Thursday, August 30, 2018

Housing: Part 318 - Affordability

Almost anyone you hear talk about the housing market today, and the recent levelling off we have seen in some measures, will mention "affordability" as a headwind on the market.  In some ways, this is true, in the same way that there is an "affordability" issue in bonds.  To get $5 of cash flow next year, you have to invest a lot more in bonds than you used to.  The same is true for housing.  If you are buying a house with cash, in many markets, you have to invest more cash in order to earn the same level of rent (or imputed rent) than you used to.

But, since this is true of both homes and bonds, then for the borrowing homebuyer, the returns are better than ever.  This is especially true in low tier neighborhoods. tracks affordability by tier (bottom, middle, and upper).  Here are the measures for the US and for Atlanta. (Most cities look, more or less, like Atlanta, in this respect.)

For borrowers, homes are more affordable than they were at any time before 2009, especially in bottom tier markets.  In the Atlanta bottom tier, before 2009, the median mortgage required about 30% of the median income.  Now, it requires about 19%.  It isn't even close.  Affordability is absolutely not a problem.

Here is a random home in Atlanta, that, as of today, is for sale for $99,700. That equates to a monthly mortgage payment on a conventional mortgage of about $415.  The Zillow rent estimate is $1,150.  The posting states: "Expand your rental portfolio. Long term tenant wants to stay. Don''t miss out!"

(This isn't the case for middle or upper tier homes, where mortgage and rent payments tend to be more similar.  Some of this might be maintenance on older properties.  But, much of it is regressive tax benefits for owners that inflate upper tier prices, higher management and vacancy costs in low tier rental markets, and higher tenant risk.  Many of those costs and risks can be eliminated by a low-tier owner-occupier who can remain in a property for a long period of time and treat it well.)

I ask you, for the long term tenant who wants to stay, is there an "affordability" problem with the $99,700 price tag?  I would argue that the primary goal of a functional housing financing system should be that it provides a way for a long term tenant who wants to stay in a home like this one to do just that, as an owner.  And while our financial system fails aggressively at that function, the conventional beliefs about the housing crisis are so wrong, they prevent these patterns from being acknowledged or noticed.

The relative affordability of bottom tier housing stock is a natural social leveler - a way for households with low incomes to get higher returns on their investment than savers with more capital can.  In order to do this they need to borrow from those wealthy savers who must accept lower returns on their mortgage securities than the homeowner receives on their bottom tier home equity.  But, the "predator" narrative and "the business model of Wall Street is fraud" narrative, along with the "bubble" narrative and the "keeping up with the Jonses" narrative all lead us to impose public obstructions that prevent millions of households from engaging in this prudent, lucrative form of savings.

When you see stories about the housing market, notice how often you hear "affordability" mentioned as a problem today.

Friday, August 24, 2018

Housing: Part 317 - Unsold inventory during the financial crisis

To follow up on the previous post, here is a Fred graph comparing various measures of homebuilding.


 Sorry, it's a bit messy.  The orange line at the bottom is homes built speculatively which have not been started yet.  The dark blue line at the bottom is completed homes that have not been sold.  This is one source of the "overbuilding" story.  Speculative building increased, basically in line with general growing sales.  The trend in speculative buying reversed soon after general sales started to decline, but it wasn't enough, and so homes that were completed without a buyer started to rise.  The green line is speculative homes under construction, and it begins to decline in 2006, but not quickly enough.  That is the extra inventory that might be blamed on overbuilding.

But (You knew there would be a "but"), notice the scale of the problem.  Even at 200,000 units, the level of unsold inventory should have amounted to just a few months' sales.  The only reason they amounted to much more than that was because sales had collapsed.  It was the collapse in demand that was the shock, not an oversupply.

