- Conventional wisdom says that the Fed’s taper is bearish for bonds and stock.
- In fact, the taper is bullish for stocks and bonds.
- Falling bond yields do not signal higher bond yields.
Wednesday, August 27, 2014
The common wisdom for understanding the behavior of the capital market since the Crash: “The Fed launched QE in order to artificially depress bond yields, resulting in the lowest bond yields in modern history. The tapering, ending and reversal of QE will remove this source of artificial demand, resulting in higher bond yields. The stock market has also been propped up by QE and will decline once this stimulus is withdrawn.”
The common wisdom, however, is untrue. The intended (if unspoken) purpose of QE was to lower the real funds rate by raising inflation expectations. Money printing is inflationary and raises expected inflation and thus bond yields. The withdrawal of QE is inherently deflationary and should lower inflation expectations and bond yields.
In his famous deflation speeches, Bernanke provided excellent explanations of the need to raise expected inflation in order to lower the real funds rate. In a nutshell: the real funds rate is the nominal rate minus expected inflation. To stimulate the economy requires a negative funds rate. When the nominal rate is zero, the only way to make it negative is by raising the expected rate of inflation. This is what Bernanke was trying to do with QE. He was ultimately able to get the real funds rate down to minus 2%, which was stimulative (but inadequate and too late).
The tapering of monetary stimulus has resulted in lower bond yields. When the Fed began to taper in January, the 10-year bond yielded 3%. Now, eight months into the taper, the 10-year yields 2.4%, a decline of 20%. In January, TLT was at 102; today it is at 118. Bond prices have risen during the taper, and continue to rise. This is because when the Fed shuts down its printing press at the end of this year and then begins to reverse QE, the impact on money growth should be negative. It’s true that QE did little to goose money growth, but its ending and reversal are unlikely to be stimulative. Depending on which monetary aggregate one chooses, the Fed has been tightening since 2012 (M2) or since January (MB). Tighter money, lower inflation, higher bond prices.
This discussion is not only relevant to the bond market; it is also crucial for equity valuation. There are now two schools of thought with respect to the level of stock prices: the CAPE school (bearish) and the ERP school (bullish). The CAPE school says that PE ratios are too high, while the ERP school says that today’s high PEs are justified by low bond yields. The CAPE fraternity says that today’s low interest rates are artificial and should be ignored in the calculation of expected equity returns. They argue that there is no rational justification for today’s elevated multiples. Once the Fed withdraws QE, bond yields will normalize and stock prices will fall. If they are right--if bonds yield rise--then the CAPE school would be vindicated. But that is not happening.
The equity valuation argument hinges on the outlook for bond yields (and inflation). In my view, falling bond yields provide conclusive evidence that the market does not expect higher bond yields. The evidence to date suggests that bond yields are already normalized and that the elevated equity premium will persist until stock prices rise to much higher levels. In a later article I will explain further why I don’t expect higher bond yields or higher inflation.
The taper has resulted in higher bond and stock prices. The end and eventual reversal of QE should provide further support.
QE: quantitative monetary easing via Fed purchase of government and mortgage securities.
TLT: an exchange-traded fund which seeks to track the investment results of the Barclays U.S. 20+ Year Treasury Bond Index.
M2: the measure of the money supply used by the Fed and most economists.
MB: the monetary base, which approximates the size of the Fed’s balance sheet.
CAPE: Robert Shiller’s cyclically-adjusted price earnings ratio which uses 10 years of inflation-adjusted earnings rather than 12 months as in the trailing PE.
ERP: the equity risk premium which measures the difference between the expected return from stocks versus government bonds.
Thursday, August 21, 2014
- The deleveraging process has ended, but overall credit growth remains low.
- The culprits are the housing sector--and the Fed.
- Low growth supports current bond and equity valuations.
The US economy has begun to dig out from the post-Lehman deleveraging process, but the current level of overall credit growth is anemic. (I am using the Fed’s flow of funds data series from FRED.)
Total Credit Growth
Total credit was growing at 10% before the Crash, contracted in 2009-10, and is now growing at 3.5%, which is low enough to be acting as a drag on money growth and the recovery. This is mainly due to the low level of activity in the mortgage sector.
Household credit was growing at 11-12% pre-crash and then contracted for four straight years: 2009-12. Only last year did the contraction end, and growth is now de minimis. The mortgage sector has not recovered from the collapse of the housing bubble. This is the main drag on growth today.
Corporate credit was growing at 14% before Lehman, contracted in 2009-10, and has since recovered to a healthy 9% growth rate. Business is not starved for credit. This is a major positive for overall growth.
