Marginal purchases will continue until real term structure steepens

Note: for those unfamiliar with terminology of TIPS, please see Give me a Break (even) for some basic discussion

 

Last night, I finally came up with a concise way of expressing my Fed policy view: "Marginal purchases will continue until real term structure steepens."

Real term structure flattening means that "too much money, not enough paper" is still valid, and marginal Fed LSAPs are reducing the supply of available financial assets enough to lower rates by increasing supply of reserves and reducing supply of risk-free assets. Bear steepening of the real term structure would mean that either marginal asset-buyers have decided other assets offer better prospective returns (flight-to-safety has ended), private credit is growing at a faster pace than the Fed is reducing supply of assets (deleveraging has ended) or, more likely, a combination of both. A side effect of rising and steepening real rates would be that the discount rate (ex-effect from break-evens) used to discount future private cash-flows would rise and therefore, all else equal, that would mean lower asset prices across the board for cash-flow generating assets. I use the real term-structure for this mental exercise because expected returns of non-risk free assets are affected by inflation expectations both in variable-rate instruments (loans, FRNs, some ABS, equities) through rate expectations and fixed-rate instruments as well through expected default rates and recovery expectations. Not to worry, though, falling asset prices due to higher real rates are an eventual inevitability of the Fed's exceptionally accommodating monetary policy and must be accepted as such. All it will mean is buying the same assets at higher expected returns, and should be welcome news for anyone with more financial assets than liabilities.

A tale of two spreads (laughing all the way to the bank)

top: spread between mortgage rates and MBS yield
bottom: spread between CC MBS and 7-year US treasury note

On the heels of the Fed announcing it's latest round of LSAPs, we are suddenly seeing a flurry of media attention around the fact that, despite rocketing MBS prices, mortgage rates are simply not budging. Of course, regular readers are not surprised, as on September 9th I highlighted this very likely possibility in, The twist (redux), A point that David Schawel originally brought up on August 6th (and whose post title I shamelessly stole).

...there is evidence to doubt whether lower MBS spreads will be passed on to customers or whether the banks will keep the windfall. Despite current coupons trading at record tight spreads, the "primary-secondary" spread remains, not only stubbornly high, but near all-time record highs! Proponents of the MBS Twist insist that the Fed can put pressure on the "primary-secondary" spread and push savings to borrowers by increasing (more in a second) their purchases of current coupons, but to me it is clear that the problem lies in the demand, not supply, side of loans. This is why, unless we see further expansion of H.A.R.P. (Home Affordable Refinance Program) which increases the pool of homeowners eligible for refinance, I think the ultimate effect of an "MBS Twist" on aggregate demand will be limited and the ultimate economic beneficiaries will be banks and security holders who see their securities increase in price.

Since Chairman Bernanke announced the latest round of open-ended LSAPs, current-coupon MBS has tightened 56bp to Treasuries while the primary-secondary spread widened 31bp to all-time record highs despite 7y Treasury notes trading 10bp wider than pre-FOMC. Meanwhile, earlier today, MBS traded flat to 10y swaps.  It is clear who's keeping the windfall for now.

Give me a break (even)

Top: TIPS  & UST curves; Bottom: break-evens

Some market participants have described the mechanism through which quantitative monetary policy (read: LSAPs) works or is intended to work to be centered around inflation expectations. The line of thinking is that the Fed is trying to stoke inflation expectations to incentivise purchase of goods today by increasing the rate at which people expect the price level to increase while holding down rates, increasing the gap between yields and expectations of inflation, commonly referred to as the "real rate" and observed in the market for Treasury Inflation Protected Securities (TIPS).

From the TIPS and US Treasury Notes and Bonds curves we can derive what we call "break-evens," or the level of future inflation at which payoffs of both TIPS and regular Treasuries are the same. There's some idiosyncrasies here because there is optionality in TIPS as and a right skew to inflation, and so it is possible (and in my opinion true) that this option is reflected in yields and TIPS holders are willing to pay an additional premium (which is constantly changing) for the embedded option which is ultimately reflected in break-evens, which are often interpreted as "inflation expectations."

5-year, 10-year, and 5-year forward 5-year break-evens (rhs)
YoY All Urban Consumers CPI (lhs)

It is hard to ignore the sudden rise in break-evens coinciding with anticipation for Fed LSAPs (QE), and I am choosing to interpret this reaction as representative of market participant "animal spirits." The sudden rise in break-evens (71bp for 5y!!) means that a level of inflation above the Fed's symmetrical target is now "priced-in" for US Treasuries. Which leaves us with the question, "Will incremental asset purchases by the Fed increase the compounded annual rate of inflation by 0.70% over the next five years?" My opinion is that they will not and break-evens are showing us that there is either panic over what additional LSAPs mean for near-term inflation or there the option embedded in TIPS is being aggressively bought and the rise in break-evens reflects the rising premium of this hypothetical call option.

