Friday, March 30, 2012

GDP Growth: the Road Ahead and the Investment Climate

The second revision of the fourth quarter GDP number was released this past week and everything pretty much stayed the same.  The year-over-year rate of growth for the fourth quarter came in at 1.6 percent…following a third quarter of 1.5 percent growth and a second quarter of 1.6 percent growth.  In the following chart, the trajectory for real economic growth in the United States is shown since the beginning of the recession in December 2007.

A very nice cycle is shown in the chart as the recovery has been going on since June 2009.  The two major differences between this recovery and many previous recoveries are the strength of the major revival and the level at which the economy continues to grow.

In many previous cycles, year-over-year growth initially jumped up over 5.0 percent sometimes reaching 6.0 percent.  This time, economic growth in the United States only reached a level of about 3.5 percent. 

In the early 2000 recession, the upswing began in November 2001 and economic growth reached a height of a little more than 4.0 percent before leveling off.

In terms of the second difference, economic growth, year-over-year, currently seems to be running modestly below 2.0 percent.  I have argued that, as we go forward, growth will continue above 2.0 percent but will probably stay somewhat below the 3.0 percent level. (See my post

Economic growth leveled off in 2004 through 2006 period in the 3.0 percent range but dropped off to about 2.0 percent in the period preceding the beginning of the last recession in December 2007.

The point is, in our recent experience, economic growth is not anywhere as robust as it was in the last half of the 20th century and my guess is that it will not regain that robustness for some time.

The current economic situation is also mirrored in the year-over-year growth rates for industrial production.  We see, in the following chart, that although the growth rate of industrial production is greater than the growth rate of real GDP for the same period, the trajectories of the two charts are roughly the same.

I believe that this is the economic environment that we will continue to face for the near future.  The general economic situation is dominated by the fact that there still is a tremendous debt overhang in the economy, where under-employment will continue to remain high, and where the state of the housing market has not yet bottomed out.  As a consequence, economic growth will remain tepid. 

The Federal Reserve will be continue to make sure that the economy has plenty of liquidity to avoid any major problems in the banking system (  However, as I quote in this previous post, Harvey Rosenblum, the head of the research department at the Dallas Federal Reserve Bank has written: “Monetary policy cannot be effective when a major portion of the banking system is undercapitalized. Many of the biggest banks have sputtered, their balance sheets still clogged with toxic assets accumulated in the boom years.” 

In other words, the Fed cannot have much impact on economic growth when the banks are in the condition they are…but the Fed needs to keep the banks liquid enough so that the banking system causes no further disruption to the growth that has already been started.

This environment should be a positive one for investments, although one still needs to be cognizant of all the possible “bumps in the road” that exist, like the European recession, a slowdown in China, higher gas prices, and so forth.  Burton Malkiel, in the Wall Street Journal, argues that common stocks should return around a 7.0 percent yield, calculated from the dividend yield on stocks (around 2.0 percent) plus the long-run growth of nominal corporate earnings (around 5.0 percent).  And, this gives a “five-percentage point equity risk premium (over the 10-year Treasury yield now around 2.0 percent)” that “is close to the historical average.” (

Malkiel goes on that “Only the so-called Shiller price/earnings ratio (based on the past 10 years of earnings) would suggest that stocks are too high.  But the average earnings over the past 10 years are likely to be well below the current nominal earning power of U. S. corporations.”

Thus, the Shiller “ratio” (CAPE) will revert to the mean, but because corporate earnings are rising in the current economic environment, not because stock prices should fall.  Furthermore, an index of market liquidity and a confidence index related to market performance are both supporting rising stock prices at this time, re-enforcing the argument that stock prices should rise in the near-term future. (See my   

Bottom line: I think common stocks are a good place to invest right now.)

Thursday, March 29, 2012

Commercial Banks: How Safe is the Banking System?

