Eurozone Recovery Continues

 2yr swap spreads have declined dramatically this year, and that's an excellent indication that the Eurozone financial system is once again liquid and healthy. This in turn is a good sign that the Eurozone economy is likely to be improving in coming months (i.e., swap spreads are good leading indicators of financial and economic health).

We can't say that the Eurozone is out of the woods yet, since more than a few countries have yet to address their fundamental problem: excessive public sector bloat and chronic deficits. But with the health of the financial markets restored, there is hope that fundamental reform is in the offing.

The Euro Stoxx index is up over 20% since early June, another early sign that things are starting to improve on the margin. I note that with this index is trading at about 10 times expected earnings, it is fair to say that Eurozone markets are still suffering from deep pessimism. As in the U.S., the Eurozone equity market is being driven not by optimism, but by a slow decline in pessimism; conditions have not turned out to be as bad as the market had feared.

Equities Rise With Inflation Expectations

The chart below provides strong support for my belief that equities are responding more to inflation expectations than they are to real growth expectations. That is consistent with the monetarist view that the Fed has very little control over real growth—you can't print your way to prosperity

The chart compares the S&P 500 to the market's forward-looking inflation expectations, the 5-yr, 5-yr forward implied inflation rate embedded in TIPS and Treasury prices.

Equities benefit from QE3 because it is likely to boost nominal GDP growth, but not necessarily real growth. Inflation is now much more likely than deflation, and future cash flows are likely to be better than expected.

This is all good news for now, but lurking in the shadows is the issue of how the Fed is going to reverse its quantitative easing in the future, and whether they can do it in a timely fashion to avoid inflation going too high.

Meanwhile, it's good to see Treasury bond yields and equities on the rise. Higher yields are symptomatic of an improved outlook.

The Business of the Federal Government is Redistribution

This post builds on an excellent post by Mark Perry. Money quote: "... the federal government has become an entitlements machine. As a day-to-day operation, it devotes more attention and resources to the public transfer of money, goods and services to individual citizens than to any other objective, spending more than for all other ends combined."

Mark's charts show the composition of federal spending and taxes as a share of total spending and total taxes; mine show them as a % of GDP. Note the relatively low level of defense spending today, even though it includes all the costs of foreign wars. Defense spending is dwarfed by transfer payments.


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