With both core and headline YoY CPI comparisons below the 2% symmetrical target, core YoY CPI displaying a negative 1st derivative and YoY comparisons getting easier (CPI rate of change peaked last year around August) it looks to me like break-evens are excessively ebullient given the evidence of quantitative policy effects on the general price level over the last 3+ years in the US. It is my belief that quantitative monetary policy alone during a period of deleveraging can not generate the necessary credit growth to drive meaningful price inflation other than through whatever transitory effect a weaker currency has on commodity inputs (which represent a small % of final price).  As I mentioned in The Twist, redux,

While borrowers continue to deleverage, any impact from lower rates will be limited and as mortgage debt outstanding continues to fall, the marginal stimulative power of monetary policy, unfortunately, diminishes.

Additionally,there is evidence to doubt whether lower MBS spreads will be passed on to customers or whether the banks will keep the windfall. Despite current coupons trading at record tight spreads, the "primary-secondary" spread remains, not only stubbornly high, but near all-time record highs! (see lower left). ... This is why, unless we see further expansion of H.A.R.P. (Home Affordable Refinance Program) which increases the pool of homeowners eligible for refinance, I think the ultimate effect of an "MBS Twist" on aggregate demand will be limited and the ultimate economic beneficiaries will be banks and security holders who see their securities increase in price. 

YoY % change in average hourly and weekly earnings
of private sector employees. (source)

That is why, unless the Fed's continuing LSAPs are paired with fiscal stimulus (hopefully in the form of an extension of the HARP program) I have a hard time believing current break-evens will be achieved. Additionally, I have chosen to interpret the Fed FOMC's decision to embark in another round of LSAPs as confirmation the economy remains fragile and the growth outlook has not improved and, with gasoline prices flirting with $5/gal, and real wages still falling, it is hard to see how marginal purchases of mortgage securities (that have marginally diminishing impact) will manage to stoke aggregate demand to a level that drives meaningful inflation in the short term. Keeping mortgage rates low provides an increase in discretionary income for homeowners able to refinance at a lower rate but, if real wages don't grow and gasoline price increases are taking a significant portion of those savings, the beneficiaries are basically just treading water. And, if I had to guess, I would guess that a non-trivial portion of savings from any mortgage refinancing will go towards paying down revolving credit.

That's why, against every piece of folksy advice* I've gotten from veteran traders, I am very much bullish on the 10-year Treasury Note. I bought exposure to this tenor because I think, in no uncertain terms, that inflation expectations have a harsh reality check coming, the embedded call in TIPS is grossly overpriced and--due to their healthy roll, favorable 2s10s steepness and high exposure to inflation expectations--the ten year note is the ideal way to play this thesis. As such, I will continue to buy weakness in the note and concentrate my duration exposure around this particular tenor. The market has become entirely too intoxicated with the promises of QE and has forgotten that monetary base expansion is not inflationary without both credit and wage growth.

The you go, that is my thesis for buying dimes. In the words of my friend Kevin Ferry, "book it, time-stamp it, laminate it, decoupage it, roll it up and smoke it!"

* "Don't fight the Fed," "Don't fight the tape," "Don't get married to a position," "There's old traders and bold trades but no old bold traders"

Shorter Monetary Policy

The twist, redux

Fannie Mae current coupon minus 10-year US Treasury note

Much has been written about the possibility of further Large Scale Asset Purchases (LSAPs, or QE) by the Fed. One of the main points of focus has been speculation about where those, if any, additional purchases will take place. One of the more probable, in my opinion, options is what has been called the "MBS Twist" by various analysts and strategists, including Harley Bassman of Credit Suisse. The "MBS Twist,"--a reference to the decision by the Fed to transact monetary policy by changing the maturity structure of its holdings, originally in 1961, and  most recently in August 2011--would be a balance-sheet neutral operation in which the Fed sells MBS holdings with higher coupons to buy so-called "current coupon" (trading closest to, but not exceeding par) MBS. This would mean selling bonds in which the embedded short call-option is in-the-money to buy bonds where the embedded option is at-the-money and longer-dated. This should, in theory, reduce the market clearing price of the embedded option which would be seen as a compression of implied volatility in the market. The idea behind this action is to compress the spread of current-coupon Agency MBS over treasuries (pictured right) and hope the compression in spread is eventually passed on to borrowers in the form of lower yields to incentivize home purchases or loan refinancing. 

Purchasing power of a $1,000 payment at various interest rates

Mortgage debt outstanding (source)

In theory, this is a pretty clever plan. Lower rates increase the purchasing power of a monthly payment exponentially (illustrated left). This helps support housing prices and increase the purchasing power of buyers. It also allows means people with existing loans can refinance, save money and hopefully spend that money on goods and services and drive the recovery in aggregate demand. Unfortunately, although I think the "MBS Twist" is highly probable, I have very little faith in its power to stimulate the economy. As it has been tirelessly repeated through the economic blogosphere, we are stuck in a balance-sheet recession, and people are continuing to deleverage (see center left) even when, as my friend David Schawel has pointed out, it might not be in their best interest.

The "primary-secondary" spread, the difference between the
yield borrowers pay, and what MBS yield.

