First published at Seekingalpha.com http://seekingalpha.com/instablog/27843163-robertbarone/2967823-bonds-got-it-way-wrong-economy-is-accelerating
In the financial marketplace, the bond market usually signals first and reflects the magnitude of a changing economic environment. The equity market, on the other hand, is often late, or at least later than the bond market in recognizing oncoming changes in economic conditions.
So, the worries now rampant on Wall Street and reflected in a pessimistic media over equity valuations are understandable given that bond prices rallied so much in May (yields fell). Generally, such a rally implies impending weakness in the general economy.
A “Perfect Storm?”
But, it seems that, this time, bonds have gotten it wrong, probably because the Fed and the world’s major central banks have flooded the global financial system with massive liquidity injections. Besides this liquidity, there are several other technical reasons for the bond rally, all coming together at the same time to form the “perfect storm.”
- The shrinking federal budget deficit: Although the Fed continues to taper its Treasury purchases, because the federal deficit is shrinking, it is still buying the lion’s share of newly issued Treasury debt, thus leaving less for the market than the existing and newly issued supply of liquidity would demand; the result is a bidding up of prices.
- Duration Matching: The unfunded liability status of private pension funds has improved significantly from what it was in the immediate aftermath of the financial crisis. As a result, those pension funds are now attempting to match asset and liability durations so that another downdraft in equity prices won’t impact their funding status.
- Currency depreciation: China, Japan and others (including the European Union) are trying to weaken their currencies so that their imports fall (higher prices in terms of their currencies) and exports rise (lower prices in terms of their currencies). By selling their currency in the market for dollars, the Chinese, for example, weaken their currency (the RMB). They then take the dollars that they have just procured by selling RMBs and buy Treasuries. This used to be called “mercantilism,” “beggar thy neighbor” policies, or simply “protectionism.” [Investors should be concerned that the move away from globalism, as affirmed in the latest European elections, and toward protectionism will have a significant impact on companies dependent on foreign raw materials.]
- Back door money printing: Through the back door, the Fed monetized the $100 billion of Treasuries dumped on the market during the Crimea (Ukraine) crisis in March/April, most likely by Russia. They did this by, allegedly, lending the money to Belgium, whose central bank balance sheet suddenly swelled by $100 billion of U.S. Treasury debt. This added liquidity was in addition to its regular QE3 monthly purchases.
- Anticipating the ECB easing: Money managers may have anticipated the ECB’s announced intent to ease, and began buying European debt early. With the downdraft in European sovereign yields, the Treasury yield curve became relatively attractive and moved in sympathy.
Note that none of these technical considerations have anything to do with underlying U.S. private sector economic health. In fact, despite all of the pessimism rampant in the media, nearly all of the economic data points to a U.S. economy that is finally accelerating.
- ISMs both over 55: Both Institute for Supply Management major indexes are over 55. The table shows both the manufacturing and non-manufacturing indexes for the past 5 months and the data shows improvement (acceleration) in almost every cell:
Source: Institute for Supply Management
- Bank lending at record level: Loans from the banking system (mainly the large banks) grew at a record level in Q1/14. The $96.8 billion was 64% higher than the $59.1 billion loaned in Q4/13. This data has been collected since 1997 with most of the quarterly data falling in the $40 to $60 billion range. There has only been one other data point in the series even close to the Q1 record level, and that was the $90 billion of loans made all the way back in Q2/00. Besides these two data points, the next highest was the $78.2 billion of loans. Just to show how hot these numbers are, there have been no quarterly numbers greater than $60 billion since Q2/06, and before that, one has to go all the way back to Q3/01! [It is through lending that the newly created money (bank reserves) by the Fed undergoes the “multiplier” effect. So, this lending may be the harbinger of the long anticipated explosion in the money supply and its impact on inflation. Keep an eye on new bank lending.]
- Consumer spending and other demand indicators: Consumption rose at a 3.3% clip in Q4/13 and at 3.1% in Q1/14. The last time we saw two consecutive quarters of 3%+ consumption growth was in Q2 and Q3/05. West coast port traffic us up at double digit rates; and rail traffic is up nearly 7% from year ago levels. The June 3rd auto sales reports show that new autos are flying out of dealer showrooms, as sales hit a 9 year high in May. Chrysler and Toyota each showed sales grew 17% from year earlier levels, while GM’s sales grew 12.6%. Overall, sales were up 11% and the 1.6 million units of sales were the highest since July, ’05.
- Inflation: The Producer Price Index (PPI) grew at a 12 month clip of 3.1% in April, up from .6% a year earlier; Consumer Price Index (CPI) growth in the service sector (which represents 90% of private sector GDP) was at a 3% annual rate in the latest 3 months. Home prices (Case-Shiller) are up more than 12% year over year. The Fed, meanwhile, is still worried about deflation. David Rosenberg (Gluskin-Sheff), a nationally known economist, recently observed that the last time the Fed raised interest rates in the summer of ’04, core CPI was growing at an annual rate of 1.7%, the average hourly wage growth was 2.0%, capacity utilization was 77.4% and the short-term unemployment rate (unemployed for 6 months or less) was 4.3%. Today, those numbers are respectively, 1.8%, 2.3%, 78.6%, and 4.1%. In each case, today’s data are stronger, yet there isn’t even a hint that the Fed will raise rates soon. Once again, it looks like the Fed is destined to wait too long.
- Labor Markets are tight: Initial weekly claims for unemployment have recently been flirting with the 300,000 level. The 4 week moving average, at 311,500, has not been this low since the week of 8/11/07. Continuing claims, too, are at low levels. We have not seen the 4 week moving average of 2.66 million this low since the week of 12/8/07. Layoffs in the private sector, at 1.4 million (March data) are at the lowest level of the series (which began in 12/00). Private sector job openings (3.6 million) haven’t been this high since ’08. And the “quit” rate, at 2.0%, also hasn’t seen levels this high since ’08. We have had 3 months in a row of 200,000+ net growth in non-farm payrolls, and if May makes it 4 in a row (as is forecast by nearly every economist polled), it will be the first time this has happened in 14 years. The old record high of total non-farm employment occurred in January ’08 at 138.365 million. April’s level was 138.252. So, if May payroll growth is more than 113,000, a new employment record will have been set. Thus, by almost any measure, the employment markets are tight, except, of course, if you are Janet Yellen, who appears to believe that it is her job to make sure that monetary policy stays ultra easy until those without job skills somehow find work.
All of the economic data not only show that the economy is growing, but growing robustly. History tells us that major corrections in equity prices only occur when a recession is imminent. The bond market is usually more accurate in forecasting near-term economic conditions. But, not this time. But the unintended consequence of the technical bond market rally is that equity markets continue to fear a major correction.
Equity markets can and do correct, and do so for a myriad of reasons, or for no reason at all. The strength in the economy would indicate that if a correction occurs in the near term, it won’t be due to issues in the economy. And history tells us that most of the time, such corrections are buying opportunities.
Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value Advisors (UVA), Reno, NV, a Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee. Robert is available to discuss client investment needs. Call him at (775) 284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.