In the next graph, the blue line (left scale) is months of inventory of new homes.  The red and green lines (right scale) are new homes sold (red) and inventory of vacant homes among existing homes.  Notice that the inventory of vacant homes also shot up at exactly the same time that sales began to collapse.  There was an event at the end of 2005 that led to a sharp collapse in demand for homeownership.  Remember, though, there was no shift in demand for the service of housing (relative to supply) because tenant vacancies remained low and rent inflation was high and increasing.
Or, maybe, this was the result of all those buyers who had been suckered into buying homes they couldn't afford.  Maybe they were getting foreclosed on and that was the source of vacancies.  But, again, notice the timing.  Vacancies started to rise in 2005.  They were already at the top of the range, over 2 million units, by the 4th quarter of 2006.

Here is data from the New York Fed Report on Household Debt and Credit.  When the vacancy level of units for sale had already reached more than 2 million units, in the 4th quarter of 2006, there were about 220,000 foreclosures.  That compares to an average of about 176,000 foreclosures from 2003 to 2006.  The foreclosure crisis mainly happened from 2008 to 2010, when every quarter more than 400,000 units were foreclosed.  When the vacancies developed in 2006, foreclosures had just barely begun to rise.

By the time the foreclosure crisis happened, builders had already contracted to practically nothing.  New building had contracted so much by the time foreclosures were happening in large numbers, that the number of unsold new homes was actually declining back toward normal levels by then.  Builders were actually quite responsive to the shock in demand.  The flooding of foreclosures onto the market didn't eat into builder sales.  Their sales were already collapsed by the time that happened.

But, here's the kicker.  The Census Bureau doesn't track cancelled orders.  So, many of those homes in the first graph that are measured as new houses sold and completed were actually homes that were sold, completed, and then cancelled.  Cancellation rates are normally about 15-20%, and they roughly doubled over the course of 2006.  So, a little more than a million homes were sold in 2006, but about 400,000 of them turned into unsold inventory instead of new, occupied stock.

Where the Census Bureau showed 200,000 finished but unsold homes in 2007, it was actually probably more than double that amount, if cancelled contracts are included.  Now, that inventory really doesn't have anything to do with subprime lending terms, etc., because new home buyers generally just have to put down a small escrow, and the mortgage isn't closed until the house is finished and the buyer takes ownership.

The homebuilders were quite disciplined, really.  From peak to trough, annual sales declined by about 1 million units, twice the change of the housing contractions of the 1970s.  Yet, months of inventory didn't rise much above the months of inventory that had developed back then, and it quickly declined from its peak, even though there were also hundreds of thousands of units of shadow inventory from cancellations were also on the market.

It would be interesting to see detailed research on this.  Was the rise in cancellations because the buyers were tactically cancelling or because their lenders were pulling out before the homes were finished?  In either case, the point is that the rise in cancellations, just like the other measures, predated the rise in foreclosures by at least a year, and was responsible for most of the rise in new home vacancies.  There has been research showing that falling prices generally led to defaults, and not the other way around.  But, here we can see that cancellations were creating hundreds of thousands of new vacancies before prices declined significantly.  A demand shock led to a change in sentiment which led to vacancies which eventually led to price declines, which led to defaults.

I have commented before on the perverse self-destructiveness of public sentiment in 2007, where stabilizing policies were routinely avoided specifically because stabilization would have prevented some people from taking devastating capital losses.  But the perversity is even deeper than that.  Consider the homebuilders.

I looked at annual SEC filings from Meritage Homes to collect sales and cancellation data from the Arizona market.  Actually, in hindsight, I'm not sure if Arizona looks much different than the rest of the country on this matter.  Oddly, it appears as if sentiment shifted downward to the extreme, in some cases well in advance of actual price shifts.  For instance, for Meritage, in Arizona, cancellations jumped to 37% in 2006.  From 2006 to 2008, the average sales price in Arizona dropped by more than 40%.  By 2008, Meritage cancellations were declining back to the norm in Arizona because nobody was bothering to sign a contract in Arizona in the first place, by 2008.