The commercial banking system in the United States does not seem to be “out-of-the-woods” yet, in spite of the fact that 15 out of the 19 largest banks in the country recently passed the stress test administered by the Federal Reserve. 

For one, many executives of the commercial banks involved don’t seem to understand how the Fed got many of its results. 

In conference calls held after the results of the stress tests were released the banks raised major questions over how calculations of capital were made.

“Healthy institutions want to understand why there were some large gaps between their own capital estimates and the Fed’s, according to people close to those banks.  Some of the five lenders that didn’t pass the test say questions about the Fed’s scoring complicate reapplying for approval to raise dividends or buy back stock…” (

Problems in interpretation were bound to occur, but, to my mind, the commercial banks have created their own nightmare.

The real problem:  mark-to-market accounting, or, the lack of it.

Executives in commercial banks don’t like mark-to-market accounting.  The basic reason is that they don’t like to admit that they have made mistakes or that they have taken on too much risk or that they just don’t want to deal with messy issues. 

When the value of bank assets decline, either because loans have gone sour or because interest rates have risen and the market value of securities have dropped, analysts argue that the banks should mark their assets to market so that they can get a real picture of how the bank is performing…whether or not the bank is solvent.

Bankers argue back that they shouldn’t be made to mark their assets to market “after-the-fact” because that forces them to change their balance sheets that were not expected of them before.  And, they also plan to hold their securities to maturity, when they would get their full value repaid, and they also need time to “work-out” their troubled loans as the economy improves.  They argue that analysts, by asking for them to go to mark to market accounting, are changing the “rules of the game” after the economic and financial environment has changed. 

So, the bankers can put on riskier loans, buy securitized bonds, mismatch maturities, place SIVs off-balance-sheet, and so forth, and when the economy turns south, they do not have to reveal to the public…and the regulators…what their decisions have done to the health of the bank!

They ask, “I have mismatched maturities to earn a few more basis points on my return of assets to try and keep up with the competitors, and now, since interest rates have gone up I have to mark the longer term assets to market?”

Well, you took the risk, you must own up to the consequences.  Arguing that you intend to hold the assets to maturity doesn’t “hold water” because as short-term interest rates continue to increase you will either have to sell your assets or work with a negative interest rate spread.

Also, Mr. Banker, when you made riskier loans…like subprime loans…you were stretching for yield.  You made the choice.  As the market moves, so does the value of your assets.  Own it.
Since the commercial banks have fought the development of an adequate mark-to-market accounting process, the Federal Reserve…and others…have tried to create a substitute for this accounting treatment of assets.  This substitute is called the “stress test.”

The “stress test” works with assumptions.  “Last November (the Fed) published test assumptions, such as a 13% unemployment rate in a U. S. recession.

But the Fed is resisting full disclosure of its methodology, hoping to retain the flexibility to make future changes and prevent the banks from gaming the numbers…”

The commercial banks “game” their own accounting numbers by not marking their assets to market.  The fear with stress tests is that the commercial banks will “game” the tests if they know what the Fed’s assumptions are.  The commercial banks want it both (all) ways.

And, how well off are the commercial banks?

Jesse Eisinger writes in the New York Times about the annual report of the Federal Reserve Bank of Dallas.  Although the article concentrates on the issue of “too big to fail”, Eisinger does print a quote from an essay in the annual report written by Harvey Rosenblum, the head of the research department at the Dallas Fed.

Rosenblum wrote: “Monetary policy cannot be effective when a major portion of the banking system is undercapitalized.  Many of the biggest banks have sputtered, their balance sheets still clogged with toxic assets accumulated in the boom years.” (

This from the head of a research department within the Federal Reserve System!

And, what about the other banks in the system?

As last reported by the FDIC there were 814 commercial banks on the list of problem banks.  There are many more on the edge of becoming problem banks.  The number of commercial banks in the United States dropped by 240 last year and only 92 of these were bank closures.  In both cases, the numbers included no banks that could be called “the biggest banks.”

