Wednesday, July 31, 2013

Minimum Wage

I was messing around with minimum wage data some more. (I revisited the data later here.)  I took employment data for several age groups back to 1954, and I did a regression of the Year over Year % change in the number of employed people within each age group against changes in the minimum wage.  This will help to account for both people who are categorized as unemployed and people who leave the labor force.  Since many minimum wage jobs are temporary, discretionary, or held by people who are marginally in the labor force (teens, seniors, and homemakers, for instance), much of the effected workers leave the labor force instead of showing up as unemployed.

There are slight differences, depending on how I describe the change in the minimum wage.

Here is the change in employment per dollar increase in the minimum wage, which doesn't account for increasing incomes over time:

Here is the change in employment per 100% increase in the minimum wage, which doesn't account for the increasing effect of the minimum wage as it increases (eg.  if the minimum wage was 2 cents/hour, we wouldn't expect a doubling to have an effect on employment):

Here is the change in employment given an increase in the minimum wage roughly equal to the average wage.  (eg. if there were no minimum wage and a new minimum wage was enacted, set at the average wage level, this would be the effect on employment).  Of course, this would not be a linear relationship, as very low levels of MW would have little effect, and if we tried to implement a MW as high as the average wage, the labor market would implode.  So, this way of addressing the effect is imperfect, but probably gives a decent result, given the typical level of the minimum wage, and it helps to scale the effect without the problem of inflation or changing MW levels, compared to the previous two charts.
It might give better results to do a regression against both the change in MW and the level, but I don't want to get too complicated for this post:
So, depending a little bit on how we measure it, we see a very large effect among teenagers, a negligible effect on middle-aged workers, and a somewhat strong effect on older workers. This is basically intuitive, since teenagers and very old workers would be more likely to be working in low-marginal-productivity jobs.  The results for 25-54 year olds tend not to be statistically significant, because only 1-3% of these age groups are working at low wages at any given time.  In recent years, 8% to 18% of teens have been working at or below minimum wage at any given time, so a change in the price floor has a statistically significant effect on them.  The one surprising outcome here is the apparent positive effect on 20 somethings in the last chart.  I wonder if there is a substitution effect happening there, where teenagers are priced out of work, which leads to a recasting of the lost jobs into more productive jobs that slightly older workers with more experience and dependableness can perform.  This could be pointing to a mitigating factor that keeps the negative effect on employment from being worse.  Low productivity workers are put out of work, and so if there are some higher productivity workers who are available for those jobs, there could be a contrary effect where there are more jobs for those workers.
Over a long period of time we have seen labor force participation decline among young people.  The minimum wage hasn't risen over this time relative to average wages, but we do see the LFP rate decline as new minimum wage increases are implemented.  A combination of the effects of the minimum wage and cultural changes appear to be leading young people into schooling as a substitute for entry level employment.  This probably relates to the internship issue I recently considered, and the distinction between training through work or school.  Wage floors force workers to seek employment status signals outside of actual employment.  They have to try to build up enough personal capital to be productive enough to earn a legal wage level.  This pushes a lot more young people into extended schooling that is probably not an optimal use of their time.  I suspect we would be a lot better off if the pendulum could swing back toward an equilibrium where more young people gained skills and status on the job.  A lot of effort and resources are being put into schooling that costs young people a tremendous amount.  The attitudes of most students about school content suggests that it is an expensive signal that is not strongly related to the accrual of actual skills.  In the alternative world, many young people would be producing instead of consuming, earning income instead of building debts, and likely would gain more skills and status in the process.
Why is it considered enlightened to have a public policy that leads to a bunch of 21 year old kids with $20,000 in debt and 2 1/2 years of classes for a liberal arts degree they're never going to get, but it's inhumane for them to stock shelves for a retailer for a couple of years for $6/hour.  It doesn't even look like a contest to me.  Instead of letting these kids do what's best for them, we're imposing anti-market biases and bourgeois pretenses on them, to nobody's benefit in the long run.

Tuesday, July 30, 2013

There was no housing bubble





Current Yield Curve & Risk Premiums

Vince Foster always is a challenging read:

Monday, July 29, 2013

Sticky Wages vs. Sticky Employment

Here is an interesting article that suggests unemployment manifests itself differently in Japan compared to other developed economies, because companies here tend to try to hold wages, so they cut costs through layoffs.  In Japan, they cut wages in order to avoid layoffs.

Here, we consider sticky wages to be a market friction that the Fed can lessen through inflation, but how would we deal with the Japanese labor market?  I suppose inflation would help there, too, as wages of unproductive workers would be pushed down in real terms as other workers received cost of living raises.  Rising profits would lead to new investment where those workers could be productive again.  But, the act of leaving the original job for a new job would still have to overcome a lot of labor market frictions, with search costs, etc.

This is counterintuitive.  We normally would consider sticky wages to be a market imperfection, but it seems like maybe in the long run, layoffs allow for a more efficient transition to new productive outlets for labor.

Sunday, July 28, 2013

Sumner & Soltas on the Fed & Business Cycles

There's a lot of wisdom there, including the comments, with George Selgin coming in at clean up.

Falling investment is the problem in recessions, not falling consumption.

Falling interest rates would normally be a sign of a structural problem, and the effect of markets adjusting to lower investment return expectations.  So the Fed tends to follow the rates down, but communicates as if it's leading the parade, so we end up with tighter money than we should have in the Fed's absence, but conventional wisdom is that the Fed is loosening.

