Thursday, October 16, 2014

Update on Interest Rates

Well, interest rates got interesting fast after I posted my update Wednesday.  Here are updated versions of a couple of the graphs.

The market reaction seemed overblown compared to the information contained in the economic data that was released Wednesday.  I have been pleasantly surprised by the reaction from FOMC officials that suggests they are willing to loosen up, at least a little bit.  I'm not sure if it will be enough to make much difference.

In the meantime, labor markets continue to look strong.  So, I think we might still be looking at a situation of weak signs in financial markets but a strong economy in terms of production and employment.

I think this is a speculator's market.  These are the kind of situations I look for in individual equities, like in my current favorite Hutchinson Technologies.  The ability of markets to provide stable and efficient prices breaks down when the distribution of possible outcomes deviates from normal behavior.  For some time, prospects for HTCH on a 5 to 10 year horizon have been such that they are likely to be worth very little or something more than $10.  They have been trading in the $2 to $5 range.  The distribution of outcomes is kind of an upside-down normal curve.  It is highly unlikely that HTCH will be trading at $3 in 5 years.  This kind of situation causes the expected cash flows of the marginal investor to take a back seat to other issues, like reputation, fear of losses, etc.  Expected monetary returns can be very high, and returns to unobservable stock picking skills become very high.

We have a similar situation now in the broader market. It has been that way for some time.  Under QE, investors were split between high inflation expectations and worries about perma-QE at the zero lower bound.  I think the decline in the TIPS spread in 2013 might have reflected a reduced variance in expected inflation more than a reduced mean expectation for inflation.  In fact, that was the subject of my very first post on this blog, and a couple of follow ups.

After the rate increases in mid 2013, through most of 2014, I had a slightly bullish position on rates (short bonds) that I traded as a synthetic short option.  (I traded so that I gained from mean reverting volatility).  That is because I forecasted a positive labor market for 2014.  I predicted that, on net, the distribution of possible outcomes in the near future would become less variable.  This is because the taper of QE3 would quell fears about inflation while the strengthening labor market would quell fears about deflation.  I expected housing to eventually recover more strongly than others seemed to expect, which would eventually bias markets even more away from deflation worries.  In the meantime, I traded the transitory volatility in the day to day markets.

I think we have mainly gotten to the place I expected us to.  Except, housing credit markets haven't seemed to recover enough to pull home prices up to levels that would re-establish a sustainable housing credit market.  So, I have retracted my bullish position on real estate and home building for now, and my bullish position on interest rates (bearish on bonds).  And, the volatility dynamics are now reversed.  Instead of reverting to the mean with declining volatility, the end result for interest rates is now probably a two-tailed monster.  Much like with HTCH above, the odds that June 2017 Eurodollar contracts will expire at 2% are very low.  But, the problem is we don't know if they will expire at 0.1% or at more than 3%, and much of the outcome depends on coming arbitrary Fed decisions.  So, a directional speculative position will eventually pay off very well here.  But, which direction is anyone's guess.  The trick now will be to take a position on that direction before the market fully prices it in.

In the meantime, this tipping-point context might mean that seemingly small pieces of information in one direction or the other could create large swings in market prices.

That said, looking at the forward Eurodollar curve, this recent move doesn't look as pessimistic as it first did.  With such a large decline in equities, it seemed like the market reaction was a reaction to more possible demand shocks.  But, especially after recovering a little, the change in rates looks like it has come mostly from an expected delay in rising rates, which could reflect some pessimism about near-term markets, but this pessimism appears to be paired with an expectation of a counter-effect of appropriately looser monetary policy.  The end result of the last three days' interest rate moves has been a move back in time of about 1 month in the first rate hike and a slightly slower expected rate of rate increases after that.  The expected date of the first rate hike had already begun moving back earlier in the month, so that, as a whole, since early October, the expected date of the first hike has moved from about June 2015 to about September 2015, according to my model.  I think that's a lot smaller change than some observers realize.

As we move out on the yield curve, forward rates had collapsed since the beginning of the year, from more than 5% to about 3.5%, and the last leg of that collapse had come in early October, along with collapsing inflation expectations.  But, with the rate drops this week, the forward rates at the long end of the curve actually held their own.

I suspect that the long end of the curve is partly a comment on the odds of being stuck at the zero lower bound.  Long term rates have shrunk by about a third, and the slope of the curve during the rate hike phase (2015-2018) has also dropped by about a third (from about 34 to about 23 bps per quarter).  This could represent a bifurcated expected outcome distribution, with a 2/3 chance of seeing rates increasing at more than 1% per year starting sometime around 2015-2016 and topping out at around 5%, and a 1/3 chance of never leaving zero.  (The slope still seems a little low, which I attribute to a weak housing credit market.)  Anyway, if this is a true reflection of market expectations, then the flip out this week may not have reflected any increase in the odds of staying at zero.

