Thursday, March 5, 2015

Housing Tax Policy, A Series: Part 19 - Liquidity Crises, Sticky Prices, and the Yield Curve

(Yes, I know, "Housing Tax Policy" is probably no longer a fully descriptive title for this series.)

Previously, I had noted that the yield curve appears to have a bias that has prevented it from attaining a negative slope when one was called for.  While the yield curve, in general, seems to be a fairly unbiased predictor of future rates, it has failed to fully foretell sharp rate drops associated with contractions.  The yield curve would go slightly negative, which has been a decent predictor of contractions, but did not go negative enough to fully price in impending rate changes.

So, there appear to be unarbitraged profits available for buying long forward fixed income contracts when the yield curve flattens.  But, previously I didn't have a speculation about the reasons behind this.

Thinking about the 2006-2008 crisis, and the role of the money supply and housing, I now have some mechanisms in mind.  In fact, these mechanisms may have been especially relevant to this crisis.  As a start, nominal rigidity (sticky prices) clearly has a role in the series of trends that tend to work their ways through an economic downturn.  Most importantly, we consider sticky prices in wages, which contribute to unemployment.  We also consider the problem of nominal debt, which remains as an overhang on an economy that has suffered a disinflationary shock, so that debts must be repaid with dollars that are worth more than they were expected to be worth.

My basic intuition here is this:  For forward interest rates to fall, the spot prices of long-duration securities must rise.  But, bidders on long-duration assets require currency.  If forward interest rates are declining because the Fed is trimming currency growth, then long-duration asset prices would be upwardly sticky.  The currency would not be available to bid up the price of those assets, thus the interest rates on those assets could not be bid down.

Perhaps the inverted yield curve has been such a good forward indicator of recessions because in these conditions, forward credit markets become inefficient.

Additionally, I think there might be an important nominal rigidity issue in housing that has been neglected because there seems to be a reluctance to model home prices as a real security.  Mayer and Hubbard had it figured out already, in 2008.  Home prices are pretty well explained by real interest rates and rent levels, especially when real long term interest rates are very low.

Incidentally, the monetary source of the crisis comes out pretty clearly in these two graphs.  First is a graph of M1 levels in the Euro zone, Canada, and the US.  Second is a graph of price to rent levels in various Western countries.
The US started crimping the money supply as early as 2004-2005, and US house prices began to drop at the end of 2005, and they stabilized after the Fed reintroduced liquidity, after 2008.  European monetary policy was accommodative until M1 growth began to flatten in 2007-2008, then again after 2009, and their home prices began to drop in 2008.  Canada didn't induce a liquidity crisis, growing M1 quite steadily throughout the period, and Canadian home prices continue to grow as long term real interest rates remain very low.  Liquidity dislocations in the other nations have pushed home prices down typically by something around 30%, if Canadian prices are a guide.

As I have been outlining in this series, these drops in housing prices are from disequilibrium in the housing market.  Because of the frictions specific to housing, the yield curve implied from home prices is equivalent to 30 year treasuries yielding something like 6%, while actual 30 year treasuries trade for less than 3%.  So, we continue to live within a context, in the extreme, where this price stickiness pushes the yield curve upward, at least in the housing market.  Because these frictions do not exist in the bond market, rates on treasuries have been able to fall along with short term rates.  The arbitrage opportunity made available by these frictions in the homeowner-occupier market has led to an unprecedented movement of cash from investors into the housing market, which began in 2006 when this rate rigidity was first triggered by tight monetary policy, and has continued as the gap between implied housing yields and treasury yields has widened.
We can see the secular trend of deleveraging here.  Profits have increased
at a higher rate than compensation, and interest payments have increased
at a lower rate than compensation.  The total return to capital (the sum of
interest and profit) has increased at roughly the same rate as compensation.
Analysts pointing out high profits usually do not understand this shift.

This graph outlines what, I think, is a conventional view of business cycle dynamics.  As much as 2 to 3 years before the drop in NGDP associated with recessions, profits begin to fall.  We can see that compensation follows a very stable path, relative to profits.  The general price level follows an even more stable path, which follows partly from our current inflation targeting monetary policy.  If I included total employment levels on this graph, we would see that, because wages tend to be sticky, a significant part of this barely perceptible drop in compensation comes from a drop in the quantity of employment, not from a drop in wages.  So, equity holders take the brunt of the downturn, in terms of income.  (That's why they earn the big bucks!)

Credit Market Instruments have been scaled x 3 for visibility
So, where we normally think about sticky prices is in the recovery from a downturn, where debtors default while attempting to repay debts with relatively deflated dollars and unemployment rises as a sort of temporary price floor on labor creates a shortage.  And, we look to moderate inflation as a salve to these issues, inflating those repaid dollars and pushing real wages down to a market clearing level.

But, I think we might step back in time, and consider that while those nominal rigidities are a result of the economic downturn, rigidities in asset prices could be a cause of it.  First, let's walk through the market for corporate debt.

We might expect that our canary in the coal mine, profits to equity, will start to signal a fall from trend NGDP.  This tends to happen along with the yield curve inversion.  In the 2001 episode, this happened a couple years before the precipitating inversion, but this could be related to the deferred earnings expectations of the internet boom, or the flirtations with yield curve inversion that happened in the late 1990s.

Both short term and long term rates tend to be high when the yield curve inverts, and we see a shift from equity to debt in corporate capital balances.  Could this be, in part, due to the attempt by savers to bid on debt securities that are priced below equilibrium?  Gross domestic investment drops during these episodes.  Yet, absolute levels of debt rise, and frequently even accelerate upward.  Could the lack of liquidity create a sort of price ceiling, leading to a surplus of buyers (debt buyers) and a shortage of sellers (corporate investments) and a drop in the demand for substitutes (equity)?

