Archive
Some Useful Charts And Thoughts About Personal Investing
I just finished a paper called “Managing Laurels: Liability-Driven Investment for Professional Athletes,” and I thought that one or two of the charts might be interesting for readers in this space.
An athlete’s investing challenge is actually much more like that of a pension fund than it is of a typical retiree, because of the extremely long planning horizon he or she faces. While a typical retiree at the age of 65 faces the need to plan for two or three decades, an athlete who finishes a career at 30 or 35 years of age may have to harvest investments for fifty or sixty years! This is, in some ways, closer to the endowment’s model of a perpetual life than it is to a normal retiree’s challenge, and it follows that by making investing decisions in the same way that a pension fund or endowment makes them (optimally, anyway) an athlete may be better served than by following the routine “withdrawal rules” approach.
In the paper, I demonstrate that an athlete can have both good downside protection and preserve upside tail performance if he or she follows certain LDI (liability-driven investing) principles. This is true to some extent for every investor, but what I really want to do here is to look at those “withdrawal rules” and where they break down. A withdrawal policy describes how the investor will draw on the portfolio over time. It is usually phrased as a proportion of the original portfolio value, and may be considered either a level nominal dollar amount or adjusted for inflation (a real amount).
For many years, the “four percent rule” said that an investor can take 4% of his original portfolio value, adjusted for inflation every year, and almost surely not run out of money. This analysis, based on a study by Bengen (1994) and treated more thoroughly by Cooley, Hubbard, and Walz in the famous “Trinity Study” in 1998, was to use historical sampling methods to determine the range of outcomes that would historically have resulted from a particular combination of asset allocation and withdrawal policies. For example, Cooley et. al. established that given a portfolio mix of 75% stocks and 25% bonds and a withdrawal rate of 6% of the initial portfolio value, for a thirty-year holding period (over the historical interval covered by the study) the portfolio would have failed 32% of the time for, conversely, a 68% success rate.
The Trinity Study produced a nice chart that is replicated below, showing the success rates for various investment allocations for various investing periods and various withdrawal rates.
Now, the problem with this method is that the period studied by the authors ended in 1995, and started in 1926, meaning that it started from a period of low valuations and ended in a period of high valuations. The simple, uncompounded average nominal return to equities over that period was 12.5%, or roughly 9% over inflation for the same period. Guess what: that’s far above any sustainable return for a developed economy’s stock market, and is an artifact of the measurement period.
I replicated the Trinity Study’s success rates (roughly) using a Monte Carlo simulation, but then replaced the return estimates with something more rational: a 4.5% long-term real return for equities (but see yesterday’s article for whether the market is currently priced for that), and 2% real for nominal bonds (later I added 2% for inflation-indexed bonds…again, these are long-term, in equilibrium numbers, not what’s available now which is a different investing question). I re-ran the simulations, and took the horizons out to 50 years, and the chart below is the result.
Especially with respect to equity-heavy portfolios, the realistic portfolio success rates are dramatically lower than those based on the “historical record” (when that historical record happened to be during a very cheerful investing environment). It is all very well and good to be optimistic, but the consequences of assuming a 7.2% real return sustained over 50 years when only a 4.5% return is realistic may be incredibly damaging to our clients’ long-term well-being and increase the chances of financial ruin to an unacceptably-high figure.
Notice that a 4% (real) withdrawal rate produces only a 68% success rate at the 30 year horizon for the all-equity portfolio! But the reality is worse than that, because a “success rate” doesn’t distinguish between the portfolios that failed at 30 years and those that failed spectacularly early on. It turns out that fully 10% of the all-equity portfolios in this simulation have been exhausted by year 19. Conversely, 90% of the portfolios of 80% TIPS and 20% equities made it at least as far as year 30 (this isn’t shown on the chart above, which doesn’t include TIPS). True, those portfolios had only a fraction of the upside an equity-heavy portfolio would have in the “lucky” case, but two further observations can be made:
- Shuffling off the mortal coil thirty years from now with an extra million bucks in the bank isn’t nearly as rewarding as it sounds like, while running out of money when you have ten years left to lift truly sucks; and
- By applying LDI concepts, some investors (depending on initial endowment) can preserve many of the features of “safe” portfolios while capturing a significant part of the upside of “risky” portfolios.
The chart below shows two “cones” that correspond to two different strategies. For each cone, the upper line corresponds to the 90th percentile Monte Carlo outcome for that strategy and portfolio, at each point in time; the lower line corresponds to the 10th percentile outcome; the dashed line represents the median. Put another way, the cones represent a trimmed-range of outcomes for the two strategies, over a 50-year time period (the x-axis is time). The blue lines represent an investor who maintains 80% in TIPS, 20% in stocks, over the investing horizon with a withdrawal rate of 2.5%. The red lines represent the same investor, with the same withdrawal rates, using “LDI” concepts.
While this paper concerned investors such as athletes who have very long investing lives and don’t have ongoing wages that are large in proportion to their investment portfolios (most 35-year-old investors do, which tends to decrease their inflation risk), the basic concepts can be applied to many types of investors in many situations.
And it should be.
Breaking Open the Piggy Bank
We have one month in the books in 2013 already; my, how time flies when you’re having fun! But the fun may not last much longer.
I have spent lots of time, over the last year, answering the question “why hasn’t inflation responded to QE?” My response has been that it has: core inflation rose from 0.6% to 2.3% from October 2010 to January 2012, rising for a record-tying fifteen consecutive months – a feat that last happened in 1973-74, as official prices adjusted to catch up for being frozen during wage and price controls. By a bunch of measures, that was an acceleration of core inflation that was unprecedented in modern U.S. economic history. As I wrote at the time (in “Inflation: As ‘Contained’ As An Arrow From A Bow“), the only reason to defer panic was that Housing inflation was overdue to level out and decelerate. Fortunately, it did.
But, as I’ve written extensively recently, that blessing has been rescinded and the question of “why hasn’t inflation responded to QE” will shortly be moot. In the next couple of months, core inflation will begin to re-accelerate, driven by the pass-through of rising home prices into rents. In our view, the best we can hope for is that core inflation only reaches 2.6% this year. Absent a change from the historical relationship between home prices and rents, some 40% of the core consumption basket is going to be rising at 3.5% or better by late this year.
So, when will markets get a whiff of this?
We are primarily motivated by valuations, and we are patient investors. Moreover, we think it makes more sense to focus effort on valuation work, because if your valuation work isn’t pretty good then timing isn’t going to matter much. But nevertheless, it is helpful to look for signs and signals that indicate time may be drawing short. So I’d like to go all ‘techie’ for a few minutes and show three charts that suggest markets are preparing for a new, higher-inflation reality.
