Tuesday, August 22, 2017

Counter evidence to the consolidation story

The idea that industry is getting more consolidated has been getting a lot of play lately.  In some ways, this does seem to be true.  Clearly, there are network effects, etc., in tech and finance that might lead to consolidation with just a few firms, at least temporarily.

One reason I am skeptical of the notion is that I think it has grown out of the idea that corporations are capturing more income at the expense of labor.  That idea is greatly overblown.  What decline there has been in labor share of income isn't attributable to firms capturing more income.  Of course, I attribute much of it to income going to real estate owners.

I think the mystery this increase in concentration is supposed to solve is that shift in income share.  Since the shift in income share doesn't really amount to much, there isn't much of a mystery to be solved.

To the extent that there has been some consolidation, I suspect that it just hasn't had that much of an effect on the labor/capital income balance.  To the extent that there are higher margins in terms of variable costs (and, taking everything into account, I'm not sure net margins are as high as all that), much of that is flowing to human capital, and since human capital has to buy access to lucrative labor markets through constricted housing markets, much of that flow on to real estate owners.

Anyway, here is another piece of evidence that seems contrary to the consolidation story.  For the past 20 years or so, it is midcap stocks that have led the way, not large caps.  If there is consolidation, this would suggest that it is consolidation that is related to creative destruction and market reorganization.

Monday, August 21, 2017

Leverage is not a sign of risk seeking, a continuing series

I have written in the past about how the typical treatment of debt levels in the business cycle tends to treat it as purely a demand phenomenon - that risk-seeking investors seek out debt in order to leverage their dangerous investments.

But, as with most things financial, there is a supply and a demand side.  And, if we think broadly about the two types of ownership - equity and debt - from a saver's point of view, debt is actually a sign of risk aversion.  Risk averse savers invest in debt.  Risk seeking savers invest in equity.

There are a lot of moving parts here.  For instance, in an economy saddled with systemic risks, debt levels will tend to be lower because the debt itself is considered riskier.  This may be part of the reason for the global finance trade, where developing market savers seek out developed economy debt for safety while developed economy firms invest in developing economy equity.

But, in the US economy, which generally is stable and which is built on the long term establishment of institutional trust, debt is generally associated with risk aversion.  And, corporate debt isn't particularly sensitive to interest rates.  Firms are price takers when it comes to risk premiums.  When interest rates are low, this is a sign of risk aversion, which means that when interest rates are low, equity investors aren't particularly interested in leveraging up.  This is also true cross-sectionally.  It is the least risky firms that tend to carry the most debt.

Here is a graph of corporate debt (credit market liabilities issued by non-financial firms) as a proportion of operating profit ("operating surplus" as defined by the BEA).  That's the blue line.  Then, the bar chart superimposed on that is a measure of the trailing 12 month change in non-financial operating surplus.

What we see here is that, in the aggregate economy, firms tend to want to settle at a debt level of about 4x to 4.5x operating income.  To the extent that things like growth expectations affect the enterprise value of firms, that generally accrues to equity values.  There appears to be a pretty stable limit to debt/income levels in equilibrium.

Now, what we see, since the mid-1980s, is debt/income that settles in around 4-4.5 during expansions, and then it shoots up above that level during contractions.  The reason debt/income shoots up is because these are unexpected income shocks.

Debt levels don't rise because risk-seeking savers get careless as an expansion ages.  Risk-seeking savers bid up equities, like they did in the late 1990s.  Debt levels rise because firms are reeling from a contraction.  And, once the contraction subsides, firms retrench until debt levels settle back at 4-4.5x.

Where in the world did we get the idea that we have to draw back the economy because firms will get too risky and borrow too much?  What data is that story based on?  It looks to me like we are actually creating the leverage problem, not solving one.

What would happen if instead of engineering contractions in corporate profits, we tried to engineer a continuation of positive profit growth?  What if that actually led to rising interest rates for savers, improved negotiating power for laborers, solid returns to pensions, and robust tax revenues?  Recently, profits have not been great, and leverage has increased as profits have declined.  And, a reason the Fed is giving for tightening is to prevent some sort of push in wage inflation...

Friday, August 18, 2017

Housing: Part 251 - Elements of our current cycle

I have been critical of the Fed's current stance.  I think they are destined to over-tighten because of Phillips Rule thinking and because rent inflation induced by throttled housing supply causes them to overestimate the inflationary effects of monetary policy.  I expect the yield curve to eventually decline to a lower level.  And, stocks might move around a bit, but I suspect they will eventually be lower than the current level over the next couple of years, though not necessarily too much lower.

In the meantime, I had been waiting for a convergence between interest rates and home prices.  There has been a divergence since 2007.  Yields on real estate (especially low tier real estate where credit constraints have cut off demand of owner-occupiers) have been at long term highs while long term TIPS yields have been very low.

