Monday, February 4, 2008

The Fear Factor

Yields for two year (blue line) and ten year (green line) Treasury securities have plummeted in recent weeks and today stand at 2.07% and 3.59% respectively (see chart below, click to enlarge). These levels were last visited in 2002, when Fed funds (red line) were already at 1.75% and on their way to 1%, a real rate so negative that it generated the largest, most participated-in capital misallocation in the history of finance: the US real estate bubble.

Chart: St. Louis Fed

The economy has come full circle: the popping of the housing bubble brought us back to where we started six years ago. Nothing was really accomplished in the intervening years, except the creation of another wealth-devouring black hole. In 2000 it was dotcoms and telecoms, today it is millions of homes sitting unsold or in various stages of repossession. And there is no better proof of deflated excess past, than Microsoft's current $45 billion takeover bid for Yahoo, which in early 2000 was worth over $160 billion.

So, are we now paving the way for the creation of yet another debt-financed asset bubble? Is this what today's low interest rates are predicating? Perhaps, but I don't think so.

For one, I don't see the assets that can be pumped up. Commodity ownership is so narrowly concentrated that the wealth effect can't be dispersed into the wider economy. Dubai, Calgary and Perth may be doing fabulously well, but they are mere droplets in the global bucket. Higher material prices also feed the goods-inflation monster at a time when consumers have limited spending power. What higher commodity prices give to the Arabs, Canadians and Australians they take away from the Americans, Europeans and Chinese. It's a win-lose game and as producers and speculators get too greedy, it will end up lose-lose because income and savings constricted consumers will necessarily clamp down on their spending.

Instead, I think low interest rates for Treasurys reflect fear, specifically fear of a deflationary spiral in credit and asset prices. How else to explain the now negative spread between the yield on 10-year Treasurys (green line) and CPI inflation (red line, see chart below) ?

Chart: St. Louis Fed

Negative real 10-year Treasury rates are extremely rare. Perhaps they are telling us something else about fear, too - or, rather, the same thing expressed in a different way: that after many years of positive returns, borrowers now can't put the money to profitable use generating returns significantly above inflation, so demand for credit is evaporating. This includes all long-term asset buyers who finance their purchases with debt, from businesses investing in plant and equipment or buying back stock, to people buying homes.

Therefore fear, or risk aversion as it is properly called in finance, comes in two versions: the first one is fear of lending, which results in tighter credit conditions by banks and other lenders. It comes and goes with the regular business cycle and, in the greater scheme of things, is not uncommon. The second one is fear of borrowing and it is very uncommon; I believe the only instances we have experienced in modern times are the Great Depression and Japan. If both of them ever come together, we may get a "perfect storm" where credit expansion goes to zero, or even turns negative.

It is hard to imagine that a situation would ever arise where lenders are unwilling to lend and borrowers unwilling to borrow, at the same time. The main reason is that usually those two classes are separate and have different interests. They are brought together by professional intermediaries, i.e. bankers who profit from matching the two in an appropriate fashion that benefits everyone. Yet...

I won't elaborate further, but I have the sneaking suspicion that the shadow banking system of originating, securitizing and widely distributing debt (chop and shop?) has turned those two classes into one super-class that may very well obey Polonius's maxim: "Neither a borrower nor a lender be".

_____________________________________
P.S. Breaking news from Reuters:

Bush's $3.1 trillion budget proposal would nearly freeze domestic spending in fiscal 2009.

This is exactly unwillingness to borrow, writ as large as can be.

40 comments:

operput said...

pretty dim

eh said...

At the moment, the equities markets are showing what I would call a lot of relative strength, i.e. meaning in relation to the seriousness of the problems described on this fine blog of yours (and many others). Or whatever "fear" there was earlier this year seems to have largely disappeared. So it is hard to put together a coherent picture of what might be going on.

Maybe it's a case of too little demand for credit at the offered rate, and this is what the Fed's rate cuts are designed to do something about. But this does not seem like a good explanation because rates were not that high by historical standards.

But without credit-driven investment, and without a robust consumer, how will growth continue at a pace fast enough to justify rising equity prices? And (as you ask) how will high asset prices ('the wealth effect') be maintained?

eh said...

I found this story interesting:

Bernanke Makes Bulls From Dollar Bears Seeing Growth

Ben S. Bernanke's decision to lower interest rates 1.25 percentage points last month will end the dollar's two-year slide, according to the world's biggest currency traders..."We're not chasing dollar weakness any lower," said Robert Robis, a fixed-income manager in New York at OppenheimerFunds Inc., which oversees $260 billion. "The Fed's actions have avoided a long recession and we may start to see a recovery later this year."