The first one is the dollar index (see chart, source Bloomberg). This one is interesting, because I am not convinced that U.S. QE will cause a uniquely American inflation. After all, everybody’s doing it. This chart is technically of a head-and-shoulders pattern, but I’m just pointing to that trendline that keeps bringing in buyers.
A break below the current level (and as a trader, I’d be tentative until the September lows broke as well) projects to a test of the bottom end of a much bigger consolidation pattern that has been forming since the beginning of the crisis in 2008 (see next chart, source Bloomberg – the green oval is the area of detail in the prior chart). Below there be dragons.
Now, at the same time we have inflation breakevens (the compensation, in nominal bonds, for expected inflation – represented as the raw spread between the Treasury yield and the TIPS real yield). I’ve shown this uptrend in breakevens and/or inflation swaps in a number of ways recently, but the chart below (source: Bloomberg) shows a long-term view. In the last three months, the 5-year breakeven has risen about 35bps (and you get a similar picture from inflation swaps, but the data isn’t as clean that far back). Right now, bond investors are demanding a fairly high level of expected inflation compensation over TIPS and their guaranteed return of actual inflation. We’ve got a ways to go before we hit all-time highs on the 5y BEI, but the 10-year BEI is only about 22bps away from all-time highs.
Those prior charts haven’t yet broken out, and so while the timer is buzzing the alarm might ultimately not be set off. But in commodities, there are some interesting signs that the lows may be in even though sentiment remains very negative. The chart below (source: Bloomberg) illustrates that in January, the DJ-UBS commodity index gapped through trendline resistance not once, but twice.
In my experience, technical analysis of commodity indices is a fraught exercise, but commodities have quietly been doing quite well lately. Although the S&P rose 5% in January to only 2.4% for the DJ-UBS, that’s mostly due to the first trading day of the year. Since January 9th, the DJ-UBS is +3.7% while the total return of the S&P is only +2.6%. Surprised?
Now, the conventional wisdom is that stocks are a great place to hide if there is inflation. That conventional wisdom is wrong. Stocks may do okay if starting from modest valuations, but a rise of inflationary concerns (especially if accompanied by rising interest rates) while stocks are at high valuations would likely be less than generous to equity investors.
So, of course, retail investors have been breaking their piggy banks open to rush into stocks, in a rush not seen for many years. It is tragic, but it is the natural result of the Fed’s misguided[1] crusade to stimulate the economy via the portfolio balance channel (see my discussion and illustration of this topic here). Where does the retail investor turn, when he sees rising gasoline prices, rising home prices, and a shrinking paycheck due to higher withholding rates? The television is telling him that it’s time to jump aboard the equity train. Although he has been prudently suspicious of equity markets for much of the last decade, he is also aware that the cash he has in the bank is evaporating in real value.
And perhaps that’s why total savings deposits at all depository institutions (the main component of non-M1 M2) has fallen more in the last two weeks than in any two-week period…ever. About $115bln has fled from savings accounts in the last fortnight. Now, that’s a volatile series, and it might mean nothing unless we happened to see it show up somewhere.
Like, perhaps, here?
The chart above (source: ICI, via Bloomberg) shows the net new cash flows into equity funds, which just happen to be at the highest level over the past three weeks (about $30bln) of any time during the period of data available on Bloomberg.
Again, it isn’t because the future suddenly looks bright. Initial Claims today was 368k, above expectations and unfortunately putting a big dent in the notion that the ‘Claims data over the last few weeks was signaling a meaningful shift in the rate of new claims. The number is probably still going to go lower, but it is likely to be a drift, not a break. And we will see a similar story tomorrow, probably, when the Payrolls figure (Consensus: 165k) and Unemployment Rate (Consensus: 7.8%, but I think it might tick up to 7.9%) will paint the same sort of picture. No, people are not reaching for their wallets to invest in stocks because they are suddenly flush. More likely, it’s because they’re frustrated and confused; they feel they’re being left behind. Perhaps there is a bit of desperation, if retirement is getting further away as the cost of retirement rises and take-home pay stagnates.
In any event, what you do not want to see, four years and 125% above the S&P lows, is people taking money out of savings to put into stocks. If you are not one of the people putting money in, then consider being one of the people taking your profits out – and looking to those markets that actually do tend to keep up or outperform inflation. I hasten to remind readers that they don’t ring a bell at the top of the market, and so one ought to be careful to rely too much on the “signs” and “timing signals” suggested above. But the sharp-pencil work suggests that core inflation is going to head back up in the next 2-3 months; in my opinion, you don’t necessarily need signs to position for that – you need excuses.
.
[1] One is tempted to say ‘evil,’ but I don’t believe the Fed actually is anticipating the pain they are likely to cause to the little guy. Indeed, they may believe that the impact of their actions may fall disproportionally on the rich: an economist at the Federal Reserve Bank of St. Louis recently co-published a paper entitled “Understanding the Distributional Impact of Long-Run Inflation,” which concludes in part that “When money is the only asset, a faster rate of monetary expansion acts as a progressive tax that lowers wealth inequality; when bonds can be traded, wealth inequality is less affected by inflation because the rich hold more illiquid portfolios than the poor.” [emphasis added]
Wrapping Up – And Some Portfolio Projections
Whether it’s with a bang or with a whimper, the year is drawing to a close. So too is this author’s year; I expect that this will be my last post for 2012. Let me take a quick moment to thank all of you who have taken the time to read my articles, recommend them, and re-tweet them. Thanks, too, for your generous and insightful comments and reactions to my writing. One of the key reasons for writing this column (other than for the greater glory of Enduring Investments and to evangelize for the thoughtful use of inflation products by individual and institutional investors alike) is to force me to crystallize my thinking, and to test that thinking in the marketplace of ideas to find obvious flaws and blind spots. Those weaknesses are legion, and it’s only by knowing where they are that I can avoid being hurt by them.
In my writing, I try to propose the ‘right questions,’ and I don’t claim to have all the right answers. I am especially flattered by those readers who frequently disagree with my conclusions, but keep reading anyway – that suggests to me that I am at least asking good questions.
So thank you all, and I hope you have a blessed holiday season and a happy new year. And now, back to our regularly-scheduled article.
.
It seems likely, although not a sure thing, that 2013 will be a better year in terms of economic growth. Certainly, we are ending 2012 in better shape than we entered it. One way or the other, the budget deficit will come down – at least partly because the prospective rise in tax rates has moved forward some realization of taxable gains – and, although that is a negative from a classical C+I+G+(X-M) perspective, I believe a smaller deficit will help assuage some business and consumer fears and be no worse than neutral … if, in fact, we get a smaller deficit! A bigger point is that while Europe is far from out of the woods, a near-term exit of Greece from the Euro finally seems unlikely. Stay tuned for Italian and Spanish dramas in 2013, and plenty of other pressures on the continent, but the worst case that we feared a year ago has been at least kicked down the road a piece.
