The Swiss choose inflation, but the Chinese do not?

The Swiss central bank recently announced it would print any amount of francs required to maintain a peg of 1.20 Swiss francs to one euro.  The response was... massive

Euro / Swiss Franc

A multi percent move in currency markets is exceedingly rare. I'm not going to spill many electrons going over why the Swiss decided it was time to fix their currency as it has been a hot topic over the last 48 hours.  The WSJ and Economist have already written about it at length.  

So why bring up the topic? Because the Chinese have been doing it for years and the dots need to be connected.  I recently commented on the threat of China 'dumping' US Treasuries and how this was not the problem everyone thought it would be.

In both the Swiss and Chinese case you have a country forcibly keeping their currency away from the market clearing price for differing reasons; the Swiss exporters are getting killed while the Chinese desire to keep their workshops fully staffed by forcibly underpricing their currency.

Whatever the reason the result will be the same -- an explosion of  domestic currency and loan demand eventually forcing up demand and inflation.  The WSJ's title on the Franc peg is The Swiss Choose Inflation  Why does one not think the same will happen in China? Chovanec has highlighted the constant struggle to contain inflation in China from both a massive increase in lending and an artificially underpriced currency. 

In both cases the Swiss Franc and the Chinese Yuan will eventually find their market clearing prices regardless of central bank manipulation, either by currency price appreciation or by domestic inflation.

edit: FT links China and Switzerland as well:
http://ftalphaville.ft.com/blog/2011/09/07/671121/what-will-switzerland-do-with-all-those-euros/

Time to refinance your home (again?)

One year ago I stated it would be a good time to refinance your home.  Once again the opportunity presents itself. The 30 year conventional home loan rate is near historic lows.

Conventional 30 year home loan rates

Theoretically the vast majority of home loans out there could be refinanced but there are a few unfortunate facts which may prevent many from refinancing: Negative equity, conservative valuations and high unemployment.  

CNN Money has a good article detailing the these 3 challenges.  

If you are wondering how monetary policy can have limits this is a good example of how and why.  In an effort to continually re-stimulated the economy and encourage society to take on more debt over time we have reached a point where historic low interest rates will just not do much for the US consumer. They are already too tapped out and low interest rates will not encourage them to borrow more let alone take advantage of the lower interest rates and buy a home; they just can't.  People 'trapped' in their homes due to negative equity also hinders future home sales as it inhibits consumers from being able to move or trade up.

Consumer home debt / GDP

The ratio of consumer mortgage debt to gdp (both nominal) was at data series highs at the beginning of the great financial crisis. Yes I know I'm comparing home debt to national GDP and not home prices but it's yet another reminder of how much debt our society has taken on.

If you are in the position to refinance and have questions give me a ring and we can talk about some of the options / pitfalls when looking for a new mortgage.

Thanks: David Merkel

The flogging will continue until morale improves

The Federal Reserve recently announced they will purchase another 600 Billion in US Treasury bonds (commonly called Quantitative Easing 2 or QE2)  I am working on a longer email regarding how our current financial situation is very different from previous recessions and recoveries but the Federal Reserve's QE 2 announcement deserved some commentary. 

The markets did not really respond until after reading Fed Chairman Ben Bernanke's article in the Washington Post on November 4:

For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.

In short Fed Chairman Ben Bernanke wants higher stock prices so you'll feel better about yourself and go buy more stuff.  
Will it work?  
I have my serious doubts (as I'll expand upon in later emails).   The banks already have so much unused money they deposit the excess at the Federal Reserve. (973 billion as of October 10)  How is another 600 billion going to change the situation? 

So why is the Fed printing? Because they can and they feel like they can't do anything else. It looks like an easy painless solution but in the long term it will not fix the problem of too much debt in America. 

The problem with QE2 is the money being created is not going where Mr. Bernanke would like it to, the real US economy.  If you look at the market's reaction before and after the announcement one sees the money shifting into commodities and emerging economies while simultaneously weakening the US dollar.   The Fed is taking the easy way out by attempting to prop up and paper over our structural problems.

Lest you think this is merely the ranting of a crazed financial advisor former Federal Reserve Chairman Paul Volcker stated the QE2 plan won't help much as well: (Yahoo, November 5, 2010)

Volcker told a business audience in Seoul that the Fed's bond plan is obviously an attempt to spur the U.S. economy but "is not the kind of action that's likely to change the general picture that I've described as slow and labored recovery over a period of time."

The Wall Street Journal (November 4, 2010) expresses caution as well:

The Fed is essentially lending enough money to the government to fund its operations for several months, something called "monetizing the debt."

In normal times, this is one of the great taboos of central banking because it is seen as a step toward spiraling inflation and because it risks encouraging reckless government spending.

Financial markets Thursday responded warmly to the Fed move, but outspoken critics of the policy issued full-throated critiques.

