Relevant and even prescient commentary on news, politics and the economy.

Fed Policy and Bond Yields

Update:  Charts and data after the read more.

With the Fed completing a two day meeting and Bernanke holding a press conference today  it may be a good time to make a few comments about bond yields.

In an open economy with a current account deficit the equilibrium interest rate is the one that attracts sufficient foreign capital to finance the current account deficit with a stable exchange rate.  If the currency is rising it indicates that yields may be too high, while a falling currency implies that yields are too low.  This is important to understand because the US 10 year T-bond yields rose 46 basis points in May and the bulk of the increase stemmed from a rise in Japanese yields.  They surged because investors decided that Abenomics was working.  This, in turn, pulled bond yields up some 25 to 35 basis points in Britain, Germany, the US and many other countries.  All of this preceded the release of the Fed minutes and Bernanke’s  Congressional testimony.  Yet Wall Street and many bloggers  seem to ignore the point that two-thirds of the May bond yield rise was due to foreign factors, not the possibility of Fed tapering.

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Stock Market Valuation

Mark Thoma had a tweet asking if the stock market is  in a bubble.

I do not think so.

The market PE  on trailing operating earnings is 15.5 and my model says that based on the historic relationship to interest rates and inflation the market PE should be 21.5%.

Obviously, either the market does not believe rates will stay this low and are using a higher interest rate or they expect  long-run trend earnings to slip far below the long run trend of  7%   The market PE is an expression of the present value of expected long-run earnings growth.  The long term historic average for the market PE is 15, almost exactly where it is now.  Of course there is no central tendency for the market to converge on a PE of 15.  If you do a histogram of the market PE you will find that the probability of the PE being on any number between 10 and 20 is about the same.

 

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Maybe we just need to look at the market from a simpler perspective.

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Solar Power

Last year I had solar panels installed on my roof under a deal where I pay nothing up front for the installation and pay the solar company for the power I produce at a rate about 75%   of  what I pay the electric utility.

I just got my April bill from the electric company.

It was a credit for $15.54, so I actually produced more electricity than I consumed in April.

Over the winter months I met about half of my electric needs from solar.

I thought that was pretty good for the Boston area.

So it will be interesting to see what happen this summer when solar production should be maximized.

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World Industrial Production

I see some evidence that higher domestic energy production and improved competitiveness of US manufacturing is having a positive impact on the US trade balance and US industrial production. But I still expects the impact to be limited. In particular, the real non-petroleum trade balance continues to deteriorate. Increased supplies of cheap natural gas helps the petrol-chemical industry, but  its impact on other industries appear limited. If their is any segment of the economy where the rule of one world price holds, it is energy. Cheap energy prices in the US will only last until the industry can remove the bottle-necks and open those markets to competition. Firms do not build new plants to exploit temporary advantages.  Work is already underway to reverse a pipeline from the Gulf Coast to Cushing, Oklahoma so the surplus oil in the Midwest can be exported.  The Boston  Globe reported that an application was just filed to reverse the oil pipeline from the Maine Coast to Montreal to facilitate exports of Canadian tar sands oil.

If you compare US industrial production to the rest of the world there does not seem to be much of a change that can not be traced to recent world economic growth rather than structural changes in US production.

 

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In real terms the total trade balance is improving because of reduced oil imports and expanded oil exports.

But, excluding oil, the real trade balance is still growing.  The rate of growth may be slowing, but that seems to stem more from weak  world growth  rather than structural changes in the US.

 

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Moreover, real non-petroleum exports are clearly peaking and may be rolling over.

 

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Employment Situation

The headline numbers in the employment report were very weak as  payroll employment rose by only 88,000  and the household survey reported a -206,000 drop in employment while the labor force fell by -496,000.  The futures markets are reacting very badly.  But the workweek expanded and aggregrate hours worked increased 0.3% as compared to 0.5% last month.

Private payrolls grew  96,000  and government employment fell 7,000 implying that the sequester is not yet having a significant impact.

After falling to  below trend last year hours worked is now back on the 0.2% trend displayed earlier in the cycle.   So basically it looks like the headline numbers are overstating the weakness.


Interestingly, my bond valuation model still says that the 10 year T Bond yield should be about 1.5%.
 The model still has fed funds in it, but  nothing else to capture other measure of fed policy..

Average hourly earnings were essentially unchanged last month, but the smoothed data still implies that wage gains have bottomed.

Average weekly earnings also still looks like it has  bottomed.

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Employment Situation

This was one of the better employment reports of this cycle.  Private payroll employment grew 246,00
while  government employment fell about 10,000 for a net gian of of 236,000.  The household survey also showed a nice gain of 170,000.

 

On a year over year change basis both series are showing nice gains.




You would never know it to listen to the news, but employment in this cycle continues to better than in the previous   cycle.

The workweek also increased 0.1% and the index of aggregate hours worked grew 0.5% of all workers and 0.9% for production workers.  The index is now back to the trend established early in the cycle.

Average hourly earnings growth has bottomed and are starting to move up very nicely.


And this is leading to an improvement in weekly earnings.


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The employment situation

This was another tepid employment report not much different than the reports in 2012.

Payroll employment rose 168,000 and the household survey showed a gain of only 17,000

 

Private payrolls expanded 168,000 while government employment fell 9,000.

 Perhaps more importantly the year over year change in employment is showing significant signs of weakness,  Both the household survey and payroll data show that the year over year gain in employment has peaked.


 Moreover, this weakness is appearing despite the fact that the annual benchmark revisions showed stronger employment growth in 2012 than originally reported.

 The revisions also significantly changed the pattern of hours worked in 2012.  Originally, hours worked fell well below trend in mid-2012 and were strengthening back to trend at year-end.  Now
it appears that hours worked were not as weak as originally reported. But with the average workweek unchanged in January, the January hours worked fell 0.2%.

 

 On the other hand the apparent bottoming of average hourly earnings growth  is still intact and was actually strengthening in January. 

 
 The growth in average weekly earnings fell back to only 1.2%  versus 1.7% in December and the low of 1.0% in October.  It is going to be very hard for consumer to absorb the increase in payroll and income taxes in early 2013.  Prospects for consumer spending in early 2013 do not appear promising.

 

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