God is a Capitalist

Thursday, June 4, 2015

The bond market's head fake

The bond market fell this week, wiping out gains for the year. Some blame it on Mario Draghi’s comments after an ECB meeting in which he expressed indifference to volatility in bond markets. If it is true that Draghi’s statements motivated the selloff, it shows how fragile is an investing philosophy that is based solely on what central banks do. Such investors are terrified of rising interest rates but want to remain fully invested until the last bell. Of course, anyone investing in bonds or stocks at these altitudes should be as nervous as a long-tailed cat in a room full of rocking chairs.
I think the bond market is giving us a head fake, like what running backs in the NFL (American football) do to defensive backs to confuse them so they can’t tackle the runner. It’s important to pay attention to central banks because a large part of asset price inflation comes from them expanding credit with artificially low interest rates. But investors should ignore the nagging fear of rising interest rates because that will not happen until the distant future. I have argued for a few months along with others that the Fed would not raise interest rates this year and recently the International Monetary Fund joined us by warning the Fed to delay a rate hike until the first half of 2016.

Investors should worry more about the danger of another recession at a time when total debt is much higher than in 2007. The omens pointing to a recession keep piling up. Nonfarm productivity fell at a 3.1 percent annual rate instead of the previously reported 1.9 percent pace. Productivity falls, for the most part, because of declining investment in new equipment, and that investment falls when the Ricardo Effect kicks in.

Another major omen has been the 6.5% drop year-to-year in new orders to manufacturers. I like year-to-year change data because it isn’t influenced by seasonality. The drop has been more severe than at any time in which the economy was not in a recession.

China’s economy is slowing dramatically and China is primarily the world’s greatest consumer goods maker. In the US, investors have fixated on the large drop in oil and gas prices but all commodities have taken a huge hit. Oversupply is an issue because demand has fallen so much.

Don’t look to unemployment numbers to gauge the direction of the economy. Employment is a lagging indicator in all models of the business cycle. The numbers improve the most just before the end of the expansion. Besides, the improvement in the latest unemployment data does not indicate a growing economy. The labor force participation rate is at the lowest point in decades. The unemployment numbers only tells us that many thousands of former workers are too discouraged to look for work and those discouraged workers are not included in the data for calculating unemployment. That data is based on a survey. The surveyor asks the person who answers the phone if they are looking for work. If that person says no, then the surveyor hangs up and that person is not included in the data.

We may be in a recession now and won’t officially know it until the National Bureau of Economic Research tells us. If the second quarter data shows shrinkage (negative growth in econ jargon) then we will officially have experienced a recession with two quarter of GDP shrinkage and bond prices will soar.
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