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A Scary Valuation Indicator

Tom McClellan – McClellan Market Report

If you want to get worried about long-term stock market valuations, this week’s chart should do the job.  I saw a version of this chart recently in a research report by Daniel J. Want, who is Analytics Director for Prerequisite Capital Management in Queensland, Australia.

What is unique about this indicator is that it combines two separate data series into one indicator.  When I first saw the version of this chart in Daniel Want’s report, I thought it was just wrong to put the CAPE data together with the Moody’s Baa yield, since the two are actually strongly correlated.  So combining them together just magnifies the same message.

CAPE ratio adjusted by Baa yield

This is because the P/E ratio is the inverse of the “earnings yield”, which should reasonably match up with bond yields.  If an investor can get a better return on his money in the bond market, then he will flee the stock market, or vice versa.  That is what keeps the earnings yield and bond yields in correlation.  But when investors are bidding up stock prices to a ridiculous point such that the earnings yield is way out of whack from the bond interest yield, then there can be a big problem.

But the more I thought about it, the more I saw the beauty of this approach of combining the two.  Low interest rates are usually associated with periods of high P/E ratios, but not always.  Sometimes the market’s average P/E ratio can get to a high level because earnings fall to a low level in a recession, as opposed to prices going way up above where they should be.  In 2008-09, for example, the SP500′s raw P/E ratio sky-rocketed, not because prices were too high, but because earnings were unnaturally too low.

SP500 Raw P/E Ratio

Analysts have struggled for years to make meaningful use of overall market P/E ratios because of problems like these.  Professor Robert Shiller of Yale University uses one method to deal with this, which is to calculate a “Cyclically Adjusted P/E” (CAPE) ratio.  This is the same Prof. Shiller who wrote the 2000 book “Irrational Exuberance“, and whose name is attached to the S&P Case-Shiller Home Price Indices.

Shiller’s CAPE looks at each month’s inflation-adjusted (by CPI) real price for the SP500, and compares it to the 10-year average of real earnings.  The intent is to smooth out the earnings fluctuations across one or more business cycles, which is an idea that dates back all the way to the work of Graham and Dodd in the 1930s.  CAPE does a better job than the raw P/E ratio of identifying extreme high and low valuation levels:

SP500 vs. CAPE

The extreme peaks and valleys are smoothed down somewhat, but we still are confronted with the difficult task of determining how high is “too high”.  The CAPE peak at the 2000 bubble top was well above everything else in the record, even including the 1929 stock market top which preceded the Great Depression.  But just because the CAPE level got up that high did not mean that the stock market had to roll over right away.  It stayed at a lofty CAPE ratio level for many months before the Internet bubble finally burst and caused stock prices to turn downward.

The indicator which Daniel Want featured in his report seems to solve some of those problems.  For the record, Mr. Want states that he saw it elsewhere and cannot remember the source, but he added it to his toolbox a long time ago after seeing the nice properties it displays.  I am a big fan of giving attribution to the creators of original ideas, whenever I can figure out who they are.  So I’ll give a tip of the hat to Mr. Want from whom I learned about this tool, even if I cannot yet discern the true originator.

“Baa” is a bond quality rating assigned by Moody’s, and it means that the bond instruments with that rating “are subject to moderate credit risk. They are considered medium-grade and as such may possess certain speculative characteristics.”  The monthly Baa rate used in this week’s chart comes from the St. Louis Federal Reserve’s Economic Database (FRED), and is the monthly average of daily yield data on all of the Baa-rated corporate bonds.

The magic of the composite indicator in this week’s chart is that by adjusting CAPE for the Moody’s Baa yield, the result seems to set a much more uniform ceiling for how high valuations can go.  Getting above a certain level says that the market is really getting to the edge, and is near a MAJOR price top.  And that is the message of this week’s lead chart, which shows that this CAPE/Baa ratio is now up to the sort of level which has always marked a MAJOR stock market top every time it has been reached.  That’s obviously a problem for the market, but it is not necessarily an immediate problem.  And I want to emphasize that the message is that the market is NEAR a major top, and not necessarily AT one.

