Fed can't keep the rates low

[KJP]

 

What I don't understand is if this is the best monetary system, why is deflation treated like kryptonite?  Deflation is a good thing for the individual consumer.  Deflation is not good for the indebted nation.  It seems like the fed mandate has changed from stable prices and low unemployment to propping up the stock market and triggering inflation.

 

Isn't the individual US consumer/voter also often massively short the dollar via a highly levered 30-year fixed-rate mortgage and, perhaps, other debt such as school loans?  And how easy is it to reduce nominal wages alongside deflation?

[wabuffo]

why is deflation treated like kryptonite?

 

JRM - I think you have to distinguish between price declines due to productivity growth/innovation (which are good for the economy as living standards rise) and price declines strictly due to the value of the dollar increasing (ie - dollar becomes "scarcer").  In the latter case, consumer/business debts become more onerous (increase in real terms) and can lead to a debt/deflation spiral and liquidation of the economy.

 

In the recent past you said you were buying value stocks (I'm assuming you meant something like like low p/b, low p/e or whatever - but my assumptions could be wrong!). So if the interest rates are low and the fed is providing a ton of liquidity shouldn't the "growth" stocks continue the same way they've been on over the past decade?

 

stahleyp - I don't let macro infect my stock selection.  I just like riffing on the stuff.  I don't do as well when the equity indices are flying.  I like to think I do better in down markets, but unfortunately down markets are becoming rare.  And when they happen, they last a week now before the monetary authorities bring out their bazookas.

 

Isn't the individual US consumer/voter also often massively short the dollar via a highly levered 30-year fixed-rate mortgage and, perhaps, other debt such as school loans?  And how easy is it to reduce nominal wages alongside deflation?

 

KJP - quite the opposite.  The Fed household wealth survey proves that most households are hurt by low interest rates rather than benefiting from them.  I've been saying for awhile now that the Fed's interest rate suppression punishes savers more than it helps debtors.  Because of this, savers save more and consume less which is the opposite goal of what the Fed is trying to do. 

 

And its easy to reduce nominal wages alongside deflation in aggregate - just create massive layoffs and unemployment.

 

wabuffo

[wabuffo]

So if the interest rates are low and the fed is providing a ton of liquidity shouldn't the "growth" stocks continue the same way they've been on over the past decade?

 

stahleyp -- I guess I didn't really answer this specific question directly.  I don't invest in a macro way - but if I did, the two macro variables I would try to forecast are: corporate tax rates (and to a lesser degree personal capital gains tax rates) and long-term Treasury yields. 

 

This makes sense right?  A dollar of pre-tax income has an annuity value of (1-tax rate)/risk-free rate.  Since mid-2017, early 2018 we got a lower corporate tax rate and generally low long-term Tsy yields.  That's been good for stocks.  For now that should continue to the fall of 2021.

 

After that?  I think we could see a double-whammy of a higher corporate tax rate (21% going to, say, 28-29% and possibly higher personal investment taxes) and long-term yields rising on the 10- and 30-year long bonds.  That will flip what was a strong tailwind for stocks into a medium-strength headwind in 2022 and beyond.  Not a disaster but not the recipe for 15-20% returns in the stock market.

 

Of course, who really knows.  I think its best to ignore this stuff and just deal with the micro of analyzing the specifics of the individual stocks in front of you.

 

wabuffo

[KJP]

Isn't the individual US consumer/voter also often massively short the dollar via a highly levered 30-year fixed-rate mortgage and, perhaps, other debt such as school loans?  And how easy is it to reduce nominal wages alongside deflation?

 

KJP - quite the opposite.  The Fed household wealth survey proves that most households are hurt by low interest rates rather than benefiting from them.  I've been saying for awhile now that the Fed's interest rate suppression punishes savers more than it helps debtors.  Because of this, savers save more and consume less which is the opposite goal of what the Fed is trying to do. 

 

And its easy to reduce nominal wages alongside deflation in aggregate - just create massive layoffs and unemployment.

