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   Brian Wesbury
Chief Economist
 
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   Bob Stein
Deputy Chief Economist
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  Bonds Misjudge The Future
Posted Under: GDP • Government • Inflation • Markets • Monday Morning Outlook • Fed Reserve • Interest Rates • Bonds • Stocks

We've always been skeptical that bond yields carry deep meaning about the future.  Low Treasury bond yields in recent years were said to be a signal of slower growth, or possibly a recession, ahead.  And the bond world said stocks were over-valued.

Clearly, the forecasted recession never came.  Not only is the economy accelerating, but the recovery is likely to become the longest on record.  And stocks have handily outperformed bonds.

Now, low bond yields are supposed to signal the Fed is getting close to being too tight.  Either too many rate hikes will cause a recession, or the Fed will hike rates only twice next year as the economy slows.  And, of course, the bond world says this too is bad for stocks.

We see at least two mistaken beliefs that are influencing bond bulls these days.  The first mistake is that the Fed will lift rates only once or twice in 2019.  We believe four rate hikes are more likely, with more to follow in 2020.  The reason is simple.  Nominal GDP is accelerating, and likely to grow at a rate of 5%+ over the next few years.

But four rate hikes of 0.25% in 2019, after two more in 2018, will only push the federal funds rate near 3.5%.  History (in 1969, 1973, early 1980s, late 1980s, 2000, and 2007) shows that, in order for the Fed to create a recession, it needs to push the federal funds rate above nominal GDP growth.  Right now, the Fed is chasing growth, and bond markets are underestimating how much rates must rise before policy becomes "tight."

This, we believe, has pushed the long-term bond market into what appears to be a bubble.  At a 2.92% yield, the implied Price-Earnings (PE) ratio for the 10-year Treasury Note is 34.2, with zero chance of an increase in earnings in the next 10 years.

That doesn't sound like a very good investment to us.  Real GDP is likely to grow at a 3% rate this year, while consumer prices should rise 2.5%.  In other words, nominal GDP – total spending in the US economy – will rise by 5.5% in 2018, which means revenue at the "average" company will grow at that pace, as well – double the yield on a 10-year Note.

Corporate profits are growing even faster than GDP – most likely 20%+ this year – and hundreds of companies have raised dividends in the past year.  The PE ratio of the S&P 500 is 21 based on trailing twelve months' earnings, and less than 17 on forward earnings.

Yet, even with all that data in front of them, many bond investors are convinced the 10-year yield is likely to decline in the next year, making long-term bonds a slightly more palatable investment.

Instead, it looks like the bond market is acting like the stock market in 1999, when our capitalized profits model said stocks were 62% overvalued.  But, like all bubbles, a vast majority of investors still believed stocks could go higher.  Obviously, they were wrong.

The second mistake animating the bond market is the belief that the narrowing spread between the federal funds rate and the IOER (Interest Rate on Excess Reserves) signals a developing shortage of reserves – a sign of tight Fed policy.

Yet, there are still $1.9 trillion in excess reserves in the banking system – which contradicts any belief that Fed policy is remotely close to being tight.  There are very few banks that actually trade federal funds, because they simply don't need them. 

Meanwhile, the Fed has been doing reverse repos with institutions (like Fannie Mae and Freddie Mac) because it is not allowed to pay them interest on reserves.  What has happened is that those reserves (the Fannie/Freddie kind) have now been mostly drained from the system, which means the difference between these short-term rates is narrowing.  This is not a sign of a lack of bank reserves, just that excess liquidity outside of the banking system is getting tighter and more competitive.

As a result, the IOER is becoming the most important short-term rate in the monetary system.  Today, at 1.95%, it is still too low.  The key question is whether the Fed can pay banks enough not to lend out that money, even as accelerating growth creates more profitable opportunities to lend.  If the Fed can do that – pay banks not to lend – then excess reserves are not a sign of easy money.  But, lending rates are still much higher than IOER, and banks have excess capital as well.

In other words, the Fed is nowhere near "tight," and the market is mis-pricing both growth and inflation risks to bond yields.  Rates look far more likely to rise than fall.

