Yeah, that's always the problem in Econ, you never have an apples to apples comparision. In some sense, it is always different this time.
To be honest, most of the arguments fly over my head. I only presented it because the firm is very well thought of and because it presented a breath of fresh air from the usual crap you hear on cnbc.
Got the juicer out again, no not that one, GaveKal: An Obituary to the Yield Curve? "In the recent revision of the US leading indicator, the yield curve was dropped. For those of us who have enjoyed getting beaten up by markets for more than a few years, this is akin to an intellectual revolution: for years, the yield curve was the sacred cow of the forecasting community. So why did it work? And why doesn't it work any longer? "The yield curve's track record was so good that along with everybody else, we used it in our forecasting efforts. But we never liked it very much, simply because we did not agree with the economic reason (or the lack of) which was generally given to explain this unblemished record. In a sense, while everybody agreed that the yield curve worked (i.e.: when short rates were below long rates, the economy was due to grow), nobody really explained why. But here was the logic: over the long term, there was (from 1945 to 1995) a rough correlation between three variables * the growth rate of nominal GDP * the growth rate of corporate profits * long interest rates "This adequation meant that the long rate gave a rough estimate of the standardized growth rate of corporate profits. And as we never tire of writing, corporate profits are what the entrepreneurs (the fellows taking risks) get. Meanwhile, the rentiers (the fellows taking no risks) get the returns provided by short rates. So when short rates move close to, or above, long rates, the rentiers start to make more money than entrepreneurs. An economic system in which this is happening moves rather rapidly "ex growth". This is why, when the yield curve would invert, within a year, a recession was on. "...But then why has this relationship broken down in recent years to the point where the yield curve gets dropped from the US leading indicators? Why is Mr. Greenspan happy to dismiss the message of the bond market? To explain this, we return to one of our recurrent and favorite themes: the under-appreciated macro-impact of the 'platform company' business model. "Indeed, with the 'platform company' business model, we find that: * "Corporate profit growth in the US over the past decade has been much stronger than GDP growth and is likely to remain so. How is this possible? Could the fact that corporate profit growth in China has been much weaker than the GDP growth have something to do with it? Very possibly...after all, when you sell stuff to Wal-Mart, only Wal-Mart is allowed to make real money on the trade! * "Most companies are now structurally in a positive cash flow mode (if, like Ikea, Dell, H&M...) you focus solely on design and sales, how much capital do you really need? * "Commercial banks which used to provide up to 90% of the financing needed by the economy are now providing around 35%. This helps remove cyclicality and interest rate sensitivity. "The 'platform company' revolution means that, in all of our models, we have to replace long rates by the structural growth rate of the economy. This makes our job, and the central bankers' jobs, a little more challenging. http://www.investorsinsight.com/
Time Inconsistency and the Greenspan Put "In fact, I submit that Mr. Greenspan's 'technically' upped the ante against himself today [in his Jackson Hole Speech], when he officially declared that policy is becoming "increasingly driven by asset price changes." Let me walk you through the logic of why, using the economic thesis of 'time inconsistency,' which won the Nobel Prize in Economics for Professors Kydland and Prescott. "Their elegant, but simple thesis was that expectations about future policy reversals can undermine the power of current policy. My favorite real world example is that of a parent who says to a teenager: get a job this summer and save some money, or you will be walking rather than me driving you to school in the fall. "If the teenager knows that the parent will, in fact, do the driving come fall, regardless of whether junior gets the summer job - because that's what happened last summer and fall - then the parent's policy is time inconsistent: if the teenager knows the summer policy will be reversed come fall, he will rationally ignore the summer policy of getting a job and instead go to the beach. The parent's policy is simply not credible. "Increasingly, it seems to me, the Fed's policy of threatening never-ending Fed funds hikes, as Mr. Greenspan implicitly did today, so as to induce lower bond prices (higher bond yields) that will 'get at' frothy property markets suffers from time inconsistency. Bluntly put, the Fed has a credibility problem, because the markets know - because Mr. Greenspan has taught us! - that the Fed's asset price bubble policy is asymmetric: "1. Deny that you can see them when they are inflating, tightening against them only if you can justify tightening on the basis of conventional inflation-pressure models and data. "2. Ease vigorously and purposefully when bubbles confirm their existence by blowing up. "...It's a time inconsistency problem! Why should we in the bond market bearishly discount an ever-rising Fed funds rate, if an ever-rising Fed funds rate will surely burst property prices, begetting a reversal to vigorous easing? To the Moon, Alan? "...So, what's the Fed to do, facing a dilemma similar to the parent trying to figure out how to get the teenager off the beach into a job? Conceptually, and consistent with the consensus of bearish pundits, the Fed could simply hike short rates until the housing market cries uncle, accepting that such a course is likely to invert the yield curve. To wit, the Fed could resignedly accept that the longer end of the curve is not going to 'do its work' and do the 'heavy lifting' itself with more nasty short rate hikes. This is, indeed, a plausible scenario." Paul then goes into a very interesting exchange between Senator Shelby and Alan Greenspan where the Chairman asserts that the yield curve no longer has its predictive power. I might point out this is a useful concept for someone who is getting ready to invert the yield curve, which has historically always forecast a recession. If inverted yield curves now don't mean