I try not to be an ideologue, and I often fail. One bias of mine is that most macroeconomic policy actions of the government or central bank either don’t help, or merely shift the problem to another place.

Tonight’s issue is the wealth effect, which tends to be favored more by conservatives.  The wealth effect is the tendency to spend more as the market value of the assets of a person rises.  I don’t think the wealth effect is zero, but I don’t think can be very big, and tonight, I will explain why.

Now, imagine that you own some assets and the value of them has grown.  You’re feeling richer, and you would like to live richer as a consequence.  How are you going to do it?  You could:

  • Sell some of the assets.
  • Borrow against the assets.
  • If you control the assets, you could increase the stream of dividends, or pay yourself a higher salary.
  • Trade the assets for assets that pay a higher income.
  • Do more exotic things, like sell call options — but let’s ignore those possibilities for now.  Those are just contingent forms of selling.

Let’s take these in order:

Sell Assets

Selling appreciated assets in most cases means incurring a capital gain and paying taxes.  It can be an effective way of raising your purchasing power on a one-time basis.  It also means that someone like you, or, one of their representatives, is going to have to part with money so that you can receive cash for your money.  The net effect for the economy is not likely to be an increase of cash spent on consumption as a result.

As an aside, some people might be averse to selling assets in a big way because they don’t want to consume capital.  They may not believe that the remainder of their assets will continue to rise in value, and as such might not be willing to spend from realized capital gains.  That said, many older people *will* have to consume capital in old age, but they aren’t well-enough off to produce a wealth effect — they worry whether their assets will last.

Borrow Against Assets

I think this is dangerous if done in a big way, though I have seen some crackpots advocating that.  We should have learned from the financial crisis that if borrowing against stable assets like a home in order to spend can result in disaster, it does not make sense to do it against more volatile assets like stocks or a private business.  Your home is not an ATM.  That same logic should apply to a brokerage account.

If you do borrow against an appreciated asset in order to spend, that may increase your spending one time, but unless the value of your assets continually increases, you won’t be able to do it forever.  And, if asset values fall dramatically, you may find that if your debts are greater than your assets, that your spending may go down considerably as you pay back debt to hold onto your assets.

Now, if a lot of people are inverted in their borrowing, an increase in the overall price level of assets could make some people un-invert and breathe easier, and after a while, spend more from their incomes.  But the rise there will likely be offset by others whose savings aren’t worth as much being reticent to spend.

Pay Yourself a Greater Dividend or Salary

If you own all of a given asset, this becomes a question of taking income versus spending on capital expenditures to grow or maintain the business.  Greater personal spending is offset by lesser business spending.  Oh, and you have to pay tax on the income you receive.  If you own part of the business, but still control it, receiving a higher salary disproportionately helps you versus your minority shareholders.  You might be able to spend more, but it comes out of their pockets.

Trade Your Assets for Assets that Pay a Higher Income

You might want to look at two articles of mine:

First, it’s a simple trade.  You might have more income to spend, but someone else has less on average.  Beyond that, it makes more sense to pursue investments that give you the best returns regardless of how much income they pay.  You can decide on the income you need via dividends, selling bits of the investment, etc.

Income is not an inherent aspect of an asset.  Within bounds, it is arbitrary, as noted in the two articles to which I linked.  As a result, choosing a higher income set of assets may not give you more to spend over time.  Even if Congress passed a law tomorrow saying that all companies, public and private, have to pay a dividend equal to 3% of market value (or fair value, however determined), it might increase personal taxable income, but many would reinvest it while some would spend.  As for the corporations, they would have to spend less on capital expenditures, or borrow more to fund them.  A great increase in spending would be unlikely.

Summary

None of the ways I mentioned for getting more money for spending out of investments is likely to produce a lot of additional spending in aggregate across the economy.  As a result, I think that the Executive Branch, the Congress, and the Federal Reserve should be cautious of trying to make asset values rise, or encourage more borrowing against assets.  It will likely not have any significant effect to grow the economy over the intermediate -to-long term.

Photo Credit: Moyan Brenn || My, now doesn't that look peaceful...

Photo Credit: Moyan Brenn || My, now doesn’t that look peaceful…

There is the temptation when market prices move fast after they have been at recent highs to assume that things are going to fall apart.  Well, guess what?  That could happen.

I don’t think it is likely though, if falling apart means a scenario like 2008-9, 2000-2 or 1973-4.  In order to have a significant drawdown in the market, you have to have a lot of leverage collapse, whether that is financial or operating leverage.