Brian S. Wesbury - Chief Economist
Robert Stein, CFA – Deputy Chief Economist
 

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Posted on Monday, June 18, 2018 @ 12:12 PM • Post Link Share: 
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  M2 and C&I Loan Growth
Posted Under: Government • Fed Reserve

 

Source: St. Louis Federal Reserve FRED Database

Posted on Monday, June 18, 2018 @ 8:17 AM • Post Link Share: 
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  Industrial Production Declined 0.1% in May

 

Implications:  After hitting the highest level on record in April, industrial production slipped 0.1% in May, primarily due to a major fire at a parts supplier in central Michigan that does business with many automakers around the country.  Due to the disruption, auto production fell 6.5% for the month, the largest single-month decline since 2011.  But excluding the drop in autos, industrial production increased 0.3% in May, a perfectly respectable number.  The worst news in today's report was that manufacturing excluding the auto sector, what we call "core" production, declined 0.2% in May.  That said, it's not unusual for that number to bounce up and down from month to month while the trend moves higher. For example, the past year has seen core production rise 2.0% despite seven of the twelve months showing declines.  The best news in May came from mining, which rose 1.8%, the fourth consecutive monthly gain, on the back of healthy increases in oil and gas extraction.  In the past year, mining is up 12.5%.  And the rig count has continued to rise in recent weeks, suggesting gains in mining production will continue in the months ahead.  Meanwhile, utilities output remained strong, rising 1.0%, as the warmest May on record drove up demand for air conditioning.  In other manufacturing news this morning, the Empire State index, a measure of factory sentiment in New York, surged to 25.0 in June from 20.1 in May, signaling growing optimism in the region.

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Posted on Friday, June 15, 2018 @ 11:28 AM • Post Link Share: 
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  Retail Sales Rose 0.8% in May
Posted Under: Data Watch • Inflation • Retail Sales

 
Implications: Consumers are feeling great.  Retail sales surged 0.8% in May, beating the most optimistic forecasts, and representing the largest gain in seven months.  The gains in May were broad-based, with 10 of the 13 major categories moving higher, led by gas stations, restaurants & bars, building materials, as well as general merchandise stores (like department stores).  And the past two months were revised up, as well.  As a result, retail sales are up a strong 5.9% from a year ago, and up an even stronger 6.4% excluding auto sales.  While we saw modest consumer spending growth last quarter - rising just 1.0% annualized in Q1 - that had more to do with the timing of growth than the trend.  And today's report shows the pace of consumer spending is accelerating, supporting our projection of 4.5% real GDP growth in the second quarter.  Given deregulation and tax cuts, we expect an average real growth rate of 3%+ in 2018 and 2019, a pace we haven't seen since 2005.  Expect overall retail sales to continue the trend higher in the months to come.  Jobs and wages are moving up, tax cuts have taken effect, consumer balance sheets look healthy, and serious (90+ day) debt delinquencies are down substantially from post-recession highs.  Put it all together, and the outlook for the consumer looks bright.  In other news this morning, new claims for jobless benefits fell 4,000 last week to 218,000.  Meanwhile continuing claims declined 49,000 to 1.70 million, the lowest reading since late 1973, back when the labor force was roughly half the size that it is today.  On the inflation front, both import and export prices rose 0.6% in May. Import prices were led higher by a 4.9% jump in prices for fuels, while agricultural exports, particularly wheat, corn, and soybeans, led export prices higher.  In the past year, import prices are up 4.3%, while export prices have increased 4.9%, reinforcing other recent data showing a rising trend in inflation.

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Posted on Thursday, June 14, 2018 @ 11:18 AM • Post Link Share: 
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  Letting the Data do the Talking
Posted Under: Employment • GDP • Government • Inflation • Fed Reserve • Interest Rates

 
To little surprise, the Federal Reserve hiked interest rates by 25 basis points following today's meeting.  Of much greater note are the hawkish changes made to the text of the Fed's statement (and with no dissents), as well as changes in the forecast materials.  While these changes are clearly in line with the continued improvement in economic data over recent months, it's a positive development from a Fed that has been exceedingly cautious over recent years in upgrading its outlook on the pace of rate hikes.

Starting with the text of the Fed statement, stronger language related to rising economic activity and the continued decline in the unemployment rate was paired with the removal of long-standing language that noted the below-target inflation we have seen over recent years. Looking forward, language on "adjustments" to monetary policy have now become "increases...consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee's symmetric 2 percent objective".  
 
A look at the updated projection materials (the dot plots) gives some insight in why the wording changes were made. The Fed's real GDP growth forecast was revised higher to 2.8% for 2018 (we expect growth will be at or above 3% this year, the fastest annual growth since 2005) - up from 2.7% in March and 2.5% at the December 2017 meeting – though projections remained unchanged for both 2019 and 2020. Inflation forecasts also moved higher for 2018, to 2.1% from 1.9%, and is expected to remain at 2.1% through 2020. The forecast unemployment rate was revised lower for 2018 to 3.6% from a previous forecast of 3.8%, while both 2019 and 2020 now show forecast unemployment of 3.5%, down from 3.6%. So across to board, changes point to improved economic conditions that justify higher rates.
 
