Friday, March 28, 2014

North Carolina Employment Update

This is an update of some of my previous posts on the North Carolina employment trends since they prematurely terminated Emergency Unemployment Insurance.  We finally have numbers through February, and there have been extensive revisions.

Here are some graphs:

The revisions have lowered the North Carolina Unemployment Rate from the summer of 2013 by more than 1/2 a percentage point.  The net result is that, even with the revisions, NC still shows very strong declines in unemployment.  But, the revisions remove most of the relative improvements in NC employment since last summer, suggesting that more of the net result of ending EUI has been a movement from unemployment to not-in-the-labor-force instead of to employment.

These large revisions show just how noisy this data is, so that there is always some question about the validity of the statistical evidence.  Evan Soltas has more on that here.

I expected to see more of a transition from unemployment to employment, as opposed to leaving the labor force, and I would have hoped for that.  In either case, if a similar trend ensues from the end of EUI at the national level, we should be left with an unemployment rate well under 6%.  It would be one thing if, in a worse case scenario, a million workers left the labor force and the unemployment rate was at 9%.  But, the tenor of this potential outcome is different when the resulting labor market is near levels we associate with full employment.

This is a place where the mistaken pessimism about labor force participation muddies the picture, because the response I see to this is that unemployment would be much higher than 6% if not for the flight of workers from the labor force.  Once we account for secular trends, the labor force, while somewhat depressed, is within the historical range.  Below, I have included a graph of LFP for the 3 male age groups with long-term linear trends.  The 25-34 age group is the only age group that is significantly below the 60 year linear trend, and even that group is only 1.2% below the trend.  On the whole, the LFPs compared to the trends are similar to where they were in 1994 and 1995, coming out of the 1991 recession.  The unemployment rate in January 1994 was 6.6% and it was 5.5% in December 1994.  EUI was terminated in the first few months of 1994, and had been much less generous than the recent version of EUI.  One caveat is that the LFP's might decline more as we exit EUI, so we might see some more deviation from trend.  I believe that EUI beneficiaries trend older, so I would expect the 25-34 group to continue to recover relative to trend, and for dips in LFP over the next few months to come in the 45-54 year old group.

The end of the program should be disinflationary, which should add to the challenge of where inflation will be over the next year, in the face of the end of QE.  On the one hand, more monetary stimulus might help move former EUI recipients back into the labor force.  On the other hand, to the extent that a number of the long-term unemployed might have marginal quantities of savings, and associated fixed incomes, unexpected inflation would reduce their real incomes.  If this is the mechanism that pulls them more aggressively back into the labor force, it might be beneficial for national production, but not necessarily beneficial for the households in question.

Thursday, March 27, 2014

A Regime Shift in Interest Rates and Stocks

I thought I would do an update on a pattern I initially mentioned last summer.

10 Year Treasury Rate (green, left scale)
real S&P 500 Level (blue, right scale)
There seem to be two regimes, regarding the relationship between equity returns and interest rates.  (I am using 10 year treasury rates.)

From about 1968 to 1995, inflation remained above 3%.  During this time, interest rates were negatively correlated with equity prices.  When interest rates went up, equity prices usually went down.

10 Year Treasury Rate (green, left scale)
real S&P 500 Level (blue, right scale)
From 1997 to the present, when inflation has generally been below 2.5%, interest rates and equity prices have been positively correlated.  Rates and equities have moved up & down together.

I wonder if this is because during the earlier period, the Fed was erring on the side of being too loose, so higher rates reflected a risk of suboptimally high inflation; but during the recent period, the Fed has been too tight, so that low rates reflect a risk of deflation and low real rates associated with economic decline.

Simple regressions for both periods produce an r-squared value of about .2 (data is monthly).  In the earlier period, a 1% YOY increase in 10 year treasury yields was associated with a 4% YOY loss in the real S&P500 level.  In the current period, a 1% interest rate increase is associated with an 11% increase in the real level of the S&P500.

This relates, I think, to my recent posts on asset allocation.  It is only in the current, low inflation regime where bonds provide strong asset class diversification.  In this regime, equities have declined when interest rates have fallen (long-duration bonds gain when rates fall).  But, this negative beta may only be in effect when interest rates are very low, when there is a dual drag on bonds - both from limited income and limited potential for capital gains.

