Wednesday, April 30, 2014

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.

Monday, April 28, 2014

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.

Friday, April 25, 2014

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.


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?


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.

Thursday, April 24, 2014

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 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, are so right, master."

Wednesday, April 23, 2014

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.

Monday, April 21, 2014

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.

Saturday, April 19, 2014

Perception is reality

Commenter Michael Byrnes hits the nail on the head at :

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.

Friday, April 18, 2014

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.

Thursday, April 17, 2014

Hooray for International Capital Flows

Antonio Fatas presents these charts (HT: Mark Thoma) comparing global growth rates  and investment rates among advanced and emerging economies.

It seems to me that this relates to a topic I have touched on here:

And here (with probably a little too much sarcasm):

It looks to me like we have a set of growing emerging markets, who are accumulating their own capital.  But, their own economies are still characterized by high risk premiums.  So, emerging market capital is hungry for a source of low risk income.  Western sovereign debt, low-yield bonds, and real estate fill that need.  So, emerging market capital is moving to the developed world.

And, in return, developed world capital is filling the gap.  American capital, especially, is lured by profitable risk, so our corporations are investing very profitably in emerging markets.  As the Western baby boomer bulge enters their twilight years, we are confronted with a time mismatch between boomer production abilities today and boomer consumption needs in 20 or 30 years.  Part of that mismatch is being bridged through investment in durable property like homes.  Part of that mismatch is being bridged through the investment of boomer savings into emerging economies, where growth of labor output is not as constrained by demographics.  Here is a graph of labor force growth in the US.  This looks like it tracks pretty closely with Antonio Fatas' graph of GDP growth.  Maybe in the US, investment is constrained by the availability of labor.

So, there is this huge, mutually beneficial transfer happening between emerging market capital and developed market capital.  This causes all sorts of problems for politically charged statistics, because, for starters, it makes it look like developed nation capital is capturing a larger portion of production, God forbid.  And, it creates a sustained trade deficit in the US.

But the actual result here is basically what we should have hoped for from global finance.  Risks are being traded off to where they are more appropriate.  And the end result is that huge populations of the world's laborers are being exposed to more opportunities for prosperity.

The increasing wages in these economies, the high growth rates, and the high returns to capital, are all products of improving market-securing institutions.  This is why I hate the subtly incorrect notion that production moves to places with low wages.  Production moves to places with rising wages, not low wages.  From a previous post:
This is basically the problem with developing economies, where institutional improvements make capital investments safer, and foreign investment is lured into the growing economy.  But, since reversals are possible, and trust requires the passage of time, firms require a higher rate of return.  Nations that reverse to poorer institutions will lead to losses for those firms.  In nations that continue to improve, the realized returns of the investing firms will appear to be high.  Over time, as trust is gained, realized returns will settle to a long term reasonable equilibrium.

This is why it appears that production moves to places with low wages, when production really only moves to places with rising wages.  The necessary development of trust creates a lag effect where the higher required returns cause wages to rise more slowly than they would without this long tail risk.  So, there is a period of time where firms earn seemingly oversized profits at the expense of lower wages for the laborers in the developing economy.  Of course, the profits aren't oversized, they are just the payment received for taking on long tail risk with a binary and unpredictable payoff.  This generally calls for a high return, and also tends to produce survivorship bias in hindsight.
 In a way, the ability of US corporations to earn excess profits by moving production to developing economies is very similar to the well-documented momentum effect on individual US stocks.  Markets have a trust-but-verify mentality.  Efficiency means that prices fairly quickly react to new information, but not all the way, because the veracity of new information has its own risk distribution, with its own long tail of failure risk.

CEO's don't necessarily even need to model their investment decisions this way.  These factors will be built into their assumptions about wage growth and other costs, and their heuristics for how risky each location is.  So, they could account for all this and still misunderstand their investment decisions as being the result of moving to places with low wages.

But, it's not the low wages that attract capital.  Improving institutions lead to capital investment and increasing wages.  That's why most capital flows to high wage countries and why Korea and Taiwan are now among them.  That's why low wages aren't drawing capital to Congo, Zimbabwe, and Niger.  And, it's why American inner cities lack retail.

We are living in much better times, globally, than is sometimes acknowledged.

Follow up post.

