Here are the rest of the answers to last week’s Q&A. I hope you find it helpful.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
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….
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.
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.
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.
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….
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.
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….
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…..
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.
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.