Rates have been in a long term secular decline, which is mostly due to demographic and long term economic changes, and if the Taylor Rule doesn't account for this, then the Fed will inevitably tighten too often so that we end up with the double whammy of low real rates and low inflation.  If the Fed doesn't account for this, we are likely to be back at the zero bound when the next recession comes.

Especially with our screwy way of accounting for health benefits, with real interest rates being very low, a 4-5% inflation target would probably be better than the 2% targets we have been at.  Of course, it would be even better if we could somehow get some structural improvements in health care spending.

Those are my thoughts.

Friday, July 26, 2013











                                (.42)               (14.5)                    (3.9)
E(HTCH) = forecast share price of HTCH
t= number of months since March 1990
NASDAQ = level of the NASDAQ Composite Index
GM= trailing 15 month gross margin
CGM = 6 month change in quarterly gross margin


Thursday, July 25, 2013


Patrick released another stellar quarterly report today.

Back when I first came up with a long term $20-$30 valuation, my DCF models were somewhat dependent on the long term recovery of manufactured homes, which used to be half of their revenue and are now less than 20%.  As well as they have managed the past few years, there could easily be a couple more doubles left here, if manufactured housing ever sees a recovery.

This is what I said in early November, 2011, with Patrick at around $2.50:
This is one of the easy ones.  This is up 30-40% in the last month, and I hate to chase stocks up, but at these prices, I have to say, back up the truck.  This is worth easily 5 times what is sells for today, and all of their target markets are in slumps.  They should see significant cyclical growth over the next several years.  There is the possibility of a "10-bagger" here, and I don't see any unusual risk.  No need for a 40 page report.  My report on this one is "Dude...come on."

Who would have thought that that forecast was too bearish?! Ha!

NAFTA helps poor Mexican farmers

HT: Cherokee Gothic

Is this the last shoe to drop for Obamacare?

Labor is turning against it.

I don't understand the public choice implications of all of this.  None of this should be a surprise.  Why were unions for it in 2010, only to turn against it now?  Is there some sort of Machiavellian knot that is being worked out here, or were the bill's supporters really that clueless about the complex consequences of piling dozens or hundreds of inter-related mandates and fees on top of each other?  Could our federal governance have gotten that bad?

Tuesday, July 23, 2013

Employment Flows

The BLS has tons of great data.  Building on yesterday's post, I was really hoping that I could find employment flow data broken out by age.  I'm coming around to the idea that so many trends that we would like to attribute politics, money supply, etc., etc. are largely demographic issues.  I was hoping to test whether the tepid JOLTS data could be a product of demographics.  Characteristics of older workers could explain the low level of quits, the high proportion of job openings to hires, etc.  But, unfortunately, I don't see it broken out that way.

The flow data is interesting, nonetheless.  Here are the historical graphs concerning flows to and from "Not in the Labor Force".  First, here is a graph of "Not in Labor Force" population.  We can see the acceleration in this category over the last 15 years, as a result of an aging workforce.  And, we can see the slight movement above trend in 2003-2005, then the slight movement below trend in 2006-2008, with a recovery back to trend in 2009 and after:

In the next graph, the blue line shows "Not in Labor Force to Employed" and the green line shows "Employed to Not in Labor Force".  I would guess that the secular growth in these categories stem from the aging labor force that I covered in the previous post.  In the 55+ age group, there are a large number of people who would not consider themselves "unemployed", but fill their days with a combination of civic involvement, odd jobs, consulting, political activities, etc.  Some of these activities would count as "employment", but for the growing number of people that meet this description, life would not fit nicely into a employed/not employed context.  We can see the long term increase of aging baby boomers here, with a temporary decline during the recession from labor market anemia, although even at the bottom of the recession, there were more flows between employment and NLF than there had been in the 90's in a booming economy with fewer older workers.  (Students could be an effect of these flows, too.)

The red line shows flows from "Not in Labor Force to Unemployed" and the purple line shows "Unemployed to Not in Labor Force".  The conventional image of the recession is that the UE>NLF flow would have increased.  But, the full picture is more complicated.  Flows in both directions have increased together.  Looking back in time, there is some cyclical behavior in these flows, but not the secular increase that we see in the employment flows.  The recent persistence of the increase in these flows is probably related to the large number of long duration unemployed.  It is interesting to note that while 11 to 12 million workers are still unemployed, there is a flow of more than 2.5 million workers between unemployed and "not in workforce" each month.  With that much circular flow, it is amazing that we don't see more noise in reported unemployment rates each month than we do.

To get more insight into how these flows relate to the business cycle, I have graphed the net effect of the "Not in Labor Force" flows to and from employment ﻿(blue) and to and from unemployment (red), and the net flows to "Not in Labor Force" from both employment and unemployment.  These are 12 month moving averages to eliminate noise.  There is always a net flow from employment to "Not in Labor Force" and from "Not in Labor Force" to Unemployment.  The persistence of these net effects relates to persistent aspects of the economy, such as the constant flow of new young people into the labor pool, retirements of employed people, etc.  The net NLF figure here does not account for non-employment related changes, such as population changes.  The changes in trend are what's important here.
First, on the total net flows to NLF (Not in Labor Force), there is probably a persistent negative flow (a flow into the workforce) over time.  Here the unsustainable trend of flows into the labor force in 2004-2005 are visible, and the unusual flows out of the labor force in 2009-2010 are visible, with the return to a neutral flow since then.
When we look at the separated indicators, we can see that there is a counteracting dynamic happening.  In the early phases of the last two recessions, the "Not in Labor Force" category was inflated by workers moving directly from employment to NLF, and this was countered by workers moving out of NLF and into Unemployment.  It is only later in the recession that we see relatively more workers moving from unemployment to NLF, which is then countered by relatively less workers moving from employment to NLF.  I would characterize the period in 2009 & 2010 where we saw the biggest dip in Labor Force Participation as mostly the product of a decline in workers flowing from NLF directly to Employment.  Looking back at my previous post, where we see the most anomalous movement in LFP among the youngest and oldest workers, I would speculate that this stemmed from older workers who normally tip back and forth between Employment and NLF having a harder time finding temporary employment, and younger workers who were having more difficultly getting entry level jobs in the face of stagnant hiring markets, exacerbated by the last hike in the minimum wage in late 2009. 