Wednesday, April 16, 2014

The deceptively strong 1st quarter

With the unemployment rate stuck at 6.7%, where it was in December, one might be tempted to think that the labor market is going through a period of weakness.  It turns out that 2014 1Q has seen a large upswing in labor force participation.  Here is a chart showing the employment-population ratio (EPR) and the labor force participation rate (LFP).

The purple line is the LFP trendline.  In other words, that is what labor force participation would be if the LFP of each age group followed long term trends.  This is what LFP would be without cyclical fluctuations.  So, we can see that LFP has dipped below trend, which is normal for a recession.

The Unemployment Rate is the difference between the EPR and the LFP (with the LFP as the denominator).  What we can see in the graph is that the past 6 months have seen an impressive uptick in both employment and LFP (the downtick in October was related to the government shutdown).  The household survey has reported a gain of over 1.1 million jobs in the 1st quarter.

That little green line at the end is the LFP that would correspond to a 6.0% unemployment rate, given the recorded EPR.  In other words, if LFP hadn't jumped so much this quarter, unemployment would nearly be down to 6.0% in March.

Now, there is a lot of noise in the household data.  But, even if we assume this is noise, and adjust LFP back down to the short term trend, unemployment would have fallen to below 6 1/2% by March, given the statistical relationship between short term noise in the EPR and LFP series.

April 2010 was the last time this sort of jump happened in LFP, and the unemployment rate dropped by 0.5% over the next two months.

The pessimistic reading of this would be that LFP has been running parallel to the trend LFP for the past two years, except that the LFP in 2013 4Q was a negative statistical outlier, so that the reported December 2013 unemployment rate was too low, and now the LFP has recovered to the short term trend.  This interpretation would mean that the current 6.7% unemployment rate isn't inflated, but we would still be looking at a good trend in EPR.

I suspect that this is partly statistical noise and partly a maturation of this cycle, where the LFP will begin to move back toward trend.  In light of the demographic trends, a sideways EPR is enough for a recovery, so if we see a sustained positive trend in EPR, this should be a very good sign for the economy.

Friday, April 11, 2014

Employment Flows

 Just poking around employment flows some more, and I thought I'd share some of the patterns I see.

In the first graph, which shows all the main flows since 1995, we can see three pairs of flows that tend to move together:
Flows between employment and not-in-labor-force (NLF)
Flows between employment and unemployment
Flows between unemployment and NLF.

These pairs basically move in proportion to the number of workers in the common category.  So, flows between E and NLF move up and down with the employment rate.  Flows between U and E move up and down with the unemployment rate.  And, flows between U and NLF move up and down with the number of workers marginally attached to the work force.

What we currently have is the E/NLF and the E/U flows basically back at levels we would see during the mature phase of a recovery.

The one pair that is not healthy is the U/NLF pair, reflecting the large number of workers who are marginally attached to the labor force.  How this recovery phase matures comes down to how this pair of flows behaves.  The trend will definitely be down for both directions of the flow.  The thing to watch will be how quickly it trends down, together with the relative movement of each flow in the pair.

There seems to be some acceleration down, which I would have expected after the end of EUI, but the acceleration downward has come from U to N movement.  I would have expected it to come from N to U movement.  The best case scenario here, which I think there is some hope for, is that N to U flows decline quickly to catch up to recent movement in the U to N flow.  If that happens, the unemployment rate will drop quickly.  Everything is moving in a healthy direction now, so there doesn't appear to be a scenario in the wings that reflects a slowdown in the recovery.

The last graph is looking at the net difference between the opposite flows in each of the flow pairs.  Here we can see that there tends to be a circular flow from NLF to Unemployment to Employment back to NLF - on net.  All three net flows tend to move cyclically, and it seems to me that when all three net flows are declining, this could be a useful leading indicator for a coming recession and labor market hiccup.

Here also, I believe is evidence for my claim that the portion of the decline in the labor force participation rate (LFP) that we can attribute to cyclical factors is as much a product of an unusually high LFP in 2007 as it is of an unusual decline in 2009 & 2010.  There was a little bit of both.  But, the strong net flow from N to E throughout 2005-2007 relative to the flow from U to N, looks like a sign that there was significant opportunistic employment during that period for marginally attached workers.  So, the net flow to NLF we see in 2009-2010 is partially just an unwinding of this opportunistic cyclical employment.