During the press conference, Chairman Powell took time to reiterate, on multiple occasions, the strength of both the economy and the labor market. And when asked about concerns the Fed has related to recent trade and tariff talk, we were glad to hear that they will let the data do the talking. In other words, don't expect harrowing headlines or doomsday scenarios from the pouting pundits to change the Fed's outlook. As with so many other events over recent years, levels of media coverage are a very poor predictor of actual impact when the day is done. 
 
That brings us, finally, to the Fed's projections for the pace of rate hikes. In March, there was a near even split between FOMC participants projecting three or fewer rate hikes in 2018, and those projecting four or more. While the shift is little changed on balance, the majority of members now expect two more rate hikes before the year is through, for a total of four.  Markets, meanwhile, have come to the same conclusion, pricing in a 56% chance of two or more hikes over the remainder of 2018. Looking forward, the Fed still expects three 25 basis point rate hikes in 2019 (we expect four), with one more to follow in 2020. If that pace is realized, the Federal Funds rate will stand in a range of 3.25%-3.5% at the end of 2020, still below the 3.9% trend in Nominal GDP growth over the past five years, a sign that monetary policy won't be tight for the foreseeable future.
 
Almost missed in the focus on rates moving forward, the Fed will continue reducing its balance sheet at a pace of up to $30 billion per month, increasing that to $40 billion in Q3, and $50 billion in Q4.  After that, the Fed is projecting it would maintain that $50 billion monthly pace until it's satisfied with the size of the balance sheet.  (For the foreseeable future, the balance sheet cuts would be 60% in Treasury securities and 40% in mortgage-related securities.)

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Posted on Wednesday, June 13, 2018 @ 4:29 PM • Post Link Share: 
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  Bernanke, Recession and Tariffs
Posted Under: Bullish • Government • Inflation • Video • Fed Reserve • Interest Rates • Wesbury 101
Posted on Wednesday, June 13, 2018 @ 12:33 PM • Post Link Share: 
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  The Producer Price Index (PPI) Increased 0.5% in May
Posted Under: Data Watch • Government • Inflation • PPI • Fed Reserve • Interest Rates

 
Implications:  Any lingering shred of doubt that the Fed will raise rates later today can be put to rest.  Producer prices rose 0.5% in May, matching the largest single-month increase in more than five years. More important, producer prices are up 3.1% in the past year, a ninth consecutive month of prices rising at or above 2.5% on a year-to-year basis, and the largest twelve-month increase since January of 2012.  And price gains have been accelerating, up 3.2% at an annual rate in the past six months, and up at a 3.5% annual rate over the last three.  While energy prices led the rise in May, jumping 4.6%, prices rose nearly across the board. Even stripping out energy and the 0.1% increase in food prices, "core" producer prices rose 0.3% in May and are up 2.4% in the past year.  The increase in core prices was led by trade services (think margins to wholesalers), as well as transportation and warehousing services. To put the rising trend in perspective, core prices rose 2.0% in the twelve months ending May 2017, and 1.2% in the twelve months ending May 2016.  And a look further down the pipeline shows the trend of rising inflation is likely to continue in the months ahead.  Intermediate processed goods rose 1.5% in May, and are up 6.3% from a year ago, while unprocessed goods prices increased 2.5% in May and are up 6.8% in the past year.  In short, inflation is running comfortably above the Fed's 2% inflation target, and, with job growth remaining robust, pressure is on the Fed not to fall behind the curve.  In addition to a 25 basis point rate hike today, look for updates in projection materials - the "dot plot" - to show a shift in FOMC member expectations towards two more hikes in 2018 (so including today's hike, four total this year), with three to four hikes anticipated in 2019.  As we noted Monday, this pace of hikes is no reason to fear. Monetary policy isn't becoming tight, just a little less loose.

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Posted on Wednesday, June 13, 2018 @ 10:00 AM • Post Link Share: 
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  The Consumer Price Index Rose 0.2% in May
Posted Under: CPI • Data Watch • Employment • Government • Inflation • Fed Reserve

