Why a recession is not likely, and the Fed has no reason to ease further

The world seems obsessed with the idea of a Eurozone collapse sparking a global recession. Capital is fleeing Eurozone banks, and seeking out the safety of the dollar, the yen, and Treasuries. It's difficult to know today what the ultimate outcome of the current Eurozone turmoil will be, and whether and by how much that will impact the U.S. economy. Should the Fed be launching another round of easing to ward off these risks?

A quick look at key market-based indicators of risk suggests that a U.S. recession is not very likely, and that there is little or no need for the Fed to do anything at this point.

10-yr Treasury yields have plunged to an all-time low of 1.5%, but 10-yr TIPS break-even rates show no sign of unusually low inflation expectations, and 5-yr, 5-yr forward inflation expectations derived from TIPS and Treasuries have actually been rising for the past 9 months and currently stand at 2.6%. This suggests that the decline in nominal yields is being driven not by declining inflation expectations—which in turn would be what we might expect if there were a need for the Fed to ease—but by sharply declining expectations for real growth. See my earlier post for more details on this theme.

Foreigners' insatiable demand for safe-haven assets that also offer a guaranteed yield is most likely the driving force behind the unprecedented low in Treasury yields, because it's hard to find evidence that the outlook for the U.S. economy is that dire. Plus, the decline in 10-yr yields began in earnest about the same time that the Eurozone financial crisis began heating up last summer, and 10-yr yields have closely tracked the decline in Eurozone equities.

The strong correlation between European economic conditions and 10-yr Treasury yields can be seen in the above chart (10-yr Treasury yields in white, and the Euro Stoxx equity index in orange). In contrast, U.S. equities have been trending higher for the past two years even as Eurozone equities have moved back to their 2009 lows. Clearly, the Eurozone is the epicenter of the world's growth and financial concerns.

I've shown this chart many times in the past several years, and it continues to be useful, because it strongly suggests that the U.S. economy is not currently at risk of a recession. What it shows is that every recession in the past 50+ years has been preceded by 1) a pronounced rise in the real Federal funds rate, and 2) by a flat or inverted Treasury yield curve. In other words, tight monetary policy has been the proximate cause of every recession in the past 50 years. Currently, we are very far from seeing either of those two conditions prevail, thus the likelihood of a near-term recession is very low.

The logic behind this chart is fairly simple. The blue line represents the real Federal funds rate, which is one of the best ways of determining whether monetary policy is tight or loose—the Fed itself uses this as a gauge of how easy or accommodative policy is. The higher the real funds rate, the tighter monetary policy is, and very tight monetary policy is main tool the Fed uses to slow economic growth and reduce inflation pressures. To judge from this chart, whenever the real funds rate exceeds 3% it's time to start worrying about a recession. Today, however, the real funds rate is -1.6%, and it has rarely been lower.

The red line measures the slope of the Treasury yield curve from 1 to 10 years' maturity, and this is another way of gauging how easy or tight monetary policy is. A steep yield curve is the result of the bond market anticipating a future tightening of monetary policy. The steeper the curve, the more the market expects the Fed to tighten in the future; by the same logic, a very steep yield curve is an indicator that the Fed is very accommodative, and can't remain that accommodative for very long before it will have to start raising rates. A flat or inverted curve, on the other hand, means that the Fed is so tight that the market expects they will have to soon begin easing, because the market senses that the economy is suffering from high real yields and beginning to slow down. Currently, the yield curve is neither extremely steep, nor flat, nor inverted. This further suggests that the Fed is not as easy as the extremely low level of the real funds rate would suggest, but they are still easy.

That is, what has happened over the past year is that the Fed has become "less easy."

Since early last summer, just before the Eurozone crisis started heating up for a second time, the yield curve by this measure has flattened by almost 150 bps; and since mid-March, it has flattened by almost 100 bps, with almost all of the flattening coming from a decline in 10-yr yields. The chart above shows the steepness of the curve in a slightly different perspective, and here it should be obvious that despite the significant recent flattening of the curve, it is still a long way from being flat or inverted. In other words, the Fed is less easy than it was a year ago, but still easy.