In very recent flows, there is evidence again of unusually high flows from NLF to E.  This is likely to reflect some noise in the data.  But, if this proves to be persistent, it could reflect coming positive pressures on employment, wages, production, interest rates, etc.

PS:  One final graph, showing the relationship between the unemployment rate and the level of continued regular unemployment claims, with beginning and end of EUI noted in each cycle.

Wednesday, April 9, 2014

February JOLTS and March Labor Flows

JOLTS data continue to portray steady recovery.  Hires are still below the 2003 trough, which puts the hires indicator at about the same relative place as the current unemployment rate.  Job openings continues to grow and is back to the levels of 2005 when unemployment was down to 5%.  Quits continue to grow and are back to where they were in 2003 when unemployment was at 6%.

The slopes of all the series continue to be reliably positive, even if not particularly steep.

Flows have been updated through March, and they also continue to show positive trends.  Flows between Employment and Not-in-Labor-Force (NLF) are at a level similar to previous economic peaks, believe it or not.  Flows between Employment and Unemployment are also back to levels associated with unemployment rates at 6% or less, and with a strong bias for flows back into Employment.

The flows between unemployment and NLF are the set of flows that remain elevated.  This is a sign, I believe, of the large pool of long-term unemployed.  Trends in the unemployment rate and other indicators of economic strength over the near term will depend on the outcomes of this group of workers.  I have suspected that we would see a normalization of this group of workers after the end of EUI.  While long-duration unemployment hasn't accelerated downward since the beginning of the year, there does appear to be some downward acceleration in these flows.  In fact, over the last two months, as many unemployed workers became employed as left the labor force.  That's the first time that has happened since 2008.  But, generally, the long term unemployed/NLF group remains a bit of a mystery.

The last graph shows net flows between unemployment and both NLF and Employment, plus the total net outflows from unemployment since 2011.  I expected to see 2014 begin with small outflows from U to N and significant outflows from U to E.   Both flows would have created downward pressure on the unemployment rate.

Instead, we have seen the opposite.  (The pattern in November and December was out of Unemployment, but there wasn't an unusual decline in EUI beneficiaries before the program ended, so this is more likely statistical noise than a trend related to EUI.)  Net outflows to Employment have been slightly under trend and Net inflows from NLF to U have been significantly above trend.

Good news over the longer-term is that, while the net rate of workers leaving unemployment has been very steady at about 110,000 workers a month since the beginning of 2011, hidden in this net figure are two positive, but countervailing trends.  Net movement both back into the labor force and into employment have been trending up.

One last graph is a comparison of JOLTS data with the yield curve spread (10 year minus 1 year treasuries, inverted).  It would be nice to have JOLTS data going further back.  Somewhere, there is some sort of job openings data that goes further back.  Please let me know if you know where this might be free and available on the web.  Both JOLTS data and the yield curve appear to have some value as forward indicators.  The yield curve right now predicts that the yield curve spread will peak in about a year, at a little over 3%, then slowly flatten as we approach 2018-2019.  I don't quite know what to make of this coincident pattern, but it might be interesting to watch over time.

Tuesday, April 8, 2014

Labor markets have demand and supply elasticity

Timothy Taylor at the Conversable Economist has a post about long duration unemployment among older workers, referencing and article from Neumark & Button, through the San Francisco Federal Reserve Bank.  The article notes that old workers tended to have much longer unemployment duration in this recession, compared to previous recesssions.  The authors assume that employers are the cause, but they don't find evidence that older workers in states with stricter anti-discrimination laws fared better.

Timothy makes some good comments about the unintended consequences of interventionist policies.  But everyone here is making the typical mistake of assuming that supply of labor is completely inelastic and that all changes in employment behavior are a product of employer behavior and preferences.  No mention is made of the unprecedented level of extended unemployment insurance and the tendency, as unemployment insurance is extended to longer durations, the pool of beneficiaries will skew older.  Clearly this policy will have an adverse effect specifically on older worker unemployment durations.

Further, and especially in the face of this unprecedented policy, no thought is given to the possibility that any household might have any priorities other than attaining new employment as soon as possible.

At this point, unemployment durations are very close to normal, except for about 1 1/2% of the labor force which has been unemployed for a very long time.  So, we could assume that 98 1/2% of labor supply is inelastic.  One does not have to be cynical or misanthropic to consider the possibility that 1 1/2% of the labor force may have some discretion about how they return to employment.  And, clearly, older workers would have more discretion than younger workers.  And, clearly, workers with some discretion, who might normally have somewhat longer unemployment durations, will have even more discretion if they are beneficiaries of more generous unemployment insurance.