One issue to watch if we move back to a high inflation regime would be TIPS.  It might be possible that inflation protected bonds will provide very low or negative beta with equities in both regimes.

PS.  I forgot about this post from last year on this topic.  I guess it took less than a year to start repeating myself.

Wednesday, March 26, 2014

Housing & Inflation Update

Here are updates with the January 2014 Case-Shiller housing data.

I have speculated that when rents and home prices rise or fall together, this might be cyclical behavior; but when rents and home prices are moving in opposite directions, this might be behavior related to the effect of low real and nominal interest rates on home prices.

I am using annualized monthly changes of weighted moving averages in order to retain the ability to see recent changes while minimizing the monthly noise in these series.  Home prices and rent are both continuing to increase.  However, home prices have stopped accelerating since mid-2013, roughly coincident with rising interest rates.

Current behavior suggests cyclical recovery, although the lack of acceleration in home prices suggests that the recovery phase may be maturing.

I expect both the continued low interest rate environment and the low level of housing starts to continue to push both of these levels up.  This is partly dependent on expansion of bank balance sheets as the Fed winds down QE3.  As the bottom graph shows, this expansion appears to be tentatively gaining traction.

Tuesday, March 25, 2014

Interest Rates in 2008

Here are a few more graphs from 2008.  I will leave most of the exposition to anyone else who would like to chime in.  A few patterns I see:

1) The Fed Funds rate was especially high, compared to short term treasury rates, from December 2007 to June 2008.

2) There appears to be a distinct pattern in October & November 2008, around the implementation of interest on reserves.  It doesn't seem to affect short term rates much, but as you move out on the yield curve, rates were declining; they would bottom the day of the IOR increase, rise for a few days, then begin to decline again; then bottom and begin rising again the day IOR were increased again.

3) Rates across the curve collapsed in November and December 2008.  The 10 year rate was 4% at the end of October, 3% on November 26, after QE1 was announced, and bottom at 2.1% on December 18, soon after the Fed Funds Rate was pushed to near 0% and QE1 was formally started.

 4)  The 3 year rate declined, uninterrupted, from July 2008 until the implementation of QE1 in mid-December.  Longer term bonds had similar declines, but with a hump, where long term (7 year and longer) rates jumped, coincident with IOR announcements, before eventually falling again.  The entire curve shifted down about 2% from July to December, in this fashion.  The IOR increases seem to have had no effect on the very short end of the yield curve.

(Added: One other interesting thing about the 2007-8 period that appears to be the case, in reference to the top graph, is that in past cycles, the slope of the yield curve at the shorter durations has fluctuated with higher frequency and amplitude than the longer-duration yield curve.  But, in 2007 & 2008, the slope of the yield curve under 3 years remained suppressed while the yield curve in the longer durations moved up.  This is evident in the second graph, where the 3 year treasury yield (red) tracks with the 1 year treasury yield through 2007 until March 2008.  So, while traditional yield curve indicators would have shown steepening in early 2008 because of the higher 10 year yields, the yield curve at the time was flat at durations 3 years and under.  This was before we hit the zero lower bound.  Short term rates were at 2% and above during this period.)

Friday, March 21, 2014

Wage Growth, Inflation, and Interest Rates

I think the topic of wage growth and inflation is one of those topics that is muddled by what I call the "Wizard of Oz" theory of the Fed.  Or, maybe a better name would be the "Pet Rock" Fed.  This is the notion that interest rates are primarily set by the Fed, so that if we move from .25% to, say, 3% short term rates over the next few years, that reflects intentions of the Fed regarding inflation control.  I would say that most of that movement is determined, essentially, by the market, and that, if the Fed is lucky, they keep their target near the market rate as we move along.

The Fed is like a gas station.  In the literal sense, they can go out to the curb each day to set the price.  But, in another sense, they are guessing at what the right price is, and tweaking it one direction or another.  If they get outside a given range for too long, bad stuff is going to happen.

Here is a graph showing wage growth, short term rates, and inflation.

Next is a graph estimating wage growth and short term interest rates, net of inflation.  Generally there is a relationship between wages and interest rates, both nominally and in real terms.