So this article basically largely contradicts conventional wisdom that low US rates mean a weak/falling dollar.

Hellasious said...

Yes, I read the article too..

Essentially, this is the "updated" Goldilocks scenario, in which the US economy suffers only a little and then quickly rebounds to new strength due to the massive rate-cut vitamin shots.

To this I say ... look at the Treasury yield curve.

3m 2.10
2y 2.20
5y 2.77
10y 3.60
30y 4.33

As I read it, this predicts at least 1-2 years of recession/very slow growth, followed by sub-par growth.

Regards,

H.

Mane The Mean said...

And by the way: whatever growth continues, it better consume less non-renewable raw materials.

A recession of current type of growth is a good thing.

Anonymous said...

This situation clearly refutes laissez-faire capitalism and trickle down economics as unsuccessful. Anyone who understands how money is created by borrowing into existence will know that while the rich get the money, the poor get the debt. Combine that with deregulation and a housing bubble, and you get disaster. I can't imagine that all this is an unintended consequence. Clearly the PhD s in economics that are policy makers could see all this happening and knew the outcome on principles. It fuels conspiracy theories in my head.

The only non-malevolent scenario I can think of is this analogy: parasites (bankers, lenders, securitizers, etc) don't want to kill the host (us regular folks, the sheeple) just suck their livelihood off it. But when the parasites sense the host is ill, they start sucking furiously to get as much as they can before the host dies. Mass self-intrest

Jason B

Anonymous said...

Ding, ding, ding, we have a winner!!

Edwardo said...

Regarding, "The Fear Factor", that was a profound if harrowing bit of blogging, sir.

eh, wrote,

"At the moment, the equities markets are showing what I would call a lot of relative strength..."


The key words there are "at the moment" It won't last long. As for the Fed's rate cuts, they follow the market, they don't set the market. And you have answered your own question by suggesting earnings won't be there to justify rising prices. They will not.

Lastly on the dollar, long term structural weakness is baked into the cake, but as the rest of the world
wakes up to the ongoing recession, and a long one will not be avoided, they will start cutting and competitive currency devaluations will occur. In that environment the dollar maintains itself or experiences relative strength...for a spell.

Ben Bittrolff said...

I've updated my post and charts: Fed CHANGES Really Scary Fed Charts

Removing TAF makes a significant difference.

$50 billion to be exact.

TAF operations are ongoing. So this discrepancy would just continue to grow.

LIBOR is also starting to misbehave, again. Nothing too serious yet (not like before Christmas) but you get my drift. Stress is creepying back into the system.

The (counter trend) rally in risky assets should just about be over, if I've interpreted this correctly.

TheFinancialNinja

John East said...

A poster above states, "This situation clearly refutes laissez-faire capitalism..."

Wrong.

Laissez faire literally means "let it happen", i.e. markets freely operating with no government interference or corruption.

I would respectfully suggest that we are nowhere near achieving such a state of affairs. Furthermore, the "solution" - more interference - will take us even further away from a laissez faire economy.

OkieLawyer said...

Yesterday I e-mailed Jerome a Paris regarding his new thesis, Anglo Disease. Basically, I told him that because currently large retail stores are making their money from finance (high-interest credit cards and the fees assessed on them) and not on the products themselves, that this has created a mispricing of products just as risk has been mispriced.

As a result, once retailers start to realize that consumers will not be willing to borrow, they will start to raise prices to recoup profits that they expect. This will create inflationary pressures after an initial deflationary spiral as retailers attempt to get rid of their inventory.

But you are right about people's unwillingness to borrow. I am using my income to pay off debt as fast as I can and I talked to an attorney back home who says he is using all of his income to pay off debt as well. These examples are merely anecdotal; but I think there is a pattern to all of this.

The 2005 BAPCPA law was designed to be punitive to borrowers. Well, this is the natural consequence of that policy. On top of the housing bubble bust and credit cards being able to raise interest rates to 30% at will, you have a lot of working class people borrowing from payday lenders at up to 1200% interest (you read that right: 100% per month in some places) because they cannot meet all of their monthly bills. (And, one of the policies not discussed much is the fact that many "monthly" bills are actually set up on a 25-day billing cycle so that the due date moves up slowly each month.)

Anonymous said...

Since our economy has been driven by a combination of cheap energy, speculation and military spending its hard to imagine any light bulbs going off within the political leadership beyond stimulus proposals for economic growth. Speculation and cheap energy is quickly being taken off the table,one has to wonder how much more military spending can be generated and payed for by foreign nations before the whole deck of cards falls.