All in all, I would say that this week's move signals some confidence in forward monetary policy.  Let's hope that's true.

More Amazing Stuff on Labor Force Participation from the Atlanta Fed

Here is a link to some great labor force participation data from the Atlanta Fed. (HT: EV)  Be sure to check out all the information on this page, too, including the interactive chart and the downloadable data.

Here are a couple of graphs.  But there are tons more.

I think this data generally backs up the notion that much of the decline in LFP has been age related.  I have attributed the disability problem mostly to aging, but the data here makes it clear that there has been a sharp increase in disability, even after adjusting for age.  In fact, among prime age workers, while most employment indicators are now improving, disability is still growing as a reason for dropping out of the labor force.

In the second graph I have posted here, most of the decline in Prime Age LFP in the "Don't want a job" category is due to higher disability claims.  Part of this is due to the unusually large number of 50 year+ workers in the population distribution right now.  But, part of this is due to an increase in disability claims within that age group  (Paging Benjamin Cole!).  Prime-Age includes 25-54 year olds, and much of the decline is due to more schooling at the low end of the age group and more disability at the high end of the age group.

Most of the increase in disability claims during the recession has been among the older working age population, but disability since 1999 has increased across all age groups.

Anyway, don't stop with my post.  Go to the links.  This is great stuff for data nerds.

Wednesday, October 15, 2014

Forward Rates and the Business Cycle

Interest rates have taken a dive recently.  This has mostly been at the long end of the curve.  Here is a kind of messy graph of expected future changes in interest rates (assuming pure expectations) and realized changes in rates.  Forward rates appear to have been a fairly unbiased predictor of rate changes in normal times, but they have tended to overstate forward rates at the extremes.  While flat yield curves have predicted economic contractions, ensuing collapses in interest rates have been much more negative than predicted by the yield curve.

One question is, does the recent decline in rates foreshadow a coming contraction?  I would say, according to the first chart, no.  A fall in the long term yield slope is not unusual, even in the early stages of rising short term rates.

In the past few cycles, the recoveries ended with short term rates that rose higher than the yield curve had predicted, then collapsed.  The same pattern happened in the mid 1990's, but we avoided the recession in that episode.

Here is another view of recent rate movements.  This is from Eurodollar markets.  We can see here that expectations about rate increases in the near term have been very stable since the beginning on QE3.  The June 2016 contract has been relatively level since late 2012.  Both long rates and near term rates rose in the summer of 2013, which I consider to be evidence that those movements were a product of improved expectations, and were not related to tapering issues.  But, once, tapering began in late 2013, long term rates began a long decline.  The recent decline worries me, because we are seeing a correction in equities at the same time that we are seeing rates fall across the yield curve.

Here is another view of yield curve movements during the current year.  Here, again we can see that the character of rate increases in the 2015-2017 time frame has been fairly stable.  But long rates have been on a relentless, steady decline.  They are almost down to the ridiculously low level I had expected of them, though I didn't originally expect it this quickly.  I had been positioning for a strong economy this year that would push rates up more quickly than the yield curve predicted.  In effect, I was ready for that bump in rates that we saw at the end of recoveries in the first graph.  But, I have become worried about credit markets in the near term because real estate credit hasn't seemed to have picked up its own steam in the face of the end of QE3.  So, I think we could have a catastrophic period ahead if rates continue to collapse and the Fed delays further accommodation.  It is possible that real estate credit regains momentum and my original yield curve forecast still could hit the mark.  It is also possible, I think, for the economy to have enough strength outside real estate to help us muddle through for a while, in which case rates and inflation might remain low for a couple more years, followed by a delayed rebound in rates.

Here is one more chart, which compares the 3 month rate with the (5,2) forward rate (the rate from,  roughly, year 5 to year 7).  Here we can see the yield curve recession indicator.  The three recessions in this period happened after the short rate hit the same level as the forward rate.  But, I think this graph is interesting, because we can see that in 1984 and 1994 the Fed raised short rates up to the level of the forward rate.  The reason forward rates remained above the short rate was because the forward rate rose along with short rates, and the Fed stopped raising short term rates when the forward rates started to decline again.  But, in 1988, 2000, and 2006, the Fed kept raising the short term rate even as forward rates were falling or remaining level with the short rate.

