Macroeconomics – The Aleph Blog

The Future is More Variable than the Present

Posted on 3 May 20203 May 2020 by David Merkel

Photo Credit: Michael Dales || Futuristic, and with a twist

Well, I am back. This post will test whether images will post or not. My guess right now is not, so maybe I have more work to do.

Once I know that images will post, I will repost the deleted articles. On to tonight’s piece:

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There are many who get annoyed at the concept that the market is rallying while unemployment is soaring. Though this is not true now, others get annoyed at the market falling when the economy is humming along quite nicely.

My friend Howard Simons said something like, �Stocks aren�t GDP futures.�� There are several reasons for this:

When corporate bond yields fall, stock valuations tend to rise. When corporate bond yields rise, stock valuations tend to fall. Corporate bond yields fall when there is economic weakness, and rise when there is economic strength.
Stocks react to changes in estimates of future profits (or free cash flow). That doesn’t have much to do with present economic distress or success.
When there is a disaster, not all stocks share in the trouble equally. Companies with strong business models. low operating leverage and strong balance sheets get hurt less. The other companies fall into distress. The financial stress on those companies can lead to sales of assets, letting go of employees, and perhaps default. Those getting unemployed often work for a different group of companies than the ones where their stock prices are rising. (Creative destruction benefits society in aggregate, but not everyone benefits. Those who benefit do not all benefit equally.)

The main thing is there is only one present, and there are many possible futures. Shifts in government policy, particularly during times of stress, can rapidly shift estimates of what the future may hold, which makes the market move.

As such, I encourage caution when markets are moving rapidly. We know the future poorly, but in general optimism triumphs so long as there is overall stability. As I said 13+ years ago:

“Moderate bullishness should be the posture of most investors because absent famine, plague, war on your home soil, and aggressive socialism, markets tend to appreciate over the intermediate term.”
Closing Comments for 3-1-07

Now all that said, don’t assume that recent bullishness is fully correct. Valuations are high. Part of that is that corporate bond yields are low. But if anything happens that shifts expectations of profit margins down for a long time, there is room for the market to fall. Treasury yields might fall in a scenario like that, but corporate yield spreads would rise more.

It’s a good time to pick through your portfolio and find what might not survive so well if the economy does not pull together as quickly as we might like. Avoid marginal names that could be subject to distress. For non-financials and non-utilities, one test is to look at the ratio of debt to market capitalization, and consider scaling back positions where the the ratio is over one.

Remember, you are your own best defender. Moderate risk taking generally wins, so trim back the aspects of your investing that don’t fit that.

PS — If you want a “blast from the past” you can read the piece When the Sirens Sing, How to Avoid Giving in� I quote some of my old lost columnist conversation posts from 2006, including one entitled “More Things Can Go Wrong Than Will Go Wrong.” Maybe that could have been today’s title.

Notes and Comments

Posted on 25 April 20206 June 2020 by David Merkel

1) I still can�t post images at my blog. If you can believe it, WordPress is trying to fix it. The one cost involved is that the last three posts will be wiped out, and all comments since 4/8.

2) I�ve spent the time since my last post improving my models. I played around with a seven-parameter model, but found that it took ~10,000x as much time to converge to a solution, and there were multiple solutions with very different results that fit close to equally well. My conclusion was that they were different ways to amplify noise.

Instead, I created a second model based on the idea that the rate of growth of total cases was exponentially decaying at a rate slower than that of the first model. The new case figures have been coming at rates far closer to the second model.

I�m sensitive to when models keep having errors in the same direction� 2-3 weeks ago, errors were close to even � as many up as down. But since then more new cases have persistently come in than the first model would have predicted.

Austria, Switzerland and Germany are fine, but most of nations I have modeled have a long way to go, if model 2 is closer to the truth. Add five weeks onto getting to the 99% point.

As such, don�t put me in the camp of optimists any more. I recognize my initial predictions were wrong. Some of it stems from increasing testing as time has gone on. Indeed, what will happen if that study in New York is correct (seems to be too small of a sample, and perhaps biased), and maybe 10-15% of the NY population caught COVID-19 with almost no symptoms? That is mostly a good thing, and might even be a testimony to how little reported cases moved up in the face of that � social distancing restrains the spread of COVID-19, particularly with those who would be most harmed distancing via self-quarantine.

