Friday, October 23, 2009

Some Thoughts on Buttonwood's Trifecta

Buttonwood’s column this week is typically thought-provoking. She starts with the observation that three major asset classes – stocks, bonds and gold – have all produced double-digit returns in the last three months. She then points out that this is not usual: indeed, it has only happened thrice in the past fifty years 1. And for good reason: the three asset classes have very different exposures to risk (equities are risky, bonds and gold are canonical safe havens) and to inflation (gold is a good inflation hedge, bonds are not, and equities lie somewhere in between). She describes various fundamental explanations (divisions in investor opinion; inefficient markets; central bank intervention; increasing risk appetites). And finally, she lays out her own explanation: liquidity.
Low interest rates are driving investors out of cash and into anything that offers either the prospect of capital gain or a yield that is higher than zero. Investors used to talk about a ‘Greenspan put’ that supported the stockmarket. This time there is a ‘Bernanke put’ supporting all asset prices.
I think that this is exactly correct, as far as it goes. But it doesn’t go far enough. Buttonwood leaves unanswered a host of interesting questions, such as: if there so much liquidity in the market today, why hasn’t it manifested itself in the inflation data? And why, on previous occasions when there was a lot of liquidity available (under, for instance, the Miller Fed), didn’t all three asset classes rally in tandem? Conversely, why did all three asset classes rally together in late 1982, a time when nobody could plausibly claim a surfeit of liquidity in the market?

The second question is the easiest to answer. Under Arthur Burns and then William Miller, realized inflation was very high and inflation expectations were well-entrenched. Asset prices reflected these fundamentals. Gold confirmed its status as an inflation hedge, rising from $35 (its pre-float peg) to over $800 over the course of the 1970s. In contrast, the fixed cashflows offered by bonds are very unattractive under inflation, hence bonds did horribly: 30-year yields rose from around 7.5% in 1970 to 15.5% in 1981. Equities merely treaded water, with higher nominal earnings cancelled out by higher discount rates.

The 1980s saw exactly the opposite dynamic. The Fed under Paul Volcker committed itself to fighting inflation no matter what the cost in terms of temporary economic pain. As a result financial assets enjoyed a golden run: stocks entered a 20-year bull market (to 2000) while the bull market in bonds lasted even longer (to 2008 – and counting). Meanwhile gold was pummeled, dropping all the way to $250 in 1999.

So far so good; all these are precisely what you would expect when changes in (Fed-sponsored) liquidity drive asset prices, first one way and then the other. And as theory dictates, the three asset classes never moved strongly in the same direction, throughout this lengthy period.

With one exception: the last quarter of 1982. Gold, stocks and bonds all rallied very sharply into the end of the year. What happened?

Here’s my theory, propounded as always with the benefit of hindsight. 1982 was the year that the markets finally ‘got’ Volcker’s plan. Tight monetary policy had already caused a short, sharp recession in 1980. 1981 saw a partial recovery, but then the economy entered a crippling double dip in 1982. Nonetheless Volcker kept policy relatively tight (certainly tighter than his predecessors would have done in the same situation). Gold rallied in expectation that this tight policy would hurt the economy and force Volcker to capitulate and ease rates 2. But Volcker stood firm. This gave stock- and bond-markets confidence that inflation was truly going to be beaten, and so it proved. Stocks and bonds continued to rally, while gold gave back its gains within a matter of months. And so it continued, for the next 20-odd years.

Which brings us to 2009. I agree with Buttonwood that the ‘Bernanke put’ (in the form of easy liquidity) is supporting all asset prices. But why don’t Treasury prices reflect this? Where are the bond market vigilantes?

I suspect the answer is that these days, bond traders, like the Fed, care more about wage and retail inflation than about asset inflation 3. And wage and retail inflation has been kept quiescent by the entry of Chinese labor into global commercial flows (a point I have made before, at length). That’s why the current flood of Fed-sponsored liquidity hasn’t entered the official figures yet; and that’s why bonds continue to be bid up.

Will it last? Or will bonds be the next great bubble to burst? We shall see.