The worst case scenario is that the forward rate keeps falling even without any short term rate increases.  That was happening before QE3 helped boost forward rates.  The forward rate has a smoother trend than constant maturity treasury rates, because it doesn't include the volatile short part of the yield curve.  (I have bootstrapped treasury rates to estimate the forward rates.)  If forward rates fall back to 2012 levels of below, that will probably be a bad sign.  If they don't, then the interaction of the short term rate with the forward rate might be something interesting to watch.

Tuesday, October 14, 2014

We really have no idea what we're doing

This would be baffling if it wasn't so predictable.  The New York Times reports of concerns among global leaders at last week's IMF meeting:
As economists and politicians heap pressure on global central banks to continue, and even escalate, their unusually loose monetary policies in order to spur global demand, the fear that these measures could provoke another market convulsion is spreading. 

“A major lesson of the last crisis is that accommodative monetary policy contributed to financial excesses,” said Lucas Papademos, a former vice president of the European Central Bank. “We are pursuing a similar policy for good reason. But there are limits — if you do this for too long, risks in the financial markets will materialize.”
Inflation is low and collapsing, households have undertaken unprecedented deleveraging, low risk bonds pay little to nothing, equity premiums are very high.....on and on and on.

And our best and brightest think monetary policy has been "unusually loose" and think our major concern right now is too much risk-taking because financial institutions are going farther and farther afield to bid up safe assets.  I think everyone agrees that the 1970's was a period of loose monetary policy.  What exactly is going on now, in terms of financial risk taking, that mimics the 1970's?  If loose money is the key factor, this should be an easy question to answer.

We tend to think of interest rates and risk premiums in an additive fashion.  We start with a risk free rate and add risk premiums to model risky assets.  I wish we, instead, began with a benchmark required return for assets and then thought of the rate on debt as a discount from that required return.  It looks to me like the market asset real required return has been fairly stable over time.  If we looked at it this way, then we would now say, "Short term risk free bonds are paying an 8% discount in order to avoid exposure to manageable cash flow risk."  It would be easier to think of increases in debt ownership as a flight from risk.  High corporate profit levels are, in part, a product of a huge pool of risk averse savers saying, "Hey, if you're willing to take the residual risk, you keep the profits.  Give me 1% a year, and leave me out of the rest of it."  Since corporations tend to deleverage when debt rates are low (and are currently not very leveraged), some savings is drawn back into equity (because it is now less volatile) and into non-corporate debt.

This is why the tendency to demonize the financial industry seems so dangerous to me.  Market prices contain a wealth of information, which we frequently misinterpret.  (Why would we expect to always understand it?).  We view investors as some sort of Frankenstein monster in a tux, and we demand that it be controlled by committees that can't tell the difference between loose and tight monetary policy.

Here is an educational video about the politics of finance and monetary policy.

Friday, October 10, 2014

Some data on households & housing

Commenter "Glenn" had some input on this post.  He motivated me to check up on some Census data.  I thought what I found was interesting enough to include on a bonus weekend post.

Here is a graph of vacancies:

I think this shows a bit more of a weak supply / strong demand signal than Glenn does.

But, then I looked up household size, which I hadn't looked at for a while.

I would have expected a sizeable hump from this recession, due to the tremendous drop in new home production.  There was a hump in 2009 and a small bump up in 2013.  But, I can't say that there is an obvious deviation from trend.  In fact, I think this is a data point against my (on hold) bullish call on homebuilders.  The decline in household size has added significant housing demand in the past few decades.  Between the probable minimum level that is likely close to the current level, which should prevent further falls in average household size, and a population pyramid that probably points to more growing households over the next couple of decades than shrinking households, this should flatten out, which might be another reason to expect somewhat lower home demand than we have seen in the recent past.  Baby boomers are mostly already in "empty nest" phase, and their children are still early in family-building phase.

At this link, there is a graph of household formation that is updated monthly.  It shows household formation regaining momentum after a weak 2013.

This is a fun graph, as there is fodder here for any framing.  The rise in homeownership could be attributed to baby boomer lifecycles, but the trend suspiciously turns sharply in 1994, when interstate banking expansion was tied to CRA incentives.  But, homeownership leveled off before the steepest part of the home price/rent ratio run up.  P/R bottomed out back at 1990's levels, which seems about right to housing bubble folks.  But it is still below the ratio of the late 1970's, when real rates were previously low, but nominal rates were in the double digits, which confirms the bias of a housing bull like me.

Evidence is Optional for Finance Cynics, a continuing series: Cash Flows to Owners

While I'm complaining about the fact that everyone seems to be wrong about everything, let's talk about cash flows to owners - dividends and share buybacks.