Financial leverage is bad debt.  We have areas of that — student loans, agricultural loans, a modest amount of subprime lending for autos, and a decent amount of lending to junk-rated corporations, but not enough to create a self-reinforcing situation where bad debts can’t be borne by lenders, and lenders then collapse.

Operating leverage is bad assets — building up too much productive capacity such that there will not be enough demand to absorb it for the foreseeable future.  Or, building capacity that isn’t productive… either way, assets will have to be written down.

There have been a number of parties kvetching about a lack of investment from US corporations, but let’s take this a different direction.  There hasn’t been a lot of bad investment from US corporations… and part of that may be due to dividend and buyback policies.  Yes, there are some IPOs that have come out that look marginal.  I’ve looked at a variety of spin-offs where the underlying business is attractive, but they loaded the spin-off with a sizable slug of debt in order to pay a final dividend to the parent company saying farewell.  But on the whole, I don’t see a lot of money being wasted by corporations on investments.  That is another reason why profit margins are high.

Now, a lot of the furor in the markets stems from China, and the effects that slowing growth and/or bad debts in China will have on the US economy.  Personally, I don’t think this is an issue to worry about, unless you have a lot of investments in China and other emerging markets.  In general, US markets don’t get deeply hurt by slowdowns or even crises in other countries.  Even if it means a slowdown in revenue growth for large US corporations, it would also likely mean that US interest rates might fall, which would often make equities fall less as bonds rally.

Also, for foreign affairs to affect the US in a big way, the US would have to have a lot of lending exposure to those nations that are struggling.  (Think of the LDC nations in the early ’80s.)  Maybe this is one of the benefits of running current account deficits — we don’t have money to lend to foreign countries from our net export earnings.

Think of all the significant foreign crises of the last 30 years.  LDC crisis, Plaza Accords leading to Japan’s lost decades, Mexico, Asian Crisis, European Union difficulties with their fringe nations, Iceland, Greece, Greece, Greece, China, etc.  There was always temporary indigestion in US markets, but when did it ever weigh on the US markets for a long period?  Really, it never did.  So why are we concerned over China?

Regarding the Fed, I abstract from this old post, which quoted a 2005 piece on Fed policy at RealMoney.com, and what blew up at the end of each tightening cycle.  I list blow-ups up to that point, and mention that I think US Housing is next:

  • 2000 — Nasdaq
  • 1997-98 — Asia/Russia/LTCM, though that was a small move for the Fed
  • 1994 — Mortgages/Mexico
  • 1989 — Banks/Commercial Real Estate
  • 1987 — Stock Market
  • 1984 — Continental Illinois
  • Early ’80s — LDC debt crisis

So it moves in baby steps, wondering if the next straw will break some camel’s back where lending has been going on terms that were too favorable. The odds of this 1/4% move creating such a nonlinear change is small, but not zero.

But on the bright side, the odds of a 50 basis point tightening at any point in the next year are even smaller. The markets can’t afford it.

Position: None

Or, these two posts, which you can look at if you want… one suggested that housing was the next bubble (in 2004), and the other critiqued Bernanke’s reasoning on monetary policy.  (Aaron Task has an interesting rejoinder to the latter of these.) — [DM: these links are dead now.]

 

Some worry now about future Fed policy — what will blow up when the Fed tightens too much?  I would encourage everyone to relax.  First, we don’t know that the Fed will do anything soon.  Second, we don’t know if they will do anything much.  Third, we don’t even know if the Fed has a coherent theory of monetary policy anymore.  Face it: Yellen has never tightened rates once.  Bernanke never tightened rates aside from finishing out Greenspan’s plan to invert the yield curve at the beginning of his Chairmanship.  Almost no one on the FOMC has any significant practical experience with tightening rates.  What will guide them out of their zero interest rate policy?  What will be enough?

Even so, tightening cycles usually end with something blowing up.  Maybe this time it is the emerging markets.  I don’t see a large concentration of US-based bad debt that the Fed might inadvertently blow up, at least not yet.  (Maybe the day will come when the US Treasury might complain about rising financing rates.  After all, debt is high, but affordable while rates are low.)

Valuation is the main issue as I see it at present, as I commented in my recent piece “Stocks or Bonds?”  When stocks are priced at a level that discounts 4.5%/year returns over the next 10 years, you don’t have a lot of margin for error, especially when you can create a safer bond portfolio that yields the same.

Now, since I wrote that piece, the S&P 500 is down around 10.5%.  The bond portfolio is down around 4.5% (it was a risky portfolio, and some of the emerging markets bonds hurt), while the Barclays’ Aggregate is up 1%.  High-yield bond spreads have widened over that time by ~1.2%.