a recession is coming, then there is no reason not to go ahead and risk an inversion! Then he gets to the main point. This is an important concept, class, so pay attention. There will be a test, at least of your bond portfolios! "Mr. Greenspan is surely right - and for the right economic reasons! - that an inverted yield might not imply a recession, as it universally has in the past. Yes, this time might be different! But it might not be, either. Thus, for the Fed to defy the risk management lesson of history - don't invert the curve unless you want to underwrite the odds-on risk of recession - would be a hugely bold decision. Is the Fed willing to make it? "I don't think so. In fact, I think there is more than a sporting chance that this whole issue becomes moot, as 'speculative fervor' in property markets exhausts itself from its own exuberance. But I wish I could say that with greater confidence. What I do feel highly confident about is that if the Fed does attempt to bearishly invert the curve a little, the market will subsequently respond by bullishly inverting it a lot. "Put more technically, the value of the Greenspan Put will rise exponentially if the curve inverts, while the cost of 'buying' that Put will actually become negative: in an inverted curve, a duration-equal barbell of cash and long bonds yields more than a bulleted portfolio. Such is the weirdness of an inverted curve: the less volatile, convex barbell structure actually yields more than the more volatile, less convex bullet. Rather than paying for insurance, you get paid for taking it!" Put in layman's terms, if you believe the Fed is going to lower rates, you are better off actually taking the lower long term interest rates, because they are going to go even lower and you can make a profit as rates go down as well as get more for your cash today! So, let's cut to the chase. The Fed will meet in 17 days. While we will know a lot more by then, there is a lot we will not know. We will certainly not be able to assess the short-term impact of Katrina by then. While gas prices should come down by October as pipelines and refineries come back online, there is no certainty. Those most affected by the storm will still be trying to figure out how to get their lies, homes and businesses back together. Even though inflation seems to be pushing upwards, Katrina may reverse that trend. We just don't know. Housing inventories, both new and used, have begun to rise in recent months, something that needs to happen before housing prices level off or decline. Further away from home, in what seems eerily reminiscent of the Thai baht having serious problems in 1998 which augured the Asian debt crisis, we are watching the Indonesian rupiah show serious signs of deterioration. China is clearly on a path to slowing down, which would take some (though certainly not all!) pressure off the commodity markets. While the argument, mentioned above, that the Fed allowed stagflation by making money too easy in the 1970's is correct, that was when then overall tendency of world prices was inflationary. Today, we have the opposite case. Deflation, except for raw commodities, is still the prime backdrop for world goods. I think Paul put his finger on the prime issue. If Greenspan continues to raise rates slowly, the market knows that it will eventually hurt the housing market as well as bring on an inverted yield curve and a recession, which is what the Fed has always done. They always go too far. The market will anticipate this and invert the yield curve for him, perhaps aggressively, making long rates lower and doing the opposite of what Greenspan is trying to do. Mortgage rates will drop and housing prices will rise. Things get weird. Further, the collective wisdom of the market is telling Greenspan that he should wait. Fed fund futures are pricing in only 25 basis points of rate hikes this year, as opposed to 75 basis points it priced last week. The market is screaming for the Fed to slow down. And let me mention the unthinkable. The National Weather Service suggests we may see 4-5 more hurricanes this season. Who knows where and how strong? It might just be prudent not to tempt fate. Greenspan: Time to Call an Audible Quarterback Greenspan should come to the Fed meeting September 20 and call an audible. He now has the perfect excuse. They should not raise rates, announcing that they would like more time to assess the affect of Katrina on the economy. With the properly worded Fed release, no one would think he (or the Fed) had lost his rate hike nerve. It is just the Chairman acting with wisdom and restraint. They could make it clear that if as it now appears that the economy will weather this storm just fine, that they will again start the measured pace of rate hikes. This is assuming the rise in "asset prices," (read your home) keep up their relentless rise. The next meeting is November 1, just 40 days after Sept 20. If they are still nervous about "asset prices" then they can start to raise rates again. 40 days of rates staying where they are is not going to bring back inflation. There is no need to rush when there is a lot of uncertainty. By November 1, we will know the effect of Katrina. We will know if rising energy prices are going to slow the economy on their own. We will know if consumer spending stays resilient. We will know if the recent trend in increased inventories of homes for sale is indeed a real trend, or a few month aberration. Between now and the next meeting, the Fed can begin to lay the framework for a specific pause in the rate hike process. Transparency is important. My bet is that the US economy will weather Katrina and that my gulf region neighbors will get it going again. But it is not certain. Greenspan's own rule is that central banks must first make sure they do no harm and avoid the most negative of outcomes. Housing prices rising another 1% in the 40 days between meetings is not a huge negative or risk. Getting us to an inverted yield curve when there is a reasonable (though not probable) risk of an energy shock is a very negative outcome. Mr. Chairman, make like Roger. Call an audible.
Fantastic article re China's ticking financial bomb: http://www.investorsinsight.com/otb.aspx " In 2000, non-performing loans were officially nearly 40% of total loans, equal to more than $750 billion. No banking system at any time in history has survived for long with bad debts over 10%, let alone such a large number. Now they are allegedly a mere 20%."