Everyone from Matthew Yglesias at Vox to the Economist are worried about massive buybacks and how this means that corporations are just pocketing your cash instead of investing in America.
Yglesias:  "It means that the basic link between healthy corporate profits and a healthy middle class is broken."
The Economist: "Share buy-backs - Corporate cocaine"
I don't want to even get into the conspiratorial tone with which buybacks are usually treated.  It's simply a return of capital to owners, no different than dividends.  The main adjustment it does demand from us is that historically dividends were the primary method for returning capital to owners, so that indexes, like the S&P500 or the Dow Jones Industrials, which tracked share prices over time also served as decent proxies for the growth of capital.  But, buybacks cause return of capital to be treated, mathematically, like capital gains.  Buybacks have gained favor in recent decades.  So, in order to compare capital growth to other measures of wealth or income, equity indexes need to be reduced by the amount of buybacks.  At this point, return of capital is causing index returns to be overstated by more than 2% per year as a measure of retained capital, which really adds up over time.

I repeat, this is simply a mathematical adjustment that needs to be made for analysis.  Total returns are unchanged, except for this arbitrary change in accounting for them.

But, forgetting all the misconceptions surrounding buybacks, the more basic point is:  There is NOTHING unusual about the current levels of payouts to equity holders.

Here is an excellent article by the inestimable Aswath Damodaran going over the basics of share buybacks.  Here is one of his graphs, showing the total level of corporate payouts to owners over the past 30 years.  The level of payouts is slightly below the levels of the 1980s.

I think arguments can be made for either looking at net payouts or gross payouts.  But, with net payouts between 3%-4% and gross between 4%-5%, both are moderate.

What if we look at a longer time frame?  Here is 150 years of dividend history, from Robert Shiller's data.  Keep in mind that this is only dividends.  Buybacks have only become popular since the 1980's, so we would compare these payouts to the gross payouts from Damodaran's graph, which were around 6% in the 1980's, dipped to 2% to 3% in the 1990's, and are back up to around 4%-5%.  Historically, payout ratios have rarely fallen much below 4%.  If anything, there is a long term downward trend in payouts to owners, following a range that current levels fall squarely within.

How can there be so many topics where so many people are so confident about things that just obviously aren't so?  Would it be a shocking coincidence if the bad guys in these stories were predictable?

How much human misery has been caused by people who got in the habit of believing things, not based on whether they were true or false, but based on whether they had a predetermined bad guy?  It's kind of the story of human history, isn't it?  I'm excited about biotech, AI, robotics, nanotech, and everything else, but, man, the real breakthrough would be if someone invented a way to point this bias out to each of us in a way that would make us say, "Oh, geez.  You're totally right.  That is what I'm doing.  I will now update my beliefs with this in mind.  Thank you."  Human progress would explode.  The main reason the singularity will happen is because, frankly, the bar is set very low - and I don't exclude myself.  We all purposefully develop strong convictions through gross avoidance of evidence.  It may be the core identifying feature of humanity.

Thursday, October 9, 2014

Framing is Everything: Housing and Monetary Policy

There is some disagreement about the interplay between monetary policy and interest rates.  I will avoid that discussion here.  But, whatever the direction of interest rates (or returns on any security), there are contradictory effects on existing owners and new owners.

If interest rates on a security go up, then for new owners, future returns will be higher.  But, in order to receive higher returns on an existing pool of assets, given a stable cash flow, the nominal value of those assets must fall.  A perpetual bond is the purest mathematical example of this.  If market rates are 5%, and I pay $100 for a perpetuity that pays $5 annually, then if market rates rise to 10%, my perpetuity that pays $5 annually will only fetch $50.  Note that if market rates fall to zero, the perpetuity's value goes to infinity.

So, we have borrowers and creditors; we have current owners and future owners.  As a first order effect, interest rates don't create anything in a closed economy.  A lower rate will mean less income for creditors and more income for borrowers - capital gains for current owners and lower returns for future owners.

It is sadly common for people to frame finance in terms of good guys and bad guys.  This set of contrary players means that commenters can pick and choose from the outcomes above as they people their narrative.  It is surprisingly common to see essays that bemoan low interest rates, because they simultaneously benefit "Wall Street" (by raising asset prices) while hurting "savers" (by lowering returns).  Sometimes, amazingly, "Wall Street" will be cast as the borrower while pensioners are the creditors.  There are so many things wrong here, including the fact that industrial borrowing doesn't rise when interest rates are low.  But, without even getting into the subtleties, savers are Wall Street.  Wall Street is savers.  The idea that "Wall Street" is a net borrower or that it pockets the capital gains from lower rates without suffering the lower returns is wholly incoherent.