 While borrowers continue to deleverage,  any impact from lower rates will be limited and as mortgage debt outstanding continues to fall, the marginal stimulative power of monetary policy, unfortunately, diminishes.

Additionally,there is evidence to doubt whether lower MBS spreads will be passed on to customers or whether the banks will keep the windfall. Despite current coupons trading at record tight spreads, the "primary-secondary" spread remains, not only stubbornly high, but near all-time record highs! (see lower left). Proponents of the MBS Twist insist that the Fed can put pressure on the "primary-secondary" spread and push savings to borrowers by increasing (more in a second) their purchases of current coupons, but to me it is clear that the problem lies in the demand, not supply, side of loans. This is why, unless we see further expansion of H.A.R.P. (Home Affordable Refinance Program) which increases the pool of homeowners eligible for refinance, I think the ultimate effect of an "MBS Twist" on aggregate demand will be limited and the ultimate economic beneficiaries will be banks and security holders who see their securities increase in price.

That being said, I want to make it clear that I believe there is a very high probability of an "MBS Twist." I believe that with inflation declining, unemployment stubbornly high and total gridlock by the pathetic cowards and liars that make-up the legislative branch, Chairman Bernanke will continue to lead the effort to maintain the recovery on-track with the tools available to the Federal Reserve, limited as they may be. And judging by the first chart in this post, I am not the only one to think so. One of the reasons that I find the "MBS Twist" or a new round of MBS LSAPs as the most probable form of additional easing is that the Fed is already doing the MBS twist. Every month the Fed receives cash-flow representing interest and principal on their approx $530 billion in Fannie Mae 4.5-5.5% pools from the first round of LSAPs. The portion of that cash-flow representing principal repayments is reinvested into current coupon MBS in order to maintain the size of the Fed's balance sheet. In other words, every month, the portion of the Fed's MBS portfolio held in the new Fannie Mae 3s increases. The fact that this is something that is already happening makes me think that simply speeding up this process would be a natural extension of present policy.

Romney displays his complete ignorance about the global economy

I recently ran across a few headlines and news stories which claimed Romney had promised to stop borrowing from China. I had to read them a few times and then a few times again because, as I remembered, Romney claimed to know a little bit about economics and this was an egregiously incorrect statement, showing either a complete ignorance about the most basic aspects of the global economy, or a wish to exploit the fears of the Republican masses. Since I'd like to think he's not a total scum-bag, I'm going to assume it's the first.

The problem with this claim is that it claims that the US is dependent on the benevolence of Chinese creditors to fund its fiscal deficit. That's simply not true. Firstly, the accumulation of US obligations in Chinese balance sheets is a function of the Balance of Payments, not the US' fiscal balance. I'll quote Professor Michael Pettis here, as his explanation is more concise than mine,

...foreigners do not fund fiscal deficits. They fund current account deficits, and as an accounting requirement the size of the current account deficit is exactly equal to the net foreign funding. Capital account inflows must exactly match current account outflows.
...
The direction of causality can go either way. If investment in the US is so high, for example, that it is impossible for US savings to supply the full demand (as occurred during much of the 19th Century), then the US must import foreign capital to make up the shortfall.
...
Suppose foreign central banks have decided for domestic reasons (for example in order to generate domestic employment) to accumulate hoards of US government obligations and so run a trade surplus. This will cause a surge of net capital inflow into the US. In that case the US must run a current account deficit equal to the net inflow.

As is obvious to anyone following the developments of the global economy over the last 10 years, the obvious scenario is the latter. The US Treasury doesn't need China's money, China needs US Treasuries as a way to warehouse its FX reserves in order to maintain its current account surplus. In fact, China reducing its holdings of US Treasuries would be net stimulative to the American economy as the US trade deficit with China means that, along with knicknacks and iPods, the US is also importing Chinese unemployment.

Unless the US Treasury starts emitting dim sums (borrowing in CNY or CNH), the US is not borrowing from China. This is not subject to discussion.

How China's Negative Real Rates Depress Consumption

If you've ever caught me ranting about China on twitter, you've seen me carry on about how negative real deposit rates are an implicit transfer of wealth from households to government. You may also recognize that point from Michael Pettis' China Financial Markets blog. In this post I'm going to try to explain how this transfer works. It's not complicated, but if you don't understand how developing economies differ from economies like that of the US it can be hard to see the mechanism at work.


