Thursday, June 28, 2012

A US Profit Recession Has Already Begun

The BEA also released revised data showing that corporate profits in Q1 were weaker than previously thought. The broadest measure, corporate profits before tax with capital consumption allowance and inventory adjustment, decreased by 0.3 percent compared with Q4 2011. As the chart shows, that was the first decrease since profits hit their cyclical low in mid-2008. After tax profits with adjustments decreased much more sharply, by 5.9 percent. The difference reflected a whopping 20 percent increase in corporate profits taxes for Q1 2012 compared with Q4 2011.

The drop in corporate profits was largely due to weakness in the global economy. Domestic profits of U.S. corporations rose by a healthy 2.6 percent in Q1 2012 compared with Q4 2011 (5.7 percent for the financial sector and 1.4 percent for the nonfinancial sector). However, foreign profits fell by 12 percent, more than wiping out the increase in domestic profits, as receipts from the rest of the world fell and payments rose. (my emphasis)
Read it at EconoMonitor
Latest Data Show U.S. Corporate Profits Falling Due to Global Woes while GDP Growth Remains Sluggish
By Ed Dolan

When the US housing decline began to create broader problems for developed economies, many people were quick to suggest that emerging markets had decoupled and would not be impacted by the developed world’s crisis. Despite those predictions being proven terribly wrong, as the current Eurozone crisis has picked up speed, the same individuals have been projecting the US will decouple and growth will be unaffected. Given the sharp decline in corporate profits, it appears decoupling proponents will once again prove mistaken. With S&P 500 earnings set to decline in the second quarter, this data suggests that current expectations of a minimal drop may still be optimistic. As Europe and China continue to slow, a turnaround in foreign profits is increasingly unlikely. It appears the US may already be in the midst of a profit recession.

Forget Europe, China Could Be Lehman 2.0

David Keohane at FT Alphaville points out that
The Shanghai composite index has now fallen for the past 7 days in a row and is down some 10 per cent since a high on May 4th.
Here’s a chart from Bloomberg displaying the index over the past year:
Not only has the index declined about 10% on the last two months, but it is down more than 20% in the past year. For all the recent bullish talk over further stimulus from China, the domestic market is certainly not buying it.

Although this chart provides a disturbing outlook for China, it has been largely overlooked by the mainstream media which continues to focus on a possible Lehman 2.0 moment out of Europe. What if the next Lehman moment actually comes from China instead? Discussing the risks posed by credit guarantee companies, Patrick Chovanec suggests:
The web of interlocking, often incestuous, and sometimes circular credit arrangements is reminiscent of Wall Street in the lead-up to the subprime crisis, in which a relatively small amount of mortgage losses, which most people believed could be contained, triggered a chain reaction that brought down major banks and froze credit across the entire global economy.
According to the article from Caixin magazine, banks were effectively outsourcing their loan review processes to these credit guarantors. Similar to mortgage lenders during the US housing boom, it appears the interests of banks and credit guarantee companies aligned to produce a massive extension of credit with little consideration about the borrowers’ ability to repay. With housing prices falling and property development no longer booming, it appears these financial institutions have begun the Ponzi finance portion of a Minsky cycle, whereby in Patrick’s words:
a lot of these firms are actually insolvent and are just borrowing from Peter to pay Paul, in order to postpone the day of reckoning.
That day of reckoning will come, but the question of timing remains uncertain. The larger concern is, how big and systemic will losses be? If it was difficult to determine the extent of the issue in the US, trying to do so in China will be nearly impossible given the general uncertainty surrounding any publicly reported economic/financial data. Could the fallout from these lending schemes actually be the next black swan? Only time will tell. For now it appears that as China’s growth is slowing, risks within the financial system and chances of a hard landing are growing.