Domestic growth to end 2012 is looking better, too. Today the Philly Fed index showed its highest print since March (8.1 versus -10.7 last month and expectations for -3.0). Existing Home Sales came in at 5.04mm, the first time above 5mm (without a government program, such as got Existing Home Sales up there briefly at the end of 2009) since 2007. The inventory of existing homes fell to the lowest level since 2002 (see chart, source Bloomberg).
Yes, there is additional “shadow inventory,” and so this isn’t the “true” inventory once you include bank REO property and other wannabe sellers who are waiting for the market to pick up, but that shadow inventory will clear a lot faster now that prices are rising. The monthly Home Price Index from the FHFA was released today, showing that nominal home prices in October rose 5.5% over last October (see chart, source Bloomberg).
Even in real terms, home prices are rising. Over time, residential real estate has roughly appreciated at the rate of inflation plus 0.5% (so that in real terms, home prices tend to just tread water). Between 1997 and 2007, however, real home prices rose some 50% before collapsing 28% between 2007 and 2011. But this latest bounce is real (see chart, source Bloomberg; I’ve merely divided the HPI by the NSA CPI price level and multiplied by 100), and it comes thanks to profligate monetary policy. To the extent that tax rates rise but the mortgage deduction persists, fiscal policy too will probably support home prices going forward. It isn’t a sustainable rise in real prices, but if it is merely sustainable in nominal prices it will heal a lot of upside-down borrowers.
On the topic of profligate monetary policy, I ought to note that M2 growth has been reaccelerating, and has grown at a 9.8% pace over the last 13 weeks. Over the last 52 weeks, M2 is +7.6%. Assuredly, it isn’t the sustained 10% pace we saw at the beginning of 2012, but it is still far more than is needed to keep prices stable with a 2-3% real growth rate…as long as velocity stabilizes or heads higher. So, while the unemployment part of the “misery index” has been improving, the inflation part of the index is likely to continue to worsen. That will be the story in 2013, I suspect, as quantitative easing continues by central banks around the globe (and continues to accelerate in places: the Bank of Japan last night increased its purchasing program by another ¥10trln) and prices or real assets are not only no longer falling, but rather starting to rise.
Where to invest in this environment? Nominal bonds are the worst of all worlds; Treasuries are priced for a -1% real return over the next 10 years, and corporate bonds are even worse with a -2.1% expected real return. (Incidentally, you can compare these estimates to those I produced in 2010 and 2011 via these links. They’re mostly worse, following a better year from asset markets than we had a right to expect!) TIPS produce a -0.74% real return for the next 10 years. Stocks are at +2.44%, which looks good by comparison but is only fair given the risk, and low compared to historical norms – and also more expensive than they were at the end of 2011 (2.57% expected 10 year real return) and 2010 (2.58%). Commodities are cheaper: by my metric, diversified commodity indices are now expected to return 5.43% per year, after inflation, over the next decade (2010: 4.30%, 2011: 4.78%, so you can see this is not an exercise in forecasting the next year’s returns!). Residential real estate has richened slightly but is priced roughly at the long-run average, so I expect returns to be around 0.2% per year for the next decade. The chart below summarizes these estimates (source: Enduring Investments).
Our Fisher model is flat inflation expectations and short real rates; our four-asset model remains heavily weighted towards commodity indices; and our new metals and miners model is skewed heavily towards industrial metals (53%, e.g. DBB) and precious metals (43%, e.g. GLD) with negligible weights in gold miners (2%, e.g. GDX) and industrial miners (2%, e.g. PICK). (Disclosure: We have long positions in each of the ETFs mentioned.)
Feel free to send me a message (best through the Enduring website) or tweet (@inflation_guy) to ask about any of these models and strategies. And otherwise, have a happy holiday season and a merry new year! I look forward to a great 2013, a robust inflation market that continues to grow (the CME is likely to list both TIPS and CPI futures in the coming year), and no small amount of volatility to navigate. This column will return circa January 3rd or 4th.
What Will the Fed Do When It’s Finally Time to Tighten?
Housekeeping note: if you missed my comment on CPI from Friday, you can find it here. And if you missed my Bloomberg Radio interview with Carol Massar on Monday, don’t worry! I will post it when Bloomberg makes it available on their site.
.
One of the busier sessions in recent memory (although still well short of 1bln shares traded on the NYSE, which was the standard not that long ago) resulted in a sharp rally in the equity market with the S&P +1.2% on the day.
The trigger for this holiday treat was the “progress” in the budget talks and what investors see as the increasing likelihood that the ‘fiscal cliff’ is averted. Be careful, however; whatever progress there was is fairly speculative, and I suspect we will see a bad news wiggle before all is resolved.
It is ironic, perhaps, that what is moving the process closer to resolution is the Republicans’ sudden refusal to be steamrolled, and to instead try and play the game rather than try to negotiate as if both parties were trying to reach a fair resolution. I refer to the fact that Speaker Boehner has begun plans to start a separate legislative track in the House of Representatives by passing a bill that would keep the Bush tax cuts in place for most Americans; the bill would not avert the spending cuts that would take effect as part of the “fiscal cliff,” but would keep the government from reaching more deeply into citizens’ pockets on January 1st. It is, therefore, just exactly what the Republicans would want in these circumstances: spending cuts without tax increases (although fewer spending cuts than they would like).
The fact that this is a good play from the standpoint of the Republicans was immediately apparent from the fact that Democrats wasted no time in accusing Boehner of not negotiating in good faith with the President, and the President himself abruptly began to try and compromise slightly from his heretofore rigid position.
Of course, the Boener plan won’t pass the Senate because it will produce exactly zero Democrat votes, and if it somehow passed by luck it would be vetoed by the President, so it has no chance to become law. However, by putting the Democrats in the position of having to vote against tax cuts, it greatly increases the chances that both parties might negotiate to something that all parties hate, and therefore passes with flying colors.
In the US system, by Constitutional writ all revenue bills have to start in the House of Representatives, so by the very nature of this process the Republicans, who dominate the House, hold the serve in this negotiation. Incredibly, this is the first time they’ve shown any desire to use that advantage to produce a bill that represents something closer to their views.
