A couple more notes on April Employment

Here is an update on the unemployment insurance claims numbers.  Both measures bounced up a bit this week, so the trend going through April doesn't look as strong as it did last week, but continuing claims still seems to have a promising trend.

Here is an amended version of the other graph I put together the other day, comparing the unemployment rate with the rate of unemployment insurance (using civilian labor force as the denominator).  Using the higher continuing claims level from this week, the unemployment level that would be parallel to trend would be between 6.5% and 6.6%.  (Last week it would have been near 6.4%.)  Of course, we should expect the unemployment rate to approach the lower typical level as the economy recovers, so it should do better than just moving parallel to the normal trend, though there will be noise from month to month.

I'm also trying to get an idea about the mysterious long duration unemployed group.  This is not a sophisticated model, but I'm just trying to work out a basic idea of the data here.  In mid-2011, the average duration of unemployment for people unemployed more than 26 weeks leveled out at around 80 weeks, and has remained at that level, even as the total number of long term unemployed workers has declined.  I am using a simple assumption that, starting around 2011, unemployment can be divided into two groups.  Short term unemployment began to recover to normal levels, and for these workers who were unemployed for more than 14 weeks, each quarter approximately 50% of them exited the unemployment rolls.  Additionally, there was a second group of very long term unemployed workers who were more persistently unemployed.  This group appears to have declined in a somewhat linear pattern, averaging about 80,000 workers per month.

So, by March 2014, there were about 3.7 million workers who had been unemployed for more than 26 weeks.  About 2.1 million were in the very long term unemployed group, roughly averaging 100 weeks of unemployment.  And, about 1.6 million were leaving unemployment at roughly typical rates for a normal economy, with an average unemployment duration of about 60 weeks.

Even in a typical labor economy, some workers have durations of unemployment over 26 weeks.  So, if we assume that Emergency Unemployment Insurance above 26 weeks has no effect on their subsequent duration of unemployment, we can assume that, given the availability of EUI, a typical proportion of workers would take payments from EUI.  This graph compares the reported number of EUI beneficiaries (blue) to my estimate of the very long term group of unemployed (red).  In addition, I estimate the number of EUI beneficiaries who are part of that very long term persistently unemployed group (green).  So, reading from bottom to top, the green line is the number of VLT unemployed who are receiving EUI.  From the green to the blue line is the number of unemployed workers who would be eligible for EUI in a typically functioning labor market (with 50% quarterly turnover, as described above).  And from the green to the red line is the estimated number of VLT unemployed who are not receiving EUI.

As the following graph demonstrates, the behavior of the long term unemployed has been very peculiar this cycle, coincidental with the unprecedented level of EUI benefits.  There has been a disconnect from a relationship of employment durations that is decades old.  EUI created significant frictions in long duration unemployment.  Some of this could have been from subtle effects on reservation wages, simple incentives for workers with some discretion, hysteresis among former beneficiaries, etc.

It is difficult to determine what we could expect from the current unemployed cohort.  If my graph above is accurate, then by the time that EUI was terminated, the unemployed workers who were still beneficiaries were mostly not members of the persistent very long term group of unemployed.  By 2014, the very long term unemployed lacked any direct connection to the remaining EUI program.  This would suggest that the end of the program may not have an immediate, direct impact on the very long term unemployed.  And this group is essentially the entire reason why the current unemployment rate is higher than normal recovery levels.  So, my optimism for unemployment in the first half of 2014 may have been misplaced.

The number of very long term unemployed who were not EUI beneficiaries (either because they timed out of the program or because they hadn't been eligible) has been pretty level at about 1.5 million for several years.  In effect, broadly speaking, each month, 80,000 VLT unemployed who were not on EUI would leave unemployed status, but they would be replaced by another 80,000 unemployed coming out of EUI.  But, if this was the case, and there was a churn of workers through EUI, then we should have seen the net number of VLT unemployed leaving unemployment increase as the number of EUI recipients declined.  This didn't happen.  The decline in VLT workers has remained pretty linear, about 80,000 per month.

So, it seems like we may not see a direct impact from the termination of EUI.  And, it's possible that either unemployment will continue to decline linearly or will decline less quickly if there are a large number of permanently unemployed workers in the VLT group.  However, I think there could be a complex set of ingredients here that still could lead to a decline in VLT unemployment as we leave EUI and proceed through 2014.

Here is a graph of the gross number of workers who leave LT unemployment each quarter. (This is the starting number of 15+ week unemployed minus the 26+ week unemployed who remain unemployed 3 months later.)  If my pessimistic scenarios above were true, we should have seen this flow decline as EUI wound down, if the remaining VLT unemployed were more persistently unemployed.  This month should add interesting information here.  This flow actually stabilized at around 2 million workers during the last year.  (This is for all workers, so about 1.6 million of these workers are workers in the recovered economy who have flowed into and back out of unemployment, and the remaining workers in this flow would be coming out of the VLT group.)  Last month, this flow dipped down to 1.8 million, but these are noisy data.  So, if this flow continues to decline toward 1.6 million, this could mean that the VLT group will be very persistent.  If this flow recovers back to 2 million, then this should bode very well for the labor market.  Even if EUI was only pulling in a couple hundred thousand workers into a VLT unemployment context, the removal of that program would mean that the net 400,000 workers leaving long term unemployment each quarter would affect the bottom line unemployment figure, and we would be seeing sharper decline in the net remaining number of VLT unemployed.

I think the factor that could make this true would be the inaccuracy of my assumption above that continued EUI was not affecting the long term duration of unemployment for the workers who have recently been becoming beneficiaries.  It is possible that, even though much of the labor market is back to normal, EUI was continuing to have an inflationary effect on the duration of unemployment for the workers who did end up in the program.  Even at the end of 2013, the program might have been feeding the VLT unemployment problem, and some of those EUI beneficiaries were being converted into VLT unemployed as they were exposed to the perverse incentives of the program.