3) I think the history books will end up calling this the voluntary recession, where governments chose ham-fisted solutions out of fear, and did not consider the long-run implications of draconian solutions like general quarantine. What are the effects on:

Unemployment
Division of labor
Pensions, both public and private
health care for those that don�t have COVID-19
Small businesses that run out of resources

Death rates rise from sudden recessions. Might it be more than the lives saved via general quarantine. What Sweden is doing makes more sense. Yes, their death rates are a little higher, but they didn�t close many things at all � their populace has covered up, and kept working. They integrated social distancing into their total lives, including work.

4) But, after the crisis is over, there will be some things that we realize we did not need. Will a video teleconference do as well as a trip to a remote office? How much additional productivity do we get or lose from having staff in a single location? Hay, I can cook for myself! I don�t have to go to restaurants! We don�t need low-end malls! And more� we just don�t know what all will change. That said, never underestimate the ability of Americans to forget.

5) There are charities that help some businesses finance their inventories. They are called commodity ETFs. Long ago, I wrote about the folly of buying ETFs that follow complex strategies. USO always underperformed. This past week was the worst of it.

Negative prices for oil futures are like negative interest rates. If you can safely store paper currency, you will never have a negative interest rate. If you can safely store oil, then a day will come when you can use or sell it.

6) One of my clients asked me what I thought about what the Fed is doing now. My answer is this: they aren�t doing much. The market took their bluff and ran with it. How is this?

All of the risk flows back to the US Treasury explicitly or implicitly, via loss of seigniorage.
They are mostly financing assets, not buying them.
When they are buying assets, they aren�t taking much risk, either in duration or credit.
The QE that they are doing is just a closed loop with the banks � it doesn�t get into the general economy.

The Fed makes me think of a nerdy kid who thinks he is being cool, but all the cool kids know he is a nerd. That said, in this case a good bluff can be quite effective if the cash keeps flowing.

Personally, I like the fact that the Fed is taking little risk. That�s the way a central bank should be. But that�s not the way the markets are interpreting the matter � they think the Fed will always rescue them.

7) But at least at present, I don�t think we are using MMT yet, unless you mean that the Fed buys government debt.

To me, the big question is when do foreign entities get sick of owning US Dollar claims? When do foreign governments finally say that they won�t subsidize exporters anymore, and will stop investing in US Dollar claims?

Of the major governments, the US is the �cleanest dirty shirt,� but when will the free ride of cheap capital end? Nature abhors free lunches, and this one has gone on for a long time� pity that the competition is so poor.

8 ) When will we learn that savings doesn�t inhibit growth? Stable households and businesses survive better, and ultimately spend more.

9) 60/40 stocks/bonds as an asset allocation has been maligned, but not for any good reason. Yes, high-quality interest rates are low. The real value of bonds is that they don�t fall as much as stocks. In a stock market where valuations are still high, though not relative to bond yields, stocks should play a larger role, but not so much as to eliminate the value of having assets that protect the portfolio against hard falls.

That�s all for now.

On Human Fertility, Part 6

Posted on 2 November 20193 November 2019 by David Merkel

Data Credit: all data in this picture and article came from the CIA factbook. (2018 data)

I write about this once every two years or so. What got me to write this time is this article The Global Fertility Crash. The title is overly sensational, but the article is mostly anecdotal, as it interviews four relatively well-off women about their family sizes and the impact it has had on their lives. To me it wasn’t very informative, and seemed a little behind the curve.

Yes, fertility is falling globally. My guess is that it is falling slower than I have stated in the past, but still falling. Using the CIA Factbook for data, the 2018 total fertility rate for the world is 2.397 births per woman that survives childbearing. That is down from 2.407 in 2016, 2.425 in 2014, 2.467 in 2012, and 2.489 in 2010.? At this rate, the world will be at replacement rate (2.1), somewhere between 2030 and 2050.

This is a story of slow cultural change, mostly stemming from women wanting to be more like men. There are other factors, like reduction of war and disease, rising living standards. More children are living to adulthood, so some reason, why bother to have so many? Why not have one fewer?

I have only seen three answers to that: 1) you can’t trust government security programs if birth rates continue to fall. 2) some don’t trust an ethnic group near them and think it would be wiser to have more people in the future than fewer, and 3) religious faith. The optimism that stems from regular religious worship tends to lead husbands and wives to a few more kids.

But the “one fewer” logic is dominant now. When you see places like Saudi Arabia below replacement rate (2.06), US exceptionalism decreases to 1.87, India decline to 2.40 — something significant is happening.

Now it’s possible that the developed nations, staring at the problems that come from an elderly and shrinking population, may be changing their minds to some degree, and starting to have more children. Take a look at the graphs below:

This next graph expands the southwest corner of the above graph.