# 1 Try as I might, I cannot replicate Buttonwood’s numbers for government bonds. The high in yields over the past 4 months was on 7 August; the subsequent low was on 7 October. Between those two (cherry-picked) dates, 10-year Treasury notes rallied by about 70 basis points, which corresponds to a return of roughly 6% in price terms. The price gains for 2-year, 5-year and 30-year Treasuries over the same period were 1%, 3% and 8% respectively. Given that Treasury issuance is overwhelming skewed to the short end of the yield curve, there is simply no way that bonds have returned double digits in the last quarter. Also, Buttonwood talks of a fifty year sample; this is actually meaningless, since the dollar was pegged to gold until 1971. But I digress; this is mere quibbling over numbers, and the arguments made elsewhere in Buttonwood’s column remain valid.

# 2There was also a large technical element to gold’s 35% rally, coming as it did on the heels of a 65% selloff.

# 3FX traders are not so accommodating; witness the continuing weakness in the dollar versus pretty much every other currency in the world.

Wednesday, October 21, 2009

Some Thoughts on the Phillips Curve

Of all the economists, journalists and assorted financial industry participants who comment on the web – and there’s certainly no shortage of them – the one whose views align most closely with my own is James Hamilton of UC San Diego and Econbrowser. I find that I rarely disagree with him, whether it’s on macroeconomics, oil, securitization, financial markets, or anything else. So I was interested to see him make the case that ‘high levels of unemployment are a factor that will put downward pressure over the next two years’.

His argument is straightforward: he regresses historically realized inflation against unemployment, and also against lagged inflation (the latter is to account for expectations of inflation). He finds a statistically significant negative coefficient for the period from 1948 to 2007, validating the classical Phillips Curve relationship. Since unemployment is currently very high, inflation is (ceteris paribus) likely to be contained over the next few years.

My quibble with this analysis is that I just don’t think historical data, aggregated like this, is a very useful guide to the future. For instance, the period from 1948 to 2007 had several very distinct macroeconomic regimes. Let’s go decade by decade:

1940s: World War II has massive effects on consumption, production, resource allocation and labor markets, effects which do not end with the end of the war. The Fed buys long bonds to finance government spending, but reduces the money supply to pre-empt post-war inflation of the kind seen in 1919-20.

1950s: A boom in capital goods and in consumer credit (think: demobilization and reconstruction) leads to a sustained period of strong employment and benign inflation; the misery index will never be this low again. But a balance of payments deficit hints at trouble to come.

1960s: Operation Twist. The Great Society. Tax cuts combined with spending increases bring about the first persistent, large budget deficits. Congress eliminates the gold reserve requirement for the Fed. Inflation rises. The draft reduces unemployment.

1970s: The US leaves the gold standard in 1971. Nixon imposes wage and price controls from 1971 to 1974. OPEC embargos oil. Arthur Burns argues that it’s okay to countenance ‘temporarily’ higher inflation if that can alleviate economic shocks. He is succeeded by William Miller who thinks Burns kept policy too tight (!).

1980s: Paul Volcker breaks the back of inflation. The Reagan recessions are followed by the Plaza Accord and the devaluation of the dollar.

1990s: China. See my previous post for details.

I think it’s fairly clear that at different times over the last 60 years, very different factors have driven inflation and employment in the US. Certain drivers remain important to this day, but others have changed utterly. (For instance: every decade has seen a different role for the Federal Reserve, from financing government debt in the 1940s, to twisting the yield curve in the 1960s, to fostering stagflation in the 1970s, to satisfying the bond market vigilantes in the 1980s). If causation has changed so much, how can we expect correlations from the past to apply today?

In fairness, I don’t think Prof. Hamilton himself fully believes the case he presents. He merely makes the observation that a forecast for low inflation going forward is not ‘crazy’, while pointing out that other factors (the dollar, commodities) may pull the other way. I can’t disagree with that ... so I guess I’m back to agreeing with him on everything.

Postscript: I’m embarrassed to admit that I only found out recently that the James Hamilton who co-writes Econbrowser is the same James Hamilton who wrote Time Series Analysis, a text which I used a fair bit in my professional career.

