Cantillon Blog

An author known as an evangelist for trend-following posted the following:-

Caught this ominous line: “Two-thirds of all U.S. houses have mortgages. Of those, an estimated 21 to 29 percent of the mortgages are underwater, or up to 16 million houses. When prices finally do rise, we can expect many of these no-longer-underwater owners to put their houses up for sale. If only one in three do, that is another 5 million homes in inventory.”

in relation to the following link:-

Somebody (LT) commented in response that the charts of the homebuilders – the XHB ETF, and components LEN and TOL were at 3+ year highs, indicating that this was of more significant than the columnist opinion.

In response to this, and to my comment, the evangelist wrote that “rising home builder stocks is one issue and homeowners underwater is another issue. Two separate facts in their own right. Deal with both as they are…right?”

I thought this was fascinating, because it is a very clear illustration of the fragmentation and absence of coherence in the way moderns tend to think about financial markets.  I believe that the inference one draws from an isolated fact regarding inventory will depend very much on what other beliefs one holds regarding the housing market.  Facts have no meaning outside of a broader context.  So that the emotional tone ‘ominous’ is unlikely to be associated with one’s interpretation of this fact if one chooses to take into account the technical picture of the homebuilders.

What does inventory mean? To the extent that there is no new picture demographically, and people continue to occupy a similar sized space and are not moving back with family, it represents a desire for somebody else to bear/manage the price and depreciation risks of ownership. It takes time for entrepreneurs to set up organizations allowing institutional capital to invest in residential property, but it is certainly happening. See the report in Marc Faber’s Gloom Boom Doom report by the founder of Sabre Value fund.

The response was that for those who are trend-followers there are no inferences to be drawn – one ought just to trade the market for what it is and accept that any  trend can end tomorrow.

It is a very much representative of our age that people look at the fundamentals in a fragmented, partial way, not considering the significance of an isolated observation in the context of the overall picture, and lacking a drive for coherence in peoples’ beliefs across different domains.  For a modern one is long the market because one’s model is bullish, and one sees no contradiction in talking to others about how awful the fundamentals seem to be.  Talking about the fundamentals is just like sport, and has no greater significance than that.

One can contrast this to another, more classical, approach that insists on finding coherence in our beliefs across domains, related and unrelated.  If the technicals are bullish, and the fundamentals appear to be bearish then, bearing in mind the proven ability of the market to forecast fundamentals, it seems likely that one is overlooking a nascent improvement in fundamentals that is as yet below the perceptual threshold for more traditional participants and commentators.

A participant who understands enough that he realizes markets have a tendency to trend, but not so much that he takes into account the tendency of markets to forecast future fundamentals is throwing away possibilities for learning.

Our good friend over at Historinhas wrote a year ago expressing satisfaction at the presence of uber-doves on the Bank of England MPC.  Posen was quoted as saying the following:-

“The Bank of England‘s leading dove has predicted that inflation will tumble to 1.5% by the middle of next year as George Osborne‘s austerity drive and the underlying weakness of the economy stifle consumer spending.

In an interview with the Guardian, Adam Posen admitted he had sleepless nights over his call for more money to be pumped into the economy and said he would not seek re-election to Threadneedle Street’s monetary policy committee if his view turned out to be wrong.

Posen said: “If I have made the wrong call, not only will I switch my vote, I would not pursue a second term. They should have somebody who gets it right and not me. I am accountable for my performance. I’m holding my nerve because it is the right thing to do.”

Despite surprises in global growth to the downside since this interview (the European crisis coming as a shock to most commentators, although not to this one ), UK inflation has fallen from 5% yoy last year to 3.4% yoy at the end of Q1 2012 (vs consensus expectations of 3.1%).  JP Morgan expect inflation to reaccelerate later in the year to 4% annualized, or 3% yoy (with core inflation near 2%) – another year of inflation significantly above target.

The doves keep very quiet about their forecasting errors.  I think it is hard to attribute the likely significant overshoot in headline inflation to drastic changes to the stance of monetary and fiscal policy since the Posen interview, although certainly these have probably been in the direction of being somewhat easier than expectations at that time.

At what point does a blip become a trend, I wonder.

I do think likely very much lower energy prices will put pressure on headline inflation in the medium term, but I think longer-term we are early in a period when inflation will turn out to be persistently higher than expected based on models calibrated to the previous regime.  Over the course of months and quarters, lower gasoline prices will tend to support consumer disposable incomes.

I am not banking on an apology from the doves, but it would be nice if their expressed confidence appropriately reflected the rather thin supporting evidence for their dovishness.

