I haven't featured this chart in over a month, and meanwhile 30-yr fixed rate mortgages have been hitting new all-time lows (both conforming and fixed!). This is a big story that deserves attention.
As some readers have reminded me at various times, Milton Friedman once observed that low interest rates are an excellent indicator that inflation is low, so they wonder why I keep predicting that inflation will rise. My response has been that while low inflation does indeed lead to low interest rates, and vice versa, the two don't necessarily move in lock step. Often it takes a period of high interest rates (the result of Fed tightening) before inflation moves down and interest rates eventually follow. The early 1980s would be a great example of this. Similarly, it often takes a period of low interest rates (the result of Fed ease) before inflation pressures rise and interest rates eventually follow. The 1970s were a good example of how low interest rates can lead to higher inflation and higher rates. I think we've been in the latter kind of period for some time now. Remember, Milton also observed that the lags between monetary policy can be long and variable.
My sense is that the market looks at today's rates that are very low and falling, adds in Milton's observation about low rates and low inflation, and infers that inflation may actually be at risk of being so low as to threaten deflation. I think there's a decent chance the market may not be reading things correctly, and may be failing to learn the lessons of the past.
In any event, it is also the case that low interest rates can be a sign of a chronically weak economy, such as Japan has suffered for decades. When investment opportunities are scarce, it doesn't take much of an interest rate incentive to balance savings flows with investment demands for cash. This could be the reason for why mortgage rates are so low and why so many continue to worry housing prices have not yet hit bottom: low mortgage rates could be signaling that there is a shortage of mortgage borrowers relative to the number of investors willing to buy MBS—thus, the demand for housing could fail to absorb all the housing supply that is due to hit the market over the next year or so as foreclosures allegedly pick up.
One needs to keep in mind, however, that there is as yet no indication that the housing market is not clearing or will soon fail to clear. (By clearing I mean that sellers are able to find buyers at some price.) According to the NAR, the monthly supply of unsold homes in the U.S. has fallen from a recession high of just over 11 months to now just under 9 months. Sales volume is up in many markets, particularly in California and Florida, and the Case-Shiller index of home prices in 20 major markets shows that prices have been flat to slightly up since early last year.
The housing market is clearing, and has been clearing for over a year. Between declining mortgage rates and declining housing prices and a recovering economy, the market has found a price that equates buyers and sellers. The ongoing decline in mortgage rates is obviating the need for lower home prices. Think of it this way: the bond market, thanks to its conviction that the economy is going to be very weak for the foreseeable future, has been acting as a great shock absorber for the housing market by bringing mortgage rates down to all-time historic lows. In this view, low mortgage rates could be signaling simply that the market is very pessimistic about the economy, not that there is a shortage of homebuyers. Higher rates wouldn't jeopardize the economy or the housing market, since they would signal rising confidence, stronger growth expectations, and the prospect of rising incomes and rising home prices. Higher rates would also be a sign of rising inflation expectations, and that would only add fuel to housing demand.
So I don't see any reason to think that the recovery is fragile or that the housing market is on the verge of another collapse. Instead, I see lots of signs that investors are very concerned about the future of the economy, and I find little or no evidence in my list of key indicators for a reason to share those concerns.
The banking industry has been releasing loan loss reserves. It is happening industry wide, not just in isolated pockets. The banks see prices firming and stable demand. It is not concievable to me that they would reduce their loss reserves if AT LEAST this were the case.
ReplyDeleteBanks had a 'come to Jesus' time very recently when their survival was in serious doubt. These are not the same 'fog the mirror' bankers of yore. Their fingers feel every pulse beat of the market and they are saying things are still not good, but they are no longer getting worse.
As low as real interest rates seem now, it may be they go even lower.
ReplyDeleteWhat does it mean when the globe accumulates more capital every year than can be suitably invested?
Economists say there is no such thing as gluts or shortages--only a price that rations the supply.
To me, that suggests we see home mortgages at 3+ percent in the future. US Treasuries at 2 percent or less.
Capital is no longer scare--it is abundant. This may require some real attitude adjustments among those with capital.
If you want near-complete security--the US Treasury--be prepared for a small negative real return.