We can also see evidence of less-easy monetary policy in the 15% decline in gold prices since last summer, in the 11% rise in the dollar, and in the 16% decline in the CRB Spot Commodity Index. (See the respective charts above.) If the Fed were really tight, commodities would be far lower than they are today; as it is, they are still significantly above the extremely low levels of 2001. Furthermore, the dollar would be much stronger that it is today, since it is still very close to historic lows and far below the highs of early 2002. All of these sensitive indicators of monetary policy have behaved in a manner consistent with monetary policy becoming less easy and dollars becoming less abundant.

2-yr swap spreads (above chart) are a good way of measuring how tight monetary policy is. When policy is very tight, dollars are in short supply and swap spreads tend to rise because systemic risk is rising and the economy is slowing; rising swap spreads are like the canary in the coal mine, warning that dangerous conditions are approaching. Although swap spreads have increased a little of late, they are still within what might be termed the safe zone—nowhere near high enough to indicate a serious problem. Again, this is consistent with monetary policy that has become less easy, but is still far from being too tight.

Credit default swap spreads can sometimes, but not always, be a measure of how tight monetary policy is. If policy is very tight, then dollars become scarce, the economy slows, and deflation risk rises, and all of those conditions increase default risk. In the chart above, we see that default risk has indeed risen of late, and currently is at a level that preceded the last recession. But taken in the context of other indicators which suggest that monetary policy is less easy but still "easy," I think it's safe to say that the cause of the rise in CDS spreads has very little to do with U.S. monetary policy and everything to do with the problems in the Eurozone. The market is legitimately concerned about the risk of Eurozone contagion, but so far there are no signs of recessionary forces building inside the U.S. economy.

How has the Fed become less easy if they haven't announced such a change in policy? That's easy: the Fed has become less easy inadvertently, because they have not responded to an increase in dollar demand from global investors. As a result, dollars have become somewhat less abundant in the past year. Not in short supply, simply less abundant. On the margin, there has been the equivalent of a modest tightening of monetary policy, but not by enough to threaten the economy. This is a very important distinction.

What this means is that the Fed should not feel greatly pressured to implement a third round of quantitative easing. The problems the world is facing are not because the Fed is too tight (like they were in 2008, when they failed to ease in response to a huge increase in the demand for dollar liquidity, which in turn led to a 25% plunge in gold and an unprecedented surge in swap spreads), but because of the trauma facing the Eurozone countries. There is very little the Fed can or should do to address that issue; it's simply not our problem.

This is not to say that there is zero risk of a recession, but rather to say that to date there are very few signs that a U.S. recession is imminent or even likely, and almost no indication that the Fed needs to initiate another round of quantitative easing.

Check out JC Penney

I'm the typical guy when it comes to shopping: I hate it. I only go to stores that I know and like, and then only when I need something. My favorite store is Nordstrom, but I only buy things that are on sale, since I can't bear to pay $100 for a shirt that must cost them less than $10. For decades, I have gone to JC Penney only every other year, when I needed new socks and underwear.

So a few months ago, before our recent trip to Argentina, I went to JC Penney for some socks and underwear, and I was amazed at what I saw.

About a year ago I remember reading that Ron Johnson, the guy who spearheaded Apple's hugely successful retail stores many years ago, had left Apple to become CEO of JC Penney. His goal: rethink JCP's entire retail strategy. The stock jumped on the news, but then settled back down. Last January, JC Penney announced their new strategy: low prices every day, plus new brands and better selection. This boosted the stock from $35 to to $43, but then it settled back down again. Three weeks ago, JCP plunged from $34 to $26 on news that the new strategy has not produced the desired results. The company reported a first-quarter loss and suspended dividends.

Tim Travis does a good job of summarizing the rationale for buying JCP at these levels. The Street, however, is very disappointed, with many arguing that a strategy of everyday low prices just won't work—too many people are addicted to sales. In any event, I hasten to add that just about all I know about the stock can be found in this post.