You wonder why the Federal Reserve has pumped almost $1.6 trillion in excess reserves into the banking system?

I have argued for more than two years now that the Fed’s ease is not just about getting the economy going again.  In my opinion the Fed has been as generous as it has been in order to allow the FDIC to close or to approve the acquisitions of troubled banks in an orderly manor so as to allow the banking system to adjust to its “insolvency” problems as smoothly as possible.

I agree with Mr. Rosenblum, I think that there are still too many “toxic assets” on the balance sheets of commercial banks…large, medium-sized, and small.

Without some kind of adequate mark-to-market accounting process in the commercial banking system, we will continue to be “in the dark” with respect to the health of banking institutions and banks will be able to continue to “game” us.

Having an adequate mark-to-market system in place will cause bank managements to conduct their businesses in a less risky fashion.  And, only by having an adequate mark-to-market system in place will bank managements move to address the problems they face in real time, something they currently are loathe to do.  

Wednesday, March 28, 2012

Ben Bernanke: "Please Understand Me!"

“Please Understand Me,” the title to the 1984 book building on the Myers-Briggs personality-type tests, constantly comes to mind each time I hear a new effort by Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System, to “communicate” with the public.

Tuesday, Mr. Bernanke gave the third of his scheduled four lectures at George Washington University about Federal Reserve monetary policy.  This has followed efforts to get the minutes of the meetings of the Open Market Committee out to the public in a more timely fashion; efforts to have periodic meetings with the press to discuss the policies of the central bank; and the recent efforts to make the economic and interest rate forecasts of the members of the Open Market Committee available to the public. 

Now, Mr. Bernanke has felt the need to get out among “the people” and discuss the conduct of monetary in a series of four lectures aimed at expanding, within an academic environment, his rationale and analysis of what the Federal Reserve did and what the Federal Reserve has achieved. 

The continuously expanding efforts of Mr. Bernanke to get his personal viewpoint across only lends credence to the feeling that “the world”, especially the financial community, doesn’t understand what Ben is trying to do and how his efforts are succeeding. 

No one in such a leadership role that I can think of has felt the need to plead, within the community that he operates, to justify his actions, as Mr. Bernanke has.

Can you imagine Paul Volcker or William McChesney Martin (Fed Chairman from April 1951 to February 1970) publically defending their actions while they were still in office?

“The Fed’s efforts prevented a ‘total meltdown’ of the financial system at a time when fears of a second Great Depression were ‘very real,’ Mr. Bernanke said Tuesday…” (

It was not pretty…what the Federal Reserve did…but it achieved its end.  A second “Great Depression” did not take place. 

Mr. Bernanke, a student of the Great Depression who learned a great deal from Milton Friedman, pursued a policy that was consistent with Friedman’s analysis of the events of the 1930s.  In the period 1929 to 1933, Mr. Friedman estimated that the Federal Reserve allowed the M2 money stock in the United States to decline by one-third!  The conclusion that Mr. Friedman drew from this is that the Federal Reserve should have done whatever was possible to have kept the M2 money stock from declining!  

This lesson did not escape Mr. Bernanke under the circumstances. The Fed’s policy during this period of financial crisis was to throw as much “stuff” against the against the wall as possible to make sure that enough of the “stuff” stuck on the wall that another Great Depression would be avoided.

What is there not to understand with this policy?

Sell Bear Stearns, rescue AIG, bailout the banking system, by mortgage-backed securities and so forth…. 

And, in a time of panic, when uncertainty reigned, anything was acceptable. (

This was all “stuff” that was thrown against the wall. 

Mr. Bernanke has followed the game plan.  The money stock did not decline in this instance.  However, the Fed does not control the money stock directly.  In terms of things it can control, like the monetary base, the Fed expanded the monetary base from about $850 billion in August 2008 to $1.7 trillion in January 2009.  In February 2012 the monetary base averaged about $2.7 trillion.  Excess reserves at commercial banks rose from about $2.0 billion in August 2008 a current level of around $1.6 trillion.