I don't know how much trading there actually is on the relationship between housing and interest rates, but the colloquial take on it is that rising rates make affordability harder, and cut into homebuilding.  I don't see any reason in the historical data to consider that relationship important.  Rising real long term rates could reduce the intrinsic value of homes, causing price/rent ratios to moderate.

However, there is a divergence now.  So, I think it will take a resurgence in residential investment to pull real long term interest rates higher again.  That resurgence either needs to come from loosening the supply constraints in the Closed Access cities or from loosening entry level mortgage standards, which have been quite tight.  So, rising rates would likely be related to surging homebuilders.  Like I said, this is contrary to the colloquial take on this, but I'm not sure it's that contrarian to past experience.

Yields aren't the binding constraint in housing, so I don't think rising rates will pull down intrinsic values in housing.  I think this will make homebuilders more positively correlated with interest rates than normal over the business cycle.  Also, at current levels, homebuilders are fairly defensive, because there is so much pent up demand.

Data from Zillow (ZVHI)
I think we are starting to see a resurgence of low tier housing.  Here are 12 month price changes in Miami.  This is pretty typical of today's market across MSAs.  By my count, in 17 of the top 20 MSAs, low tier prices are rising faster than high tier prices.

We need this.  Cumulatively, since the late 1990s, low tier prices have lagged high tier prices in most cities - by 15% on average (more than that outside the Closed Access cities).  This is because in most cities, low tier prices didn't behave much differently than high tier prices during the boom, contrary to common reports.  But, when we clamped down on lending, low tier prices collapsed.  So, they have a lot of ground to make up in the return to normalcy, if it ever comes.

We have also seen moderate very recent rises in mortgage lending, according to some measures.

In the meantime, though, Fed policy might be pulling interest rates down by causing economic contraction.  So, I'm not sure we will see an immediate convergence of housing yields and interest rates (rising home prices and falling bond prices).  On the other hand, there could be some interesting ways to create defensive hedges that also have upside potential as these markets evolve.

And, this could happen sort of under the radar.  The entry level markets don't amount to much in total dollars, because the home values are low.  So, I think we could see healthy improvement in entry level homebuilding while credit markets look meager because a lot of these homes might be purchased without moving the total dollars borrowed that much.

In the meantime, if these trends lead to a pick up on the margin of homebuilding in these markets, finally, it could really perk up some homebuilders, even if the macro-economy doesn't look that exciting.

Wednesday, August 16, 2017

Housing: Part 250 - Interest Rates and Home Prices: Open Access, Closed Access, and Canada

Before I really started to dig into the details of the housing boom and bust, I used to excuse the run-up in home prices simply by using real long term interest rates.  Long term real interest rates declined by about 2%.  That's a sharp decline for real rates at the long end of the yield curve.  This is the rate that should dominate intrinsic values of homes, because homes are real assets. (Their values and cash flows shift with inflation.)

A basic rule of thumb in fixed income is that the value of a cash flow will shift in proportion to its time in the future.  The present value of a cash flow one year from now will decline by 1% for each 1% rise in the one year discount rate.  The present value of a cash flow 30 years from now will decline by about 30% for each 1% rise in the 30 year discount rate.  For a bond, this sensitivity is called its "duration".

If we think of home ownership as a claim on all future rent value, then homes clearly have a very long duration - something similar to a 20 or 30 year bond.  That means that, hypothetically, a 2% drop in real long term interest rates could justify something around a 50% increase in home prices.

It so happens that Price/Rent ratios did increase by about 60% from 1997 to 2005.  So, it seemed possible to me that interest rates could explain that rise without requiring any influence from credit access, speculation, etc.

But, I was making a fundamental error, as I now know.  There was no American housing market, per se.  There were cities where Price/Rent ratios increased by maybe 20%.  There were other cities where Price/Rent ratios more than doubled.  That can't be explained by interest rates.  And, in fact, I have come to the conclusion that local supply effects are a primary factor in rising home prices in the US and abroad.

It so happens that Edward L. Glaeser, Joshua D. Gottlieb, and Joseph Gyourko have estimated that home prices are not that sensitive to long term interest rates.  They have a sensitivity of about 8% for each 1% change in long term interest rates.  And, it so happens, if we apply that sensitivity to home prices among the major US metropolitan areas (MSAs), that sensitivity can justify home prices in cities where Price/Rent ratios only increased by about 20%.

In other words, with Glaeser, Gottlieb, and Gyourko's sensitivity, interest rates basically explain all of the changes in home prices from the 1990s to the peak of the boom in cities that didn't have supply constraints.  That leaves most of the price increase in the Closed Access cities unexplained.