Looking at past major tops, the final price top does not usually arrive while the CAPE/Baa ratio is in its steepest slope of an up move, like that which we are seeing right now.  We also see that the price peaks in 1966 and 2000 came after this indicator had already peaked and turned down.  The point is that there is considerable variability about the nature of how tops are built, and it can take a while to complete the process.  The message for now is that the rubber band is getting stretched really far, and that is a problem for the really long run for stock prices.  Today does not have to be the final moment for the long bull run, but it is the time to begin planning for the final moment.

Related Charts

Mar 23, 2012

small chart
SP500 Undervalued Versus M2

Nov 19, 2010

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Is Gold Overvalued?

Jan 21, 2011

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Why Even Fundamental Analysts Should Watch A-D Line

Chart In Focus Archive

Why No One Listens to These Economists

A recent poll from the University of Chicago shows that economists overwhelmingly believe that the fiscal stimulus helped the economy coming out of the Great Recession.  And this has lots of economists scratching their heads (see here and here for instance).  After all, if the stimulus helped then why, with such a muddling recovery over the last 5 years, were we so eager to argue against the possibility of more fiscal stimulus?   The answer is simple in my view – the opinions of those economists matter a lot less than the opinions of the constituents which our elected officials have to answer to.

This disconnect between the opinions of economic experts and constituents speaks volumes about the divide between the two sides.  But it makes complete sense when put in the right perspective.  Let me summarize why I think there is this great divide in views:

  • First, the economy is really confusing and most Americans don’t even have an entry level understanding of basic finance and economics.  See this SEC study for instance.
  • Second, the average American is skeptical of just about anything an economist says because economists themselves disagree on so much and many economists seem to work with models of the world that the common person can’t even come close to relating to.
  • Third, we are inundated with propaganda about how bad the government is.  Americans are trained from the day they are born to be skeptical of the government.  It’s in our DNA.  And that skepticism is healthy up to a point.  But it becomes unhealthy when the skepticism turns into dogmatic rejection.  Our government does some really great things for us.  It also does some pretty crappy things.  But we shouldn’t just reject any increase in government spending on the false assumption that all government intervention in the economy is automatically bad.
  • Lastly, there are actually a whole bunch of economists and media outlets who would vehemently reject the idea that the fiscal stimulus worked even though the CBO has already confirmed for us that the stimulus helped (but who needs facts from an apolitical entity when you have economic dogma to fall back on?).

So, there’s this tangled web at work here.  It’s all very political.  It’s all very misinformed.  And it’s all very dogmatic.  And the result is a whole lot of emotional disagreement that leads to nothing good.

Did 2013 Prove That Fiscal Stimulus Doesn’t Work?

Scott Sumner has confidently declared that the 2013 growth figures prove that fiscal stimulus doesn’t work.  And he says so because a lot of Keynesians came out prior to 2013 declaring that the sequester would torpedo the economic recovery.  But since the economy was actually quite strong in 2013 during a period of fiscal tightening then Sumner says this MUST mean that fiscal policy failed.

There’s just one big problem with this analysis.  Some Keynesians (if you want to bunch anyone who supports fiscal policy at all, like myself, at times – though not at all times), ahem, me,  said that the economy wasn’t going to suffer a serious downturn in 2013 due to the sequester.  I also said in a research note that the “austere” environment of 2013 wasn’t nearly as austere as many were making it out to be.  I repeated this on the blog several times last year (see here, here and here).

Now, what was important to understand about 2013 was a few items:

  1. The actual “sequester” was practically nothing.  The government didn’t make any really substantive cuts to the budget deficit and the total government deficit actually averaged $1.2 trillion in 2013, down from $1.4 trillion in 2012.  Yes, that’s down, but when you’re running a deficit that’s 7% of GDP it’s pretty hard to call that “austere”.
  2. More importantly, much of the decline in the deficit wasn’t from cuts and “austerity”, but came from increased tax receipts.  In other words, the “austerity” wasn’t really self inflicted austerity at all.  It was due to improvement in the private sector which led to higher government tax receipts which endogenously reduced the size of the deficit.