In Texas, the cancellation rate was 35% in 2006 and it increased to 40% by 2008, but the average price of Meritage homes over that period was basically flat.  Finally, from 2008 to 2010, Meritage home prices in Texas declined by a little bit less than 10%, but Texans had been getting cold feet for several years before that happened.

Maybe this is because buyer quality had become so bad that suddenly nearly half of potential buyers realized by the time the house was completed that they couldn't possibly afford their mortgages? But, after 2005, when this was happening, sales were declining - first time buyers were declining pretty sharply.  It doesn't make sense that the period of time where borrower quality was deteriorating was the period where the number of buyers was dropping like a stone - unless the decline in borrower quality was from a liquidity shock.

Here are the Meritage numbers for Arizona.  In 2006, they had new contracts for 2,910 units.  Of those, 1,833 were built and sold and 1,077 were cancelled so that Meritage had new, unplanned inventory.  Then, in 2007, net orders after cancellations were 1,203.  So, after accumulating 1,077 unplanned vacant units in 2006, total net sales in 2007 were only 1,203.  In the meantime, they accumulated another 642 cancelled units, and 2008 net sales were only 884.  For years, in Phoenix, there were developments full of empty homes.

I was planning on ending this post with a discussion of systemically risky terms on subprime loans and how, even if there wasn't an oversupply of housing, those type of loans by investors were likely an important part of the panic.  And, they probably were.  But, this is a part of the story few talk about.  These cancellations have nothing to do with lending terms, or owners vs. investors.  In all cases, they would have created a small escrow fund to initiate building.  In all cases, they would have been likely to tactically put the home back on the builder.  Neither owner nor investor would have had an emotional history with the property at that time, and the size of their down payment or their interest rate terms were irrelevant to the decision.  However, lower interest rates in 2006 would have probably helped to reduce this problem, because buyers would have been more optimistic about housing markets and they would have been able to close the sale with better terms.  Surely, that would have improved the cancellation rate.

But, here is where I ask you to think about the perversity of public sentiment in 2006 and 2007.  The public discussion was all about subprime borrowers and homeowners who were in over their heads.  The public discussion was all about overbuilding and oversupply.  It was about corporations using predatory tactics against regular people.

And, the primary initial shock in 2006 and early 2007 was among homebuilders.  What were homebuilders doing?  First, in Phoenix, they couldn't get permits fast enough to meet demand.  So, rather than overbuilding, in 2005 they were holding lotteries at the new developments to determine which buyers could order a new house.  They were clearly not able to build at a fast enough pace to meet demand.  Then, they got signed contracts from qualified buyers who ordered new homes.  Only after they had a contract and an escrow account for a new home did they begin to build.  And, at that time, it was probably generally several months before they even broke ground, since they were running at capacity.  Far from being predatory, builders take a generous approach.  They take the construction risk.  They finance the construction, and they generally give buyers an easy out to walk away if there is some reason why they don't want to complete the transaction in several months when the house is ready.  Even in good times, cancellations frequently run over 10%.

So, the homebuilders were eating all of this inventory and taking it on the chin.  The Fed had steered the economy in this direction and had seen the decline in residential investment as appropriate, then in 2007, they held off on lowering rates because doing so would let speculators off the hook and would fail to discipline the marketplace.  At that point, even though prices in much of the country remained stable, new home sales had collapsed.  And, homebuilders were sitting on inventory of hundreds of thousands of homes.  Their sin was that they had built homes for paying customers who had signed contracts to order them.

What were they supposed to do?  Should we have a policy that homebuilders should refuse to build homes for paying, qualified customers who fund escrow accounts?  Should we have a policy that homebuilders must require buyers to put down escrow amounting to 20% of the home prices and wait for 9 months before they can move in, so that builders have more power over buyers during the construction process?