This expansion of monetary assets is historically unique!  The “stuff” got put out there!

And, the “stuff” will stay out there as long as there are weak spots in the economy and the financial system.  For example, the banking system is still extremely weak with more than 800 banks on the FDIC’s list of problem banks and more than that are on the edge of being problem banks.  And, this is with large numbers of home foreclosures in the future along with a continued weakness in the commercial real estate area.  Bank failures along with bank consolidations still proceed at a relatively rapid pace.   

Whether we get another round of quantitative easing or not, we will see the “stuff” around for some time yet.  Excess reserves in the banking system of around $1.6 trillion!  My guess is that we won’t see this declining by much until the banking system gets a lot healthier.

What is there not to understand about what the Fed has done and is doing?

Mr. Bernanke seems to feel that it continually needs explanation and justification.  I believe that this feeling is just Mr. Bernanke’s problem.   

Monday, March 26, 2012

Europe Still Bubbles

The headlines coming out of the weekend: “Italy warns Spain over budget” (; “Germany ready to boost size of firewall” (; Europe’s bailout bazooka is proving a toy gun” (; “Greek bond yields jump as trading in credit default swaps put on hold (”  And so on, and so forth.

Bets on, recently, put the odds of the European fiscal union cracking apart by the end of 2013 at a little more than 36 percent.

There are all sorts of scenarios that picture the demise of the current arrangement.

But, there is one major thing that seems to keep holding the union together: the fact that the cooperative structure added to the common market has provided the vision of an economic bloc that can be competitive in this modern world with the other major economic areas of the world like America, China, Brazil, Russia, and India.

Combination is better than separation.

Yet, the path to deeper integration and greater centralization of the fiscal authority is ugly. 

One reason for this is that the countries of the eurozone have centuries of history, of wars, of hatred, of irrational biases to get over.

As the recent movements on the Greek crisis showed, the shadow of the past was not far from people’s minds as references to the Nazis and German domination bubbled up into the debate.

The past is not going to be forgotten…and there is a lot of it.

Yet, here in the 21st century, the economic reality of the situation, I believe, will win out.  The eurozone will hold together for the alternative, small, separate states competing against each other and “biggies” of the world, is not a real choice.  And, most officials in Europe, I believe, realize this.

One continuing problem in the effort is that these European officials repeatedly fail to “get their arms around a situation”. 

The “good” news over the weekend: “Germany is set to bow to international pressure and allow a temporary increase in the eurozone’s financial ‘firewall” this week, to prevent the crisis in the region’s periphery spreading to other member states.” (See “Germany ready to boost size of firewall” cited above.)

The “bad” news: the “rescue umbrella” is not big enough.” (See “Europe’s bailout bazooka…” cited above.)

The “umbrella” may be able to handle any problems coming from the smaller states, like Greece and Ireland, but it would not be able to handle Spain…or Italy.

The Italian prime minister, Mario Monti, is concerned about this and warned Spain that it should not back off from fiscal efforts and weaken its “budget-cutting credentials.” (See “Italy warns Spain…” cited above.)

But, financial markets still reflect the uncertainty about what is happening.  Greek bond yields reached new post-bailout highs on Friday as yields on Portuguese bonds remain quite high and those on Spain’s bonds rose by about 30 basis points toward the end of the week. 

The rise in the yields on Greek debt spilled over to the credit default swaps market as investors showed fear that the CDS trigger process might be subject to some immediate payout problems.  There was additional concern that this issue could impact other eurozone bond markets. 

So, the process of integration continues.  And, as mentioned above, the process is not pretty.

It is hard for sovereign nations to give up their fiscal powers, especially when their elections are so dependent upon the “free lunches” that politicians promise to the voters.  Yet, this is where events are leading.

It is going to be a bumpy road and there are many ways that the “end game” could be played out, but, in my mind, one way or another, the euro will survive and Europe will eventually prosper because of it.       