The anticipated return on the S&P 500 has maybe risen by 1%/year over the next 10 years, to 5.5%.  That said, so has the yield on the risky bond portfolio.  I see the selloff as being in-line with the yields of risky debt, which at some higher level of spread, will attract buyers, given that there have been no significant defaults recently.

The US stock market could go down another 20% from here, but I think it will be less.  My main point is that we shouldn’t get a big washout, but just a correction of valuation levels that got too high relative to other risky assets, like junk bonds.

So don’t panic.  You could still move some assets from stocks to bonds if you want to sleep better, but don’t do anything severe.

Too often in debates regarding the recent financial crisis, the event was regarded as a surprise that no one could have anticipated, conveniently forgetting those who pointed out sloppy banking, lending and borrowing practices in advance of the crisis.  There is a need for a well-developed model of how a financial crisis works, so that the wrong cures are not applied to the financial system.

All that said, any correct cure will bring about a predictable response from the banks and other lending institutions.  They will argue that borrower choice is reduced, and that the flow of credit and liquidity to the financial system is also reduced.  That is not a big problem in the boom phase of the financial cycle, because those same measures help to avoid a loss of liquidity and credit availability in the bust phase of the cycle.  Too much liquidity and credit is what fuels eventual financial crises.

To get to a place where we could have a decent model of the state of overall financial credit, we would have to have models that work like this:

  1. The models would have to have both a cash flow and a balance sheet component to them — it’s not enough to look at present measures of creditworthiness only, particularly if loans do not fully amortize debts at the current interest rate.  Regulatory solvency tests should not automatically assume that borrowers will always be able to refinance.
  2. The models should try to go loan-by-loan, and forecast the ability of each loan to service debts.  Where updated financial data is available on borrowers, that should be included.
  3. The models should try to forecast the fair market prices of assets/collateral, off of estimated future lending conditions, so that at the end of the loan, estimates can be made as to whether loans would be refinanced, extended, or default.
  4. As asset prices rise, there has to be a feedback effect into lowered ability to finance new loans, unless purchasing power is increasing as much or more than asset prices.  It should be assumed that if loans are made at lower underwriting standards than a given threshold, there will be increasing levels of default.
  5. A close eye would have to look for situations where if the property were rented out, it would not earn enough to pay for normalized interest, taxes and maintenance.  When asset prices are that high, the system is out of whack, and invites future defaults.  The margin of implied rents over normalized interest, taxes and maintenance would be the key measure, and the regulators would have to have a function that attributes future losses off of the margin of that calculation.
  6. The cash flows from the loans/mortgages would have to feed through the securitization vehicles, if any, and then to the regulated financial institutions, after which, how they would fund their future liabilities would have to be estimated.
  7. The models would have to include the repo markets, because when the prices of collateral get too high, runs on the repo market can happen.  The same applies to portfolio margining agreements for derivatives, futures, and other types of wholesale lending.
  8. There should be scenarios for ordinary recessions.  There should also be some way of increasing the Ds at that time: death, disability, divorce, disaster, dis-employment, etc.  They mysteriously tend to increase in bad economic times.

What a monster.  I’ve worked with stripped-down versions of this that analyze the Commercial Mortgage Backed Securities [CMBS] market, but the demands of a model like this would be considerable, and probably impossible.  Getting the data, scrubbing it, running the cash flows, calculating the asset price functions, implied margin on borrowing, etc., would be pretty tough for angels to do, much less mere men.

Thus if I were watching over the banks, I would probably rely on analyzing:

  • what areas of credit have grown the quickest.
  • where have collateral prices risen the fastest.
  • where are underwriting standards declining.
  • what assets are being financed that do not fully amortize, including all repo markets, margin agreements, etc.

The one semi-practical thing i would strip out of this model would be for regulators to score loans using a model like point 5 suggests.  Even that would be tough, but even getting that approximately right could highlight lending institutions that are taking undue chances with underwriting.

On a slightly different note, I would be skeptical of models that don’t try to at least mimic the approach of a cash flow based model with some adjustments for market-like pricing of collateral and loans.  The degree of financing long assets with short liabilities is the key aspect of how financial crises develop.  If models don’t reflect that, they aren’t realistic, and somehow, I expect that non-realistic models of lending risk will eventually be the rule, because it helps financial institutions make loans in the short run.  After all, it is virtually impossible to fight loosening financial standards piece-by-piece, because the changes seem immaterial, and everyone favors a boom in the short-run.  So it goes.

