Posts Tagged ‘FED’
Yield Curve Inverting
There has been a good bit said lately about the yield curve inverting. Historically, so they say, an inverted yield curve forecasts a recession. I decided to explore that concept a bit. Like all generalizations, this may have a grain of truth in it, but there is more than meets the eye.
By the way, this topic has been explored in greater depth, and with more granular data, by economists who actually focus on this topic. (Just as a reminder, my area is Real Estate Securities). If you are reading this with an eye to fleshing out some masters thesis somewhere, I’d suggest you keep looking for authorities. That said, the FED leadership is meeting in Jackson Hole this weekend, and you can bet this is on the agenda.
Speaking of the FED, I grabbed a bit of data from them — monthly 10 year treasuries and 6 month bills back to December, 1958. I actually explored some other time periods and even daily data, but this was the best pairing I could get in short order. Anyway, the “shape” of the yield curve is essentially the gap between these longer term rates and the shorter term ones. For a normal yield curve, the long bonds (10 year) should be about 2 to 4 percentage points above the short term yields. That makes some intuitive sense — in “good times”, borrowers are willing to pay more to borrow longer term, and investors are willing to accept less return for shorter term loans. When borrowers sense that there may be trouble ahead, they are less willing to borrow long-term, and hence the demand for long term money falls relative to short-term stuff. When things go really topsy-turvy, the short-term money is actually more expensive than the longer term, because borrowers simply don’t want to borrow long-term at all. The topic is w-a-a-a-a-y more complex than this, but hopefully you get the picture.
Speaking of pictures, I then took the difference between these two yields and graphed it. Along with that, I graphed the incidence of all of the recessions since 1958. Here’s what I got:
Data courtesy Federal Reserve, graphic (c) Greenfield Advisors, Inc.
Not EVERY inversion was followed immediately by a recession. although almost all were. The only exception was in 1966. That one is generally considered a “false positive” because it was triggered not by general economic trends but by a short-term reduction in Federal spending.
More interestingly, though, is the long-term bull market of the 1980’s, which was followed by the recession of 1991. That long-term market followed the double-dip recessions of 1980 and 81, which are often considered one long recession. (I know — I was there.) More to the point, the recession of 1991 was not following a yield curve inversion. Indeed, the yield curve spread, measured on a monthly basis, never got below 0.38%, in November, 1989. Also, notably, the behavior of the yield curve over the course of the 1980’s mimics what we’ve been seeing of late.
There is also an argument that rates are behaving more like the 1992-2000 period, and there is some rationale for that. If that’s the case, then the question is whether the yield curve recovers from here or takes a swan dive below zero. If the former, then we may have 2 years or so of continued positive GDP. If the latter, then we’re headed for a rough patch.
The yield curve spread ended July at 0.78%, and closed yesterday down at 0.59%. Again, this is the data the FED leadership is discussing in Jackson Hole. We’ll keep you posted.
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The FED — “Everything Old is New Again”
Even though we’re both South Carolinians, I didn’t meet former FED Chair Ben Bernanke until 2004, when we were introduced at the American Economic Association’s annual FED luncheon in San Diego. He was, at the time, a member of the FED Board of Governors, a seat he would soon resign to become the Chair of President W’s Council of Economic Advisors, and shortly thereafter the FED Chair, succeeding the long-serving Alan Greenspan.
So now, somewhat in contrast, we have Jerome Powell nominated to be the new FED Chair. Like Bernanke, Powell will come to the job having served as a FED Governor. He also served in government, as Treasury Undersecretary, but spent most of his career in the private sector, most recently, intriguingly, at the Global Environment Fund, focused on specialty finance and opportunistic investments. After several years of Yellen and Bernanke, we tend to forget that many prior FED chairs came with significant private sector experience. Greenspan spent nearly his entire career on Wall Street, interrupted by a stint as President Ford’s Council of Economic Advisors Chair. Paul Volker before him had two long stints at Chase Bank, interrupted by a brief period in the Kennedy Administration as an Undersecretary of the Treasury. William Martin worked as a stockbroker at A.G. Edwards, Thomas McCabe was the CEO of Scott Paper, and William Miller was CEO of Textron.