Friday, March 23, 2012

TIPS Auction Still Negative

The TIPS auction that took place yesterday continued to place inflation-protected yields in negative territory.  The yield on the issue was -0.089 percent and the ten-year yield closed to yield -0.111 percent. (

The negative yield on these inflation-protected securities does not mean that investors will not make any money on their holdings because the principal of these securities will increase if inflation rises. 

The yields of the TIPS are negative because the yields on the US Treasury yield curve are so low.  And, the yields along the yield curve are so low because of the amount of money that has flowed into this market through a “flight to quality” arising from the debt problems faced by Greece and other eurozone countries. (

The 10-year US Treasury bond closed to yield 2.28 percent yesterday.  If one takes the difference between this bond yield and the yield on the 10-year TIPS issue as an estimate of inflationary expectations, then one can state that investors are expecting that inflation will average about 2.4 percent over the next ten years in the United States.

That is, if 10-year bonds are yielding around 2.30 percent in the market and the inflationary expectations of investors are approximately 2.40 percent, then the TIPS yield must be around
-0.10 percent to fully incorporate the possible effect of inflation on the real value of the bonds.

In the latter part of January 2012, when the last auction of TIPS came to market, 10-year US Treasury bond yield was around 2.00 percent and the yield on the 10-year TIPS issue was around -0.15.  The relationship between the two yields implied that investors expected inflation to average around 2.15 percent over the next ten years.

At the end of December 2011, inflationary expectations were around 2.00 percent, calculated in the same way.

The most important conclusion that can be drawn from this is that, in the financial markets, investors are now building more inflationary expectations into their future projections than they were several months ago. 

The actual rate of consumer price inflation, year-over-year, was 2.9 percent. (Note that this rate of increase is down from a near-term peak of 3.9 percent in September 2011.)

Inflationary expectations, as reflected in the bond markets, tend to lag behind actual inflation.

The auction yesterday reflected strong investor interest as Wall Street dealers, who underwrite the Treasury auctions, were left with only 39 percent of the offering, which was down from the 50 percent they received in January’s auction.  Also, this was the second lowest share of the 10-year TIPS auction for dealers since the market began in 1997.   

If one is looking for some evidence of when the bear market for US Treasury securities might begin, then this, I believe, is a good place to start.     

As I have argued earlier, the yield on the 10-year US Treasury security is currently as low as it is because the United States Treasury market still has a lot of funds that are there for “safety” reasons.  My belief is that this yield should be above 3.00 percent if the “flight to quality” money was not in the market. 

Thus, the yields on US Treasury securities, in my mind, need to rise just in order to get back to a range that is more consistent with where the United States is in the economic cycle. 

But, the next concern of the investors seems to be about a coming “bear” market in bonds.  This “bear” market is to come once the economy begins to grow faster…more than the 2.0 percent to 2.5 percent rate of growth now being experienced…and when all the money the Federal Reserve has pumped into the banking system starts to really impact prices in the economy. 

 My suggestion is to watch the spread between the yield between the 10-year Treasury bond and the yield on the 10-years TIPS issue. 

As real economic growth begins to pick up, the TIPS yield will have to increase to reflect the growth of the real economy.  This yield will not be determined the way it has been determined in the recent past.

And, if the real yield on the TIPS issues rise the yield on the 10-year Treasury bond must rise as the investor’s inflationary expectations get added onto the yield they are getting on the TIPS.  If the real yield on the TIPS issues rise to, say, 1.50 percent and investors expect inflation to be in the 2.5 percent range, the 10-year bond should yield at least 4.00 percent. 

As expectations of the real rate of return rise and inflationary expectations rise, the yield on 10-year bonds should be off to the races.  Then one can say that the bear market had arrived.    

Wednesday, March 21, 2012

Ryan's Republican Budget Plan

Representative Paul Ryan has produced another picture of what it would take to get the government budget under control and bring down the soaring fiscal deficits now being experienced. 