But, I think, instead of thinking of wage growth as a cause of inflation, which, in turn, causes Fed tightening through rising interest rates, I think it makes more sense to simply think of wages and interest rates as two symptoms of a thriving investment market.  Firms with a high demand for investment are bidding up both the price of capital and of labor.

Inflation may reflect Fed policy, but real interest rates and wages tend to rise and fall together in both high and low inflationary periods.  Wage growth might signal interest rate increases, but not necessarily because the Fed plans it that way.

On the other hand, during the 1980's, wages did tend to move pretty tightly with inflation, while debt retained a high real premium.  Perhaps the secular downward pressures on real interest rates are so strong that we will see the reverse over the next decade or two, with growing wages while interest rates remain pinned near inflation.

Could it be that when the baby boomers were young, healthy, and poor, capital was more scarce than labor, but now that baby boomers are old, retiring, and flush with capital, labor is becoming more scarce than capital?

Wednesday, March 19, 2014

Fed Forecasts

Just for kicks, here are the FOMC projections since 2007.  They are all based on 4th quarter numbers (4Q over 4Q for rates of change).  NGDP is implied from the RGDP and the PCE inflation projections.

NGDP saw a negative shock in 2009, but 2010 & 2011 came in about where the Fed wanted.  2012 & 2013 were below the Fed's original expectations.  This might be cause for some doubt about Scott Sumner's position on monetary offset, although I would generally subscribe to that view.

Unemployment came in around expectations in 2010 & 2011.  In 2012 & 2013, unemployment improved at roughly twice the pace the Fed had expected, and 2014 looks to be on track for similar results.

Tuesday, March 18, 2014

The Fed in 2008

There have been some good reviews of the Fed in 2008, since the transcripts have been published.  Matthew O'Brien at the Atlantic has a very good review of the transcripts of the meetings over the summer & fall.

Marcus Nunes builds on that here.  From his post:
Plosner (July 22): Keeping policy too accommodative for too long worsens our inflation problem. Inflation is already too high and inconsistent with our goal of — and responsibility to ensure — price stability. We will need to reverse course — the exact timing depends on how the economy evolves, but I anticipate the reversal will need to be started sooner rather than later. And I believe it will likely need to begin before either the labor market or the financial markets have completely turned around.
Hoenig (July 16): “While the comparison to the ´70s can be useful(!), the present economic situation is also different…
However, like the 1970s, monetary policy is currently accommodative(!)…In this environment there is a significant risk that inflation and inflation expectations could move higher in coming months.
Thus, it will be important for the Federal Reserve to monitor inflation developments and inflation expectations closely, and to move to a less accommodative stance in a timely fashion”.
Scott Sumner has some posts, including this one.  There have been many others.

I don't have much to add, but I tried to pull details and dates out of these posts and the sources they link to, to construct a timeline of late summer 2008.  Normally, a pithy narrative develops as I put these things together.  That hasn't come to me yet, but I thought some of you might find the chart I put together useful.

1) It is amazing how well markets held up in mid-September 2008, considering the sheer number of catastrophic economic events that happened in succession.  And this was after nearly a year of financial disruptions.  The Ted Spread exploded in the days after the quick succession of financial crises, but the S&P 500 and inflation expectations held up pretty well for another couple of weeks.

2) 129 mentions of inflation and 4 mentions of systemic risk at the September 16 meeting?  I don't have words.  For nearly a year, the Fed balance sheet had been accumulating unconventional assets.  And, the day before the meeting, Lehman had failed.  The 2 days after the meeting, AIG & the Reserve Primary Fund need capital and Bernanke tells Congress "we may not have an economy Monday".

3) The market expected inflation to average 1% for the next 5 years as they sat in that meeting discussing inflation 129 times.  Between then and Nov. 5, the Fed decided it would be a good time to institute a new policy to pay banks to hold excess cash reserves.  By the end of November, expected 5 year inflation was -2%.  During this period, they did lower the federal funds target rate, however their treasury holdings declined during this period.  There is no sign that the targeted rates were accommodative.