Yes, it’s true that lots of Keynesians came out in 2012 and 2013 saying that the declining deficit would cause an economic downturn, but there were also people like myself saying that the sequester really wasn’t a big deal at all and that the “austerity” of 2013 really wasn’t “austere” at all (I even said in early 2013 that Paul Krugman was wrong to be emphasizing the degree “austerity” at work).  So the bottom line is, 2013 doesn’t prove anything about the efficacy of fiscal stimulus.  Maybe it proves that some economists let their politics cloud their forecasts.  More likely, 2013 is just further proof that all of these debates about “monetary policy” and “fiscal policy” often overlook the thing that really drives a healthy economy – THE PRIVATE SECTOR.

Expect Higher Treasury Yields in Second Half of 2014

By Sober Look

While many investors refuse to accept this fact, we are clearly marching toward higher treasury yields later in the year and in 2015. Even after today’s bond selloff, we are still around the yield levels we had during the dark days of the government shutdown. Here are a couple of key factors that will drive yields higher from here.

1. Many are pointing to record low yields in Europe (see chart), suggesting that on a relative basis treasuries look attractive. Perhaps. But it’s important to make that comparison based on real rates rather than nominal. And given the disinflationary environment in the Eurozone (see chart), a significant rate differential between the US and the Eurozone is justified. After all, we’ve had a tremendous differential in nominal yields between the US and Japan for years. Furthermore, economic growth (and expectations for growth) in the euro area and in the US have diverged significantly (see chart). Today’s US GDP report confirmed that trend.

2. The net supply of treasuries is not static. In particular when it comes to treasury notes and bonds (excluding bills), the Fed has been the dominant buyer (see chart). With the Fed tapering, the net supply is expected to rise.

Net supply of treasuries


Foreign buying of notes and bonds has declined and is not expected to replace the Fed’s taper. It will be primarily driven by China’s rising foreign reserves. But given declining support from the Fed, China is likely to make bills (vs. notes and bonds) a larger portion of its purchases. And bill purchases will have a limited impact on longer dated treasury yields.

To be sure, we are going to have plenty of demand for treasuries going forward. But given such a spike in supply and improved growth expectations, something on the order of 50-75 basis points increase in the 10-year yield in the near-term is not unreasonable.
It is also worth pointing out that with the dealers remaining cautious holding significant inventory and the Fed out of the picture, higher volatility in treasuries becomes more likely.

Rising Rates: The Good, the Bad…No Ugly

By Doug Peebles and Ivan Rudolph-Shabinsky of AllianceBernstein

The US Fed has said it will almost certainly boost short-term interest rates by 2015, and many bond investors are focused intently on managing the risks of rising rates. But it’s also important to recognize that there are benefits.

By their nature, bonds are generally sensitive to interest-rate movements—when rates rise, prices typically fall. With short-term rates on the way up, other interest rates won’t stay low forever, either. But across all bond sectors, from high grade to high yield, rising rates can have positive effects. We believe investors should see a rise in rates as, ultimately, a good thing for bond portfolios. (And by ultimately, we mean just a few years.)

The Value of Higher Yields…and Time

Most investors can be relatively comfortable investing with a five-year horizon. You’ll face some emotional challenges, especially when markets are volatile (and short-term volatility is almost a given with higher-yielding bonds), but if you can sit tight for a few years, history suggests your bond investments can gain even if rates rise.

We’ll present two simple scenarios to show how this works.

Let’s say you own a portfolio of bonds spread across maturities from one to five years, with an average yield of just over 3% and an average duration (or interest-rate risk) of just under three years. Given the level of US Treasury yields today, this portfolio would include high-yield investments. In the first scenario, rates don’t change and you earn a little more than 3% over a five-year time period (Display, blue line).

Distenfeld_Rising-Rates-Improve_d8 (1)

In the second scenario, you also earn a 3% yield at the outset, but the very next day interest rates rise by 1.25% (125 basis points) and remain at that level for the five-year investment horizon (Display, green line). This yield increase causes an initial price loss of about 3.4%—certainly a painful experience. However, the loss is eventually offset by a higher growth path.

What’s the source of this higher growth? First, as you reinvest the coupon income that your portfolio pays, you’ll be able to reinvest it at higher yields. Income matters: for investors who use bonds to generate income, rising rates change from a threat to an opportunity. Second, as the bonds in your portfolio mature, their price pulls back to par, and you can reinvest their principal value in newer, higher-yielding bonds.