It also happens that there is a strong correlation between rent inflation and the unexplained rise in MSA home prices.  In other words, where supply is limited, rents increase and are expected to continue to increase.  Rents in cities like Dallas and Atlanta have risen at about the rate of general inflation, and home prices in those cities never depended on expectations of rising rents.  On the other hand, excess rent inflation in the Closed Access cities has averaged about 2-3%, annually since the 1990s, and a basic cash flow valuation model for homes in those cities can justify their peak 2005 home prices with rent inflation somewhat lower than that for the next 20 years or so.

But, I still wonder if this sensitivity to interest rates is still a product of treating the national market as a single entity.  I wonder if there may be a correlation between rent inflation and interest rates that is dependent on local supply constraints.

Here is a basic equation relating rent to the price of a home.  (Rent here is after expenses and depreciation.)

This is just a specific version of a standard Gordon growth model.  Cash flows are in the numerator and the discount rate is in the denominator.  Here "C" is a multiple to reduce the sensitivity of home values to long term real interest rates.  Using the estimate above, we might set this equal to the rate on a 30 year inflation protected treasury, with only a 40% sensitivity to changes in that rate.

Here's the tricky thing, though.  In a city where supply can respond to price signals, we should see two mitigating forces.  First, lower rates should increase the value of homes and this should induce more building.  That new building - a rightward shift in supply - should reduce rents.  In the equation above, "Growth rate" means the expected rate of future rent inflation, above general inflation.  So, in a city with elastic supply, when the interest rate declines (lowering the value of the denominator), this should directly effect rent inflation.  Rents should decline.  And, since the growth rate is subtracted from the denominator, this should raise the value of the denominator.

In other words, in an open city, when homes have higher values because of declining interest rates, they should also have lower values because of decreasing rent expectations.

And, that would look a lot like a housing market where home prices were just less sensitive to interest rates.  In fact, to the extent that this should happen pretty mechanically in an unencumbered market, I don't see how we would tell one from the other.  Expected future rent would be an unmeasurable value.  How could we determine this relationship quantitatively?  I don't think we could very easily.

But, guess what happened in places like Dallas and Atlanta?  When rates went down, housing starts went up, and rents went down.  It's like Econ 101 in those cities.


So, could it be the case that in Dallas and Atlanta, home values are as sensitive to long term real interest rates as we would expect a durable asset to be, but they are also sensitive to changing rent expectations that would naturally come along with those changing interest rates?

What if that is the case?  Then, how would that change our model of home prices in the Closed Access cities?  It is surprisingly indeterminate.

Let's rearrange the equation above so that we solve for the growth rate.  In other words, given the rent and price in a given city, what rent inflation is required to justify prices in that city?

In the following scatterplots, I have plotted actual rent inflation from 1995 to 2005 for each city on the x-axis, and I have plotted the implied excess rent inflation from 2005 home prices on the y-axis.  The first graph uses the low rate sensitivity (only 40% of the sensitivity of 30 year treasury bonds).  The second graph uses a high rate sensitivity (the same sensitivity of 30 year treasury bonds, which is about 20 years, depending on rates).

These are all cities with both a Case-Shiller price index and a BLS rent measure.  I would say that these two scatterplots could both be realistic.

In the first version of the model, future rent inflation expectations are less in every city than the trailing 10 year average rent inflation had been.  So, there is nothing outrageous about the expected rent inflation implied by home prices in any city.

On the other hand, causation goes both ways.  There had been a sharp housing correction in the early 1990s, and real interest rates were high throughout the 90s, with moderate housing starts.  Rent inflation was high just about everywhere, and that shouldn't be expected to continue in a low rate environment.

In the second model, only the most expensive cities required any expectation of rent inflation.  In this version of the model, low long term interest rates are responsible for most of the rise in home prices in just about every city.  This also seems reasonable enough.  Expected excess rent inflation in Atlanta and Dallas, with this version of the model, is between -1% and -1.8%.  Well, during the boom, when rates were low and building was strong, excess rent inflation in those cities ranged from zero to -4%, as we saw above.  And, at the national level, after a decade of persistent rent inflation, by 2005, rent inflation had finally declined down to about the general level of inflation.

If we had allowed housing starts to continue to be strong, we should have expected rent deflation.

So, is the sensitivity of home prices in the range of 8% for each 1% change in long term rates, or is it more like 20%?  You tell me.  I think it could be either.  Either could be reasonable.  I suspect it is somewhere in the middle, but I think the sensitivity might very well be closer to the high version here.

What I find interesting regarding the housing bubble thesis I have been building, in terms of the causes of the bubble, it doesn't matter what the sensitivity is.  In either case, there is a strong relationship between rent inflation in a given city and home prices.  Clearly, the difference between cities - and the difference between cities is the most important factor of the housing bubble - is largely about rent inflation.  It is about supply.


