Claims back on track

As I noted last week, the jump in claims was bogus, the result of flawed seasonal adjustment assumptions. This week claims fell by more than they rose last week, so claims are back on their declining trend.

At this rate, it won't be long before we see claims fall to 300K per week or a bit less, and that is about as good as it gets for the labor market. The most important thing that claims tell us is that there is no sign of any deterioration in the labor market, and therefore a recession or even a signficant slowdown in growth is very unlikely.

One of the most significant trends in today's labor market is the decline in the number of people receiving unemployment insurance. That is down by over 19% in the past year, or 1.24 million people. This is a powerful trend, since it creates incentives for large numbers of people to seek out and accept employment. Many have no doubt been discouraged in this effort, however, as witnessed by the very weak growth of the labor force—millions have simply "dropped out" and decided to stop looking for a job. But many of those are likely still on standby, ready to re-enter the labor force should job opportunities and other incentives to work improve.

Come and get it

This isn't the first time I've called the low in mortgage rates, but it could be the last. The chart below shows the nationwide averages according to BanxQuote: currently 3.49% for conforming, and 3.68% for jumbo loans. Jumbo rates briefly dipped to as low as 3.55% last December. That could well prove to the be lowest level in my lifetime. All it takes for rates to move higher is continued economic growth, even if it's relatively sluggish. That would bring the Fed closer and closer to the end of its QE3 program, and the Fed is already hinting that they might well discontinue it before the end of this year, or as early as mid-year.

The Fed now owns about 11% of the nation's $9.5 trillion of home mortgages (data in the chart only goes up to the end of last year, but the Fed is still buying $40 billion of MBS per month). This is not likely to increase much before QE3 ends. I don't think that Fed purchases of MBS have resulted in any meaningful reduction in mortgage rates, but I could be wrong. In any event, the end of QE3 means that the Fed thinks the outlook for the economy is improving, and that should help dissuade the market from continuing to pile into and/or hold long-term, fixed-income securities that are trading very near all-time lows.

For investors it's a warning shot across the bow. For home buyers, it's "come and get it!"

And if I'm wrong and mortgage rates continue to decline, it's relatively easy and cheap to refinance.

UPDATE: I should add that with the deductibility of mortgage interest and inflation, a 30-yr fixed-rate mortgage is essentially free money. The CPI has averaged about 2.5% for the past 15 years, and most folks with a jumbo loan should be able to deduct about 35% of the interest. The after-tax interest cost would be about 2.5%, and subtracting inflation of 2.5% gives you zero.

There are of course downside risks. You would be exposed to a further decline in housing prices, another recession, and/or a bout of deflation. But if any or all of those happen, interest rates are likely to decline further, leaving open the possibility of refinancing.

Impressive progress in the federal budget

Thanks to a gridlocked Congress and a recovering economy, the federal budget has registered some impressive improvements in the past three years. Spending has not increased at all, while tax revenues have surged by over $550 billion, with the result that the burden of the federal budget deficit has dropped almost in half, from 10.5% of GDP to 5.75%. As the federal government absorbs less and less of the economy's output, this opens the door for a stronger private sector. This is a very encouraging development that is not widely appreciated or understood.

For the 12 months ended March, 2013, federal spending was $3.49 trillion. As the chart above shows, spending has not increased at all since the end of the 2008-09 recession. Revenues, in contrast, have risen from a post-recession low of $2.02 trillion to $2.58 trillion in 12 months ended March, 2013. The federal budget deficit has fallen from a high of $1.47 trillion in late 2009 to $910 billion in March of this year. Revenues are now only about $20 billion shy of an all-time high. This is real progress: the best way to grow revenues is to grow the economy without raising tax rates, and the easiest way to "cut" spending is to just not let it grow.

Despite no effective increase in tax rates in recent years (and in fact a 2-yr reduction in payroll taxes), revenues have grown much faster than GDP—as is typical during a recovery.

With spending flat but nominal GDP now up over 15% since the recovery started, federal spending as a percent of GDP has fallen from a high of 25.2% to about 22%. It is now within the post-war historical range.

The chart above combines the previous two charts for a better historical picture of what's happening. Both revenues and spending are slowly but surely coming back into line with their historical averages.

The reduction in the burden of the federal deficit has been impressive, although it is still a bit larger than it was at its Reagan-era peak.

One important source of the reduction in spending has been automatic stabilizers like unemployment insurance. As the economy has grown, the number of people receiving unemployment insurance has declined by 3.3 million from its peak in mid-2010.