Nobody has to be gaming the system, nobody has to be lazy, the recession doesn't have to be the result of voluntary "vacations".  It might be possible that an exceedingly small portion of the labor force might just have slightly more agency and discretion than an orphan in a Dickens novel.  One and one-half percent of the labor force might just have some savings in place with which to buffer a bad labor market.

This doesn't have to be the only reason for the long term unemployment situation.  It doesn't even have to be the main reason.  But, it's a shame that so many analyses don't even allude to this obvious factor.  It's understandable, given the cynical public shaming that tends to answer this sort of commentary.  But, it's a shame that public policy with seen and unseen consequences is so commonly discussed in an environment where obvious facts are not-to-be-named - especially when this policy change was so starkly different than any other previous regime and the resulting labor market behavior was so starkly different than it had ever been before, in precisely the way one would have predicted if one expected EUI to have adverse effects on unemployment duration.

PS:  The relationship I am talking about is noticeable in this graph.  Here I divided the unemployed into two groups, those unemployed for less than 26 weeks and those unemployed for more than 26 weeks.  Normal UI covers 26 weeks, and the recent EUI policy covered up to 99 weeks - a period much longer than in any previous recession.  Until 2008, the unemployment durations of workers in these two categories moved with a fairly tight relationship.  But, after 2008, when very generous EUI was implemented, the durations of >26 week unemployment became highly inflated compared to <26 week unemployment.  The green line is the average unemployment duration we would expect to see among the >26 week unemployed, given the duration we see in the <26 week group.

Monday, April 7, 2014

More bank balance sheet stuff

Here are a couple more graphs regarding bank balance sheets.  The first one shows both monthly and weekly levels in Loans & Leases in Bank Credit, which includes commercial credit, real estate credit, and consumer credit.  The recent sharp uptick is clear, and the weekly indicator confirms that this new level of growth should continue in the monthly data at least through March and April.  (The jump in 2010 is due to an accounting change.)

However, the second graph shows the longer term trend.  There is a very stable exponential growth rate until 2008, which then flatlined.  This new level of growth is not exceptional.  In fact, this is the minimum we need to expect in order for economic growth to remain strong coming out of QE3.

The third graph compares annual rates of growth in bank loans and leases.  The YOY growth rate in periods of economic expansion is always between about 5% and 12%.  That would correspond to a growth in L&L assets of $30 to $80 billion a month at current levels (or $7 to $18 billion a week).  The growth level in the 12 weeks since Jan. 1 has been about $11 billion per week.  So, as extraordinary as this appears compared to recent bank expansion, this is not much more than the minimum we need to see for typical growth.  Of course, we are only halfway through the taper, so maybe we can expect this to continue to accelerate.

Next, is a graph comparing the level of securities in bank credit (low risk securities like Treasuries & Agency debt) to total bank assets (minus cash), commercial & industrial loans, and real estate loans.  There is a clear cyclical pattern in which banks increase the level of credit risk (through C&I and RE loans) during recovery periods and increase the level of low risk securities (treasuries and agency debt) during downturns.  In the great moderation period, these indicators have all bottomed at about the same time, and the initial cyclical increase in short term interest rates has coincided with those bottoms.  During the current cycle, however, C&I Loans bottomed in late 2010 while real estate and total assets, as a proportion of govt. securities, leveled out in early 2013.

This is probably related to QE.  I think we can look at QE from the Federal Reserve as a substitute commercial bank that limits itself only to Securities in Bank Credit.  Here is what these proportions of bank assets look like if we include the QE assets and QE related reserves as part of the ratios.  Here, all the proportions are still declining.  I think we should expect them to turn around with the end of QE3.  The commercial banks might rebuild their stock of Securities in Bank Credit initially, which might keep these ratios near the current bottoms.  But, if there is some causality in the direction from bank asset levels to interest rate levels, then when we see these proportions start to climb again, there should be pressure on short term interest rates to also increase.

Also, while there has been some substitution of funding for real estate and corporate loans outside the banks, evidenced by the increase of all-cash real estate purchases and loan funds with non-bank funding, the net effect of QE was probably still to concentrate more capital in govt. securities instead of corporate or real estate credit.  This might be why corporate credit spreads have remained unusually high and are just now falling toward typical recovery levels as QE is tapered.