As noted above, equities reacted very well to the Republicans’ show of spine. I’d noted several weeks back that I thought the Republicans had little incentive to negotiate, since going over the fiscal cliff represents smaller government and this may be the only opportunity that party has to get smaller government in the next few years. If this move persuades the Democrats of this fact, and the President moves to address the spending problem rather than just trying to soak the rich, then the fiscal cliff may be averted. It’s really important in a negotiation, especially if a true compromise is to be reached, that your counterparty knows that you may walk away.
Personally, I think the odds are still against this happening before year-end, but some resolution fairly early in the new year is probably odds-on. However, with the debt ceiling also approaching, 2013 may well see more of these cliffhanger negotiations.
Bonds, interestingly, sold off. You would think that the prospect for a smaller deficit, even marginally, would help the Treasury market but in this case I think investors are reacting to the fact that if the fiscal cliff is averted, it lessens the chance of near-term recession and brings forward the day of reckoning for the Fed. Today, 10-year Treasury yields rose to 1.82%, which is near the highest level since early May, and 10-year real yields rose to -0.73%. Over the last five days, nominal yields have risen 16bps, and all of that has come from real yields. That is, inflation expectations have barely moved and 10-year breakevens remain at 2.50%. Ten-year inflation swaps are at 2.77%, and the important 1-year inflation, 1 year forward has risen to 2.23%.
So, whether the ‘day of reckoning’ for the Fed is near, or far…what do they do, when they’ve hit that point? And, more importantly, what does it do to the market?
Let’s assume that we are at some point in the future and either the Unemployment Rate has dipped below 6.5%, the forward PCE inflation rate has risen above 2.5%, or inflation expectations have become “unanchored.”[1] The first thing that the Fed will do is to stop unlimited QE: the statement does not imply that they will immediately start trying to get out of the hole they are in, only that they will stop digging the hole. But suppose that inflation continues to tick up – since the evidence is that inflation is a process with momentum. What does the Fed do next? This is the real question. How quickly can the Fed react to adverse inflation outcomes?
The traditional option is that the Fed raises the overnight rate. The Fed announces this move, but the important part is what happens next: the Open Market Desk (aka ‘the Desk’) conducts reverse repos to decrease the supply of reserves, or sells securities outright if it wishes to make a more-permanent adjustment. This causes the price of reserves (also known as the overnight rate) to rise, and the Desk adjusts its activity so that the overnight rate floats near the target rate.
The problem is that this won’t work right now. There are far too many reserves in circulation for the overnight interest rate to be increased by reverse repos or small securities sales. In fact, if it wasn’t for the interest being paid on excess reserves, the overnight rate would certainly be zero, and might even be negative because the supply of reserves greatly outweighs the demand for reserves. They are called “excess” reserves for a reason – the bank doesn’t need them, and will lend them overnight for pretty much any available rate.
So in order for the Fed to push the overnight rate higher, it must first soak up all of the excess reserves in the system – about $1.5 trillion at the moment – by selling bonds. Obviously, this is not something that can be done in the short-term.
But this misses the point a little bit anyway, because it isn’t the rate that matters to monetary policy but the amount of transactional money (such as M2). The Fed can set the overnight rate at 1% by simply agreeing to pay 1% as interest on excess reserves (IOER). But that won’t do anything at all to M2, because it won’t change the amount of reserves in the system and doesn’t change the money multiplier that relates the quantity of those reserves to M2.
So the short rate is dead. It isn’t going to move for a very long time, unless the FOMC decides to help the banks out by paying a higher IOER. And if they do that, it’s not going to affect inflation so it would just be a sweet present to the banks.
Okay, so perhaps the Fed can sell those long-dated securities and push long-term interest rates higher, slowing the housing market and the economy and squelching inflation, right? That’s partly right: the Fed can sell those securities, and it can push long rates higher (although the Fed has oddly claimed that if it sold those bonds, interest rates wouldn’t rise very much, which makes one wonder why they did it in the first place since presumably the opposite would also be true and buying them wouldn’t push rates down), and that would slow growth. However, it wouldn’t affect inflation, because inflation is not meaningfully affected by growth (I’ve discussed this ad nauseum in these articles; see partial arguments here, here, here, and here). But you don’t have to believe all of the evidence on that point; just play it in reverse: if driving long rates down didn’t cause a sudden jump in inflation, why would driving long rates up cause a sudden dampening in inflation?
Fama, in that article I quoted last week, had a very good point which I thought it was worth developing in more detail. The Fed has its hands off the wheel with respect to inflation…which isn’t a problem, except that they’re sitting in the back seat. The back seat of a very, very long bus.
In any event the issue isn’t when the Fed starts its tightening, but when inflation stops going up. These are not the same things. If core inflation were to start ticking higher today, at a mere 1% per year, I think it would take 6-9 months for the Fed to stop QE (core PCE is at 1.6%), probably another 3 months at a minimum before they started to tighten, and then at least 1-2 years before they could have any meaningful impact on the money supply and cause inflation to slow. Maybe I’m being pessimistic, or maybe I’m being a bit generous by assuming that after a year the FOMC would start doing something very dramatic to sop up reserves, like issuing a trillion dollars in Fed Bills, but even assuming that everything works out just about as well as it conceivably can, if inflation started heading higher in that way then you’re looking at a core CPI figure of 4-5% before it stops rising. Like I said, it’s quite a long bus, and that translates to long “tails” of inflation outcomes.
How would markets react to this? Obviously, bond rates would be much higher, but would this be good or bad for equities? The conventional wisdom holds that equities are good hedges for inflation, because over a long period of time corporate earnings should broadly keep pace with inflation. While that is true, it is also the case that earnings tend to be translated into prices at lower multiples when inflation is high (a fact that has been known for a long time; in 1979 Franco Modigliani and Richard Cohn described this as an error but there isn’t consensus on that issue) so that stocks tend to do relatively poorly when inflation is rising and better when inflation is falling from a high level. Moreover, stocks do especially poorly in the early stages of inflation when short-term inflation is surprising to the upside, as the chart below (Source: Enduring Investments) illustrates.
This chart highlights headline inflation, rather than core, but the point should be clear: nominal bonds and equities produce good real returns when inflation is surprising to the low side (even if that means that inflation is just going up slower than expected), and very poorly when inflation surprises to the high side (even when the overall level is low).
In my mind, this means that every investor needs to have some inflation protection, but especially now when the chances for an ugly inflation surprise are significant. For the record, the best asset class when inflation is surprising to the high side as measured here? Even inflation-linked bonds have produced negative real returns in such circumstances, because the real yield increase outweighs the higher inflation accruals in the short run. But commodities indices historically produced a 4% real return over that time period when inflation surprised at least 2.5% to the upside.