The asset class least exposed to risk free interest rates is probably equities.  In low inflation environments, higher risk free interest rates are usually associated with lower risk premiums, and corporate leverage doesn't increase when rates are low, and is fairly stable anyway, so that equity values are only marginally associated with interest rate changes.  Increases in equity prices mainly reflect increased aggregate demand as the Fed reaches policy more optimal for everyone in the face of a negative demand shock.  (Another widely believed pair of opposites is that corporations are binging on easy money to spike their profits and also corporations are sitting on piles of cash instead of investing in the American economy....both at the same time.)

Note that the longer the duration of cash flows on a security - the closer it is to a perpetuity - the more elastic is the price as a function of the required return (the market rate).  A T-bill paying off $100 in one year will only change slightly in price as rates change.  30 year bonds are the longest bond durations we usually see in the US.  Stocks are a type of perpetuity, but since their required returns tend to be higher than bonds because of income uncertainty (decreasing the present value of their future cash flows), and the equity risk premium tends to move contrary to risk free bond rates, their interest rate exposure is usually not so great.  The asset that is closest to a perpetuity is real estate.  And, since real estate rents will rise with inflation, the interest rate that determines broad asset values in real estate is the very long term real rate, which tends to be lower than the nominal rate.

Here, I have used the FHFA All-Transactions Home Price index and the CPI Rent of Primary Residence index as proxies for home prices and rent to estimate an implied real return on ownership of homes, based on a 100 year home life.  Then, I compare this to the 30 year mortgage rate (minus core CPI), using the 30 year mortgage as a proxy for the required rate of return.  The difference between the implied return and the real 30 year mortgage rate is an estimate of alpha (excess return) to home ownership.  In many financial markets, we would expect this to be arbitraged away.  Frictions to arbitrage include the advantages of owner-occupation, tax preferences for owner-occupants, lack of access to credit for potential owner-occupants, etc.

The absolute level of return is arbitrary.  I am assuming that the costs of ownership are stable over time as a proportion to rent.  If this assumption is relatively benign, then the relative level of excess return should be comparable over time, given an assumed proportional cost.

The first pair of charts assumes low costs of ownership, and thus high alpha to home ownership.  We see that in the low interest rate environment of the 2000's, access to home ownership spread, which led to a decline in alpha.  Price to Rent ratios collapsed in the crisis, as well as long term interest rates, so that alpha to home ownership is again very high.  The alpha isn't the result of difficult monthly payments, as it had been 30 or 40 years ago.  It's due to the dead real estate credit market.

This is why cash and investment buyers have been such a large part of the market.  The level of alpha has been high enough that home ownership provides excess risk-adjusted returns even without the tax benefits of owner-occupation.

Let's say that this version of the model understates costs of ownership.  Interestingly, since this leads to lower implied returns, the cash flows discounted from the future rent payments are relatively larger, the duration of the home itself is longer, the home is more like a perpetuity, and thus the intrinsic value of homes is improved even more by today's low real long term interest rates.  So, an assumption that implies a housing bubble (negative alpha on homes) also implies that current alpha on homes is very high.  In other words, regardless of how much excess returns home ownership provided in the past, it is currently providing very high excess returns.


Here's my point, regarding framing (no pun intended).  A common view about the Fed is that they are helping "Wall Street" with loose monetary policy and that one way this happens is through nominal inflation of durable assets.  But, this view is confused by a lack of appreciation for the mathematical relationship between asset prices and implied returns on those assets, which I described above.

For a case in point, look at what we have in housing.  Home prices are low because Fed policy has been too tight.  I think everyone would agree that looser monetary policy would raise nominal home prices.  But, who benefits from rising home prices?  By and large, middle class families.  And, who benefits from low home prices?  Well-funded "Wall Street" investors, who earn excess returns on the homes because of the limited number of buyers.  (You might, rightly, suggest that I have just reversed the double standard that I described above.  But, here, I am referring specifically to excess returns over the fully arbitraged market rate.  We would see a sort of revealed preference, here, if home prices do increase by 10% or 20%, at which time we will almost certainly see many more owner-occupier, mortgage-based buyers, and many fewer "Wall Street" buyers).  And who loses because of low home prices?  How about a million construction workers?  How about young families facing rising rent because of crimped housing supply?

Now, let's just imagine that everyone could fold up their tail feathers for a moment, and stop squawking about winners and losers and good guys and bad guys.  We've got people who would like to buy houses, but they can't.  People who would like to live in houses, but there aren't enough.  People who'd like to build houses, but nobody is hiring them.  All these things happen when the prices are right.  The prices aren't right.  This graph is why.