The only policy that fixes this problem is to provide accommodation sometime over the 18 months between early 2006 and the 2007 panic.  Lower rates to, say, 4%, instead of 5.25%.  Or, lacking that, in 2007, let people off the hookActually help stabilize markets that are panicked.  God forbid, maybe even allow some speculators and lenders to avoid financial ruin in the process.  By the time the Richard Fisher of the Dallas Fed told the FOMC in September 2007, "I’m very concerned that we’re leaning the tiller too far to the side to compensate risk-takers when we should be disciplining them.", the homebuilders had been disciplined for a good 18 months in the face of sharply declining nominal investment and sentiment.  To the extent that speculators were involved in that shift in activity, they had already taken their small losses by surrendering their escrow funds.  And, by September 2007, the homebuilders were far along passed the time where they needed to be reminded to be careful about speculative building.

PS.  Here is a chart from the Calculated Risk link that shows cancellations across several builders, which has the same pattern I found at Meritage.

Wednesday, August 22, 2018

Housing: Part 316 - The phases of the bust.

There was one answer from my podcast interview with David Beckworth at Macro Musings that I feel like I sort of flubbed, so I am clarifying the issue in this post.  David asked me about the early shifts in the migration event and what caused it to stop.

I have covered the timeline before, so some of this might be a repeat, but I think my thinking has evolved a little bit on this as new information comes in, so there might be subtle differences and additions to previous posts.  For this topic, my moving chart of home prices over time is helpful.

1990s to 2003:
For this period of time, supply constraints dominated.  Cities that were more expensive to start with were generally becoming even more expensive over time, because the reason they were expensive was that they lack sufficient housing and so rents are high and rising.

November 2003 to June 2004:
For this brief period of time, home prices in Los Angeles accelerated relative to other places.  It is plausible that the newly expansive private securitization market, which was especially active in California, was the source of this unusual price appreciation.  Added demand from new homebuyers in Closed Access cities created a surge in the out-migration that tends to come out of these cities.  Since the housing stock is relatively stagnant in Closed Access cities, more housing demand from one household means less housing stock is available for other households, and someone has to move away.  The price appreciation appears to have triggered a boost in the outmigration of homeowners, who were cashing out as prices increased.  So, there was an increase in migration among both owners and renters.

July 2004 to November 2005:
The Federal Reserve started to raise interest rates in July 2004.  This was probably appropriate purely as a monetary policy shift, and the economy, in general, was still clicking.  So, Phoenix had two forces pushing on its housing market.  Aspirational migration was strong.  In a typical year, about 50,000 households move into the Phoenix area from places that aren't "Closed Access".  During this time, the rate of migration from other places moved up slightly to about 60,000 by 2005.  Those were probably mostly households moving up from less expensive places or moving to Phoenix for retirement, as is typical.  That increase was due to a strong economy, flexible lending, etc.

From 2002 to 2005, migration from Closed Access and other Contagion cities increased from about 12,000 to 21,000.  These were households moving down-market.  They were moving to Phoenix to lower their housing expenses.  There would have been several forces at play with this group of movers.  Loose lending in California was a force that was inducing the outflow.  The high prices that had developed in California were inducing more selling and migration from homeowners.  And, rising interest rates were likely adding to that selling pressure as homeowners expected rising rates to eventually be a drag on rising prices.  So, there was an extended period of time where continued economic growth and changing sentiment in the California housing market were both putting upward pressure on the Phoenix population and on its housing market.

This is clearly visible in the moving chart, as Los Angeles price appreciation moved back down to the national norm, even though private securitization mortgages were very active there.  At this point, the added demand those mortgages created in California was mostly creating new local housing supply by inducing out-migration and selling by existing owners.  Rising rates probably had something to do with that.  So, rising interest rates and selling pressure were pulling down prices in Los Angeles, where credit-fueled demand might have otherwise pushed prices a little higher and they were pushing prices up in Phoenix because of the migration that ensued.  (Note that any effect here was purely from expectations or sentiment, because 30 year mortgage rates and long term interest rates in general did not actually rise until the Fed had flattened the yield curve in late 2005.)

