Saturday, March 21, 2020

An article at Politico about letting banks help pump some cash into the pandemic scarred economy

Here is the Mercatus Center version:

https://www.mercatus.org/publications/covid-19/get-cash-more-families-need-it-now-give-banks-more-discretion-make-home-equity

Here is the Politico.com version:
https://www.politico.com/news/agenda/2020/03/21/how-mortgages-can-ease-the-downturn-140317

An excerpt:
Certainly, the 2008 financial crisis has created some reasonable fear about mortgage lending. But the dangers that were present in 2008 are not present today. There aren’t millions of recently purchased homes in cities where prices have suddenly doubled in a short period of time. Most borrowers will be long-time homeowners who braved the worst housing market in nearly a century and managed to hold on. In other words, unlike the housing bubble, these borrowers won’t be na├»ve new buyers speculating on a frenzied market; they will be established homeowners seeking financial safety during a pandemic. If ever there was a time to suspend the post-crisis regulatory framework, that time is now.

Thursday, March 19, 2020

The current issue of the National Review focuses on housing.

I have the cover article in the current issue of the National Review.  The issue includes a few good articles on the housing affordability topic.


Here's the conclusion:
The best solution to the entire problem is greater access: freer and more-open markets, in both mortgage-funding and urban land use. 
The financial return on owning a house should come mainly from its rental value, not from excessive capital gains. That should be enough to make owning a home worthwhile. If it isn’t enough, more people will choose to rent, rents will rise, and so will the rental value of homes and the financial return on homeownership.
Today, families are not necessarily choosing to be renters. Many are renters even though it would be worthwhile to them to own their home if they could. Rents are rising just about everywhere today because we have eliminated choices. 
Solve the problem of access, and affordability will follow. Choices are the key to the goal of affordability and fairness. We need to make more of those choices legal again. 

Friday, March 13, 2020

Long Term Yields as a call option

A long time ago, I played around with the idea that when yields are near zero, forward yields act more like call options on future interest rates than unbiased market expectations of future rates.

The second half of this post.

And here I discuss the idea.


What this means is that there is an unreliable relationship between long term yields and uncertainty.  That is because there could be uncertainty about the business cycle, or rising concern about a contraction, which would normally cause rates to decline.  But, there could also be uncertainty about the various potential states of the future.  For instance, let's say that the marginal expectation for 5 year forward rates is 0.5%, with a standard deviation of 0.5%.  What if there is a change in uncertainty that, somehow, leaves the marginal expected rate the same, 0.5%, but increases the standard deviation of that expected rate.  Since all of the expected future rates that were already below zero would still all just be truncated at zero, this would actually raise the market rate, because in those future scenarios where rates are higher, they wouldn't be truncated at zero.

In the chart here, think of each forward rate as the expected value of a range of potential rates, shown here as normally distributed expectations.  But, those distributions are truncated at zero.  The expected value of all potential scenarios would be higher than the median value because every value below zero would only count as zero.

Basically, this is just like a call option.  Call options can rise in value because, either (1) the expected future price of the underlying security increases or (2) the variance of expectations about the future price increases, making expected positive outcomes more valuable.

Yields have had some strange behavior this week, and I wonder if this could be part of it.  In options speak, maybe long term expected rates have been falling but with higher implied volatility this week.

I have been wondering when the right time is to sell long bond positions.  Earlier this week might have been the best time.  But, I suspect, because of this effect, when there is a positive shock from a Fed announcement or something that signals optimism to the market, the initial effect may be that interest rates decline quite a bit because there will be more certainty about the future economy.  I doubt that there will be a strong force pushing actual rate expectations much higher in the near term.  The net effect may be that the first move in long term rates will be to settle at a lower level that is actually more in line with what expectations are now, but which market prices are now biased away from due to uncertainty.

Treasury markets seem a bit unable to perform price discovery this week, and I assert that that is evidence in favor of my hypothesis.  If the Fed can get Treasury markets to calm down, long rates might decline.

One side effect of this would be that, if the Fed announces some big stimulus that calms markets, that should trigger declining long-term rates, and that will make it look like the Fed creates stimulus by lowering rates all along the yield curve.  I think that is not a useful way to think about Fed policy.  Stimulative Fed policy should cause the long end of the yield curve to rise.  In this case, it could very well cause median expectations of future rates to rise from 0% to 0.4%, but simultaneously reduce uncertainty so that the market rate falls from 1% to 0.6%, or something.  That would give a false statistical signal about how Fed policy affects the yield curve.


Disclosure: long UBT

Monday, March 2, 2020

February 2020 Yield Curve Update

Well, this month appears to have presented the triggering event that will tip the Fed's hawkish bias over the tipping point.  It seems likely now that the Fed will chase the natural rate down to zero from here and there will be some sort of traditional contraction or recession related to the cycle.  In other words, in the second chart, we should have hoped for the dots to move up, but instead, they will likely move sharply to the left.  That chart uses monthly averages, so the 10-year yield is already well below the February point (in red).  The Fed is expected to announce an emergency rate cut.  Obviously, they should.  But, unless sub-1% short rates somehow leads to the 10 year moving up to 2% or 3%, there will likely be some period of economic contraction before rates increase again.

That means there probably still are some gains to be wrung out of a long bond position.  Regarding the other asset classes, however, housing looks increasingly bullish, and is relatively defensive in the current context, so I don't think there is much to fear in real estate.  And, equities certainly could decline, maybe even enough to become a legitimate bear market, but it is possible that they won't decline precipitously.  I think the jury is still out on that, though whatever the indexes do, this will likely be a trader's market for a while.  At some point, beaten down stocks will present long opportunities.

That relates to one bright spot in this month's update.  The yield curve has been inverted at the short end since early 2019.  The date of the expected rate low point had been September 2021 for a while.  As the last chart shows, we seem to have been moving toward that date, suggesting that there has been enough momentum in the economy to get back to a normal yield curve eventually.  But, the curve has been flattening lately, and it looked like it might tip back to December 2021 or even March 2022, which would suggest that we aren't really moving closer to a normal yield curve and that, as with the periods between QEs, more Fed loosening would be necessary to kick rates up over time.

But, with the corona virus dust up, even though yields have dropped down significantly, much of that has been at the short end.  In other words, markets expect the Fed to react.  So, even though most indicators in the past week have been negative, the yield curve has actually tilted up a little bit, and now the rate low point has moved to June 2021.  In other words, the negative thesis has probably been confirmed (We will proceed through a standard yield curve related contraction.) but as we proceed through the contraction, the market expects the Fed to be nimble enough to prevent it from being too deep or long-lasting.  I hope that's the case.






Disclosure: I have long positions in HOV, VNQ, and UBT.