Take a look at the light blue line in both graphs. That’s the dividing line between fertility rising and falling. Countries above the line have rising fertility 2010-2018, and countries below the line have falling fertility. You will note that the high fertility nations in 2010 have had falling fertility on average, and low fertility nations have had rising fertility on average. The balance point is at 1.7. Now the nations below 1.7 in 2010 are a smaller portion of the total population than the nations above 1.7 in 2010 — overall fertility has fallen, and is likely to continue to do so. But as I said in the last piece:

I?m chuckling a little bit as I write this, because this [fertility rising in low fertility countries] is an interesting result, and one that I never thought I would be writing when I started this project. ?Interesting, huh? ?My guess is that there is a limit to how much you can get people to reduce family sizes before they begin to question the idea. ?Older parents may say, ?What was that all about?? but children are usually fun and cute when they are little if they are reasonably disciplined.
On Human Fertility, Part 5

I think most of these changes stem from cultural factors and not government incentives. When women conclude that the rewards of society (money, power, approval of peers) go to those with fewer children, that?s a tough cultural idea to overcome. ? Subsidies will not move the needle.

Some husbands and wives may conclude that family life is worth investing in, and they will have one more kid. At present trends, more will conclude that the investment in the future that a child represents is not worth their time, and they will have one fewer kid. Most will just imitate what they see in others, and not think about the issue (or, their issue 😉 ).

To the group having fewer kids, I would tell them that hey are being short-sighted. They should consider their old age. Now, they might be better off financially than those with more kids in their old age, but they will lack key supporters who love them when they are too old to fend for themselves. People without such supporters tend to live less happily, get taken advantage of more often, and lose sanity younger.

And, the future may not be as stable as it is today. Older people rely on stability far more than those who are young. Having young allies is more important when things go bad.

And so I close the article with a note that I am likely to be blessed by my first grandchild next month. I smile and look forward to a future that will hopefully be rich with younger people who love me.

What Caused the Financial Crisis?

Posted on 15 September 201816 September 2018 by David Merkel

Photo Credit: Alane Golden || Sad but true — the crisis was all about bad monetary policy, a housing bubble, and poor bank risk management======================

There are a lot of opinions being trotted around ten years after the financial crisis.? A lot of them are self-serving, to deflect blame from areas that they want to protect.? What you are going to read here are my opinions.? You can fault me for this: I will defend my opinions here, which haven?t changed much since the financial crisis.? That said, I will simplify my opinions down to a few categories to make it simpler to remember, because there were a LOT of causes for the crisis.

Thus, here are the causes:

1) The Federal Reserve and the People?s Bank of China

For different reasons, these two central banks kept interest rates too low, touching off a boom in risk assets in the USA.? The Fed kept interest rates too low for too long 2001-2004. The Fed explicitly wanted to juice the economy via the housing sector after the dot-com bust, and the withdrawal of liquidity post-Y2K.? Also, the slow, predictable way that they tightened rates did little to end speculation, because long rates did not rise, and in some cases even fell.

The Chinese Central Bank had a different agenda.? It wanted to keep the Yuan cheap to continue growing via exporting to the US.? In order to do that, it needed to buy US assets, typically US Treasuries, which balanced the books ? trading US bonds for Chinese goods ? and kept longer US interest rates lower.

Both of these supported the:

2) Housing Bubble

This is the place where there are many culprits.? You needed lower mortgage underwriting standards. This happened through many routes:

US policy pushing home ownership at all costs, including tax-deductibility of mortgage interest.
GSEs guaranteeing increasingly marginal loans, and buying lower-rated tranches of subprime RMBS. They ran on such a thin capital base that it was astounding.? Don?t forget the FHLBs as well.
Politicians and regulators refused to rein in banks when they had the power and tools to do so.
Securitization of private loans separated origination from risk-bearing, allowing underwriting standards to deteriorate. Volume was rewarded, not quality.
Mortgage insurers and home equity loans allow people to borrow a far greater percentage of the value of the home than before, for conforming loans.
Appraisers went along with the game, as did regulators, which could have stopped the banks from lowering credit standards. Part of the fault for the regulatory mess was due to the Bush Administration downplaying financial regulation.
The Rating Agencies gave far too favorable ratings to untried asset classes, like ABS and private RMBS securitizations. This is for two reasons: financial regulators required that the companies they oversaw must use ratings for assessing capital needed to cover credit risk, and did not rule out asset classes that were unproven, as prior regulators had done.? Second, CDOs and similar structures needed the assets they bought to have ratings for the same reason.
There was a bid for yieldy assets on the part of US Hedge funds and foreign financial firms. Without the yield hogs who bid for CDO paper, and other yieldy assets, the bubble would not have grown so big.
Financial guarantors insured mortgage paper without having good models to understand the real risk.
People were stupid enough to borrow too much, assuming that somehow they would be able to handle it.? As with most bubbles, there were stupid writers pushing the idea that investing in housing was “free money.”