Regarding the gross flow out of LT unemployment, all else equal, if that flow declines down to 1.7 million in the April report, the unemployment rate will be at 6.7 6.6%, and if it recovers to 2 million, the unemployment rate will be 6.5 6.4%.  The over/under on this month's report could indicate what we might expect as we move through the year.

Construction Employment, Return to Normalcy, and the Crisis

Paul Krugman posted this Fred graph on Tuesday.  (He included just the construction unemployment rate.  I have added the broader unemployment rate for reference.)

I noticed that, after 5 years of stair-stepping down, construction unemployment has finally reached normalcy.  (Strangely, Krugman's reason for posting the graph was to justify public infrastructure spending, because: "It also wouldn’t divert labor from other uses: unemployment among contraction (sic) workers remains high: So it’s deeply irresponsible NOT to spend this money...".  Weird.  There might be ways to make that argument, but this graph doesn't seem like it's one of them.)

I noticed that the peak of construction unemployment this winter roughly matched the peak construction unemployment of 2004-2005, when unemployment was around 5.5%.  This is another great sign that unemployment is closer to full recovery than it might first appear.

Then, I looked at construction employment, and this is what I saw.  Total employment is just now surpassing the previous peak.  But, even though construction unemployment is back to normal, construction employment is still more than 1.5 million below the peak.  That accounts for most of the remaining excess unemployed workers...except that they aren't showing up as unemployed construction workers.  So, almost all of the decline in construction unemployment seems to have come from labor transitions to other industries or out of the labor force.

The extreme behavior of construction employment has been a point in the structural vs. demand debate.  This would appear to be a point scored for the structural side.  But, I don't think it necessarily is.  For starters, construction employment is still down at 1997 levels, and I don't think most supporters of the theory that we had too much construction would say that the proper level is back at 1997.  But, further, it seems plausible to me that the sharp liquidity crisis that the Fed created along with the resulting credit crisis coming out of the crippled banking sector, could have been especially damaging to a sector that relies on long term investments and a liquid and functional credit market.  I'm not sure it's so easy to separate supply and demand effects into nice, separate baskets here.

It will be interesting to see if construction employment accelerates, if we see a return of growth in real estate loans at the commercial banks.  Surely, construction is due, at this late date, for a rebound.

New Home Sales and Prices

The conventional view seems to be that housing is "bubbly".  Here is the monthly annualized change in the Case-Shiller 10 city home price index.

Home prices have been increasing by around a 10% annualized rate for two years.  (Case-Shiller is already smoothed enough that I don't see the need for a YOY treatment.  This is annualized monthly percent change.)Interestingly, while the Case-Shiller Index reflected much higher increases in the 2000s than the Census Bureau's new home price series, both series are moving up at a similar rate now.

Here is a recent post by Political Calculations on the topic.  Ironman is taking the bubble position.  Bill McBride at Calculated Risk is more optimistic.  He thinks that a recent downswing in new home sales is temporary, and that new single unit home sales will eventually recover back to about 800,000 - less than before the crisis, but about double the current level.  I think he expects home prices to settle down, but he doesn't think we have a bubble.

Ironman sees prices as a function of median income.  McBride sees a pullback because of the increase in mortgage rates.  I think both of these perspectives are subtly wrong, in that they both miss the importance of real long term rates on the intrinsic value of the home.

The Crazy, but true, Counterintuitive Effect of Real Interest Rates

Rent may be a function of median income, but home values should be a product of the discounted future value of those rents, which is highly responsive to the discount rate, especially when rates are as low as they are now.  One sign of this is the current low level of mortgage debt service - at 5, compared to a long-term level of 6.  This actually understates the depressed level of real estate credit, because given a stable expected inflation, lower real rates should raise the mortgage payment on a home with a given implied rent.  This is counterintuitive, but it's true.  The subtle mis-reading of thinking home values are a product of the mortgage payment is wrong.  When you divide interest rates into real rates and an inflation premium, and treat a home's value as the present value of future net rent payments that rise at the rate of inflation, the justifiable mortgage payment will decrease if expected inflation decreases, as we would expect, but it will increase if real interest rates decrease.  If you are skeptical, it's a simple model you can put in a spreadsheet in 2 minutes.

That's been a theme here lately.  Look how this subtle interpretive error completely reverses the interpretation of the housing market.  If you think that home prices increase because falling nominal rates lead people to bid up houses until they have the original mortgage payment, then that graph above of mortgage debt service looks like a rational market until 2005, when speculative froth caused people to be so irrational that they bid the price of houses up beyond that point to where they were making larger mortgage payments.  Your model of home prices would assume that there was no reason for this, and it would seem to obviously be a bubble.

But, if you see this counterintuitive effect of real interest rates, you would expect the low real interest rate environment of the 2000's to lead to higher mortgage debt service levels.  You would wonder what frictions in the home market kept the mortgage debt services levels from rising earlier than 2005.  Remember how homebuilders would hold lotteries to see who could buy homes at the listed prices that week?  Remember how homes would receive multiple offers above the list price?  That seems like an obvious bubble, doesn't it?  But, understanding this subtle change in interpretation, those activities now look more like a sticky price issue.  I find sticky prices to be a much more plausible explanation of those incidents.  There is a tremendous amount of  mental benchmarking in home markets - consider the use of comparables, etc.  When home prices need to move by more than 15% or 20%, it takes a while to get there.  These price inertias are so strong that home sellers were still underpricing their homes, even when they were surrounded by homes that had been bid above their list prices.  The housing market wasn't out of a rational equilibrium in 2005 and 2006 with prices that were too high; it was out of equilibrium in 2003 when prices were too low, because of sticky prices.