4) They held the Federal Funds rate target at 2% at the September meeting, and signaled that rate increases were around the corner!  The effective Federal Funds rate went haywire until the October 8 meeting, when they lowered the Fed Funds target while initiating interest on excess reserves.  At that meeting Timothy Geitner scolded members who dared to take responsibility for an erosion of confidence!

5) It looks to me like the Fed had been sterilizing unconventional asset
accumulation by selling treasuries, since late 2007.  During this time the monetary base was flatlining.  And, again, while QE1 was purportedly an injection of liquidity into the economy, the Fed balance sheet did not expand from the level it stood when QE1 was announced.  At best, QE1 was reinjecting liquidity into the economy as the Fed unwound other unconventional assets.  While inflation expectations did increase from their deflationary levels of late 2008, they remained below the 2% level throughout QE1.

While the EMH is generally a good starting point for looking at financial markets, our money supply is not the product of a market.  The Fed seems to be operating with the understanding that their actions in 2007 and 2008 were reasonable.  They also seem to continue to have excessive fear of inflation, and they associate this fear with increasing real estate prices.  As long as this is the perspective they hold, going forward, carefully taking prospective positions that would capture extraordinary gains during disruptive deflationary episodes is probably warranted, for either speculative or hedging purposes.

PS.  ....From the September 16, 2008 FOMC meeting.
Mr. Dudley, Manager, System Open Market Account (pg. 26-28 of transcript):

If I could add a few thoughts on market expectations about this meeting—I think it looks as though easing is priced in for two reasons. One, dealers do expect the federal funds rate to trade soft as we add excess reserves, so I would not take the softness in the September federal funds futures contract as indicative of necessarily expecting an easing. Two, I think it is important to recognize that the rates embodied in those fed fund futures contracts are means not modes. So I would characterize the market expectation as either that things get very, very bad and the FOMC cuts rates significantly or that the FOMC does nothing.
I think that actually a 25 basis point cut is probably the least likely outcome that the market anticipates. As evidence of this, a couple of dealers yesterday did change their forecast to a 50 basis point rate cut. I’m not aware of anybody who has changed to 25. Probably people like that are out there. I know that my colleagues at Goldman Sachs, where I used to work, are saying that they think the FOMC is going to keep rates unchanged today but, if they were to move, it would be 50.

That gives you a sense that it’s really a bimodal kind of view and that putting different probabilities on 50 and zero gives you some easing priced into the federal funds rate futures market. So I think the consensus view still in the marketplace is that the Fed probably will not cut rates today. That would be a disappointment to a degree because there’s some probability placed on the idea that the Fed might do 50, but that’s how I would interpret what’s priced into the markets today....
....I think on Friday the mood was basically that the funds rate was going to be flat for a long time. Probabilities placed on either easing or tightening were quite low, and since then the probability of easing has gone up fairly significantly. But I think it’s hard to interpret because it’s really not about 25 versus zero. It’s really about zero versus 50 or maybe even 100 as you look out longer term. Either the financial system is going to implode in a major way, which will lead to a significant further easing, or it is not.

Here is a good example of the content of the meeting.  This is from Sandra Pianalto, head of the Cleveland Federal Reserve Bank:

I am hearing that credit is harder to come by for many borrowers who in the recent past would not have thought twice about their creditworthiness.....One of my directors, who heads a very large regional banking organization, reported at our board meeting last week that many banks are shedding assets and that in some cases they are walking away from longstanding customer relationships in order to do so. He said that investors are very skeptical about putting new equity into banking deals and that those who have done so in the past vow not to be burned twice, let alone a third time.  
Of course, inflation remains an important issue as well....most of my contacts agree that the commodity price environment has stabilized considerably, making me more confident that core inflation will gradually slow over the next couple of years. (Even so, she favored leaving the Fed Funds Rate at 2% and waiting some more to see how the economy performed.) 

I don't blame the committee members.  Having a committee manage a monopoly in cash is ludicrous.  They are bound to fail.