[1] It isn’t clear to me why you would want to wait until they were unanchored, if anchoring matters, since presumably it isn’t easy to anchor them again. After all, the whole reason the Fed wants anchored inflation expectations is because a regime change is thought to be hard – so if they are unanchored, you’ve just made it really hard to get inflation back down. In any event there’s not much evidence that “anchored” inflation expectations matter to actual inflation outcomes, but it’s just weird to me that the Fed would imply that they’d wait until expectations get loose from the anchor.
The Gravity of the European Situation
Markets continue to gyrate in what seems like wider and wider arcs as volumes gradually decline but the density of news headlines does not. Today, at least one meaningful piece of news that pressured stocks early was that hedge fund (and market-maker) SAC Capital told its investors that it has received a Wells notice from the SEC (indicating that the SEC has determined it may bring legal action against the firm), alleging insider trading. An allegation against the firm, as opposed to individuals within the firm, is a much bigger deal and the concern is that if SAC is impacted or distracted by the charges that liquidity in certain parts of the market may suffer.
This concern didn’t linger very long, though, as stocks were back in the black by lunchtime.
New Home Sales were reported significantly weaker-than-expected, with a downward revision to the prior month’s reported sales. While sales of existing homes have been on a steadily improving pace for a while, New Home Sales have been stuck around 365k since January. Economists had expected a number more like 390k, which sounds aggressive when you look at the chart (source: Bloomberg) below but recall that last month’s figure had been previously announced at 389k and the economists’ estimates don’t seem so outlandish.
This figure doesn’t appreciably change my positive view of the housing market (and more important for me, price change in the housing market) going forward, for two reasons. First is that sales of new homes are dwarfed by sales of existing homes, so that the latter is simply lots more important and the data more statistically useful (e.g., the year-on-year change in the median price follows the same path, but as you can see below in the Bloomberg chart, the new home sales number is dramatically more volatile).
The second reason is that I suspect one reason for the failure of New Home Sales to rise more aggressively is that the gross inventory of new homes has recently been at the lowest level on record (dating to at least 1963). This is a better number to look at, incidentally, than the “months of inventory,” which still shows slower inventory turns than was normal back prior to the bubble. But that’s because of the denominator (monthly sales), not the numerator (houses for sale). And at some level, there are just not enough of the right kind of homes where they are needed. With just 147,000 new homes available for sale, there is only 1 new home for every 2,200 Americans. And they’re mostly bunched together. I suspect this dampens new home sales, and so I am looking much more closely at existing home sales for both activity indications and for price indications.
.
I had the honor of speaking today at the Euromoney Forex Forum 2012 in New York, on a panel concerning the future of the Euro and how much that future depended on individuals as opposed to bigger historical/economic forces. Readers will be unsurprised to hear that I was fairly firmly on the side of “in the long run, economics wins.”
But as often happens when I am running my mouth, I hit on what I think is an interesting analogy for the Euro and the Euro crisis, and for why “kicking the can” makes at least a certain kind of sense.
The analogy is astronomical in nature, and concerns the process of accretion as it applies to planets. The way that planets are thought to form is by the gradual accretion of small bits of matter – asteroids, rocks, dust into larger and larger bodies until the resulting body is able to sweep its orbit clean of anything which might otherwise accrete. But in the process of that accretion, there are two main determinants of how quickly the accretion occurs (actually, there are probably hundreds, but an analogy is supposed to be a simplification, right?). One is the speed of rotation of the body. A body that is spinning rapidly has a greater tendency to fling stuff outward, while a body that is spinning slowly allows more stuff to clump together. The second is the radius of the body: the larger the body, the greater the angular momentum of the outlying bits for a given rotational speed.[1]
Now, the unification of the Euro was like the creation of a planetoid from seventeen different asteroids, each of which was originally moving with a different vector. As you may recall, the Maastricht Treaty described convergence criteria that required all of the member states to essentially match their inflation rates, their debts, deficits, and interest rates, because the treaty signers wisely realized that if the countries were all moving at different speeds when they joined, there was no chance that they would accrete into a single, unified entity (a planet in my analogy).
But the planet never entirely formed, and some pieces of it on the outer fringe are in danger of being ejected by inertia. The crisis is effectively spinning the planetoid faster and faster, making it harder and harder for the pieces on the outside to avoid flying off into new orbits of their own. In this context, it makes sense to try and slow the rotation, on the theory that if everything just stops spinning long enough, the natural gravity will take over and the pieces will fall back in towards the center and everything will be okay. So policymakers kick the can down the road, assuming that if they can just keep everything together for long enough, it will get easier and easier to do so.
The problem, though, is that this body isn’t acting in isolation. There are tidal forces acting to rip the body apart, in the same way that the comet Shoemaker-Levy 9 was ripped to pieces as it approached Jupiter – the difference in the the pull of Jupiter’s gravity from one side of the comet to the other was so significant that there was no way that the object’s gravity could hold it together .
In the same way, in my view, the many significant differences between the periphery and the core of Europe, combined with the effects of over-indebtedness and a debt market no longer willing to ignore the question of a state’s ability to repay the debt, are tidal forces that are destined to rip the periphery from the core, eventually. I recognize that Europeans will tell me that the gravity of the Euro itself is far greater than I think it is, and if they’re right then the Euro will not splinter and the policymakers are correct to kick the can. But I don’t think they’re right.
[1] These two forces work against one another, for when the radius of the body decreases because stuff falls towards the center, the speed of rotation accelerates because of the conservation of angular momentum, but that little detail doesn’t enter into the analogy.
Does ‘Straight Up’ Qualify As Volatility?
The stock market gained 2% today, and commodities jumped 1.25% led by energy, metals, and softs. There was no news that could have rationally justified such a move, and volumes were as light as they have been in two weeks. Some commentators, grasping for straws, suggested that the decent NAHB Housing Market Index number (up to 46 versus 41 expected, to the highest level since 2006) and modestly stronger-than-expected Existing Home Sales figure (4.79mm versus expectations for 4.74mm) triggered the rally, but that ignores the fact that most of the equity move was completed prior to the 10:00ET release of these figures.
Others resolved the conundrum by saying that “apparent progress on the fiscal cliff” led to the rally, but the only progress made was that neither side was hurling epithets at the other in public. There is no sign of any agreement being made, and certainly no chance of any agreement being made that would persuade investors with big gains to avoid realizing taxes this year (since it is exceedingly unlikely that the upper end of the tax structure will be unchanged or lower next year). Now, I’d suggested last week that “this is mostly a cycling of positions, a re-setting of tax basis at a higher level, and shouldn’t amount to a major selloff by itself,” but there are other reasons to be less-than-exuberant about the market’s immediate prospects too.