It seems as though there could be a leading indicator hidden in here somewhere, since early in recessionary markets we see a local minimum in flows through unemployment, a local maximum in flows through employment, a divergence of flows between NLF and Unemployment as well as between NLF and Employment, and, as shown in the last graph below, an increase in the persistence of unemployed workers.

The counteractivity of many of these indicators means that these movements can start to be visible here before they are visible in measured LFP or the unemployment rate.  Interestingly, the last chart also shows how flows in and out of NLF and the persistence of unemployment are much more volatile than the flow of workers from Employed to Unemployed.

Surely, there is a leading indicator buried in here somewhere, although the noisiness of this data might make it hard to read in real time.  These will be interesting to watch when we enter the next bear cycle.  These indicators certainly do not bear out my earlier concerns about weakness in the JOLTS data, so this is more evidence that we have a ways to go before we need to worry about a new downturn.

Monday, July 22, 2013

Demographic distortions in the Unemployment Rate

There has been a lot of public discussion about the unemployment rate, and how it would be higher, if not for dropping labor force participation.  I will argue here that the unemployment rate is overstated, and that, notwithstanding anemic hiring, the properly adjusted unemployment rate is probably more or less recovered.  We are still 2-3% from what would normally be considered a fully recovered unemployment rate.  I think that a decent portion of that could be explained with the following factors, in reverse order of importance:

I have added some additional analysis on some of these issues here.

Saturday, July 20, 2013

A spotting

Normally, Jennifer has to wait for me because of this:
Duty Calls



Friday, July 19, 2013


Hutchinson Technology will report 3Q 2013 results on Thursday, July 25.  Their two public customers report on the 24th (Seagate & Western Digital).  Their near term forecasts, and probably some stock performance will depend on sales and projections from WDC and STX, although, in the longer run, the HTCH narrative is about regaining market share, so my long run sentiment wouldn't be effected as much by current changes in broader hard drive sales.


Any changes in the broader industry would mostly serve as means for me to sell at something near the target price earlier than expected, or buy/convert to options if further gains simply look to be delayed by industry noise.  The biggest danger would be bearish reports by STX & WDC, followed by disappointing guidance by HTCH, which would leave me in the position of wanting to lighten up, but without a decent price point at which to do it.

I regressed HTCH against both STX and WDC over the period since December 2011, when HTCH first started bottoming out.  The regressions tend to reflect the narrative here of a HTCH-specific price change that reflects its strengthening position within the industry more than the strength of the industry itself, even though the industry has certainly had a couple of good years.

The beta to both STX and WDC is around .35 against both stocks, and the alpha (weekly) of HTCH after accounting for its correlation to those stocks is nearly 1% per week over that time, although most of that alpha has been achieved in the past few months.  The beta is low even if I leave out the recent period with HTCH's sharp rise.  Considering the fact that HTCH is a more volatile stock, the extremely low beta is surprising, even to me.  And, oddly, the weekly beta is lower than the daily beta.  I would have expected daily noise in HTCH trading to make the correlations stronger on a weekly basis.  The point of all of this is to say that the STX and WDC effect on the HTCH share price over the next few weeks may be less than one might expect, although I would expect a reaction on the day of the earnings reports.

In any case, industry wide sales had seen a decline in the past couple of years compared to estimates from 2011.  HTCH might have been above $10 by now if not for that disappointment, so they are not wholly immune from industry trends, but I'm still looking for anywhere from $12 to $25 before I am through here.  We're trading at around $5 right now.

Chart forHutchinson Technology Inc. (HTCH)

Nice post on Forward Earnings as an indicator

I liked these graphs:
Forward Earnings 2013

6-22-2013 5-28-39 PM

As for the current market, it's another mixed message, as year-over-year expectations continue to show growth, but the forecasts for each period are not showing any upward momentum.....

Thursday, July 18, 2013

Labor, Bonds, and the Equity Risk Premium

I have recently seen an explanation for the equity risk premium (which is supposedly higher than some risk models would justify) that seemed reasonable to me.  The explanation was that there is an unavoidable observational bias, in that, it is only because we are in an extended period of peace and prosperity that we are systematically measuring ERP, and that kind of period would naturally lend itself to unusually high equity returns.  In other words, returns to equities will almost always appear to be slightly inflated, except for those few occasions when they are highly negative - the ERP has a bond-like range of outcomes.

In the end, the universe has an expected range of payouts much like a bond - even a lizard spends months or years hanging out under his bush, munching on a tasty grub now and then, until when he least expects it the hawk's talon hooks him one day while he's basking in the sun.