One reason I have slowly tended toward believing there is a higher rate sensitivity is the international data.  Since 2007, the US market has been broken.  Our supply problem is as bad as it has ever been, but we have sharply curtailed mortgage access, so we have created a regime shift in housing by creating a demand shock.

In the other "bubble" countries - here I show the UK, Canada, and Australia - prices have continued to remain high or to rise higher.  It happens that during this time, long term real interest rates have fallen even further.

When I look at Canadian data, housing starts and rent inflation in cities like Vancouver and Toronto don't seem as extreme as they are in the US Closed Access cities.  There is some building - not nearly enough to meet demand, but some - and, at least as measured, rent inflation doesn't appear to be the reason for recent price appreciation.

Australia also appears to have boosted housing starts, but with little effect on prices.

This is what we would expect to see if interest rates were more important than expected rent inflation in explaining the high price levels.

Clearly, in the US, rent inflation has been correlated with price growth.  But, could it be that those high prices don't depend so directly on rent expectations?  Maybe, since homes are a low risk asset, and future rent expectations are an uncertain factor, homebuyers aren't willing to pay much of a premium for expected rent inflation.  Maybe, in a Closed Access context, homes represent two sources of value - the low risk source of value (shelter and location) which calls for a low discount rate (a high price/rent ratio), and the high risk source of value (future rent expectations) which calls for a high discount rate, and thus doesn't really affect the price that much.

If that's the case, then once we get past a certain threshold, all Closed Access cities will sort of look the same.  Once there are enough political limitations to housing growth that local housing starts just aren't that sensitive to shifting interest rates and rising prices, maybe it doesn't matter that much whether excess rent inflation might come in at 0%, 2% or 4%.  Maybe it's enough to simply block the moderating influence of rising housing starts, so that declining interest rates don't trigger rent deflation.  Then, that means that in all cities, home prices rise significantly when interest rates fall.  And, then, there are cities where housing starts can rise, cyclically, pulling those prices back down.  And, there are cities where housing starts can't rise, cyclically, so that the full effect of falling rates is felt.

Tuesday, August 15, 2017

July 2017 CPI Update

New trends seem to be holding.  For the third month in a row, core CPI inflation, excluding shelter, was at 0.6%.  Shelter inflation continues to slowly moderate from last year's level.

Not much to do but keep watching.  Things could still go either way.  It does appear that today's reading caused Fed Funds Rate expectations to fall a little, with the expectation that the Fed might pull back on the pace of rate hikes.  That is good news, I think, although I still suspect that the baseline scenario here will be that a rate decrease will be in order, and that is simply outside of the Fed's current frame of view.  In that case, they would hold rates level, considering that accommodative, when it would really be a tightening.  And, the tightening would worsen as the rate remained there, just as it did in 2007.

Thursday, August 10, 2017

Question for readers about money management

I have a question for IW readers.

I have successfully managed investment portfolios privately for about 17 years.  Currently, I am making arrangements to manage investments for clients based, in part, on the ideas I have been developing on the blog.  How many of you would be interested in this service?

We are entering a dicey period in the business cycle where careful asset allocation can make a big difference.  IW readers should have a sense of the strategies that I would deploy in these portfolios and the breadth of the conceptual approach I am taking.  This combination of ideas that I have developed can provide significant defensive and speculative potential as well as some long term sources of solid returns. 

This is an interest survey for the new venture.  If you would have any interest in allocating assets to a portfolio managed with the sort of analysis you have seen here, or if you know of a group of friends or acquaintances who would be interested in a presentation about being an initial investor, please e-mail me at idiosyncraticwhisk@gmail.com .

Many readers have conveyed to me the value they see in this analysis.  I would really like to hear from you if you think you or someone you know would like to utilize this work in the allocation of your own funds.

Housing: Part 249 - It's all about rent.

I have posted graphs before that show how rent has become an increasingly important factor in home prices at the MSA level, before, during, and after the housing boom.  They are near the end of this post.

Today, I thought it might be helpful to look at that graph in terms of Price/Rent and Rent.  Here it is.

Source: Zillow
The relationship between the median Price/Rent and the median annual Rent of an MSA just keeps getting stronger.  And the reason is that MSA housing supply limits are the primary factor influencing housing markets today.

What causes this relationship?  I can think of three potential connections:

1) Where rents are high, it is the result of limited housing in cities where that obstruction to migration allows incomes and rents to continue to rise.  Expected rent inflation raises the value of those homes.

2) Where rents are high, the income is from economic rents that come from political exclusion, not from capital allocation.  The value of housing units, then, accrues to land, not to improvements.  Land does not depreciate, so Price/Rent levels are bid higher because landlords require lower gross returns on their properties.