"It is doubtful the Fed decision will produce any results," Brazilian Finance Minister Guido Mantega told reporters following a cabinet meeting with Brazilian President Luiz Inacio Lula da Silva. Officials in Brazil, which averaged 850% annual inflation in the 1990s, have been critical of the Fed's easy-money policies because they are spurring price pressures abroad and could encourage new asset bubbles outside the U.S.

If all else fails, keep doing what you did before seems to be the rule at the Federal Reserve.  By his actions Ben Bernanke is attempting to artificially raise asset prices and reduce the value of the dollar.  We shall see if he is sucessful, but what happens when the crutch of QE money is removed? 

The Fed is exacerbating the move in bonds

The recent Federal Reserve August 10 announcement to reinvest principal paydowns from its very large  (1+ Trillion) mortgage backed security portfolio into longer dated US Treasury securities is providing additional downward pressure on home loan rates.

Because interest rates have dropped since the completion of purchases,  (March 31,2010: Federal Reserve MBS Faq)  the frequency of individual homeowners refinancing has gone up. As such cash flows back to the Federal Reserve have increase to a rate higher than initially expected.

If you look at the first chart attached you can see 10 year bond prices were already marching higher before the Federal Reserve reinvestment announcement of August 10. (Shown here as a white vertical line)  Since then they have continued higher.

These principal payments are being invested in longer term Treasury Bonds which then pressures long term interest rates down, causing more refinancings, causing more cash to be sent to the Fed which then buys more Treasury bonds.  Do you see the pattern here?  This does not mean long bond yields WILL drop, but it places additional pressure for them to go down until the current refinancing burst (Paper Economy) ends.

I wonder if the Fed thought this all through?

A word about the change in Fed policy today

Today the Federal Reserve altered their policy regarding principal payments on their Mortgage Backed Security holdings.

From the press release:

To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. The Committee will continue to roll over the Federal Reserve's holdings of Treasury securities as they mature.

The stock market immediately moved upwards from the news, reducing the losses for the day.  The ten year treasury bond shot upwards in value.

A few comments regarding the change in policy:

Before the announcement the Fed intended allowing MBS principal paydowns to slowly reduce the Fed's balance sheet over time which would have reduced the quantity of narrow money in the economy.  With this news the the Fed's balance sheet will remain the same size (for now) but the composition will change from GSE backed assets to Treasury bonds and bills.

If the Fed had allowed the MBS paydowns to shrink their balance sheet the narrow and broader money supplies would have shrunk as well.  As you can see from this chart the M2 gauge of money supply has been very sluggish of late and shrinking the Fed balance sheet at this time would have slowed M2 growth even further.

This measure is not stimulative, no more money is going to be injected into the system.

If the economy was on the mend why did the Fed alter their strategy of slowly removing this stimulus?

Is a steep yield curve leading us astray?

Does a steep yield curve guarantee future economic growth?  Usually but maybe not this time.

A recent article on BusinessInsider got me thinking about the yield curve and its power to predict when a recession is NOT likely. 

The article title and copy was interesting:  Unless 'This Time It's Different', There's Now Zero Chance Of A U.S. Double Dip

Substantial research suggests that the difference between interest rates for 10-year and 3-month U.S. treasuries is a reliable leading indicator for the U.S. economy, so much so that the New York Federal Reserve even creates charts using this metric, boldly titled "Probability of a U.S. Recession".
Let's hope the science holds, since according to the New York Fed's latest chart there's almost zero chance of a U.S. recession now. In April, the treasury-spread-based probability of recession collapsed to 0.04%.
We're not going to claim we're completely sold on this metric, but have to concede that historically it has worked and it's also hard to imagine why the U.S. would fall back into recession in the near-term given the rebound already in place. Things would have to start deteriorating first, and we haven't seen that yet. Should this time be different? That's not a rhetorical question. You can read the New York Fed's justification for this metric here and decide for yourself.

Here's the chart produced by the NY Fed as of June 21, 2010 which BusinessInsider refers to. As you can see it is saying there's effectively NO chance of a recession anytime soon. 

This relationship is considered so solid the yield curve is part of the leading economic indicators published by the Conference Board where the yield curve is 10% of the LEI index.

Even Krugman of the NYT has commented on how a steep curve implies positive future growth.

Now, this spread could be fairly small if people expected the economy to remain in the dumps for a long time; see Japan. What the large spread now tells us is that the US economy is in the dumps now, but that investors see a reasonably good chance of a strong recovery in the not-too-distant future. That’s good news, not bad news.

Both the Fed and Pimco have web sections devoted to discussing the yield curve and its predictive powers.