OkieLawyer said...

Re: The new budget

The reports I read said that it proposed increasing spending while cutting more taxes -- increasing the deficit to $410 billion dollars. And, this proposed budget does not include the spending on the Iraq War. What was that you were saying about not willing to borrow writ large?

damocles said...

OkieLaweyer,

I have noticed a similar trend. I don't know how many people have quietly told me, "I'm just glad I don't have any debt" or "I'm just glad the only debt I have is the house and I should be able to pay that off soon," over the the past few months. It's been quite a few. They all mention it very quietly after a longer discussion of the economy. What strikes me is that it's usually revealed with the air of a deep dark secret -- like, "don't tell anybody, but I'm that freak who's not in debt."

Spyware said...

Hellasious says:
“For one, I don't see the assets that can be pumped up. Commodity ownership is so narrowly concentrated that the wealth effect can't be dispersed into the wider economy. Dubai, Calgary and Perth may be doing fabulously well, but they are mere droplets in the global bucket. Higher material prices also feed the goods-inflation monster at a time when consumers have limited spending power. What higher commodity prices give to the Arabs, Canadians and Australians they take away from the Americans, Europeans and Chinese. It's a win-lose game and as producers and speculators get too greedy, it will end up lose-lose because income and savings constricted consumers will necessarily clamp down on their spending.”

For one, I would like to see more serious and informed comment upon this issue(s) in these pages, i.e. with the commodity economies of Dubai, Canada and Australia. There is an almost obscene provincial obsession with the U.S. economy: Bernanke, Bernanke, Bernanke (not to mention “the Fed”) ad nauseam to the virtual exclusion of the rest of the world. I have considerable financial interests in Australia, largely in real estate holdings, and the direction I see the Australian economy heading: flat out inflation and spend, spend, spend frankly scares hell out of me. It is as if the residents of Down Under are as unaware of the financial collapse presently taking place in the U.S. and Europe (largely led by the U.K.) as the citizens of the U.S. are of them!

When, how and why’s it all going to unravel in Oz with panic house selling together with all the SUV’s and power boats sitting out front with “For Sale” signs on them I’d like to know (or at least read some informed opinion thereon). Perth is presently a profligate, gold rush tinsel town, no question about it. At no point is it touching on the reality of the greater world economy. Australians, as usual, sleepwalking their way into the 21st Century.

Common—let’s have a broader perspective chaps. I’m sure you can do better than sit on your haunches in Podunk Junction pouring scorn on the efforts of the Fed and the hapless Mr.Bernanke. Well, can you?

Bradhart said...

Okielawyer, there is a flipside to that coin. Companies expand capicity to meet current demand, that demand has been inflated by artificially cheap credit. Less credit = less demand. Housing and autos are a preview of what happens once credit contracts, prices have fallen. It does not matter if a business wants to raise prices if they have no customers at those prices.

Hellasious said...

Dear spyware,

Let me give it to you straight... when the US sneezes the rest of the world dies of pneumonia. And no matter what they say about "decoupling", I think this is more true today than at any other time in the history of mankind.

This is not parochialism. In fact, it is the rest of the world that has gone out of its way to become more Americanized, from adopting economic paradigms, to cultural integration along the Hollywood lines.

Since you want to talk about Aussie: Walk into ANY cinema multiplex in the world. You might as well be in Paramus, NJ. It's not just that the movies are the same; the popcorn, the soda fountain, the popcorn, the design abd decoration, the herding mentality...

All brought to you by the masters at Village Roadshow, who "successfully" copied and globalized the US movie model..

Best,
H.

Brian Woods said...

H.

Thanks for putting up the Kuhn recommendation.

Brian P

Anonymous said...

U.S. = Largest of world economy
Australia = #15

Maybe that's why

wkwillis said...

test

wkwillis said...

Australia's baby boom lasted years longer than the American one. Their immigration numbers are also lots higher per capita. Perhaps this means that their boom will also last years longer than ours.

OkieLawyer said...

OT:

Christian Science Monitor: Feds Main Task: Save the Banks

San Francisco Chronicle: Stimulus Plan A Scam to Benefit the Rich

Jesse said...

"Bush's $3.1 trillion budget proposal would nearly freeze domestic spending in fiscal 2009.
This is exactly unwillingness to borrow, writ as large as can be."

No, since the budget still is deeply in the red despite the usual DC antics. It is not an unwillingness to borrow, which it does. It is a priority that says the military industrial complex gets the lion's share while education and social programs get capped and cut back.

Anonymous said...

The plot thickens.