3) Where rents are low, housing supply is elastic, which means that low long term real interest rates might increase the present value of homes, but they also induce new building, which pushes down rents.  This makes housing in elastic cities less sensitive to real long term interest rates.  There is little supply response in cities where rents are high.  This means that when long term real interest rates decline, there is no mitigating effect on rents.  This allows home values to be more sensitive to low long term real interest rates, as we would expect a very long-lived real asset to be.

Whatever the reason, until we can actually have a conversation that acknowledges rent as the fundamental factor here, analysis of the housing boom and bust will be less than useless.  Right now, there are schools of thought among economists divided between the "credit supply" school and the "credit demand" school.  Both schools of thought are based on the premise that rent had nothing to do with changing home prices, so entire papers written on this topic don't even mention rent at all.  This is really crazy, because if you go talk to residents in San Francisco, New York City, etc., they are complaining about the rent!  And the hundreds of thousands of households that either move away from those cities each year or refrain from moving in are largely renters with lower incomes.  They are fleeing from cities with lucrative income opportunities because of the rent.  This is such an overwhelming factor in our current economic context, it simply can't be denied.

And, yet, entire seminars among economists are based on erasing this from the set of priors.

Meanwhile, while every guy at the end of the bar and every internet amateur Austrian economist agrees that economics is useless and that economists were complicit in the errors that led to the Great Recession, the one thing they all seem to agree on is that economists have this totally right!  Prices are irrational and have nothing to do with rent.

Wednesday, August 9, 2017

Unwinding the Fed's balance sheet

My retelling of the financial crisis and the recession requires some review of monetary policy, if for no other reason that the Fed frequently focused on housing during the crisis.  Generally, individual sectors are only very selectively mentioned in FOMC statements.  From May 2006 until recently, housing was mentioned in every FOMC statement except for October 2008:

May to August 2006:
Some version of:
Recent indicators suggest that economic growth is moderating from its quite strong pace earlier this year, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices. 
September to December 2006:
Some version of:
Economic growth has slowed over the course of the year, partly reflecting a cooling of the housing market. . 
January 2007
Recent indicators have suggested somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing market. 
March to June 2007:
Some version of:
...the adjustment in the housing sector is ongoing.  
August to December 2007:
Some version of:
...the housing correction is ongoing
January to April 2008:
... deepening of the housing contraction...
June to September 2008:
...the ongoing housing contraction...

After that, housing was generally mentioned with regard to household wealth, housing starts, and the Fed's MBS purchases.  Clearly housing was important, as it should have been.

Anyway, it bothers me a bit, because every Tom, Dick, and Harry, including those with much better credentials than me, has a criticism of the Fed, and I find most of those criticisms to be horrendously wrong.  Why do I think I'm any different?

Yet, despite the fact that most everyone is wrong, the Fed is important.  Actually, because most everyone is wrong, the Fed becomes important.  What 'r ya gonna do?

I have recently been critical of rate hikes because of declining inflation and flatlined lending (although very recent bank real estate lending has turned up).  I fear the Fed Funds target is already pushing above a neutral level, and if that is the case, the Fed will certainly be too slow to reverse course.

And, I think this issue with the balance sheet will make it worse.

I really don't understand much of the academic treatment of Fed policy.  I certainly could be wrong.  I am not formally trained in these matters, so there is much I am certain to miss.  Please correct me in the comments if you feel that I am wrong and salvageable.

Much of the treatment of Fed policy seems to treat long term rates as if they are simply a product of the sum of the intervening forward rates (that much is somewhat defensible) and that those intervening rates are purely a product of future Fed policy stances in a ceteris paribus world.  It seems to me that more than even a few quarters forward, rates will be increasingly the product of factors out of the Fed's control or factors in the Fed's control that push rates in the opposite direction of short term Fed machinations.

Low long term rates were, famously, a "conundrum" for Fed officials in 2005-2006.  The fact that they see this as a mystery seems like part of the problem to me.  Policy rates during the time were basically neutral.  There was no reason for forward rates to rise because expectations were muted.  Far forward rates were actually declining during the time.  That's not because as the Fed was rapidly raising rates from 1% to 5.25% everyone was becoming convinced of their commitment to loose policy.  It's because there was a sharp shift in sentiment, a massive buildup of savings, and a lack of risk-taking investment.  Part of this is visible in sharply dropping housing starts and homeownership rates at the time.  Yet, the Fed generally seems to have viewed those low rates as stimulative.

The other thing I think is strange about reviews of monetary policy is that the liquidity effect seems to be treated as the overwhelming effect on interest rates.  This is especially weird because these are extremely liquid markets.  So, the idea generally seems to be that when the Fed loosens, it buys treasuries, which injects buying pressure into fixed income markets, pushing up prices.  When the scale of these effects is measured, it seems to usually be done as a sort of event study.  This is common in financial markets.  But, that is because financial markets are generally perceived to be extremely liquid, with little room for a liquidity effect.  Prices shift immediately because future buying pressure is presumed as part of the current price.  So, the effect of policy changes is measured by measuring the liquidity effect at the point of the shift.  But, if the liquidity effect can be anticipated and priced by markets, then how can there be any liquidity effect at all?