3) Bank Asset-liability management [ALM] for large commercial and investment banks was deeply flawed. ?It resulted in liquid liabilities funding illiquid assets.? The difference in liquidity was twofold: duration and credit.? As for duration, the assets purchased were longer than the bank?s funding structures.? Some of that was hidden in repo transactions, where long assets were financed overnight, and it was counted as a short-term asset, rather than a short-term loan collateralized by a long-term asset.

Also, portfolio margining was another weak spot, because as derivative positions moved against the banks, some banks did not have enough free assets to cover the demands for security on the loans extended.

As for credit, many of the assets were not easily saleable, because of the degree of research needed to understand them.? They may have possessed investment grade credit ratings, but that was not enough; it was impossible to tell if they were ?money good.?? Would the principal and interest eventually be paid in full?

The regulatory standards let the banks take too much credit risk, and ignored the possibility that short-term lending, like repos and portfolio margining could lead to a ?run on the bank.?

4) Accounting standards were not adequate to show the risks of repo lending, securitizations, or derivatives.? Auditors signed off on statements that they did not understand.

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That?s all, I wanted to keep this simple.? I do want to say that Money Market Funds were not a major cause of the crisis.? The reaction to the failure of Reserve Primary was overdone.? Because of how short the loans in money market funds are, the losses from money market funds as a whole would have been less than two cents on the dollar, and probably a lot smaller.

Also, bailing out the banks sent the wrong message, which will lead to more risk later.? No bailouts were needed.? Deposits were protected, and there is no reason to protect bank stock or bondholders.? As it was, the bailouts were the worst possible, protecting the assets of the rich, while not protecting the poor, who still needed to pay on their loans.? Better that the bailouts should have gone to reduce the principal of loans of those less-well-off, rather than protect the rich.? It is no surprise that we have the politics? we have today as a result.? Fairness is more important than aggregate prosperity.

PS — the worst of all worlds is where the government regulates and gives you the illusion of protecting you when it does not protect you much at all.? That tricks people into taking risks that they should not take, and leaves individuals to hold the bag when bad economic and regulatory policies fail.

The Pips are Squeaking

Posted on 15 May 2018 by David Merkel

Photo Credit: sid=================

This should be a short post.? I just want to note the degree of stress that many emerging market countries are under.? The Fed raises rates, and something blows up.? That is often the class of debt that has grown the most in the bull phase of the cycle, or, the one that has financed with short-term debt.? This is the “volatility machine” that Michael Pettis wrote so well about.

The Brazilian stocks I own have been falling.? A little lower, and I will make them double-weight positions.? Five times earnings for utilities that cannot be done without?? Wave the shares in.

Look at Argentina, Indonesia, and Turkey.? Fundamentally misfinanced.? Maybe own assets there that have enduring demand.? I own IRSA [IRS].

Russia is fundamentally sound.? I own shares in RSXJ, which is not so connected to the energy sector.

Buy the emerging markets generally, avoiding those markets are fundamentally misfinanced.? Or wait, and buy later.? Emerging market selloffs are often sharp and significant.? I’m not sure what is the right way to do it, so you could buy half now, and wait.? If it rallies, be glad you got some cheap.? If it sells off more, buy the full position.

There are some good values now; they could get better later.? Buy a little and wait like my “do half” strategy says.? Don’t get greedy, look for decent gains over 3-5 years.

And now for something completely different:

https://www.youtube.com/watch?v=gLyoBCIBCW8?t=1343

I appeared on RT Boom/Bust two weeks ago, and offered my thoughts on Wells Fargo at the end of the show.? I think they still have more problems to be revealed.? That said, things aren’t getting worse, so this might be a good time to buy the shares of Wells Fargo.

Full disclosure: My clients and I own shares of IRS, SBS, ELP, BRF, and RSXJ

Why I Watch the Thirty

Posted on 19 April 2018 by David Merkel

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I like long bonds.? I am not saying that I like them as an investment.? I like them because they tell me about the economy.

