Tuesday, May 27, 2014

Bonds and Real Estate as Giffen Goods

Chart 1
My last post discussed trends in Commercial and Industrial Loans as a proportion of total bank credit (chart 1).  One obvious issue in that graph is the tremendous drop in C&I Loans over time.

Interestingly, the level of C&I Loans as a proportion of GDP is pretty level over many decades (chart 2).

Chart 2
So, the change isn't so much a product of decreasing C&I Loans as it is of Increasing Bank Credit in general.  Chart 3 shows securities in bank credit (treasuries and federal agency bonds) as a proportion of GDP (inverted), compared to inflation rates.  These proportions seem to move with inflation and nominal rates.  As rates decrease, securities in bank credit increase.

Chart 3
Here is an old article, by Frank Steindl, discussing how cash and bonds could interact as Giffen goods.  Alternatively, Scott Sumner frequently discusses how the opportunity cost of holding cash is higher when rates are high, so as rates go up, central banks can actually reduce their asset bases, counterintuitively.  I don't know if this is precisely the description of a Giffen good, but it does mean that the more money a central bank produces, the less of it the market will demand.  Recently, there has been mention of treasuries as Giffen goods, with regard to default risk.  Here is an Economist article that suggests the flight from risk is so strong that high public debt and sovereign default risk can actually increase demand for U.S. Treasuries.  Treasuries would be a Giffen good.

Chart 4
I believe all of these explanations of Treasury bonds as Giffen goods have some merit.  But, looking at C&I Loans got me thinking about bonds as a Giffen good from a slightly different perspective.  Chart 4 shows the relative change in the level of C&I Loans, real estate loans, securities in bank credit, and currency in circulation, over time, as proportions of GDP.  (Real estate loans are slightly complicated by a long term positive trend.)  Currency, securities, and real estate all show an inverse relationship to inflation & nominal rates.

Currency can be explained by Scott Sumner's point, that the market is more indifferent about holding cash when rates are low.

Chart 5
But, I think what real estate and bank securities have in common is that they are low risk long term cash flow instruments.  Their nominal rate levels are relatively low because of low credit risk, but they do have duration risk.  The longer the duration of a bond, the more vulnerable it is to changes in interest rates.  Prices and yields are inversely proportional, which means that as yields get lower, the price becomes more sensitive to yield changes (chart 5).  In other words, as rates decrease, bonds get riskier.  But, since real estate and government bonds are the least risky parts of bank balance sheets, banks might react to this higher risk by accumulating more of these assets.  When the price of these low risk bonds goes up, their risk goes up, and when their risk goes up, banks want more low-risk assets.  We can intuit how the hierarchy of risk in a bank's or a household's balance sheet would begin with low risk assets and add higher risk assets as conditions allow.  These assets aren't exactly what we would call an inferior good, yet their place in balance sheet construction would be parallel.

I have discussed how the Price to Rent ratio for homes should increase as real interest rates decrease.  This can happen through an increase in price or a decrease in rents.  In practice, it appears to have come entirely from increases in real estate prices.  Could it be because low risk long term securities are Giffen goods?  As their values increase, the economy's propensity to hold them also increases, whether in terms of ownership of properties or bank ownership of securities.

PS.  Here is a chart from this Economist article.  At that site the chart is interactive.  Note that house prices across the Anglosphere have followed similar trajectories for the last 40 years, until 2008.  Since then, the US is the outlier.  It is tempting to think that the US has reverted back to a normal valuation level, but I think this is a product of mental accounting biases.  If US home prices recover to pre-crisis levels, they will be catching back up to these foreign markets.


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