So, my mind boggles when I see so many analyses of Fed policy that claim the QEs were effective because at the point of the policy shift, forward interest rates declined.  This is a backwards interpretation of the signal forward rates are giving, based on a signal that shouldn't exist.

Now, I must admit that in the very short term there does appear to frequently be a shift in long term rates in the same direction as a short term policy shift that doesn't really make sense if, say, loose policy signaled by lower short term rates should cause long term sentiment, inflation expectations, and therefore rates, to rise.  I can't say forward rates confirm my complaints on a second-by-second basis.*

But, over longer periods, I don't see how these conventional versions of Fed policy review hold water.  It seems clear to me that, as they were implemented, the QEs were associated with rising long term rates, which then fell each time as QEs were terminated.

One of the great failures of my trading life was that I was set up with a position that was highly sensitive to rising rates in the summer of 2013, and I managed to screw up the execution so badly that I ended up with nothing to show for it.

Anyway, what is odd to me is that conventional analysis of the QEs reverses this.  So, unwinding the balance sheet is expected to raise long term interest rates.  Here is Gavyn Davies in the Financial Times:
...the Fed will shed only around one third to one half of the assets it accumulated during the expansion phase, implying that the balance sheet will drop by $1.2-1.8 billion over several years. The total effect of this might be to increase 10 year bond yields by about 40-60 basis points...
The article later says:
Janet Yellen has suggested that the expectation of balance sheet normalisation has already increased the bond yield in 2017 by 15 basis points, which she says is equivalent to two 25 basis point increases in the fed funds rate. The market seems to think that the balance sheet run down will have an even larger effect on short rates than Yellen implies, which is perhaps why it is so reluctant to price in the full rise in rates implied by the FOMC’s “dot plot” for 2018-19.
So the liquidity effect, which must assume some sort of short term inefficiency in bond prices, has been anticipated.  Rates have already risen by 15 bp because spot prices reflect the inability of future spot prices to anticipate temporary shifts in Fed buying.  (Please tell me how I have this wrong!  I really would love to know that I am wrong.)

So, just because of institutional inertia, and the fact that rent inflation is wrongly attributed to monetary policy, I would expect the Fed to hold the Fed Funds Rate too high for too long, just like they did in 2007.  But, here, we have an added problem.  The expectation is that long term rates will rise as they unwind the balance sheet that was built up by the QEs.  But, I don't think they will.  As the program is implemented, long term rates will fall.  Maybe not by much.  But, I think they will fall a little bit.  And, instead of seeing that as a problem, FOMC members will say, "Well, we were worried, because we thought unwinding the balance sheet would raise rates, but rates are falling.  This will stimulate asset markets, which will allow us to continue raising rates."

Of course, these events would lead to an inverted yield curve, which is a bad sign, and, according to research at the New York Fed that I (and many other finance folks) do find useful, is associated with recessions (and, thus, declining interest rates).

Will the Fed raise rates as the yield curve starts to flatten?  Surely they wouldn't, I want to think.  But, there is 2006 and 2007.  And, the consensus FOMC view seems to be that, if anything, rates should have risen higher and sooner.

This all is moving in slow motion, and there is some chance that some sort of economic momentum will outrun Fed tightening.  So, this may come to pass in 2018, later, or never.  But, it seems to me that a defensive posture is increasingly called for, and that, at some point, probably after another rate hike, a speculative position on sharply falling rates will be lucrative.  I suppose, if I'm not crazy here, there is a variation on the old cliché at work. "The Fed can remain irrational longer than you can remain solvent."  On the other hand, I generally prefer the corollary to that old cliché, which I heard someone say a while back.  "The market can remain solvent longer than you can remain irrational."  This probably describes the bulk of the speculative losses that have been excused by the original version of the cliche, and might also apply to mine.  You should probably hope that's true.

