Interest Rates Gettin You Down?
Chuck Ponzi November 3rd, 2006
Well, you’re not the only one.
And, we found out earlier this week that productivity has abated, while wage pressures are mounting… Signaling potentially more inflation. So, enjoy your low interest rates while you can.
If the bond market has called it wrong and the FED is required to raise rates, not lower them any time soon, we could see the short end of the yield curve rise, putting even more pressure on the long end. That snap-back of the yield curve might just lead to a credit event… the unwinding of which could cause housing lending to really stop in its tracks (relative to current practices, not historically).
There is already evidence that the FED’s move might be a move up next. Lacker (the one dissenting FED voice) has repeatedly signaled to resume upward movements to the interest rates. And, although the world’s central banks have not recently taken up the cause, there is mounting dissent that the world is awash in a sea of liquidity that needs to be mopped up with higher interest rates.
Bloomberg delivers the news:
Interest rates in the main economies have still not been raised enough,” says Tim Congdon, visiting fellow at the London School of Economics and one of the “wise men” who advised the U.K. Treasury in the 1990s. “There is a buoyancy in asset prices one gets with high-risk monetary growth.”
Without further tightening, central bankers may have new asset bubbles and inflation risks on their hands. The European Central Bank, whose officials voice the most concern, is convening a conference in Frankfurt next week on the role of money growth in guiding interest rate policy. Among participants: Federal Reserve Chairman Ben S. Bernanke, People’s Bank of China Governor Zhou Xiaochuan and Bank of Japan Deputy Governor Kazumasa Iwata.
With a depressed long end already inverted, and a rising short-end, we could have an almost sure signal that we are entering recession. However, MarketWatch’s Rex Nutting reports that it may not be that simple.
The inverted yield curve does not cause a recession; it’s just a signal of a pending slowdown.“Forecasters are really bad at forecasting recessions,” said Lakshman Achuthan, managing director at Economic Cycle Research Institute, which did forecast the 2001 recession, based on ECRI’s own leading economic indicators.Achuthan doesn’t think the yield curve is the “holy grail of economic forecasting.”“The yield curve doesn’t pass our test to be included in our leading indicators,” he said. His firm is not forecasting a recession this year or next, but is “by no means bullish.”
The recession odds have been above 50% eight times in the past 45 years. Six times, a recession followed within a year. The only occasions the economy avoided a recession were in the mid-1960s and the mid-1980s, both periods when the federal government flooded the economy with fiscal stimulus, noted David Rosenberg, chief North American economist for Merrill Lynch.
That fiscal stimulus, is however, unlikely to surface (the mid 60’s and mid 80’s were 2 major rewrites of the tax code to lower higher marginal taxes) with our current federal deficit. If it were to surface, the purchasing value of the Dollar might negate any stimulus this might provide, causing foreign goods to become more expensive.
But, that might already be upon us.
China is exporting their inflation to us by buying US treasuries. No, it is not so much a blame as it is a statement of fact. China’s ballooning currency reserves are one of many pressures keeping the long-end of the yield curve depressed. This week, we found out that their currency reserves have reached nearly $1 Trillion; estimated to be 70% in USD. Is our inversion simply a manifestation of our own undoing by a sea of trillions of US dollars desperately seeking returns? If so, our recession indicator may not so much signal the prescience of the bond market as much as it shows how economic cycles are born. Excess monetary stimulus seeks ever lower returns, finally exhausting itself by taking on greater risk than a return will support. Because risk is detatched from credit decisions by months or years, it is usually far too late to stop the excessive risk taking before the clear signs surface.
Bringing it Together
The worst part of this is imagining it all being brought together at once. Imagine if investors caught a whiff of Lacker’s higher inflation, increased risk aversion, and China begins a rebalancing or reduction of US reserves? The result could be catastrophic to our debt-based economy. No longer would borrowing be cheap. No longer would funding be plentiful. No longer would assets be liquid.
It reminds us of something Greenspan said last year:
This vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent… But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low-risk premiums.
The part that is not surprising, is that all of the evidence was here for months, if not years for everyone to see. The part that is surprising (at least to me) is that so many ignored it for so long. Any amount of use asset inflation will at some point translate into core inflation when each person recalibrates their spending accordingly. There is no such thing as a free lunch. Monetary inflation endly leads to inflation of all kinds, there is no other way out.
What does this mean to the housing market in Southern California?
