you pay people to not work, don't be surprised if you find that more people are not working. 5.66 million are still receiving unemployment checks today, substantially more than the 4.6 million who were receiving unemployment checks at the peak of the 1981-1982 recession. As a percent of the labor force, the number on the dole today is still far worse than most of the recessions of the past 30 years.

The bond/equity disconnect

Very low yields on Treasury securities—and on most developed country sovereign debt, for that matter—are symptomatic of a market that holds out very little hope for growth, and a market that believes that central bank accommodation for an extended period is necessary to (at worst) keep the economy from sinking into another recession or (at best) pump up growth a little. There has been a fairly good correlation between equity prices and interest rates because of this perceived connection between weak growth and low interest rates—until late last year, that is. In the U.S. we now see equity prices approaching post-recession highs, while bond yields are still extremely low. What does this mean? 

One possible answer is that even though equity prices are nearing a post-recession high, they are still depressed compared to earnings and thus reflect a market that is very reluctant to see any good news on the horizon. According to Bloomberg, the trailing 12-mo. P/E of the S&P 500 is now 14.2, and the expected P/E is now 13.1. Both those ratios are substantially below the 16.6 average P/E ratio over the past 50 years.

And P/E ratios are very low considering that corporate profits are very close to record high levels compared to GDP. Very low P/E ratios are thus best interpreted to mean that the market is very pessimistic in regard to the future potential of profits. In a sense, the market is priced to a significant decline in profits, and that would imply that the market believes that growth is going to be miserable in coming years. This market is not optimistic at all. It was extremely optimistic in 2000, as we now know, when P/E ratios were extremely high but corporate profits as a % of GDP were relatively low; back then the market was priced to a continuation of robust rates of growth for as far as the eye can see. Today, in contrast, the market is priced to doom and gloom.

As this last chart shows, the bond market is not entirely oblivious to the improvement in equity prices. The 5-yr, 5-yr forward breakeven inflation rate that is derived from TIPS and Treasury yields (the Fed's favorite measure of inflation expectations) has moved up more or less in line with a stronger equity market in recent weeks, and is now at a one-year high.

My interpretation of all this is that equity prices are improving not because the economy is getting stronger, but because the economy is not deteriorating to the extent reflected in bond yields. Since the economy is not getting materially stronger, the bond market still expects the Fed to stay on hold for a long time, and so Treasury yields remain extremely low. But now the bond market is sensing that the risk of a Fed overshoot—i.e., not reversing its accommodation in a timely fashion—is rising, and that means that inflation could be somewhat higher in the future than the market had been expecting. Treasury yields are not going to rise meaningfully (thus "catching up" to equity prices) unless and until the economy proves to be much stronger than it is currently perceived to be.

Risk of a near-term Eurozone collapse is way down

I have yet to see any meaningful steps taken by the PIIGS to rein in the size and scope of government, and thus I don't think the Eurozone crisis is a thing of the past. But the Eurozone, with the help of the ECB, has made great progress in reducing the risk of a near-term blowup. Markets everywhere are breathing a sigh of relief for what should prove to be more than a temporary, if not a complete, reprieve. 

U.S. swap spreads remain quite low, signifying that systemic risk is low, the financial system has plenty  of liquidity, and the outlook for the economy is likely to be improving, if only modestly. Eurozone swap spreads are still somewhat high, but they have declined significantly so far this year.

Euro basis swap spreads have been good leading indicators of this improvement, since they show that Eurozone banks are no longer having much difficulty in accessing dollar liquidity. This may also signify that capital flight out of the Eurozone is moderating. Taken together, these spreads show that liquidity in the Eurozone financial system has improved remarkably, and systemic risk has declined significantly. The likelihood of a near-term disaster is thus much lower. The Eurozone has bought itself a good chunk of time to work out its problems.

Zeroing in on individual countries, we see that 2-yr Spanish and Italian yields have dropped considerably in just the past week or so. They are not out of the woods yet, but the market is judging that near-term default risk has declined quite a bit.

5-yr CDS show a somewhat different story, since they are driven by the longer-term outlook. We don't see a whole lot of improvement of late, and that makes sense because these countries haven't yet fixed their underlying problems, even as they have made great strides towards remaining solvent for the near-term. Note how French 2-yr yields are almost zero, but French CDS are trading around 150 bps—even the long-term outlook for France remains somewhat suspect. For reference, I've included the current rate on generic 5-yr high-yield corporate CDS, which is trading around 550 bps. Spain, Italy, and Ireland are all considered to be about as risky as the typical junk bond. That sounds a lot worse than it really is, since junk bonds have been excellent investments in recent years, almost matching the total return on the S&P 500 since the rally started in early March 2009 (98% vs. 121%).