This puts your total return on a higher trajectory than in the first scenario. After less than a year, the portfolio’s value is back to its starting point. By the third year, the portfolio has not only caught up to where it would have been had rates never risen, but it’s continuing to grow at this higher rate. This break-even point, where the two lines crossis equal to the duration of the portfolio—regardless of how large the rate rise. From that point forward (about three years in our example), you’ll likely be better off thanks to higher rates.

In fact, you could say that as long as the duration of your fixed-income portfolio is shorter than the amount of time you’re investing, rising interest rates can boost your total returns.

(Institutional investors employing liability-driven investing use a similar strategy: they buy long-duration bonds so they don’t have to worry about whether rates are rising or falling as they fund future obligations such as employee retirements. The longer bonds allow them to match the duration of their bond portfolios to their longer investment horizons.)

A Couple of Caveats

What if an investor says, “I’ll just wait until yields rise”? That’s fine if you think you can guess when yields are going to rise and when they’ll hit their peak, but given that cash is yielding 0%, that’s a very expensive guessing game to play today. And if you need income, it’s not wise to let your assets sit too long in cash.

There are risks that can impact some of our scenarios. For higher-yielding portfolios, investing in high-yield securities—where defaults are a possibility—will be necessary. Any default will reduce returns in either scenario, so stretching for even higher-yielding CCC-rated bonds may prove costly. In our view, for more conservative portfolios, it’s best to stick with BB-rated and B-rated bonds that offer some yield above investment-grade issuers, but considerably less credit risk than CCC-rated bonds.

What if an investor isn’t reinvesting income, but spending it? As long as the rate of spending in our two scenarios is equal, the break-even point is the same, since spending reduces the returns of both scenarios.

Let Time Do Its Work

In our view, investors with a multiyear investment horizon can feel fairly confident that all but their longest bond investments will be worth more at the end of their investment horizon than they are today. And, if that investment horizon exceeds the duration of their investments, rising interest rates may actually benefit investors’ bonds over time. The challenge is to be patient enough to let time work to your advantage.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Douglas J. Peebles is Chief Investment Officer and Head of Fixed Income and Ivan Rudolph-Shabinsky is a Portfolio Manager of Credit, both at AllianceBernstein.


The Zero Interest Rate Decade

Over the last few years I’ve repeatedly stated that interest rates are likely to remain at zero when the next recession occurs.  The consensus still sees rate hikes occurring in mid-2015, but I don’t necessarily agree.   And it looks like I am in some pretty good company now.  David Levy, Chairman of the Levy Forecasting center had some similar comments in a recent research piece titled “The Zero Interest Rate Decade”.

In case you’re not familiar, the Levy Center has a strong Post-Keynesian influence and researchers there have views that are highly complementary to my own.  We use very similar frameworks for understanding the financial system and focus on things like accounting and sectoral balances much more so than other analysts tend to.  I’m not so bearish at present on economic growth, but that could change within the time frame mentioned by Levy.  Anyhow, here’s some of the highlights:

  • the Fed has made it clear that it will not raise rates for a while, likely a year or more, and with each passing quarter the global economy will become even less able to withstand rising U.S. interest rates.
  • Thus, interest rate hikes are unlikely to occur before the next global recession, which has a high probability of beginning between six and twenty-four months from now, and more likely in the former half of that range than the latter.
  • Fed hikes would be unthinkable during the next recession, which will be long, deep, accompanied by unusual financial problems in most of the world, and deflationary.
  • The deflationary and severe nature of the next global recession will lead to a long, troubled aftermath during which the Fed will not entertain the thought of lifting rates off the floor.


Exter’s Defunct Pyramid

I had never seen this before, but a reader pointed out a concept that is often used by gold bugs to promote the idea that gold is the ultimate safe haven.  It’s called “Exter’s Pyramid” and is named after a former Fed official named John Exter.

Here’s how Wikipedia describes the concept:

“Exter is known for creating Exter’s Pyramid (also known as Exter’s Golden Pyramid and Exter’s Inverted Pyramid) for Extervisualizing the organization of asset classes in terms of risk and size. In Exter’s scheme, gold forms the small base of most reliable value, and asset classes on progressively higher levels are more risky. The larger size of asset classes at higher levels is representative of the higher total worldwide notional value of those assets. While Exter’s original pyramid placed Third World debt at the top, today derivatives hold this dubious honor.”