In October 2011, the gross public debt of the United States government was in excess of $15 trillion.  Over the past two years or so, I have been arguing that there is a very good chance that in the next ten years the debt outstanding will double. 

President Obama has produced his outline for a new budget trajectory with debt increasing by only about $6.5 trillion over the next ten fiscal years.  However, I have absolutely no confidence in the ability of Mr. Obama to lead in this area and so I would argue that this proposal is DOA.

The growing body of literature on the economic leadership of the Obama administration is unanimous about the failures embodied within this organization.  Here I reference the book by Ronald Suskind, “Confidence Men,” the recent book by Noam Scheiber, “The Escape Artists,” and the Washing Post report about the negotiations between Obama and the House Republicans over the “big picture” deal-making last year that collapsed when House Speaker John Boehner told the President “We don’t have time to reopen these negotiations.”

The liberal writer John Chait in New York Magazine expanded upon this latter story: “How Obama Tried to Sell Out Liberalism in 2011.” (

Perhaps the most damning comment on the process of conducting economic policy in the Obama administration is the one attributed to Larry Summers, who repeatedly told Peter Orszag, director of OMB that, “with Obama as President, ‘we are home alone.’” (See Suskind’s book.)

The Obama proposal cannot really be considered to be credible.

One could argue that the Republican budget put forward by Representative Ryan may never be put into effect but it adds one thing to the discussion that is very helpful.  It is a credible effort to state what needs to be done to bring the federal budget under control. 

You may not agree with all of the choices included within the document, but Ryan does present us with a picture of the extent things need to be brought into order.

Does it promise a balanced budget?

Yes, but not until 2040.

But, we were close to a balanced budget in the late 1990s…what happened?

Well, I think if you seriously examine the budget situation you see how seriously we have gotten out-of-control over the past ten years or so.  The discipline and effort that must be forthcoming to even think about balancing the budget in 2040 shows how far events have gotten away from us.

Robert Mundell, Nobel Prize winning economist from Columbia University, was interviewed on Bloomberg Radio the other day.  Mundell, in his provocative way, stated that “The public is looking for free lunches and the political competition for votes makes the politicians off them free lunches.”  He added, “That’s what gets us in to the difficulties of insolvency.”

Well, lots of free lunches have been purchased by the federal government in recent years.  The problem is, how do you take “free lunches” away from the electorate once they have been given to the voters?

Mundell continued, “You could have fiscal stimulus back in the days of (John Maynard) Keynes, when the government was a small proportion of gross domestic product and there was no insolvency problem.”  Today, you just don’t have the space to create more debt, issue more bonds to pay for the deficits, and expect everything to work out well.

Representative Ryan gives us a credible place to start.  And, given that presidential candidate Mitt Romney has bought on to the plan, we will be hearing a lot more about Ryan’s plan in the future. 

If you don’t like Ryan’s plan…that is OK.  Tell me how you would arrange things…let me see how you would work things out. 

I don’t believe the United States economy can be all that it can be in the next ten years if the federal government adds another $15 trillion to the gross public debt.  I don’t believe that the economy can be that vibrant if we even add $6.4 trillion to the debt as President Obama has proposed.

What’s your plan.  Let’s talk seriously about it.  I believe that Representative Ryan has done us a service by presenting his plan for all of us to see.  Let’s respond!  

Tuesday, March 20, 2012

Treasury Bond Yields Will Continue to Rise

Treasury bond yields are on the rise and will continue to do so over the next year. 

In my opinion, the Federal Reserve System has been given more credit than it is due concerning how low long-term Treasury securities had fallen in the past year or so.

The research I have seen during my professional career has shown that the Federal Reserve, from time-to-time, has attempted to influence the yield on long-term Treasury issues but has never been very successful, either in terms of the its ability to lower long-term yields by much or in terms of keeping them lower for an extended period of time.

This is not true, however, of short-term yields. 