* On the other hand, there are some pretty epic, and sort of funny, counter-examples in favor of the POV I am describing here.  I remember hearing a press conference with Ben Bernanke in June 2013, when, in response to the "taper tantrum" the Fed decided to promise to stretch out QE3 a little longer.  He said, "These large and growing holdings will continue to put downward pressure on longer-term interest rates."  Interest rates shot up literally as the words were coming out of his mouth.  From the day before to the day after that FOMC meeting, the yield curve moved up about 40 basis points.  Expectations destroyed the liquidity effect.  To add a wrinkle to that, the move was effectively all in real rates - not in inflation expectations.  The "taper tantrum" a month earlier had also been all in real rates.  That might seem strange.  But, when the primary effect of tightened monetary policy has been to collapse real investment, should we expect a reasonable loosening to be inflationary?  I would like to attribute the May 2013 rise to improved real economic expectations, rather than to the proposed slowing of QE3, and the June rise to monetary accommodation.  I realize that is a "just so" story.  (Note, however, that the rise in May was gradual while the rise in June was a sharp reaction to the FOMC meeting.)  But, if you judge that, then you need a story that explains coherently how rates moved sharply higher as the Chair of the Fed explained that today's policy shift is intended to move rates lower.

Sunday, August 6, 2017

Growth means change, and change is hard.

Today, I would like to draw on a couple of recent posts.  One was on our tendency to interpret events based on what I think Tyler Cowen would call "mood affiliation".  In that post, I note that journalist Matt Taibbi seems to be certain that the GSEs performed terribly because management teams were persistently corrupt and incompetent at both firms (even with a purge of executives at each firm!) and seems to be equally certain that the exceptional performance of the GSEs during the housing bust shows that affordable housing targets didn't lead to any of their problems.  There is an axiom here: redistributional public programs don't fail.  Management fails.  This axiom remains true, even if both factors must define the results of a single institution.

Now, to be fair, it seems to me that much of the damage of the housing bust was the result of the opposite axiom, that public programs fail.  This led to many public policy postures and implementations meant to counter supposed effects of the GSEs that, frankly, to me, seem to either wholly contradict the facts or to use facts that bear little resemblance to reality.  For instance: the frequently repeated complaints that the GSEs represent a subsidy to housing that pumps up the market and fed the bubble.  This has both factual and conceptual problems.  Compared to things like tax subsidies, the GSEs have a miniscule effect on home prices.  And, they were a countercyclical force during the housing boom and bust, if anything - at least until the feds took them over.

What everyone can agree on, it seems, is that management is corrupt and incompetent.  The GSEs had four sets of executives that were each dragged over the coals for allegations that were remarkably correlated with public mania over time.  I've pointed out before that as management at both firms was being accused of hiding their credit risk in late 2007, the previous two CEOs were settling the cases against them from several years earlier for managing earnings, which included the sin of over-reporting their credit losses.  In both cases, though, we could count on a basic national consensus that the executives were greedy and corrupt, so it was easy to form a consensus on some form of liquidationism.  Bastards had it comin', after all.  So, we sort of did the nationwide version of urban rebellions.  We burned our collective Main Street down until we felt confident that Wall Street felt our pain, and we consoled ourselves that it was their fault that we had to do it.


The other recent post was about the Phillips Curve.  We tend to think of the Phillips Curve as a sort of measure of the negotiating power of workers.  When unemployment is low, they can hold out for higher wages.  If one thinks this leads to inflation, then one believes that firms have pricing power, and the higher wages just come out of the pockets of consumers, leading to a sort of zero sum outcome.  If one believes that firms don't have pricing power, then the higher wages come out of profits, leading to a gain for workers at the expense of firms.

I don't think either of these forces are particularly strong.  I think the primary force is about sorting.  At low unemployment, workers can have more confidence about trying out new sources of income.  And, for that matter, so do firms and investors.  Wage growth does tend to be strong when unemployment is low, but this isn't paid for by consumers or by firms.  It's paid for by growth.

So, how do these things fit together?


Well, when unemployment gets low, managers tend to complain about a lack of available workers.  As a reaction, you see a lot of commentary about how those (incompetent or stubborn or dishonest) managers are short sighted and/or ignorant of economics, and if they would just pay the market rate, they wouldn't have any problem finding workers.  The problem is that they are being stingy.

While I have been drawn into that sort of thinking myself, I think there is some justification for the posture of those managers.  Probably a good manager has to be careful about buying into a boom of cyclically overpriced labor.  Certainly, if we are going to demand the heads of, say, homebuilders and bankers, for "dancing while the music plays", we can't really also complain that they aren't outbidding each other for new production in an aging expansion.

We get to play that game because in the realm of "mood affiliation", few are looking for ways to bolster the status of managers.  So, they are always available as "the reason" why things aren't working out.  Ask anyone why the US auto firms lost domestic market share.  I bet most of them will say it was the mistakes management made in the 70s or 80s.  You and Matt Taibbi will never be disinvited from a cocktail party or fired from Rolling Stone for staking out that position.

But, I think if we really think about what is going on in the labor market there is more going on than just managers avoiding commitments that have costs that have been cyclically distorted.  I think we are actually seeing those secular shifts that lead to real growth - those laborers who aren't using negotiating power to demand a marginally higher wage, but are using it to shift to new sectors and new opportunities.