Substantial research from the Federal Reserve on the yield curve shows it is a good predictor of future economic growth.
From Federal Reserve: July/August 2006 - Current Issues:

Conceptual Considerations
The literature on the use of the yield curve to predict recessions has been predominantly empirical, documenting correlations rather than building theories to explain such correlations. This focus on the empirical may have created the unfortunate impression that no good explanation for the relationship exists—in other words, that the relationship is a fluke. In fact, there is no shortage of reasonable explanations, many of which date back to the early literature on this topic and have now been extended in various directions. For the most part, these explanations are mutually compatible and, viewed in their totality, suggest that the relationships between the yield curve and recessions are likely to be very robust indeed. We give two examples that emphasize monetary policy and investor expectations, respectively. . . .

Here's the important part . . .

A rise in short-term interest rates induced by monetary policy could be expected to lead to a future slowdown in real economic activity and demand for credit, putting downward pressure on future real interest rates.

So an inverted yield curve chokes lending which then slows economic growth.  Conversly a steep yield curve induces lending which stimulates economic growth.  Lets look at some data provided by the Federal Reserve from 1974 onward comparing yield curves and recessions.  As you can see there is a strong relationship between the two. In all cases an inverted curve preceeded or coincided with recessions as shown by the gray recession bars. Furthermore no recessions occurred without a yield curve inversion (or nearly so) happening beforehand.  Also note how steep the yield curve is now as compared to recent history.  Rarely has the curve exceed 4%

It's no wonder the steep yield curve is considered such a reliable indicator.

Let's take it one step further and look at the relationship between a steep yield curve and economic activity through the mechanism of lending growth. This graphic adds bank loans and leases at commercial banks.  Looking at the graphs you can see in each case an inverted yield curve resulted in a recession and a slowdown in lending.  Once the yield curve returned to 'normal' with higher long term rates bank lending resumed growing and the country exited a recession  . . . except this time. Bank lending continues to decline which is exceptional.  (Before you get excited about what appears to be a sudden spike in the rate of lending you should know that is due to off balance sheet lending vehicles being brought back onto bank balance sheets.  Annaly's blog has the details.) 

Annaly's recent blog post on debt and GDP growth reinforces the previous picture.  Real credit market growth is strongly linked to real GDP growth. 

My contention is the steep yield curve is no longer an accurate predictor of future economic growth due to the lack of credit growth.

Has there been another time when a steep yield curve has led us astray?  Yes.  Robert Shiller provides some excellent long term historical data going back to the 19th century.  Let us examine some data from 1928 through World War II. While the data fields are not precisely similar they are close enough to provide analogs to modern data sets on this topic. 

Here the difference between 1year and 10 year rates is shown as compared to real earnings on the Standard and Poors equity index. 

While this does not show lending activity it does show what one would hope results from increased lending namely earnings growth.

Some interesting relationships can be observed:

The yield curve was very inverted in 1929 and returned to a 'normal' curve in 1930. Earnings did rebound from their lows but did not exceed their 1929 peak until after World War II.

More importantly a serious fall in earnings in 1937 coincided with a non-inverted yield curve.

The rarely mentioned mechanism (credit growth) between a steep yield curve and economic growth is not working.  It is my contention until credit growth at least stops falling the steep yield curve rule of thumb should be ignored and one should be concerned with very tepid (if at all) real GDP growth.

If my thesis is correct and this rule is broken it could come to quite a shock to those who consider it dogma. Considering the yield curve is part of the Leading Economic Indicators from the Conference Board it may well be used by many in portfolio allocation decisions.   If you hear in the future how the steep yield curve is showing how we can't go into a recession remember the yield curve alone does not create economic growth but creates the opportunity for increased credit growth which then causes economic growth.

This Time It's Different.

Sources:

Federal Reserve FRED data
Federal Reserve section on steep yield curve

Robert Shiller

edit 01/28/11: As has been pointed out to me in other conversations Japan has had a few recessions over the last 15-20 years while their yield curve has not been inverted.

Well that was exciting. What's next?

I'm certain you already know by now but the markets took a serious hammering today.  While some are claiming a trade error took us down nearly 1000 points on the Dow before recovering the proximal causes of this recent selloff are still with us:

Greece is on a slow downward spiral towards default or a very severe recession / depression.  After the most recent bailout announcement the markets calmed down for one day before continuing to de-risk.  The contagion has spread and now Spain, Portugal and Italy are possibly next.  Who and when is next I don't know.

China continues tightening and is determined to stamp out rising property prices.  I have some more information that I intended to post on this but I've been a bit busy.  Fortunately I was finishing up de-risking a few portfolios yesterday.

The Fed's purchase of mortgage backed securities ended March 31 so from now on the money supply will start to contract.  The Fed is effectively tightening right now.

The home buyer tax credit deadline ended a few days ago so the housing bounce is over with.

Bank lending continues to contract for both households and small companies.

I've gone over these items before but the Greek situation started the ball rolling downhill.  Until several of the above items are resolved what happened today was not a 'one time event'.

"Fear the Boom and Bust" a Hayek vs. Keynes Rap Anthem -- Economists in a modern world

This has been making the rounds and is actually pretty funny... :)




Hippity Hop and Economics; you see them together all the time, right? :)

ht: zerohedge