During the bubble, the financial sector was growing in the low teens, then contracted very sharply, and has not yet resumed growth. Like housing, the financial sector has not yet recovered from the crash.
Pre-crash, federal debt was growing at a modest 3%. During the crash, it grew very rapidly (2009). Following the Fiscal Cliff, federal debt growth has fallen to 6% which is neither contractionary nor stimulative. One could say that government finance has normalized at “neutral”.
I believe that the current low level of overall credit growth is acting as a drag on the Fed’s monetary policy by countering the Fed’s efforts to grow M2. Larry Summers has suggested that the US economy can only grow rapidly during credit bubbles. I don’t agree. I would reformulate that to say that the nominal economic growth rate will tend to grow at the nominal rate of aggregate credit growth. You can’t have economic growth without credit growth, but it need not become a bubble. We don’t need 12% household credit growth to achieve 6% NGDP growth; we can make by with household credit growth in the mid-single digits.
At present, aggregate credit growth is stalled at 3.5%. If it can accelerate (i.e., if housing and/or inflation can pick up) then I would expect to see the benefits of the quantity equation, resulting in higher nominal growth. Of course, that is almost a tautology. It would appear that everything hinges on the bugaboo of the bubble years: house price appreciation and the availability of mortgage credit.
I do not mean to contradict monetarism or to absolve the Fed of its unwillingness to accelerate money growth. I am only saying that by handcuffing itself the Fed is making the economy hostage to the housing market. The growth rate of the nominal economy is within the control of the Fed, if it is prepared to reflate. The Fed’s ongoing satisfaction with inadequate inflation means that we are swimming on our own. At present, neither the government nor the Fed are providing any stimulus.
We are looking at an economic dashboard where almost every dial is on LOW: credit growth, money growth, velocity, inflation, nominal growth. This suggests to me that the outlook for inflation and bond yields remains low. This in turn supports current stock and bond valuations, and it explains why the bond market yawned when the FOMC minutes were published. The fact that the Fed is plotting to reverse QE is deflationary, not inflationary. In fact, I am reminded of the monetary fiasco of 1937-38, when the Fed hit the brakes much too soon. The FOMC continues to be “Austrian Lite”. Monetarism is nowhere to be found.
Bottom line: current bond and stock prices are supported by the low trajectory of credit and money growth.
Tuesday, August 12, 2014
Friday, August 1, 2014
- The market selloff was prompted by noise rather than real data.
- On a YoY basis, the signals remain in range.
- There is no call for higher bond yields.
- Stocks remain cheap to bonds.
Once again, the bond market has demonstrated that it has a higher IQ than the stock market. Three numbers came out (second quarter growth, the July employment report, and the second quarter employment cost index) which spurred fears of higher inflation and interest rates, prompting a 500-point selloff in the DJIA. The bond market reacted much more calmly because bond investors study the data rather than reacting to a headline.
The data indicates that nothing has happened that would lead to higher interest rates. One can grow old quickly if he annualizes single data points. Annualized growth and employment data have a high noise to signal ratio when observed in isolation. I much to prefer to view the data on a year-on-year basis. This removes most of the noise and makes the trend visible and intelligible. On a YoY basis, there is no real news in the latest data.
Economic growth remains low, with NGDP growing at 4% and RGDP growing at 2.4%. Nominal growth at 4% is abysmal for an economy in recovery. In the post-inflation era (1983-2006), the economy often grew at 6-7%, which left plenty of room for 4% real growth. With 4% nominal growth, the post-Crash output gap will never close. We are in a new era of low money growth, steadily declining velocity, low inflation and low growth. This is not a promising environment for higher interest rates. Yes, the Fed is winding down QE. If that has any impact on money growth (doubtful), it will be negative, which means deflationary. So the end of QE is a reason to buy bonds, not to sell them.
Next, the employment data. Employment grew by 1.9% in July on a YoY basis, and by 1.8% on an annualized basis. This is within the range of employment growth since the recovery began. It is not a spike. There is no employment boom.
The employment cost index (all civilians) rose by 3% on an annualized basis, but by only 2.1% YoY. The 3% annualized rate is the highest since the Crash, but the 2.1% YoY rate is still within range. And price inflation? Core PCE inflation for June was 1.5%, which remains 25% below the Fed’s target.
So, in sum, there is very little news when you extract the headline-grabbing noise in the most recent data. We are on a stable path of low growth and low interest rates.
Tomorrow, Professor Aswath Damodaran will publish his estimate of the equity premium for today at the closing bell. It should be quite a bit higher than it was on July 1st (5.45%), given the selloff. I expect it to approach 6%, which is historically high and means that we are being paid a lot of money to hold stocks versus bonds.
Investment Conclusion: Don’t panic. Buy stocks.