Friday, January 15, 2016

Step 1 of the worst case scenario

There are a lot of positives, clearly, in the US economy right now.  We should keep in mind, though, that both bond markets and equity markets are leading indicators.  Things like bank credit and labor markets are lagging indicators.  I suppose trend changes in housing starts are considered a leading indicator.  But, I don't think the boxing referee stops counting until you get off your knees, so housing doesn't really count as an indicator of strength.

Normally, I would be trumpeting the positive slope in the yield curve as an important bullish indicator, but I think this is off the table.  The Fed Funds Rate was raised on December 16, and now I think we have a clear pattern of both long term yields and equity prices dropping.  This is a clear recessionary indicator.  The Fed erred.  The only question at this point, I think, is how much of a contraction we are in store for while they attempt to save face.

I think if they reversed the hike soon and expressed confidence in the economy and a commitment to monetary support, we would see a continuation of the recovery.  But, the longer this goes, the worse it will be.

We could also be saved by mortgage expansion, but after a promising November, closed-end real estate loans at commercial banks have flat-lined again.  There is a broad consensus against supporting mortgage expansion or real estate markets or implementing any public policy that might be seen as supporting stock prices.  That is a context ripe for a contraction.

The first graph here shows the evolution of the yield curve.  It could be that uncertainty combined with the asymmetry caused by the zero lower bound will prevent long rates from falling much lower.  And, the slope of the curve coming off the initial rise is down to about 40 basis points per year.  This is as low as it has been during the entire recovery.  This may be pretty close to the equivalent of an inverted yield curve at this point.

For years in the 1990s and 2000s, in a deflationary context, Japanese 10 year bonds ranged between 1% and 2%.  Ten Year Treasuries are now just over 2%.

In the period where inverted yield curves signaled recessions, the inversion happened with the Fed Funds Rate above at least 5%.  Here is a graph of the Fed Funds Rate and the 10 year Treasury Rate in the 1950s.  Twice we had recessions without inversions.  The Fed Funds Rate topped out at about 3% and 4%.  The 10 year remained about 1/2% above the Fed Funds Rate.

The drop in long term bond yields and the stock market are clear symbols of approaching declines in broad incomes.  This is probably not the best time to have cyclical exposure.

Added: Update from Marcus Nunes, with many graphs.


  1. What does it say about an economy that 25bps breaks it? Or that it needs near-constant monetary stimulus? I think we should be spending a lot more time answering those questions than arguing about 25bps in either direction. The incredible focus on monetary policy is a massive distraction from what should be the focus: productivity.

    And yes, your work on real estate has been helpful there. Unfortunately the conclusion is real estate is rather unproductive and getting worse.

    1. I remember that the Japanese, prior to the crash, offered my uncle, who has since passed away, 600k for a house in Belmont Shore (Long Beach). That was in the early 90's, I believe. When Japan crashed, all that demand in SoCal tanked and went away. I wonder if that will happen to the Chinese demand that is pushing much of the mid to upper real estate in SoCal now.

    2. Mark:

      > What does it say about an economy that 25bps breaks it?

      It's not the 25 bps. It's what the Fed said. They said that monetary policy had been too loose for too long, and that they needed to tighten, and wanted to tighten as fast as they could, and plan to do several more hikes, etc. Why? The Philips curve!

      If they said the 25bps increase was because they were changing to a 4% inflation target and figured higher nominal rates were needed to avoid real rates from going too low, we'd have a very different reaction.

      Their tone-deafness to actual economy is why financial markets are so pessimistic.

      See also this brilliant Nick Rowe post:


    3. Mark, thanks for your input. I like to think of monetary policy as backing up a truck with a trailer. If you want to go left, first you turn to the right, then you turn sharply to the left to straighten it out at the new trajectory. In 2005, the Fed turned left, and then they turned right, but never so far right to straighten us out.

      Saying there has been near-constant monetary stimulus is like saying something is wrong with the trailer because it keeps going left, even though we have had the steering wheel to the right for a long time.

