Thursday, July 24, 2014

Inflation and Interest Rates in 2014 & 2015

I have been generally expecting positive surprises in the labor market to lead to a steepening of rates in the short end of the yield curve.  The manifestation of recent economic improvements in rate movements has been more muted than I would have expected, especially considering recent strength in some inflation readings.  The 1st quarter GDP reading might have some influence here in addition to a deceleration of growth in housing, but most other economic indicators have been strong.

In any event, I will construct a forecast path for interest rates over the next couple of years.  This will probably be a bit too precious, but I would just consider this a possible narrative, built on some of the peculiarities where my model of the economy might differ from the marginal investor, and thus lead to potential profit or loss.
Here are graphs of recent changes in the Eurodollar yield curve.  The first graph shows the change over time in the expected first date of short term interest rate increases and the expected rate of further increases after that.  Since late 2013, there has been a slight positive trend in the expected date of the first increase, from summer 2015 to spring 2015.  But, at the same time, there has been a decrease in the expected rate of subsequent increases.  To put this in perspective, in the previous two cycles, the Fed Funds rate increased at a rate of about 35 to 50 50 to 75 basis points per quarter.  Currently, forward rates are priced for a rate of about 25 basis points per quarter.  This would be very slow.

This suggests that the market generally is pricing in some of the same expectations that I have about future monetary policy.  If we look at the full Eurodollar yield curve, we can see that, in terms of bootstrapping the rates of longer term bonds, these near term changes in short term rates have been swamped by a significant decline in the terminal rate at the long end of the curve.  I agree with what the market is saying here.  QE3 doesn't appear to be having much effect on the immediate economy, but the end of QE3 and other signals from the Fed suggest that they will continue to be very tight with monetary policy as we move forward.  Also, note that, as with the previous rounds of QE, the liquidity effect appears to be completely non-existent in the current environment.  When the Fed buys long term bonds, their prices go down (yields go up) and when the Fed stops buying long term bonds, their prices go up (yields go down).  The fact that so many observers, including the Fed itself, still frame monetary policy as if the liquidity effect is the overriding effect, in the face of repeated evidence plainly suggesting the opposite, gives me confidence that there are inefficiencies to be exploited regarding monetary policy.  But, as this graph demonstrates, the market in general is already with me, at least part way.

I expect rates to rise a little sooner and a little more steeply than current prices imply, and I expect them to level off a little sooner.  At that point, further developments will depend on discretionary decisions by the Fed, and the main speculative dilemma will be to guess when they will decide to be catastrophically tight again.  At that point, a long position in intermediate term bonds will be the potential speculative position.

I continue to have confidence about the near term forecast.  Bank credit continues to expand as we exit QE3 and employment continues to exhibit strength.  Here is my graph of continued unemployment claims and the unemployment rate.  There could be some statistical pull-back for the rest of the month, but if claims for July average what they were on the July 12 report, the expected decline in unemployment would take us down to 5.9%.  (And this week is already a confirmation of last week's low number.)  If we factor in the expectation that the unemployment rate should be edging back toward more typical levels, relative to continued claims, the unemployment rate range we should expect in July is probably 5.7%-6.0%.  (It would be really fun to see the bottom of that range.)

Before I move on, I want to pause a moment on this.  The other estimates that I have made of the unemployment rate declining to 5.5-5.7% by year end did not rely on continued improvements in unemployment insurance numbers.  The results for the rest of this year could be very strong.  And this brings me to a pseudo-fact that it seems we have concocted in the last decade.  Let's say the economy goes gang-busters, and we find ourselves looking at temporary YOY NGDP growth of maybe even 7% or 8%.  Does that mean the Fed should pump the brakes on the economy?  If you answer "Yes", then I have a question for you.  WHY?! WHY WHY WHY WHY?!?!?!  What possible evidence is there that NGDP growth occasionally hitting the high single digits is catastrophic?  I've seen highly informed and intelligent people claim that housing in the 2000's was a "bubble" that happened because the Fed temporarily allowed 7% NGDP growth.  What in the hell has gotten into the water?!  I'm all for an NGDP target, and if we had a target, then 5% would probably be fine.  But until we do, for the love of Pete, can we imagine it heading back into normal territory without having a communal freak out?  The average NGDP growth rate since 1948 has been 6.6%.  This includes recessions.  Nobody wants 8% inflation again.  But, it's almost as if the zeitgeist now has it that the Fed has to destroy the economy to save us from 3% inflation.  I wish everyone would stop being insane....Well, I take that back.  There would be no profit in my work if everyone wasn't a little bit insane.  But can we all try to be a little LESS insane?  Be just insane enough to leave a mispriced microcap here & there...