But, none of these people are going to get the things they want, except those darned Wall Street investors who are raking it in with their real estate investments while we patiently wait for homeowner mortgage buyers to come back from the dead.  I really doubt that large scale non-bank real estate investment funds have single-handedly captured the Fed so that they could grab a few extra points on their rental holdings until things get back to normal.  The Fed is just reflecting the national demand for policy failure.  As a matter of fact, housing speculators are the only participants in this story whose activities are actually helping push things back to normal.

I'd say a good measure of the intellectual sanity of this country would be the number of stories we might see in op/ed periodicals, from left-wing to right-wing, lauding housing speculators for helping workers, renters, and homeowners recover from this mess.  Instead, it seems that everyone agrees that homes are too expensive and speculators are to blame.  But the information in defiance of this belief is clear.  Debt service as a proportion of income is at record lows while mortgage debt as a proportion of home values is still too high.  By these measures, home prices have never been more out of whack - to the low side.  I'm beginning to think that there is no error the consensus wouldn't be willing to embrace.  The data is there.  It's not hard to look it up.  The imbalance here - in the opposite direction of conventional wisdom - is unprecedented.

As a speculator, I appreciate the fact that there is no shortage of those willing to take the wrong side of so many trades, but I'd prefer that we stop cutting off our nose to spite our face.  We are the 100%, after all.

PS. Sober Look with additional comments.

Wednesday, October 8, 2014

Young adult male employment and the housing bust

In yesterday's post, I reviewed labor force by age and gender and found that about 1/3 of the movement below trend in LFP seems to come from males under the age of 35.  There are about 35 million working-age males between 20 and 35, and LFP rates for this group (though this data is a bit noisy) are roughly 2 1/2 to 3% below trend.  About 1 million young adult males have disappeared from the labor force.

Here is a graph of construction employment and unemployment.  With September's reading, the construction unemployment rate is 7.0% - basically back to 2004 levels, when the construction unemployment rate was 6.8% and U-3 unemployment rate was at 5.4%.  Note, though, what has happened to construction employment over that time.

In September 2004, there were about 7 million construction employees.  In September 2014, there were about 6 million.  A loss of.....about 1 million workers from the construction labor force.  What proportion of these workers would be males under 35 years old?  It must be pretty high.

This is a topic where I think supply vs. demand issues are not easily disentangled.  The Fed allowed a tremendous demand shock, which we have mostly grown out of.  But, the one area where credit markets aren't nearly back to a healthy equilibrium is in housing, where homes are still much more leveraged with debt than they have ever been before (I have postponed my bullishness on housing since that post, waiting to see if we can overcome the credit problem.).  This leverage is entirely the product of the decline in home values that came out of the demand shock.  But, the disequilibrium is creating a supply shock now, because overleverage in the housing market has stalled housing credit markets, which is hampering existing home sales and new home construction.  Rent inflation is high right now.  (It's the only source of inflation in core CPI right now.)  So, this is a supply problem, but the solution is more aggregate demand to push up home prices by another 10% or so.

So, this is an aggregate demand problem, but it doesn't have anything to do with sticky wages.  These young males aren't out of the labor force because their reservation wages are too high.  They are out of the labor force because there aren't any houses to build.  But, the solution is still inflation.  Ironically, household formation has been low.  These young males would be building houses for themselves!  If the Fed had provided just a little bit more liquidity before ending the QE programs, these young males would have jobs and they would have houses - with lower rents than the houses that are available now - because the demand problem is a supply problem.

The Fed just released a new labor indicator that suggests a very strong labor market - similar in measure to 1987, 1997, or 2005, when the economy was basically settling into full utilization (here is a cautionary comment).  I agree with the finding in this measure.  We have a strange situation, where the economy is very strong, except for housing, which is dead as a doornail.  It was recovering, but has stalled out over the past two years.

I was readying myself for a speculative position, based on the idea that homes are much cheaper than people seem to be accounting for.  But, the prices may not be able to overcome a market without functioning credit markets or Fed-provided cash.  (Yesterday, calculated risk noted that, at least in Phoenix, non-cash buyers were up 10% YOY, so maybe there is hope if the second derivative of mortgage levels can be sustained.) So, while I have been right in my bullish calls on unemployment this year, I am afraid that the futures market has been right all along about the weak yield curve in 2015-2016.  Growth in investment might have to come entirely from industry for the next couple of years.  The downside risk is that there isn't enough escape velocity, and the Fed will not take part in another round of liquidity.  The neutral scenario is probably that we muddle along, with middling inflation and low interest rates.  Even though the balance between savings and investment will continue to improve, all that savings will have to be filtered through industry.