      But, we never got straightened out. You want 10 year Treasuries at 6% and 6% NGDP growth? We need a sharp turn to the right. Instead, the Fed is already pulling the wheel to the left.

      If you're ever backing up with a trailer and you haven't straightened all the way out yet, try turning the wheel just slightly back in the other direction. The trailer will just go more sharply in the direction it was headed. That's how a 25bp move can have such a large effect.

    4. "The incredible focus on monetary policy is a massive distraction from what should be the focus: productivity."
      Well, I guess one could say there's really no such thing as a neutral monetary policy, so whether you focus on it or not, it's there.

      In the short run, little can really be done to improve productivity public policy-wise, just to avoid as much as possible inhibiting already active producers.

    5. "You want 10 year Treasuries at 6% and 6% NGDP growth? We need a sharp turn to the right. Instead, the Fed is already pulling the wheel to the left."

      But what if, Kevin, the artificial demand for bonds in the derivatives markets makes this target impossible even if NGDP were targeted? I don't know for sure, but it appears that if bonds lose price value, people will have to buy even more to shore up their collateral in the derivatives markets, interest rate swaps in particular.

      I wrote an article pushing your views, though:

  2. Great blogging.

    I have no problem at all with a Federal Reserve that conducts a permanent QE program. In fact this could be manna from heaven-- lower tax rates as the national debt is paid down and some portion of spending is financed through QE.

    Of course in every economy there are structural impediments that should be reduced, whether they be minimum wage regulations, property zoning or an oppressive and parasitic national security complex.

    But to monetarily suffocate an economy to counteract the inflationary impacts of structural impediments is the worst solution.

    1. Problem is, they need to, as Cullen Roche has said, buy non financial assets, not bonds that are in short supply already.

  3. Note to Kevin E: You might get a kick out of the 1956 movie, the "Man in the Grey Flannel Suit," starring Gregory Peck. You can see it on youttube.

    In the movie, Peck portrays a struggling middle-class suburban New Yorker, making $7,000 a year. The CPI converts that to (9.15x) to $64,150 a year, in today's dollars. Peck gets a new job, at $9,000 or $10,000 a year, or $82,300 to $91,500 a year.

    House prices are discussed in the movie, and they run from $10,000 to $20,000. The rough takeaway is that housing in the 1950s, in suburban New York, run from one to three times typical middle-class salaries.

    In 1956, FICA taxes were minuscule (about 4% combined employee-employer cut, vs. 14% today), and sales taxes lower.

    In watching this movie, you will wonder if after 60 years, the middle-class is any better off in the NYC area. Peck drives a large automobile, lives in rambling house, has furnishings, TV etc. and non-working wife.

    The picture today might feature a working couple, a tin-can car, and a town-home. Yes, better gadgets inside the house, the Internet.

    This same story applies to L.A. in my estimation.

    My takeaway? House prices and taxes have pushed the middle class to a standstill for decades in many parts of the nation.

    1. It would be interesting to look at changes in standard of living over time in cities like New York in part just because it might say a lot about how location preference influences standard of living. It's a difficult factor to quantify, but the fact that a great many people it seems would rather live on a heating vent in Manhattan than in a small mansion in North Dakota doubtless has a significant effect on relative standard of living.

      Thinking about this has me a little confused. Maybe we should count overly inflated rents in New York as contributing to standard of living, and that excess rent is the surcharge for the unquantifiable luxury of getting to live in New York, which apparently confers a great deal of utility to people?

      In terms of traditional notions of standard of living, it's interesting to wonder how much higher the standard of living would be in the US if people treated residency location the way they treat other products. Price of Sprite goes way up relative to Sierra Mist? Everyone substitutes Sierra Mist for Sprite. The price of living in New York goes way up relative to living in Vermont? Almost no one leaves for Vermont.

    2. This is correct, Mark. This is one of the major errors in economic analysis of the last 20 years. We are measuring these rent increases as monetary inflation. They are not. They are a measure of preferences. So, as a first step, real GDP growth has been underestimated and inflation has been overestimated.