The basics:

• Outside the upper-middle and upper classes, consumer credit is not easily available in developing economies. You can't just call Experian and check someone's FICO. Large amounts of the population is unbanked, underbanked or has no credit history at all.
• The deposit and lending rate (and therefore the spread between them) are set by the central government.
• Michael Pettis has estimated real deposit rates are suppressed by "at least 400-600 basis points" (China Financial Markets)

Negative real deposit rates are a transfer of wealth from depositors and creditors to debtors
Because of the limited access to credit that households have, households are the main source of deposits in the system. Like in other developing and under-banked economies with limited access to consumer credit, in China you need to save money until you have the full price to pay for X good (e.g. durables) which, when combined with inflation, forces the households to accept negative real rates. Accepting a 2% yield when there's 5% inflation may mean -3% real rate, but it's better than the -5% cash yields. Reasons for savings include emergencies, possible medical expenses, savings for a home, vehicle purchase or a child's education or every-day cash management. Remember, the rest of the world doesn't use their Capital One to pay for their groceries. With this kind of saving pattern, real rates have inverse effects on saving because, the more negative real rates are, the higher the savings must be to achieve a savings goal or maintain the real value of the savings balance. Without access to credit, negative real deposit rates force the household sector to save more. Money channeled towards savings by the household sector is money that is not spent on consumption. An approximation of total tax on households--and consumption--would be the product of the average daily balance of total deposits multiplied by times the gap between market and government-set rates multiplied by the percentage of household deposits in the system. That estimate excludes any effect from misallocation of resources by borrowers.


Who are the creditors? Who is receiving the transfer?
In April 2009, the Hong Kong Institute for Monetary Research published a paper which claims that state-owned enterprises (SOEs)--which account for about 37.6% of total value added in their respective industries and 25% of GDP--are only, or mostly, profitable due to a preferential cost of capital. According to the authors, "SOEs’ profits would have been entirely wiped out if SOEs were made to pay the same interest rates as otherwise equivalent private enterprises." How big is the problem? Well, "although SOEs’ contribution to the Chinese GDP was around 25%, they received about 65% of total loans."

Seeing as how a large portion of the SOE are involved in investment-related activities (in the GDP sense) and SOE's account for a majority of Chinese GDP the easy conclusion is that investment is being financed by taxing households through the banking sector. Net-winners? Anyone involved in that supply chain and the SOEs. So the transfer is moving from Households to government and business. Which businesses? Well, since, "about 41% of private enterprises have no access to credit and 56% have no access to bank credit," I'm going to guess big businesses.

Negative real rates impede a growth in household consumption by transferring wealth to government and business as long as households bear the cost of those negative real rates.

This leaves us with one way to increase consumption:

1. reduce the burden carried by households as a result of negative real rates.

And two possible ways of achieving that:

1. Raise real rates
2. Transfer some of the cost of negative real rates elsewhere

Barring a flood of foreign depositors itching to deposit funds into RMB-denominated accounts at negative real rates or holding RMB as FX reserves, option two means either government or business. Analyzing the effect to the SOEs is beyond the scope of this post, but since profits ultimately go back to the state, we can look at SOEs and government as one, and consider that subsidy as a tax. It's simply a way for the government to decide how citizens spend their own money. Unless the government stops trying to do that (fat chance), reduced subsidies to SOEs and government would just require more taxes/state-borrowing or less spending, of which the ultimate recipients are the household sector again.

Essentially, the other two beneficiaries of negative real rates, households and private industry with access to credit, are free-riding on this policy and benefiting from low-cost financing, creating a regressive re-distribution of household wealth. This is one of the many reasons we've seen restrictions, like higher down-payments, placed on mortgages of second and third home purchases.

Suggestions
The simplest fix to the problems caused by negative real rates (under-consumption, regressive redistribution, resource misallocation, asset-price inflation) is simply to raise real rates. Of course, raising real rates could cause a surge in NPLs from SOEs that wouldn't be profitable without the implicit subsidy. In the event of a SOE being rendered unprofitable by having to access capital at market rates, the implicit subsidy could simply be turned into an explicit one if the firm's activities were deemed important enough. Otherwise, the firm would go away or shrink, eliminating the dead-weight loss from misallocated resources. The banking system? The risk is already implicitly (and sometimes explicitly) socialized and the problem won't simply go away if Beijing keeps waiting.

Moving real interest rates up doesn't necessarily have to be contractionary for the economy. Sure, the loss of the implicit transfer from households to SOEs / Government would reduce investment capacity, but at the same time it would increase consumption capacity by an equal amount, although probably not the kind of consumption Beijing would prefer. Given the reduction in losses from negative real rates, households would be more able to absorb tax increases if Beijing wished to keep subsidizing investment.

Additionally, stepping closer towards market rates would allow the expansion of consumer credit. Widespread access to consumer credit wouldn't really co-exist well with real negative rates unless there was exterior financing, which would require major changes to the current account. Notwithstanding Q1 2010 numbers, I simply don't see consistent trade deficits for China in the horizon, so the next the easiest and healthiest road to increasing access to consumer credit is simply positive real rates.

Why increase access to consumer credit? In many ways--although not all--savings can be replaced by access to credit. Many people have savings so that they have enough purchasing capacity in short notice in case of an emergency. Credit can replace that cushion in many cases, reducing the need for short-term time or demand or deposits. Following this logic, giving someone access to credit allows them to spend deposits on consumption because the emergency purchasing power they needed is still there in the form of credit. Just this action, without any actual household borrowing, would shift some savings to consumption by reducing the quantity of household savings that need to be parked at deposit institutions.