Of course, Exter lived in a very different era than today and one where gold played a much more significant role in the global economy than it does at present.  So it’s not surprising that Exter viewed gold as being totally unique.

I would argue that the pyramid is probably wrong today with regards to gold.  I’d argue, that in a true fiat system, the nation or nations with the largest output backing its currency or currency system is the global safe haven.  And I think recent history proves this is true.  After all, when the sh*t really hit the fan in 2008 it wasn’t gold that rallied.  It was the USD relative to other currencies as well as US government debt.  Gold, on the other hand, actually declined by 20%+ at points during H2 2008.

Of course, this doesn’t mean gold isn’t viewed as a safe haven at all.  It just means that without a gold standard the price of gold is a lot less stable than some might presume….

Spot the Secular Stagnation

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

This Great Graphic was tweeted by the Financial Acrobat. The charts show US and euro area GDP in log charts that also plot the pre-crisis trend.

It is clear that the crisis has thrown the US off its prior path, but it now appears to be on a parallel path, that is lower.

secular stagnation

Growth in the euro area has also broken down. It has yet to initiate a new expansion trend, which is in part, why some do think that it has not really and truly exited its recession.

One of the big macro views that has shaped the debate in recent months is the resurrection of the previously discredited “secular stagnation” hypothesis by Lawrence Summers. The concept was first proposed by Alvin Hansen in the 1930s. It died an ignoble death as the US (and world) entered a long expansion wave. Marxists, like Magdoff and Sweezy tried reanimating the theory in the late 1980s, but offered a considerably nuanced view.

Magdoff and Sweezy generally argued that while mature capitalism was prone to stagnation, there were a number of mitigating factors, like government spending and permanent government deficits. In an essay published in the early 1980s, Sweezy wrote: “Does this mean that I am arguing or implying that stagnation has become a permanent state of affairs? Not at all.”

Looking at chart on the left, the idea of secular stagnation in the US does not come to mind. The slope of the GDP in the euro area is not as steep as the US prior to the crisis and the economy appears to have gone no where in the last 6-7 years. Does this qualify as secular stagnation?

Dangerous Investment World Generalizations


“Think long-term”

“Buy and hold”

“Passive investing”

“Stocks for the long-run”

These are all common and seemingly harmless terms that are thrown about by financial people on a regular basis.  And I hate most of them because they are often used as dangerous oversimplifications of something that is in fact personal and complex.  The problem is, when we spread these terms without being specific we are often just making matters worse even if they’re spread with the right intentions.

For instance, I constantly see articles about how you have to “diversify”.  Lots of smart people think that a diverse portfolio is crucial to meeting your financial goals.  But these articles almost never define what your financial goals are and they almost never define what they mean by “diversification”.  Do they mean owning lots of different types of stocks?  Do they mean lots of different asset classes?  Do they mean lots of different strategy styles?  And how true is this as a generalization to begin with?  Should a 75 year old with no risk tolerance really be that “diversified” at all?   Most definitely not.  So the vague generalization leads to even more vague implementation.

My favorite terms are “think long-term”, “buy and hold” or “stocks for the long-run”.  This is all great in theory.  In fact, the concept is generally sold to investors using long-term performance data ranging from 30-200 years.  As if any of us have an investing time horizon that is actually that long.  Worse, it overlooks the fact that most of us don’t really have much of a “long-term” at all.  Much of our savings is not necessarily “long-term” at all.  It’s constructed around the need to purchase a home, send kids to college and other not-so-long-term spending needs.  So the concept of “think long-term” often results in investors thinking they can just “ride out” the stock market ups and downs which leads them to take on more risk than is appropriate for them and then when 2008 comes along they realize they made a huge mistake and that their “long-term” wasn’t really so “long-term”.  This textbook “long-term” is sold using a largely unrealistic presentation of our actual financial lives.

I’ve deconstructed the marketing pitch known as “passive investing” in some detail in past posts so I won’t regurgitate my thoughts there.  Plus, I am starting to ramble.  But the point is, be wary of people who oversimplify portfolio construction to the point where they constantly rely on these vague generalizations to make their points.  They’re often coming from a good place, but that place is often so nondescript that it becomes counterproductive to a large degree.