Anyway...inflation has also started to imply a healthier economy and rising interest rates, but this month it took a breather.  I think it is helpful to separate housing from Core CPI because of the peculiar nature of recent housing markets.  If we do that, we still see pullback in June inflation.  Core minus Shelter inflation has been much lower than other measures of inflation, but it also shows more upward momentum, even after the June pullback.

Here is a graph of the same three indicators, shown in the more traditional trailing 12 month measure, with some notes.  Here we can more clearly see the pattern of Core minus Shelter inflation, which was very weak until March of this year, and has now begun to move back up.

I estimated Shelter to be 40% of the Core CPI basket for the entire period, for simplicity.

We need to be careful about Shelter inflation, because home supply, prices, and rents have had a peculiar relationship recently that is not simply a product of the business cycle.  This is partly what caused the inflation signal that steered the Fed off course in 2007 and 2008, in my humble opinion.  Until 2005, (Period 1) home construction was boosted by the need for long term savings.  This helped to keep rent inflation in check.  The housing boom was deflationary.  (I will also note that while rent inflation was stable, it was by no means weak.  How exactly rent remained so steady in the story of massive overbuilding in a housing bubble, spurred on by predatory lenders and a crazed nation of homebuyers, should be a mystery.  It wouldn't be a mystery if the real story was that home prices were too low in 2002 & 2003 and sticky prices in real estate kept them from efficiently responding to low real interest rates until rates had increased in 2006.)  By 2006, (Period 2) long term real rates had increased, causing a pause in home construction growth, and this pause in production may have led to rent inflation.  (Core minus Shelter (CmS) inflation was down to 1 1/4% by mid 2007.  But, Core Inflation was boosted, counterintuitively, by the slowdown of supply.  Or, alternatively, I wonder if survey responses on Owner Equivalent Rent tend to track mortgage payments, which would have been increasing at the time, as house prices and mortgage payments topped out.  Whether stated rents were increased by supply or by statistical aberration, the effect would have been to boost stated inflation.)  By late 2007, (Period 3) the Fed was thoroughly engaged in fighting inflation.  By September 2008, when the Fed took its last, fated, stand against inflation, CmS, Core, and Shelter inflation were all at about 2.5%.  The collapse in rent lasted until about the end of 2010.  CmS Inflation bumped up above 2% during QE1 & QE2.  And, by 2011 rent and home prices were increasing again (Period 4).  While low real interest rates continue to justify high nominal home prices, the recovery of both indicators is probably mostly from cyclical demand recovery and limited supply.

That brings us to the summer of 2014.  Banks and regulators appear to be quantitatively and qualitatively loosening up on real estate lending, finally.  This is happening, not coincidentally, as home equity and debt levels reach their comfortable relative values.  I believe we have been seeing a short term dip in home building activity and home price appreciation, as the market transitions from an investor cash-only buyer market to a mortgaged homeowner market.  Commercial bank real estate loans have a lot of acceleration to go to get back to previous growth levels (at least double the growth rate of the first half of 2014).  As we proceed through 2014, home production and home prices will move up higher than is widely expected.  This will help GDP figures.  But, note, the added supply should cause rent inflation to moderate.  So, Core inflation will moderate.  This might leave room for the Fed to allow CmS Inflation to rise above 2%, even with their hawkish sentiment.  I think the economy will accelerate during this period, and the Wicksellian interest rate will rise dramatically.  This will also give the Fed cover among hawks, as this will be interpreted as the Fed raising rates.  So, we could see tame core inflation, NGDP above 5%, and short term interest rates above 2% or 3%.

The problem I am looking out for is that long term real rates will probably remain relatively low - in the range of the rates of the 2000's.  Home prices in a reasonable credit market should push up higher than the prices of the 2000's.  I am afraid that the Fed will misinterpret this as inflationary or as an asset "bubble", and will start to clamp down on credit markets and the money supply.  I hope that doesn't happen, but the speculative position to take then will be exposure to collapsing near-forward interest rates.  I hope that speculative opportunity doesn't present itself.

By the way, here is a graph (log scale) of home equity, home mortgage levels, and real estate loans kept on the balance sheet at commercial banks.  Of course, in the 2000's, we had a massive housing bubble where home prices and house construction went bonkers, fed by predatory and excessive mortgage debt, and banks unscrupulously unloaded all of that rotten real estate debt to unwitting securitization investors.  I have a Golden Ticket for anyone who can point that bubble out to me on this graph.  For the life of me I can't find it.  That sure is one heck of a something that happened in 2007 & 2008, though.

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