Economic Implications of the Japanese Earthquake & Tsunami

I'd like to start this post by point out I am not a macroeconomist. I did obtain a B.S. in Economics from Northeastern University, but my transcript is anything but impressive. Please question everything I say here and if you see any flaws in my logic be sure to point them out to me in the comments.

The first reaction I saw in the twitter finance / economics crowd was that, while the destruction was very tragic, reconstruction would act as Keynesian stimulus, possibly helping the economy. Some even joked that the combination of increased demand and stimulus in ZIR environment could cause hyper-inflation. So, let's try to step through this piece by piece:

There was massive destruction of the capital stock of Japan. This helps nobody, we are all collectively poorer as a result. There is simply less goods in the world now than there was a week ago. The same can be said for wars. The economic damage to Japan is likely humongous, but that's partly because Japan is a very wealthy country.

Replacement of the damaged capital stock will likely take years, but certain things will be replaced quicker than others, like insured cars, homes, household staples and durables. This sudden replacement will goose demand in the short term, providing stimulus to the economy, putting people to work and utilizing capacity.

A large part of the money for cleanup, reconstruction and replacement will come from exposed insurers and re-insurers. These companies will pay out claims from their assets. Some of the claims will be paid out from their most liquid assets, like cash and cash-equivalents or highly liquid instruments, including but not limited to, sovereign paper. If there is need for additional liquidity to pay out claims, other assets will have to be liquidated. I am no insurance expert, but common sense would dictate that insurers would be likely to liquidate the most liquid and least risky assets first, and then gradually adjust their risk and liquidity exposure in order to avoid paying too much for liquidity or having to take unfavorable bids (I started writing this before the TSE opened, but as of now the JPYUSD has already hit 80.80 and the Nikkei was almost 200pts down).

The initial move up in the Yen is hardly surprising. However, repatriated currency and any carry unwind help support JGBs, especially the front of the curve. Additional liquidity provided by BoJ does the same (Y7T and counting). As supply is set to increase there will be a firm bid for safe haven assets. Risk assets will have it more difficult, especially until losses are sorted out, especially financials.

Overall, this will essentially be bearish for JGBs in the long term. The economy's Supply capacity was just reduced (S curve moves left) and demand is about to be goosed (D curve moves right). Because of increased demand and reduced supply, I'd expect to see price increases. I'm not talking about price gouging, but pricing power is moving to suppliers, both of goods and of labor. Whether this will be enough to shock the country out of the deflationary trap remains to be seen, though.   If it does succeed, the natural thing to expect would be a gradual uptick in nominal rates, which would be bearish for JGBs in Yen terms. The currency is a different matter.

At first, as we are seeing already, JPY is going to be strong. JPY is a flight-to-quality  currency and a carry funding currency. Any unwind of carry will come with demand for Yen and supply of the carry currency, putting upward pressure in the Yen. The carry trade is so big that there's no way in hell BoJ can do anything about it. After this, though. I see a bearish path for the JPY. What you are going to inevitably end up with is an increasingly indebted country and a reduced capital stock.  Best case scenario the crisis kickstarts the economy and deflation ends, but--again, in the long term--inflation will be bearish for the currency from a PPP standpoint.

PS: anyone telling you that the flight-to-quality is going to lower exports is in the wrong time frame. Techinically, yeah, a strong JPY would hurt exporters, but there's about to be such a HUGE boost to internal demand, that it ain't no thang.

For those of you that like to play, here's some long ideas. (no short ideas because if you short disaster victims you're a real asshole)
Managed timber; Durables and materials retailers; Equipment sales and leases; Construction; Auto dealerships; furniture retailers; electronics (TVs, computers, etc retailers). Basically go long the people who are going to sell the stuff that needs to be replaced and were either undamaged or probably protected by insurance. Also, anyone that rents out heavy machinery.

Someone at the BoJ doesn't quite grasp supply and demand

From Bloomberg:

Bank of Japan Pledges to Steadily Buy More Assets"...The BOJ’s purchases of real-estate investment trusts and exchange traded funds have bolstered stock prices, a sign the stimulus has supported sentiment even as global growth slows."

Uhm. I guess it's nice they are at least buying some hard-assets instead of government paper as far as the Yen is concerned, but someone ought to tell the peeps at the BoJ that if you have a stable, aging (and soon to be declining) population while you forbid foreigners from buying real-estate, chances are you are not going to have much luck supporting real-estate prices. Especially not when interest rates are already at record lows. It's that supply and demand thing you can learn from Mankiw's book.

My suggestion? Start letting immigrants in. Seriously.

China Money Supply: October 2010

To see the latest data please see the label Chinese Money Supply

 

I was going to stop publishing these, but after looking at the blogger statistics, I noticed they were the most popular recurring item in terms of pageviews, so I decided to update them again. As always, the data is released in an unpredictable schedule--often late--so I can't predict when the next update will be.

You might notice that I changed the scale of the nominal graph to a log scale. It made sense. The only reason I hadn't done it before was because the formatting was poor, but I finally gave in and decided function was more important than form in this case.