When inflation continues to exceed target despite a soft economy, is it the inflation doves or the hawks who are insane?  I would say neither, but those who continue to place their faith in econometric models that have had a terrible track record of predicting turning points and those who have no previous successful record of forecasting to back their over-confident pronouncements.

I would like to do a longer post on this at some point, but would like to make just a quick observation on how I have found it useful  to think about developments from 1929 onwards.

America has been blessed as a nation, and one can find most things one needs within the country.  For many Americans, what happens abroad is simply of little relevance.  This has tended for many years to shape the culture, such that there is a general neglect – even at the highest levels – of the influence of international developments in shaping events at home.  The narrative of the 1930s depression in the US has tended in cartoonish form to link the stock market boom of the 20s to the depression that followed, and the depression is often thought to have been both caused and triggered by the stock market crash of 1929.

Scott Sumner, a man who, for both good and ill, is very much a product of his era, succumbs to this narrative.  Because there seemed to be no apparent immediate real economy effect of the 1929 stock market crash, he denies that there was any financial market crisis until 1931, when there was a wave of US bank runs that had severe contractionary effects on the real economy.  This fits nicely into the narrative he wants to paint, which is that depressions and downturns are caused entirely by overly tight monetary policy during the bust (and not at all by fundamental misalignments induced by prior overly easy monetary policy during the boom).  He is a man of his era, because this stripping of context, and wanting to view events as being the linear product of direct causes is very much a feature of left hemisphere consciousness (as described by Iain McGilchrist).  He actually goes on to accuse all previous authors of having misunderstood the situation, accusing editors of neglect of their duties in allowing such sloppiness to pass by unchecked.  Such an absence of humility is quite a sight to behold!

Unfortunately for him and – given the likely appeal of his kind of thinking to a broader audience – for us, he is very much mistaken.  It simply isn’t right to look only at the US equity market when, as Martin Armstrong points out, the bond market was very much bigger and the great preponderance of issuers went on to default, in one way or other.  October 1929 was when the Bank Austria (central bank) cut off discount window financing to the BodenKreditAnstalt and forced it to merge with Credit-Anstalt.  It was the failure of the new entity that was to kick off the acute phase of the crisis in 1931.  So there is a direct continuity between the events of 1931 and those of late 1929.

I reproduce a couple of comments I made to his blog here.  He does not really respond to these.

Cantillonblog
25. March 2012 at 11:48

Scott Sumner – the bond market in the late 20s was bigger than the stock market, and almost every sovereign issuer ended up defaulting. The private sector didn’t fare so well either. So you might want to look at credit spreads rather than equity prices. Obviously if the market is closed to new issuance and to refinancings, that starts to become a problem some time before the situation gets bad enough to reach the stage of bank runs.

One should also consider the international aspect, since Europe was in many ways the epicentre of the crisis. The BodenKreditAnstalt had trouble financing itself as early as October 1929 when the Bank Austria (central bank) closed the discount window. The forced merger with Credit-Anstalt created the new entity that was to kick off the acute phase of the crisis in 1931.

So I do not understand why you write with such certainty that there was no crisis until 1931. The fire ignited in 1929 but was not noticed till some time later.

Cantillonblog
25. March 2012 at 11:54

To say there was no crisis in the US in 1929 is like saying there was no peripheral crisis in Europe in 2007. The whole thing was one rotten episode that took its time to spread. But in 2008 it was inevitable that the recognition of trouble in the US would inevitably lead to recognition of underlying problems down the line in Europe, no matter how aggressively the ECB eased. The problem wasn’t that the ECB tightened too much, and didn’t ease enough. The problem was that trusting German Landesbankers had lent money at stupidly low interest rates to countries that didn’t make good use of the money nor have an alternative financing source when the Germans awoke. All the liquidity in the world isn’t going to make that problem go away.

Cantillonblog
26. March 2012 at 17:57

The 1987 equity market crash was in part a recognition of trouble that had been brewing in the bond market since the beginning of the year. This being said, the credit market stayed open. That is really the key point, and the reason why 1931 should be seen as part of the same episode that began in 1929, just as the European peripheral crisis of 2011 should be seen as having begun in 2007-2008.

It is astonishing that somebody can speak of linkages between financial markets and the real economy without giving any evidence of understanding the tremendous importance of the credit markets.

Cantillonblog
28. March 2012 at 17:21

Dr Sumner would you care to enumerate in history those instances that saw the bursting of a bubble in the credit market where the central bank acted sufficiently fast and vigorously that everything worked out fine and there was not hell to pay?