 

wabuffo

 

Which Fed survey are you referring to?  This one? https://www.federalreserve.gov/econres/scfindex.htm

[thepupil]

KJP - quite the opposite.  The Fed household wealth survey proves that most households are hurt by low interest rates rather than benefiting from them.  I've been saying for awhile now that the Fed's interest rate suppression punishes savers more than it helps debtors.  Because of this, savers save more and consume less which is the opposite goal of what the Fed is trying to do. 

 

can you elaborate here? this makes sense to me for someone of substantial means (say a retiree with $5mm and a $1mm mortgage and a couple of 0% financed cars). that wealthy retiree would benefit more from his $2mm bond portfolio having actual yield than the cheap debt on the mortgage/cars.

 

But for the vast majority of normal americans, particularly those that only have a little wealth, much of which is tied up in home equity (particularly minorities),it would seem to me that housing deflation / higher rates would be pretty devastating for the more median and below households. at the least the transition to a different regime where rates are higher would be painful.

 

 

 

[rb]

How much is GDP influenced by debt and deficits?  I can borrow a lot more money to spend at 0% than at 15%.  Have 40 years of falling interest rates skewed the USD to GDP comparison? 

 

For a while I've given into the narrative that the boomers are robbing from the younger generations.  Now I'm starting to think the retired boomers are the ones who will get screwed.

Haven't they also benefitted from a massive increase in asset prices driven by declining interest rates?

[rb]

This all is reasonable and makes sense.  I think less sophisticated people see the debt and deficit spending and think something must be wrong.  The idea of matching money supply with demand makes a lot of sense to me, and is the biggest detractor for having a fixed gold monetary system (could still create reserve system backed by gold though).

 

What I don't understand is if this is the best monetary system, why is deflation treated like kryptonite?  Deflation is a good thing for the individual consumer.  Deflation is not good for the indebted nation.  It seems like the fed mandate has changed from stable prices and low unemployment to propping up the stock market and triggering inflation.

Deflation is treated like Kryptonite because it discourages consumption which is not something you want. It's worth pointing out that now we actually know how to beat inflation Volker did it. The only time we've beat deflation is with WW2 and I don't think we want to try that again.

[wabuffo]

Which Fed survey are you referring to? 

 

KJP - this one:

https://www.federalreserve.gov/releases/z1/20201210/z1.pdf

 

cop a squint at p. 144.  I'm attaching it here [click for full-size viewing]

 

can you elaborate here?

thepupil - sure!  I've highlighted in yellow the relevant balance sheet items for US households in aggregate from the Z-1 table I ripped out of the Fed's report above.

 

Most Americans biggest source of wealth is their home equity.  In addition, they have $12 trillion in short-term rate sensitive instruments like time deposit/savings accounts and money-market funds.  But their liabilities are largely unaffected by rate changes.  Most mortgages are fixed-rate so they won't change if rates change.  Consumer credit is largely credit cards and car loans which some, if not most, is fixed rate as well. Let's swag that approx $4 trillion of the total household debts are variable rate. 

 

Thus, households have about $8 trillion of NET exposure to short-term rates, so a 1% increase in rates adds about $80 billion to annual income.  But if rates drop 1%, then savers save more to recover that lost $80 billion of income. 

 

Are there individual households that are underwater? Sure.  But its the aggregate numbers that move national consumption and that, in turn, moves GDP, IMHO.

 

wabuffo

[Cigarbutt]

...

Of course, who really knows.  I think its best to ignore this stuff and just deal with the micro of analyzing the specifics of the individual stocks in front of you.

wabuffo

Of course, you're right.

But this stuff is sooo fascinating...

Just think of the oncoming emission of coordinated and consolidated excess reserves into a world already awash with excess reserves.