November 2005 to August 2007
By November 2005, the Fed had increased the Fed Funds Rate high enough to flatten the yield curve.  I would argue that at these levels (about 5% at the time) that is basically an inversion.  As is clear in the moving chart, there was a uniform national reaction in the housing market.  All measures began to collapse everywhere.  Sales, housing starts, etc., and inventory of homes for sale rose.

Now, from this new perspective, which says that there were never too many homes anywhere and that home prices in 90% of the country generally reflected fundamental factors like rising rents and low long term real interest rates, this is a huge red flag.  Clearly, the economy was already in a state of dislocation.

This was clearly a monetary event.  I don't even think that is a point that is open to debate, for several reasons.  First, as I said, the premise is doing all the work here.  If the premise changes so that we don't presume that there were too many houses selling for too many dollars, then the shifts in the housing market were extreme and moving in unison across the country in an extreme contraction that wasn't called for.  This was not a subtle shift.  Second, the Federal Reserve, itself, considered the downturn in the housing market to be a product of their policy choices, and they were pleased by the downshift at the time.  They were very focused on housing markets at the time and mentioned them in nearly every FOMC press release.  Third, many economists who have commented on Fed policy at the time attribute high home prices to loose monetary policy, they attribute some power to the Fed to be able to pull prices down, and many of them argue that the Fed should have targeted home prices earlier and tightened policy earlier in order to do it.

There is a question as to what mechanism was at work.  Sentiment? Money supply? The effect of yields on valuations or lending?  (One interesting facet here is that mortgage growth was a fairly late factor, still growing slightly even when the 2007 panic hit.  But, home equity had been declining for some time, and much of that decline appears to have come from unmortgaged owners selling and exiting the market.  According to the Survey of Consumer Finances, in 2001, 23.1% of American households owned homes with no mortgage.  That declined to 19.9% by 2007.  So, even though there is an abrupt shift in price trends when the yield curve flattened, it appears that sentiment and money supply were more important than lending in the early phases of contraction.  I consider an inverted yield curve to be an important forward contractionary signal, but what exactly causes the signal and what the inversion itself causes to happen remain a mystery.  The 2005-2007 period, to my mind, both confirms the importance of yield curve inversion and adds to the mystery of what is actually happening.  Maybe these flows out of home equity as an asset class and into other forms of long term fixed income are an important part of that puzzle.)  But, as to whether those mechanisms were related to monetary policy, there is no argument left here.  Once the premise changes, the conclusion changes with it.  The Fed put a stop to the migration event as a side effect of causing a housing contraction.  That is stipulated.  The argument is whether they should have.  Before blaming the Fed too much, keep in mind that in 2007, nearly everyone thought they should have.

So, the collapse in migration that led to an especially tough housing collapse in Phoenix was actually part of a national negative monetary shock.  Both nominal and real GDP growth were marginally at levels that have normally been recessionary.  And, as shown in the chart here, employment growth, which had not been particularly strong, started to decline in 2006.  Nationwide, it didn't decline sharply like it usually does in a recession.  There is a typical recessionary downshift in the Contagion cities in 2006. (Here I show the Phoenix metro area and the state of Florida.)  Because the economy had become so characterized by these inter-metro migration patterns, the initial result of this wasn't a rise in unemployment.  It really is quite striking.  With such a negative shock to employment growth in Phoenix in 2006, the unemployment rate didn't bottom out until June 2007!  All of the shocks to employment markets were buffered by a reversal in migration flows!  In Contagion cities, the shock didn't lead to higher unemployment.  It led to an end of the migration event.  In other cities, employment didn't collapse in 2006 the way it normally does at the beginning of a recession because at the same time that employment growth was slowing, population growth got a boost because households stopped moving to the Contagion cities.