So, now, because everyone knows that the increase in mortgage debt service was a sign of bubble behavior, when mortgage debt service starts moving above 6% again, there will be a groundswell of demands for the Fed to pop the supposed bubble.  It's a shame.  This is a perfectly understandable misinterpretation, but it is a misinterpretation, and if we continue to take that interpretation seriously, we will continue to create undue economic hardship.

Regarding Current Prices

I don't see any relationship in the data between mortgage rates and home sales or prices.  At the time frame of the business cycle, the correlation can be positive or negative - rates tend to go up as the economy strengthens, and so do prices and quantities.  So, I don't see any reason to attribute monthly or yearly price fluctuations to mortgage rates, and I don't see any strong basis for this in the data.  However, what makes sense to me, and what I believe we can see in the data, is a long term relationship between home values and real long term interest rates.

Rising rates can create a drag on demand by locking some households out of the mortgage market.  But, this effect should be minimal at any level we will be seeing in the next several years.  Rates like we saw in the late 1970's - over 10% - can start to have noticeable effects, but even when those rates were in effect, home prices were rising because home values were bolstered by the low real rates of the time.  Home prices began to fall after 1980 when real rates jumped, even though nominal mortgage rates declined.

The funding mechanism is fairly arbitrary.  All of the public policy measures that we have to encourage mortgage funding have some marginal effect on the cost of funding.  The mortgage interest tax deduction is probably the most distortionary.  But, generally, the value of an asset is not a function of the method used to finance it.  I believe this general principal has been lost due to the high correlation between mortgage rates and the discount rate that should apply to the discounted cash flow value of homes, and the misinterpretation that comes from that confusion.

In any case, the current value of homes is not constrained by mortgage rates or by the intrinsic value of future implied rents.  The current value of homes has been constrained by the lack of liquidity imposed by tight Fed policy and the lack of capital from banks that has resulted from that liquidity crisis.

Here is a graph of price to rents (using both Case-Shiller (blue) and Median new home prices (red), 1987=1).  These were rising as real interest rates fell (shown here with an approximation using mortgage rates minus U. of Michigan inflation expectations and with 10 year TIPS).  I believe that Case-Shiller reflected the justifiable price of homes even near the top of the market.  (As a simple example, an asset discounted from 20 years in the future will increase by about 50% when the discount rate declines by 2% and by 75% when the discount rate declines by 3%.  This is the range of the change in long-term low risk real interest rates and the corresponding change in home
price-to-rent, as reflected in the Case-Shiller Index, over this period.)  Notice that home prices were declining slightly in 2006 and 2007 as rates rose.  This relationship broke down in late 2007 as the liquidity crisis intensified.  Price to Rent at 1.7 in 2007 was mainly a product of the interest rate environment.  The drop from 1.7 to 1 was a product of the liquidity crisis.  It is at 1.3 now.  Even if rates rise an additional 2%, so that 10 year treasury rates are at 5%, a Price to Rent ratio of 1.7 is justifiable.  At worst, it's somewhere between the Case-Shiller and the Medium New Home levels from the 2000s.  And, it could be a decade before 10 year treasury rates are sustainably above 5%, unless the Fed begins to allow inflation to rise above 2%.  So the market, when credit markets are functioning, will be reaching for Price to Rent levels 30% higher than current levels, and in the meantime, rent inflation is accelerating.  And, looking back at the first graph, there is no sign of home price growth subsiding when we look at the month-to-month Case-Shiller index.  Calls for a market top are getting ahead of the data because so many people are convinced that we have a bubble.

Political Calculations sees a market top in the March decline in new home sales.  It will be interesting to see how the data proceeds.  I suspect that we are seeing a temporary dip because much of the all-cash investor demand for real estate was essentially funded by QE3.  (Perfectly reasonably, IMO.)  Now that QE3 is being tapered, that demand is falling away, but the banks are just now garnering the ability to extend their own credit to replace the liquidity that QE3 was creating.  I think we will see bank credit continue to recover, but if it doesn't, my thesis could be busted by more liquidity problems.  Here is the weekly level of real estate loans at all commercial banks.  It appears to be rebounding over the past few months.  This may reflect the winding down of foreclosure activity as much as an increase in purchasing activity, but at least it is a move in the right direction, and it signals a willingness or ability for banks to add to their real estate exposure.  If this process takes a few more months to gather full momentum, home prices may look like they are beginning to moderate before they reassert their movement toward previous highs.

This could also reflect a lack of demand.  The relationship between price and demand is complicated on a durable asset.  I don't want to go down that rabbit hole right now, but suffice it to say, I'm not entirely confident with my understanding of exactly what is keeping real estate loans depressed at the banks.  Please let me know in the comments if you have insight.

A Caveat

I am considering being more bearish than Bill McBride on one factor, and that is the projected quantity of new home sales.  He expects a doubling from around 400,000 units to around 800,000 units.  That seemed reasonable to me.  But, looking at demographics, I'm not sure if that is sustainable.  To approximate the demand for single family housing units, I have compared the annual change in the number of males in the labor force to the SAAR quantity of new home sales.  (For male labor force I used the YOY change in the 12 month moving average, in an attempt to reduce noise.)  The labor force series carries an array of information regarding business cycle and demographic trends and plots remarkably well against new home sales.  (I used males because their age-specific labor force behavior has generally been stable for decades.)

Going forward, annual increases in male labor force participation are expected to remain around 500,000 per year for several decades.  There might be a cyclical rebound of an additional 500,000 or more over the next couple of years.  Also, baby boomers' movement out of the labor force may predate their movement out of single family units. Also, the excess capital associated with this demographic shift may move some homebuilding back in time.  So, we might get to that level of 800,000 units or more, temporarily.  But, I think it may be prudent, when modeling future cash flows of homebuilder, to base it on long term annual new home sales more in the range of 600,000.  I continue to see unexpected profits for homebuilders resulting from rising property values, but I think unit sales may remain significantly below where they were before the crisis.