What has been happening in certain balance sheets is puzzling, to say the least:

https://www.yardeni.com/pub/peacockfedecbassets.pdf

 

On a first-level analysis concerning what others are asking, reading the Z.1 financial accounts (especially since the GFC) would suggest that low interest rates have been, on a net basis, a positive contribution. i guess my position is similar to yours (ie we need higher interest rates) but the second-level answer (going above short term implications) is more complicated in a way, perhaps the same way an investment's +NPV may necessitate negative investment cashflows for a while.

But yes, this board is no place to discuss the anemic secular growth of real wages for most in a declining productivity world and it does not matter (directly and in most cases) if your job is to micro-select within available opportunities.

---

BTW thank you for your inputs in general and more specifically about the book you recently suggested: For good and evil: the impact of taxes on the course of civilization. i just made it to part 2 (the Romans) and am enjoying the topic, style etc. i agree with most of what the author says so far and only have reserves at the margin (of course, that's where the fun is).

[KJP]

Which Fed survey are you referring to? 

 

KJP - this one:

https://www.federalreserve.gov/releases/z1/20201210/z1.pdf

 

cop a squint at p. 144.  I'm attaching it here [click for full-size viewing]

 

can you elaborate here?

thepupil - sure!  I've highlighted in yellow the relevant balance sheet items for US households in aggregate from the Z-1 table I ripped out of the Fed's report above.

 

Most Americans biggest source of wealth is their home equity.  In addition, they have $12 trillion in short-term rate sensitive instruments like time deposit/savings accounts and money-market funds.  But their liabilities are largely unaffected by rate changes.  Most mortgages are fixed-rate so they won't change if rates change.  Consumer credit is largely credit cards and car loans which some, if not most, is fixed rate as well. Let's swag that approx $4 trillion of the total household debts are variable rate. 

 

Thus, households have about $8 trillion of NET exposure to short-term rates, so a 1% increase in rates adds about $80 billion to annual income.  But if rates drop 1%, then savers save more to recover that lost $80 billion of income. 

 

Are there individual households that are underwater? Sure.  But its the aggregate numbers that move national consumption and that, in turn, moves GDP, IMHO.

 

wabuffo

 

If I understand your source correctly, it's an aggregate number across all households.  How do you decompose it to look at the exposure of, for example, the median household/voter?  Unsurprisingly, the Survey of Consumer Finances shows that the median household is well behind the mean in terms of financial assets and net worth.

 

My original comment was responding to JRM's question about why policymakers don't actively seek to create deflation.  Putting aside what would actually have to be done to create deflation, my initial take was that the median household/voter would be opposed to deflation because they are wage earners who would be greatly opposed psychologically to any cuts in their nominal wages and who perhaps are short the dollar due to long-term, fixed rate debts (home mortgage and education loans) exceeding their exposure to financial assets that might benefit from deflation (e.g., bonds), though perhaps this is mistaken to the extent these liabilities can be refinanced into negative rate loans.  I had not considered the big pension entitlement asset listed in your source which may benefit some people in this situation.

 

thepupil seems to be asking about the opposite scenario -- inflation/rising rates causing housing prices to decline.  This may temporarily affect the homeowners' balance sheet, but if their wages are rising with inflation, don't they get to pay off debts with cheaper and cheaper dollars?  So would their income statement look better even if their balance sheet might be underwater for a bit? 

 

 

 

 

[JRM]

How much is GDP influenced by debt and deficits?  I can borrow a lot more money to spend at 0% than at 15%.  Have 40 years of falling interest rates skewed the USD to GDP comparison? 

 

For a while I've given into the narrative that the boomers are robbing from the younger generations.  Now I'm starting to think the retired boomers are the ones who will get screwed.

Haven't they also benefitted from a massive increase in asset prices driven by declining interest rates?

 

That's true, but I think the wealth is pretty concentrated. 

[rb]

How much is GDP influenced by debt and deficits?  I can borrow a lot more money to spend at 0% than at 15%.  Have 40 years of falling interest rates skewed the USD to GDP comparison? 

 

For a while I've given into the narrative that the boomers are robbing from the younger generations.  Now I'm starting to think the retired boomers are the ones who will get screwed.