One of these is the conflict in and around Israel and the territories under her control. While there is loose talk about a ‘cease-fire,’ Israel is demanding a long-term agreement to stop the rocket fire and Hamas is saying “Israel started it.” I think it says something about our political discourse here that it is probably easier to resolve the Israeli-Gaza-Syria-Egypt-Iran conflict than to resolve the Fiscal Cliff discussions, but also keep in mind that Israel still wants to do something about Iran’s nuclear capabilities, so a cease-fire strangely may not be in her interest at the moment.
There is no doubt that our domestic housing market is getting better, to be sure. I’ve pointed out periodically (see here, here, and here for example ) that home prices are rising again and not surprisingly that is making home builders happy again. The chart below (source: Bloomberg) shows the NAHB index I alluded to earlier.
It looks suspiciously like the chart of home builder Toll Brothers (TOL) shown below (source Bloomberg), suggesting that there is not a lot of true analysis going on among the buyers of that stock. Toll Brothers has a current P/E of 61 on trailing earnings, and 50 on estimated forward earnings. I don’t have a position in TOL, nor do I plan to; I just point this out in case your child was thinking of becoming an equity analyst. Help him or her along a different path.
Part of the reason for today’s surprise in home builder sentiment might be the sudden promise of new home building activity along parts of the eastern sea board, courtesy of Sandy, but the trend has been well established for a while. While there is ample inventory of existing homes (though these are being drawn down as well, slowly), the inventory of new homes has been at a 50+ year low for more than a year (see chart, source Bloomberg) and it was just a matter of time before more were built. An existing home is a good, but imperfect, substitute for a new home.
Now, as an inflation guy the reason I care is because the decline in home inventory, coupled with virtually free money for builders and home buyers who can qualify, is pushing up the cost of a big chunk of the consumption basket. Owner’s Equivalent Rent (which is 60% of housing, which in turn is 40% of CPI) has been rising at slightly faster than that of core inflation. As the chart below shows, there is a distinct relationship between prices in the market for existing homes and the general increase in rents (both direct and imputed) 15 months later.
It’s not a new story, but rather one I’ve been talking about for some time, and remains a key reason I remain bullish on inflation despite global central bank protestations (and asset manager convictions, as far as I can tell) that deflation is a more proximate threat.
Meanwhile, other economists have concluded that the reason inflation has been rising rather than falling despite huge amounts of slack globally must be that … their Phillips curve needs recalibration. In a recent funny note by Goldman’s economics group – though it was not meant to be funny – entitled “A Flatter and More Anchored Phillips Curve,” they said
“We have long argued that labor market slack would weigh heavily on inflation in the aftermath of the Great Recession. This view has generally worked well as core (ex food and energy) inflation has fallen substantially since 2007. But the decline in core inflation abated in late 2010 and—despite recent signs of renewed disinflation—core inflation has generally been stickier than the large amount of slack would have suggested.
“A candidate explanation is that the inflation process (or “Phillips curve”) has changed in recent years. Economists have argued for some time that improved central bank credibility, globalization and downward rigidity of nominal wages have altered inflation dynamics since the inflationary 1980s.
Considering that the Great Recession didn’t really kick in until late 2008, and core inflation (ex-shelter, which was suffering from the implosion of a giant bubble) rose from 2007 until late 2009, another ‘candidate explanation’ would be that their model was not mis-calibrated but rather completely mis-specified. The Phillips Curve, which relates wages, not core inflation, to slack in the labor market, is not useful in forecasting inflation. This is well known, and yet expensive economists have worked incredibly hard to resurrect the theory. (Here’s a fuller illustration/explanation of why the Phillips Curve as typically used is wrong).
But beyond that – if you need to keep changing the calibration of your model to fit the facts, then it’s not a good model. That’s sort of Modeling 101. The economists explain/plead further:
Economic principles suggest that core inflation is driven by two main factors. First, actual inflation depends on inflation expectations, which might have both a forward-looking and a backward-looking component. Second, inflation depends on the extent of slack (or spare capacity) in the economy. This is most intuitive in the labor market: high unemployment means that many workers are looking for jobs, which in turn tends to weigh on wages and prices. This relationship between inflation, expectations of inflation and slack is called the “Phillips curve.”
Well, no. Economic principles suggest that inflation is mainly driven by money and the velocity of money. Some discredited principles suggest what they say, but it’s not working. Their own chart, showing they’re off by some 100%, is reproduced below.
On to happier items. In case anyone still thought France was a AAA nation, Moody’s announced their opinion this afternoon that it is not, in downgrading the nation from Aaa to Aa1. Moreover, France remains on watch negative, due to structural challenges and a “sustained loss of competitiveness” in the country. I guess on second thought, that’s not so happy. How did France lose competitiveness? Do you think it has anything to do with the incredibly expensive social contracts and the short working week and year? But no, perhaps they didn’t spend enough on education and national health care.
Honest, Abe?
Today was CPI day, which after Christmas and Thanksgiving is one of my most favorite of days. Here is what I tweeted earlier today (and there’s lots more commentary below):
- unrounded core CPI at +0.18%, a bit higher than what dropped off. Not exactly alarming, but higher than Street expectations.
- y/y core to almost exactly +2.000%. Apparel rose again after the recent rise had slowed in the last couple of months.
- Subindices: ACCEL: Housing, Apparel, Transp, Food/Bev (75.2% of basket). DECEL: Med Care (6.9% of basket). UNCH: Recreation, Comm/Ed, Other
- OER was unch…rise in Housing came from primary rents (that is, you actually pay rent) and lodging away from home.
- Core goods inflation stayed stable at +0.7% y/y; core services stable at +2.5%. I think the former number is going to rise.
This was actually something less than the most exciting CPI report in history. It was better than the Street expected, and although the year/year figure barely nudged higher the components of the number were strong. The rise came from Housing, which ought to continue to accelerate for a while given rental tightness and other forward-looking indicators, and Apparel resumed its rise as well. See the chart below (source: Bloomberg) for the update to what is rapidly becoming one of my favorite inflation-related charts.
The Cleveland Fed’s Median CPI dropped just enough to round down to +2.2% on a y/y basis, and the Atlanta Fed’s “Sticky” CPI is also at 2.2%. These measures are other ways to look at the central tendency of the inflation figures, and suggest that the current 2.0% from the traditional Core CPI is likely to converge higher rather than vice-versa.
But today didn’t change any inflation paradigms.
There was other news, however, that struck me as inflation-related and worth commenting on.