April Employment

Although there is a wide range of possible readings for unemployment in any given month, I think that we might see a gap down this month.  Generally, readings in economic indicators have been running along the path they have been for a while - some ups and downs, but generally positive.

As I have mentioned, the 1st quarter labor market was very strong, despite the inertia in the unemployment rate.  This was probably a combination of a genuinely strong rebound in labor force participation plus statistical noise that might have pushed the unemployment rate down in late 2013 and up in 2014 1st quarter.  So, I suspect that the unemployment rate in April is due for a little spring-back.  In addition, there should be some more strength from weather related recovery from January and February, and employment flows coming from the end of EUI, that push down on unemployment in April.

Initial and continued unemployment claims have taken a dive this month.

While, again, the relationships here have a lot of wiggle room from month to month, they tend to trend together quite strongly.  Even if unemployment claims were flat, we should expect the unemployment rate to continue to decline, because at this point in the cycle, (1) unemployment claims are getting pretty close to their cyclical lows so they will tend to level out even though the unemployment rate will tend to continue to fall, and (2) long term unemployment has been especially high (which, as I have previously indicated, we might owe largely to EUI).  Here is a graph of the relationship between continued unemployment claims and the unemployment rate.  I have extended this graph to April 2014, using the April 12 level of continued unemployment claims (seasonally adjusted) and an April unemployment rate of 6.4%.

I am not exactly forecasting a 6.4% reading, but, as the graph shows, this would not be an unusual movement in the UER, given the precipitous decline in UI claims.  And, I would have expected a decline to 6.5 or 6.6% even if UI claims had been more level.  This month could be a real shocker, IMO.  And, I still think we might be tickling 6.0% or at least very low 6's by summer.

It continues to look more and more like if we categorize the labor force by duration of unemployment, the labor force is divided between two groups.  98.5% of the labor force is at full employment levels, and 1.5% of the labor force is unemployed and has been unemployed for an average of about 2 full years.  That group has been declining in size by about 800,000 per year, but the average duration of unemployment for that group of excessive long-duration unemployed workers has not declined as its membership has decreased.

It will be interesting to see how quits behave in April, given that we are seeing this decline in insured unemployment.  We might see an increase, which is a bullish indicator.  Additionally, the direction of the economy over the next year depends a lot on that 1.5%, what their situation is, and where they end up.  I don't have any certainty about that, and most of what is written seems to be what Tyler Cowen would call mood affiliation.  The first 3 months of this year haven't been very enlightening about that direction.  So, I am very curious about the second quarter.

The Peculiarities of the Mortgage Market and More Financial Villains

Many of the problems in the housing market are a product of peculiarities that we take for granted because of mental benchmarking.  One problem that I have mentioned before is that homes are different than most other investments, because we don't tend to treat them as divisible investments.  If you want to purchase a home, it is unusual to be able to buy shares of partial ownership.  Instead, you enter into hedged financial instruments - a home and a related mortgage - and so your personal financial leverage balloons.

We also take for granted the way mortgages are owned.  They have a built in call, generally, where, if rates go down after you take the mortgage, you can just pay the mortgage back at face value (even though its market value, absent the call provision, would be higher than face value) and institute a new mortgage at a lower rate.

But, strangely, this doesn't tend to happen in the other direction if rates go up, the bank also can demand face value.  If rates go up, the mortgage is worth less to the bank.  If they originally had a $100,000 mortgage that earned $6,000 a year when $6,000 was the going rate, now they have a $100,000 mortgage earning $6,000 when $8,000 is the going rate, which means they really have a mortgage that's worth more like $80,000.

But, as far as I know, it is not typical for homeowners in that position to go to the bank and say, "You know, I'm selling the house, and so I'll be paying off the mortgage.  I see the market value is $80,000.  I'll pay you $85,000, and we'll call it a day."  The bank would just say, "Either make the payments or don't, but if you don't we'll just foreclose and pay ourselves face value."  So, a transaction that would be perfectly normal in most financial markets becomes difficult, and leads to all sorts of dislocations.

This is perfectly understandable, and I don't have an obvious way to fix it.  If the bank sold that mortgage to another bank, it would sell at the discounted price.  Corporate bonds can be bought back at a discount because their ownership is diffuse, and there is a marketplace for them.  But, mortgages are either owned by a single bank, or if they are split up into smaller shares, it is as part of a pool of mortgages, so that even though the pool of mortgages could sell at a discount, the individual mortgage can't be removed from the pool for this purpose.

This is especially a problem now, when very low long term interest rates are pushing up the value of homes, and making the price of homes more volatile, like a long-duration bond.  There are plenty of reasons why home prices could reasonably move up 30% - 50%, if we compare them to alternative low risk investments.  The problem is, if the prices do get bid up to those levels, then a homeowner who purchases a home with a large mortgage, will be faced with this dilemma.  If interest rates rise, the intrinsic value of homes will decline.  But, if the homeowner has to move, she will be stuck selling a home with a lower nominal value, but paying off a mortgage at the original face value.  The mortgage does not work as a hedge against a declining sales value of the home when interest rates go up.

(Note that the public programs involving mortgage renegotiations coming out of the recent crisis are not products of the same issue.  Interest rates are still low, so those mortgages would only have impaired value because they are in default and the homes are impaired.  If those mortgages were being paid dependably by the homeowners, they would still have a value near the original face value as marketable securities.)