Treasuries as volatile as stocks!

The NYT has a story about how long-term treasurys are sensitive to changes in yield. Socking, I know.

“There could be near-equity-like volatility” coming for these bonds, warned Joseph H. Davis, chief economist and head of the investment strategy group at the Vanguard Group.
...
The Vanguard Long-Term Treasury fund, for example, has lost around 8 percent of its value in just the last two and a half months

and,

In the first six months of 2009, the average long-term government bond fund lost 23 percent of its value, only to climb around 14 percent in the subsequent four months, slump 8 percent in the next six months, and soar 26 percent between April and August of this year.

I applaud Mr. Lim for his mention of duration in the article, it's nice to see a journalist not treating his/her readers like idiots, but I wish he would have gone the extra mile and mentioned convexity. By bringing down long-term yields, the Fed was the one that increased volatility in bond prices by increasing duration. Just like the decline in long-term yields has created great gains for bond holders, it is putting them at great risk. To see why, look at the graph below.

Image borrowed from thismatter.com

As you can see, the line turns nearly vertical as yields approach zero. This is the same effect that you see in the graphs displayed in the housing affordability posts. The slope of that line is the sensitivity of interest rates, in fact, the slope of the tangent is the duration that Mr Lim mentions. What I wish he had mentioned, however, was that that volatility is natural at rates this low. Changes in yield have not really been violent, but these instruments are very sensitive to yield levels. in the future, it will not be ticks up in yield that are at fault for making bond investors lose money, it will be the Fed for bringing down far rates to such low levels, and investors for not doing their homework.

Of course, investors need not lose money even if yields move up. Mr. Lim accurately explained how coupon payments may make-up for loss in bond price, but he forgot one more thing, the yield curve. With a positively-sloped yield curve, the value of a bond naturally increases as time passes because the rate on near-term securities is lower than those on longer-term securities. In other words, if the 30-yr rate is 6% and the 20-yr rate is 5%, then an investor could absorb a 1% rise in the 20-yr rate over 10 years without having to absorb a loss on the price of his/her bonds. This may do little for investors in the 30-yr bond, but when you consider the gap between the 3 and 7 is 126bp, you see how that positive slope can provide a little cushion to bond holders. In the mean time, though, investors looking for low volatility are cordially invited to invest in one of the safest assets out there, cash and cash equivalents.

China Money Supply: September 2010

To see the latest data please see the label Chinese Money Supply

 

So here's a collection of updated charts with the latest money supply numbers from the People's Bank of China and the National Bureau of Statistics of China. Velocity of Money, YoY growth after the jump.

Please note that, purportedly because of demand for physical currency, there is a significant distortion around the Chinese New Year.

Nominal money supply numbers as reported by the People's Bank of China

China Money Supply: August 2010

To see the latest data please see the label Chinese Money Supply

 

So here's a collection of updated charts with the latest money supply numbers from the People's Bank of China and the National Bureau of Statistics of China. Velocity of Money, YoY growth and some new GDP ones after the jump.

Please note that, purportedly because of demand for physical currency, there is a significant distortion around the Chinese New Year.

 

Nominal money supply numbers as reported by the People's Bank of China.

Indexed growth of the money supply compared to growth in GDP (2005=100)

Stopping Deflation with Government Stimulus

Credit NY Fed

This post was inspired by a comment over at The Big Picture. Barry Ritholtz posted some interesting chart pr0n from the NY Fed's report on Household Debt & Credit and a commentator by the name of "HelicopterBen" brought up Richard Koo, whom I've written about before, and whose book I reviewed.

I feel like a broken record, but I'll say it again: Koo's GIGANTIC assumption is that the government will spend the money in projects with a NPV greater than zero. I quote myself below:

I'm just not comfortable leaving that decision up to the guys that decided to try to reflate the bubble by pulling-forward demand, subsidizing toy arrows and foreign liquor and build useless airports. Just sayin.

As I said in my response in TBP (I comment there as "X on the MTA"), trying to return to the good times by maintaining the money supply inflated is like trying to--ignore the negative connotation of disease for a second--infect a patient by inducing the symptoms. Or, if you prefer, curing the symptoms instead of the disease, either analogy works for me. I'm not going to rant about malinvestment, because I've already done so--although Pettis said it better  and then what Steve Waldman said it best. instead, I'm going to make a quick point about the money supply.

One of the Fed's goals is to maintain relative price stability. When Paul Volcker was first appointed Chairman of the FRB, he changed how things work and decided to try to control inflation by targeting the size of the money supply. Little '84 hiccups aside, it is in my opinion he did a good job navigating this new, uncharted territory. At the time this "monetarist" thing was fairly new, but it makes sense to control inflation by controlling the growth of the money supply. This works well because the Fed can act in the markets via the FOMC, and they can release accommodate expansion when it's needed and tighten when things are heating up too fast.