Haven't they also benefitted from a massive increase in asset prices driven by declining interest rates?

 

That's true, but I think the wealth is pretty concentrated.

There's lots of homeowners out there.

[wabuffo]

Unsurprisingly, the Survey of Consumer Finances shows that the median household is well behind the mean in terms of financial assets and net worth.

 

What point are we arguing?  I think this argument is confusing household balance sheets vs household income statements.  You and thepupil are talking wealth, I'm talking annual income.  I'm not disagreeing that some households may have negative net worth.  Where I am disagreeing is that even negative net worth households have a mismatch of floating vs fixed rates on their income statement -- floating on their meagre interest-earning assets and fixed on their vast interest-paying consumer and mortgage debts.

 

Thus, even a household with negative net worth will see a drop in annual income when rates drop.  And that's what drives consumption. 

 

wabuffo

[KJP]

 

What point are we arguing? 

 

I think we were having different conversations.  I was still trying to respond to JRM's question about why policymakers don't seek to create deflation, which I understood to refer to a general fall in nominal price levels across the economy.  So, on the theory that policy in a "one person, one vote" system is driven by the desires of the median household/voter, I was exploring the situation of that household/voter vis a vis deflation. 

[JRM]

 

What I don't understand is if this is the best monetary system, why is deflation treated like kryptonite?  Deflation is a good thing for the individual consumer.  Deflation is not good for the indebted nation.  It seems like the fed mandate has changed from stable prices and low unemployment to propping up the stock market and triggering inflation.

 

Isn't the individual US consumer/voter also often massively short the dollar via a highly levered 30-year fixed-rate mortgage and, perhaps, other debt such as school loans?  And how easy is it to reduce nominal wages alongside deflation?

 

All good points.  The falling interest rates for the past ~40 years has masked the decline in real wages for the majority of workers.  I guess back to my original question, how much does declining interest rates skew the deficit-to-GDP percentage that wabuffo posted?  I don't know if it is easily quantifiable, but it seems like our heavily financialized economy is responsible for a good portion of GDP instead of actual productivity increases or exports.

[maplevalue]

I don't know if it is easily quantifiable, but it seems like our heavily financialized economy is responsible for a good portion of GDP instead of actual productivity increases or exports.

 

In 2017 1 of every 50 dollars of Canadian GDP came from real estate transaction fees!

 

Source: https://www.cbc.ca/news/business/real-estate-fees-home-sales-1.4226630

[Cigarbutt]

...

What about Treasury yields?  I think that's noise right now.  There are a lot of monetary plumbing things happening over the next 4-5 months that could create a lot of noise in Treasury yields.  We'll see.  Because of some of things that may or may not happen (SLR regs getting extended, Congressional debt limit kicking back in on Aug 1st, etc) - its really hard to make a prediction.  But if I had to guess, SLR will get extended but the US Treasury will have to suppress its net bond issuance so as to hit its account balance requirement before Aug. 1st.  That would put pressure on Treasury yields and cause them to go lower - especially if the Fed is still buying $100b of Tsys per month.

...

wabuffo

This is not the type of topic which is exciting but begs the question: is this a free market anymore?

Anyways, some people appear concerned (excess reserves, excess deposits, regulatory ratios):

https://www.bloomberg.com/news/articles/2021-03-09/banks-press-fed-to-preserve-600-billion-in-balance-sheet-leeway?srnd=markets-vp

 

When thinking about all these 'temporary' measures, i see that the BOJ has recently instituted a complex multi-tier excess reserves system with a category of 'marginal' excess reserves and a way to compensate financial institutions to hold the massive amount of reserves that the system has created. The BOJ is also trying to find a way to temporarily increase its holdings of common stocks. It's OK because real prosperity is just around the corner.

[scorpioncapital]

one day, they will just call for a reset of the price level on the back of all the measures over the years. it happened in soviet times and eastern europe. one day they just cut off a few zeroes from the currency. old people had it very bad.