Photo credit: jonesylife || Oh look, a dozen doves flying at the FOMC!

Photo credit: jonesylife || Oh look, a dozen doves flying at the FOMC!

June 2015July 2015Comments
Information received since the Federal Open Market Committee met in April suggests that economic activity has been expanding moderately after having changed little during the first quarter.Information received since the Federal Open Market Committee met in June indicates that economic activity has been expanding moderately in recent months.No real change.
Growth in household spending has been moderate and the housing sector has shown some improvement; however, business fixed investment and net exports stayed soft.Growth in household spending has been moderate and the housing sector has shown additional improvement; however, business fixed investment and net exports stayed soft.No real change. Swapped places with the following sentence.
The pace of job gains picked up while the unemployment rate remained steady. On balance, a range of labor market indicators suggests that underutilization of labor resources diminished somewhat.The labor market continued to improve, with solid job gains and declining unemployment. On balance, a range of labor market indicators suggests that underutilization of labor resources has diminished since early this year.No real change. Swapped places with the previous sentence.
Inflation continued to run below the Committee’s longer-run objective, partly reflecting earlier declines in energy prices and decreasing prices of non-energy imports; energy prices appear to have stabilized.Inflation continued to run below the Committee’s longer-run objective, partly reflecting earlier declines in energy prices and decreasing prices of non-energy imports.No real change.
Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.Market-based measures of inflation compensation remain low; survey‑based measures of longer-term inflation expectations have remained stable.No change.  TIPS are showing higher inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.10%, up 0.07% from April.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandateNo real change.
The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of earlier declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of earlier declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.CPI is at +0.2% now, yoy.  No change in language.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.No change.
The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.No real change.

No rules, just guesswork from academics and bureaucrats with bad theories on economics.

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.No change.  Changing that would be a cheap way to effect a tightening.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.No Change.

“Balanced” means they don’t know what they will do, and want flexibility.

Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.No change, sadly.

We need some people in the Fed and in the government who realize that balance sheets matter – for households, corporations, governments, and central banks.  Remove anyone who is a neoclassical economist – they missed the last crisis; they will miss the next one.

Comments

  • This FOMC statement was another great big nothing. No significant changes.
  • Don’t expect tightening in September. People should conclude that the FOMC has no idea of when the FOMC will tighten policy, if ever.  This is the sort of statement they issue when things are “steady as you go.”  There is no hint of imminent policy change.
  • Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.  Wage growth is weak also.
  • Equities and long bonds rise. Commodity prices and the dollar are flat.
  • The FOMC says that any future change to policy is contingent on almost everything.
  • Don’t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain’t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.
  • We have a congress of doves for 2015 on the FOMC. Things will continue to be boring as far as dissents go.  We need some people in the Fed and in the government who realize that balance sheets matter – for households, corporations, governments, and central banks.  Remove anyone who is a neoclassical economist – they missed the last crisis; they will miss the next one.

There’s a lot of talk about the Chinese stock market falling. I look at it as an opportunity to talk about why bubbles develop in markets, and why governments don’t take steps to avoid them until it is too late — also, why they try to prop the bubbles up, even though it is hopeless.  But first an aside:

Three weeks ago, I was interviewed on RT/America Boom/Bust.  Half of the interview aired — the part on domestic matters.  The part on Greece and China didn’t air, and what a pity.  I argued that China today was very much like Japan in the late ’80s, where the Japanese had a hard time investing abroad, and had an expansive monetary policy.  People had a hard time figuring out where to put their money.  Savings and fixed income didn’t offer much.  Real Estate was great if you could afford it.  The stock market was a place for putting money to work — and it had a lot of momentum behind it.

China has the added complexity of wealth management products which are opaque and many are Ponzi schemes.  Also, the fixed income markets in China are not as mature as Japan’s markets 30 years ago.  Both have the difficulties that they are too big for some of the indexes that international investors use.

Another reason for the bubbly behavior was use of margin, both formal and informal, and, the tendency for stock investors to have very short holding periods.  Short-termism and following momentum is most of what creates bubbles.  Ben Graham’s voting machine dominates, until the weighing machine takes over, and the voting machine votes the opposite way.

Long term assets like stocks should be financed with equity, or at worst, long-term debt.  Using a lot of margin debt to finance equity leads to a rocket up, and a rocket down.  When the amount of equity in the  account gets too low, more assets have to be added, or stocks will have to be liquidated to protect the margin loan that the broker made.  When enough stocks in margin accounts are forced to be sold, that can drive stock prices down, leading to a self-reinforcing cycle, until the debt levels normalize at much lower levels.  This is a part of what happened in the Great Depression in the US.