"The real solution has nothing to do with the Fed"

A couple days ago I commented that The Fed Can Do More...But It Won't Do Much in response to Stephanie Kelton’s question, Can the Fed Really Do More? Edward Harrison furthers the argument against Fed action...
First, as I said previously, the Fed’s actions have not lowered rates. The Fed’s QE2 raised inflation expectations, causing interest rates to rise and nullifying the effects of lowered risk premia. Second, low rates are toxic to savers and bank net interest margins. When credit demand is weak, the loss of interest income overwhelms the reflationary effects of low rates. Third, as Yellen herself has noted, it is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage. Low rates encourage releveraging, not deleveraging.
Despite having have been highlighted previously, these points are worth rehashing. Edward’s conclusion succinctly states the real problem that needs to be addressed:
the demand for credit is still weak. Some point to the importance of the psychology of balance sheet recessions. Others like myself point to the debt stress from falling asset prices and weak job and income growth. Either way, absent a rebound in incomes or a reduction in private debt, the recovery will remain weak irrespective of how many supply side solutions the Fed implements. If the US (the UK, Ireland or Spain) wants to get the credit ‘transmission mechanism’ working again they will need to increase demand for credit by reducing real debt burdens as a percentage of income or increase income and job security enough to allow debtor’s to focus instead on today’s low debt service costs. If these countries focus on deleveraging instead of releveraging, that would necessarily mean large private surpluses and therefore large government deficits in the absence of significant currency depreciation.
Bottom line: The real solution has nothing to do with the Fed because the constraints are demand side and not supply side. But people will continue to exhort the Fed to do more and so they will do more.

Wednesday, June 27, 2012

Spain Should Bailout Households Not Banks

Rom Badilla directs to the most recent Global Strategy Weekly note from Albert Edwards of Societe Generale, where he writes:
And so it is in the Eurozone: Spanish banks need recapitalization because of the deflationary policies forced on them to reduce Spain’s public sector deficit at a time when the private sector is also de-leveraging. Clearly this has a lot further to go and house prices will fall even further as a result. But the lesson from Japan was that overly focusing on the banks as ‘the problem’ is misguided and until or unless deeply deflationary policies are altered, the Spanish banks will be back for another bailout before too long.

This fits well with the case I previously laid out that private debt continues to drag down Europe.

This above dynamic is especially important for understanding Spain, where sovereign debt levels (at least those officially reported) are not particularly high. Spain’s housing bubble, however, continues to decline putting further pressure on private sector balance sheets. The public and private sectors cannot both successfully deleverage, in tandem, without destroying incomes and growth.
As the first chart from Edwards’ shows, households have not yet begun to seriously deleverage and unemployment is already well over 20%. This process will continue to put downward pressure on house prices, which may fall by another 35%.  As prices fall Spanish banks will ultimately be forced to write down mortgage values, further impairing their balance sheets. By focusing the bailout on banks, Spain in not only following the path of Japan but also that of Ireland. Despite significantly larger bailouts relative to the size (GDP) of Ireland, Irish banks remain insolvent. Putting these pieces together, it becomes obvious that Spanish banks will require further bailouts.

A lesson pointed out in the title of Edward’s note that should have been learned from Japan is that “banks are not the problem.” Unfortunately Spain, Ireland and several other countries have made this same mistake during the current crisis. Private debt deleveraging, especially by households, is at the heart of the current crisis and remains unaddressed. Until private sector balance sheets return to health, economic growth will continue to languish (at best) and highly leveraged banks will become increasingly insolvent. For countries without the ability to print currency (ie. the Eurozone), use of public funds to bailout the banks may eventually topple the sovereigns.

Heading into another Euro Summit, I fail to see any signs that policy makers will soon change course and address private balance sheets. The crisis is speeding up but the policy solutions remain unsuitable for the problem at hand.

Markets are 'natural' and money is important

Brenda Rosser discusses the assumption that markets are ‘natural’ using David Graeber’s recent book, Debt: The First 5,000 Years, as a guide. The basic gist of Graeber’s selected quotes appears to be that government policy and money are necessary to enable functioning markets. This is mentioned in contrast to the presumed view of economists which
have come to see the very question of the presence or absence of money as not especially important, since money is just a commodity, chosen to facilitate exchange, and which we use to measure the value of other commodities.
While this may be true of most mainstream economists, I have previously highlighted the fallacy of monetary neutrality and the need to incorporate money into economic models.

Stemming from Graeber’s text, Brenda concludes that
Money brings markets into being.  Not the other way around, as most economists would have it.
While I don't disagree that governments set rules for the market or that money is important to market transactions, I think it is a stretch to suggest that governments or money is necessary for markets to exist. Surely there have been periods throughout history, where prior to governments or money, people exchanged goods or services. In fact, it is unlikely that governments or money would have come into being unless individuals had previously learned to exchange ideas, goods and services. Given that markets can/do exist naturally, it would still be a mistake to assume this minimizes or nullifies the role of government policy and money. It is in combination with government policy and money, that markets will almost certainly prove most abundant and beneficial.