When currency growth and inflation were high, in the 1970s, note that the yield curve was able to invert substantially.  And, these cyclical movements between equity and debt values were less extreme.  The 2001 episode is somewhat difficult to consider because of the currency fluctuations related to the Y2K scare.  But, let's look at the previous two downturns more closely.

This graph shows 10 year treasury rates and the Fed Funds rate, as well as the rate on a 30 year TIPS bond maturing in 2028.  It also includes:

Total market value of nonfinancial corporate equities/GDP.  These will tend to move up and down with aggregate demand and growth expectations.

Total nonfinancial corporate debt/GDP.  This quantity tends to move, both cyclically and secularly in the same direction as nominal interest rates (which I have noted before, and is clear in the graph above).  Here, I am positing that the cyclical movement results from an inflow of savings because of upwardly sticky prices during periods of low liquidity.  One thing to think about here is that supply of debt reflects underlying risk postures of savers, so that savers would react to this price disequilibrium by increasing quantities, whereas firms would be indifferent to capital balance, and would adjust debt to equity levels based only the market price of these capital forms.  I don't think firms would necessarily be induced to change their capital balance by inefficiencies in rate levels, and market rates would be their only clue to investor risk appetites.

Home equity/GDP.  Because cash flow (rent) is relatively stable, and adjusts with inflation, home values tend to move inversely with real long term interest rates.  The disequilibrium that pulled savings into mortgages and corporate debt could not find their way to this asset class in the 2006-2008 episode because of frictions in the real estate market, including limited access to credit and the ubiquity of owner-occupiers who would be individually limited in scale.

Mortgages/GDP.  During this period, mortgage levels should move roughly in line with home equity.  However, along with corporate debt, I also posit that savings was induced by the disequilibrium into funding mortgage debt.

When the yield curve inverted in June 2000, both real and nominal long term rates began to fall reasonably well.  Home values rose significantly, and corporate debt rose slightly.  Equities fell significantly, due to falling profits and growth expectations.  By December 2000, the Fed was already lowering short term rates, and as soon as they did, long term rates took an extra step down.  I believe that this is normally attributed to a rational expectations cause - that the lower long term rate reflects lower expectations for forward rates.  But, I have always found this to be unsatisfactory, since lower short term rates (all else equal) should lead to higher rate expectations at some future point on the yield curve.  Here, I am suggesting that there was a price disequilibrium in credit markets, due to the lack of currency that would be needed to bid up the price of long term securities, and the liquidity associated with the reduction in short term rates relieved that constraint.

That problem must not have been severe, since home equity was rising during this period, but this was partially funded by mortgage growth.  Also, corporate debt stopped growing when the yield curve turned positive again.  Also, see the graph to the right.  Foreign dollars piled into the US during both of these periods, at unprecedented levels.  Also, note from one of the earlier graphs that, except for the odd currency fluctuation around Y2K, currency was still growing by nearly10% per year (2.5% per quarter in the graph).

Summary for the 2001 episode:  The downward jump in long term rates when short term rates were decreased, the inflow of foreign dollars, and the slight increase in corporate debt levels concurrent with the yield curve inversion suggest that there was a small disequilibrium in long term rates, but a quick shift to short term rate cuts, those foreign inflows, and especially the still relatively healthy growth in currency, all helped to keep enough liquidity in capital markets.  The sign of this success is that home equity was able to rise as long term real rates decreased.

In the 2006-2008 episode, long term rates began to fall after the inversion, but then stalled.  Corporate debt rose slightly in this early part of the episode.  But, here, the Fed did not introduce liquidity that would have lowered short term rates and allowed long term rates to continue to fall.  So, by the beginning of 2007, savings was pushing more into mispriced corporate debt, causing its growth to accelerate.  Foreign dollars were again rushing into the US (and continue to), but currency growth was negligible by this time.

The leveling off of home prices up to early 2006 might have been a natural movement in the equilibrium price of homes associated with naturally rising real long term rates.  But, by the beginning of 2007, the lack of liquidity was keeping real estate prices from rising, and the stable long term real rates were a product of disequilibrium.  Households were tapping the mortgage credit market in an attempt to purchase homes which were now underpriced, greatly increasing homeowner leverage in 2006.  But, this avenue was used up by early 2007.  If the Fed had loosened during this period, long term rates would have fallen and home prices would have risen, as rates across asset classes would have moved together in equilibrium.  But, 2007 marks the beginning of extreme disequilibrium in long term fixed income markets (including housing).

When rates finally did drop, the feedback to the mortgage credit markets from the dislocations in the real estate market had overwhelmed the housing market, and since that time, fixed income has been split between high yielding real estate and low yielding long term bonds.  In fact, 10 year treasuries held up at above 3.5% through the summer of 2008, while the Fed Funds rate dropped to 2%.  I wonder if this separation still reflected a decent disequilibrium, so that the drop in long term rates in November and December 2008 was a return to equilibrium, while the subsequent rises in long term rates were associated with forward real and nominal rate expectations related to the QEs.

Foreign capital and investor capital for the rental market continue to push into the real estate market in a bid toward equilibrium prices.

In future downturns, if currency growth remains very low, we might be wary of signals coming from stable long term interest rates.

PS.  I admit, the behavior of equities in the 2006-2007 period doesn't fit well into my narrative.  Profits were falling and currency was scarce.  I do not see the source for corporate capital gains.  Even without viewing the period through this model, I have been perplexed by the solid growth of equity values during that time.

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