I hope ultimately this leads to a property and equity boom. It may also lead to central bankers incorrectly reading the reasons for low interest rates, and then tightening too much.
That will mean deflation--and death for property and stocks.
BTW, Friedman famously said low interest rates are actually a sign of tight money. He was right.
interesting times.
Benj, Somewhere, sometime, all that capital is going to be looking for a return. It won't find it is treasuries (which I think are a decent short) and it won't find it in corporate bonds (unless they are lower rated ones). Sometime soon it will be seeking high quality stocks and real estate. When the worm turns, the crowd will stampede. For a long time it has seemed like it will never happen but I believe it will and when it does, it will happen very fast.
ReplyDeleteJohn-
ReplyDeleteFrom your lips to God's ears.
The winds of change blew in 2008. Time for you folks to read the tea leaves. The party is over and the downtrend in prices and psychology over housing is firmly entrenched for a generation.
ReplyDeleteCase-Shiller is heading south second half of this year. There is no need to buy real estate when you can find it at a cheaper price in the future.
We will repeat that mantra for a decade.
Benji, John, Pub,
ReplyDeleteI would side with John in this one. Investors will, I believe, move the trillions of excess capital into the fastest appreciating assets once the movement of pricing has been going on long enough to be modestly convincing. Any story will do. Remember Dot Com, R/E, Commodities from 1996-2008 we had three enormous asset bubbles. To me they were merely extensions of the same bubble created by to easy monetary policy and credit. We won't have the easy credit for the foreseeable future but...can I interest anyone in a condo in Shanghai or maybe Toronto?
Don, I agree another bubble is on its way. However, once a massive bubble pops, that asset class does not reign supreme the very next bubble.
ReplyDeleteIn my opinion, real estate is a dead asset class...in the US, GB, ES, PT, GR, IR etc etc.
Pub,
ReplyDeleteYou don't mine if I call you pub do you? Agree completely. Any thoughts on whats next? Probably commodities as that bubble seemed so unsatisfying the first time.
I don't mind Pub at all Don.
ReplyDeleteI am torn about what to do. There is a lot of bearishness out there. However, I think the Japanese scenario is definitely in play unlike Mr Grannis.
Don,
ReplyDeleteI am/have been interested in the idea of soft commodities being a fund destination. The recent wheat crop failures in Russia have reinforced my suspicion that demand for protein rich food in emerging markets is a long term trend worth keeping an eye on.
If this is indeed viable, what would be some investment/speculative ideas on how to participate?
"If this is indeed viable, what would be some investment/speculative ideas on how to participate?"
ReplyDeletejohn, i have seen people argue to bet on water, whether pio (etf for international water utilities mostly) or lnn (a nice little ag irrigation company) based on the dynamics of brics etc moving up the food chain...but i think this is a second derivative bet that requires you to be very patient. me, i am mostly in financials (which btw also requires me to be patient).
Love this piece. Deflation is exactly what the economy needs to completely eradicate the mal-investment. The longer the government tries to fight it, the longer the struggle to right the ship will be.
ReplyDelete"Just as inflation is generally popular for its narcotic effect, deflation is always highly unpopular for the opposite reason. The contraction of money is visible; the benefits to those whose buying prices fall first and who lose money last remain hidden. And the illusory accounting losses of deflation make businesses believe that their losses are greater, or profits smaller, than they actually are, and this will aggravate business pessimism.
It is true that deflation takes from one group and gives to another, as does inflation. Yet not only does credit contraction speed recovery and counteract the distortions of the boom, but it also, in a broad sense, takes away from the original coercive gainers and benefits the original coerced losers. While this will certainly not be true in every case, in the broad sense much the same groups will benefit and lose, but in reverse order from that of the redistributive effects of credit expansion. Fixed-income groups, widows and orphans, will gain, and businesses and owners of original factors previously reaping gains from inflation will lose. The longer the inflation has continued, of course, the less the same individuals will be compensated.
Some may object that deflation "causes" unemployment. However, as we have seen above, deflation can lead to continuing unemployment only if the government or the unions keep wage rates above the discounted marginal value products of labor. If wage rates are allowed to fall freely, no continuing unemployment will occur.