Why The Fed Doesn’t Have to “Unwind” QE

One of the more common questions I get is about QE and the Fed’s “exit strategy”.   Many people seem to think the Fed has to unwind its balance sheet before the Fed can raise rates or tighten policy.  So, the concern is that the Fed has a $4.5T balance sheet and when inflation starts to rise they’ll have to hastily unwind the balance sheet which will put pressure on financial markets and the broader economy.  But this concern is unfounded.  The Fed doesn’t have to unwind the balance sheet to tighten monetary policy.

This was best explained in a 2013 SF Fed piece:

“Paying interest on reserves gives policymakers more control over the federal funds rate

The Fed’s new authority gave policymakers another tool to use during the financial crisis. Paying interest on reserves allowed the Fed to increase the level of reserves and still maintain control of the federal funds rate. As the Board’s website states, “Paying interest on excess balances should help to establish a lower bound on the federal funds rate.” The Board’s October 6, 2008, Press Release described the new policy this way:

The payment of interest on excess reserves will permit the Federal Reserve to expand its balance sheet as necessary to provide the liquidity necessary to support financial stability while implementing the monetary policy that is appropriate in light of the System’s macroeconomic objectives of maximum employment and price stability.

This was compelling in the months after September 2008, as the financial crisis deepened, Fed lending from the discount window soared, lending from the newly created liquidity facilities spiked, and excess reserves climbed into the hundreds of billions of dollars range, far exceeding depositories’ required reserves.

In this situation, the Federal Reserve Bank of New York said that the Open Market Desk

…encountered difficulty achieving the operating target for the federal funds rate set by the FOMC, because the expansion of the Federal Reserve’s various liquidity facilities has caused a large increase in excess balances. The expansion of excess reserves in turn has placed extraordinary downward pressure on the overnight federal funds rate. Paying interest on excess reserveswill better enable the Desk to achieve the target for the federal funds rate.

Essentially, paying interest on reserves allows the Fed to place a floor on the federal funds rate, since depository institutions have little incentive to lend in the overnight interbank federal funds market at rates below the interest rate on excess reserves.  This allows the Desk to keep the federal funds rate closer to the FOMC’s target rate than it would have been able to otherwise.

Interest on Reserves will play an import role in the Fed’s ‘exit strategy’ as well

Finally, the Fed can change the rate for interest on reserves to adjust the incentives for depository institutions to hold reserves to a level that is appropriate for monetary policy. This also provides an important “exit strategy” tool, which will allow the Fed to better control the level of excess reserves when it begins to remove monetary policy stimulus.”

Basically, the payment of interest on reserves allows the Fed to maintain control of the Fed Funds Rate even when the balance sheet is expanded.  So the Fed can raise interest rates no matter what the size of the balance sheet is because it can simply increase the rate of IOER.

Also, it’s important to note that the Fed likely won’t unwind its balance sheet over time.  My guess is that the Fed will simply let the securities on its balance sheet mature which will reduce the balance sheet naturally over the course of time.  So the Fed can stop QE at any time and raise interest rates which will tighten monetary policy.  And if it really wanted to tighten policy it could kick QE in reverse and raise interest rates.  But it doesn’t have to do that to tighten policy.  Raising interest on reserves will tighten policy sufficiently when the time comes.  And it will do so simply by raising the rate paid on reserves.

FRED on “Spurious Correlations”

This is pretty funny.  From the St Louis Fed.  No comment necessary:

“Relationships between macroeconomic time series are not usually straightforward enough to establish with a simple graph. The problem is that almost all time series tend to grow in the long term as an economy grows. So, any measure in nominal terms will grow even more, since inflation rates are almost always positive. Because time series can exhibit a common trend, it becomes difficult to interpret whether there is a relationship between them beyond that common trend. We call this spurious correlation. There are various ways one can isolate the common trend, and we show some here using M2 and total federal debt. Above, with just the raw series, all we can see is that they both tend to increase in the long run at roughly the same rates.”


They go on to show how such a chart can be manipulated intentionally to create the appearance of a correlation where there is none.  It’s a clever, funny and totally accurate post.  Go have a read.


Q&A Answers – Part Deux

Here are the rest of the answers to last week’s Q&A.  I hope you find it helpful.

jmacdon says:

Eddie Elfenbein had a recent post about a model for the price of gold, based partly on Gibson’s paradox.

