Implications:  Housing starts rebounded sharply in May, easily beating consensus expectations to reach the highest level since 2007.  Starts rose 5.0% in May to a 1.350 million annual rate, and are now up 20.3% in the past year.  The Midwest was entirely responsible for the gain, surging 62.2%, while other regions had declines.  This May was unusually strong relative to the trend, while May 2017 had the slowest pace for housing starts in all of 2017 - that pushed the year-over-year gain above trend.  We expect further gains in the year ahead, although we expect the pace of gains to slow.   One way to cut through the monthly noise is to compare the first five months of 2018 versus the same period in 2017.  By that measure starts are up 10.2% from a year ago.  New single-family construction continues to be the main driver of trend growth, as the chart to the right demonstrates.  We expect further strength from single-family starts in the years ahead, and a continued transition to more growth in single-family construction from multi-family will be good news for the overall economy.  On average, each single-family home contributes to GDP about twice the amount of a multi-family unit.  The worst news in today's report was that permits for future construction fell 4.6% in May, as both single-family and multi-unit permits showed declines.  That said, overall permits are still up a healthy 8% in the past year.  Further, the horizon is brightening, with the number of units currently under construction at the highest pace since 2008.  Developers are also completing units at the fastest pace since the recession, freeing them up to start construction of new homes.  Housing starts are still up in spite of a significant uptick in mortgage rates, which some analysts claimed would derail the housing recovery.  As we have argued, higher interest rates can be sustained as long as jobs and incomes are rising.  Based on population growth and "scrappage," look for housing starts to rise to an average of about 1.5 million units per year by late 2019.  And the longer this process takes, the more room the housing market will have to eventually overshoot that mark.  That said, there are a couple factors that seem to be holding this process back.  The National Association of Home Builders claims 84% of developers cited labor shortages and the rising cost of building materials as one of their biggest problems in 2018.  Both these issues seem set to continue as an increasingly tight labor market keeps the number of job openings in construction elevated and tariffs on lumber, steel, and aluminum drive up input costs.  Highlighting these issues, the NAHB index, which measures homebuilder sentiment, fell slightly to 68 in June from 70 in May, primarily reflecting concerns about rising lumber costs that have added an estimated $9,000 to the price of a new home since January 2017.  We understand why some would look at this as a negative, but the Homebuilder Index is still at a high level and we remain bullish on housing in the year ahead.

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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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Source: St. Louis Federal Reserve FRED Database

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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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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