One was a story in the UK Daily Mail citing the case of a Denny’s franchisee (he owns a few dozen Denny’s restaurants) who is planning to add a 5% “Obamacare surcharge” to customer dining checks.
Now, the sum of all of the sales of this man’s Denny’s restaurants is a tiny part of the CPI category “Food away from home,” which is itself a small part of CPI, so it won’t have any impact on the numbers. Even if lots of restaurants followed suit, it wouldn’t have much of an impact since “Food away from home” is only 5.6% of the consumption basket (so a 5% surcharge on all checks would cause a rise in CPI of 0.28%), but it serves as a good reminder of one important point.
The higher taxes and other costs of doing business that are going to be targeted at business is going to show itself to individuals one way or the other. The higher cost of Obamacare compliance, and any other increased business taxes, will not be paid by businesses for the simple reason that businesses are pass-through entities. That is, businesses don’t make money; people who own businesses (partners or shareholders) make money. So whether the higher costs show up as higher prices to the consumer (in which case the government’s attempt to raise revenue from business will result in higher inflation prints, as the transition takes place) or as lower profits to the businesses themselves, the cost will end up being borne by real humans.
At the end of the day, how much of these costs is absorbed by the owners and how much is paid by the consumers is determined by the elasticity of supply and demand for the product. For example, if the elasticity of demand is infinite, then the owners will bear the entire cost; if the elasticity is zero, then consumers will pay it all. My personal guess is that given the current level of gross margins, more of these taxes and higher costs will be paid by owners – implying lower equity earnings – than by consumers, but we will see. But notice that either way, you get lower real earnings. Either nominal earnings fall, or prices rise. Not good for stocks in either case; bad for bonds in the latter case, too.
Then there are the actions of several central banks in the other hemisphere. A story in the Wall Street Journal, and echoed elsewhere such as in this Australian news outlet, suggests that the Reserve Bank of Australia has adopted a form of QE by allowing its foreign currency reserves to rise in order to push down the currency. The RBA has been one of the bastions, at least relatively, of ‘hard money’ in a world of central banks that have gone wild, so this isn’t a positive development unless you’re long inflation-related assets.
And also hard to miss were the comments by the leader of Japan’s main opposition party, Shinzo Abe, who may become the next prime minister quite soon. Abe suggested that the Bank of Japan should target 3% inflation, rather than 1% inflation, and threatened to revise the law that (supposedly) insulates the BOJ from politics. Note that 5-year Japanese inflation swaps are near all-time highs, but still only at 0.77%, and 10-year inflation swaps are at only 0.48%. Under Abe’s pressure, we would likely see a substantial acceleration in QE by the BOJ, which has already succeeded in pushing core inflation in Japan from -1.6% to -0.6% over the last two years (see chart, source Bloomberg).
We are increasingly moving into a one-way street for central bank policy. Central bankers are essentially engaging in a sophisticated version of competitive devaluations. The Fed does QE, the BOE does QE, the ECB does QE (but claims it doesn’t), the SNB and BOJ and now the RBA does QE. It is a one-way street because whoever stops printing first will see his currency shoot higher as investors flock to the harder currency. The chart below shows what has happened to the Aussie dollar over the last decade versus the USD. While the strengthening trend was interrupted by the 2008 flight-to-quality, it quickly resumed. Since that time, it has risen roughly 50% (and 100% overall since 2001).
Now, a strong currency is good. It makes foreign goods cheaper and raises the standard of living overall. However, it also hurts exports, which slows the economy and results in visible layoffs while the economy adjusts. There’s only so much of this a country’s politicians are willing to take, and it seems Australia may have reached its limit.
If everyone is printing, exchange rates may not move at all. It has frustrated many dollar bears that the greenback hasn’t declined under the profligate printer Bernanke; printing money is supposed to destroy a currency. It has done so repeatedly over the course of history, and it happens for obvious reasons: when you get a bumper crop of something, its price tends to fall. More supply induces lower prices. In this case, it induces a lower price of a currency unit in terms of other currency units.
But that only happens if the relative supply of a currency is changing. If everyone is printing at roughly the same pace, there is no reason that currencies should move at all relative to each other. They should all fall relative to non-printers, or to hard assets. And that’s why it’s even more incredible that commodities are not shooting higher. Yet.
Those effects, in my view, absolutely swamp in importance the weak growth news we’re getting these days. Today, the Philly Fed report and Initial Claims were both quite weak, but the data is going to be polluted by hurricane Sandy for a while and hard to interpret. I don’t think the hurricane had anything to do with this story, or its timing for that matter:
FHA Needs Bailout From Treasury to Plug Budget, Bachus Says
“Nov. 15 (Bloomberg) — The Federal Housing Administration will need billions of dollars in aid from the U.S. Treasury before the end of the year to fill a financial hole caused by defaults on mortgages it insures, House Financial Services Committee Chairman Spencer Bachus said today.
“… The agency is “burning through” its last $600 million and FHA officials have briefed him that they will need a financial backstop within a month, the Alabama Republican said during a press conference in Washington.”
So, we are trying to figure out how to raise a trillion dollars over ten years to start closing the budget gap, but it helps to remember that there are other groups who are going to be bellying up to the bar for a hit of government help. The FHA, the postal service (-$15.9bln this year, although they expect to lose only $7bln next year), probably California before long. We’d better get our act together quickly…but as yet, there is no sign of it. Nice of Bachus to wait until less than a month before the FHA runs out of money to mention this, by the way.
And I haven’t even mentioned the sudden explosion of violence in Israel, which doesn’t give the impression of a fire that will quickly burn out. It may not spin out of control, either, but it bears watching very closely since our influence in the region has significantly ebbed since the change of control in Egypt, our exit from Iraq, and our distancing from Israel.
I don’t think 2013 is shaping up to be a very fun year. But we’re not there yet!
Kissing Assets Goodbye
No, thanks for asking but the power is not back on, and not likely to be coming back on for some time. But one finds a way – after all, this is the whole point of a “disaster recovery” plan. I won’t be penning many articles in the next few days, but given the circumstances I thought it relevant to comment on disasters and economic growth.
After a hurricane or other natural disaster, there is always a significant confusion among economists about whether the disaster will hurt U.S. GDP, because many consumers and businesses are unable to consume for a period, or help GDP because of reconstruction expenditures.
This is a crazy debate, and it underscores a key shortcoming of economic statistics. The usual economic result is a short-term (a couple of weeks, perhaps, or a month) of softness in private expenditures, followed by an increase in GDP because of rebuilding. Disasters, measured by GDP, are usually additive: that is, growth in the quarter immediately after the event is higher than it would otherwise be, because more money is spent from savings and government expenditures rise (because of explicit relief payments but also because of increases in automatic expenditures such as unemployment claims and other such things).