Though I argued to the Obama Administration that they should issue Fifties, Centuries and Perpetuals, the Thirty-year bond remains the longest bond issued.? I think its yield tells us a lot about the economy.

How fast is nominal growth?? Look at the Thirty; it is highly correlated with that.

What should the Fed use for its monetary policy?? Look at the Thirty, and don’t let the Five-year note get a higher yield than it.? Also, don’t let the spread of the Two-year versus the Thirty get higher than 1.5%.? When things are bad, stimulus is fine, but it is better to wait at a high spread than goose the spread higher. Excesses in loose policy tend to beget excesses in tight policy.? Better to avoid the extremes, and genuinely mute the boom-bust cycle, rather than trying to prove that you are a genius/maestro when you are not.? Extreme monetary policy does not get rewarded.? Don’t let the yield curve get too steep; don’t invert.

Finally, the Thirty is a proxy for the cost of capital.? It’s long enough that it is a leap of faith that you will be paid back.? Better still for the cost of capital is the Moody’s Baa average, which tracks the bold bet of lending to low investment grade corporations for 20-30 years.

That said, the Thirty with its cousin, the long Treasury Inflation Protected Security [TIPS] gives you an idea of how long term inflation expectations and real rates are doing.? The thing that kills stocks is higher long term real interest rates, not inflation expectations.? The main reason for this is that when inflation rises, usually earnings do also, at least at cyclical companies.? But there is no reason why earnings should rise when real rates rise.

This is why I pay more attention to the Thirty rather than the more commonly followed Ten.? I know that more debt gets issued at a maturity of ten years.? Granted.? But the Thirty tells me more about the economy as a whole, and about its corporations.? That’s why I carefully watch the Thirty.

Notes on the Fed Announcements

Posted on 22 March 2018 by David Merkel

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Listening to the Fed Chair’s press conference, there was one thing where I disagreed with what Powell was saying.? He said a few times that they only made one decision at the FOMC meeting, that of raising the Fed Funds rate and the reverse repo rate by 0.25%.? They made another decision as well.?The decided to raise the rate of quantitative tightening [QT] by increasing the rate of Treasury, MBS and agency bonds rolloff by $10B/month starting in April. They did that by increasing the rate of reduction of MBS and agency bonds from $8B to $12B/month, and Treasuries from $12B to $18B/month. The total rate of QT goes from $20B to $30B/month.? This may raise rates on the longer end, because the Fed will no longer buy so much debt.

There was also a little concern over people overinterpreting the opinions of the Fed Governors, especially over the “dot plot,” which shows their opinions over real GDP growth, the unemployment rate, PCE inflation, and the Fed funds rate.? My point of view is simple.? If you don’t want people to misinterpret something, you need to defend it or remove it.

Personally, I think the FOMC invites trouble by doing the forecasts.? First, the Fed isn’t that good at forecasting — both the staff economists and the Fed Governors themselves.? Truly, few are good at it — people tend to either follow trends, or call for turns too soon.? Rare is the person that can pick the turning point.

Let me give you the charts for their predictions, starting with GDP:

The Fed Governors have raised their GDP estimates; they raised the estimates the most for 2018, then 2019, then 2020, but they did not raise them for the longer run.? I seems that they think that the existing stimulus, fiscal and monetary, will wear off, and then growth will return to 1.8%/year.? Note that even they don’t think that GDP will exceed 3%/year, and generally the Fed Governors are paid to be optimists.? Wonder if Trump notices this?

Then there is the unemployment rate.? This graph is the least controversial.? The short take is that?unemployment rate estimates by the Fed governors keep coming down, bottoming in 2019, and rising after that.

Then there is PCE Inflation.? Estimates by the Fed Governors are rising, and in 2019 and 2020 they exceed 2%.? In the long run the view of the Fed Governors is that they can achieve 2% PCE inflation.? Flying in the face of that is that they haven’t been able to do that for the duration of this experiment, so should we believe in their power to do so?

Finally, there is the Fed Funds forecast of the Fed Governors — the only variable they can actually control. Estimates rose a touch for 2018, more for 2019, more for 2020, and FELL for the long run. Are they thinking of overshooting on Fed Funds to reduce future inflation?

Monetary policy works with long and variable lags, as it is commonly said.? That is why I said, “Just Don?t Invert the Yield Curve.”? Powell was asked about inverting the yield curve at his press conference, and he hemmed and hawed over it, saying the evidence isn’t clear.? I will tell you now that if the Fed Funds rate follows that path, the Fed will blow something up, and then start to loosen again.? If they stop and wait when 10-year Treasury Note yields exceed 2-year yields by 0.25%, they might be able to do something amazing, where monetary policy hits the balancing point.? Then, just move Fed funds to keep the yield curve slope near that 0.25% slope.