What I don’t understand is why anybody would think there is a paradox. It seems to me that the interest rate should be highly correlated to the price level, not inversely correlated. In other words, even under a gold standard, money is only useful to get stuff.

So if I lend someone money and we are in a deflationary or disinflationary regime, I would think the interest rate would be low (because the money I get back later is presumably going to buy me more stuff, so I don’t need a high interest rate). And the converse would be true as well; If prices are rising, I would want a higher interest rate because the money I get back later will buy less stuff. So I want to ensure I get sufficient ‘stuff buying power’ returned over time.

Am I missing something here?

CR:  Gibson’s Paradox is the theory that gold prices are inversely correlated to real interest rates.  In other words, gold prices will be bid up in times of negative real interest rates based on the assumption that this is likely to be an inflationary environment.  As you’re getting at, the relationship there obviously doesn’t seem grounded entirely in reality so yes, I think you’re right to question whether there is a paradox at all here.  In general, I think it’s more useful to analyze the macroeconomy using a framework of realistic understandings and then applying that framework to the capital structure and the utility of various assets when considering an asset allocation strategy.  So I find this sort of research interesting, but I like to rely on more empirically grounded facts than this sort of theoretical stuff….

Jamie says:

Some related questions on bonds/QE from a non-finance reader. Sorry for the number of questions but they seem to follow from each other.

I understand that the Fed doesn’t require the Treasury to pay interest on the bonds it owns (or returns the interest after it is paid)? Is that correct? What is it that makes a bond a bond if it’s not the payment of interest?

What happens when bonds owned by the Fed mature? (Has this happened already)? Does the Treasury issue new bonds to the market to pay the Fed for the maturing bonds? Does the Fed then buy these new bonds on the market? That seems a bit circular.

Could the Fed and the Treasury just agree to write off the bonds owned by the Fed when they mature (or before they mature) to avoid the money-go-round of the previous paragraph?

Do you think that QE will be unwound? If so, approximately when and how? If QE stimulates the economy then does unwinding QE do the reverse? Would there be any long term consequences if QE were never unwound?

Do you think that anyone thought through the unwinding of QE before starting out on the QE regime, or are the rules being set as we go along?

CR:  The Fed remits interest after expenses to the US Treasury at the end of each year.

When bonds mature they are wiped off the slate and the balance sheet naturally declines in size.  And since the Treasury has been running constant budget deficits while QE has been going on the Fed has been a net buyer of bonds.

I don’t think QE will be unwound.  There’s no need.  With the Fed paying interest on reserves the Fed can raise rates without unwinding QE.

Yes, the Fed thought this through and one of the main reasons for paying interest on reserves was specifically to avoid the unwind scenario.

CR:  econonymous asked why I deal with difficult readers.  Well, most of you are pretty awesome and I find the community here to be pretty fantastic in general.  The internet can be a pretty awful place and I think Pragcap is generally pretty good.  So I don’t mind having to deal with an inevitable difficult every once in a while.  It comes with the territory and frankly, I deserve a hard time every once in a while.

Dinero says:

Any comment on the effects of the ECB reserves policy after one month the policy

CR:  I don’t think the policy is really significant enough to make a noticeable impact on anything.  I’ll try to reach out to some European bank contacts and see if they’re seeing anything, but I haven’t heard anything yet which makes me think it’s not really having much of an impact.

JWG says:

How are your book sales doing?

CR:  Good question.  For a book about macroeconomics I am pretty pleased so far.  It’s a timeless book so I will judge it in 5 years, not 5 weeks.  I mean let’s be honest – it’s not like I wrote a real attention grabber, a political grabber like Piketty or a get rich quick book….So my expectations are pretty low and in my opinion, realistic.  I really wanted to write something that would help people construct a general framework for understanding the financial world.  It’s not a sexy book, but I think it’s useful in ways that many of the sexy books aren’t so hopefully people see it the same way at time goes on.

Bob says:

If there had never been QE in the U.S. where would long (10 and 30) treasury rates be? Higher or lower?

Is the Fed the marginal buyer or is it the base load? Does it matter which one it is?

Assuming the marginal buyer thesis, if everyone knows the Fed is leaving the market, who would lock in a known loss from current levels?