What really gets me excited is that I have visited a JC Penney store about five times in the past month or so, and every time I've bought things I wasn't even looking for. This is not the store I remember, not at all. The prices (all rounded to nearest dollar, which makes me feel like they aren't trying to fool me) are extremely reasonable and in many cases unbelievably cheap. The quality is excellent, and they have the latest fashions, with lots of name-brand merchandise.

If you haven't already, I strongly recommend you visit a JC Penney store and check things out for yourself. I can't believe that great stuff for low everyday prices won't eventually be a winning formula. And for those that like sales, they have a special every month on a certain collection of things. Today I bought Father's Day stuff (all on sale: two shirts and a pair of shorts) for myself, and was stunned when I saw the total: $49, including tax. My wife thought they were fantastic. I'll be wearing them to a BBQ tonight.

I am going to be looking closely at taking a position in JCP.

Car sales disappoint, but remain very strong

May sales of autos and trucks came in below expectations (13.7M vs. 14.5M). That makes a total of five series released today—all traditionally volatile on a month-to-month basis—that have been weaker-than-expected (payrolls, unemployment, manufacturing, construction, and auto sales). It's a "perfect storm" of weak news coming on a Friday, amidst escalating tensions in the Eurozone, and so it's no wonder the market sank.

But back to autos. In the past three years, auto sales have risen at an annualized rate of no less 11.7%, even counting May's 4.5% decline from April. That's weak? On the contrary, we have just seen two years of fabulous, double-digit growth in a sector of the economy that was fighting for its life just threee years ago. No one would have dared predict back then that sales would be this strong today.

In any event, the larger trend (see chart above) is much more important than the month-to-month fluctuations. It's very important to remember that the reported number is a seasonally adjusted annualized sales rate, so a rather small change in actual monthly sales, or a slight error in the seasonal adjustment factors, can result in big swings in the reported number. If you were to extrapolate each monthly swing in this series into the future and trade on that basis, you would be whipsawed to death inside of one year.

Going into today's releases, this market was on tenterhooks, fearful that the economy was on the verge of sinking into another recession. It could be mere coincidence that five series came out on the weak side of expectations, or it could be that the economy has lost some forward momentum. It's also important to reflect on the approaching fiscal cliff, which as Larry Kudlow notes is contributing greatly to the market's unease:

If all the Bush tax rates go up, incentives will go down and liquidity will leave the system. You can’t pick up a newspaper these days and not find a story about how the fiscal cliff is elevating uncertainty and slowing U.S. growth. House Speaker John Boehner asked Obama for help in extending the Bush tax cuts this summer. But Obama said no. Instead, he wants to raise marginal tax rates on successful upper-income earners, capital gains, dividends, estates, and many successful corporations.

Where’s the corporate tax reform that would lower rates and broaden the base and end the double-taxation of the overseas profits of American companies? A business tax cut would help enormously, but it’s nowhere in sight. Obama is too busy trashing Bain Capital profits and Romney’s business career, both of which, by the way, have recently been praised by former president Bill Clinton. (It was Clinton, you might recall, who lowered investment taxes and presided over an economic boom.)

The larger trends, however, remain intact: jobs are growing, incomes are rising, sales are rising, layoffs are declining, manufacturing is doing pretty well, and residential construction has turned up after 5 years of decline. The economy doesn't change on a dime, and not even 5 disappointing reports in one day can disprove that.

Oil price update

Crude oil prices have fallen rather sharply since late February, down almost 25%. This is likely the result of oil production being up, demand being a little softer than expected, and crude oil inventories reaching a new all-time high (but only 3% above their year ago levels). In other words, crude production responded to the high prices we saw earlier this year by increasing, and demand responded by weakening. Consumers are now breathing a little easier as prices decline to a new clearing level.