So, in the end, what has finance gained us?  We want to be insulated from risk.  Humans, like all social animals, have always depended on familial and community bonds to grasp hands and pull through famines as a group.  But, in simpler societies, there were still a tremendous amount of risks, dangers, and famines that were too much to handle, even together.

Modern complex societies allow us to trade and share risk much more effectively.  Since most of us aren't in the risk business, we seem to have settled at a social equilibrium where we have bifurcated into risk buyers (business owners, equity investors) and risk sellers (laborers, creditors).  Creditors are actually on both sides of this equation - they buy risk from laborers and sell it to equity holders.

Labor and creditors share that same payout - they each produce a premium for the risk buyers (the equity holders), and in exchange, they receive very standardized, predictable outcomes....., until the day that default or layoffs come.  I wonder, in the end, how healthy this is.  Morally, it allows us to pretend that the tendencies of the universe are suspended, that abundance is secure and predictable.  But, we've really just paid the equity holders a premium to take all the noisy, manageable risk from the fat part of the range of outcomes.

I think this might lead to biased moral reactions to risk.  Equity holders have explicitly acquiesced to accept a certain kind of risk, so we see their success or failure as acceptable.  But, since laborers have sold most of their small risk away, we see the imposition of risk on them as less acceptable.  There was never any evidence that anyone could have accepted the long tail risk, but our daily experience in the world of normal outcomes, we compartmentalize people among the risk bearing and the non-risk bearing.  We hiss at equity holders who layoff workers in order to move a factory to a less expensive location, but we don't take the same offense if the factory stays open but goes bankrupt, leaving the jobs and bondholders intact, but the equity holders with nothing.  These are both the result of unfortunate long-tail outcomes.  Is the moral double standard justified?

This might explain an additional ingredient into the ERP, because this moral framing causes us to create social policy countering these moral reactions.  Tax policies and other regulations tend to favor debt over equity and labor over capital, depositors over banks, etc.  But, even these policies cannot overcome the broader universal reality of long tail risk.  So, they simply create more demand for the kind of seemingly risk-free trade offs that push more investment out of broad risk-exposure and into this binary payoff world.  This payoff structure, and the excessive dependence on it in an economy, creates more danger of systemic risk, because there are fewer participants willing to take on economic risks explicitly.  The system becomes less robust.  And, when systemic crisis hits, our moral predisposition leads us to politically forgive the long tail risk of the risk averse.  Bond holders are bailed out, while equity is wiped out, labor protections and insurance are expanded.  These are more or less predictable reactions which increase the de facto long term cost of risk, and would, theoretically, increase the ERP.

An extreme example of this phenomenon is in banking, where the federal government guarantees deposits.  Deposits are a form of debt, from the perspective of the bank.  Additionally, a form of financing called a repo, which is essentially a loan that is given favorable legal treatment, has also become popular.  So, banks have these tremendous sources of debt financing with very favorable legal treatment.  This has the effect of pushing up the debt ratio that banks use.  The government counters this effect with capital requirements, so in order to compete, the banks have to leverage up to the maximum allowed amount of debt.  Normally, as leverage rises, debt-holders are less protected from downside risks, so they demand a higher premium, in the form of higher interest rates, and a balance is reached between the levels of debt and equity.  In non-banking industries, typical leverage levels depend on the factors in a given industry, but they are always naturally much lower than in banking.  Since accounting and government policy insulate debtors (including repo buyers and depositors) from financial risk, the debt on bank balance sheets increases with no natural impediment.  As long as these policies remain in place, if banks didn't also have capital controls, they would be essentially fully leveraged 99.9999%, with the small equity holder taking gains while they came, and leaving the FDIC with the remains when failure encroached on the organization.  In earlier banking regimes without these regulations, bank leverage was much lower.

When crises hit, the equity holders are wiped out, and generally we undertake additional political policies to salvage the bondholders and depositors.  Equity in banks should call for an extremely high risk premium in this context.

Monday, July 15, 2013

Fantastic interview on the mindset of a successful speculator

Original article:

Very early indications of macroeconomic headwinds

I have been a macro optimist since 2008.  Even now, indicators generally seem to be headed in the right direction, and housing is finally settling into a cyclical recovery period, which I think still will have positive forward effects in the labor market.

But, some very early indicators are starting to cause concern.

The lack of inflation in the face of QE3 could be a sign that the Fed has reached a point that the expectations channel is the only source of influence they have left and that the small inflationary effect of exchanging treasuries for cash that eventually ends up as excess reserves is dwindling.  Sober look suggests that we are seeing the effect of some ECB tightening.  There are also fiscal reasons why inflation might have dipped.  Expectations appear to be for a rebound, but further drops in inflation would be very bearish.

Here is a graph of bank credit (blue), and commercial loans (red).  Both are showing some flattening.  The green line is the inverted unemployment rate.  Normally, we would see unemployment bottoming as these measures flatten, and we aren't seeing that yet.

However, the labor market is a bit of a mystery:

The blue line is total unemployment.  The green line is the rate of unemployment if we subtract out unemployed workers who are on extended unemployment insurance.  Most of the excess unemployment in this cycle consisted of long term unemployed with extended unemployment insurance.  Much has been said about how high this number was and how slowly the number of long term unemployed workers has declined.  Interestingly, all of the decline in unemployment has been in long term unemployed workers with extended insurance (blue line - UEI):

Both short term unemployment and long term uninsured unemployment have flatlined since 2010.  Oddly, initial and continuing unemployment claims have continued to drop.  But, I would have expected this to show up in lower numbers for short term unemployment (less than 26 weeks).  But, again, oddly, an unemployment forecast based on initial and continuing claims (shown in the red "UE trend" line above) would seem to have given a fairly tight correlation to total unemployment.