Now governments never argue with bubbles when they expand, because no one dares to oppose a boom.  (Note: that article won a small award. Powerpoint presentation here.)  The powers that be love effortless prosperity, and no one wants to listen to a prophet of doom when the Cabaret is open.

Now, the prosperity is mostly fake, because all of the borrowing is temporarily pulling future prosperity into the present.  When the bubble pops, that will revert with a vengeance, leaving behind bad debts.

Despite the increase in debts, and speculative changes in economic behavior, most policymakers will claim that they can’t tell whether a bubble is growing or not.  Their bread is buttered on the side of political contributions from financial firms.

But when the bubble pops, and things are ugly, governments will try to resist the deflating bubble — favoring relatively well-off asset owners over not-so-well-off taxpayers.  In China at present, they are closing down markets for stocks (if it doesn’t trade, the price must not be falling).  They are trying to be more liberal about liquidating margin debt.  They are limiting share sales by major holders.  They are postponing IPOs.  They are inducing institutions to buy stock.

China thinks that it can control and even reverse the deflating bubble.  I think they are deluded.  Yes, they are relatively more powerful in their own country than US regulators and policymakers.  But even if their institutions were big enough to suck up all of the stock at existing prices, it would merely substitute on problem for another: the institutions would be stuck with assets that have low forward-looking returns.  If you use those to fund a defined benefit pension plan, you will likely find that you have embedded a loss in the plan that will take years to reveal itself.

As a result, since China is much larger than Greece, its problems get more attention, because they could affect the rest of the world more.  For Western investors without direct China exposure, I’m not sure how big that will be, but with highly valued markets any increase in volatility could cause temporary indigestion.

The one bit of friendly advice I might offer is don’t be quick to try to catch a falling knife here.  It might be better to wait. and maybe buy stocks in countries that get unfairly tarred by any panic coming out of China, rather than investing in China itself.  Remember, margin of safety matters.  More on that coming in a future post.

Photo credit: jonesylife || Oh look, a dozen doves flying at the FOMC!

Photo credit: jonesylife || Oh look, a dozen doves flying at the FOMC!

 

April 2015June 2015Comments
Information received since the Federal Open Market Committee met in March suggests that economic growth slowed during the winter months, in part reflecting transitory factors.Information received since the Federal Open Market Committee met in April suggests that economic activity has been expanding moderately after having changed little during the first quarter.Shades GDP up.  Why can’t the FOMC accept that the economy is structurally weak?
The pace of job gains moderated, and the unemployment rate remained steady. A range of labor market indicators suggests that underutilization of labor resources was little changed.The pace of job gains picked up while the unemployment rate remained steady. On balance, a range of labor market indicators suggests that underutilization of labor resources diminished somewhat.Shades labor use up.
Growth in household spending declined; households’ real incomes rose strongly, partly reflecting earlier declines in energy prices, and consumer sentiment remains high. Business fixed investment softened, the recovery in the housing sector remained slow, and exports declined.Growth in household spending has been moderate and the housing sector has shown some improvement; however, business fixed investment and net exports stayed soft.Shades up their view of household spending.  Drops a comment on consumer sentiment (that only lasted one month).
Inflation continued to run below the Committee’s longer-run objective, partly reflecting earlier declines in energy prices and decreasing prices of non-energy imports.Inflation continued to run below the Committee’s longer-run objective, partly reflecting earlier declines in energy prices and decreasing prices of non-energy imports; energy prices appear to have stabilized.Notes stable prices of energy, even though prices have risen over the last two months.
Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.No change.  TIPS are showing lower inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.03%, down 0.07% from April.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
Although growth in output and employment slowed during the first quarter, the Committee continues to expect that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.No real change.
The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of earlier declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.CPI is at -0.1% now, yoy.  No change in language.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.No change.
The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.No change.

No rules, just guesswork from academics and bureaucrats with bad theories on economics.

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.No change.  Changing that would be a cheap way to effect a tightening.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.No Change.

“Balanced” means they don’t know what they will do, and want flexibility.

Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.No change, sadly.

We need some people in the Fed and in the government who realize that balance sheets matter – for households, corporations, governments, and central banks.  Remove anyone who is a neoclassical economist – they missed the last crisis; they will miss the next one.