There would be enough slope to allow prudent lending to go on, but not enough to go nuts.? Much better than the present policy that amplifies the booms and busts.? The banks would hate it initially, and regulators would have to watch for imprudent lending, because there would be no more easy money to be made.? Eventually the economy and banks would adjust to it, and monetary policy would become boring, but predictably good.

Just Don’t Invert the Yield Curve

Posted on 21 March 2018 by David Merkel

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Jerome Powell is not an economist, and as such, has the potential to try to remake the way the Fed does monetary policy.? Rather than hold onto outmoded ideas ideas like the Phillips Curve, which may have made sense when the US was a more insular economy, there are better ways to think of monetary policy from a structural standpoint of how financial firms work.

(Note: the Phillips Curve relies on a very simple assumption that goods and services price inflation stems from wage inflation, and that wage inflation occurs when domestic unemployment is low.? In a global economy, those relationships are broken when labor can be easily added from sources outside of the US.)

Financial firms tend to grow rapidly when the yield curve is steeply sloped.? Borrowing short and lending long is profitable, at least in the short-run.? This provides a lot of credit to the economy, which in the short-run, encourages growth, as businesses borrow to build supply, and consumers borrow, which temporarily boosts demand.

Financial firms tend to shrink?when the yield curve is flattish and certainly when negatively sloped.? Borrowing short and lending long is unprofitable, at least in the short-run.? This reduces credit to the economy, which in the short-run discourages growth, as businesses don’t borrow to build supply, and consumers borrow less, which temporarily reduces demand.

If there are misfinanced (too much short-term borrowing) or over-indebted areas of the economy, there can be considerable economic failure with a flat or inverted yield curve.? As I have said before, when the FOMC tightens without thinking about the financial economy, they keep tightening until something blows up, and then they loosen too much, starting the next cycle of over-borrowing.? I said this at RealMoney in 2006:

One more note: I believe gradualism is almost required in?Fed?tightening cycles in the present environment ? a lot more lending, financing, and derivatives trading gears off of short rates like three-month LIBOR, which correlates tightly with fed funds. To move the rate rapidly invites dislocating the markets, which the FOMC has shown itself capable of in the past. For example:

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

I also commented that housing was likely to be the next blowup in a number of posts from that era.? Sadly, they are mostly lost because of a change in the way theStreet.com managed its file system.

As such, it behooves the Fed to avoid overly flattening the yield curve.? In late 2005, I wrote at RealMoney.com that the Fed should stop at 4%, and let the excess of the economy work themselves out.? By mid -2006, they raised the Fed Funds rate to 5.25%, flattening to invert the yield curve, which collapsed the leverage in the economy in a disorderly way.

It would have been better to stop at 4%, and watch for a while.? Housing prices had peaked, and I wrote about that at RealMoney.com as well.? The Fed could have been more gradual at that point.? There really wasn’t that much inflation, and the economy was not that strong.? Bernanke may have felt that he needed to prove that he wasn’t a dove on inflation.? Who knows?? The error was unforced, and stemmed from prior bad practices.

In this case, the Fed does have an alternative to crashing the economy again.? I would encourage the FOMC to not raise rates over 2.5%.? When they get to 2.5%, they should start selling the longest bonds in their portfolio (note: I would encourage them to end balance sheet disclosure before they do this, after all, the Fed suffers from too much communication not too little.? The Fed was better managed under Volcker and Martin.)

This would test the resilience of the economic expansion, and if the economy keeps growing as long bonds rise in yield, then match the rises in long yields with rises in the Fed Funds rate.? This is a neo-Wicksellian method of managing monetary policy that could match the ideas of Jerome Powell, who was more skeptical than most Fed Governors about about Quantitative Easing [QE].

The eventual goal is to manage monetary policy aiming for a yield curve that has a low positive slope, allowing the banks to make a little money, but not a lot.? The economy would expand moderately, and not be as prone to booms and busts.

My summary advice for the FOMC would be this: before you flatten/invert the yield curve, start selling all of the long MBS and Treasury bonds with average maturities longer than 10 years.? That will slow down the economy more effectively than flattening the yield curve, and it is not as likely to lead to a crisis.

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I have no illusions — the odds of the FOMC doing this is remote.? But given past failures, isn’t a new idea worthy of consideration?