Tuesday, June 26, 2012

The Fed Can Do More...But It Won't Do Much

In any event, we’re in a balance sheet recession. We should be encouraging the private sector to borrow less, not taunting people with negative interest rates and encouraging them to leverage up. And we should recognize that the government’s deficit is the key to helping the private sector de-leverage.

Reducing the government’s deficit means cutting the non-government’s surplus, which frustrates their efforts to pay down debt.
We need rising incomes to support a recovery that can be sustained by private sector spending, and the Fed isn’t the agency we should be looking to for help on this front.
Read it at Naked Capitalism
Can the Fed Really Do More?
By Stephanie Kelton

Kelton expresses her frustration, which I share, with the unrelenting calls for further “stimulus” from the Fed. As I’ve mentioned repeatedly on this blog (see here, here, and here for examples), the mechanism by which monetary policy can induce real growth is weak, at best, especially when the private sector is deleveraging. Despite the efforts of Kelton and many others with an MMT/MMR/Post-Keynesian background, this message has still not gotten through to the mainstream media. Hopefully our experimentation with monetary policy will not cause too much damage before its ineffectiveness is finally understood.

Cullen Roche - Misunderstanding Banking is Helping Bankrupt an Entire Society

What is Wall Street’s job?  Wall Street’s job is simple.  It is to increase earnings for their shareholders.  It is not to provide jobs for the private sector.  It is not to make sure the US economy is running smoothly.  It is not to make sure you feel good about your day to day life.  It is to generate a profit for its owners.  This is the essence of private banking.  To generate a profit.  But banks play a unique role in our capitalist system.  I’ve explained before that banks are not the engine of capitalism.  They are simply the oil in the machine.  As the oil in our machine, banks must be functioning smoothly in order for the machine as a whole to be functioning smoothly.  So when big banks do bad things that threaten their well-being parts of the system begin to malfunction.  And sometimes when these mistakes are big enough the contagion leads to the entire machine malfunctioning and requiring a major repair (hello 2008!).
But make no mistake, your local bank is not your best friend or a public purpose serving charity.  For instance, when a bank extends a mortgage (a word literally meaning “death security pledge” from the latin root “mortuus” for death and germanic “security pledge”) they are not doing you some charitable service to help you buy your home.  They are rating your credit risk and evaluating you as a potential profit engine for their shareholders.  That might not be the most pleasant way to think about it, but it is what it is.  A bank is not a charity.  It does not really care if your mortgage results in jobs or happiness for you.  Of course, it would be great if this did because that might result in more future business, but the bank does not need these things from you in order to generate a profit.  It really just wants to manage its risks in a way that helps to generate a profit for their shareholders without excessive risk.  Obviously, the debtor finds the mortgage advantageous, but don’t confuse this service for charity work.  It’s just good old fashioned profit seeking and offering a service where one is needed (in this case, the debtor being able to obtain money they could not otherwise currently obtain).
Read it at Pragmatic Capitalism
Misunderstanding Banking is Helping Bankrupt an Entire Society
By Cullen Roche

Cullen remains one of my primary go-to sources for a clear, objective view of our monetary system. While this post is strong in many facets, it appears to downplay the role of government in the current environment. Deposit guarantees, creditor bailouts and tax laws are just a few of the ways in which government alters the price of credit. These actions, which impact the decisions of both banks and consumers, may unintentionally exacerbate the normal boom/bust cycle.