Comments

  • This FOMC statement was a great big nothing. No significant changes.
  • People should conclude that the FOMC has no idea of when the FOMC will tighten policy, if ever. This is the sort of statement they issue when things are “steady as you go.”  There is no hint of imminent policy change.
  • The FOMC has a stronger view of GDP, energy prices and labor use.
  • Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.  Wage growth is weak also.
  • Equities rise and long bonds are flat. Commodity prices rise and the dollar falls.  The FOMC says that any future change to policy is contingent on almost everything.
  • Don’t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain’t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.
  • We have a congress of doves for 2015 on the FOMC. Things will continue to be boring as far as dissents go.  We need some people in the Fed and in the government who realize that balance sheets matter – for households, corporations, governments, and central banks.  Remove anyone who is a neoclassical economist – they missed the last crisis; they will miss the next one.

I had the fun today of taping a segment with Ameera David on RT Boom/Bust. The above video covers the first half of the session, and lasts about seven minutes. We covered the following topics (with links to articles of mine, if any are applicable):

The second half, should it make it onto the show, deals mostly with international issues.  Enjoy the video, if you want to.

Photo Credit: Moyan Brenn || What's more illiquid than the desert?

Photo Credit: Moyan Brenn || What’s more Illiquid than the desert?

I’ve read a lot of articles about bond market illiquidity, and I don’t think it is as big of an issue as many are making it out to be.  The bond market often runs hot and cold, and when prices and yields are moving, it is difficult to get off trades at levels you might like unless you are resisting the trend.  And if you are resisting the trend, will you like the trade one week later, when the trade might look poor in hindsight?

Part of the difficulty is that the buy side has gotten more concentrated.  Bigger players by their nature can’t move in and out of positions without moving the market against their interests.  Illiquidity is a rule of life for them.  They may as well become market makers to some degree — offering bonds they want to keep at prices at which only the desperate would want to buy.   Also, they could bid for bonds at levels at which only the desperate would want to sell.

Add into that the amount of bonds tucked away in ETFs.  The ETFs may seem to offer liquidity at no cost, but retail investors tend to panic more rapidly than institutional investors.  If retail investors run away from any part of the market, the ETFs in that part of the market will be among the managers selling into a falling market, and there is a cost to that, at least for those slower to sell the ETFs in question.

But away from that, current monetary policy leaves many on pins and needles waiting for short rates to rise.  Now, there is no guarantee that short rates will rise in 2015.  The Fed has shown itself to be extra slow to act in this cycle, and the current FOMC has no hawks — not that the hawks matter — their views are not a part of current monetary policy.

But even if short rates rise, there is no guarantee that long rates will follow.  In the last tightening cycle, long rates stayed the same with a lot of noise that included falling long yields in the early phases.  The global economy isn’t that strong, and interest rates in the middle of the curve tend to track nominal GDP growth (with a lot of noise).

You can position yourself for rising short rates, but you have to give up a lot of income (carry) to do so.  How long can you bear to earn very little, particularly if you are earning a management fee that eats up a lot of the income?

Situations like this are naturally twitchy, because things are unclear, but as things clarify, there may be many who will want to sell longer bonds to buy shorter bonds where rates will rise.  If long rates do rise along with short rates, who pray tell will be the philanthropist that holds onto the long bonds and eats losses for clients that want positive (or at least small negative) total returns?

There is a price for almost every asset, but there is no guarantee of being able to sell a lot of long bonds if rates are rising, and certainly not without offering a large price concession.  That’s illiquidity, which naturally happens if you try to trade against a large trend in the bond market.

That brings me to my main point:

Bonds should be illiquid now.  Why should you expect otherwise?

No one is out to do you voluntary favors in the markets.  Why should markets have narrow bid-ask spreads when there is significant policy uncertainty, and large players that hold a large fraction of the total bond market?  At a time like this, I would only want to make a market if the compensation was significant.

Two unrelated notes before I sign off.  First, I sold my position in long Treasuries about a month ago, when 30-year yields crossed 2.80%.  I had owned the long bonds for quite a while and had decent profits on them.  I felt the current selloff might have legs, which may be true (or not).  So, I am below market duration at present, and earning ~4% off of a variety of short investment grade corporates, bank loans, junk bonds, TIPS, and foreign bonds… so far so good, but I can’t express any significant confidence that this strategy will be a winner.  It’s my best guess for now, as I don’t see many immediate credit risks.  After all, look how little damage the energy sector took on even with oil prices that fell hard.  There is a lot of money looking around for bargains.

Second, if I were a large corporate bond issuer, I would look to form a consortium with my fellow large issuers to set up an auction market for the new issuance of bonds, and bypass Wall Street.  Why?  Because the new issue yield premiums are large.  Why should large money managers benefit from the new issue market?  Yes, I know that offering liquidity should receive some reward, but not as large as it is at present.