Powell will be the 9th FED Chair since WW II, and most intriguingly, one without a degree in economics or finance. Yellen, Bernanke, Greenspan, and Burns all had doctorates, so we tend to think that’s de rigueur. Actually, it would appear that holding a Ph.D. in economics isn’t a prerequisite at all, and in fact of all of the FED Chairs in history, only those 4 held doctorates. McCabe, the first FED Chair after WW II, held an BA in economics. Martin, who succeeded him, studied Latin, originally considering a career as a Presbyterian minister. (Originally appointed by Truman in 1951, Martin served as FED Chair under 5 presidents, leaving office in 1970.) Miller, who served under Carter, was also a lawyer (and before that a Coast Guard officer) before joining Textron. The great Marriner Eccles, who served as Chair for 14 years under Roosevelt and Truman, had an undergrad degree and came out of his family’s business in Utah. (Intriguingly, this FED Chair who helped define Roosevelt’s New Deal was a registered republican. Go figure…)
So, why the history lesson? In part, to reflect on the fact that Powell may be one of the most mainstream appointments this White House has made. While FED chairs tend to have an agenda, the job tends to be somewhat more reactive than proactive. Consider the storm that Bernanke waded into, or the aftermath which Yellen has had to manage. Powell’s job will be to stay the course, which has been quite good the past few years. One tends to feel a bit sorry for him, recognizing that his will probably be an unenviably tough term of office.
(Footnote — Many will disagree with my comment about doctorates, and argue that Paul Volker had one. He did not. Volker held an MA in political economy from Harvard, and went on to do advanced graduate work in the subject at the London School but without the award of a degree, not that it appears to have held him back…)
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Demand & Supply
I just read a nice piece by Deloitte’s Robert T. O’Brien, their Global and U.S. Real Estate and Construction Leader, titled Commercial Real Estate Outlook 2017. It’s far too interesting and too packed with info to summarize here, so have a glance for yourself. However, I’ll point out a couple of things I believe stand out in his analysis.
First, homebuilders are under pressure due to what he calls the “demand-supply dichotomy.” I’ve been concerned about this for a while. During the recession — which admittedly was several years ago — big chunks of the housing infrastructure collapsed, including acquisition-development-construction (ADC) finance, skilled labor, permanent finance securitization, and local government permitting capabilities. As such, we now actually have a bit of a housing shortage in hot areas (think “Seattle”). Mr. O’Brien worries that homebuilders’ financial projections may be dampened. I’m a bit more concerned with the upward price pressure on houses, which could put us back in a bubble situation. Deloitte believes interest rates hikes by the FED may temper some of the demand side.
He believes private equity fundraising will decline this year, “…as managers focus on deploying existing funds.” He believes managers will face increasing competition looking for good investments. I would add that new managers or managers with a new story to tell will find 2017 a bit easier for fundraising than 2016.
O’Brien also sees slowing in the commercial construction arena, and so slugging financial performance for engineering and construction firms. REITs should do well, though, albeit with continued portfolio repositioning.
Deloitte sees GDP growing about 2.5% this year and unemployment below 5%, which is in line with metrics we see here at Greenfield. They also see several things disrupting the economy both this year and in out years. The “collaborative economy” will certainly have implications for the way new start-ups use and lease commercial real estate. The internet is rapidly disintermediating brokerage and leasing services, with implications for traditional brokers. A shortage of talent in the STEM area and other shifts in the way millennials view the workplace have implications for location strategies. Speed and mode of retail delivery — the “last mile” disruptions of Amazon — are still being sorted out.