Jobs growth still moderate

There is no way we are even close to a recession when the number of people working in the private sector grows at a 1.75% annual pace—or about 160K per month—and that is exactly what we have seen so far this year, according to the establishment survey. The increase in new jobs is disappointingly slow, to be sure, but it is not something that can be dismissed as meager or recessionary.

Yesterday I suggested that the July jobs increase reported today was likely to be better than expected, and that proved to be the case (+172K private sector jobs vs. 110K expected). I based that guess on the observation that this year's growth in jobs as reported in the household survey has been much stronger than reported by the establishment survey, and that perhaps it was time for the establishment survey to "catch up" to the household survey. That indeed happened, and as it turns out, the household survey reported a decline in jobs, thus narrowing the gap between the two from both sides. Splitting the difference between the two surveys is a strategy I've always favored, and doing so puts the growth rate of jobs somewhere in the range of 1.5–2.2%. That's just about what the pace of jobs growth was in the 2004-2006 period, in fact. In any event, no matter how you slice and dice these numbers, jobs are growing and there is absolutely no sign of a recession. 

Those in the public sector will disagree, however, since public sector jobs have been contracting for the past three years, with no end in sight. The folks at Brookings lament this fact, but they fail to recognize that there are still many more public sector jobs today than there were in 2000, whereas the number of private sector jobs has barely risen at all. Public sector jobs are declining because of public sector bloat that is being painfully reduced, and we will all be better off as a result, once the dust settles. It's also appropriate to note that wealth is created in the private sector, so that's where it is important to see the growth in jobs.

UPDATE: Today's jobs report also served to vindicate the ADP report from last Wednesday.

The Fed "disappoints" and that is good

Seems there were a lot of people hoping that the FOMC might decide to "do something" about the persistently weak recovery. Instead, while yesterday they acknowledged that economic growth has "decelerated somewhat over the first half of this year," they added merely that they will "closely monitor incoming information ... and provide additional accommodation as needed." That's hardly a clarion call for more aggressive monetary ease, and that's a good thing, because there's not much more they can or should do at this point.

Thanks to two Quantitative Easing programs, the Fed has already created an astounding $1.6 trillion of bank reserves—17 times the amount that existed prior—of which $1.5 trillion remain on deposit at the Fed in the form of Excess Reserves. In order to support the current level of bank deposits, banks only need about $100 billion of "required" reserves, leaving $1.5 trillion available to make new loans and otherwise expand the money supply. If banks are content to hold $1.5 trillion of excess reserves today, would they be much less willing to hold the same amount of reserves if the Fed cut the Interest on Reserves to 15 bps (from the current 25) as many have suggested they should? It's hard to believe that a 10 bps reduction in the yield on excess reserves would make a significant difference. (Going to zero might make a small difference, but it would also drive money market funds out of business or force them to pay negative interest rates.) If the banking system prefers to earn almost nothing on a mountain of excess reserves instead of making loans at a rate that is many multiples of that, then that can only mean that banks are too risk-averse to make more loans today, and/or borrowers in aggregate are too risk-averse to take on more debt.

In other words, the problem of weak growth cannot be traced to any shortage of money or lack of sufficient reserves, or to the level of short-term interest rates. Risk aversion and a lack of confidence are the most likely culprits, and it's hard to see how a Fed that repeatedly acknowledges that it is very concerned about the outlook for growth is making any positive contribution to the problem.

Should the Fed attempt to force-feed the financial markets with new lending? Argentina is trying to do this, by ordering banks to increase their lending between now and year end, and to do so by making loans with interest rates lower than the current level of inflation. Last time I checked, that move hasn't made a whit of difference to the Argentine economy, but it has helped push down the value of the peso on the black market, where pesos now trade at a 32% discount to the official exchange rate.

Should the Fed adopt negative interest rates? That's just another way of force-feeding money into the economy: encourage more borrowing by ensuring that borrowing costs will be lower than inflation and lower than nominal GDP. Borrowers are almost sure to win, but lenders are almost sure to lose. That's a zero-sum game that can't result in any positive contribution to growth. Money gets pumped into real estate and commodities (i.e., into real assets that will likely benefit from higher inflation) and into speculative (e.g., leveraged) activities, but not necessarily into productive (i.e., job-creating) activities. Indeed, the transparently inflationary nature of policies such as this can only induce greater risk-aversion. That's why Argentina's economy is sinking rather than picking up, precisely because the government is so transparently trying to goose lending.

Can the Fed do anything to reduce risk aversion and boost confidence, and thus address the real underlying problems? Well, yes: they could refrain from pumping yet more reserves into an already-over-stuffed banking system, and they could refrain from reducing already-very-low short-term interest rates to zero. And that's exactly what they did with their statement yesterday. They have reduced risk aversion because they have reduced the chances of a catastrophic error of monetary policy, in which they are slow to reverse their accommodation, thus creating a huge excess supply of money which could be very inflationary. That helps explain why the dollar today is trading at close to a two-year high against other major currencies, and why gold is down 16% from last year's high.