Wednesday, October 14, 2009

Jobless Recoveries and Asset Market Bubbles

Asset markets around the world have rebounded quite substantially from their lows of earlier this year. As a result, attention has increasingly become focused on the Federal Reserve’s ‘exit strategy’1. Can the Fed raise interest rates, or even credibly threaten to do so, given the bleak state of the labor market? Some central bankers think so; here’s the Philly Fed’s Charles Plosser:
As the economy and financial markets improve, the Fed will need to exit from this period of extraordinarily low interest rates and large amounts of liquidity. We recognize the costs that significantly higher inflation and the ensuing loss of credibility will impose on the economy if we fail to act promptly, and perhaps aggressively, when the time comes to do so. The Fed will need courage because I believe we will need to act well before unemployment rates and other measures of resource utilization have returned to acceptable levels.
Others are more cautious, and would like to see a rebound in employment data before removing policy accommodation. Here’s the St Louis Fed’s James Bullard:
We’ve got this short term deflation risk; if we get into that trap it’s going to be hard to get out of, and that’s why we want to avoid the Japanese style outcome right now.
We know labor markets are going to lag, but we’d at least like to see them go in the right direction and start to improve. We’d like to see positive results in labor markets.
You want some jobs growth and you want to see unemployment coming down. That’s a prerequisite [for an increase in interest rates].
This entire debate misses the point. In my opinion the emphasis on labor markets is overdone, simply because we are not likely to see a rebound in the employment data – payroll expansions or wage increases – any time soon. The mechanisms for robust and rapid growth in payrolls and wages just do not exist any more.

Thanks to a lowering of international trade barriers, thanks to outsourcing and off-shoring, and thanks above all to Chinese labor’s entry into the global marketplace, workers in the first world have no bargaining power any more2. Gone are the days of strong unions and collective wage agreements.

It is no coincidence that the last few recessions – specifically, those after China’s entry to world commerce – have been followed by jobless recoveries.

Source: Calculated Risk

Indeed, the shape of the world’s labor market today is such that ‘jobful’ recoveries are guaranteed not to happen. A policymaker who waits to see such a recovery before raising rates will have waited too long.

If the flood of liquidity provided by central bankers does not go into the labor market, then where does it go? Into asset markets. It is also no coincidence that the last few recessions and jobless recoveries have been followed by asset market bubbles, first in technology stocks, then in housing.

Thus the conventional wisdom, that China ‘exports deflation’ to the world, is only partly true. Over the last twenty-odd years, China has indeed exported deflation, but this has been concentrated in very specific segments of the economy: in the prices of retail goods, and in worker salaries. It so happens that these segments are precisely the ones captured in standard measures of consumer inflation. Central bankers, lulled by this quiescence in measured inflation, have time and again erred on the side of loose monetary policy, leading directly to the asset price bubbles that have done so much harm in recent years.

Of course, there is no guarantee that the Federal Reserve will go down the same path this time around. Policymakers today are very sensitive to the charge that they kept rates too low for too long in the early 2000s, and thus inflated the housing bubble; they will be keen to avoid repeating this mistake. But policy is inseparable from politics, and it will be difficult if not impossible for the Fed to completely ignore labor market conditions when making its next few interest rate decisions3. These will be interesting times indeed.


# 1‘Exit strategy’ is the currently fashionable euphemism for the painful process of raising interest rates. In the 2004 hiking cycle, the euphemism of choice was a ‘measured removal of policy accommodation’.

# 2If anything, this lack of bargaining power is even more obvious, and its effects even more pronounced, during economic downturns. Corporations increasingly take advantage of recessions to make dramatic cuts to payrolls, cuts that they would find politically inexpedient to make in good times. When the recovery comes (as it eventually must), the replacement hires are, more often than not, made overseas. Thus cross-border labor arbitrage – the gradual replacement of first-world workers with their cheaper third-world counterparts – is not a smooth process but a step function.

# 3Personal opinion: while I sympathize with the intent of those seeking to alleviate the condition of the working middle class, who have been hammered hard in recent years, I can’t help but feel that monetary policy is absolutely the wrong tool for the job. If you want to improve the employment data, implement deep-structural changes (investments in education, infrastructure, research and technology; a better tax code; incentives to save and invest rather than consume; and so on – all easier said than done, of course) designed to bring about that outcome; don’t count on the Federal Reserve to come to the rescue. In any case the Fed can, at best, merely buy a few years of breathing space; it cannot change the underlying fundamentals, and it would be foolish to expect otherwise.

Wednesday, October 7, 2009

Feedback in Financial Markets

In a previous post, I mentioned that bubbles were characterized by – indeed, defined by – positive feedback. This idea, and more generally, the importance of feedback in driving market dynamics, deserves a lot more ink. Here’s a first installment.