Institutional Investors

My working theory on the high number of institutional investors in the home market has been that the real estate market was so hobbled by the damaged credit market that home prices have fallen low enough to be valuable, even to buyers without the mortgage tax deduction.

But, I wonder if institutional investors have an advantage in this market.  If low interest rates lead to volatile home values, institutions can raise money on the corporate credit markets, and buy the homes with that capital.  If rising long term interest rates end up pulling home prices down, and the investment firms need to liquidate any real estate holdings at a loss, they will use the proceeds of the sales to buy back some of their bonds at a discount.  To the extent that home values are a product of interest rates, they will have a relatively useful natural hedge.

Homeowners

For mortgaged homeowners, this set of conventions creates a kind of no-win situation when real interest rates are low.  In a high inflation environment, home buyers must commit to buying a large portion of the equity in the house in the early years.  (The real value of the house will tend to grow slowly, while the real value of the outstanding mortgage will decline steeply, because the mortgage payments will be very high and its nominal value will be stable.)  In a low inflation environment, home buyers will be able to qualify for mortgages more easily, but they will be vulnerable to potential drops in nominal home values.

There isn't any organic reason for these risks to exist.  I would expect market conventions to evolve to solve these problems, but I suspect that there is a strong level of inertia because many of these conventions are enforced legally, either through banking regulations or through conventions enforced by the federal mortgage support agencies (Fannie, Freddie, etc.).  These kind of scleroses in contract conventions are a subtle product of standards imposed through public regulation.  I suspect that the costs of this sclerosis are not generally accounted for, if ever, when reviewing the costs and benefits of these regulations, but it isn't difficult for me to imagine that the costs far outweigh any benefits, especially because the costs aren't direct costs, but instead are risks or transactional obstacles that are difficult to manage or quantify.  What would the benefit have been to homeowners, let alone the economy in general, if in 2006 & 2007, mortgages would have been packaged in such a way that they could easily be paid off at market value?

Conclusion

Looking at it this way, the surge in all-cash institutional home buyers could be viewed as a sort of regulatory arbitrage.  Institutional investors are able to capture the excess future expected cash flow of homes without the irregular risk profile that is imposed by the regulated mortgage market.

So, market dynamics are solving a regulatory problem.  Homebuilding is a powerful way to pull production back in time as baby boomers age through their prime productive years and transition into retirement.  Institutional investors are able to step in and help pull home prices up to levels that incentivize that production, where these peculiar risks and recent memories of collapse are dampening homeowner demand.  Home construction still needs to rise.

But, generally, people look at these same facts, and they intuit that homes are not necessarily a safe investment for households, and they see home prices being bid up by institutional investors, and they interpret this to mean that speculators are hurting households by creating a housing bubble.  And, again, we see what a difference a paradigm can make in creating a picture of the world as it is.  Good guy/bad guy framing balances on a knife's edge.  Tyler Cowen says when you use good guy/bad guy narratives, imagine subtracting 15 points from your IQ.  I say that's conservative.  For starters, shortcomings in mental framing don't just create normally distributed errors around a stable ideal.  As with this topic, a slight tweak in the mental framing means one version of this story is really, really wrong.

One reason I tend to dwell on these issues is that the bad guy narrative is so prevalent in financial contexts.  There are so many issues where a slight tweak in the framing creates a substantial speculative opportunity.  I will bet against the bad guy framing every time - I figure a 15 point IQ advantage should be very profitable.  Even in individual stocks, this is fruitful.  If a firm is set up for a highly variable pair of possible binary outcomes, the opportunities that offer huge profit possibilities are frequently those where you take the position of giving management the benefit of the doubt.  If you're wrong 50% of the time, the cynic will hold on to a lot more assets than the naïf will.  So, the trusting positions tend to pay off very well for investors without agency issues, but not for money managers.  I think this explains, partly, why even finance professionals tend to be cynical about finance - it's survivorship bias.

See, there?  With just a slight tweak in framing, and a ready explanation, I just said something that really either has to be insightful and clever, or really, really dumb.  That's why you can build speculative models where you can frequently safely fill in all your ignorance with an EMH assumption, but still expect to capture gains from large disconnections.  Even if inefficiencies are few, they can have unstable equilibria.

A Very Basic Housing Post

This is a very simple graph comparing the relative mortgage payment (based on the typical 30 year mortgage rate and the Case-Shiller 10 city home price index <blue> or the CPI median home price <purple>) to the level of rent approximated by the Owner's Equivalent Rent series in the CPI.  The CPI measure didn't show the same price increases in the 2000's that the Case-Shiller Indexes did.  I suspect that the Case-Shiller index reflects the experience of existing homeowners in major cities, and the CPI index reflects the experience of homebuilders and rural homeowners.  (The green line reflects the CPI Housing price index more generally, as an alternative to OE Rent.)

(As an aside, I wonder if the Case-Shiller/CPI disconnect is related to the difference between long-term expected price behavior for urban dwellings compared to rural locations.  At very low long term real interest rates, adding a small amount of excess expected returns can cause present value to skyrocket.  This is a problem when doing discounted cash flow valuations on stocks, where changing the long term growth rate by 1% can swamp the scale of all the work you might do in the short term cash flow forecast.  This is especially the case on very long-duration assets with very low discount rates.  So, if this divergence reflects an urban/rural split, I will suggest that this also is a sign of the power of low real rates on home values.)

As I have explained, many times, a house is a very long term inflation protected asset.  The intrinsic value of a home is no more dependent on the use of a mortgage than is the intrinsic value of a stock dependent on whether you buy it on margin or not.  (Of course, tax treatment of mortgage debt does provide a consistent boost to the value of an occupied home, but this is a relatively constant factor over time.)  I have explained that homes should be worth more, in nominal cash value, during times of low real long-term interest rates.  This means that even the ratio of mortgage payments to rent payments should increase, because the mortgage has a relatively short duration, while implied rent would grow and extend further into the future.  Low real interest rates inflate the value of those future rent values more than they inflate the value of the mortgage payments, so the equilibrium mortgage payment to rent payment ratio should increase when real rates decrease.