I continue to believe this.

The yield on the 10-year Treasury security has been extremely low for several months now.  Around the end of July 2011, the yield on the 10-year was about 3.00 percent.  It dropped precipitously after that time, falling around 2.10 percent by August 18 and then falling below 2.00 percent the second week of September.

Since then, this yield has fluctuated between approximately 1.80 percent and 2.10 percent until last week (except for a three day bump up right at the end of October).

The most interesting move during this time period, however, has been the move into negative territory of the 10-year TIPS bond.  At the end of July 2011 the 10-year TIPS was trading around a 0.50 percent yield (which was already low historically).  On August 10 the yield had become negative, trading around a -0.155 percent yield.  That is, we had a negative real rate of interest. 

For a good portion of the time since then the yield on the 10-year TIPS has been negative.  Yesterday, this issue closed at -0.056 percent yield.

The reading on this behavior?  The movement into Treasury securities this summer was a “flight to quality” and was not a result of the actions of the Federal Reserve System. 

The Federal Reserve cannot force interest rates…long-term or short-term…below a zero interest rate.  The Fed has been very successful in keeping its target rate of interest, the Federal Funds rate near zero, but admits it cannot force this rate below zero. 

Why would investors invest in something that had a below-zero interest rate on it?  The basic reason is that these investors wanted to invest in Treasury securities…regardless of the yield.  This represented a “flight to quality” and the movement of funds affected the yields on all long-term Treasury securities.

One should note that with all the liquidity available to the financial markets, the spread between US Treasury issues and Aaa Corporate bonds rose during this time.  You do not find this type of behavior taking place except in times when there is a flight to quality.

One should also note that there was also a “flight” to German sovereign debt at this time as the yield on the 10-year German government issue fell, although not by as much as did the yield on the US Treasury issues.

The movement in Treasury yields last week was a movement back into riskier assets.  This is confirmed in a New York Times release this morning concerning the actions of hedge funds. (See “Hedge Funds Ditch Treasuries in Droves: Report”,

A good deal of the recent flight from U.S. Treasuries has been driven by hedge fund selling…

Last week was the biggest weekly decline for U.S. Treasury prices since last summer. The big sell-off in government debt pushed yields to their highest levels in more than four months.
It was a sign investors see less need to put money in Treasuries for safekeeping now fears of a messy Greek debt default are fading and the U.S. jobs picture looks brighter.”

This, to me, makes much more sense than does the argument that this movement is the beginning of the bear market in bonds. (See “Bond Bear Market is Growling but Yet to Roar,”

Also, as the yield on 10-year Treasury securities rose last week the yield on 10-year German bonds rose as well.

Long-term yields will begin to rise at some time in the future but I don’t believe that we have reached that stage of the cycle at this time.  The bond market still needs to re-position itself to risk-based assets and reduce its need for a “safe haven.”  This will continue, I believe, for the short-term. 

I think that the yield on the 10-year Treasury needs to return to above 3.00 percent and the yield on the 10-year TIPS bond needs to get back up into the 0.50 percent to 1.00 percent range.  This will restore some of the relative yield spreads to levels that are more consistent with current economic conditions. 

These yields will begin to rise along with economic growth as the economy picks up steam.  However, I don’t see that there will be much “steam” in the next three or four quarters. ( 

Furthermore, the Federal Reserve will continue to err on the side of ease until the economic recovery does appear to accelerate.  Although Fed ease will not hold down long-term interest rates once they begin to climb on any experienced economic pickup, the Fed wants to avoid disruptive bank failures or other surprises that might occur on the path to recovery.

Of course, we could always have another situation in which a further “flight to quality” would cause long-term Treasury yields to drop.  Greece is not out-of-the-woods yet, and there is still Ireland, Portugal, Spain, and Italy to deal with.    

Monday, March 19, 2012

The Credit Markets: Two Apparent Contradictions

The yield on the 10-year US Treasury bond closed at 2.301 percent on Friday.  The dramatic rise in this yield at the end of last week has many analysts worried that the bull market in bonds is over. 