In the Contagion cities, the inflow of households slowed down.  I would expect that the retrenchment among renters with lower incomes was related to declining employment opportunities.  The retrenchment among home sellers was likely related to the fact that home prices had levelled off.  As prices had been rising, on the margin, more homeowners had been selling, collecting their capital gains, and moving away from Closed Access cities.  But, when prices levelled out or started to fall slightly, that would have induced many fewer tactical sales.  The inflow of both households and capital to the Contagion cities slowed down as a result.

At the same time, the outflow of households out of the Contagion cities to other places that were now more affordable continued to rise, so net inmigration fell dramatically.  The reason for the outmigration is because the liquidity shock had thrown the construction market into disarray, and the Contagion cities, who already were struggling to build enough homes to meet the demand from in-migration now had a terrible shortage of homes themselves.  Inventories of homes for sale had shot up, because the liquidity shock had created barriers to home buying, and vacancies of owned homes increased in the Contagion cities, related to that.  But, rental vacancies remained low for some time after the shock in 2006.  In Phoenix, rental vacancies were low until 2008.

Prices, nationally, should never have declined at all, and when they finally did in the summer of 2007, it was only after this had been going on for a year and a half, housing starts had retracted as far as they could to buffer the decline in demand triggered by the disrupted buyers' market, and when declining sentiment led to the panic in privately securitized mortgages, the general mood of the country was that it wasn't anyone's job to right the ship.  Political sentiment made the unnecessary price collapse inevitable.

So, what specifically caused the migration event to end?  Monetary policy has a lot to do with it.  Essentially, a proto-recession had already been induced, and it hit the Contagion cities the hardest because their home prices had been driven up by that migration event.  For a year and a half, during that proto-recession, relative to previous trends, recessionary conditions were mitigated in the rest of the country because they were matched by a temporary population boost.  Whereas Austrian school economists might argue that loose money induces unsustainable demand that leads to a boom and bust, what might have been happening in 2006 and early 2007 was that money was relatively tight, but that non-Contagion markets were induced into unsustainable demand that kept them at the margin of recessionary conditions because they had a temporary boost in demand through population flows.

Home prices, even in the Contagion cities, remained relatively strong as housing starts collapsed along with those migration flows.  The reason is that the Contagion cities didn't have enough homes.  It is possible that if things had turned out differently, and the migration event had wound down without being induced by a monetary shock, that home prices in the Contagion cities would have dropped a bit.  It is clearly plausible that home prices there had been boosted by cyclical pressures related to the migration event.  And, it is plausible that if the Fed had been accommodative in 2006, home prices in California would have still peaked, cutting off the flow of wealthy home sellers into Phoenix, and plausibly, the economy might have grown while the Phoenix market corrected.  But, that isn't what happened.  The Contagion cities never had too many houses, so in 2007, rent inflation was high and gross out-migration was rising, and prices remained relatively stable until the country accepted the development of a series of financial panics.

Accommodative monetary policy in 2006 would have been very useful, and one important result of it would have been stabilizing the housing market in the Contagion cities.  Don't get me wrong.  I'm not saying that the Fed should be in the business of stabilizing prices in various asset classes.  The primary reason that it would have been important to see improvements in the Phoenix housing market wasn't to ensure that investors or lenders didn't have losses.  It wasn't even to create employment growth in construction.  The reason it would have been important is because the Contagion cities needed houses and the fact that they couldn't manage to build them and that buyers couldn't manage to fund them was already a signal of disequilibrium.  Given public sentiment at the time, it would have been impossible for the Fed to have seen this in real time, or to have acted on it.  But, in hindsight, we must understand what happened.

Given that in 2007, we had the premise wrong, and we thought that a credit bubble that was destined to bust was our problem, one can imagine how Federal Reserve officials could have read these signals as positive.  They had managed to slow down the housing boom.  They thought that was the right thing to do.  And they thought that their biggest challenge was going to be limiting the damage to the rest of the economy.  In May 2007, when Ben Bernanke was assuring the public that the subprime crash would be contained, he was looking at the economy in Phoenix that had just had a massive shock.  It's housing market was DOA.  And unemployment there was at 3.2%.