This is a modern era, and the need for intermediaries in the IPO market for bonds is less needed.  Let the buy side, which is starved for new bonds and yield, pay up for the privilege of receiving the bonds.  Who knows?  Maybe the issuers might borrow a little more as a result.

Hey, CFOs of large bond issuers!  This is your chance to become a hero.  Grab the opportunity, and issue your bonds with your peers through a mutually owned central auction house.  Who knows?  One day you could spin it off, and it could become… an investment bank. 😉

Photo credit: jonesylife

Photo credit: jonesylife || Oh look, there are twelve doves flying!

March 2015April 2015Comments
Information received since the Federal Open Market Committee met in January suggests that economic growth has moderated somewhat.Information received since the Federal Open Market Committee met in March suggests that economic growth slowed during the winter months, in part reflecting transitory factors.Shades GDP down.  Why can’t the FOMC accept that the economy is structurally weak?
Labor market conditions have improved further, with strong job gains and a lower unemployment rate. A range of labor market indicators suggests that underutilization of labor resources continues to diminish.The pace of job gains moderated, and the unemployment rate remained steady. A range of labor market indicators suggests that underutilization of labor resources was little changed.Shades labor use down.
Household spending is rising moderately; declines in energy prices have boosted household purchasing power. Business fixed investment is advancing, while the recovery in the housing sector remains slow and export growth has weakened.Growth in household spending declined; households’ real incomes rose strongly, partly reflecting earlier declines in energy prices, and consumer sentiment remains high. Business fixed investment softened, the recovery in the housing sector remained slow, and exports declined.Shades down their view of household spending.  Adds a comment on consumer sentiment.

Also shades down business fixed investment and exports.

 

Inflation has declined further below the Committee’s longer-run objective, largely reflecting declines in energy prices. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.Inflation continued to run below the Committee’s longer-run objective, partly reflecting earlier declines in energy prices and decreasing prices of non-energy imports. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.Notes lower prices of energy and imports.

TIPS are showing lower inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.10%, up 0.16% from January.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.Although growth in output and employment slowed during the first quarter, the Committee continues to expect that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.No real change. They are fitting Einstein’s definition of insanity – doing the same thing, and expecting a different outcome.
The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of energy price declines and other factors dissipate. The Committee continues to monitor inflation developments closely.The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.CPI is at -0.0% now, yoy.  No change in language.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.No change.
Consistent with its previous statement, the Committee judges that an increase in the target range for the federal funds rate remains unlikely at the April FOMC meeting. Deleted
The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.No change.

No rules, just guesswork from academics and bureaucrats with bad theories on economics.

This change in the forward guidance does not indicate that the Committee has decided on the timing of the initial increase in the target range. Deleted
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.No change.  Changing that would be a cheap way to effect a tightening.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.“Balanced” means they don’t know what they will do, and want flexibility.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.No change, sadly.

We need some people in the Fed and in the government who realize that balance sheets matter – for households, corporations, governments, and central banks.  Remove anyone who is a neoclassical economist – they missed the last crisis; they will miss the next one.

Comments

  • With this FOMC statement, people should conclude that they have no idea of when the FOMC will tighten policy, if ever. This is the sort of statement they issue when things are “steady as you go.”  There is no hint of imminent policy change.
  • The FOMC has a weaker view of GDP, labor use, household spending, business fixed investment and exports.
  • Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.  Wage growth is weak also.
  • Forward inflation expectations have reversed direction and are rising, and the twitchy FOMC did not note it.
  • Equities rise and long bonds rise. Commodity prices fall and the dollar rises.  The FOMC says that any future change to policy is contingent on almost everything.
  • Don’t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain’t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.
  • We have a congress of doves for 2015 on the FOMC. Things will be boring as far as dissents go.  We need some people in the Fed and in the government who realize that balance sheets matter – for households, corporations, governments, and central banks.  Remove anyone who is a neoclassical economist – they missed the last crisis; they will miss the next one.

Photo Credit: Alcino || What is the sound of negative one hand clapping?

Photo Credit: Alcino || What is the sound of negative one hand clapping?

As with many of my articles, this one starts with a personal story from my insurance business career (skip down four paragraphs to the end of the story if you want):

25 years ago, when it was still uncommon, I wanted to go to an executive course at the Wharton School for actuaries that wanted to better understand investment math and markets.  I went to my boss at AIG (a notably tight-fisted firm on expenses) and asked if the company would pay for me to go… it was an exclusive course, and very expensive compared to any other conference that I would ever go to again in my life.  I tried not to get my hopes up.