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Thus Spoke Janet
Yeah, who else tried to slug their way thru Thus Spoke Zarathustra back in their halcyon days? Now that the storms of autumn breath over my career, I find the pronouncements of Janet Yellen every bit as obtuse as Nietzsche.
I’ll try to make it simple. CNBC had an excellent piece this afternoon. If you borrow money, you’re going to pay more. If you invest in debt instruments, you’re not going to get paid more. Simple?
So what does this mean for real estate? I’ll posit a few axioms.
- If you have a home equity loan and a first mortgage, and you have positive equity, you need to rush to your friendly banker and refinance all that into a fixed rate loan before happy hour this evening.
- If you’ve been planning to buy a house with a loan (as most people do) then yesterday was the day. Today maybe. Tomorrow… eh…..
- If you can invest in rental property, look for “equity positive” locations. These are cities with solid economics, but the cost of construction is disconnected to the local rental rates. Existing rental houses sell for a discount to new construction. Buy all you can grab.
- There are three different explanations for the shape of the yield curve — rational expectations, debt stratification, and liquidity preference. Today, liquidity preference trumps the other three.
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FED raises rates — now what?
There is plenty of news about the FED bumping rates today — a whopping 0.25% (“yawn”) and only the 2nd time in a decade. The argument is that the FED no longer sees low rates as a needed crutch for the economy. Perhaps they’re right. My interest is real estate — how will higher rates impact property returns? More to the point, if the Trump administration goes ahead with infrastructure spending, as was promised, and the FED follows with further rate bumps, as has been projected, will real estate continue its upward climb?
Rather than answer that directly, there’s a great piece on that topic from TIAA — you can access it by clicking here. Looking at data from back to 1980, TIAA finds that real estate appears to perform just as well during periods of rising rates as it does in other times. Indeed, they find a 70% correlation between acquisition cap rates and long-term Treasury rates, suggesting that real estate buyers are agnostic on rates, within reason. Indeed, as the graphic above indicates, the most upsetting quarterly property returns came during periods of relatively stable, downward trending long-bond rates. For the last half-decade, quarterly property returns have tracked the long-bond quite nicely.
So there ya have it, folks.
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A Movie Review of Sorts
I just saw HBO’s “Too Big To Fail”, staring a whole host of Hollywood “names” (James Woods, John Heard, William Hurt, Paul Giamatti, Cynthia Nixon, Topher Grace, Ed Asner etc.). Sadly, it’s a fairly boring movie, albeit about a terrifically exciting piece of near-term history. It focuses on the collapse of Lehman Brothers, mostly through the eyes of Treasury Secretary Hank Paulson (played spot-on by William Hurt). Asner does a wonderful Warren Buffett (who almost, albeit reluctantly, came to Lehman’s rescue) and Giamatti is a wonderful Ben Bernake. (As an aside — Bernake is the most dead-pan person I’ve ever met. Giamatti’s version of Bernake is even more deadpan than reality.)
The movie gets one thing right and one thing wrong. First, the wrong, and then the right.
The movie keeps referring to Lehman’s “real estate”. No one will buy Lehman if they have to buy its real estate holdings, too. Lehman’s real estate “problem” is at first estimated at $40 Billion, then $70B, then “who knows”. The truth, of course, was “who knows”. Cynthia Nixon plays Paulson’s press secretary, who serve as an amiable foil to allow Paulson and his Chief-of-Staff Jim Wilkinson (Topher Grace) to explain the nature of the crisis to her (and thus to the viewer). Unfortunately, Lehman’s “real estate” isn’t “real estate” but “real estate mortgages”. More to the point, they have “tranches” of real estate mortgage pools, and to understand what a “tranche” is would be well beyond the capacity of a two-hour movie. Tranche, by the way, comes from the French word for “slice”. Imagine we pool $100 million or so in mortgages, then split up the ownership into three equal parts — an “A” tranche which will get paid in full, including interest, before anyone else gets paid; a “B” tranche which gets paid next, and a “Z” tranche which only gets paid after everyone else gets paid.