The failure of the committee itself isn't even the most damning aspect of this system.  The most damning thing is that the Lehman Bros. collapse was the product of poor Fed policy leading up to September 2008, and the Fed just kept moving along with the same policy.  The Fed was taking a billy club to the shins of the financial sector without even knowing it.  Even after the banks absorbed a 25% decline in home prices over nearly two years, the Fed plunged us into deflation.  And, in the aftermath, the standard story is that the heroic Fed saved us from falling off the economic precipice, but that we're all supposed to be a little upset because they "bailed out" the banks - the banks that were sitting on balance sheets loaded with receivables backed by collateral measured in nominal values based on the one and only thing the Fed is supposed to produce - those lucky, lucky banks.  This is mass insanity.

Sunday, March 16, 2014

Another observation on home prices, rents, and homebuilders

I recently discussed the housing market.  In one post, I used this graph:

In another post I used the next graph:
Rent Inflation - core CPI (left scale), Price/Rent (right scale)

I think these graphs are helpful in showing the two influences on the housing market that I have been pondering.

Until the late 1990's, there was a fairly consistent set of cyclical behaviors in the housing market.  Cyclical factors would depress home prices, rent inflation, and housing starts.  At the same time, inventories would rise (note, the blue line in the first graph inverts the inventory of houses, in months).

Real and nominal long term interest rates were high enough throughout this period to remain a secondary factor, so a basic supply & demand framework was a coherent way through which to view these changes through time.  I will point out, though, that the one period of low real long term rates, which peaked in the late 1970's, coincides with the pre-2000 high point in real home price appreciation, and this happened during a period where a large number of new homes were being built, home inventory wasn't particularly low, and nominal mortgage payments were astronomical.

But, both graphs display the change in behavior starting in the late 1990's.  Inventories were cut to very low levels, where they remained for years.  Home price rose along with these low inventory numbers, as we might expect.  But there was no supply response, and after a brief rise, rent inflation dropped back to neutral levels.  This seems like more evidence that the home price increases during that time were a product of the changing value of homes as a security, not of supply and demand for housing.

Graph of 10-Year Treasury Constant Maturity RateFinally, in 2002-2003, as rent inflation peaked at a very high level, supply increased.  But, long term interest rates did not rebound after the 2001 recession, remaining low in both nominal and real terms.  This was not a product of a loose money policy by the Fed.  This was a product of market and demographic forces that were creating low real long-term rates, and a very long-term policy of tight money, which had been bringing down long term inflation expectations for 25 years.

FRED GraphReal rates rose in 2005 and 2006.  By the end of 2006, home prices, relative to rents, had leveled out, and rent inflation had risen.  Housing starts began to decline along with declining home prices and increasing inventory.  But, rent inflation continued rising into early 2007.  By mid-2007, rent levels were heading south with all the other indicators.  In hindsight, it would have taken a more inflationary policy to counteract these forces in 2007, so that homes didn't contract so much in nominal terms.

Today we are seeing high home price increases and low home inventories, just like in the late 1990's and early 2000's.  But, today, this is accompanied by increasing rent inflation.  I think this is because both the real interest rate factor and supply and demand are pushing up nominal home values today.

The cash infusion of the QE's has allowed homebuyers to fund purchases from outside the banks, pushing nominal home values back toward where they should be, considering real interest rates and the alternatives for fixed income.  Now that QE is tapering, this funding will need to come from the banks again, and recent indications seems to point to increasing bank credit levels.  This should continue to increase home prices, relative to rent levels.

But, at the same time, rent levels are increasing because of the incredibly low level of housing starts.  If starts remain this low, then rents should continue to increase.  This will push the changing level of nominal home prices even higher.

Homebuilders will either respond to this with large increases in supply, or, if they don't, their home prices should increase substantially.  It looks to me like homebuilders face one of two likely scenarios: (1) continued home price increases with higher-than-expected increasing sales volume, or (2) higher-than-expected increases in home prices with moderate increases in sales volume.

Either scenario should benefit homebuilders with land holdings, options on land holdings, large quantities of available lots, and high operating and financial leverage.  It might be time to look at "low quality" firms in this industry.

Here is a recent update from Calculated Risk.  Notice that home prices aren't just rising, they are accelerating.