Koo--correctly, in my opinion--argues that during a large-scale deleveraging, when rates are already pushing zero, monetary policy becomes impotent. He argues that no matter how much money a central bank puts out, it won't create inflation if businesses and households are all focused on paying down debt. I think he is totally correct. Where I disagree with him is where he argues that the government should become the borrower of last resort to keep the money supply from shrinking. Yeah, the government can soak-up funds when there's an excess, but can we trust them to release them when the private sector needs them? More so, can the government allocate capital in anything but a wasteful manner? Which brings me to my main point: why do we need to keep the money supply inflated, and businesses and households leveraged? I am not saying we should allow a violent deflationary crisis to take place, or the government shouldn't stimulate when it makes sense, I'm just saying there is nothing wrong with having excess reserves when there's nothing to invest them in. Americans are simply not going to halt spending because of small price declines are expected. I'll put money on that.

Borrowing is contracting and there is excess reserves because people want to save and pay-down debts. Some may need to save the money for future expenses, others may want to pay down the underwater component of a mortgage so they can refinance at a lower rate or sell and move. CC debtors may need to lower their debt-service so they can start spend that money elsewhere. Some may want to lower DTI ratios so they can borrow in the future. Slack in the system is a good thing, just like cash in an investment account. There is nothing wrong with not being fully leveraged or fully invested. Businesses and households are preparing and keeping their powder dry so that once a suitable investment comes, they can act on it. That is healthy and rational.

Businesses and households may be paying down debt because they have ugly balance-sheets as a result of the decline in asset values. Fixing balance sheets is not a bad thing, it leads to strong businesses that can grow once their internal problems are fixed. Trying to keep businesses and households in their current, insolvent and over-leveraged state to prevent a few bankruptcies is like locking up junkies and keeping them high so that they don't have to go through withdrawals: ultimately counterproductive.

I would favor going through a painful deflationary cycle and dealing with the bankruptcies of weak businesses and households, but if the Koo sympathizers really want to transfer debt from businesses and households to the government aka "the borrower of last resort", maybe we could do it by having the government borrow large amounts at record-low rates and sending checks to tax-payers instead of poorly investing it. Tax payers could then use that money to pay-down debts, get out of homes they can't afford, or consume and invest if they are so inclined. If nothing else, it would speed-up the process of getting consumers back to a healthy place where they can start spending again so businesses have an incentive to start investing again. Of course we'd have to deal with higher taxes to serve that debt, but something tells me Uncle Sam has a better rate than Joe the Plumber's Capital One card.

Housing Affordability 1971-2009: Interest Rates and Borrowing Capacity

This post is part of the series Housing Affordability 1971-2009

We'll begin the series by talking about interest rates and borrowing capacity. If you are already familiar with the subject, this may not be of interest to you as the discussion will be a bit basic. There will be more interesting things in the future, I promise.

For purchases that are as large and have as little equity as most home purchases, the effect of interest rates is very large. For example, a $100 monthly payment at the current rates of 4.4% could buy a $22,188 home assuming a 10% down-payment. The same monthly payment at 18.45%, last seen in October 1981, could only buy a $7,197 home assuming the same 10% down-payment; that's about a third of the purchasing capacity. While I picked the most extreme points in the data-set, the example serves its purpose. For this same reason, it is useless to talk about home prices without also talking about interest rates, as affordability is measured in the monthly payment, not total cost, for most people. With mortgage rates at historic lows, the buying capacity of a monthly payment is the most it has ever been. Furthermore, if deflationary pressures and extremely loose monetary policy don't cease, we could see that capacity increase even more, since purchasing capacity increases at an increasing rate as interest rates drop, as you can see below (click for larger image).

Housing Affordability 1971-2009: Introduction

This post is part of the series Housing Affordability 1971-2009

The purchase of a first home by people I know in their mid-late 20s--a purchase many believed they had been permanently priced out of a few years ago--has been a common theme lately--and for good reason, homes are more affordable now than they have been since at least the 60s. From some of my work friends, to some of my old high-school friends, not a week went by over the last six months where I didn't hear or see (primarily on facebook) a reference towards buying or shopping for a new home, and it makes sense. With mortgage rates at historic lows, lower prices in many areas and a little help from the government, there hasn't been a moment in the last 39 years where housing has been so affordable when compared to buying capacity at current median incomes.

Chinese Money Supply: June 2010 Reserves keep trending down, loans increase

To see the latest data please see the label Chinese Money Supply

This is the latest money supply data from the People's Bank of China and China's National Bureau of Statistics. The English language version hasn't been updated in quite some time, but the Chinese-language version is regularly updated, although it seems like not in a normal schedule. As I've mentioned before, one of the requirements for a Chinese property bubble would be a large and rapid expansion of credit.

Please note that, purportedly because of demand for physical cash money, there is a significant distortion around the Chinese New Year.

As you can see in the first graph, the reserve rate keeps dropping, indicating an increase in loans, but the second graph shows us that, even if growth is still positive, it is at least no longer accelerating. This is what Pettis described as Beijing's stop-and-go measures in May of this year.