In theory, all three tranches should be good securities, since the underlying mortgages are pretty safe bets, and in practice the “A” and “B” tranches really were pretty good. However, the “Z” tranches will bear all the default risks. Banks (both mortgage and investment) made tons of money on these things, because the default risks could be “priced” as long as market continued to rise. Various investment banks then borrowed money to buy “Z” tranches, and coupled with credit-default swaps (essentially, a mutual insurance pact among investment banks), they were able to borrow huge amounts of money with very little capital.
The Paulson/Wilkinson explanation in the movie makes it sound like the whole problem came from mortgage defaults and foreclosures. In reality, mortgage defaults DO cycle up when a recession comes along, but these are usually predictable cycles. The REAL problem came from borrowing huge amounts of money — with almost no capital — to buy “Z” tranches that didn’t reasonably price the increased in defaults. A slight up-tick in defaults sent everyone to the emergency room, and when owners couldn’t sell or re-finance, the whole market went down the tubes. THAT was the “real estate” problem which plagued Bear Sterns, Lehman Brothers, Salomon Brothers, Morgan Stanley (my old alma-mater) and all the others. Sadly, the movie perpetuates the myth that the real estate down-turn was an exogenous event, and fails to discuss the sins of the secondary mortgage market which took a simple, cyclical downturn and turned it into a long-term, world-wide crisis.
But, even with that, the movie got one thing so very right that made up for the mistakes. In one pivotal scene, Paulson and his team are presenting the TARP idea to the leaders of Congress. (Central Casting found some excellent look-alikes for Pelosi, Dodd, Shelby, Frank, and the rest.) Note that this comes very late in the movie, well after Paulson (an almost billionaire, who really didn’t sign on for this level of stress) and his team have tried ever possible solution to stem the crisis. The movie does a great job of playing Paulson up as the unsung hero who really saved the world’s economic life, by the way. Anyway, the leaders of Congress don’t “get it” until Giamatti’s Bernake gives the most important 2-minute economic lecture in history. He notes that while the Great Depression started with a stock market crash, it was the failure of the credit markets which made the depression last so long. The current crisis, if left un-solved, would spin the world into a much worse, much longer economic depression. Giamatti really nails the tone of the reality which was facing the nation’s top economic thinkers at the time.
Anyway, I don’t watch very many movies. I saw Adam Sandler and Jennifer Anniston in “Just Go With It” on an airplane last week, and thought it was a hoot. As movies come-and-go, “Too Big To Fail” doesn’t even rise to the entertainment level of “Just Go With It”, but as an educational piece, it’s a must-see, even with its critical flaws.
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Housing Finance — Take 2
Again, from the Wall Street Journal, we find reasons for concern. The “Ahead of the Tape” column in today’s Journal, we find an excellent — but troubling — article by Kelly Evans titled “Economy Needs a Borrower of Last Resort.” It really follows my theme from yesterday, and I couldn’t agree more.
Graph courtesy The Wall Street Journal
Imagine a dollar (or a hundred thousand dollars) injected into the system which is loaned to a family buying a new home. They pay the builder, who deposits the money in the bank (actually, paying off the construction loan) and then that money can be loaned back into the system. Some of it bleeds off into taxes, exports, and such, with each iteration of the deposit-and-loan cycle, but still, the money cycles thru the system. Since each subsequent deposit and loan doesn’t happen instantly, there is a little bit of a lag. Nonetheless, over a short period of time, the system should work. The math behind this is called the “Cambridge Velocity Equation” and it’s been known to economists for hundreds of years.
So, since November, the FED has purchased $684 Billion in bonds, which SHOULD have resulted in trillions of dollars in new money creation. Instead, M2 (the abbreviation for the money supply, defined as all of the cash, bank deposits, and money market funds in the system) has only increased by $326 Billion, suggesting that the velocity of money is about 0.5. Note that it SHOULD be 2 or 3 or more in a vibrant economy. This means that for every dollar injected into the system by the FED, half of it has dissipated.