Here I need to walk back some complaints I have made in the past about pundits who claim that employers hope for recessions in order to get the upper hand on labor.  I won't walk it back too much, because, in the aggregate, clearly it is employers who are hurt far worse in downturns than laborers are.  Profits drop by something like 8% to 10% for every 1% drop in wages.  Unemployment and falling wages are really mostly a side effect of how much equity is hurting.

But, I must admit, I see how they can get that impression.  There are employers who will suggest that a little downturn could be useful.  This is horrible.  I can't believe in the 21st century, where we spend more than a decade in full-time education, this sort of nonsense can pass.  But, I can see why they feel that way.  The reason is that Growth means Change!  It's the same reason why all forms of material and spiritual improvement are met with resistance.  If you have some stake in the status of today's moral or physical world, then improvement is a threat.  Creative destruction is destruction, after all.

The reason some employers wonder if a downturn could help - the reason some employers complain that good workers aren't available at reasonable wages - is because in a humming economy, permanent growth - permanent change - is in motion.  For practically any firm that occupied some little corner of yesterday's economy, in this context, that little corner is bound to shrink.  It will comprise a smaller portion of the ever-evolving aggregate basket of goods and services.

So, we shouldn't snark about how those employers are stingy or how they don't know their economics.  We should pity them, because really what is happening is that we are winning - we, as in the emergent collective of a free people in a free economy.  We are winning, and that has to come at their expense.  We're all blind men feeling the elephant, and their part of the elephant, on the margin, is atrophying as the elephant morphs into something new and unimaginably better.  We, the collective, are winning, and they, individually, on the margin, must lose.

Would blacksmiths or film developers or candle makers have saved themselves if during the relentless march to a better material world they had simply raised their wages enough to keep drawing workers in from the auto factories, the digital imaging firms, or the incandescent bulb manufacturers?  Those complaining employers aren't necessarily going the way of film developers tomorrow.  But, on the margin, I think it is this process that they are noticing.  It is painful to them.  And, in spite of that, it is everything right with the world.

Among the countless things I see that seem backwards, one of the big ones is this horrible idea that recessions do some good by squeezing out the "weak hands".  My goodness, that is a toxic idea.  You know what squeezes out the weak hands?  Expansion!  Growth!  You think we don't use many blacksmiths anymore because we wisely imposed recessions on them?!  NO!  The blacksmiths went away because of growth!  Now, I wouldn't be surprised if most of those blacksmiths, individually, actually failed during, and in some immediate sense, because of, economic contractions.  But, can you see how wrong it would be to argue that progress came from the recessions?

The next time you see an employer complaining about tight labor markets, tell them, "My condolences, friend!  What wonderful news!"

Friday, August 4, 2017

The Overton Window is moving.

Reader Benjamin Cole shared this link to an article from Robert Shiller.  I have been hard on Dr. Shiller occasionally, because I think his housing bust call is suspect.  The bust he was expecting was different than the bust we got.  There was never any bubble-busting supply in the Closed Access cities.  But, that is what would bust a bubble in Dr. Shiller's explanation of events.

Further, even in the Contagion cities, it wasn't really supply that busted the bubble.  What caused the bubble was some expansion in lending availability and in economic activity that allowed households with high incomes to purchase Closed Access homes more aggressively.  That accelerated the sorting of haves and have-nots into and out of the Closed Access cities and it also triggered some tactical selling by existing Closed Access homeowners who sold their homes to aspirational young families and moved away.

The Contagion city bubble busted because in 2006 and 2007 monetary and credit contraction sharply slowed down that migratory sorting.  Suddenly, migration into the Contagion cities dried up from about 1 1/2% of their resident population each year down to nothing.  That is a huge negative demand shock for those local housing markets.  It had nothing to do with oversupply.  Rents were rising in the Contagion cities, and outmigration had actually been moving up in those cities because they couldn't build enough new homes to meet that Closed Access refugee crisis.

The reason that migration dried up was that, even though there was no bubble-busting supply in the Closed Access cities - in fact homebuilding was already slowing - the demand shock that was targeted at residential investment reversed the trend of the boom.  During the boom, households were expanding their personal housing footprint.  In the Closed Access cities, with fairly fixed housing stock, that meant de-population (and out-migration).  When that reversed - when households began piling and crowding back into homes in order to economize - they stayed in the Closed Access cities instead of moving away.

The reason we imposed this shock on ourselves was because of the relentless clamoring about the supposedly unsustainable bubble and how we needed to stop it before it got any more out of hand.  Dr. Shiller was certainly in the middle of that clamoring.

But, credit where credit is due.  Shiller is now discussing work from economist Richard Florida about limits to supply!  The Overton Window is moving, friends.  Even Dr. Shiller may be within spitting distance of accepting some evidence contrary to the received wisdom about the housing bust.