(Admittedly, this is an in-sample regression.  However, in the other two most recent recessions, we see the same pattern:  At the initial recessionary unemployment surge, the unemployment rate rises more quickly than unemployment claims would predict.  This is because, as shown in the JOLTS data, the initial cyclical issue in the labor market is from anemia, not from too much turnover.  After the initial surge, the relationship between continuing unemployment claims and the unemployment rate becomes surprisingly linear.  The peak of the recovery is signaled by a breakdown in this linear relationship, as the unemployment rate now proceeds to a lower rate than would be predicted by unemployment claims.  This is the result of healthy new turnover in the labor market.  This is mitigated by new entrants into the labor force, reflected by an increasing labor force participation rate.  In summary, an unemployment forecast from continuing claims that overstates unemployment and an unusual rise in labor force participation both should be early signals of a cycle peak.  These signals are not currently active, although labor force participation will be difficult to read, because demographic factors are creating a declining secular trend line, so that the LFP rate may be flat in absolute terms when it begins to hit unsustainable levels.  These interpretations might be somewhat novel, which I am hoping means that I can use them to create profitable positions leading into the next cyclical downturn.  But, the these signals would predate recessionary markets by even 2 to 3 years, so the fact that they are not active probably means that my other concerns about the labor market are premature.)

The most optimistic reading I can give of this is that there is still a considerable amount of competition between short term unemployed and long term unemployed workers, and that eventually short term unemployed workers will re-enter the workforce more quickly as the long term unemployed are brought back into the workforce.

This is where the JOLTS data bothers me (12 month moving averages in black):

What JOLTS data makes clear is that recessions are related to sclerosis in the labor market as much as they are related to excessive layoffs.  JOLTS data is fairly young, but what we can see from the start of the bear cycle in 2007 is that the first signs of the recession came from flatlining quits (aqua) and hires (blue), which can be seen as early as 2006.  Job openings peaked in 2007 (red).  Layoffs (green) are a lagging effect, and they only show unusual activity in 2008 & 2009.  This was a peculiar cycle, so this process may not be universal.  I believe Scott Sumner's account that we had a small and manageable contraction related to the housing bust, which was developing in 2006 and 2007, and that the worst part of the recession was due to a liquidity crisis created by the Fed in 2008.  If that is the case, then the large bump in layoffs late in the cycle is not typical.

But, the current situation is a setup for bad news.  Hires have been flat for a year, even as Job Openings has increased.  This could be a very early bearish indicator.  And, in the past 3 months, the moving average for Quits is up only 9 thousand.  If Quits confirms a cyclical peak over the next few months, I am afraid that we will be in a very dangerous situation, where we will be lucky if unemployment drops below 7% before we hit the next downturn, and we could have a Fed that could be unwilling or unable to counter deflationary forces.  If we continue to be saddled with federal policies that are hamstringing employers, the downside risks in that scenario would be high.

A resumption in the fall of initial claims and a continuation of the fall in continuing claims would be encouraging, but I consider the Quits rate in the JOLTS data to be a key very-early indicator of potential problems to come - at least as important as Hires.

Corporate profits have leveled out, which deserves watching, and the number of unemployed per opening is starting to level out.  This is a bearish indicator, although the number of unemployed persons per opening is still much higher than in previous recoveries, so it is another indicator that is odd in the current context.

On the positive side, bank loan spreads, demand & standards all continue to look strong, housing is strong, and currency in circulation is strong.  It would be unlikely to have a fresh downturn before these indicators turn sour.  And, possibly most bullish of all, the yield curve is relatively steep, and has recently steepened significantly.  I would expect the yield curve to flatten coincidentally with these other leading indicators.  On the other hand, this is a unique situation, where the Fed has had little success in creating inflation, and has built up a tremendous balance sheet in the process.  We have short term rates pegged at zero, even though the Fed hasn't bought a short term bond in years.  Normally, this would come about partially from rising short term rates, and there might be some combination of a movement of demand for credit from the long term to the short term out of concern for the nominal economy, or overtightening of monetary policy by the Fed.  But, either demographics, foreign politics, or fear, have put so much money into short term risk free securities, I am not sure anything could pull short term rates from zero.  That means a low term spread would have to come entirely from lower long term rates.  I would consider a sharp decline in long term yields to be very bearish, but I wonder if we could see a recession without such low rates.  Maybe this is the cycle where that indicator breaks down.

Normally, downturns wouldn't happen in the face of an ostensibly accommodating Fed.  But, I'm afraid that we could find ourselves in a position where the Fed, having failed to inflate the currency, watches us descend into a long stagnation because they don't want to risk hyperinflation with all of the duration risk they now have.  I suspect that if they were able to work more outside the box, four years ago they could have bought a few hundred billion dollars worth of S&P500 index funds, and we would have seen an immediate inflationary boost without all this hand wringing about the risks of QE.  Or, for that matter, buying floating rate bonds would have helped.

The awful kinds of fiscal responses we could see in the possible bearish context would be likely to make things worse.

This is all still speculative, though.  I consider recent rate moves to be a bullish sign.  What I am describing above would be the first signs of a problem among the earliest indicators I follow, and at this point, the concerns haven't been confirmed.