As the article points out, this is why the recovery has remained so anemic. I would posit that a big problem is in the home loan business, which is far weaker than merely “anemic” — it’s on life support with the undertaker waiting in the lobby.
Kelly Evans posits that the market needs a lender of last resort, which is exactly what I was saying yesterday. Unless and until the system starts turning into the skid, by fixing the totally busted mortgage market, a double-dip recession seems inevitable.
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Tis the season….
Intriguing mixed messages from the economy. Employment continues to lag, but holiday shopping was up. Go figure?
Two or three things may be in store. First, I’m sure that some of the more profitable businesses, fearing future tax increases, were holding off spending tax-deductable money until 2011 rather than 2010. The key lesson for lawmakers — get some stability and predictability into the tax system.
Second, while “on-line” shopping went up, the unmeasured impact of on-line was the ability to target shopping. Lots of holiday shopping went at bargain prices, and I’m interested to see how much sustainability there will be in the increases. It’s very difficult to imagine, with the underlying instability in economic fundamentals, just how long the shopping bubble can be sustained.
But, on to real estate. What looks good right about now? What looks bad? We continue to be doom-sayers on housing construction into 2011. Normally, in a recession, there’s a build-up of excess supply (construction in the pipeline pre-recession get unsold DURING the recession). However, past recessions rarely have a contemporaneous melt-down in homeownership rates (see the following).
Note that since we began keeping records in 1960, ownership rates have inexorably trended upward but for two instances — this one and the 1980-84 period. After 1984, it took until the mid-1990’s for rates to start trending upward again, and many would suggest that this up-trend was only the result of Greenspan’s “easy money” policies. In a more cautious lending environment, it’s hard to say where the true equilibrium might lie. However, it’s intriguing that the run-up in the 1970’s is often blamed on the high levels of inflation (making home ownership the favored “inflation hedge” for families) and that in the post-recession, low-inflation period of the late 80’s and early 90’s, rates seemed to hover around 64%.
If in fact that’s where the equilibrium lies, then the U.S. has about three more percentage points in owner-occupied homes to absorb. This absorption occurs in one of three ways — growth in the population, conversion of homes to other uses (usually rental in lower-end or transitional neighborhoods), or demolition. Whatever the reason, with the current slope of the trend-line (which, intriguingly, matches the slope of the 1980-84 period), we see that it took about 5 years (2004 through 2009) to get from about 69% to about 67%. At this rate, getting to 64% will take another 7 – 8 years, suggesting a best case scenario of stability in the 2016 range.
This scenario, interestingly enough, matches some of the employment-growth scenarios I’ve seen, which suggest we’re looking at the mid-to-late teens for unemployment to get back down to pre-recession levels.
So, if owner-occupied housing stinks, what looks good on the menu? Apartments. In very rough numbers, we WERE building about 1.5 million homes per year prior to the recession (year-in, year-out, with a HUGE amount of variance from year to year). Now-a-days, we’re building about a third of that or less, suggesting an un-met demand for housing of about a million units per year, more or less. Apartment construction also flat-lined during the recession, primarily because banks simply didn’t have the money to lend for construction financing. (Permanent money comes from other sources, and it’s available, but the construction financing problem is still with us.)
As credit continues to ease — particularly with the recent announcements by the FED in that regard — we can see some strong lights at the end of that tunnel. Good news for construction workers — their unemployment rates have been huge lately, but the same folks who drive nails for owner-occupied homes can also drive nails in apartment complexes. Easing credit in this area will thus fuel job growth, which also fuels consumption, home purchases, etc. Thus, addressing the housing demand/supply problem may be the most important single thing policy makers can do to restore the economy to good health.
From a small northwestern observatory... 