Unfortunately, the impressive progress to date in the budget is threatened by the looming onset of Obamacare, which will almost certainly increase government spending significantly as it also raises healthcare costs. Moreover, the financial health of social security worsens with each passing year, due to the very low level of labor force participation and increasing life expectancies. But at least for now we are making excellent progress.

Note: in calculating revenues, spending, and the deficit as a % of GDP, I have assumed that nominal GDP grew at a 4.4% annual rate in the first quarter.

Stocks and bonds are not at odds with each other

I'm seeing more and more observers commenting on the apparent disconnect between the stock and bond markets. Reader "Rob" recently linked to a post by Thomas Kee at Smart Money that is typical. Kee argues that bond buyers these days are likely smarter than equity investors, because "they are educated and intelligent, and they make decisions for longer-term purposes." Whereas equity investors are more short-term focused ("fast money") and currently have been lulled into believing the recovery is real, when in fact it is "fabricated."

I think it's very difficult to defend the belief that one class of investors (bond buyers) see the world differently than another class (equity buyers), when both operate in the same capital market and both have access to the same information. To assert this, however, I need to show how it is that bond and equity investors today share similar beliefs about the economic fundamentals. If I'm right, then the "disconnect" is not really a disconnect, it's simply the result of how two very different asset classes react to the same information.

The chart above is a good illustration of the alleged "disconnect" between the stock and bond markets. Over the past three years, stock prices have been in a rising trend, while bond yields have been in a falling trend. That doesn't make sense, so the thinking goes, because falling bond yields are symptomatic of a market that is increasingly risk-averse, whereas rising equity prices are symptomatic of a market that is increasingly risk-loving. I think both interpretations are wrong.

As the first chart above shows, there is a decent correlation between the level of real yields and the strength of the economy. Real yields and real economic growth were both quite high in the late 1990s and early 2000s. The economy had been booming for several years, and the market expected this to continue. The real yield on TIPS had to compete with the very strong real yields on equities. This makes perfect sense. Now, over a decade later, real yields on TIPS are negative and the economy is in the midst of its weakest recovery ever, with a so-called "output gap" that could be as much as 13%. As the second chart shows, consumer confidence is extremely low; although it has risen in recent years, it is still at levels that in the past have coincided with recessions. The first chart suggests that the level of real yields is consistent with market expectations of almost zero growth for the next several years.

As the chart above shows, the equity risk premium—defined here as the difference between the earnings yield on equities minus the yield on 10-yr Treasuries—is extremely high. Why would the market be indifferent between an almost 5% earnings yield on equities and a paltry 1.7% yield on 10-yr Treasuries? The only explanation that makes sense is that the market has almost no confidence that corporate profits will maintain their current levels; instead, the market fully expects profits to decline significantly.

As the chart above shows, the earnings yield on equities tends to track inversely the real yield on TIPS. In other words, when real yields fall, as they have over the past decade, the earnings yield on equities has risen. The more gloomy the market becomes over the prospects for economic growth, the higher the equity yield that the market demands in compensation for what is expected to be a big decline in profits.  The two lines have diverged of late, and perhaps that is significant, but such divergences have happened before.

As the chart above shows, it is very unusual for the earnings yield on equities to be higher than the yield on BAA corporate bonds. Would you pass up the opportunity to buy stocks with a higher earnings yield than available on corporate bonds if you thought the economy was going to be healthy? No, because that would mean giving up the opportunity for price appreciation. Investors today are willing to accept a lower yield on corporate bonds because bonds are higher in the capital structure and have first claim to earnings, which the market suspects may be in for trouble.

But what about the fact that stock prices are at all-time highs? Doesn't that conflict with the fact that Treasury yields are close to all-time lows? Not necessarily. As the chart above shows, in inflation-adjusted terms the S&P 500 is still almost 25% below its 2000 all-time high. From a long-term perspective, the chart suggests that current equity prices are about "average," having followed a 3% trend growth rate, which happens to be the average real growth rate of the U.S. economy. Moreover, corporate profits today are almost 200% above the levels of late 2000. By these metrics, stocks are not optimistically priced at all. Today's S&P 500 PE ratio is just above 15, which is below its long-term average of 16. Shouldn't PE ratios be much higher than average considering that risk-free discount rates are at all-time lows?

Bonds and stocks are both priced to pessimistic assumptions about the future health of the U.S. economy, no matter how you look at it. And as for the assertion that the recovery has been "fabricated," I refer the reader back to many of my posts which show abundant evidence that many sectors of the economy are posting solid, undeniable growth, beginning with this recent post. This recovery may be the weakest ever, but it is no less real because of it.