But that’s clearly nonsense, to the dispassionate observer. The citizen’s welfare, his standard of living, is clearly lower than it was before the disaster; if it was not, we could regularly ignite the economy by destroying buildings and homes and rebuilding them.
Yet, the numbers are not wrong, per se. By definition, GDP=C + I + G + (X-M), and total expenditures clearly rise as savings (public and private) decline in the aftermath of a disaster. The problem isn’t that the numbers, such as they are, are wrong but that there is a deeper philosophical problem. Most economic data measures flows, not levels (the proper term is “stocks,” but I didn’t want to confuse readers by sounding like I was talking about equities – I am not). There is no economic “asset” and “liability” account for the nation. If the disaster occurred to a company instead of to a nation, the company would record an expense for the impairment of an asset (a destroyed building, equipment, etc) as one transaction and then separately record the purchase of a replacement asset (if it was a durable asset, this second transaction would merely exchange one asset, cash, for a durable asset). The net result would clearly be a decline in the net value of the company. But there is no national asset or liability accounts to credit for the destruction of national assets.
And there should be. If policymakers had to focus not on increasing the expenditures of the nation, but on building its “net worth,” I suspect we would see more sensible national policies.
However, that’s not the way it works – but we all know that disasters hurt our economy, whatever effect they have on GDP.
Mounting Pressure
The most striking facet of today’s trading was that the stock market actually reacted to the Fed’s announcement, which was precisely as universally expected: no change in anything but the technical language about where the economy currently stands. It wasn’t a huge reaction, but the fact that the S&P actually dropped 5 points on the news is mind-boggling to me because it implies that some people were expecting big things out of the Fed today.
To be sure, the arrow of action on the Fed is clear and pointed to ever-increasing amounts of liquidity, but this wasn’t ever on the docket for today. However several Street economists have predicted, plausibly I think, that when Operation Twist expires in December (partly because the SOMA will run out of short-dated Treasuries to sell) the Fed might keep going with the buying leg of the Twist – effectively increasing the monthly outright purchases of paper to $85bln (including Treasuries) from $40bln (all mortgage paper) currently.
Operation Twist has been a useless operation from the standpoint of monetary policy – it has neither added nor subtracted liquidity from the system. It may have had some value from the standpoint of asset-market-maintenance policy, by removing duration from the market and forcing investors to accept more risk for the same amount of reward. So it may be the case that Twist had some effect, but mostly a bad effect since it certainly doesn’t seem from market pricing that investors have been timid about taking risk. And I suppose it ought also be observed that “asset-market-maintenance” isn’t part of the legislative mandate of the Federal Reserve. However, legislators can be generous when markets are being pumped up – it’s when the air goes out that they’re unhappy.
Weirdly, though, I would prefer Operation Twist, which has little impact, to what is likely to replace it (additional QE).
Policymakers globally are growing increasingly bold about quantitative easing. In Europe today, ECB President Draghi told German legislators that outright bond purchases by the ECB “will not lead to inflation. In our assessment, the greater risk to price stability is currently falling prices in some euro-area countries. In this sense, OMTs are not in contradiction to our mandate: in fact, they are essential for ensuring we can continue to achieve it.” (See also this story.)
Central bankers are getting bold, but I’m not sure I understand why. They clearly see the connection between QE and inflation – fending off deflation was the purpose of QE2 and Draghi is clearly indicating the same even though core inflation in the Eurozone has risen from 0.8% in 2010 to 1.5% now (see chart below, source Bloomberg). That’s not exactly flashing red signals on inflation, but it is utterly fantastic to suggest that it indicates deflation is a greater risk.
In the U.S., QE3 and the likely acceleration of QE3 later this year is happening in the context of year-on-year rises in median new home sales prices (released today) and existing home sales prices (released last week) of over 11%, as the chart below (Source: Bloomberg) shows. Note that the existing home sales data is much more dependable on a month-to-month basis, because the number of existing homes and existing home sales swamps the number of new homes sold, but both show the same, clear trend. Home prices are now rising nearly as fast, nationwide, as they did in the bubble years.
For the record, the all-time record one-year price rise in existing home sales was 17.4% in May, 1979. Of course, in May 1979 core inflation was rising at 9.4%. In fact, with the exception of the last phases of the bubble of the early ‘Aughts, existing home sales prices are rising at the fastest margin above core inflation ever, as the chart below shows (Source: Bloomberg; Enduring Investments calculations)
Policymakers, and investors, seem to be numb to the threat of additional QE for one of two reasons. Either it is because of the belief that prior QE did not cause inflation (incorrect, as illustrated above and by the statements of intentionality of the policymakers themselves) or because they’re buying the line that QE is only adding to “sterile” excess reserves.
I think that this is dangerously sanguine. In fact, although it is true that QE initially results in greater excess reserves only, and these have only slowly trickled into transactional money, I think there’s reason to believe that adding more QE may increase that pace of transmission. Picture a large cylindrical vat, open on top with a small valve at the bottom. The water in the vat represents excess reserves, and the water trickling out through the valve is transactional money.
Many things can affect the pace at which the vat water flows through the valve – lending opportunities tied to credit demand and credit quality, disincentives to lend such as Interest on Excess Reserves (IOER), and moral suasion in both directions. Crank IOER to 25%, and all of the water poured into the vat remain as sterile excess reserves and QE is just reliquifying the banking system. Put IOER at a 10% penalty rate, and all of the water going in the top will flow out of the bottom very quickly – and all of the other water that’s already in the vat, too.
But even if you don’t adjust the valve at all, the greater weight of water in the cylinder, as you keep adding more water, will increase the flow out of the valve. Adding more QE is akin, economically, to increasing the weight of water in the cylinder.
The parallel economic concept is that a greater of excess reserves increases the opportunity cost of reserves. The average return on assets for a bank gradually declines as more of these assets become excess reserves rather than required reserves against lent funds. Leverage also declines, with the result (as I have pointed out before) that return on equity suffers. The chart below (Source: Bloomberg) shows the return on equity for large banks (those with more than $10bln in assets). You can see that while bank earnings have recovered significantly from the nadir of the crisis, they also appear to have leveled off at around 8% compared to the 15% that was the consistent standard prior to 2007.
The lending officers in these banks, although they’re being told to increase the quality of their loans, are being told more and more to also increase the quantity of their loans. They cannot do both, but as the pressure of too many reserves on the balance sheet builds, the pressure to make more marginal loans increases as well. This is the part of the valve that the Fed cannot control, and where danger lies going forward. The multiplier may well respond, eventually, to the weight of the reserves themselves.