      But, this isn't exactly true. Those higher rents are economic rents on a scarce resource. So, they don't really represent economic growth. They are just a transfer payment from productive households to those with limited access ownership. I suppose it's not that different than the effect of OPEC oil price spikes in the 1970s. There, we could refer to it as inflation, because it had a similar effect. Today, I think that may not be the case, because the effect of these high rents is to actually raise nominal incomes in the high cost cities as highly skilled workers claim more of the consumer surplus of their output as income, but then funnel that extra income through to landlords. These real estate economic rents raise nominal incomes in a way that higher oil prices didn't.

      The market reaction should be for there to be a massive increase in real housing in these highly valued locations. If that happened, rent inflation would dissipate. And, since the claims on consumer surplus by the workers in these areas would be reduced, I think we would see some combination of higher real growth and lower inflation in the sorts of products and services that are produced in these cities.

  4. Mark-Yeah, I know what you mean about puzzling things over, and if $780,000 for a small house in West L.A., or a condo in Brooklyn, reflects higher living standards or not.

    However, Kevin E. has done some good posts on the dearth of housing starts in Manhattan, and the actual decline in the number of housing units in Manhattan over the years.

    And much of L.A. has been downzoned, or is single-family detached, or just really difficult to get approval to build anything due to NIMBYism. Mark has done some good numbers on that too.

    My guess is that yes, several million people do want to live near the Pacific Ocean in SoCal, but cannot, as we have criminalized high-rise condos along the water. So, people get shoved into the Inland Empire instead. Actually, the middle class gets shoved in Hollywood, and downtown etc, and the lower-class gets pushed into the Inland Empire. There are low-income pockets everywhere in L.A., but shrinking. Some people do give up and move to Las Vegas (almost of suburb of L.A. now) or Phoenix.

    No one in his right mind would live in those two blast-furnace cities over the SoCal coast. There was a reason people passed over those hellholes on their way to the Pacific, in the pioneer days. No one reached the SoCal coast and said, "You know, it was better back in the desert."

    Really, we should hope for an end to any sort of property zoning within one mile of the SoCal coast. This would result in a huge building boom, and several million people moving into the nicer climate. Maybe a middle-class guy could have a condo with a balcony facing the water.

    Why people want to live in Manhattan is an interesting question. I guess the cultural opportunities must be much better than anywhere else. You don't need a car. It can't be the weather. I guess it is better than Buffalo.

  5. "No one in his right mind would live in those two blast-furnace cities over the SoCal coast" That is the most absurd statement I have heard from you. Perhaps you haven't heard of Steffi Graf, or Andre Agassi, or many actors, singers, musicians, and wealthy people who far prefer Las Vegas to the crush that is the 405. Give me a break. If I wanted to live in the LA area I would choose Temecula over Santa Monica.

    And Ben, did you know that recently, Ben Bernanke said that if there are no financial crises, that risk not sufficient? There has to be enough risk in the system to risk financial crises according to Ben Shalom.

    The sad thing for you and Kevin Erdmann is that this means bubbling and unbubbling is a conspiracy, a criminal enterprise. Because we know that the Fed mispriced risk in the housing bubble. Even BAC said it misprices risk all the time. So, it creates a bubble by mispricing risk. Then it takes down that doomed bubble by looking at stuff like inflation instead of NGDP and LIBOR.

    And you guys think this is all random? Hahahahhaha.

  6. Gary-

    Steffi Graf and Andre Agassi have residences in Las Vegas, probably for tax reasons. Maybe they like gambling too. It would interesting to know if they spent more time in L.A. or LV.

    But go ahead, live in LV if you like. I prefer Santa Monica. But then I find breezy, sunny and 76 degrees preferable to 115 degrees, dead-flat heat.

    The thing is, I can afford LV, but not Santa Monica.

    As for commutes, if there was wall of condos and offices up and down the coast, you would probably have mass transit running north-south too.

    No matter. The NIMBYs from Santa Barbara to Orange County and even SD will prevent building. My ideas are just...ideas.