Finally, deflationary credit contraction is, necessarily, severely limited. Whereas credit can expand … virtually to infinity, circulating credit can contract only as far down as the total amount of specie in circulation. In short, its maximum possible limit is the eradication of all previous credit expansion."
http://mises.org/daily/4602
And for Benj:
ReplyDelete"the dangers of deflation are chimerical, but its charms are very real." Inflation, on the other hand, only helps those who are massively indebted and inefficient — governments.
Pub-
ReplyDeleteOh boy, I disagree on deflation.
I think deflation is deadly to investors, and not just for a few years, but for two decades and counting-see Japan.
Property values down 75 percent in 20 years, and also the Nikkei Dow down 75 percent in 20 years.
In the USA, small businesses rely on collateral for loans--that means property. When property deflates, forget small business.
Yes, debtors and the US government (meaning all US taxpayers) would benefit from some inflation. Many properties would be brought from undewater to the surface, bringing banks back to life. Really, the benefits seem huge from growth and inflation at this time. I can see no negatives to 5 percent growth and five percent inflation for five years. 5-5-5 hould be the goal. The triple nickel.
I hope the Fed prints money until the plates melt. I hope rings of undetectable counterfeiters produce billions upon billions dollars more. I hope the drug lords send back the the US the hundreds of billions of Benjamin Franklins evidently circulating the globe (or sitting on pallets in Kabul airports).
Hey-suze Alou, I do not like recessions or depressions, and what the Fed is doing now is criminal. They think the psychic income they will derive from deflation is equal to the lost real income the rest of Americans will suffer.
Take China--they expanded their money supply by 25 percent, and they are booming. Inflation is running at 3 percent. Horrors, 3 percent inflation.
You may wish you were Chinese before this stupid Fed is done with its religion about zero inflation.
Benjamin: I would caution that correlation does not imply causation. Is deflation really the cause of Japan's sluggish growth and the miserable performance of the stock market? I don't think that's an obvious conclusion. There are other factors, such as fiscal policy, demographics, and culture, that could account for the poor performance of Japan's economy over the past two decades. One thing that stands out head and shoulders above deflation is Japan's history of large and persistent budget deficits, and its current federal debt/GDP ratio that is well into triple digits. I know of no country with such debt levels that has enjoyed healthy growth.
ReplyDeleteI agree with Scott.
ReplyDeleteIn my opinion, Japan continues to fight deflation with every tool possible but the effort only perpetuates the mis-allocation of capital throughtout the economy.
Deflation only hurts the debtors who financed their activities hoping inflation would continue.
However, those who are not indebted benefit + stand to takeover the means of production at a lower cost. Because prices drop for the inputs of production too, the new owners can charge a lower price and still make profits.
Deflation is the necessary counter balance to runaway inflation and credit expansion.
I am slowly rolling out of bonds into value/dividend stocks but adding VIX for insurance purposes.
ReplyDeleteI have a feeling Bernanke's DNA is baked with loads of inflation cake in it. Short-term pop, long-term disaster.
Pub,
ReplyDeleteI think rolling out of bonds into dividend paying stocks is a good idea. The trend is still young but it is, I believe, a trend.
See verizon (VZ) and AT&T (T). Also, Pepsi (PEP), Coca Cola(KO), and utilities Southern Co. (SO) and Teco (TE). Also pharma...see Pfizer (PFE) and Novartis (NVS) among others. All these charts show strong accumulation. It appears to me money is seeking yield. It is gone from treasuries and high grade bonds. High quality companies with great businesses and management can pay and raise dividends even in a slow economy.
Cyclical industries like tech and retail are lagging. Global capital is seeking yield. It is finding it is high quality large cap companies. If we get a correction in september/october, I will be buying these types of names.
Maybe it is just another cyclical bull market, and maybe its something more, but I think the hunger for yield is just beginning.
The market is not paying much attention...it is too fixated on deflation, doubledip, unemployment, etc. but two companys dependent upon consumer discretionary spending (Disney and Macys) both reported excellent quarterly financials. It appears there is more spending going on than many are willing to concede.
ReplyDeleteWe get Cisco after the close. It will tell us something about business investment.
I really think deflation is deadly to investors. And the market is not even that attentive.
ReplyDeleteVictoria Mortgage Brokers
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