The yield on the 10-year Treasury was 2.384 percent at the close on last October 27 and at the end of July 2011, the yield was around 3.00 percent, where it had been for some time.

Note that a large portion of the time that the yield on the 10-year Treasury had been at these higher levels, the Federal Reserve had been operating under a policy of quantitative easing.

What set off the decline in yields in August and September was a series of things that lead to a rush into gold and a flight to quality in the financial markets. 

The price of gold had remained relatively stable in the May and June period, but began steadily increasing in July and August.  By August 2, the price of gold reached $1660 per ounce and then flew through $1700 on October 8, the day of the S&P downgrade of US debt.  By August 18, the price closed at $1828 and almost closed at $1900 on August 22.

Even more startling, the yield on the 10-year TIPS turned negative in early August.  On August 10, this yield was -0.155 percent!  In late July it had been trading to yield above 0.500 percent. 

The 10-year Treasury yield plummeted from about 3.00 percent on July 29 to 2.40 percent on August 4 and about 2.00 percent on August 10.

The stock market was also highly volatile during this July/August period. 

And, Treasury yields remained low through the whole Greek debt restructuring that took place throughout the fall into the new year of 2012.

My view: over the past month or so, financial markets have calmed somewhat, primarily due to the Greek situation, and this has been leading to a movement of funds out of US Treasury issues and into riskier “stuff”. 

Then we got the news last week from Mr. Bernanke that the Fed was not going to do much in the way of bond purchases in the near future and, in particular, there was no inclination on the part of the Open Market Committee to engage in a new phase of Quantitative Easing. 

These two factors, I believe, are leading to a reversal from the previous “flight to quality” in the financial markets. 

Since January the ratio of the yields on government bonds relative to Aaa-rated corporate securities has been rising, indicating funds were flowing more freely into other sectors of the financial markets.  Furthermore, the ratio of yields on Aaa-rated corporate securities to Baa-rated corporate securities was rising indicating a relative move to less highly rated credit. 

Therefore, I am less concerned about an end to the “bull market” in Treasury securities than I am about a market adjustment that has followed the “flight to quality” that took place last summer. The economy continues to expand ( and monetary policy will continue to be supportive of a still fragile banking system. 

I am looking more for a relative rise in the yield on US Treasury securities as an indication that funds are flowing back into other areas of the financial markets rather than for a cyclical increase in yields due to a strengthening of the economy. 

There is a second issue I would like to clear up that was brought to my attention by someone commenting on the above mentioned blogpost. (

In this blogpost I discussed the continued deleveraging taking place in the American economy and the rise in bank lending, which I took as a positive sign that the economy would continue to grow.  One person who commented on this post stated that the idea that deleveraging was to continue but bank lending was increasing seemed to be contradictory. 

As such, the two pieces of information does sound contradictory.  In arguing that “both” of these conditions can exist within the economy I draw on a point I have made continually over the past several years.  My argument has been that over the past fifty years or so the United States government has conducted a policy of credit inflation.  This credit inflation has helped to bifurcate the society as those with more wealth and better access to advice and consulting have been able to protect themselves from the inflation or even take advantage of the inflation to improve their position in the economy.  The less-well off have not been able to even keep up with what is going on.  As a consequence, the income/wealth distribution in the United States has become even more skewed to those possessing wealth. 

As I have described in other places, the current economic policies of the United States government just exacerbate this movement.  That is, the economic policies of the United States government are making things even worse.  Deleveraging continues, but generally amongst those that are less well off, those who are heavily in debt, those who often find themselves underwater with respect to the ownership of their own home, and those who have little or no savings. 

Lending is picking up to others, businesses as well as households, that are not is such a situation.

Thus, you can have bank loans increasing in the economy while many in the economy still have to reduce their financial leverage to even keep going.  I believe we are in such a situation.