A thought about deflation in the United States

As I have written before, I believe that the natural state of an economy that is progressing and becoming more efficient is a deflationary one.

In a closed economy, a rise in productivity increases the amount of goods provided, leading to price decreases as the number of good rises and the amount of money stays the same. In this scenario productivity increases and money supply growth can coexist and maintain price levels stable, even if a small amount of money is being printed.

That is an oversimplification, but it gets the general point across. If we keep the monetary base stable, increases in population or increases in productivity will both have the same end result: higher potential output and a lower nominal price level. We use monetary policy as a tool to protect ourselves from this monster because the people in control of the big money machine are economists, and economists believe that people are rational utility-maximizing machines. What that means is that if people get used to the idea that prices steadily decline, they will continuously put-off spending because things get cheaper, which will drive sellers to lower their prices, creating a self-feedback loop that eventually will end up in the economy grinding to a halt. Generally, this makes some sense, but I just want to throw this one thing out there:

China: Exchange rates, productivity and inflation

Pettis writes today:

China is faced with a difficult policy choice. It can maintain an undervalued exchange rate, it can run the risk of inflation, or it can increase the domestic costs of financial repression. How Beijing balances these separate forces will determine the pace and form of its necessary rebalancing.

Which is much along the lines of what I wrote a couple of weeks ago. As always, I highly recommend reading all of Pettis' blog, which is very informative. What I found most interesting this time around was his discussion in inflation. In a closed economy, a rise in productivity increases the amount of goods provided, leading to price decreases as the number of good rises and the amount of money stays the same. In this scenario productivity increases and money supply growth can coexist and maintain price levels stable, even if a small amount of money is being printed.

China, bubbles, trade wars and balance of payments

Let's start with the alleged "property bubble," I still have doubts about that big crash coming, increases in property prices have been high, but accounts of high inflation would mean that catastrophic nominal price declines are doubtful. Property prices may lower or stagnate in real terms, but a high rate of inflation--which has its own, different problems--would keep nominal paper profits intact, reducing the risk of widespread loan defaults and huge banking losses that would lead to US-style crash and subsequent balance-sheet recession. Double digit inflation has its problems, but Latin American and other emerging economies have been doing it for many, many years, and they're OK--it's not catastrophic.

Putting aside events that have not happened yet, it's important to look at a bigger picture. As Pettis so eloquently put it last week:

5. If Europe’s current account surplus grows, there must be one or both of two automatic consequences.  Either the current account surplus of surplus countries like China and Japan must contract by the same amount, or the current account deficits of deficit countries like the US must grow by that amount, or some combination of the two.
6. If the Chinas and Japans of the world lower interest rates, slow credit contraction, and otherwise try to maintain their exports – let alone try to grow them – most of the adjustment burden will be shifted onto countries that do not intervene in trade directly.  The most obvious are current account deficit countries like the US.

What we are seeing here is a tough problem for China. On one side it needs to tighten to get a hold on on inflation and prevent potential asset-price bubbles but, on the other hand, doing so would transfer more of the global adjustment burden to itself, losing exports and hurting local businesses. If China decides to keep interest rates low to defend its exporters, potentially negative real interest rates would inevitably create mal-investment and fuel potential bubbles. If it doesn't, then it would risk a recession and widespread pain to its exporters as the result of drastic drops in imports by trade deficit countries as they try to curtail said deficits or even become net exporters. The money-supply data posted earlier is indicative that Chinese "tightening" still leaves pretty loose monetary policy. It really looks like China is in a real bind as a result of its unsustainable attempt to grow at the cost of other nations.

Pettis argues that because China has seen de facto revaluation as a result of the EURUSD drop, China could buy Euros, lots and lots of them, strengthening the Euro vs the Yuan. The problem I see, and Pettis describes, is that trade deficit countries are trying to lower their deficits or even become exporters, but too many people are trying to do the same thing at once, and China, the country with the largest trade surplus, doesn't want to give part of it up. The scary thing I see here is that depressing one's own currency is being seen as the key to exports and therefore prosperity, but if everyone is playing that game, what we'll be left with is a fiat-currency race to the bottom--something I hope never to see in my lifetime, as I don't like guns or canned food.

In my opinion, what China could to do is develop a larger domestic demand for its products. Playing a little game of this thing that looks like that thing, the current practice of exporting stuff and importing money seems a tad Mercantilist, in my opinion. Maybe instead of exporting stuff and importing money (debt, actually) they could import and export stuff. Or keep more of their goods at home, allowing for a larger accumulation of goods by the Chinese people--after all, value creation is not a zero-sum game. Moreover, I firmly believe that the people of China would be better served by working on their country instead of building us trinkets. By that, I mean that the marginal utility of undertakings like education (child and adult alike), immunization, water-treatment, waste disposal, infrastructure improvements and investments in whatever increases quality of life is higher than that of factory work making trinkets for sale in the US. Sometimes I really wonder if policymakers understand that the best and most sustainable path to increasing your wealth is not to take someone else's, it's to create your own.