Jobs report more noise than signal

As Ed Lazear points out in a very timely op-ed in today's WSJ, "Beware the Monthly Jobs-Report Chatter," the numbers are estimates that:

... are subject to significant revision, they are volatile, and they tell us very little about the direction of the labor market. There are subsequent revisions, one and two months after the first announcement, until the number becomes final, sometimes up to two years later. The error in any given month tends to be very large, which means that its reliability is low.

I have lived through perhaps 300 jobs reports, and I have seen the numbers revised time and again, often by very large amounts. As Ed correctly notes, "... the average error in the initial report is almost as large as average job creation itself."

So today's jobs number "miss" (95K private jobs vs. 200K expected) could well turn out, after revisions are made over the next few months and years, to be not a miss at all. At the very least, we know that one weaker-than-expected jobs report does not a recession make. Are there other signs of a significant slowdown in the economy? None that I can see. In fact, there are many areas of the economy that are growing at decent rates, with no sign of any significant or sudden disruption. Besides, the March shortfall needs to be put in the context of the previous 5 months' worth of private sector job gains which averaged 223K per month. Today's number is most likely just noise. The signal—that jobs continue to grow at a moderate rate—is unchanged.

This first chart shows the monthly change in private sector jobs. Note that the "noise" in this series—the average magnitude of month-to-month variations—can be almost 200K per month. The March number falls well within the range of normal fluctuations.

Taken in the context of the past six months, the annualized growth in jobs is about 2%, the same as it has been on average for the past two years.

The tepid growth in the labor force continues to be the most disappointing aspect of the jobs market. The labor force grew only 0.21% in the past year, and it has grown only 0.24% since the end of 2008. We've never seen anything like this. Upwards of 10 million people have "dropped out" of the jobs market; they've either retired or given up looking for a job. Until we can somehow entice many of these folks to come back to work—by offering more and better job opportunities—the economy is going to be growing at a disappointingly slow pace. The decline in the unemployment rate to 7.6% is a by-product of the very slow grow in the labor force, not a sign of a healthier economy.

This last chart reminds us of the trends that are still likely in place. This recovery has seen a fairly large decline (about 735K) in the number of public sector jobs, but that decline appears to be leveling out. The private sector continues to create jobs at a pace of about 2% per year, or about 190K per month. That combination is enough to give us real growth of 2-3% per year. Not every exciting, but certainly better than a recession.

Dollar update: still weak, but improving

The Fed's calculation of the inflation-adjusted value of the dollar against both major currencies and a very large basket of currencies shows the dollar has improved on the margin over the past two years, but it is still fairly close to its all-time lows. This is a reminder that optimism about the prospects for the U.S. economy, at least insofar as it is reflected in the world's desire to own dollars, is in relatively short supply. The outlook is not good, but at least it is improving on the margin (i.e., things are getting less bad).

One helpful development is the recent weakness in the yen, propelled today by the Bank of Japan's strenuous efforts to weaken the currency in order to reduce and perhaps eliminate the deflationary pressures that have plagued the economy for decades. As the chart above shows, the yen rose significantly (even awesomely) beginning in 1985. It reached a peak about a year ago, by which time its had more than tripled in value vis a vis the dollar (put another way, the dollar lost about 80% of its value vis a vis the yen).

As I've noted before, the yen's recent weakness has been a source of great cheer for the Japanese stock market. This is not the result of Japan engaging in "competitive devaluation." Rather, it is a case of Japan attempting to reverse the crippling, relentless revaluation of the yen that has made life miserable for the country's exporters for decades.

UPDATE: The Nikkei is up almost 4% in Friday trading, and the yen has fallen to 97. This is the hottest trade on the planet right now: long Nikkei/short yen.

Stockman is wrong about Doomsday

Times must still be bad if publishers think that yet another Doomsday book will sell, especially David Stockman’s The Great Deformation; The Corruptions of Capitalism in America. The NY Times last week published a short version, just a few days before the book’s recent release, and you can read an excerpt from the book here.

Stockman has been predicting the-end-of-the-world-as-we-know-it for a long time, ever since 1985, when he left the post of OMB Director in the Reagan administration and warned that federal budget deficits and the failure to raise tax rates would be disastrous. His first Doomsday book was published in January, 1987: The Triumph of Politics: Why the Reagan Revolution Failed. Around that same time, Reagan pushed through another significant tax reform, including a reduction in top tax rates. Contrary to Stockman’s warnings, the economy grew at a 3-4% pace for the next several years, tax revenues soared some 30%, and the burden of the federal deficit dropped from 5% of GDP to 3%. After a brief recession in 1990-91, precipitated by a tightening of monetary policy, the economy went on to boom for most of the next decade thanks to spending restraint, welfare reform, lower taxes, and a strong dollar. And the deficit briefly turned into a surplus.