What the Fed has yet to do is explain in greater detail why monetary policy cannot provide a magical solution to the world's problems at this point—that fiscal policy holds the key to future progress. On that score we are still waiting to see credible attempts to rein in the size and scope of government and to minimize tax and regulatory burdens in most of the world's major economies. Draghi can't come up with a ECB program that will fix that overnight; the ECB, like the Fed, can only do so much.

Slow growth, but no signs of recession

Today's economic releases shed no new light on the state of the economy, which remains one of disappointingly slow growth. Although it's very clear the economy has slowed down, there are as yet no indications that it is going to slow further or enter a recession. 

After a month of very volatile numbers, the picture of the weekly unemployment claims has clarified: the volatility was almost entirely due to seasonal adjustment factors—which attempt to predict the timing and magnitude of scheduled layoffs in the auto industry—that did not match up with the reality. By now, however, these problems are water under the bridge, and today's release is probably an accurate reflection of the underlying realities: new claims for unemployment continue to decline. On an unadjusted basis, claims are down 9% from a year ago. This is important, since if the economic fundamentals were deteriorating, we should be seeing an increase in claims, not ongoing declines. The economy is growing slowly, but it is not deteriorating.
 

Thanks to the scheduled expiration of emergency claims beneifts, and to the ongoing decline in new layoff activity, the number of people receiving unemployment insurance continues to decline on a seasonally-adjusted basis: down over 1 million in the past year, or -15.4%. This creates important new incentives in the workforce, since more people have an incentive to find and accept job offers, even though they may not be ideal jobs. This—relocating workers to the areas of the economy where they are needed and adjusting the cost of labor to new realities—is part of the natural healing process of any recession, and it has been retarded for way too long by Congress' decision to keep extending eligibility for unemployment insurance.

Announced corporate layoffs continue to run at very low levels. Once again, here is a key indicator of underlying economic fundamentals that shows no sign of deterioration.

Nondefense factory orders declined in June, and they have fallen at a 9% annualized rate so far this year. The deterioration in factory orders and related subcomponents (e.g., capital goods orders) is mirrored in the recent decline of the ISM manufacturing index, and it reflects conditions that existed 1-2 months ago, so it is arguably not new news.

Key indicators of financial health and systemic risk, captured in Bloomberg's Financial Conditions Index (first chart above), are behaving in relatively normal fashion. The Vix index of implied equity volatility remains somewhat elevated, at 18.7, but swap spreads (second chart above) are trading at relatively low levels in the U.S. and are even down significantly from recent highs in the Eurozone. The market is still in the grips of fear, and risk aversion is still high (viz. 10-yr Treasury yields at 1.46%), but markets are liquid and functioning normally. Arguably, the illiquidity that struck markets in the wake of the Lehman collapse in late 2008 was a very important factor aggravating the recessionary conditions that had been building up to that time. With banks almost frozen, for example, letters of credit were almost impossible to get, and global trade virtually collapsed. Today's liquid and relatively tranquil market conditions show no signs of deteriorating fundamentals that might threaten the U.S. economy going forward.

Mixed economic releases

The ISM manufacturing index for July came in about as expected, and it doesn't change what we already knew: the economy is in a "slow patch" with growth likely to be between 1 and 2%, as the above chart suggests. However, there is still no sign in this indicator of a recession, and that ends up being a mild positive in my view, given how bearish the market is (e.g., 1.5% 10-yr yields). 

The ADP estimate of the change in private sector employment in July was somewhat stronger than expected (163K vs. 120K), but of course this is still a fairly weak number. However, based on the above chart, the ADP number is pointing to a stronger-than-expected payroll report this Friday. The market is expecting only 110K private sector jobs to be found in Friday's release—if it came in at or above 160K that would probably be a welcome and positive surprise for the market.

This chart from last month gives yet another reason to expect a stronger-than-expected payroll report. What stands out is the very strong gains in private sector employment that have been found in the household survey so far this year, especially when compared to the fairly weak numbers we have seen in the establishment survey. It may be time for the establishment survey to "catch up" to the household survey. 

Construction spending in June came in about as expected, and it extends the upturn in the sector which began early last year. Total construction spending is up about 13% from last year's low. That's encouraging on the margin, but nothing to write home about.

UPDATE: July auto sales were ever so slightly higher than expectations (14.05M vs. 14.0M), but this is a rounding error in a series in which monthly sales are annualized and seasonally adjusted. All we know is that the uptrend in sales, which began over three years ago, appears to remain intact: since the early 2009 low, sales are up 50%, and over the past year, sales are up 15%. Both are rather impressive figures.