But, ignore all of that for now, and let's look at this simple chart taken on the most simplistic terms of the rent-vs-own comparison.  Even ignoring all of that, homes are still cheaper now than they had ever been before the crisis, relative to renting.  There is no bubble.  There is the opposite of a bubble.  There is a big, giant, wet blanket of a non-bubble.

If there is bubble talk now, I hate to think of how much pressure there will be on the Fed to cut off our nose to spite our face when home prices go up another 30%.  But, they need to go up that much just to get mortgage payments back to the relative level of rent payments.  Lord help us if housing prices actually get back up to where they should be in a low rate environment.  If that happens, there will be calls for Janet Yellen to literally walk down alleyways with Molotov cocktails, burning houses down to save us from ourselves.

We live in a time where finance is treated as suspect, a priori, at just the time where financial intermediation is especially needed.

It's interesting how many thoughts the average person can hold in their head.  For instance, everyone knows that the average mutual fund underperforms the market.  These finance guys - you know how they are - they try to convince you to pay them a bunch of fees because they'll supposedly beat the market for you.  It can't be done.  Everyone knows that.  They are scamming you.

And, also, everyone knows that housing in the 2000's was a bubble.  And everyone knows housing is getting all bubbly again.  It is clear. As. Day.

Everybody KNOWS both of these things....at the same time.  Prices can't be predictably wrong, and, also, prices are predictably wrong.

And, when we manage to pop those bubbles, isn't it nice that we have the finance guys to blame.  They only care about one thing: money.  They don't even MAKE anything.  They just want profit.  And, they will destroy the whole country to try to get it.  They'll even finance a house for you, and stick it right there on their balance sheet, even when we all know it's a bubble.  And, it doesn't even hurt them, because villainy is magical.  Just slap the term "bailout" on a half-dozen different policies regarding thousands of different financial professionals, and ignore that list of banks in FDIC receivership - the details aren't important.

What a nice story.  Magical villains can really bring a narrative around.  It's just about the only thing Republicans and Democrats seem to agree on.  Even market-supporting economists can earn street cred by asserting that finance is all just a bunch of rent-seeking.  (Never mind that negligible trading fees and spreads and low-fee index-type funds are fairly recent and now-ubiquitous innovations.)

PS.  Speaking of which, here's an interesting interview of Stalin by H.G. Wells, from 80 years ago.  To me it is chilling to read this conversation between a mega-murderer and a Western intellectual impressed with men-of-system.

It's kind of funny that Wells says this of J.P. Morgan: "Take old [J P] Morgan, for example. He only thought about profit; he was a parasite on society, simply, he merely accumulated wealth." And, it takes Stalin to come to Morgan's defense, though noting that profit-seekers will never be friends of the revolution.

But, knowing what has happened in the world since then, how the world has changed, and what Stalin was up to, it's sad how much of that conversation could be right at home in many of today's publications and university campuses.  We live in a world of mind-boggling human innovation, yet it seems that we are incapable of learning anything.

In 1934, Wells could profess his confidence to Stalin that the profit-based system was collapsing, and New Statesman readers could nod in agreement.  In 2014, the end of the old system is still professed.  The system of profit-seekers and "1 percenters" is toppling by its own weight.  And blog readers and Facebook friends click "Like".  In another 80 years, knowing intellectuals will use their neurotransmitters to telepathically emote hatred for those slimy profiteers to their Mega Corp 2000 brand robot-butlers, and robot lights will gleefully blink in agreement, "Bleep, blop, bloop...you are so right, master."

The Yield Curve and Rate Movements

I was taking a look at interest rates during the Great Moderation period.  Here is a graph of rate changes over time.  This probably requires some explanation.

First, this is based on data from treasury rates and the fed funds rate.  I probably should have used 3 month treasuries, but I don't think it affects the general analysis.  It is based on a monthly forward yield curve that I produced with a combination of bootstrapping and curve fitting.  So, again, these aren't exact numbers, but they are close enough for some basic analysis.

The red line is the expected change in short term rates, given by the yield curve.  In other words, if two years ago, the 2 year forward rate was 2.5% and the fed funds rate was .25%, then the yield curve was predicting a 2.25% increase in the fed funds rate over the intervening two years.

The green line is the raw change in the Fed Funds rate over two years.  If 2 years ago, the Fed Funds rate was .25% and today it is .5%, then the Fed Funds rate has increased by .25%.

The blue line is the difference between the forward 2 year rate from two years ago and the Fed Funds rate today.  So, if the 2 year forward rate two years ago was 2.5% and the FF rate today is .5%, then, today's rate has decreased by 2% over two years.

The dates are the end date of the two-year period.  One way to read the graph is that the Green line is the sum of the red and blue lines.  The Green line is the total change in the interest rate.  The red line is the portion of the change that was predicted by the yield curve and the blue line is the portion of the change that wasn't predicted by the yield curve, and therefore could have been captured by taking a forward position on the yield curve two years ago.

Here are correlations between the yield curve slope (red line) and the subsequent change in the short term rate (green line), and between the yield curve slope (red line) and the subsequent change in future short term rate compared to the starting 2 year forward rate (blue line).

The yield curve has been a very unbiased predictor of the subsequent change in short term rates (Future rate minus current rate) during this period (the first graph).  If the yield curve slope increases by 1%, then you better darn well expect future rates to be 1% higher.  It's not a good forecaster - there is a lot of noise around this correlation - but it is unbiased.