Lo, and behold!  AIG went for it!

A month later, I was with a bunch of bright actuaries at the Wharton School.  The first thing I noticed was aside from the compound interest math, and maybe some bond knowledge, the actuaries were rather light on investment knowledge, and I would bet that all of them had passed the Society of Actuaries investment course.  The second thing I noticed were some of the odd investments described in the syllabus: it was probably my first taste of derivative instruments.  At the ripe old age of 29, I was learning a lot, and possibly more than the rest of my classmates, because I had spent a lot of time studying investments already, both on an academic and practical basis.

I had already studied the pricing of stock options in school, so I was familiar with Black-Scholes.  (Trivia note: an actuary developed the same formula for valuing optionally terminable reinsurance treaties six years ahead of Black, Scholes and Merton.  That doesn’t even take into account Bachelier, who derived it 73 years earlier, but no one knew about it, because it was written in French.)  At this point, the professor left, and a grad student came in to teach us about the pricing of bond options.  At the end of his lesson, it was time for the class to have a break.  I went down to make a comment, and it went like this:

Me: You said that we have to adjust for the fact that interest rates can’t go negative.

Grad student: Of course.

Me: But interest rates could go negative.

GS: That’s ridiculous!  Why would you ever lend money and accept back less than you gave them, and lose the time value of money?!

Me: Almost of the time, you wouldn’t.  But imagine a scenario where the demand for loanable funds leaves interest rates near zero, but the times are insecure and violent, leaving you uncertain that if you stored your cash privately, you would run too large of a risk of having it stolen.  You need your cash in the future for a given project.  In this case, you would pay the bank to store your money.

GS: That’s an absurd scenario!  That could never happen!

Me: It’s unlikely, I admit, but I wouldn’t say that you can never have negative interest rates.

GS: I will say it again: You can NEVER have negative interest rates.

Me: Thanks, I guess.

Well, so much for the distant past.  Here is why I am writing this: yesterday, a friend of mine wrote me the following note:

Good evening.  I trust you had a blessed Lord’s Day in the new building. 

Talking bonds today with my Econ class.  Here’s our question. Other than playing a currency angle why would anyone buy European debt with a negative yield?  The Swiss and at least one other county sold 10 year notes with a negative yield.  Can you explain that?  No interest and less principle [sic] at the end.

Now, I didn’t quite get it perfectly right with the grad student at Wharton, but most of it comes down to:

  • Low demand for loanable funds, with low measured inflation, and
  • Security and illiquidity of the funds invested

The first one everyone gets — inflation is low, and few want to borrow, so interest rates are very low.  But that doesn’t explain how it can go negative.

Things are different for middle class individuals and large financial institutions.  Someone in the middle class facing negative interest rates from a checking or savings account could say: “Forget it.  I’m taking most of my money out of the bank, and storing it at home.”  Leaving aside the inconvenience of currency transaction reports if the amount is over $10,000, and worries over theft, he could take his money home and store it.  Note that he does have to run a risk of theft, though, so bringing the money home is not costless.

The bank has the same problem, but far larger.  If you don’t invest the money, where would you store it?  Could you even get enough currency delivered to do it?  if you had a vault large enough to store it, could you trust the guards?  Why make yourself a target?  If you don’t have a vault large enough to store it, you’re in the same set of problems that exist for those that warehouse precious metals, but with a far more liquid commodity.

Thus in a weak economic environment like this, with low inflation, banks and other financial institutions that want certainty of payment in the future are willing to pay interest to get their money back later.

Part of the problem here is that the fiat currencies of the world exist only to be units of account, and not stores of value.  Thus in this unusual environment, they behave like any other commodity, where the prices for futures are often higher than the current spot price, which is known as backwardation.  (Corrected from initial posting — i.e. it costs more to receive a given cash flow in the future than today, thus backwardation, not contango.)  The rates can’t get too negative, though, or some institutions will bite the bullet and store as much cash as they can, just as other commodities get stored.

To use another analogy, a while ago, some market observers couldn’t get why anyone would accept a negative yield on Treasury Inflation Protected Securities [TIPS].  They did so because they had few other choices for transferring money to the future while still having inflation protection.  Some people argued that they were locking in a loss.  My comment at the time was, “They’re trying to avoid a larger loss.”

Thus the difficulty of managing cash outside of the bond/loan markets in a depressed economy leads to negative interest rates.  The financial institutions may lose money in the process, but they are losing less money than if they tried to store and protect the money, if that could even be done.