Was Dr Krugman ever a great economist in the sense that Hayek, Smith, or Pareto were great economists?  He received a Nobel prize for his work on technical advancements in trade theory, but I wonder whether that necessarily puts his work on the same level as the truly great thinkers of previous eras.

Whether or not that is  the case, it seems to have been many years since he has been anything but a partisan hack.  As Bruce Charlton points out, the situation today is so bad that the problem is no longer even that public intellectuals today are not oriented towards discovering what is true; it is not merely that they are only pretending to discover what is true, but it is that they are not even bothering to pretend these days.  Charlton was writing about scientists, but the situation is surely much worse in the domain of commentary on current economic affairs.

Dr Krugman in his latest NYT blog piece mentions “warnings… that the ‘floodgates’ of inflation may be about to open”, without naming the opponents he has in mind.  Of course a true intellectual would attack not just the case made by his strongest opponents, but the strongest version of that case that it would be possible to make.  Clearly, that is not Dr Krugman’s style – he prefers to erect an Aunt Sally, to knock it down triumphantly and to crow to his followers about the immensity of his achievement.

We all know that there are lags between monetary policy and its final effects.  The reason for being concerned about the Fed’s expansionary monetary policy is not that inflation next quarter may exceed its target; it is that policy today may start us down a path that will lead inexorably towards higher inflation, and that once we have started down that path it may become very difficult to bring inflation back under control without great sacrifices in terms of foregone output and employment.  It was the easy monetary policy of the 60s that set the stage for subsequent unhinged inflation in the 1970s, and I suspect current monetary policy may be doing the same.  Dr Bernanke says he is certain that he will be able to bring inflation back under control, but the track record of his beliefs vs outturns does not encourage great confidence in his words.

Thirty year breakeven inflation implied expectations are trading at around 2.50%, and according to Dr Krugman and his activist friends the economy still has supposedly such a great degree of slack that further dramatic easing in both fiscal and monetary policy is required.  One wonders how high inflation expectations will rise once such slack is eliminated.

I am not in the very near term concerned about breakeven expectations and headline inflation becoming unhinged since I expect crude and related energy prices to come down sharply, pushing down headline inflation.  Although this will impact shorter-dated breakevens most heavily, it will tend to weigh on the back end of the curve too.

Longer-term though I rather think that the inflation hawks will turn out to be right.  I shall make a note in my diary for April 2015 and we shall see whether Dr Krugman’s dismissal of inflationary concerns turns out as well as his cheering-on of the inflation of a bubble in housing.

http://www.themoneyillusion.com/?p=13706&cpage=1#comment-145379

Without looking at credit markets (the real origin of the problem – equities were a canary in the coalmine), he somehow determines that the recession of 1931 caused the financial crisis, denying that there was a financial crisis in 1929.

http://www.themoneyillusion.com/?p=13661&cpage=1#comment-145403

However the bond market in the late 20s was bigger than the stock market, and almost every sovereign issuer ended up defaulting. The private sector didn’t fare so well either. So you might want to look at credit spreads rather than equity prices. Obviously if the market is closed to new issuance and to refinancings, that starts to become a problem some time before the situation gets bad enough to reach the stage of bank runs.

One should also consider the international aspect, since Europe was in many ways the epicentre of the crisis. The BodenKreditAnstalt had trouble financing itself as early as October 1929 when the Bank Austria (central bank) closed the discount window. The forced merger with Credit-Anstalt created the new entity that was to kick off the acute phase of the crisis in 1931.

So I do not understand why you write with such certainty that there was no crisis until 1931. The fire ignited in 1929 but was not noticed till some time later.

To say there was no crisis in the US in 1929 is like saying there was no peripheral crisis in Europe in 2007. The whole thing was one rotten episode that took its time to spread. But in 2008 it was inevitable that the recognition of trouble in the US would inevitably lead to recognition of underlying problems down the line in Europe, no matter how aggressively the ECB eased. The problem wasn’t that the ECB tightened too much, and didn’t ease enough. The problem was that trusting German Landesbankers had lent money at stupidly low interest rates to countries that didn’t make good use of the money nor have an alternative financing source when the Germans awoke. All the liquidity in the world isn’t going to make that problem go away.

and apparently is quite the specialist in frame control…

http://www.themoneyillusion.com/?p=13682#comments

Scott Sumner and David Beckworth welcome the recent rise in long-term yields.  Sumner recommends Beckworth’s post, in which he claims that “the recent rise in long-term yields can be interpreted as the bond market pricing in a rise in the expected growth of aggregate demand”.