His message today hasn’t changed much, except that the coming Apocalypse will not be just the Republican’s fault, as it was back in the 1980s, but the fault of all of Washington: the Fed, the Congress, and our ever-growing entitlement programs. He’s right on many counts, but wrong on others, and I’d like to think we can avoid a calamity once again.

He’s right that we are “piling a soaring debt burden on our descendants,” and he’s right that Washington seems “unable to rein in either the warfare state or the welfare state.” But he’s wrong to suggest that the only solution is to raise taxes. We need more growth-friendly policies, such as a lower, flatter tax rate structure with fewer exemptions and loopholes, lower corporate tax rates, and reduced regulatory burdens. We need to reform social security by privatizing it and/or extending the retirement age. We need to introduce market-based reforms to healthcare, not more government controls. This is not rocket science, it’s just letting the market take over many of the functions that government has tried and failed to manage.

He’s dead wrong when he says “the Fed has resorted to a radical, uncharted spree of money printing.” I explain here why this is not true. The Fed is only swapping bank reserves for notes and bonds, and the evidence suggests that they have been doing this to satisfy the world’s demand for safe assets. The Fed may well make an inflationary mistake in the future if it fails to unwind its QE in a timely fashion, but that remains to be seen—it is not yet baked in the cake.

He’s right when he argues “we’ve had eight decades of increasingly frenetic fiscal and monetary policy activism.” Fiscal and monetary policy mistakes are at the root of almost every major economic problem this country has faced. Keynesian “stimulus” policies have proven not to work, and monetary policy is a very poor tool for fine-tuning economic growth. The Fed undoubtedly contributed to the housing bubble by keeping interest rates very low in the early- to mid-2000s. As government has grown in size and power, it has created a culture of crony capitalism (e.g., Solyndra), and by promoting housing with easy money from Freddie and Fannie and subsidized mortgage rates, it also contributed to the housing bubble. 

The list of government failures is unfortunately long and depressing. Where it looks like the market has failed and is corrupt, it's because government has not allowed the market to work. For a superb discussion of how and why government is the culprit behind the housing bubble and the financial crisis of 2008, I highly recommend John Allison's book The Financial Crisis and the Free Market Cure.  

Stockman’s fatalism is on display when he says we are at “an end-stage metastasis [and] the way out would be so radical it can’t happen.” What does he recommend? “If this sounds like advice to get out of the markets and hide out in cash, it is.” Unfortunately, most of his doomsday arguments have been the subject of headlines for years. It’s no secret that the U.S. suffers from some seemingly intractable problems. But it’s an underappreciated fact that the economy is growing and the burden of the federal deficit has declined significantly in the past three years, from 10.5% of GDP to less than 7%. I explain this here and here. It’s due to the simple combination of a growing economy and spending restraint. 

In any event, it’s arguably a little late to worry now that the end of the world is upon us. “Hiding out in cash” is extremely expensive, since it means forgoing much higher yields in other assets as long as the economy fails to crash. As I explain here, risk-free short-term interest rates are zero or very close to zero in most of the world’s major economies because investors are very risk-averse, not because the Fed is artificially driving rates to zero. Investors everywhere are already “hiding out” in cash: savings deposits at U.S. banks have swelled from $4 trillion to almost $7 trillion in the past four years, despite the fact that they pay almost no interest. U.S. currency in circulation has increased by over $300 billion since 2008, with much of that increase going overseas where $100 bills are seen as the ultimate safe haven. In the past 5 years, domestic equity mutual funds have suffered net outflows of over $500 billion, while much safer but very low-yielding bond funds have enjoyed over $1 trillion in net inflows.

Should concerned investors seek out the safety of gold instead? Here again it may be too late. Investors who fear the type of Apocalypse that Stockman is predicting have already bid up the price of gold to 3 times its inflation-adjusted price over the last 100 years.

In the end, Stockman is right to call our attention to the central problem we face, which is too much government. But there is no reason to think that calamity is unavoidable. Government can be fixed. Monetary policy is not a preordained disaster. The economy is growing and can continue to grow in spite of the fiscal and monetary policy headwinds it faces.