 
Implications: Rising costs for gasoline and housing led the consumer price index 0.2% higher in May, continuing the uptrend in inflation that started in late 2015.  Consumer prices are now up 2.8% in the past year, the largest twelve-month increase since early 2012.  More important than reaching a recent high, consumer price inflation has now exceeded 2.0% on a twelve-month basis in each of the last nine months.  In other words, this isn't a blip higher that is likely to reverse in a month or two ahead.  The (modest) pickup in inflation that the Fed has been looking for is here. Now the onus is on the Fed not to fall behind the curve.  Taking a deeper look at today's report, energy prices as a whole rose 0.9% in May, with a jump in gasoline prices only partially offset by declining costs for natural gas (think home heating) as the US saw the warmest May on record.  Meanwhile food prices were unchanged in May as lower costs at the grocery store offset increased prices for eating out.  Strip out the typically volatile food and energy components, and "core" prices increased 0.2% in May and are now up 2.2% in the past year.  A closer look at "core" prices shows housing once again led the increase, and we expect housing costs to continue to be a key driver of overall inflation in year ahead.  On the wages front, real average hourly earnings rose 0.1% in May.  These inflation-adjusted hourly earnings have shown little movement over recent months, however this earnings data does not include irregular bonuses – like the ones paid by companies after the tax cut.  We expect a visible pickup in wage pressures in the year ahead. Paired with continued strength in employment, the trend in inflation has essentially locked in a rate hike at tomorrow's Fed meeting, and we expect two more hikes (likely in September and December) to follow, for a total of four hikes in 2018. 

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Posted on Tuesday, June 12, 2018 @ 10:10 AM • Post Link Share: 
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  Is 2020 the Year for Recession?
Posted Under: GDP • Government • Monday Morning Outlook • Fed Reserve • Interest Rates

According to former Fed Chair Ben Bernanke, the U.S. economy will get a Wile E Coyote surprise in 2020.  You know, just when everyone thinks he caught the Roadrunner, Wile notices he has run straight off a cliff, plummets seemingly forever before hitting the bottom in a cloud of dust, and then, just for spite, an anvil lands on his head.

In other words, Bernanke sees a 2020 recession looming.  Other analysts are saying it, too.  And whenever they do, they get their name in the headlines. Scaremongering attracts attention.

But there is good news here: The Pouting Pundits of Pessimism don't think the crisis starts tomorrow.  No longer does some exogenous crisis event – say, Brexit, or Grexit, student loan defaults, etc., – threaten imminent collapse.  Now, the recession doesn't happen for another two years. 

Another interesting detail: the new problem is that the economy is growing too fast.  Remember when analysts used to say, "since the economy is growing less than 2% annually, it means a recession is coming"?  Now, Bernanke says the U.S. applied stimulus (in the form of a tax cut) "at the very wrong moment," with the economy already at full employment.  In other words, real GDP growth is too strong, so the Fed will over-tighten and a recession is inevitable.

Now we agree that a recession is coming – someday.  Recessions are a fact of life, like death and taxes.  But predicting one in 2020 - and being right about it – is like reading tea leaves, it's pure chance.  No one, and we mean no one, can honestly see that far in the future – not with the clarity expressed by these dated forecasts.

No one knows exactly what the Fed will do, not even the Fed.   Let's say they follow their forecasts, raising fed funds to 3.5% in 2019. That alone doesn't tell us if policy is "tight."

While most recessions are caused by an excessively tight Fed, we don't think the Fed is too tight until it drives the federal funds rate close to, or above, the rate of growth in nominal GDP.  Over the past five years, nominal GDP has averaged about 3.9%.  Which means if the Fed were to raise the funds rate by 0.25% three more times in 2018 and four times in 2019 (reaching 3.5%), and if nominal growth slowed to 3.5%, the Fed would be tight at that point. A recession would be possible.

However in the past year, nominal GDP growth has accelerated to 4.7%, and next year it could be as high as 6%.  That means a 3.5% federal funds rate would not be restrictive.  The Fed would have to raise rates faster and farther than any forecast we have seen in order to be "tight" going into 2020. At the same time, there are still at least $1.9 trillion in excess bank reserves.  Until those reserves are eliminated, no one knows if raising rates can actually cause a recession. 

We do have one major worry.  Government spending is rising rapidly, and the deficits this spending creates will put pressure on politicians.  If they were to raise tax rates, this could cause potential problems for U.S. growth.

But the bottom-line remains: the U.S. is not facing an imminent threat.  That's why doom and gloomers have shifted to forecasting future recessions, not looming crises.  But we think it's not going to be the economy that gets an anvil on its head in 2020.  More likely, it'll be investors who believe in the recession forecast.

Brian S. Wesbury - Chief Economist
Robert Stein, CFA – Deputy Chief Economist
 

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Posted on Monday, June 11, 2018 @ 11:24 AM • Post Link Share: 
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  M2 and C&I Loan Growth
Posted Under: Government • Fed Reserve

 

Source: St. Louis Federal Reserve FRED Database

Posted on Monday, June 11, 2018 @ 8:08 AM • Post Link Share: 
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