[Dalal.Holdings]

The other steep curve:

 

With the current ttm earnings yield of the S&P at 2.5%, any spike in rates would have large implications. One must consider the tail event -- even if low in probability, the magnitude of loss would be quite large with a rise in rates even to 3-4%.

 

When rates are low, asset prices are much more sensitive to increases in interest rates due to the steepness of the curve...

 

Even though I usually don't care about macro, this might be one of the few times where macro has a huge effect on equity pricing...

[wabuffo]

With the current ttm earnings yield of the S&P at 2.5%, any spike in rates would have large implications.

 

Now imagine if they also raise the Federal corporate tax rate, too.....  8)

 

wabuffo

[Dalal.Holdings]

Yeah, corporate rates going 22% to 29% would reduce earnings by 9% bringing the earnings yield to 2.25%...

 

It’s astonishing how nonlinear the trend gets as you get down closer to zero rates: interest rate sensitivity of asset prices becomes very high in the regions closer to zero. I hope no one is using the 10 year yield as a discount rate in computing intrinsic value...

 

If the S&P earnings yield goes to 5% without a change in earnings, that means the index is cut in half.

[spartansaver]

Yeah, corporate rates going 22% to 29% would reduce earnings by 9% bringing the earnings yield to 2.25%...

 

It’s astonishing how nonlinear the trend gets as you get down closer to zero rates: interest rate sensitivity of asset prices becomes very high in the regions closer to zero. I hope no one is using the 10 year yield as a discount rate in computing intrinsic value...

 

If the S&P earnings yield goes to 5% without a change in earnings, that means the index is cut in half.

 

I would say that bond investors are using close to the 10-year in computing intrinsic value.

[maplevalue]

It’s astonishing how nonlinear the trend gets as you get down closer to zero rates: interest rate sensitivity of asset prices becomes very high in the regions closer to zero.

 

Yes, and closely connected to the big risk that exists in the market. 10yr risk free rate of ~1% vs. a pre-GFC 10yr risk free rate at 4%+ has wildly different implications for where the broad indices trade. Ultimately it will be driven by the inflation outlook, and with the financial markets increasingly divorced from the real economy the assumption of a continued Fed put is a dangerous one.

 

With this risk out there makes sense to stay defensive a be less sensitive to what the performance of the index is.

[LearningMachine]

With the current ttm earnings yield of the S&P at 2.5%, any spike in rates would have large implications. One must consider the tail event -- even if low in probability, the magnitude of loss would be quite large with a rise in rates even to 3-4%.

 

If the S&P earnings yield goes to 5% without a change in earnings, that means the index is cut in half.

 

Well said.  Not a risk to be ignored.

 

Now, imagine if inflation due to what Powell calls "bottlenecks" ends up being 6-10%, and interest rates follow. 

 

In 1970s, some claim cause was oil bottlenecks and minimum wage increases prior to that.

 

If the probability comes true this time, beyond minimum wage increases, wonder what will be the bottlenecks with pricing power of current era that we'll try to blame for starting inflation when looking back.

[JRM]

With the current ttm earnings yield of the S&P at 2.5%, any spike in rates would have large implications. One must consider the tail event -- even if low in probability, the magnitude of loss would be quite large with a rise in rates even to 3-4%.

 

If the S&P earnings yield goes to 5% without a change in earnings, that means the index is cut in half.

 

Well said.  Not a risk to be ignored.

 

Now, imagine if inflation due to what Powell calls "bottlenecks" ends up being 6-10%, and interest rates follow. 

 

In 1970s, some claim cause was oil bottlenecks and minimum wage increases prior to that.

 

If the probability comes true this time, beyond minimum wage increases, wonder what will be the bottlenecks with pricing power of current era that we'll try to blame for starting inflation when looking back.

 

Oil is a good linchpin because so much of our economy revolves around it.  I think there is a good case for higher oil prices this summer.

 

There is also a shortage of housing, and millennials are starting to move out of their parent's basement.  Lumber is up, but housing could drive the economy for the next few years, too.