Saturday, July 13, 2013

Interest Rate Trading Strategies

As 2012 progressed, and especially as QE3 developed later in the year, I became convinced that a short position in Eurodollars would be lucrative (a position that gains from increasing interest rates) for a couple of reasons:

1) I think that there is too much pessimism about the unemployment rate, and that the decreasing labor force participation rate is much less cyclical than seems to be widely believed.  It is mostly a demographic and cultural shift, so that continuing falling unemployment won't need to push against a headwind of a recovering labor force participation rate.  This isn't necessarily good for our typical measures of economic output, but it would lead to interest rates increasing to more normal levels more readily.  The Fed continues to have to readjust their unemployment rate forecasts down, even as their other indicators flounder, so I believe that I have been more or less right about this.

2) I thought that QE3 would boost inflation, which it has not, at least given the fiscal context that has developed around it.  The year end fiscal deal that included tax increases and a continuation of extended unemployment benefits probably pushed against both my inflation and my unemployment forecasts.

3) These forecasted factors would help to both move the expected date of the first Fed Funds Rate increase sooner in time and increase the slope of the yield curve after that time.  In addition, I suspect that there was a kind of negative maturity premium in effect in the term structure of interest rates, due to uncertainty about the Fed's balance sheet, which was pushing rates in the 2015-2018 futures range below the pure expectations rates.

In any case, I did eventually get my sharp kick up in interest rates.  I had expected it to happen in late 2012, similar to what we saw during QE1 & QE2, but it took 9 months for it to happen, and the move probably came about without any help from current or future inflation expectations.

In addition to my forecast, I felt like I had a fairly tight window of expected losses in the Eurodollars futures market.  In September 2012, June 2017 Eurodollar contracts were priced at around 2%.  There was some danger of a Japan-type scenario that could leave short term rates at 0% indefinitely, but I felt that this risk was small.  As it happened, rates on the Eurodollar contracts fell to as low as 1.6%.  As long as there was some expectation of short term rates eventually rising, that seemed about as low as you'd need to worry about on a short contract.

So, I wanted a trading strategy that only needed to handle maybe 50 basis points of potential losses, and was poised for a quick pulse of a substantial rate increase.  Following is a chart with several trading strategies, and their performance over the past 10 months.

(Note that Eurodollars are priced at a discount from 100, so 98 is equivalent to a 2% interest rate, etc.)
The green line is a static short position.  It moves linearly with rates, and probably would have performed as well as the other strategies in this period.

The blue line is the aggressive approach.  The line shown is not a fully leveraged position, as that would have flatlined after several months of losses.  This reflects a method of reinvesting all gains back into the position aggressively, and deleveraging the position when losses are taken.  If prices don't move directionally, then this means a lot of detrimental trading - buying high and selling low.  The payout resembles being long on a series of option contracts.  It gains exponentially on sharp favorable gains, and its losses are actually more muted than in the other strategies.  But, over time, trading decay takes its toll.  On the plus side, a fully leveraged position like this that was taken with impeccable timing would see exponential gains well off the chart.  On the negative side, the chart actually shows a favorable version of this strategy, since it is based on daily closing prices.  In reality, after the first move in rates, when the contracts were in the 97.6-97.8 range, even though daily price changes don't look very volatile, intraday movements devastated more leveraged versions of this position.  But, as can be seen, even after nine months of decay, this eventually would have briefly outperformed all the other strategies, although it would require perfect timing, as the recent volatility that has come after rates peaked could have quickly removed the previous gains.

The purple line is a version of the momentum trade, but by using contracts in the 2014-2015 range, where the yield curve is convex, I had hoped that some of the trading decay of the momentum strategy would be mitigated so that the position could be held indefinitely without seeing losses from time decay.  As shown, this strategy did not work well in the current environment.  Three factors appear to be (1) the contracts in that time range are more sensitive to changes in the expected first date of short term rate increases, and most of the rate increases over this period came from a steeper yield curve after that period, (2) there is some decay in the prices of those contracts themselves that tended to dampen gains over the long term, and (3) there isn't as much volatility in those contracts.

The red line reflects a value strategy.  This is basically the opposite of the momentum strategy.  You buy low and sell high.  It is like taking a short position on a series of option contracts - large losses can be devastating, but it earns a time premium.  The parameters I used on the strategy shown here were to leverage up or down in such a way that the position would not suffer a margin call as long as the contracts were less than 98.4, so as shown here, the strategy loses power as the market price moves away from the limit price.  Further, this strategy would benefit from intraday volatility and also from pulse shocks to the contract price that commonly come from relevant market news announcements like FOMC meetings and monthly employment reports, so the performance here is probably understated.

In effect the momentum and value strategies are like a dynamic hedge, but taken for speculative purposes.  Where an option contract would have a time premium based on expected volatility, these strategies experience the time premium as it happens, based on actual volatility.

There is still uncertainty due to economic factors and Fed management, but the Eurodollar contracts do currently, in my view, reflect a reasonable expectation of forward rates given current estimates of employment growth and Fed activity.  With June 2017 Eurodollar contracts priced around 97, a two-sided value strategy might be useful in this context.  In this case, a midpoint (let's say 97) would be chosen, with a range of expected possible rates for the trading time frame.  The position would be neutral at that point, and contracts would either be sold if the price went above 97 or bought as the price went below 97.  The amount of leverage used here is important, because this position becomes increasingly compromised as interest rates move outside the range.