Perhaps the dynamics are different at the short end, but why should the end of QE lead to higher long rates?

CR:  That is a great question. I’ve thought about that a lot.  I’ve even done a good bit of research on that.  The core CPI and long bond have converged over the last 20 years as inflation has declined.  The spread between core CPI and the 10 year note is about 60 bps today.  That’s much lower than the 20 year average of 180 bps.  So I think QE has reduced long rates at least some amount.  It’s impossible to say how much, but I think there’s definitely some QE premium in the price of bonds.

I personally don’t think it mattters if the Fed is the marginal buyer or not.  I have no doubt that demand for T-bonds would be very high with or without QE.

The end of QE might actually lead to lower rates.  After all, if investors think it’s been stimulative then the reduction in the stimulus means the economy will be weaker in the future which means inflation should be lower….The “QE = higher rates” thesis isn’t thought through very well by those who make the argument….

Bik says:

Hi there,

It is reported that with a $25 trillion, and counting, banking sector which is more than the US + EU banking sector for an economy 1/3 of the combined size, China’s corporate sector is becoming dangerously addicted to debt.

If you add that during the last financial crisis in the 90′s in China, the rate of non performing loans shot up to 20%, another one of those would wipe out the much-vaunted $3.5 Trillion of currency reserves the country holds.

We are talking about real liabilities here in form of loans, not a balance sheet expansion à la QE.

My question : are we in for some rough times in the Middle Kingdom (not a rhetorical question) ?!

CR:  I am extremely skeptical of data in China.  I’ve been reading about the coming China collapse for 10 years.  And I read so much contradictory data that I just don’t have a good answer here.  Sorry.

Stoopidos says:

How do you take your coffee ? Cream ? Sugar ? Both ? Black ?
Need to know.

CR:  I use an espresso maker with half and half and Stevia.  That sounds really weird and pretentious as I write it, but I am really weird about my coffee….

tealeaves says:

Sometimes the talking heads on TV will say that junk bonds are expensive now but emerging markets debt or treasuries are cheap. How does one “measure” the value of bonds to see if they are full of it or onto something.

CR:  They are generally referring to the low spread between t-bonds and HY bonds.  I believe the spread has never been lower which tells us that bond buyers think HY bonds are very safe relative to US T-bonds.  There’s good reason for skepticism about this view…..

Boomer says:

OK, try these two!

What kind of a dog is Callie and how old is she/he?

Who’s Erica?

Told you, now don’ t chicken out.

CR: Callie (I call her Cal) is a rescue dog from Los Angeles.  Some jerk dumped her at a kill shelter.  They took THIS (see picture) and took her to a kill shelter.  Anyhow, I actually don’t know what she is.  She looks and acts like a border collie and Australian Shepherd.  The vet guessed Aussie, but we aren’t sure.  She’s about 2.5 years old.

Erica’s my fiance.  We met at Georgetown way back in another decade and I was whipped from the start.


Sheila says:

On the potential transmission of QE liquidity to consumer inflation: QE intentionally inflates asset prices – that is explicitly part of the transmission mechanism for QE to influence broader economic growth. My question is this; what is the dividing line between markets for assets and for inputs to the production of consumption goods – clearly there is none, there is only a low elasticity of substitution between financial assets and consumer goods for those who have the liquidity to invest. Given the unprecedented scale of QE – not only here, but in Japan, UK – how can it be clear that this liquidity will not ultimately drive up the prices of inputs to production, resulting in cost-push inflation for consumer goods. This has happened only to a limited extent so far (housing), but it seems conceivable that this is a process that could accelerate even if aggregate demand remains subdued.

CR:  I don’t really see a powerful connection between QE and cost inputs.  QE reduces the cost of investment by reducing interest rates, but also increases the amount of deposits within the economy.  But the problem there is that the operation is an asset swap in effect so while it increases “money” it doesn’t increase net financial assets.  From there, I think the only real inflationary side effect is through channels like the wealth effect where we rely on the capital gains of certain asset classes to drive spending.  I don’t doubt that there’s a connection there to some extent, but I generally think the inflationary side effects of QE in a normalized market environment like today are vastly overstated by many analysts.  I just don’t think there’s a strong direct transmission mechanism.  All of the transmission mechanisms are weak and multi-faceted.