Follow up.

Monday, August 20, 2018

The Great Sorting Continues

"The pending departure of North Face, a landmark outdoor apparel company founded in San Francisco in 1966, highlights the challenges for nontech businesses in a region with the country’s highest housing costs." (HT: Roland Li)

"Spectrum Location Solutions, a consultant for company relocations, found that 9,000 California companies had moved their headquarters or chosen to expand outside of the state between 2008 to 2015."

The article includes a long list of recent corporate moves away from the San Francisco area.

We can argue all day and night about all of the causes of this, or all of the excuses for not allowing these cities to grow, or all of the reasons why each individual housing development to be obstructed.  But, in the meantime, the status quo is a situation where the good things that a healthy society does - productivity growth, innovation, mobility - lead inevitably to a bidding war for an arbitrarily limited number of spots on the party boat.  And the process for who gets those spots is, inevitably, a process of growing tension and distress until some more folks give up.

The housing bubble was simply an acceleration of this process so that cities like Phoenix were overwhelmed with families burdened with the choice of moving to their remaining, compromised options.  In 2007 and 2008, we conducted public policy in such a way to remove that compromised option for many families, and we slowed the Great Sorting down.  But, we did nothing to stem the growing tension and distress that comes from the core problem.

PS: It looks like the phrase, "The Big Sort", has already been coined.

Saturday, August 18, 2018

Housing:Part 315 - The geography of inequality

Here's just a quick graph.

This uses the median household income for the 100 largest metropolitan statistical areas.  A lack of housing access is a large source of diverging incomes.

Sunday, August 12, 2018

What counts as an inverted yield curve?

I have previously wondered about the actual measure we should use for yield curve inversion.  My impression is that generally, the absolute flat level is considered the inversion to watch for, and that, if anything, inversion at lower interest rate levels is considered less dangerous because low rates are stimulative.  To the extent that that is a common approach, I think it is an example of how looking at the capital asset pricing model upside down can be helpful.  Low rates aren't stimulative.  Low real long term rates are, themselves, a sign of risk aversion and contraction.

And, I have noticed that when interest rates were high, inversions were a lot deeper while inversions at low rates have been shallow.  This makes sense, because the closer you get to the zero bound on nominal yields, the more option value there is in long term rates.  In addition, the inflation premium will tend to revert to long term norms, so when rates are high, it is easier for long term rates to decline with falling inflation expectations.

Here is a scatterplot of the fed funds rate over time compared to the 10 year rate.  I have also added a 45 degree line to show where inversion would happen (both rates being the same).  It seems like a pretty general rule that inversions are deeper at higher rates.

Note that at very low rates, the spread bottoms out at more than zero.  In fact, the curve never inverted before the 1957 and 1960 recessions.  Rates were very low then.

Anyway, I finally sat down and looked at the numbers.  I found the month with the lowest yield curve slope (10 year yield minus federal funds rate) before each of the last 9 recessions, and I noted the Fed Funds Rate and the 10 year rate at each of those months.

Then, I regressed the 10 year rates against the corresponding federal funds rates for each of those 9 months.  The relationship is so linear, I almost don't trust it.

Here, I have added the current rates, along with rates from 1 and 2 years ago.  We are basically right on the trendline that marks the deepest inversion point for the previous 9 recessions.  But, oddly, we were also on the trendline one and two years ago.

Here is a graph of the monthly rates, showing June 2004 to the present.  Here, the line is the trendline of previous recessions rather than the 45 degree line.  When the Fed started raising rates in 2004, the yield curve was fairly steep, and since long term rates remained flat as the Fed raised the target rate, eventually, by 2005, the rates were pretty similar, and by 2006, true inversion happened.  I would argue that by late 2005, we were already tickling inversion territory, and that by late 2006 we were already into marginal recessionary territory, comparing nominal and real GDP growth at the time to previous recessions.  The boom had included a mass migration event away from prosperous cities, so the initial dip into economic contraction was moderated by a reversal of that flow.  You can see this in the collapsing employment growth in Contagion cities Miami and Phoenix in 2006.  This didn't lead to rising unemployment rates until late 2007 because the initial effect was just a downshift in population growth in the Contagion cities.