Institutional Investors, QE, Banks, and Home Prices

Here is a Bloomberg article (HT: calculated risk) about trends among institutional residential housing investors.  According to the article, the purchases from these investors peaked in 2013.  This has been facilitated in part by QE3, I believe.  The cash from QE3 has been funding non-bank financed investments, which have moved as a counter to bank assets.  This could be because these investors were crowding out banks in the market for asset funding, or possibly the increased interest rate levels reduced bank capital during the QEs, and these non-bank sources of funds, flush with QE cash, made up the difference.  In any case,  I am not surprised that the level of activity from these real estate investors has been coincident with QE3.  You could also see this activity as a process of capital capturing excess returns that are available in residential real estate as a result of the broken down mortgage market.

I also note that home prices are accelerating, even as these investors dial down their activity.  This is because, from a supply & demand perspective, banks have finally begun expanding real estate credit again, and from a valuation perspective, the intrinsic value of homes, relative to other similar investments is still low.

Thursday, March 13, 2014

Homebuilders going forward

Chart forSPDR S&P Homebuilders ETF (XHB)Considering homebuilders have already tripled off the 2009 lows, I'm probably late to this party.

But, with the apparent nascent turnaround happening in bank assets and consumer credit, I wonder if there is a second act left in this sector.

Here is a chart comparing months of inventory, home prices, and housing starts, over time.  The thing that is out of whack here is housing starts.  A doubling in homebuilding activity in short order would not be outrageous.  That coupled with the continued upward pressure that we should see on home prices, coming from the low interest rate environment, should provide tremendous upside for some firms in the homebuilding and real estate sector.

Wednesday, March 12, 2014

January JOLTS and February Flows

Here are updated graphs of JOLTS (January) and employment flows (February).  Watching these series from month to month is kind of like watching grass grow, but they generally continue to show tentatively positive trends.

I use weighted moving averages with the JOLTS data to cut down the noise.  Churn is slowly increasing in all the relevant measures.  In late 2012, these trends began to flatten.  They are flattening again (see graph of slopes), so this is something to watch in coming months.  If the trends start to decline, that could signal a danger as the Fed looks to tighten monetary policy.  This could be a sign that the economy can't overcome the disinflationary effects of the taper.

The Beveridge Curve continues to approach the pre-crisis trend.  This will mostly be a product of the unemployment rate declining.  The Beveridge Curve for the 45+ age group moved especially toward the old trend (the blue dot left of Dec. 2013 is the Jan. 2014 point).  This is probably related to the steep decline in long-duration unemployment in January.  Much of the long-duration unemployed are from this age group.  This might reverse in February, when long-duration unemployment moved back up.

I would hope to see hires accelerate and the Beveridge Curve shift left as we move away from extended unemployment insurance (EUI), but as of February, outcomes appear to be mixed.  Weather-related issues don't appear to be as strong in March, so next month will give us interesting information about the direction of labor markets.

The Employment Flows data is updated through February.  The trends there continue to give a positive picture of post-EUI employment.  The flow of unemployed workers out of the labor force has actually declined significantly in the last 2 months.  Relative flows out of the labor force have come from employed workers.  These are positive trends.

Monday, March 10, 2014

Housing, Interest Rates, Rents, and Inflation

I have floated the idea that housing prices during the housing boom could be explained largely by low real long-term interest rates.  Home ownership can be described as pre-paid rent - a long position in a very long-duration, inflation-protected bond.

This graph basically tells that story:

In this graph, I compare bonds, stocks, and houses all based on the same mental framework - the price of each type of asset at any point in time, expressed in proportion to a stable measure of returns.  Bonds in the secondary market are valued this way, but bonds are usually reported in terms of yield.  Homes are basically valued this way, since implied rent is a fairly stable measure of cash flow.  Stocks are basically valued this way, except that instead of a stable coupon rate, stocks represent a volatile earnings stream.

Here, I have attempted to present all of these assets in a way that can be comparable.  And, the point I have been making in my housing posts is that, when we use a standardized mental framing, we see that home prices were never out of line compared to the other asset classes.  They remained very low in the 1990's, and at the top of the housing boom, the relative value of homes in 2005 compared to the 1980's was similar to a 30 year bond.  A home is essentially a perpetuity of rent payments on real property, so price behavior similar to a 30 year + bond is hardly uncalled for.  (The equivalent rent component that I use to construct the Price-to-Rent price index only goes to 1987, but, as you can see in the graph below, PtR was high in 1978-1979, and bottomed out in 1983, along with the other asset prices shown here.)