Classical economics is often concerned with analyzing various equilibrium outcomes (“comparative statics”). These outcomes are usually generated or maintained by some sort of negative feedback. The simplest example is that of security prices. Under the efficient markets hypothesis, each security has a fair price reflecting its ‘fundamental value’; furthermore, this fundamental value is known to market participants in aggregate. If the actual market price drops below this value, people step in to buy the security; if the price rises above it, people step in to sell. As a result of this negative feedback, the market price equilibriates to its natural or fundamental value.

Unfortunately markets do not always tend to equilibrium. Negative feedback is not always the dominant mechanism at work. And fundamental value is not always well defined. Bubbles provide a clear example of each of these counterfactuals.

In a bubble, the dominant mechanism is positive feedback; the key to understanding bubbles is understanding this positive feedback. How, then, does positive feedback arise?

The most obvious explanation is the conventional one: positive feedback is a consequence of irrationality in the market. And there’s certainly an element of truth in this explanation. Greed, self-delusion, unjustified extrapolation, caring more about relative returns than absolute profits (a.k.a. “keeping up with the Joneses”), conformism (a.k.a. “if everybody else is doing it why can’t we?”), confusing the improbable with the impossible (“house prices will never go down nation-wide”) and other persistent behavioral flaws lead inevitably to bubbles. This has been true throughout the history of speculation.

But one doesn’t have to invoke irrationality to explain positive feedback. Positive feedback can arise quite naturally when rational traders encounter flawed institutional mechanisms, as my previous post makes clear. Short-term incentives, asymmetric outcomes, incomplete information and firm-wide pay structures could all lead to perfectly rational actors taking actions which lead to positive feedback and hence bubbles.

Both of these are what I would call ‘technical’ explanations, in that they depend on trader behavior (which has various causes) to move market prices away from some underlying fundamental value. But there is another, and to my mind more interesting, form of positive feedback in which the fundamental values themselves change.

Consider this example from the FX markets. A currency strengthens. This acts like a tightening of monetary policy. Hence inflation expectations diminish. Hence the currency strengthens further. The initial move has thus changed the underlying fundamentals so as to justify itself; it has become a self-fulfilling prophecy.

Or consider this example from the equity markets (private email from my friend WB):
Markets prices impact fundamentals. If Amazon's stock price goes up as it did in 1999-2000, it makes it that much easier to raise capital either from debt markets or from equity markets. If Amazon raises more money it can invest more and make improvements which make the future look that much brighter. That pushes up prices even higher. That's not a negative feedback cycle. In fact it's downright positive feedback. This can go on for a very long time, but then one day the reality just doesn't offer as much as was priced in and we have an enormous collapse which again acts in a positive feedback way. So in the end over medium horizons, markets can be mean-averting or create trends while in the longer term picture they are mean-reverting.
Or, closer to home, consider this example from the real estate markets (lifted from Wikipedia):
Lenders began to make more money available to more people in the 1990s to buy houses. More people bought houses with this larger amount of money, thus increasing the prices of these houses. Lenders looked at their balance sheets which not only showed that they had made more loans, but that their equity backing the loans—the value of the houses, had gone up (because more money was chasing the same amount of housing, relatively). Thus they lent out more money because their balance sheets looked good, and prices went up more, and they lent more.
Of course, the conditions required to foster a ‘fundamental’ positive feedback loop don’t arise very often, but when they do, the outcome is dramatic.

The final word belongs to George Soros, who treats feedback as a special case of his larger socio-economic theory, ‘reflexivity’. Soros’ book The Alchemy of Finance contains many more examples of ‘fundamental bubbles’; rather than quote them all, I’ll leave you with two short excerpts from this 1994 speech:
I must state at the outset that I am in fundamental disagreement with the prevailing wisdom. The generally accepted theory is that financial markets tend towards equilibrium, and on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal by the theory of efficient markets. Such boom/bust sequences do not arise very often, but when they do, they can be very disruptive, exactly because they affect the fundamentals of the economy


For instance, in a freely-fluctuating currency market, a change in exchange rates has the capacity to affect the so-called fundamentals which are supposed to determine exchange rates, such as the rate of inflation in the countries concerned; so that any divergence from a theoretical equilibrium has the capacity to validate itself. This self-validating capacity encourages trend-following speculation, and trend-following speculation generates divergences from whatever may be considered the theoretical equilibrium. The circular reasoning is complete. The outcome is that freely-fluctuating currency markets tend to produce excessive fluctuations and trend-following speculation tends to be justified.
And there you have it, straight from the greatest trader of the twentieth century. Further comment would be superfluous.