We can decompose nominal yields into real yields + implied inflation expectations (‘breakevens’), the latter being dirty in that it may incorporate some element of liquidity and risk premia.  At the present time I believe it is acceptable to presume that this latter component does not explain recent changes in pricing.

Have long-term growth expectations changed lately?  Let’s look at 30 year Treasury real yields(click on image to see it fully):

There has basically been no real change since the levels of the height of the crisis in October.

Breakeven inflation expectations on the other hand have risen significantly:

Whether one thinks this is a positive thing or not depends on various other beliefs one holds.  But the picture is certainly more consistent with the elimination of deflationary fears than it is with the idea that decent growth is now priced in to Treasuries.  The question might be rather, what would happen to Treasuries if growth does get priced in from here.  I suspect real yields will not remain at negative levels when that does occur.

(and Marshall got it, possibly indirectly, from Mills (1867))

Re-reading Loasby’s excellent The Mind and Method of the Economist, he says the following:-

“Marshall’s explanation of trade depression in his Principles is very brief: it is loss of confidence by customers”.

“For when confidence has been shaken by failures, capital cannot be got to start new companies or extend old ones.  Projects for new railways meet with no favour, ships lie idle, and there are no orders for new ships…  The greater part [of the evil] could be removed almost in an instant if confidence could return, touch all industries with her magic wand, and make them continue their production and their demand for the wares of others”.

One is reminded at the present juncture of Pigou’s quote about errors of pessimism following the errors of optimism that preceded the bust:

“Prosperity ends in a crisis. The era of optimism dies in the crisis, but in dying it gives birth to an era of pessimism. This new era is born, not an infant, but a giant; for an industrial boom has necessarily been a period of strong emotional excitement, and an excited man passes from one form of excitement to another more rapidly than he passes to quiescence. Under the new error, business is unduly depressed.” – Arthur Cecil Pigou, quoted in Business Cycles by Wesley Clair Mitchell.

It is interesting to see some market commentators who are otherwise distinguished by the left hemisphere utilization bias of their preferred approach to orienting themselves towards the world of macro and finance (in other words who think in terms of abstracted linear cause and effect rather than a web of influences where context, history, institutional richness and mass psychology work together to shape outcomes) starting to pay attention to indicators of herd mentation, such as cover stories.

Blogging is a more informal medium than an article in an academic journal, but it would still be good form to acknowledge the first person to discover the usefulness of the cover story as a contrarian indicator – Paul Macrae Montgomery, of Montgomery Capital Management.  An unfortunate consequence of the habit in our day of neglecting to trace ideas back to their root is that they tend to take on a stripped-down, cartoonish nature.  Returning to the source, I am often struck by how much more an awareness of the context leading to the development of the original idea adds to one’s understanding in a generative manner.

The question with cover stories is always how to interpret them in the context of the mass psychology prevailing at the time.  I highly doubt one will make money over time by simply positioning oneself in the opposite direction to that implied by the story itself.

My own take would be that Bernanke is benefiting from the rising mood associated with what must be one of the most-hated bull markets in history.  There is quite a lag between the market bottoming, and the mass media really starting to feel more positive about the world.  This cover story is likely both a belated recognition of the bull market in risk assets, and likely also tends to confirm my belief that we have seen a climax to the downside in growth expectations with talk from the likes of Bridgewater of a 15-20 year period of deleveraging ahead.  Real yields are negative because of this belief of the collective that we have seen merely a financial market rally, and that the actions of policymakers have done nothing to resolve the underlying problems – of too much debt in relation to income for the west, and in addition of a misaligned real exchange rate in the case of the European periphery.

The collective did not see the financial crisis coming, indeed dismissed those who raised its prospect as the fringe prophets of doom and gloom, and in a sadly predictable manner now that it has arrived, it has adopted the superstition of those newly converted to a belief in the supernatural.  Every creak on the stairs or rustling of the curtains is the sign of some daemonic influence.  When growth is okay, and unemployment surprises to the upside, it is a sign that the labour market is broken.  When growth is okay, and unemployment starts to surprise to the downside, it is a sign that we are doomed to a future of low growth, and that the labour market is broken (in a slightly different way).