If we look at the second graph, this is the subsequent change over two years, starting with the 2 year forward rate and ending with the eventual short term rate after two years have passed (future rate minus forward rate).  There is no persistent correlation.  In other words, if you take naïve positions on two year forward rates, based on the slope of the yield curve at the time, there is no systematic profit available.

The y-intercept for both of these correlations is -1.85% over 2 years.  It would be possible for there to be some bias in the yield curve, reflecting maturity premiums or skewed risk profiles.  But, here, I believe this is simply a product of the decline in interest rates across the curve over the past 30 years.  This decline cannot continue, since we are at the zero bound.  So, forward rates should have a neutral or positive bias.  First, because the zero bound will limit the negative outcomes.  Eventually, rates might trend up again, although I suspect this will not happen soon.  The combination of a hawkish Fed and demographic pressures will probably keep a lid on rates for some time.

But, I think there is a pattern here that might be exploitable.  In cases where the yield curve is negative, the future short term rates are almost always lower than the initial forward rates would have predicted.  There are a few outcomes where future rates are higher, coming from the episode in 1998 where the yield curve flattened and then the economy recovered.  But, in all the other cases where the yield curve inverted (including all the cases that triggered the Federal Reserve yield curve inversion recession indicator), yields had much more negative movement than the yield curve would have predicted.

If the Fed gets scared by rising home prices, I suspect this might happen again.  If the yield curve has a bias, it might be an inability to signal a money-supply-related recession when the Fed is inclined to impose one.

Of course, if we remove the points where the yield curve is inverted, then the yield curve at positive levels stops correlating so well to future rate movements.  At positive slopes, it overstates the future rate by about double, so that there appear to be persistent profits from positioning against the yield slope, but with a tremendous amount of variance.

Looking back at the initial graph, in the recoveries after the previous two recessions, there were brief periods where rates increased by more than the yield curve had predicted (the green line is above the red line).  I have been positioning for this movement again.

If expected yields remain where they are, the 2 year forward rate when short term rates start to climb will be slightly over 2% more than the spot rate.  But, with interest on reserves, tremendous excess reserves which can be unwound, etc., there are a number of mitigating factors in play.  I don't have as much confidence in the expectation that rates will move more than that as I once did.

But, I do believe that there will be a point where a long position on Eurodollar futures (which gains when rates decline) should have a decent likelihood of profit.  This will be the case when the curve flattens, and maybe even when it is still positive.  I also believe that the combination of demographic factors and a hawkish Fed that has taken very little blame for the 2008 fiasco, and faces public pressure for disinflation because of broad misunderstanding of the role of housing in financial markets, eliminates much of the risk of having an unexpected interest rate bump (either in real rates or in the inflation premium) go against that position.

I wish that wasn't the case, but I'm afraid it is.

 In general, although the scatterplot of interest rate changes shows a large amount of unpredicted changes, there does appear to be a decent amount of serial correlation in the error.  Generally, if the yield curve has been sloped too steeply, and is beginning to show a decline in the error for the two year periods coming to an end, it seems likely that it will continue to decline until it begins to under-predict the actual coming changes in rates.  There might be a somewhat regular tendency for the error to move in waves through the business cycle.  This pattern would suggest that contracts expiring around 2017 or so will predict the 2017 interest rates fairly well, possibly being a bit low, and by 2019 or 2020, long positions might tend to be profitable, with interest rates in 2019 and 2020 coming in below the original expectations.

That's probably the optimistic case.  The bad scenario would be if the economy starts to falter before short term rates ever get off the ground.

Minimum Wage Hikes Hurt Job-Keepers

Obviously, a minimum wage hike is damaging to employees who lose their jobs because of it.  Additionally, some economists have made the point that, even for workers who see wage gains because of the minimum wage, these gains are offset by losses in non-wage factors, such as fringe benefits, job flexibility, training, safety, etc.  This is the idea I would like to explore here.  I think it is optimistic to say that these wage gains are merely offset by losses from these other factors.  The marginal worker who receives a wage increase due to an increase in the minimum wage, and remains employed, almost certainly would experience a loss of total utility, even with the higher wage.

Imagine a worker making $8/hour (compared to the current MW of $7.25).  First, we can say that this wage level is the product of some balance of market forces.  There is some skill or value that the worker in question brings to the table which pulls the wage level up to $8.  The wage could have been legally more or less than $8, but some complex balance of value and power between the worker and the employer and other stakeholders in this contract has led to a value of $8/hour.

Whatever effect the MW may have on wages or employment, it is not going to change anything about the underlying balance of these market forces.  The total cost incurred by the employer for this worker is a product of these forces, so that the total cost incurred, which includes an $8 cash payment plus many other considerations, will not change, ceteris paribus, if the means exist for the employer to adjust non-cash costs.

Further, the total utility gained for this work can be imagined as a sort of production-possibility frontier.  Cash payment will form a large part of the benefits to the worker.  But, as mentioned above, there are many factors about any job that can be changed, to the relative cost or benefit to the worker or the employer.  If the worker values flexibility more than the employer, an $8 job with more flexibility may be more valuable to both the worker and the employer than an $8.50 job with an unyielding schedule.  There are innumerable non-wage factors that we could imagine with any job, and most jobs come with a set of conventions and non-cash benefit equilibria that reflect a complex evolution of the relative values and needs of both workers and employers.  Most of the time, we take these factors for granted - some types of workers are home every day at 5, others have to stay late when work is heavy, others have to put time in on the graveyard shift.  Some types of workers can show up a couple hours late when their child needs to go to the doctor and make the work up later, others have to find a way to cover their shift.  For the most part, these kinds of job-specific demands are the product of a web of competing needs so complicated, they would be impossible to calculate.  But, for every individual worker, through conventions, negotiations, and compromise, an equilibrium is reached, and is constantly monitored and tweaked, in conscious and unconscious ways, by both the worker and the employer.  (This can be as formal as allowed vacation days, or as informal as a willingness to put up with a co-worker's poor hygiene.  The number of variables here is endless.)

