The Practical Economist

EDITOR'S LETTER - June 12, 2017

EDITOR'S LETTER

We think that, to many readers, this current column may seem funny coming after the most recent content in which we laid out our simplest case why you should expect a slowing economy.

In short, we want to talk about the case for an upturn in the economy.

Please remember: it's about time-frames.  We have consistently said that we cannot use the podium of our forecasting voice to make anything like definitive statements about the economy more than three to six months out.  Anyone who says that they can is someone you should listen to with great caution.

But we're not averse to theorizing about time frames that are further out, based on what we would call ultra-macro economic data points and perspectives.

Did you read the current Investment Outlook?

If you did, you know that we laid out our case for why you should expect long-term interest rates to begin turning north in the medium-term (think six to 12 months' time).  This is a critical juncture to remind that the effects of the factors that create momentum in long-term rates are not felt for at least 12 months' time. 

So, that raises the obvious question: what do rising interest rates hold for us, in terms of the general economy?

It's too easy to simply say that rising interest rates are associated with expanding economies.  Not only is that true, but it's also not necessarily true that the two go hand-in-hand.  As in solving problems of probability, sometimes it's helpful to solve for the opposite of the problem you want the answer to.

If you buy into the scenario that has long-term interest rates rising, under what scenario would you see that happening in conjunction with a downturn in economic conditions?

Again, we're The Practical Economist; anything can happen, but let's stick to the most likely scenarios.

We could see long-term rates rise because inflation begins to rise at a rapid and sustained pace.

We could see long-term rates rise because the creditworthiness of the United States Government drops considerably.

We could see long-term rates rise because of a severe credit and capital crisis that makes the availability of capital severely restricted....a very dear commodity, so to speak.

(We are discounting the scenario in which long-term rates rise because of accelerating demand for commodities due to the outbreak of a protracted military conflict.  Such scenarios do result in inflation, but they are also accompanied by expanding economies.)

And if you're a regular reader, you do know that we have a very large long-term concern about the sustainability of the fiat currency system.  If such a crisis were to occur within the next two to three years, we argue that you'd see other key touchstones indicating larger problems that are looming.  And we do not see those at this time.

How about hyperinflation?  In the context of a central bank that not-long-ago raised short-term interest rates?

We argue that, in context of an economy that has been improving, and a budget deficit that is still large but significantly down from where it was four years ago, a severe decline in the creditworthiness of the United States is possible, but unlikely.

A capital crunch?  Again, we think that there will be signposts indicating that such is afoot, and there is nothing particularly amiss in terms of the economy running "business as usual."

You are permitted license to believe that there are ominous forces that will drive long-term rates high in the two-three year time frame, but it is very difficult to form a sound and reasoned argument for believing that such is going to be the case.

And so, as you would do to solvee a probability problem, we ask to solve now, for 1-X, where "X" is the set of scenarios under which long-term rates rise for inclement reasons. 

What you are left with is a case for understanding that the more likely scenario in the longer time frame is toward an expanding economy, with a sounder currency as its base.

That is our longer-term "soft" forecast.  It is theoretical in nature rather than being driven by the data that informs our economic model.

Of course, if such topics are of no interest to you, there is no compelling obligation to find them so.  But if the answer is an important input to your activities, we argue that it's folly, at the least, to abdicate your responsibility to create an understanding of how you should be forming and altering your investment strategy.

In short, what is the reasoned argument for the contrary position?  We don't think there is any.

 

 

et's talk about the big economic picture, the big domestic picture. 

If you're a long-time reader you know that one of the touchstones of our model is the movement in both yield on the government's 10-year bond and in commodity prices.  Our goal today?  To make sure you know why that is the case, and secondly to make sure you understand what that data is telling us right now.

Please understand that we are about to make several general statements.  The point is that these statements about market dynamics are generally accurate, especially over the medium- to long-term.  The fact that traders and investors occasionally "get it wrong" is irrelevant; over the medium- and long-term traders are never wrong.  As we have posited before, there are no people on the planet smarter than bond traders.  There just aren't.

The first half of this equation has to do with those bond yields.  Generally speaking rising bond yields are an indication that the market expects upward pressure on the Fed to raise rates.  Now, there are two economic-based reasons that there could be upward pressure on rates.  One is commodities-based inflation.  The other is economic-based inflation....inflation, that is, that is derived from increased economic activity.

To the extent that we can strip out commodities-driven inflationary pressure from upward changes in bond yields, we can detect upward movement in economic activity and...economic expansion.

This algorithm, in theory, is elegant and it's not difficult to see, on paper, why it would be compellingly predictive.

The challenge is in executing the theory.

We will keep the methodology simple for you.  What we do is merely relate, numerically, the bond yield level to the commodities price index level. 

Given an unchanging commodities price index but a rising bond yield, you should expect an expanding economy.

And, given an unchanging bond yield, but a rising price level in commodities, you should expect downward pressure on the economy.  It is that simple.  And, this metric--that is, how the metric changes, is astonishingly accurate with regard to economic trajectory.

Let's give you an example from the recent past.  In March 2014, the 10-year bond yield was roughly 2.71% and the commodity price index stood at 134.52.

By March 2015, those two metrics moved to 2.04% and 98.12, respectively.

You will notice how far down the bond yield fell.  But you will notice, as well, how steeply commodity prices dropped.

When we compare the actual ratios of the March 2014 time frame to that of March 2015 we find that it rose 15 points.  That's a moderately bullish signal.

If you were looking for a strong basis for understanding the moderate expansion that we experienced in the 2015-2016 time frame, it's right there for you to see.

Now, let's contrast the March 2016 and March 2017 time frames.

In March 2016 the 10-year bond yield stood at 1.89% and the commodity price index was at 78.83.

In March 2017 the 10-year bond yield was at 2.60% and the commodity price index was at 84.50.

You will notice that the bond yield rose rather dramatically.  You will also notice that commodity prices rose substantially.  How to balance the two movements?

We look to our ratios, and what we find is that, year-over-year in March, that ratio rose just 1 point. 

That's right, just one point.  Armed with that data understanding, would you expect the economy to continue to grow through the balance of 2017 and into the start of 2018?

And...it's even worse than that, because that 10-year yield has fallen, over the last six weeks, on the order of 25 basis points while, in the same time frame, the commodity price index has remained roughly stable.

This analysis and understanding of how to understand what the market can tell us is, to our mind, the most compelling early indicator of economic trajectory.  It's all already in our economic model  So, if you've been keeping up with the Domestic Scorecard, you'll have noticed that the Leading Indicator Score has been dropping.  This analysis, that we just went through on this page, is a is a big reason why.

Consider yourself embarrassed if you're surprised by an economy that is found, come late fall, to have significantly slowed during the spring and summer. 

You have been warned.