Saturday, April 5, 2014

March 2014 Employment Report Review

Here are updates on a few of the indicators I have been following.

First is unemployment, by duration, from the household survey.  I expected to see a sharper drop in long term unemployment, coming off of the termination in emergency unemployment insurance.  I expected it to mostly reflect stronger employment numbers, along with some attrition out of the labor force.  The recent data revisions for the state-level numbers from North Carolina suggested that labor force attrition would be the larger factor.  Of course, these data are noisy, especially when dealing with sub-categories, like state-level numbers or unemployment by duration.  Lo and behold, the national numbers are telling the opposite story of the North Carolina numbers.  In the 3 months since the end of EUI, we have seen relatively strong employment, but that hasn't led to a lower unemployment rate because we are seeing a rebound in labor force participation.

Here is my indicator for the rate at which workers unemployed for more than 15 weeks leave unemployment over the next 3 months.  This is rising nicely, although, again, I had hoped that we might see more of a continuation of the jump in January, coming out of the EUI termination.  That would have pulled unemployment over 26 weeks from 3.6 million in January down to 3.3 million in March.  Instead, long term unemployment bounced back up to 3.7 million.

Finally, here is an update of a graph I have that compares inflation adjusted wages to the unemployment rate (through February).  Wage behavior in this business cycle was very unusual.  Wage growth remained too high, compared to the unemployment rate.  I suspect that this has to do with the fact that this is the first recent recession that experienced such high unemployment levels during a period of generally low inflation.  Nominal wage stickiness may have been more of a problem in this environment.  Wage growth is now tracking in the same direction as unemployment.  This is another indicator I would expect to show some convergence this year, with wage growth leveling off, at least temporarily, and unemployment falling back to a more typical relationship.

On the whole, reported labor force participation has rebounded back from the lows at the end of 2013, and is now at the same level as it was in September.  That means that over 6 months, we have seen a decline in unemployment of 1/2%, with no decline in labor force participation.  That's the kind of movement that I think we will continue to see if the economy continues to recover this year, although my hope after the January report of 5.5% by December is looking too optimistic now.  But, in the six months since September, from the household survey, the labor force has grown by more than 700,000 workers, consisting of about 1.5 million more employed workers and about 700,000 fewer unemployed workers.  That's solid momentum.

Friday, April 4, 2014

The QE Taper, Bank Assets, and Economic Growth

I've been trying to get a grasp on how NGDP and interest rates will proceed as we exit QE3.

Here is a graph of the expected date of the first rise in short term interest rates since the beginning of QE3.  After moving inexorably into the future since the beginning of the crisis, the expected date of rising interest rates finally found a static trend since the beginning of QE3, and has actually moved back in time as the taper has been implemented.  With the termination of previous rounds of QE, interest rate expectations continued their march into the future.  One big current question is, "Will we see that happen again?"  My hope is that banks are healthy enough now to counter any disinflationary effects of the end of QE3.

On the other hand, inflation is as weak as it has been since the beginning of the crisis.  The graph to the right is of the PCEPI and the core CPI - two forms of inflation measurement.  The graph on the left is of 5 year implied inflation expectations from the TIPS spread.

Bank Balance Sheets

Here is a history of total loans & leases, real estate loans, and commercial & industrial loans, expressed as a percentage of bank assets.  I have also shown each series as a percentage of bank assets, net of cash, to show the effect of QE related excess reserves since 2008.

Two things I would note: (1) for total loans & leases and for C&I Loans, the behavior since 2008 looks like normal recovery behavior if we look at them as a percentage of total assets, net of cash. (2) Real estate loans have taken an increasing proportion of bank balance sheets over the past few decades, but they have not begun to recover since the crisis.

The next graph, which shows bank assets as a % of GDP, clarifies these changes some more.  C&I Loans have remained fairly stable as a percentage of GDP, while real estate loans have grown.  Bank assets have grown to accommodate the growing level of real estate values, so the growth of real estate debt doesn't appear to have crowded out C&I Loans over time.  I have added the background relative valuation indicator in order to show how the bank balance sheet expansion was related to low interest rates.  (I speculate that the spike in the late 1970's didn't lead to more real estate expansion because of the exceedingly high nominal interest rates at the time.)