Greece Offers Once-a-Century Investing Opportunity

I was reading an article from one of the banks that was talking about how low Greece’s CAPE was (the article cited around 2).  I wanted to examine what happens when a CAPE was really, really low.  So, we looked at the database for all instances where CAPEs were below 5 at the end of the year.  We only found nine total out of about 1000 total market years.
US in 1920
UK in 1974
Netherlands 1981
South Korea 1984,1985,1997
Thailand 2000
Ireland 2008
and…Greece in 2011
Can you imagine investing in any of these markets in those years?  Me neither.  In every instance the newsflow was horrendous and many of these countries were in total crisis.
Now what would happen if you invested in these markets, the literal worst of the most disgusting terrible markets/economies/political situations?  Below are local country real returns (net of inflation):
On average:
1 Year:  35%
3 Year CAGR:  30%
5 Year CAGR:  20%
10 Year CAGR:  12%
Read it at World Beta
Blood in the Streets, or Greece
By Mebane Faber

Looking at the headlines makes one extremely hesitant about investing in Greece or the other European periphery nations. However, this data provides a tempting reason to take a contrarian point of view. Current economic deterioration is proving politically unstable, which makes drastic actions increasingly likely in the next few years. At such low levels of investor sentiment, the chances that actions/outcomes surprise to the upside are ever more favorable.

(Note: I’m currently long EWP, the iShares MSCI Spain Index Fund)

Related posts:
Niels Jensen - "a eurozone exit is not the Armageddon"
Is Non-Existent Austerity Priced in to Euro Stoxx?
Bring Back the Deutsche Mark!!

Talking About Demand Leakages

Demand leakages are unspent income. And if any agent doesn’t spend his income, some other agent has to spend more than his income or that much output doesn’t get sold.
And if the non govt sectors collectively don’t spend all of their income, it’s up to the govt to make sure its income is less than its spending, or that much output does’t get sold, which translates into what’s commonly called the ‘output gap’. Which is largely a sanitized way of saying unemployment.
And with the private sector necessarily pro cyclical, the (whopping) private sector spending gap in this economy can only be filled with by govt via either a (whopping) tax cut and/or spending increase, depending on your politics.
Read it  at The Center of the Universe
Demand leakages- the 800lb economist in the room
By Warren Mosler

For many years the desire of some individuals to save was countered by a growing number of other households/corporations willing/able to spend more than their income. As rising interest costs on outstanding debt began outpacing meager income growth, debt levels became unsustainable without infinitely rising asset prices. During this period government was acting equally pro-cyclical, encouraging the massive expansion of credit.

As Warren correctly notes, the government can make up for lack of private sector demand through larger deficits. However, this is not the only possible solution and holds untold costs of its own. Another possibility is to force major writedowns of outstanding private debt, my preferred solution. There are many ways to attack this problem, if so desired, but the first key is to make this issue a widespread topic of conversation.

Monday, June 25, 2012

Subordination in Spain will cause pain

Citing Sony Kapoor's post on the myth of seniority in the Spanish bank bailout, Felix Salmon concludes that
Basically, channelling new money to a liquidity-constrained debtor is always good for existing creditors, even if the new money is senior. That’s obviously the case if the new money prevents insolvency, but it’s also the case if it doesn’t:
Imagine a country has an NPV of expected future primary surpluses equal to x euros, which defines its sustainable debt carrying capacity and that its debt stock is y euros; we don’t need to say whether x is bigger than y or not. Now on a date say the 1st of Jan 2013, it gets a public bailout equal to z euros. Its debt repayment capacity is x+z euros as it now has the equivalent of z euros in a bank and its total debt is now y+z euros. If y>x then y+z>x+z and nothing changes. Assume x = 0.8 y, then bondholders would face a 20% haircut, whether before or immediately after the public injection of z euros.
Now imagine that the z euros bailout is at a concessional rate of interest. Then it will improve the sustainability of debt, all else remaining the same and increase the potential pay out to private bondholders. Equivalently, if the country invests the z euros it obtains in NPV positive projects, the sustainability of its debt improves, making the outcomes for private bondholders more positive.
Reading this section I was struck by the presumption of a positive “NPV of expected future primary surpluses.” What if the NPV is negative (ie. the entity is insolvent)?

Felix continues with the following quote from Kapoor:
There is one exception to this rule, which is when the conditionality accompanying a public bailout is so flawed that it makes the recipient country adopt policies that actually hurt growth prospects and reduce its debt carrying capacity thus increasing the likelihood of insolvency and the size of private sector losses. This is a big and legitimate fear given the current excessive focus on austerity in the Eurozone and may play some part in the panic around Spain.
So the question of current insolvency remains unanswered but Felix points out that the real problem is implied austerity from the bailout, not the seniority of public sector funds.