Our current housing prices are fueled entirely by easy, cheap credit, as is evidenced by our high ARM content, and astronomical house-price to income ratios. If a credit event does occur, we have the most to lose. However, all other unwinding scenarios depends on many other moving parts of our global economy to work in clockwork like precision. While the current slowdown is a manifestation of the bubble stretching under its own weight, it is likely that the added pressure of a credit event (and likely even the perfect unwinding as described) would pancake the entire housing and local retail economies that are so dependent on lending. While I would admit I still don’t believe the residential real estate bubble has yet popped, the true test of future direction will be in the credit markets over the next year, not in the for-sale housing market.
John,
This is from en.wikipedia.org:
“The opposite situation—short term interest rates higher than longer term rates—also can occur. For instance, at November 2004, the yield curve for UK Government bonds (i.e. the bonds which the UK Government issues to borrow money - see gilt) was partially inverted. The yield for the 10 year bond stood at 4.68% but only 4.45% on the thirty year bond. This is almost always due to the market’s anticipation of falling interest rates. Although negative liquidity premiums can exist, specifically if long-term investors dominate the market, current financial philosophy is that positive liquidity premium dominates, so only the anticipation of falling interest rates will cause an inverted yield curve. Strongly inverted yield curves have historically preceded economic depressions. “
My current feeling on this is that the yield curve will continue to progress from being inverted to being strongly inverted with the passage of time. It really does seem like the Fed has painted itself into a corner in that it will be unable to jam the Fed Funds rate to zero on the next go around.
However, I also agree on your idea of a snap back event in the credit markets. That idea seems very plausible and possible to me.
Anyway, the weekly progression of the yield curve can be monitored at the following link:
[Link]
V/R
bubble_watcher
bubble_watcher
Historically, strongly inverted yield curves have historically preceded economic depressions… and normal inversions have preceded recessions.
I also agree that we have a “normal inversion” signalling a potential economic recession.
One of the questions that is somewhat debateable is still what makes this time different:
1. There is a lot of liquidity still in the system. China, for instance, has waaaaay too much currency reserves, and heavily weighted towards USD… depressing our rates in treasuries, likely setting off our really low mortgage rates as well. Mortgage rates could snap back due to a variety of situations, not the least of which would be higher defaults. Of course, the cows have already left the barn, the question only remains how fast will lenders close the gates?
2. Lending standards in the mortgage area are likely the lowest they have been in history. Lenders are offering neg-am option-arm, no-doc, teaser rate loans to people one day out of bankruptcy. Best Funding here in L.A. even advertises to this kind of people. I don’t know how you can get any lower than that.
3. Bank reserves are frighteningly low. Why the FED has not yet stepped in to raise reserve rq’s is beyond me. It’s like a drunk asleep at the wheel. I just don’t know when it crashes, but it’s going to. I wonder how much the FDIC designation is going to mean then… I wouldn’t recommend to anyone to exceed those amounts… open more accounts at more banks if you have to, but you dont’ want to take a haircut on cash.
4. The stock market is surprisingly bullish (might be a sucker rally, but I can’t say for sure). Either way, I can sense the tenseness on Wall Street. I am tempted to liquidate everything and hold cash for a while, just because spooked investors can pack the exits at any time.
Some time ago, someone was mentioning stagflation… something which is absolutely garbage. There is no comparison of now to the late 70’s. Still, i might be led to see the uncanny similarities to the ‘72-’73 market.
By your statement, you and I are both asset deflationists, however, the FED can (under pressure) jam the ZIRP pedal and go to infinity with debt monetization to stimulate the economy. It would tank the dollar, but we might actually start producing stuff again. If that doesn’t save us from price deflation, then there is no hope for monetary policy in the future.
Here is the conundrum for the county. We had generally good news today; the employment numbers are at record lows at 4.4%. However, treasuries and the market were pushed lower today. Why? Think of the ridiculousness of the current system, the stock market is betting on lower rates. But having lower rates is based on having a slowing economy…at least slowing in terms of numbers. So now, we have inflation pressure, jobs steady, no wage-growth, and the market generally stagnant. The housing market is already dancing on its third leg imagine what a rate increase would do? Heck, even a couple of weeks ago we were talking about decreasing the fed funds rate. Not anymore.
We are in a Catch-22. Housing will come down now or come down later. It will come down fast or come down slow. There is some poetic justice to this all. You want to know how easy credit is in our economy? You can go on Prosper.com (a peer2peer lending site), if you have okay to decent credit, and get a $5,000 loan at 9.5 percent for three years. Your payment will be $162 a month. But this is simple interest. So if you break it down, you are probably paying close to 5 percent (compounded) interest on this loan. Why do I bring this up? Because I was able to do this and this is an absolute bargain - if you invest and know where to find higher gains (which are very limited currently). But at the same time, the majority of people are borrowing cash for buying condos, homes, cars, vacations, etc. I used the funds to invest at a higher rate but you catch the drift of the overall consumer which is 70 percent of GDP. Money is literally everywhere chasing higher returns. Unfortunately this easy credit bubble will burst and we are starting to see cracks in the system.