Here is a graph of the nominal level of bank assets since 1973.  They never strayed far from the trend of 7.3% (log) growth over the period.  The next graph shows the nominal level of bank assets in the more recent period, both gross and net of cash.  Since the beginning of QE3, total bank assets have been growing at the long term trend rate.  They aren't catching back up to the previous trend level, but at least they are growing at a typical rate.  But, as can be seen by the level of bank assets net of cash, until recently, all of this growth was due to excess reserves accumulated as a result of QE3.  In fact, since the crisis, bank assets net of cash have barely grown at all.

The next graph compares cumulative changes in commercial bank asset and deposit levels since the beginning of 2008.  I find it interesting that bank asset levels have moved in a contrary direction to QE.  The level of cash built up during each QE period.  And, we can see here that during those times, bank credit tended to flatline.

Between QE2 and QE3, bank assets were growing.  Gross bank assets weren't growing as quickly as they had during QE2, but they were growing.  QE3 caused gross bank assets to grow at a faster pace again, but once again, this growth appears to have come at the expense of bank credit.

The graph after that shows a recent view of C&I Loans as a percentage of bank assets, both gross and net of cash.  It is interesting that when viewed net of cash, the recovery of C&I Loans is very linear and normal looking, and has even surpassed the pre-crisis high.

But, the graph of real estate loans shows a different picture.  There has not been any recovery.  At least, the relative decline in credit leveled off during QE3, as a proportion of assets net of cash.  Very recent weekly H.8 releases from the Fed are showing signs of recovery here, too, but it is still too early to tell.

QE is a shadow bank

I think the best way to interpret this is that the banks were constrained mostly by capital and possibly also by a lack of investment demand.  The Fed used QE to create bank assets without capital.  The commercial banks are operating as they were before the crisis, but with diminished capital.  In addition to them, we now have a "bank of the Fed".  This bank's balance sheet doesn't show up as part of the H.8 report on Commercial Banks, except that the commercial banks hold its deposits, which appear on their balance sheets as "Deposits" which are held by the Fed as excess reserves.  But, the Asset side of the balance sheet for this bank is completely obscured.  Officially the "bank of the Fed" holds treasuries and MBS.  But, the credit created by this bank takes a mysterious path through the stock market, private equity, real estate, and consumption before it ends up at the Commercial Banks as deposits.  Clearly some of this cash ended up in consumption, as inflation tended to move up with each QE.  Clearly it also funded billions of dollars in all-cash real estate purchases, some equity investments, and even some forms of private corporate loans.  But, those details are lost out in the ether.

What Happens Now that the "bank of the Fed" is closing down?

The good news is that the commercial banks are picking up the slack so far.  During the period between QE2 and QE3, they could almost keep total assets growing apace.  Since the beginning of the taper of QE3, total assets has even accelerated a bit.  Growth in C&I Loans is straight as an arrow.  The question is whether the incipient resurgence of real estate loans can gain traction.

If we look at the QE cash and the "bank of the Fed" as a sort of separate entity from the commercial banks, with the banks holding these deposits as a sort of inert middle-man, and we view the constraining factor in credit markets, not as reserves and liquidity, but as bank capital, profitable investment demand, and regulatory and debt overhang issues in real estate, then asset growth among the commercial banks will need to grow to counter the lack of new credit coming from QE.  But, the existence of these reserves should have only a small effect on inflation.  Interest rates could move regardless of what happens with the excess reserves, but not because of some sort of hyperinflation resulting from the mass expansion of these reserves into new credit.

In this view, the main effect of a rise in interest on reserves may be through mark-to-market losses caused by the higher rates.  But, the deposits making up excess cash reserves were never really loanable funds anyway, if the banks were constrained by other factors.  The Fed could choose to unwind them, which would be deflationary, but I don't see any reason why short term interest rates couldn't move up by several percentage points during that process, and I doubt that there will be inflationary pressures if the cash reserves remain in the banks for a while.

The high number of moving parts in this context makes thinking about interest rates through this period difficult.  They can raise the Fed Funds rate, raised interest on reserves, or sell securities, and all of these actions will have different effects on interest rates and the money supply.  I'm fairly confident that at some point the Fed will create another liquidity crisis as real estate tries to reach its higher justified price level again, but I'm losing faith in my ability to figure out interest rates in the 2016-2017 time frame.