PS — there is another factor here.? What happens to the financing costs of the profligate US government?

Estimating Future Stock Returns, December 2017 Update

Posted on 14 March 2018 by David Merkel

The future return keeps getting lower, as the market goes higher

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Jeff Bezos has a saying, “Your margin is my opportunity.”? He has found ways to eat the businesses of others by providing the same goods and services at a lower cost.? Now, that makes Amazon more productive and others less productive.? The same is true of other internet-related businesses like Google, Netflix, etc.

And, there is a slight net benefit to the economy from the creative destruction.? Old capital gets recycled.? Malls that are no longer so useful serve lower-margin businesses for locals, become homes to mega-churches, other area-intensive human gatherings, or get destroyed, and the valuable land so near many people gets put to alternative uses that are better than the mall, but not as profitable as the mall prior to the internet.

Laborers get released to other work as well.? They may get paid less than they did previously, but the system as a whole is more productive, profits rise, even as wages don’t rise so much.? A decent part of that goes to the pensions of oldsters — after all, who owns most of the stock?? Indirectly, pension plans and accounts own most of it.? As I have sometimes joked, when there are layoffs because institutional investors representing pension plans? are forcing companies to merge, or become more efficient in other ways, it is that the parents are laying off their children, because there are cheaper helpers that do just as well, and the added profits will aid their deservedly lush retirement, with little inheritance for their children.

It is a joke, though seriously intended.? Why I am mentioning it now, is that a hidden assumption of my S&P 500 estimation model is that the return on assets in the economy as a whole is assumed to be constant.? Some will say, “That can’t be true.? Look at all of the new productive businesses that have been created! The return on assets must be increasing.”? For every bit of improvement in the new businesses, some of the old businesses are destroyed.? There is some net gain, but the amount of gain is not that large in aggregate, and these changes have been happening for a long time.? Technological progress creates and destroys.

As such, I don’t think we are in a “New Era.”? Or maybe we are always in a “New Era.”? Either way, the assumption of a constant return on assets over time doesn’t strike me as wrong, though it might seem that way for a decade or two, low or high.

As it is today, the S&P 500 is priced to deliver returns of 3.24%/year not adjusted for inflation over the next ten years.? At 12/31/2017, that figure was 3.48%, as in the graph above.

We are at the 95th percentile of valuations.? Can we go higher?? Yes.? Is it likely?? Yes, but it is not likely to stick.? Someday the S&P 500 will go below 2000.? I don’t know when, but it will.? There are enough imbalances in the world — too many liabilities relative to productivity, that crises will come.? Debt creates its own crises, because people rely on those payments in the short-run, unlike stocks.

There are many saying that “there is no alternative” to owning stocks in this environment — the TINA argument.? I think that they are wrong.? What if I told you that the best you can hope for from stocks over the next 10 years is 4.07%/year, not adjusted for inflation?? Does 1.24%/year over the 10-year Treasury note really give you compensation for the additional risk?? I think not, therefore bonds, low as they may be, are an alternative.

The top line there is a 4.07%/year return, not adjusted for inflation

If you are happy holding onto stocks, knowing that the best scenario from past history would be slightly over 3400 on the S&P 500 in 2028, then why not buy a bond index fund like AGG or LQD that could virtually guarantee something near that outcome?

Is there risk of deflation?? Yes there is.? Indebted economies are very susceptible to deflation risk, because wealthy people with political influence will always prefer an economy that muddles, to higher taxes on them, inflation, or worst of all an internal default.

That is why I am saying don’t assume that the market will go a lot higher.? Indeed, we could hit levels over 4000 on the S&P if we go as nuts as we did in 1999-2000.? But the supposedly impotent Fed of that era raised short-term rates enough to crater the market.? They are in the process of doing that now.? If they follow their “dot plot” to mid-2019 the yield curve will invert.? Something will blow up, the market will retreat, and the next loosening cycle will start, complete with more QE.

Thus I am here to tell you, there is an alternative to stocks.? At present, a broad market index portfolio of bonds will likely outperform the stock market over the next ten years, and with lower risk.? Are you ready to make the switch, or at least, raise your percentage of safe assets?

Surprise! Return to RT Boom/Bust

Posted on 1 March 2018 by David Merkel

After almost three years, I returned to RT Boom/Bust on Tuesday.? There are many changes at RT.? Many new people, and a growing effort to put together an alternative channel that covers the world rather than just the US or just the developed world.? They are bursting at the seams, and their funding has doubled, so I was told.