Gasoline is still pretty expensive, but the good news is that it's going to get cheaper, as suggested by the second chart above. This chart compares the price of wholesale gasoline futures (white line) with retail gasoline prices at the pump (orange line). Note how retail prices lag futures prices, which is what you'd expect. With the recent declines in futures prices, we can expect gasoline prices at the pump to fall to $3.30/gal. or less in coming weeks; that would represent a decline of at least 15% from the early April highs, and possibly more before all the dust settles. It was just a few months ago that the market fretted over the possibility that rising gasoline prices would amount to a significant headwind to growth, but now that risk is fading.

Meanwhile, the huge decline in natural gas prices in recent years is acting as a big stimulus for the economy, transforming entire industries as they switch from more expensive energy sources to very cheap natural gas.

Construction spending is picking up

It continues to look like the bottom in the construction sector occurred just over a year ago. Spending on residential and nonresidential construction is up 6% and 7%, respectively, in the past year. Total construction spending is up at a 5% annual rate in the past six months.

After it's worst slump ever, residential construction spending is now growing faster than the rest of the economy. The gains are still minimal, but the important thing is that we have turned the corner and conditions are now improving, albeit slowly. Construction will once again be contributing to GDP growth, and that should be the case for many years to come, given its recent steep decline and the ongoing growth in the population: lots of catch-up to come here.

Manufacturing sector still healthy

The May ISM manufacturing report was about in line with expectations, and it didn't change the meme: the manufacturing sector continues to do better than the rest of the economy. As the top chart shows, the current level of the ISM index is consistent with economic growth of at least 2% or better. As the second chart shows, the employment index is actually very high from an historical perspective. So manufacturing continues to expand, and the prospects for future growth remain relatively bright. Nothing to get concerned about here, and no signs of any deterioration.

Jobs growth still moderate

It's been more than 30 years that I've been following the monthly employment report, and I've never understood why it is that the market places so much importance on a single number. Especially since that number can and most likely will be revised significantly in the future, it is subject to seasonal adjustment factors that are never completely accurate, and it is volatile from month to month. I've also never understood why the market focuses on just the establishment survey of jobs and almost completely neglects the household survey. Both have their problems, and sometimes they can diverge a lot, but over time they tell the same story, only from different perspectives. I've found that looking at both surveys can be very useful, and I make a point of doing that on this blog. The household survey is especially important to follow in the early years of a business cycle expansion, because it can pick up the growth of small start-up companies which aren't covered at all by the establishment survey until future revisions which match the survey data to tax records.

I also try to focus just on the growth of jobs in the private sector, since that is where the real action is. It makes even more sense these days, since state and local governments have been shedding jobs. In my view, the public sector has gotten way too big, and cutting it back is not only necessary but actually quite healthy, since it leaves more room for the more-productive private sector to grow. 

According to the establishment survey, private sector jobs growth has been disappointedly low for the past two months: about 85K on average. But according to the household survey, private sector jobs growth has averaged 160K for the past two months. As the charts above suggest, the household survey has enjoyed some pretty impressive growth this year, following a period of fairly slow growth. The household survey is finally doing what it usually does, which is to lead the establishment survey. (Since the low water mark in early 2010, the household survey shows a gain of 5.2 million jobs, while the establishment survey shows a gain of 4.3 million.) I think the household survey should get the benefit of the doubt here, and that's why the title of the post says that jobs growth is still "moderate" rather than disappointingly low. 

The unemployment rate ticked up last month, in part due to renewed growth in the labor force. The labor force is still way below trend, however, since some 5 million people have stopped looking for jobs, either because they have retired or have given up finding one. But if you look closely at the chart above, you will see that the labor force actually has been growing in fits and starts since last summer, and that is a positive sign. If the economy continues to slowly improve and the labor force continues to slowly expand, the unemployment rate is not likely to decline further, and could in fact rise some more, at least until the pace of jobs growth starts picking up.

So I think the market's reaction to today's news has been excessively pessimistic. I don't see convincing signs of deterioration in the outlook; I see an economy that continues to grow at a sub-par pace, and that's been the case for the most of the past three years.