In the meantime, these marginally attached young males will remain non-employed and ill-housed.  And baby boomers who would prefer the long-term return profile of real estate will have to save through less favored means.

The end-game seems to be vulnerable to a tipping point - either another deflationary crisis, or an economy hot enough that it builds to where home leverage reaches normal levels and then explodes in a flurry of credit creation.

PS:  Good news from the Fed today.  If this more accommodative posture continues, the effect on interest rates, at least in the medium and long term parts of the yield curve, should be positive.

Tuesday, October 7, 2014

Labor Force Participation by Age and Gender

Here is the infamous Labor Force Participation chart.  Next, is the chart, broken out by age and gender.  The shape disappears when we disaggregate, except that the one-time increase in the 1970s & 1980s in the female working age categories parallels the one time increase in aggregate LFP.

I estimate that after accounting for age and gender, labor force participation is between 1% and 1 1/2% below cyclically adjusted trend.  There are a few categories that don't have long-term linear behavior.  There are cultural changes in the 55+ category, which had, many years ago, been very high among men, then bottomed in the 1990s but are now increasing again as productive lifespans increase.  These have leveled out after rising, and it is hard to know whether any of this leveling is cyclical.  Most of the issue of Social Security disability benefits plays out in this age group, so my simple analysis here doesn't help to quantify that issue very much.  The 16-19 year old category has declined tremendously, also, for cultural reasons, and it displays significant cyclical movement.  It has been stabilized since 2010, and was likely affected by the minimum wage increases of 2007-2009.

The remaining categories have linear patterns that allow us to estimate their cyclical deviations.

 These are pretty noisy series, so these will be broad estimates.  Here are the high participation male groups.

The 45-54 male category has shown some significant cyclical behavior.  It has recovered and is within about 1/2% of the trendline.  The 35-44 male group had less cyclical behavior and is also near trend.

The 25-34 male group had sharp cyclical behavior and is still about 2-1/2% below trend.

The 45-54 group is probably echoing some of the long term trend among the older group, where more people are able to at least partly disengage from the labor force as we become wealthier in general.  Age 50 is a trigger year for disability benefits, so the long term decline among 45-54 year olds is probably a signal of that issue.  I think this signals that recent increases in disability claims are more a sign of boomers hitting 50+ than they are of age adjusted changes in claims.  So, I think this problem will stop drawing down the LFP trend as the boomers age.

Here is the Male 20-24 category.  Like the male 25-34 category, this group has seen a sharp cyclical decline.  It is still about 3% below trend.

The female groups are a little harder to estimate because the trends are shorter and there seems to be more noise.  I don't see any obvious cyclical drops in the younger groups (including 20-24 year olds, not shown in this graph).  It depends on where you set the trends, but as a whole, there is probably less than a 1% deviation from trend.

Aggregate LFP tends to move about 0.5% above and below trend through business cycles.  In this cycle, it may be about 1 1/4% below trend, even after adjusting for age & gender.  I think we can broadly divide this decline into three roughly equal parts:

1) Cultural changes among 16-19 year olds and 55+ year olds, which may have been affected or amplified by cyclical issues.  These changes are mostly the product of wealth and longevity, and are probably not a concern.

2) Sharp declines among men under 35 years old.  I don't think the data show a surge of college admissions among men, relative to women, so I don't think that is the explanation.  The good scenario is a leveling of gender expectations - more house-dads, etc.  The bad scenario is that there is a budding underclass of unemployable unskilled males.  It is important to keep in mind the scale here.  We are talking about maybe 2% of the males in this age group.  But, I would say that this is the category that does represent a potential structural issue that might need to be addressed or that might represent involuntary or dysfunctional changes in labor force behavior.  There has been a distinct change in young adult male working behavior coincident with this cycle.  Could this be related to the collapse in construction labor?  Cyclically, we tend to think of the lower LFP in these ages as related to returning to school during downturns.  But, over the longer term, education correlates with higher labor force participation.  Could there be a new wave of long term convergence between male & female LFP, beginning in the younger groups, that is related to the very high relative levels of higher education among young women?

3) Fairly normal cyclical behavior among the prime working age males and females.

But, there is one additional issue:

4) The labor force might be overstated by up to 0.4%-0.5% if the VLT unemployed would normally have been categorized as exiting the labor force.

Monday, October 6, 2014

September Employment Review

Well, I juuuust barely got my gap down - 5.94%, as reported - almost dashed by rounding.