But, as long as one can be confident that the range is safe, you can look at this as a kind of interplay of kinetic and potential energy.  As prices move away from the midpoint target, the liquidation value of the account would decline, but the trades being made into that decline would hold a kind of kinetic energy that will be released when the price moves back to the midpoint.  At that point, the account would achieve its original value, plus a profit from the trade.  So, over time, the value of the account moves up.  This would look like the value strategy above, except with a hump in the middle and legs down on both ends, with a gradual movement upward.

At current levels of volatility, with additional frequent pulse shocks, this strategy appears to be profitable enough that if it starts with a full range of 100 basis points (96.50 to 97.50), its safe range would expand by 20 to 30 basis points a month unless the position's profits were used to increase the position size.  This would seem to allow for plenty of room to either take losses from unexpected swings in rates or from occasional repositioning of the midpoint, even while allowing the range to expand over time.

I have added the mid-point strategy to the other strategies dating from September 2012.  The position of the midpoint and the amount of leverage can be adjusted to create different payout ranges.  It looks to me like the original value strategy, which in effect used a moving mid-point and a fixed range specification, worked better when the market price was far from the target price, but that the strategy with the fixed mid-point works better as the market price matches the target.  This should be intuitively obvious, since the parameters are basically being changed here to reflect past market conditions.  The trick would be to maximize the potential leverage while avoiding catastrophic market moves.  It seems to me that it would generally be easier to have a directional position, which could always be easily changed to a midpoint strategy as the market price approached the target price.  If you are in neutral mid-point strategy, and you decide to change the mid-point in the direction of the market price, a loss would have to be incurred.  There would be a lot of psychological discipline required here, because the cost of changing the midpoint would increase as the market price deviated from the target price.  The point where changing the target would be the most expensive would be the point where the risks of not moving it would be the most dramatic.  A typical example of a seemingly standard risk/reward tradeoff that ends up being much more about emotions and confidence.

Friday, July 12, 2013

More on June interest rate swings

Here is a survey of primary dealers from early and late June:

As usual, there is fodder for more than one point of view.

When asked in early June why rates increased in May (question 5), dealers gave low importance to inflation and economic growth and high importance to changes in Fed posture and uncertainty about Fed policy.

Before the June meeting, dealers expected tapering to begin in December (question 6).  After the June meeting, they expected tapering to begin in September/October (question 6, appendix).

The conventional point of view is that the Fed lowers interest rates by buying bonds, so that this reduction in the expected rate of bond buying would cause rates to rise.

My contrarian opinion includes the notions that:
  (1) the Fed has been too tight since 2007
  (2) especially in the current context, the liquidity factor of Fed open market operations is vastly overemphasized, and the inflation factor is much more important, especially at the long end of the yield curve (which is the only end fluctuating right now), and further, that since the Fed has been too tight, we would expect looser policy to increase inflation expectations and expectations of real economic growth, ceteris paribus, so that when the Fed buys bonds, we should see rates rise.

(As an analogy, I would compare the Fed manipulating the money supply by buying bonds with created money to the Fed manipulating the rental market by buying apartments and upgrading them to upscale condos.  (Remember prices fall when rates rise.)  The conventional approach to the idea seems to be that the Fed  would be causing rental rates to increase because they would be pulling apartments out of the market.  The typical approach is that upgrading the condos takes time, so that initially rental prices do increase, and eventually they fall as the effect of the condos is felt.  First, I think that empirically since 2007, at least, the liquidity effect has been fleeting, at best.  Secondly, what we have now is the Fed prospectively announcing changes in their bond buying activities, and pundits are explaining market movements as a result of future expected liquidity effects from OMO the Fed hasn't even completed yet.  I can't imagine how a coherent liquidity effect could play out as a forward looking phenomenon, but I admit that I haven't reviewed the academic work on the matter.)

So, conventional Fed interpretations would say that the Fed will gear down QE3 more quickly than previously thought, and that this caused rates to rise, due to some notion of a forward looking liquidity effect.  That is what the primary dealers appear to be saying in this survey.

The fact that equities declined immediately after the June Fed policy announcement (around June 19), is being taken as evidence of this interpretation.  But, I will point out for those who believe that the Fed is being recklessly loose, then a tightening of policy should, if anything, skew toward higher equity prices, as decreased uncertainties about future inflation would improve outlooks on real economic growth.

But, I think there are some interesting nuggets in that survey that bear me out.  First, I'll note that in question 3, which asks about expected future Fed Funds rate levels, the expected rates remain basically unchanged.  The rate in 2017 is 3 to 3.25% both before and after the Fed announcement.  Actual market rates (adjusting from June 2017 Eurodollar futures) moved in May from about 1.5% to 2.25%, when this question was first asked, and moved to around 3% after the Fed announcement.  So, if the dealers held the marginal market opinion about these rates, why was the market discounting June 2017 Eurodollars by almost 1% in late May?  And why did that discount go away?

Other than the expectations for earlier tapering, the only other change I saw in the survey was a decrease in uncertainty about the Fed's balance sheet.  Question 8 shows that on the range of the possible size of the SOMA portfolio at the Fed at the end of 2014, probabilities for a portfolio under $3.5 trillion remained the same, but at the other end of the probability distribution, the probability of an exceptionally large balance sheet decreased, due to more certainty about balance sheet remaining under $4 trillion.

