Today the release of the October FOMC minutes increased the likelihood (now about 70% according to implied pricing) of a modest rise in short-term interest rates next month. The market has been dreading such a move for years, but now that it is finally upon us, investors are shedding their fears, albeit slowly. After all, if the Fed is confident enough to end ZIRP, shouldn't we all be a bit more confident in the future? The economy is certainly not sizzling, but neither is it sputtering. It's been growing at a 2 - 2.5% pace for some six years now—the weakest recovery ever, to be sure, but a fairly steady one. Moreover, the economy has already withstood several shocks over the years—the PIIGS crisis, a Greek default, the fiscal cliff negotiations, the collapse of oil and commodity prices, and the devaluation of the Chinese yuan and the plunge in Chinese stocks—without skipping a beat. Perhaps most importantly, the prices of gold, stocks, and TIPS have been pointing to better times ahead for some time now.
The chart above shows the ratio of the S&P 500 index to gold prices, and it is divided into periods in which the ratio was rising (white) and falling (green). The numbers in red show the annualized rate of GDP growth during each period. Growth has been slower during times when gold is outperforming stocks, and faster when gold is underperforming. The ratio has been trending up for several years now, suggesting that growth could pick up further in the years to come. Investors tend to prefer gold during times of great uncertainty, and they tend to shun gold during times of rising confidence. Think of the green periods as times when investors run away from financial assets and embrace hard assets, and the white periods as times when financial assets look more attractive than hard assets. Good times for financial assets mean investment is generally strong, and investment is ultimately what drives growth.
Gold prices started falling in early 2011, and a year or so later TIPS prices started falling as well (the chart above uses the inverse of the real yield on TIPS as a proxy for their price). I've referred to this chart repeatedly in recent years, citing it as a good sign that pessimism is being slowly replaced by optimism.
Falling TIPS prices are the flip side rising real yields, of course, and real yields tend to track the economy's underlying real growth rate. So falling gold and TIPS prices are good signs that the market is becoming more confident about economic growth, and all this has happened as stocks have outperformed gold.
Real yields on 5-yr TIPS can be thought of as the market's expectation for the average real Fed funds rate over the next 5 years. Rising real yields over the past two years are a sign that the market has gradually become more confident that the Fed would sooner or later start raising real short-term interest rates. In the years to come, we are likely to see both TIPS real yields and real short-term rates continue to rise, and they should be accompanied by an improving economic growth outlook.
The chart above compares stock prices (blue) with the ratio of the Vix index to 10-yr Treasury yields (red), the latter being a proxy for the market's fears, doubts, and uncertainties. Every selloff in stock prices has been accompanied by a sharp rise in the market's fears, while rallies have tended to occur as fears have subsided.
Not surprisingly, as the chart above shows, consumer confidence has been rising since 2011, along with the fall in gold and TIPS prices, and the rise in stock prices.
All of the above point to better times ahead, driven fundamentally by improving confidence.
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