Some time ago, someone was mentioning stagflation… something which is absolutely garbage. There is no comparison of now to the late 70’s. Still, i might be led to see the uncanny similarities to the ‘72-’73 market.
That’s true. The economic conditions of today seem to be setting us up for a set of economic conditions that strongly resemble the 1930’s (or worse), IMHO.
By your statement, you and I are both asset deflationists, however, the FED can (under pressure) jam the ZIRP pedal and go to infinity with debt monetization to stimulate the economy. It would tank the dollar, but we might actually start producing stuff again. If that doesn’t save us from price deflation, then there is no hope for monetary policy in the future.
That’s correct. Under those conditions, it would be far better to ‘buy and hold’ gold and silver than to be fully invested in short term dollar denominated paper (i.e. Treasury bills). However, I am also of the opinion that under a very severe deflationary environment in which the currency disappears, that gold and silver will once again prove themselves as being viable mediums of exchange. If anything is ‘different’ at all between the 1930’s and today, it is that the US dollar is no longer backed by gold. Pre-1965, our coins (dimes, quarters, and half dollars) were made out of 90% silver. The old memories of gold and silver being used as mediums of exchange (i.e. hard currency) have not been lost.
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If you don’t have a subscription to decisionpoint.com, then I would highly recommend getting one.
I look at the interest rate charts there daily, and right now the markets are saying that the Fed will continue to hold rates where they are as bond yields continue to trend lower.
…
Anyway, I pointed this out once before on ocrenter’s blog, but you can get an online Treasury bill/bond account at the following website:
[Link]
However, I’m too much of a ‘chicken’ to play the bonds, since I think that your snap back scenario in the credit market is both realistic and a frightening possibility.
Current Treasury Bill yields can be found here:
[Link]
It just strikes me that the democrats might have a very short lived victory in the elections this year. They get in office just as the asset bubble crashes.
Of course they will have some bizzare over the top tax raises to try to get the situation under control. I’m really not sure if that is the best approach.
Anyhow, this reminds me of the last time we had to withstand another mercantalist assault from Japan. I guess this is China’s turn.
I’m thinking of rolling some 401K money in to a uranium investment.
LAEF2
how would you address the fact that a decline in home prices in the future may be offset by a corresponding rise in interest rates. In this scenario housing will still not be affordable so when some claim that those who did not buy in the past are forever priced out, is there any merit to their statement?
No, there is no merit to that statement.
There is soon to be a cool site launching called http://www.pricedoutforever.com which is being developed by Timothy Ellis. Should be very cool, funny, and informative.
John Doe
how would you address the fact that a decline in home prices in the future may be offset by a corresponding rise in interest rates.
Higher interest rates help those who have lots of cash and in a deflationary environment, cash is king.
Now with the election over things should start to settle down. Too many opinions bouncing around the economic and RE issues. I have everything liquid at the moment just in case. I’m in the fine jewelry biz so I have other portable assets including gold. I think in 07 we should start to see momentum. Thankfully I left california last year and can watch from the sidelines. I’ll be back after the dust finally settles should be a sizable out migration by then as most will have lost their suicide homes.
I’m thinking of rolling some 401K money in to a uranium investment.
In Iran? I hear their uranium industry is booming…
Uranium futures might be a good idea if they start significant enrichment.
I was thinking that uranium might be a good response to reduce dependance on oil and lower greenhouse gas emmisions.
Anyhow. That is not an investment it would just be another form of speculation. Which is what I’m trying to avoid.
Over on calculated risk they were talking about currency trading. Looks like the dollar is down 30% against the euro. That is a sure sign of the inflationary policies that we have seen recently. Makes me think the asian investors are going to wise up about their risk and return on those MBS. Probably look at significant capital flight that the FED will need to fight with higher rates quite soon.
I’m pretty sure the democrats will try to manuever the FED so the shift is slow and give people time to reorganize their debt in to more managable fixed rate products. I’m not sure how much damage that will cause to the economy long term. I’m hopefull the get bogged down fighting about Iraq and other issues long enough to allow the market to crash.
Just waiting for the long crash of 07-08-09
[...] sloping yield curve. That is not at this time portending a recession like it was when I wrote this back in November [...]