The optimal cash/non-cash combination of considerations captured by the worker will be the combination where the marginal cost to the employer of substituting a non-cash consideration for cash is equal to the marginal benefit to the worker.  So, the curved line in the figure represents the costs the employer is willing to bear for the employment contract.  The total value to the worker is the combined value of cash and non-cash considerations.  The diagonal line shows the potential cash/non-cash combinations that would have the same value as they do at the optimal wage.  Of course, this line is tangential to the curve of possible combinations, with the total value to the worker decreasing as the wage departs from the optimal wage.

For our hypothetical worker, that equilibrium settled at $8/hour, plus some long list of potentially mutable demands or benefits.  We can suppose that while perfection is rare, this contract, and contracts in general, tends toward an optimal equilibrium, where the trade-off between cash and non-cash considerations is optimal.  It easy to imagine that employers would be enthusiastic about finding employment contracts that attracted workers with lower cash payments, and that they would utilize non-cash considerations that were valued by potential workers whenever possible.

Now, imagine that the minimum wage was raised to above $8/hour.  To imagine that the wage would simply be raised, with no change in non-cash considerations, we would have to believe two things - (1) that the entire universe of non-cash considerations valued by the worker are entirely immutable, and (2) that the firm held some sort of monopoly power that allowed it to sustain a total labor cost at below the competitive rate.  Number one is simply unlikely, and number two begs the question.  Whatever competitive pressures led to the job settling at $8/hour (plus the original non-cash considerations), those pressures would tend to move the cash/non-cash compensation along the utility frontier.  They wouldn't lead to a rise in cash wages with no corresponding change to non-cash compensation (the green line in the figure).  The frontier reflecting the total available cash and non-cash considerations doesn't just go away because a wage law was passed.

So, to the extent that the context of the job is mutable, the balance of cash and non-cash considerations available to the worker will settle at the original frontier, but at the new, higher wage.  This will not be the optimal balance of cash and non-cash considerations.  For the employer to settle at the original total cost, the worker will have less total utility as compensation for this job.  The worker will be worse off.

The Irony

The ironic conclusion to this puzzle is that the impetus for minimum wage legislation is the conception of low-wage employers as powerful taskmasters who have broad power over the level of wages and terms of employment.  These happen to be the characteristics that would lead to a long term equilibrium that pinned the total utility at the original frontier of cash/non-cash compensation.

If excess profits exist as the result of some competitive monopolist context that the employer enjoys, but the original low wage was a product of a power mismatch between the worker and the employer, so that the employee was not capturing any of the surplus, then, the same competitive imbalance will be in place with regard to non-cash considerations, and the employee will be denied utility through the denial of non-cash considerations after the wage hike.

If the employee is able to capture all of the surplus resulting from the wage hike, then why would we assume that he wasn't capturing all of the surplus to begin with?  So, that, in that case, with no surplus left to share, the firm will be forced to either pin the total cash+non-cash cost back at the original frontier, at the new, sub-optimal balance, or terminate the worker.

The likely outcome, especially in the long run, appears to be a loss of utility for everyone, especially the workers - even the workers that don't lose their jobs.

It may be possible for some firms to experience gains resulting from the exit of weaker competitors after a MW hike, which might allow for some ability for workers at these firms to remain at a higher total consideration, at least temporarily.  Here is a previous post where I tried to think through some of the implications of MW hikes among different firms.  But, the resulting expected change for the typical worker affected by a MW hike, all else equal, seems tilted to the negative to me.

Perception is reality

Commenter Michael Byrnes hits the nail on the head at themoneyillusion.com :

A big problem: If monetary policy is tightened inappropriately, so as to pop bubbles, it will produce (what appears to be) evidence that there were bubbles that needed popping. This will happen whether or not there are any bubbles.

The value of low risk investments for emerging markets

This is a follow-up to the previous post on the benefits of international capital flows in helping to match risk demands between emerging markets and developed markets.

I think the idea that capital from the developed world is a beneficial input for production growth in developing economies is easy to intuit.  But it seems somehow strange, or wrong, or at least not the result of some natural equilibrium, that so much emerging market capital would be parked in low risk securities in the developed world.  After all, we don't need emerging market capital; they do.

But, I think it is easy to underestimate the value of low risk savings vehicles for emerging markets.  For economies that exist within a context of high risk premiums and high uncertainty, relative to developed economies, I think we can see how there would be a demand for low risk investments.

But, I think the benefits of these savings outlets may be much deeper than is obvious.  The rise of functional market economies, at their base, is a triumph of a set of cultural and institutional norms that is fundamentally entangled with the conflicted human relationship with risk.  So many of the social impediments to market-based abundance are seated in a desire to avoid risk - the complex sharing norms of extended families in subsistence economies, political impositions of power of one group over another, limited access property rights, corruption in the service of protecting the existing control of land, production, captured demand, etc.

In many ways, these mechanisms that end up blocking the universal, individual right and access to property are the products of a demand for safety.  At their worst, in political form, these mechanisms create safety for a limited class at the expense of others.

Could it be the case that the external availability of highly trusted low-risk savings vehicles helps to meet this demand for safety, and allows the more powerful, capital rich factions of developing economies to achieve a level of risk low enough that the demand for more corrupt versions of risk abatement is sated?  I submit that this seemingly inapt escape of capital from the very places where capital would be most useful might be the most important leg of the set of international capital flows that have defined our era.  Functional mechanisms for protecting prior gains in emerging economies might be replacing the dysfunctional mechanisms that have kept generations of peasants from access to the possibility of accumulation.