Here are the durations.  Mostly what we saw this month, I think, was a correction in the noise among short term unemployment to finally reflect what we're seeing in the unemployment claims data.  Long term unemployment stalled.  So, it seems that we have seen most of the decline in unemployment that will have come from faster exit rates associated with the end of EUI.  Further declines will come from the 0.8-0.9% of the labor force that has been unemployed for more than 2 years and the slow continued improvements typical of maturing recoveries.  The very long term unemployed had been linearly declining for two or three years at a rate of about 0.05% per month, but this decline has stagnated for 3 or 4 months.  Here is a graph of my estimate.  This could be typical noise.  If it is noise, we might hit 5.5% by December.  If there is some sort of deceleration here, then we might hit 5.7% in December (though, of course, the reading of any given month can range over several tenths).

Here is a comparison of the September reading and my running December forecast levels:

The pessimistic scenario assumes that all the durations under 27 weeks will stabilize and that among the 27+ week durations, there will just be 0.1% of a decline among each of the more recently unemployed as the post EUI cohorts continue to fill this category and as the VLT unemployed level just reverts back to the 0.8% level that it has been hovering at since June.

The optimistic scenario reflects a slight decline in regular 15+ week durations and a reversion to trend among the VLT unemployed.

Here is my graph of unemployment claims and total unemployment.  It tells the same story.  This month, unemployment declined in line with the decline in unemployment claims, but there was no reversion back toward the long term norms, since the very long term unemployed have held steady.

The main question, going forward, is whether the VLT unemployed continue to exit steadily, pulling the unemployment rate slowly down similar to the previous 25 years' experience, or does unemployment stagnate as it did in the 1980s at a slightly higher level.  I'm not sure that anyone has any idea, since this cohort of unemployed workers doesn't have a precedent in post-WW II US.

Looking at flows, I'd say the trends still look good.  The new decline in the unemployment rate comes mainly from an increase in net UtoE (green line in Flow1), which I would characterize as mean reversion after a couple of months where this flow was weak.  Weakness in labor force came from flow from employment.  Flows from unemployment out of the labor force were right on trend.

The unemployment rate comes from the difference between the net UtoE flow and the net NtoU flow.  While my analysis above seems to suggest an unemployment rate that will begin to stall, when we look at flows in this way, with such strong trends in these net flows, it seems more likely that unemployment will continue to fall.

Looking at smoothed net flows over a longer time frame (Flow2 - note the color legend is different than in Flow1) net flows also continue to look strong.  Flows between unemployment and employment (red) still look good.

Changes in labor force participation are reflected in the difference between net NtoE (the green line in Flow2) and net UtoN (the blue line in Flow2).  The incredibly strong labor market in 2005-2007 is clear here.  While net UtoN is still a little high and probably will be for some time while VLT unemployment remains elevated, net NtoE has been very strong this year, hitting levels similar to the 2005-2007 period.  This is another signal of our bifurcated labor market.  While there are a large number of marginally attached workers and very long term unemployed, the rest of the labor market has signs of a mature and bullish business cycle.  Or, maybe as with so many issues, the demographics make this more benign than we imagine.  Possibly, with more older working-age people, there is simply more opportunistic, temporary employment and more marginal employment behavior.  There are clearly cyclical movements, but maybe the demographics inflate both the secular and cyclical trends.

Looking at the individual flows (Flow3), all trends are good.  The flows between E and U finally reflected a fall in EtoU, which has been signaled by unemployment claims for several months.  This decline should be sustained, and not just a single monthly deviation.  The U and N flows continue to decline to recovery levels.  And, the net flow from EtoN appears to mostly have come from and increase in the EtoN flow.  In other words, the decline in labor force participation this month was not a product of marginalized workers leaving the labor force.  It was from employed workers leaving the work force.  Workers coming straight from Not in the Labor Force to Employment remains fairly strong.

Finally, regarding wages, I disagree with the negative reactions that I'm seeing.  Clearly, inflation needs to be accounted for.  And, I think it is more accurate to think of wage levels and employment levels as both being affected by the broader economic context.  Real wage growth is right where we would expect it to be in this context.  Even if the unemployment rate is overstated, which I think it is, and the current labor market is similar to what would normally be about 5% unemployment, 1% YOY real wage growth would be fairly typical.  If inflation is going to keep reverting to around 1.5%, there is little reason to expect nominal wage growth of 3-4% in any labor market.  It could happen, but I don't see why the current wage trajectory would be disappointing.  I suspect the complaints about wage growth reflect social desirability bias, as much finance reporting does.