So, the dealers themselves, while saying that the change in the tapering schedule somehow created a huge increase in interest rates across the yield curve, also say that the change in the tapering schedule (1) didn't change their long term Fed Funds rate expectations, (2) didn't increase the risk that the Fed would shrink the balance sheet any faster than it might have before, (3) and did reduce the level of uncertainty about the Fed balance sheet remaining too large.

So, the dealers' and the Fed's own opinions aside, I will not be moved.  I propose that the dealers are wrong - Fed uncertainty was making rates too low.  Improving economic indicators and a slightly tightening Fed with less Fed uncertainty meant inflation expectations decreased  but real growth expectations increased from April to late June, with rates boosted by a reduction in uncertainty about the Fed balance sheet.  (Rates may have also been boosted by central bank developments in China, Japan, and Europe.)

"Guaranteed free compulsory education"

"Guaranteed free compulsory education"

I have seen this basket of ideas more than once as part of the current notion of human rights.  I admit that it baffles me.  The idea that someone has a right to be compelled to do something kind of makes my head explode.  But, further, I think that if we really think about those three adjectives, we would find that each can only exist to the exclusion of the other two.

Even simply "compulsory education" itself brings to mind leading horses to water.  My wife will attest that on some matters, in practice, education cannot be compelled upon me with anything short of divine revelation, and even then is probably not likely.  My experience with other students would indicate that I am not unusual in this regard.

This movement seems to have found the mathematically most concise prescription for failure. 

Successful institutions tend to have the following three attributes:

1) Failure as an option (in other words, not guaranteed)
2) Value that compels users to voluntarily return some form of compensation (not free)
3) The ability of unsatisfied users to leave (not compulsory)

In contrast, this policy means that other people will be forced to pay for a school that you will be forced to attend despite the fact that the school will have no direct reason to serve you well.

I'd like the right to choose the school I prefer, to leave when I am unhappy, and to see better schools replace failing schools as this process repeats.  Is this so hard?

Monday, July 8, 2013

Thursday, July 4, 2013

A Just-So story about the recent divergence of stock prices and interest rates (Pt. 2)

I ran across this reaction to the June Fed announcement from JP Morgan:

JP Morgan June 21, 2013 Market Bulletin

They agree with me that the main change from the Fed announcement was the decline in uncertainty about the Fed's balance sheet & future inflation, not a change in the average expectation of Fed actions.  The place where they diverge from my previous post is that they think the drop in equities was an overreaction.

In addition to the idea of equities being an inflation hedge, which could explain a small sell-off on this news. It has occurred to me that an additional factor could be at play:

Here is a graph of the 60 day daily beta between a long term TIPS ETF (LTPZ) and the S&P 500:

Inflation protected bonds have been highly negatively correlated to stocks as a result of tight Fed policy.  As the economy normalizes, and there is less danger of erroneous Fed discretion, this relationship should not be as strong.  As shown here, the correlation began breaking down in late May and the reversal strengthened at the Fed announcement.  This can become a self-fulfilling outcome, because, per modern portfolio theory, the high negative correlation could have been driving leveraged long positions in both equities and TIPS bonds.  A sudden shift in that relationship could cause a sell-off in both asset classes.

One last comment on the JP Morgan bulletin, and on market commentary in general:  Everyone treats the rise in interest rates as a Fed failure, which is understandable given the Fed's own stated goal of lowering rates.  But, the Fed's unfortunate policy of communicating through rate targets notwithstanding, I consider the higher rates to be clearly a positive, if for no other reason than that the greater distance from the price floor of the zero lower bound allows fixed income markets to clear with less distortion.  In the current context, higher rates should be taken as a sign of Fed success unless there is clear evidence to the contrary.

Addendum:  I need to do some more work on this.  Here is a chart that shows the correlations (weekly, 30 periods, rolling) between TIPS, nominal bonds, and expected inflation, all correlated with the S&P 500.  The correlations here are positive because this is based on yields, not bond prices.  Some of my intuition about the recent context is still possible.  A higher correlation between inflation and equities in general suggests that the Fed has been too tight.  I think real (TIPS) rates rising roughly coincident with the QE phases suggests that periods of loosening did create positive real effects in the economy.  But, I need to wrap my head around the relationship of changes in real rates to equity returns.  I have a graph here of nominal rates regressed against equity returns, again weekly in 30 week rolling periods, and the positive correlation of the past decade is anomalous.  It could be that the correlation itself is negatively correlated to the general level of inflation, so that the bond yield to equities correlation is only positive in low inflation contexts.  Or, there could be something structural about long term changes in the source of American equity earnings.
In any case, I can make an argument for the apparent drop in correlations being a product of reduced inflation uncertainty.  But, the case seems weaker if I can't tie it into a fuller explanation of long term rate correlations.

Signs of stagnation in the JOLTS data lead me to worry that we are in the midst of a period like the 70's, where either demographics or political structural issues create poor real economic growth, low real interest rates, and persistently high unemployment.  If the Fed remains hawkish, sticky wages and prices could worsen these problems (especially since some of the structural political problems create high inflation in non-wage benefits).  If the Fed turns dovish, they might push inflation to uncomfortably high levels if structural unemployment proves persistent.  The Fed seems extremely hawkish right now, but a paradigm shift could certainly happen if unemployment bottoms out above 6%.  Of course, while loose monetary policy can mitigate against unemployment at low inflation rates, the lesson we learned from the 70's was that this relationship breaks down at high inflation rates.  In other words, tight money can exacerbate unemployment problems, but loose money can't solve structural unemployment problems.