I get surprised by who watches RT and sees me.? My? congregation is pretty conservative in every way, but I have some friends working in intelligence come up to me and say, “Hey, saw you on RT Boom/Bust.”? And then there is my friend from Central Africa who says, “The CIA has you on their list.? Watch out!”? He’s funny, hard-working, but very earnest.

I’ve never seen anything in what I have done where there is any hint of editorial control.? Maybe it is there, but I think I would be smart enough to see it.

Anyway, the topic at hand was alternative monetary systems, and the thing that kicked it off was the Vollgelt in Switzerland, where they are trying to create a monetary system where the banks can’t lend against deposits.? Here were my notes for the show, with a little more to fill in:

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Mr. Merkel, what exactly is a sovereign money system?

The banks can?t lend against deposits.? Deposits are segregated, and wait for the depositor to use them.? The deposits no longer can be used by the bank but only the depositor.? There would be no need for deposit insurance, because deposits are off of the bank?s balance sheet.

What is the difference between a sovereign system and the way banks handle your money now?

You would have to pay for your transactional account, because the bank can?t make money off of lending against the deposits. Banks would no longer do ?maturity transformation? by lending long against short-term deposits.? Long-term lending would have to be other entities in the economy, such as insurance companies, pension funds, endowments, private individuals, foreign lenders, mortgage REITs, and banks funded by matching sources like CDs, bonds, and equity.

Switzerland is poised to vote on a sovereign money system, or Vollgeld in German. How likely is this vote to pass?

Not likely for three reasons.? First, the Swiss turned down a proposal to back the Swiss Franc with 20% gold.? Not one canton voted for it.? Only 22% of the electorate voted for it.? Second, things aren?t that bad now, and the financial system isn?t that levered.? ?If it ain?t broke, don?t fix it.?? Third, this is a total experiment with no real world precedents.? Many criticize economists for imagining what the world should be like and then proposing policy off their unrealistic idealized models.? This is another example of that.? We don?t know what the unintended consequences might be.

Some unintended consequences might be:

Transition would be difficult
Recession during the transition, because middle and small market lending would likely suffer
Pay for transactional accounts ? no interest even if inflation is high.
Increase in savings accounts, which might be short-dated enough to be transactional
Gives a lot of power to the SNB, which might be halfhearted about implementation (Regulators dislike change, and risk).
Could be subverted if Government becomes dependent on free money, leading to inflation
Moves monetary policy from rate targeting to permanent quantitative monetary adjustment. Unclear how the SNB would tighten policy; maybe issue central bank bonds to reduce money supply?

Could something like this rein in credit bubbles? Are we facing another credit bubble?

Yes, it could.? Most credit bubbles result from short-term lending funding long-term assets.? This would rein it in, in the short-run, but who could tell whether it might come back in another unintended way?? If some new class of lender became dominant, the threat could reappear.

We aren?t facing a credit bubble now, because the last crisis wiped away a lot of private debt, and replaced it with public debt.? Perhaps some weak nations with debts not in their own currency could be at risk, but right now, there aren?t any categories of private debt big enough and misfinanced enough to create a crisis.? That said, watch margin loans, student loans, and auto loans in the US.

Are there any modern day equivalents we can compare Vollgeld to?

None that are currently being used.? There are a lot of theoretical ideas still being tossed around, like 100% reserving, lowering bank leverage, strict asset-liability matching, disallowing banks from lending to financial companies, etc.? These ideas get a lot of press after crises, but fade away afterward.? Most of them would work, but all of them lower bank profits.? Concentrated interests tend to win against general interests, except in crises.

You mentioned there is a similar concept for derivatives that no one is talking about. How exactly would that work?

Derivatives are functionally equivalent to insurance contracts, but they are not regulated.? I believe they should be regulated like insurance contracts, and require that those seeking insurance have an ?insurable interest? that they are trying to hedge.? Only direct hedgers could initiate derivative transactions, and financial guaranty insurers would compete to fill the need.

This would prevent the unintended consequences of having multiples of protection written on a given risk, where a weak party like AIG is incapable of making good on all of the derivative contracts that they have written, which could lead to its own systemic risk if other derivative counterparties can?t absorb the losses.

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I know that is over-simplified, but I read through the papers of both sides in the debate, and I thought both overstated their cases significantly.

I know fiat money has its problems, and so does fractional reserve banking, but if you are going to propose a solution, perhaps one that fits the basics of how a well-run bank at low leverage would work would be a good place to start.