This analyst believes the banks may be out of reserves. http://market-ticker.denninger.net/

Are we to seriously believe that panic is not around the corner?

Have we learned nothing from the Bear Sterns, and other funds, concerning redemptions or, more importantly, the lack thereof?

Do people honestly believe they will be treated fairly should the worst occur?

I used to worry about accumulating wealth but now I am kind of glad I don't have millions of dollars worth of wealth. Honestly, I think it would be the opposite of the old saying, "Better to have lost at love than to never have loved at all."

In other words, it is going to be hell going from riches to rags.

artichoke said...

@jesse: The US government should be funding massive public works projects now. In the 1930 it was the WPA. Now it could be ... the WCA. (I don't know what it would stand for, maybe "Works Construction Agency", but in the 1930's we had the HOLC, now there's a proposal in Congress for the HOPC (Homeowners Protection Corporation), so the acronyms "match". ;)

The fact that we are not starting a massive program to employ people rebuilding bridges, reclaiming rail lines, and doing other infrastructure work -- desperately needed upgrades anyway -- means the government is unwilling to spend a reasonable amount in the current circumstances.

Thai McGreivy said...

Jesse said... "It is a priority that says the military industrial complex gets the lion's share while education and social programs get capped and cut back".

Please get your facts checked, this is simply not true.

I did not vote for Bush, nor have I ever been fond of his presidency, but even Krugman
would tell you to call a spade a spade.

The real philosophical issue is who pays for increases in spending. But make no mistake, social spending is up more than military spending under Bush both in absolute $ and as an increasing % of GDP.

You can visually view the US budget for yourself at Death and Taxes

As for monetary contraction, Krugman basically agreed with Hell today as well.


Hell, I asked you about metals the other day, I was wondering if you saw this, and if so what you thought?

Thanks

Thai

artichoke said...

Oops it shoulda been WLA not WCA. What would WLA stand for? Welfare Labor Act?

Juan said...

>What higher commodity prices give to the Arabs, Canadians and Australians they take away from the Americans, Europeans and Chinese. It's a win-lose game and as producers and speculators get too greedy, it will end up lose-lose because income and savings constricted consumers will necessarily clamp down on their spending.”<

Higher commodity prices have dramatically increased surpluses in most commodity export economies, especially the oil exporting nations.
Some portion has been invested domestically but a large portion has, over the years, refluxed into Treasuries and Agencies. At one level, this might be seen as a 'win-win', but a far different situation at the level of the avg. consumer who has - no matter long-run real wage stagnation - been paying for this transfer and is becoming progressively less able to do so.

Soon enough large commodity traders will begin to grasp the world economy's actual forward trajectory and what was noted in Jan '06 by the Sydney branch of a well known global bank will reverse:

Commodity markets have always been strongly influenced by speculation. For example, surging investor demand contributed to the 1994-95 boom. In this cycle though, funds deployed are perhaps double the previous high.

Since early 2004, when this investment cycle began, funds invested have tripled.
(and moreso since early '06)

Long standing investors in commodity markets (hedge funds, CTAs, etc.) are being joined by long-only funds (mutual funds, pension funds, etc.) who are implementing an asset allocation shift away from more traditional sectors.

...the flows are massive compared to those of commodity markets, and the present high prices risk distorting the supply-demand fundamentals...

Past cycles of investor buying have proved short-lived. An asset allocation shift by long-only funds could provide the basis for a more protracted period of investment.
(it has been protracted).

Rather than salvation through lower commodity prices, reversal brings a new phase of crisis.

Thai McGreivy said...

I am sorry, I somehow posted the wrong link, ignore my link titled this.

Instead, I meant this link

OkieLawyer said...

Thai:

Here is a post where I used a graph of the national budget. That was when the national debt was "only" $6 trillion. Now is over $9 trillion; so the interest share must be higher.

Another problem with your argument that Bush has increased social spending faster is that a lot of the Iraq War funding is kept "off budget." So military spending is a lot higher than what is officially reported.

Occamsrazors said...

"I have considerable financial interests in Australia, largely in real estate holdings, and the direction I see the Australian economy heading: flat out inflation and spend, spend, spend frankly scares hell out of me. It is as if the residents of Down Under are as unaware of the financial collapse presently taking place in the U.S. and Europe (largely led by the U.K.) as the citizens of the U.S. are of them!