Also, I will note here that it would be incoherent to claim that high long-duration bond prices are sign of loose money and a signal for the Fed to tighten.  Yet, this is basically how Fed watchers, and the Fed itself, have been interpreting the 2000's.  Both long term bonds and homes were "expensive", yet everyone "knows" that the Fed was too loose in the 2000's.

So, I say, home prices weren't too high in the 2000's.  Instead, a lack of access to the home market, created by the peculiar way we finance real estate investments, has frequently led to markets where home prices were not bid high enough.  The frictions dampening home demand were increasing the implied yield on home ownership, which means that these frictions have frequently kept home prices too low, making homes a very good investment for those who could qualify for the financing.  This is why conventional wisdom about buying a home usually worked.  It didn't work in the 2000's because the behavior of home prices in the 2000's was much more bond-like, did not reflect a liquidity premium, and therefore homes were not necessarily appropriate investment vehicles for many households that could qualify for them.

Price/Dividend and Price/Rent Ratios
Prices are relatively low again, because the mortgage credit market has flatlined.  Price-to-rent was surprisingly high in the late 1970's, even in the face of double-digit nominal rates, because real long term rates were very low at the time - most of the high rates were a product of a high inflation premium.  Here is a graph from this paper, which shows price-to-rent multiples farther back in time than the data I show above.  As this graph shows, home prices, relative to rent, were rising into the late 1970's until the monetary shock of the early 1980's led to a long period of high real long term rates, and declining home prices, relative to rents.

Moving into Equilibrium

If this effect is somewhat dominant, we would expect rising prices to drive up land prices, then new home supply would dampen home prices.  This would pull future house supply back in time, increasing current supply and pulling down rents.  These competing forces push in opposite directions.  This should lead to an association of low real rates with both high home prices and deflationary pressures in the equivalent rent component of the CPI.  This is why I think the complaint that the housing component of the CPI understated inflation in the 2000's is misguidedHigh home prices that are a product of low real interest rates would be associated with consumption disinflation.
P/R (red, right scale), Rent (blue, left scale)

Interest Rate series are on the right scale, which is inverted
I'm using Case-Shiller data with rent data that only goes back to 1987.  Until the late 1990's, relative implied rent inflation and the house price-to-rent ratio tended to move together, probably reflecting business cycle and demographic factors that were driving the price of homes.  Note that, while real and nominal interest rates had declined from their peaks in the early 1980's, they generally plateaued in the 1990's at levels that weren't especially low.

But, starting in 1998, home prices began to rise.  At this point, the relationship between prices and rents inverts, so that from 1998 to 2007, rising prices are associated with less inflationary rents.  Rates fell into the 2001 recession, but coming out of that recession, long term rates remained low, so that real long term rates stepped down permanently after 2000.  (Keep in mind that interest rates and prices are inversely proportional, which means that prices rise more quickly with each fall in rates.)  This period where real and nominal rates were significantly lower than any recent experience is when house prices accelerated and house prices moved in the opposite direction from rents.  This is what we would expect in an environment where low real rates were the dominant factor.

Note that from 2005 to 2007, real rates rebounded slightly, and at the same time Price-to-Rent retrenched slightly and rent inflation increased.  But, when the Fed began sucking liquidity out of the economy in 2007, both home prices and rents collapsed.


Since 2007-2010, home prices have rebounded somewhat because of the continued low real rate environment, in spite of a hobbled banking system.  Rents have rebounded somewhat because of the lack of homebuilding since the crisis.

Real long term rates are still at least 1% below the low levels we saw in 2002-2004.  If I am on the right track here, that means that even in a rate environment with some more long term rate increases, as banks recover, we should be prepared to see home prices increase by another 40%, in real terms.  We should also expect to see home building doubling from its current levels.  And, we should expect this to be a disinflationary phenomenon.

For a start, it's probably worth taking a look at a long position on homebuilders with financial and operating leverage or other firms that are leveraged for higher homebuilding quantities and prices.

Secondarily, as I have expressed before, I am afraid that in this scenario, there will be a groundswell of public calls for the Fed to pop the housing "bubble", and we will be thrown unnecessarily into another recession, where the Fed will be tightening the money supply in an environment of low real rates and low inflation.