While I agree with Felix and Sony that austerity (a reduction in deficits) is negative for short-term economic growth and therefore repayment, I still have reservations about how decisively positive public bailouts are being described. After clicking through to Sony’s blog, I found the answer to my question:
The only circumstances under which a public bailout will make private investors worse off is if the public bailout money is ‘wasted’ or spent on items that are NPV negative.
This sentence, which appears in between the sections selected by Felix, was clearly omitted on purpose. Both Sony and Felix appear to be downplaying the possibility that bailout money could be “wasted”, however reality appears to suggest otherwise.

Under the terms of the proposed Spanish bank bailout, the funds will be provided either directly or through a sovereign fund to Spanish banks that are probably (certainly?) insolvent at the moment. It is not a stretch to infer that these banks have been engaging in negative NPV activities, which led to their insolvency. Now the hope is that after receiving bailout funds, these banks will cease those actions and begin making smarter, profitable decisions. But why should we expect the banks to perform any better going forward? Having been bailed out once (and gaining implicit future protection), why not increase the level of risk taking and/or double-down on previous actions?
By bailing out the banks, there is a non-trivial probability that public funds will be “wasted”. In that case, private creditors currently facing potential haircuts will have their holdings subordinated as the assets from which they will be repaid are allowed to dwindle further. Subordination therefore will negatively impact current creditors, along with the technocratic stipulations tied to future bailouts.

Related posts:
Unending Subordination of Private Creditors Continues

Corporate Profits Set to Decline...Has the Recession Arrived?

Three months ago I mentioned the possibility of a forthcoming profit recession hinted at by Richard Bernstein and James Montier. Profit margins appeared to be peaking at historically high levels and despite their strong mean-reverting tendency, earnings projections assumed profit margins would remain near peak levels. With an increasing number of companies reporting negative earnings growth (year/year) and the probability of declining government deficits, the downside risks to those forecasts seemed pronounced.

According to Bloomberg,

Analysts predict members of the Standard & Poor’s 500 Index in the U.S. will report a 1.1 percent average drop in second- quarter earnings, after estimating a gain as recently as last month
A significantly stronger dollar combined with weakening growth in Europe and China may have brought about a US profit recession even earlier than growth pessimists expected. While the federal deficit may be large enough to maintain mediocre economic growth in the US, it appears inadequate to support a continuing rise in corporate earnings. For the time being, analysts are expecting earnings growth to rebound substantially in the second half of the year and return to double-digit growth in 2013 and 2014.

The important question for investors is whether this quarter of declining earnings will be the first of several consecutive, similar to the past 2 recessions, or if current expectations for a return to growth will prove true, similar to 1998. My bet is on the former, although I expect current forecasts will prove too high in either case. If earnings are beginning a sustained period of decline than current multiples may also need to be revised lowed. The likelihood of this combination taking hold seems largely overlooked by the present market. The current earnings season will shed light on how significant the deterioration in earnings has been and looks to be going forward. I have a feeling the market will not be happy with the results.

Related posts:
Earnings Beat But Growth Slows

Friday, June 22, 2012

Currency Intervention and the Myth of the Fundamental Trilemma

On Monday I linked to an article from VoxEU about the fundamental trilemma of international finance to display the recent massive increase in the Swiss National Bank’s (SNB) monetary base and foreign assets.
“The fundamental trilemma of international finance maintains that a country cannot simultaneously peg an exchange rate, maintain an independent monetary policy, and permit free cross-border financial flows (Feenstra and Taylor 2008).”
A conclusion of that article, which I accepted at the time, was that the SNB had given up control over its monetary policy in order to maintain a currency floor against the euro. Switzerland therefore provided a modern example of support for the trilemma.

The same article was posted over at Angry Bear earlier today. After thinking about the topic for a couple days and following comments by Philip Pilkington, I’m persuaded that my initial acceptance of the article’s conclusion was, in fact, incorrect. This view, in part, hinges on how one defines “monetary policy”, which I interpret as control over interest rates, and an “exchange rate peg”, which I take to include setting a currency floor. As Philip notes:

They could easily maintain control over interest rates by paying a set rate of interest on reserves, just like the US/UK/Japan do with their base rate.
As long as the SNB is willing to acquire unlimited amounts of foreign assets, it CAN “simultaneously peg an exchange rate, maintain an independent monetary policy, and permit free cross-border financial flows." The fundamental trilemma is therefore not fundamental at all, but simply another misunderstanding of our modern monetary systems.