When, how and why’s it all going to unravel in Oz with panic house selling together with all the SUV’s and power boats sitting out front with “For Sale” signs on them I’d like to know (or at least read some informed opinion thereon)"

Spyware, look around the world. US housing market in disarray. The UK is starting to get home owner stress:

http://www.dailymail.co.uk/pages/live/articles/news/news.html?in_article_id=511874&in_page_id=1770

The Spanish govyt is trying to save its housing market:

http://www.telegraph.co.uk/money/main.jhtml?view=DETAILS&grid=&xml=/money/2008/02/05/cnspain105.xml

For 15 years all we've heard is how global the world economy is, how deep, complex and international supply chains are. And yet we are now expected to believe that economies are decoupled and that, for example, the Australian economy will keep sailing on the breeze? I don't think so.

In Melbourne, where I am, house prices rose 18% last year, but interestingly Perth prices are now flat (1% increase for the year):
http://www.abc.net.au/news/stories/2008/02/04/2153842.htm?section=business

It is likely to day we will get another interest rate hike taking a variable mortgage rate to 8.85%

The Vic govt has taken away caps on land tax for investment properties and businesses

http://www.theage.com.au/news/national/land-tax-shock-for-victorians/2008/01/31/1201714153263.html

Given all the above, I couldn't see a better time to sell your property investments. 18-20% rise int he last year, after so many years of growth? Not much left in that tank I think.

Remember commodities (whose wave our economy ir riding high at present) are notoriously cyclical. So our time in the sun may set after some others, but it will surely set.

Muppet said...

For spyware (and any other lurking Aussies), check out Associate Professor Steve Keen's view of the recent RBA rate rise, and all things debt-related down-under:

http://www.debtdeflation.com/blogs/

Thai McGreivy said...

Okielawyer

I read you blog. Kudos on the post! I agree with everything except for your analysis in the last paragraph--I'll post there so not to bore everyone.

... please don't misunderstand me, I am not a spokesperson for US military spending (though I suspect we recapture more of our expenditures than is commonly recognized in the form of oil block nations 'renting' the US military via subsidizing treasuries at absurdly low rates), but the truth is that entitlement programs have increased greatly under Bush-- senior prescription benefit plan to name just one.


@Occamsrazor... there is at least another possibility: if wealth distributions in society do follow Pareto fractal/Power law distributions, as Sugarscape clearly suggests they may, western societies may now be moving from weak pareto optimum to strong Pareto Optimality. If that is the case, not all property may be a bad investment, just most property.


PS-- I am unaware of ANY 'realistic' complex adaptive system model that has been able to prevent this from occuring. If any of you are aware of a realistic model that has, please share as I am not at all saying this is a good thing, just a real possibility per econophysics modeling.

Anonymous said...

Artichoke
The US government should be funding massive public works projects now.

No the US government should quite meddling in the financial markets and the housing market and let this thing run it's course. They are the party that is probably more responsible for this current mess then anyone else and they damn well had the power to stop it before it came to this. The US government is in hock up to it's neck. They are currently having to borrow money to pay interest on the interest. Social programs need to be cut, military spending needs to be cut, government in all areas needs to shrink, and taxes should be raised. If the US dollar ever loses it's status as the worlds reserve currency the American people are in for a sever shock and current policies being deployed to try stop this downturn may damn well lead to exactly that.

Anonymous said...

America a Banana Republic, Without the Bananas or the Republic
http://www.liveleak.com/view?i=866_1202168169

Anonymous said...

Explains why banks have no reserves, even for your checking account balance.
http://acheson.wordpress.com/2008/02/02/loopholes-swallow-bank-reserve-requirements/

Roland said...

In Canada's case, the export boom in energy and minerals has caused serious imbalances between the various provinces.

Ontario and Quebec, home to over half of Canada's population, are energy-importing regions with considerable manufacturing industry. The high Canadian dollar and high energy prices are hurting them.

Given Canada's chronic political divisions, expect some sharp interprovincial conflicts in the next couple of years. What will make everything even more fun are the minority parliaments we've had since 2004.

Gilded Empire said...

OT but I have a question.

I get the whole money = credit = debt = money thing. I get that destruction of any of the above is a very bad thing under our perpetual growth paradigm. So am I wrong to think it's odd that banks would intentionally reduce any of the three? So what's going on when I read in the news that Citi is cancelling CC accounts in the UK and various others are slashing credit lines. By taking these actions aren't the banks destroying money? When the "available credit" that was conjured out of nowhere disappears, doesn't the money it represents vanish as well?

I realize they might be afraid of massive defaults on unsecured debts, but doesn't destroying the "money" first just accellerate the crisis? Wouldn't it be better for the economy to keep playing musical chairs, turning credit into debt via the purchase of goods. If the debt gets written off, how is that different from credit being rescinded? The money disappears either way.

Juan said...

Good point Roland, and may apply to some other nations as well.

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