So, for a year or so, yields were moving up at the top end of the inversion zone, and eventually in 2006, the yield curve inverted more and in 2007 rates started to decline, but remained inverted until the Federal Reserve drastically cut rates in early 2008.  The Fed paused at 2% in 2008, where, in hindsight, there clearly wasn't enough accommodation.  If the trendline could be considered the bottom of inversion events, could that 2%-4% spot in 2008 still be in the range where the yield curve is flat enough to be considered inverted on this adjusted scale?  For any Fed Funds Rate above about 6%, on this adjusted scale, a yield curve slope 1% above the trendline would still be inverted in absolute terms.

But, if that was the case, then for the past two years, we would have been squarely in (adjusted) inverted territory.  It appears that we are in the 2005-2006 part of the process, where short and long term rates are both moving upward in a near inversion.  I have reasons for moving recessionary conditions back in time from 2007 to 2006.  But, I don't have a similar story for today.  If we really are in inversion territory, what has prevented there from being more of a contraction?

I don't know.  I am pretty confident in this general framework, but I am not confident in the precise specification of the trendline.  Maybe I have it set too high.  Maybe QE did create a permanent downshift in long term rates that affects the measured yield curve.  Maybe there is a market-based reason why the relationship isn't linear at this level or why there has been a shift over time to lower long term rates relative to short term rates.

But, it certainly seems reasonable to consider this dangerous territory at yield curve slopes well above zero when rates are this low.  And, as the fed funds rate is pushed up, a shift down in 10 year rates would be a bearish sign, even if it wasn't any lower than rates in recent memory.  It also means that when the Fed starts to lower rates, tepid moves that aren't matched by rising long term rates will probably not be stimulative enough.  If we end up back at the zero lower bound, with 10 year rates in the 1.5% to 2% range, that could be really bad news.

PS: Here are two additional charts.  The first one plots the spread against the Fed Funds Rate, to show that the high correlation in the chart above doesn't come from the co-movement of both rates.  There is a high correlation between the spread at the bottom of inversion and the rate level.

Also, when rates were high, rates were also more volatile.  In recent events, the spread has changed slowly and remained inverted or nearly inverted for an extended amount of time.  When rates were high, the deepest inversion usually only happened for a few months.  This added volatility probably causes my measure of the deepest inversion to be overstated when rates were high.  To reduce the noise, I have taken the 1 year average rates, centered on the most inverted month.  I have added a second series to the graph, which shows the relationship using the 1 year average, and it does flatten the relationship somewhat.  It also weakens the relationship, but it could be that the strength of the relationship for a single month is partly coming from relationship between rate levels and rate volatility.

I have also added a new version of the graph of recent rate movements.  The relationship from the annual average rates makes the recent rate behavior less mysterious.  According to this relationship, rates could follow a path similar to 2006.  In that scenario, the Fed would raise the target rate to something around 2.5% or so, and the 10 year rate might eventually fall to about 2.5%, which would be a signal similar to the 2007 signal, but with a yield slope almost 1% steeper than the 2007 curve because of the lower rate level.

Friday, August 10, 2018

July 2018 CPI

Well, for two months in a row, non-shelter core inflation has been near a 2% annualized rate.  That's something.  If it's a trend, then maybe the Fed isn't ahead of the curve in their efforts to tighten up.

I still expect this to increase the Fed's confidence about rate hikes, leading to overtightening.  In fact, today the yield curve has flattened on the news.  Interestingly, market estimates of Fed hikes have pulled back slightly.  I might have expected the short end of the curve to move up while the long end moves down.