Rating Agencies Now Detract Value

Now that the well telegraphed downgrades are over, bank CDS are tightening this morning (MS and JPM CDS shown below).
At this point Moody's might as well downgrade major banks to below investment grade level and be done with it. Over time rating agencies will become less relevant for large bank credits as all major banks involved in capital markets will converge to roughly the same rating.
Read it at Sober Look
Rating agencies will become less relevant for bank risk
By Walter Kurtz

Where I wonder about the ongoing impact of rating agencies is with investment funds (primarily mutual and pension). I think many of these funds are only allowed to hold debt with certain ratings, so at some level they may be forced to sell or no longer hold bank debt. This would remove a significant bid from debt of those banks (or other companies for that matter). Anyone have a sense of how large that issue might or might not be?

Separately, the reaction in markets today (improving CDS and debt) may disappoint banks who were expecting a boost to profits from DVA.

Warren Mosler on Stagnation in Europe, US growth and China's Potential Hard Landing

Great interview here with Warren Mosler. In his eyes, government deficits in Europe and the UK are now large enough to stabilize GDP but not promote growth. Meanwhile the US deficit will remain high enough to support ~2% growth. As for China, Warren notes that throughout history practically all attempts to rein in inflation have resulted in hard landings. Overall this suggests little concern for stocks at current levels.

Apart from the discussion of growth relating to stocks, Warren also provides his usual great insight on the actual monetary operations of our nation (and others). More specifically, he discusses the ineffectiveness of monetary “stimulus” due to lost interest income, the ECB’s back stop of illiquid (maybe insolvent?) banks and the role of deficits in supporting aggregate demand. These topics and more are presented in an extremely clear, concise manner in Warren’s book The 7 Deadly Innocent Frauds of Economic Policy (which I’m currently reading free online).

Thursday, June 21, 2012

Oil Prices Crashing...Are Stocks Next?

Here’s a fun chart from Bloomberg comparing the price of oil (WTI-Crude) to the S&P 500 since the beginning of 2009...

Both markets were moving together until the past six weeks when oil began its sharp sell off. Considering the US remains heavily dependant on oil as a source of energy, among other things, it is often considered a sign of aggregate demand and thereby economic growth. Some analysts are trying to explain the divergence as a short-term oversupply issue in the oil markets, yet futures contracts across the board have been dropping rapidly. Similar price declines experienced by broad commodity indexes offers further support to global growth concerns.

US equity markets are increasingly becoming the odd-man out in global asset markets. The recent resilience can either be seen as a sign of strength or as a sign of complacency. If the latter option proves correct, markets may be setting up for a massive sell-off.

Related posts:
Extension of Operation Twist Suggests No QE Until After Election
One More Rally Before the Crash

Mismeasuring Housing Distorts Inflation Data

One major pet peeve of mine, regarding economic data, is the manner by which inflation is calculated and the certainty often prescribed to that calculation. A notable criticism stems from the recent bubble and bust in housing. As Evan Soltas notes:
With the exception of the GDP deflator, the CPI and the PCE all use a measure of housing prices called "owners' equivalent rent," or OER. What OER basically entails is the Bureau of Labor Statistics (BLS) asks homeowners for their own assessment as to the potential rental price of their own home -- and as a result, what OER has failed to count has been the asset-price inflation of housing.
To provide a more clear depiction of this failure, here is a chart comparing the CPI-OER and a broad measure of housing prices (S&P Case-Shiller 20-City Home Price Index) since 2000:

As seen above, housing prices have been extremely volatile during this period compared with the measure of OER. Equally noteworthy, the OER has continued to rise over the past several years even as nationwide housing prices have cratered. Given the influence this data has on monetary and fiscal policy, ensuring the accuracy of its relevance to prices faced by households is critical.

Evan continues:
I bring this up, in part, because there's been movement by the Office for National Statistics in the UK to replace their CPI and RPI, or Retail Prices Index, with a CPIH, which would include some OER and some mortgage payment costs. (The mortgage payment component is a proxy for asset prices.) At the same time, Eurostat, which compiles the HICP inflation numbers for the Eurozone, is considering a new approach to owner-occupied housing.
Both the Bank of England and the European Central Bank have figured out that they are mis-measuring housing; it's time for the Fed and the Bureau of Labor Statistics to introduce a CPI-H.

