I don’t claim to know how the Russian-Ukrainian war will play out, but I can shed some light on its impact on the US and Eurozone economies. Unsurprisingly, the US economy continues to grow, while the Eurozone economy has taken a serious hit. However, everyone is suffering from higher than expected inflation. Central banks live in fear of war risks and are therefore reluctant to tighten. Consequently, monetary policy is still very accommodative almost everywhere and should not pose a serious risk in the short term.
The February jobs report was quite strong and contained the good news that the labor force participation rate (see bottom chart above) rose significantly. Chart 1 also suggests the reason for the surge, namely the sharp drop in transfer payments. It’s funny how things work: if you pay people who don’t work, you won’t find many who want to work, and when you stop paying them, they’re more likely to work. (Our economy isn’t suffering from a lack of jobs, that’s for sure.)
Graph #2 compares the level of jobs in the private and public sectors. Two positives: private sector employment has recovered almost all of its Covid-related loss, while public sector employment has recovered less than half. (In my book, private sector jobs are much more productive than public sector jobs.) Government has become less obese, and that’s good news.
On the other hand, the level of private sector jobs today is still at least 5 million lower than it might have been in the absence of the Covid crisis.
Swap spreads, shown in Chart 3, are excellent indicators of a) liquidity conditions and b) the outlook for corporate earnings and overall economic health. Swap spreads have increased a bit in the US, but not enough to be cause for concern (in a normal economy, you would expect swap spreads to be 15 to 35 basis points). Conditions in Europe are not as good, however, with swap spreads having reached recession-era levels. Limiting Russia’s ability to use the SWIFT payment system is a significant factor in reducing liquidity abroad.
Chart 4 is my favorite chart for assessing recession risk. All but the last recession have been preceded by very high real yields and a flat or inverted yield curve. We’re not even close to either at this point. Real yields on the fed funds rate are at record (and eye-popping) highs, which means liquidity conditions are plentiful and the Fed and banks are practically begging people to borrow money. Combine that with Chart 3 and you see that the three indicators that normally precede recessions are not in worrying territory at all, at least in the United States.
Chart #5 compares the price of gold to the actual 5-year TIPS yield (inverted, so as to be an approximation of their price). This tells us that TIPS and gold are highly sought after for their risk reduction properties, which means the market is very worried. There’s no shortage of things to worry about, and from a contrary perspective, it’s bullish. The last time the markets were so worried was in the period 2011-2014, when Europe faced the risk of national defaults and the collapse of the euro.
Chart #6 shows the nominal and real 5-year Treasury yields, and the difference between the two (green line), which is the market’s expectation for the average CPI over the next 5 years. Inflation expectations have now reached new highs (about 3.3%) as the market is slowly beginning to see that the surge in inflation that began early last year will not be transitory. I expect these expectations to continue to rise over the next year, which means that nominal interest rates are almost certain to rise significantly.
Chart #7 compares the real yield of the 5-year TIPS to the current real yield of the fed funds rate. In effect, the red line is what the market thinks the blue line will average over the next 5 years. In short, the market thinks the Fed will keep short rates negative in real terms for a long time. Borrowing at a variable rate is therefore likely to be attractive for a while.
Unfortunately, as I have explained many times in recent articles, the persistence of negative real yields contributes to weakening the demand for money, which in turn fuels the fires of current inflation. The Fed will have to do a lot of tightening at some point to bring inflation down.
Chart #8 compares the Vix index (the worry index) to the level of the S&P 500. Whenever the market gets very worried, stock prices drop (unsurprisingly). However, the level of worry is not yet extreme today, so things may get worse before they get better. On the other hand, a healthy dose of worry means the market is prepared for bad news, and that acts as a buffer.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.