A real fun article from the NY Times about the pizza slice price war in Manhattan.
Pizza Slice Price War
Fed Chair Bernanke gave a talk today at a conference organized by National Association for Business Economics. His talk today was about recent improvement in Jobs growth and it revealed some interesting information about his current thinking. Bernanke noted that it was sort of puzzling that even though the job market has improved recently, GDP growth has not picked up. There is a relationship in economics called Okun’s law which relates change in the unemployment rate with GDP growth. According to Okun’s law we should have seen around a 4% GDP growth rate to see the kind of drop we have seen in the unemployment rate, whereas in reality we only got about 2% GDP growth in 2011. Bernanke thinks it could just be businesses finally undoing some of the extreme layoffs they did during the recession. To have sustainable jobs growth we will finally need better GDP growth, therefore he thinks it is important to keep a very accommodative monetary policy so that GDP can grow at a faster pace and we continue to see a reduction in the unemployment rate. Conversely one can also draw the conclusion that this improvement in the job market will be temporary if GDP just grows at last years pace. Below is a link to the talk, if you have a chance go and read it. It is very well written and informative and not too technical.
Bernanke Talk at NABE conference
The markets are down today because of weak manufacturing data in China and most of Europe. In the US, jobless claims came in better than expected pointing to continued improvement in the labor market. Coming out the financial crisis, global growth was the one positive factor which allowed S&P 500 companies to have good profit growth. Now it seems we are seeing the opposite. The US is continuing to show improvement in economic conditions whereas rest of the world is starting to slow down.
Over the last few months we have had a rising stock market mainly driven by a reduction in risks of financial contagion in Europe and improving economic data in the US.
The main cause of improvement in Europe was due to the action taken by the ECB where they offered banks 3 year loans and also reduced the quality of the collateral they would take to secure the loans. The program called Long Term Refinancing Operation (LTRO) has allowed the banks to borrow around 1 trillion Euros. This has averted a liquidity crisis in Europe because banks had to roll over a lot of debt this year and they were having trouble raising money in the private credit markets. Now the banks have met their refinancing needs through the LTRO.
On the economic front the US economy is showing signs of improving. The jobs data has been coming in stronger than expected and the unemployment claims data has been hitting new lows not seen since 2008. Due to operation twist from the Fed we have also had no increase in yields which generally puts a damper on economic growth and the stock market.
Due to the reasons outlined above, risk assets like equities have done very well. This week though we have had two data points which are raising some red flags. One was that the Durable goods orders month over month came in quite worse than expected. They were down 4% for January and even ex-transportation (which is very volatile) they were down 3.2%. Expectations were for a flat reading. The main reason for the drop was that December was pretty good due to an expiry of tax credit, but still the drop was worse than expected. The other data point which was not good was the manufacturing ISM index which was released today morning and came in at 52.4, worse than the expectations of 54.6. Considering the good numbers coming from the employment front, one would have expected an acceleration in the economy but these numbers are sort of throwing water on those expectations. These numbers don’t point to a recession but they do lower expectations for a stronger recovery.
The WSJ has an article today which talks about exactly the same issues I raised in my previous post about the Treasury market not behaving normally. They raised the same points about operation twist and the fed revealing its forecast for short term interest rates remaining at zero till 2014.
One very interesting statistic in the article is that since operation twist started, the Fed has bought 91% of all the supply from the US Treasury for bonds maturing in 20 to 30 years. That is clear indication that the Fed is having a big influence at the long end of the yield curve. The Fed is succeeding in providing stimulus to the economy this way as mortgage rates still remain near all time lows when they should have normally started to go up.
Over the past few weeks we have seen mostly positive economic reports and improvement in Europe (yields of Italy and Spain have dropped below 6%). As expected the stock market has been rising steadily and the S&P 500 is close to a yearly high (NASDAQ is already at a new yearly high and at the highest level in 11 years). In light of these circumstances one would have expected that Treasury bond yields would have risen up a reasonable amount also. But we are not seeing that. Typically treasury yields move down when their is a flight to safety or decreasing inflation. In the current scenario you have risk coming down and data to support an improving economy. Other asset classes like Stocks and commodities are behaving as expected that their prices are going up. The 10 year treasury yield as of today is around 1.95% which is near the lower end of the range for the last 6 months, whereas stocks are comfortably at new 6 month highs. If treasury yields would have not broken down their correlation with stocks, they should have probably been in the 3% range by now.
So what is really happening. Here are a few reasons why I think this divergence is happening and I will order them based on what I think is the most probable cause
- I think the main reason for this behavior in bond yields is the Fed. The Fed is suppressing yields in two ways. First, through Operation Twist the Fed is selling shorter term bonds and buying longer term maturities to push those rates down. The Fed is soaking up some of the supply of these bonds so they have artificially suppressed the yields for these long term maturities. Second, just recently the Fed openly revealed that their current view is to keep short term interest rates near Zero till 2014. By declaring this they have seduced bond traders into thinking that they don’t face much interest rate risk in the medium term.
- The other possibility, although I don’t strongly believe in it, is that the bond market traders are thinking differently than stock market traders. It is possible that the bond market does not believe in the current economic strength and feels we will head back into economic weakness pretty soon and we might again face possibility of deflation.
I think a lot of traders feel that the fed has committed to keeping interest rates near zero till 2014, but in reality this is just their current viewpoint. The Fed can easily change its view with new data, so traders shouldn’t read too much into this 2014 forecast.
I am back after a 2 month hiatus. I was in India for a 4 week vacation and just busy with starting my business. I am hoping to update the blog on a much more regular basis going forward.
Today we had two economic releases which were across the board good.
- The jobs report came in a about 100K better than expected and most of the internal components of the data like average work week(increased by 0.1hrs), average hourly earnings(increased by 0.2%) were all good. The job growth was also pretty broad based across all sectors
- The other big surprise of the day was the Non-Manufacturing ISM survey which came in quite good at 56.8 vs expectation of 53.3. The most encouraging were the internal components, both new orders and employment had strong jumps from previous months.
The stock market as expected is reacting very positively to this data. Looking at most data points it does appear the US economy is starting to accelerate. In fact the US seems to be doing one of the best among developed nations. We also have some improvements in the European credit markets. The improvement has mainly been driven by the strong actions taken by the ECB in December where they announced a 3 year loan program for European banks. They have also approved their permanent bailout fund the ESM whose size will be 500 billion Euros.
The main red flags now we have are coming form Asia. There are good indications that the Chinese real estate market has slowed down dramatically. Indian growth has also slowed and that was my observation when I was visiting there. The European problem is far from resolved also, it is a slow work in progress.