(Note: Evan’s post links to a couple CPI-Housing adjusted graphs he created on FRED that may prove useful. Check out his post for the links!)

Destroying Markets To Create Jobs?

Felix Salmon offered his views on Why Bernanke’s not doing more following yesterday’s FOMC statement. Although there are several points with which I disagree, one quote in particular was striking:
Of all the things to worry about right now, price discovery and capital-allocation distortions are pretty low down the list. I’d happily do enormous damage to both of them if I thought it would do any good in terms of creating jobs.
While I don’t think Felix is alone in this sentiment, far from it, his comment is far more explicit than most others. A few questions immediately come to mind...

Does this view imply that damaging price discovery and capital-allocation does not kill jobs? Or, it only hurts future jobs, which are less valuable than current ones? Is there some ratio of current to future job trade-off that would make damaging those items worthwhile?

This view makes little sense given my understanding of economics, but clearly others have a different perception. If readers agree with Felix’s view, how would you answer the above questions?

Hurdles Remain High For Europe

Brief, yet interesting chart here from SocGen, courtesy of FT Alphaville. What stands out to me is how few options currently have a low hurdle and nearly all options that offer even a sentiment change hold a high hurdle. While markets celebrate Spain’s continued ability to access bond markets, though at unsustainable levels (since Spanish growth shows no signs of turning), Germany’s economy is slowing more rapidly. With Europe almost certainly in a recession, the ESM still awaiting ratification and further actions not forthcoming, the current optimism will once again prove misplaced.

Related posts:
ESM Flaws Emerge Prior to Ratification
Europe's Leaders Should Learn From Game of Thrones
Despite Bailouts, Irish Banks Remain Insolvent...Spain Too?
Unending Subordination of Private Creditors Continues

Wednesday, June 20, 2012

Extension of Operation Twist Suggests No QE Until After Election

David Merkel offers a Redacted Version of the June 2012 FOMC Statement with comments on changes from the prior statement. Overall the Fed appears to have lowered its future growth and inflation expectations to a small degree. The specific change that market participants were all waiting on is the following:
The Committee also decided to continue through the end of the year its program to extend the average maturity of its holdings of securities. Specifically, the Committee intends to purchase Treasury securities with remaining maturities of 6 years to 30 years at the current pace and to sell or redeem an equal amount of Treasury securities with remaining maturities of approximately 3 years or less. This continuation of the maturity extension program should put downward pressure on longer-term interest rates and help to make broader financial conditions more accommodative.
As many forecasters predicted, the Fed is extending Operation Twist through the end of the year. Omitted from this statement is the specific size of the program, which was $400 billion for the previous round. One reason for this omission may be the limited remaining supply of short-term Treasury securities. Highlighting this topic in a recent post, Sober Look noted that:
BofA is projecting that by the time of the FOMC meeting this month, the Fed will have $175bn of short-term treasuries on its balance sheet.
If these projections from BofA represent a valid approximation, the Fed will be unable to maintain the current pace of operations for the next six months. To comply with their statement, the Fed would therefore either have to lower the current pace, shorten the time span, or increase the maturity of securities being sold.

Regardless of the which option the Fed chooses, the effects of this program will be minimal, at best. As Gary Becker recently pointed out:
The Fed in what is called “Operation Twist” could try to further lower long term interest rates relative to the negligible rate on treasury bills by buying long term bonds. This might reduce further the spread in interest rates (that is, flatten the interest yield curve), but this effect is limited by a fundamental economic equilibrium condition. Long term interest rates tend to be an average of current and expected short term rates since more investors would shift into short term rates when long term rates are below this average; conversely, investors shift into long term rates when these are above the average of current and expected future short term rates.
With yields on 30-year Treasuries already below 3% (currently ~2.75%), it’s hard to envision much of an incremental gain from another 25-50 basis point reduction. Asset (primarily equity) markets may rally on this news, but the short-term wealth effects are proven to have little carry over to real economic variables.