Friday, March 7, 2014

February 2014 Labor Report Review & Beveridge Curve notes

Well, that's just about the way it usually goes.  I predicted a positive surprise, but I thought the report was slightly disappointing.  The market, however, appears to think it was a positive surprise.

Here are updates of a few indicators I've been watching.

Durations did not move in the direction I thought they would.  Long duration unemployment actually kicked up a beat last month.  I expect this to move strongly in the other direction over the next several months.  Of course, there is some noise in this data.

Next, is my estimate of the proportion of long-term unemployed workers who exit the unemployment category (more than 15 weeks) over a 3 month period.  This indicator had moved strongly higher over the last couple of months, but this month, it pulled back.  The trend should continue to move higher, though.

Next is the year-over-year change in average wages.  This continues to show strength.  Average wages are accelerating, even as inflation remains low.  This indicator is quickly entering territory that would normally be associated with rising interest rates.

Quits, Job Openings, and Unemployment

Finally, I want to address quits, job openings, and unemployment.  Scott Sumner linked to this post by Evan Soltas.  Evan's post includes this graph, comparing quits and unemployment.

If I understand Evan correctly, he's addressing observers who believe that labor markets are in worse shape than the unemployment rate would suggest.  He's saying that since there is a pretty stable relationship between quits and the unemployment rate, the unemployment rate is probably a decent indicator of slack in the labor market.

I think Evan should take it even further.  The unemployment rate is understating tightness in the labor market.  Pro-cyclical labor policies, especially the highly extended unemployment insurance (EUI) which has recently been retracted to normal levels, temporarily and significantly raised the natural unemployment rate by adding a sort of friction into the labor market that caused unemployed workers to re-enter employment more slowly.

The addition of employable workers to the roster of the unemployed caused both the quits rate to fall and the unemployment rate to rise, relative to where they would have moved in a typical business cycle.

The more accurate indicator of economic recovery in this context is the level of job openings.  That is why the Quits to Unemployment relationship remains stable - these measures are both being affected in proportionately similar fashion.  But, the Beveridge Curve did break down.  And, also I have a graph here, comparing quits to openings.

data are weighted moving averages to reduce noise.
The unemployment level was increased by this policy, which moved the Beveridge Curve to the right.  The Quits rate was decreased by this policy, which moved the Openings-Quits curve to the left.  Both of these shifts happened coincident with the implementation of EUI and the start of the labor crisis.  The shift remained in place for 5 years as employment recovered, and both relationships have now begun to shift back to the previous proportions, coincident with the end of EUI.

Note that job openings are back to where they were in 2005 while quits and the unemployment rate remain at or worse than the cycle trough of 2003, when the unemployment rate had topped out at 6%.  Wages are increasing at a rate similar to the rate of 2005 (see chart above).  Adjusted for consumer prices, wages are as strong as they were in 2006.  So wage growth corroborates the signal we are getting from job openings.

There are jobs available, but since unemployed workers have been incentivized to re-enter employment more slowly, these jobs remain unfilled.  Employed workers can't safely quit because qualified competition is on the sidelines, and employers aren't filling the jobs with less qualified available workers because potential workers are available, even if those workers aren't being as aggressive about taking the available jobs.

For an employer, it's like the situation an oil company would face if they had access to $60 oil in a $100 market, but they knew that there were countries with closed oil markets that had $40 oil in the ground.  As long as those countries had untapped potential reserves, oil supply development would fall somewhere below the level that would be predicted by markets with $100 oil.

(Please, as always, understand, that I am speaking of this in broad terms for narrative ease, but that all of these changes result from marginal subtle changes in behavior among many diverse and reasonable workers and employers.  I am not making some boogeyman out of unemployed EUI recipients.  And, we are talking about maybe 1% of the labor force.  These changes are very subtle.)

So, with the end of EUI, we will see the Beveridge Curve and the Openings vs. Quits relationships move back toward their normal levels.  We will see unemployment decline, to more accurately reflect the strong demand in the current labor market.  And, we will see a boost in real output resulting from the return to higher efficiency in the labor market.  In the last few months, coincident with the termination of EUI, we have already seen the beginning of this movement.