I rather think that we have pretty strong real growth ahead, and not-low inflation.  The labour market should do fine, with the beginnings of an improvement in the prospects for lower-skilled workers and an end to the multi-decadal trend of rising female participation in the labour force.  I agree with Tony Boeckh contra Ray Dalio that the Kondratiev cycle peaked in the early 70s, and I believe it troughed in 2008.  The debt accumulation since the early 70s was in part the consequence of an attempt to maintain a stable standard of living in the face of stagnant growth in real hourly wages.  It would be true to say that nothing has been fixed if we were still in the down phase of the Kondratiev wave with winter still ahead of us.  However I think that 2008 pretty much was winter for the private sector, with restructuring of the public sector still to be completed (but finished at a state level).  Dalio thinks the Kondratiev cycle is a cycle of willingness to leverage, whereas I think the Kondratiev cycle reflects long-lived physical and human capital and cyclicality in debt is a consequence both of this cycle and various other factors.  If I am right then Dalio must be wrong about 15-20 years of deleveraging ahead.  We can grow our way out, as we did the last time the Kondratiev cycle bottomed c 1946-48.  This is not to say there may not be certain difficulties ahead, but I do not believe the situation is as the bears paint it.

So, if I am right, we could see quite substantial upside to real yields, and decent upside for selected equity markets (notably for the Nikkei, which has tended in the past to track bond yields quite closely).  I do not think Bernanke is to be lauded, but at the same time I think mass loathing of the Fed is held for somewhat misplaced reasons.  Policy measures taken since 2007 will have consequences for many years to come, but I do not think deflation, stagnation, or hyperinflation are things to worry about for now.  History shows that inflation starts to become more of a risk once food prices turn, and once this happens it may well be the case that the Fed succeeds in palming off the blame onto unforeseeable shocks – even though any thoughtful and well-read schoolboy could make the link between money-printing today and uncomfortably inflation down the line.  The economy is not like the hydraulic Keynesian machine once constructed at the LSE.  Sometimes government does something stupid and nothing bad happens for quite some time.  Cause and effect may be separated by many years.  Even in the extreme case of the Weimar hyperinflation, money-printing started in 1914, but the mark did not start to see its external value severely impaired till some years later.  (In this case I even expect the dollar to rally).

Bearing in mind that almost nobody at the beginning of 1994 expected anything like what was to materialize, JPM in their weekly GDW are possibly over-optimistic about their ability to anticipate the factors that might lead to a repricing of the US Treasury market:

Value is exhausted. Aren’t bonds in a bubble? The rally
of recent months has tightened credit spreads from recession
levels to cycle averages, but they are far from expensive.
Equity risk premia versus cash and government debt
have moved from half-century highs to still extremely high.
Bubbles require leverage and extreme expensiveness.
Bonds are extremely expensive and have been bought on
leverage by banks. Most of the rise in bond holdings is
with central banks (QE and reserves) that can withstand
losses and have no liquidity problems. Bonds are in extreme
danger once inflation comes and central banks need
to unwind their super easy stance. But these central banks
will not want to create bond carnage and will telegraph
their intentions well in advance. A super 1994-style bond
bloodbath is not here yet.
…
A familiar explanation for recent dollar strength, the March
pattern has been US economic outperformance: since
China is slowing, Europe stagnating, and US labor markets
plus housing improving, US rates will rise and US assets
will outperform. This reasoning also underpins expectations
for a regime change in which the dollar becomes procyclical,
or positively correlated with growth and stocks.
This hope has been a familiar one in the three years since
the Fed cut rates to zero. Rarely does it hold for more than
a month or two, and 2012 shouldn’t be much different—
there are too many obstacles to a trend rise in US rates.
Rather than turning on US outperformance, currencies will
probably continue adjusting in coming weeks to global
mediocrity in which most major and EM economies deliver
below-trend growth in the first half of the year, and in
which the carry trade, which might normally deliver high
returns in this environment, ironically underperforms since
most high yielders in the currency world are also commodity
exporters, so too exposed to China. Thus carry makes
less sense in FX than in bonds or credit until China bottoms.

Perhaps, once again, everyone is wrong.

Core CPI 2.9%

Cleveland Fed Median CPI 2.3%

Ten year breakevens are 2.44%.  Perhaps a touch low, but not obviously out of line unless one expects an aggressive pickup in wage growth – something hard to imagine until the labour market overall is in better shape.

Real GDP YOY peaked 3.5% in Sep 2010 and last quarter was 1.6%.  ISM suggests next year will be a fair bit higher.

Ten year real yields start at a level of –8 bps.  Quite expensive, unless we really are entering a depression, or ‘D’-word period.

Suppose we were to have sharply lower crude prices (maybe US and Israel do not attack Iran; impact of Saudi increased production is felt on market with a lag; US releases SPR reserves; US/global increased production from shale oil starts to be priced; cheap shale gas takes market share from crude; China slows down).  That would tend to boost US consumer disposable income, spending and hiring, pushing up real yields but depressing breakevens in the near term.  It would be a difficult scenario for gold.