Even if we accept some minor benefits from the reduction in yields and rise in asset prices, those benefits are largely offset by the reduction in interest income to the private sector. This aspect of Operation Twist is often overlooked but equally important to understanding its impact on the real economy. By swapping short-term Treasury securities for longer-term issues, the Fed is not only increasing the duration of its portfolio but also the yield. This means that the Fed will collect a greater amount of interest income which otherwise would have been accrued by the private sector. In this manner, it’s certainly possible that Operation Twist could have the unintended effect of reducing aggregate demand.

Lastly, the FOMC’s decision to extend Operation Twist for the remainder of the year suggests that the Fed will not enact another round of balance sheet expansion (QE) until after the election. This may disappoint many investors who were expecting that “stimulus” to provide support for equity markets. Since the Great Recession began, the Fed has waited for the completion of each unconventional measure before electing to engage in further actions. Unless Europe or equity markets start to really unravel, I doubt the Fed will alter this typical progression right before a Presidential election.

Overall, the Fed’s new actions should once again have minimal effect on real economic growth or unemployment. With further action now on hold through the election, it will be interesting to see how markets hold up.

The Fallacy of Monetary Neutrality

Referring to a recent post by Scott Sumner, in NGDP Targeting: Altering Theory to Fit History I asked:
What happened to the causal effect whereby a “decline in nominal GDP brought about a sharp decline in real GDP”?
Underlying this question appears to be a deeper one regarding the potential neutrality of money. Accepting that money is neutral implies that changes in the quantity of money can alter real GDP in the short-run, but in the long-run has no real impact (only nominal). It is through assumptions such as this that economists believe they can ignore money and the financial system in macroeconomic models of the economy.

Nick Rowe attempts to establish the neutrality of money, to which David Glasner responds that Money Is Always* and Everywhere* Non-Neutral. Glasner’s thoughtful insight is well-worth reading in full, but the conclusion is that:
every economic equilibrium is dependent on the expectations held by the agents. A change in expectations changes the equilibrium. Or, as I have expressed it previously, expectations are fundamental. If a change in monetary policy induces, or is associated with, a change in expectations, the economic equilibrium changes. So money can’t be neutral. Ever.
Changes in the supply of money do have causal effects on real GDP, even in the long-run. Incorporating money and credit into models of the economy is therefore imperative to improving forecasting and better informing policy making.

Dynamic Hedge - Fundamental Top-Down Macro for the Brain Damaged

Fundamentals have nothing to do with the market, brah.
Interior decorating is rock hard science compared to economics practiced by amateurs.- Antonin Scalia (never actually said this)
Macro economic analysis can be pretty frustrating.  Many economists justify an attractive annual salary by coinciding, smoothing, and transforming the public into mass confusion.  The sheer number of data releases issued over the course of a year is rivaled only by the number of opinions as to the sensitivity of the economy to each data point.  This makes it nearly impossible for the casual observer or even market professionals to get on top of.  Most investors simply agree with the pundit that makes the most short declarative sentences.  The good news is that most of us already posses the most important skill set of macro economic analysis: the ability to squint.
That’s right, close your eyes.  Now open them up just enough to make out shapes and colors.  This is the correct way to look at any chart originating from a government agency or academic institution.  The data is always of questionable integrity and almost always subject to revision.  Not to mention the host of other statistical problems continuously pointed out and debated by super smart people on the internet.  The point is that you’re never going to see the whole picture in any one report.  All you care about is the general direction.  Most importantly, the general direction you can make out when squinting and glancing at a chart for no more than 3 seconds is the correct one.
I subscribe to the 80-20 principle which states that 80% of the results come from 20% of the causes.  This means that you can safely disregard most of the economic data published and just focus on the important stuff.  As far as I can tell most of the sentiment of the economy is captured in the metrics below (in no particular order).  Most of the data moves so slowly that the trend changes are obvious.
If you’re looking for quick trades and short-term actionable ideas, this stuff probably won’t interest you.  Macro analysis is the long-con.
Read it at Dynamic Hedge
Fundamental Top-Down Macro for the Brain Damaged

If you’re reading this post there is a good chance that, like me, you follow a number blogs and try to keep up with as much news as possible related to the financial markets. With a constant stream of information flowing through social media sites/apps 24 hours a day, 7 days a week, it is often hard to step back for a moment and glance at the big picture. Posts, such as this one, are a good reminder for those of us concerned primarily with the macro picture.