Bob Carlson

The latest data on housing starts was released. Media reports often misinterpret this data, so it’s important to have a good analysis, such as this one by Calculated Risk blog. Bill McBride generally is optimistic about housing and the economy. If you’re on the pessimistic side or reading some of the pessimistic forecasts, then you might be surprised or disappointed. But I think it is a solid analysis that shows housing is doing well but still has a long way to go to get back to normal. There’s no bubble to worry about, and in general things slowly are improving.

Overall the housing starts report was a little disappointing with total starts at a 914 thousand rate on a seasonally adjusted annual rate basis (SAAR) in May. This was below the consensus forecast of 950 thousand SAAR.

• However starts are up significantly from the same period last year. Over the first five months of 2013, multi-family starts are up close to 40% from the same period in 2012, and single family starts are up 24%. Those are significant increases in activity. Based on permits and the June homebuilder confidence survey, I expect starts will increase further in June.

Investors generally are too pessimistic these days. It’s understandable. They remember too clearly 2008. But things have changed, and you should recognize that.

Here’s one good review, set up at 10 Key Questions About the Economy. I agree with much of these views. One I disagree with is inflation. I don’t see any sign of rising inflation and continue to believe that deflation is more of a risk now than inflation. Read this piece and compare it with a lot of the pessimistic forecasts out there. I’m not a pollyanna or blind optimist. There are a lot of problems out there, and things could get worse down the road. But for now, the trends are positive and are likely to remain that way at least through the end of the year.

The bond market’s gone haywire ever since Ben Bernanke’s May congressional testimony, when he indicated that the Fed would change monetary policy “in the next few meetings.” I’ve expressed previously the belief that the market over-reacted to and misinterpreted Bernanke’s remarks. Here’s a good summary of what the bond market appears to be telling the Fed. It might be a little bit technical or jargon-filled for some of you, but I think it is accessible to most of my readers.

One thing the market is saying is that inflation expectations are low. In fact, the bond market seems to be saying that deflation is a real possibility. Bonds also are saying that short-term rates are likely to rise sometime in 2014. The Fed probably didn’t intend that, expecting long-term rates to rise before short-term rates do. Another thing the bond market is saying is that the Fed is likely to make the same mistake it has made many times in the past: It will tighten too rapidly once it decides to tighten. Take the classic case of 1994, the worst year for bonds, when the Fed surprised investors with its tightening and then increased interest rates rapidly.

Ben Bernanke will try to clarify things today.

The “lower for longer” message on rates, which has been so carefully crafted by the FOMC’s forward guidance, seems to have been thrown overboard by the bond market with remarkable alacrity as soon as the Fed has indicated that it may slow the pace of policy easing. The reason for this is that past history is replete with episodes in which the Fed has tightened policy very rapidly once its enthusiasm for easing has started to wane.

The 1994 example, when the Fed failed to guide the markets about the likely pace of tightening, is of course part of the folklore of the bond market. Less well remembered is the example of 2003, when the first signal that the Fed was slowing the pace of easing was followed by a 100 basis point rise in bond yields within a few months, even though the Fed’s forward guidance about tightening at a moderate pace was increasingly explicit.

The problem is that, once the market starts to believe that the Fed is “done”, it will inevitably start to build into the yield curve a rising probability that the FOMC will embark on a normal path of tightening before too long. In order to mitigate this, Mr Bernanke is likely this week to remind the markets that the intention to slow asset purchases “in the next few meetings” is contingent on events in the labour market, is not the start of policy tightening, and is completely distinct from any intention to start raising rates.

The recent Flow of Funds statement from the Federal Reserve indicated that household net worth now exceeds the 2007 high. So, the first conclusion is that we’ve more than recovered the net losses from the crisis. But a look at the details paints a somewhat different picture. I llnked to some of the commentary previously, but this piece from The New York Times attracted a lot of attention. It especially focuses on how younger households have lagged behind in the recovery. They’ve lagged substantially. This is another reason why the rate of economic growth after the bottom has been low, and while it is likely to remain low for a few more years.

Those averages are deceptive, in that they are raised by the high wealth of a relatively small number of households. A very different picture emerges from looking at the median — the level at which half the households are richer and half poorer. That statistic can be calculated from the Fed’s triennial survey of consumer finances. In the studies conducted in the 1990s, the median net wealth was about one-quarter of the average. In the 2000s, the median fell to about one-fifth of the average, and in 2010, it was down to about one-sixth of the average.

During the housing boom, said William R. Emmons, the chief economist of the Center for Household Financial Stability at the Federal Reserve Bank of St. Louis, “exactly the people you would think need to act conservatively were doing the opposite.” Homeownership rates, and mortgage debt levels, rose for younger households, as well as for less educated and minority ones. Those groups suffered more during the crisis, he said, and have been slower to recover.

It’s no secret that Japan’s stock market has been on a roll and its currency in decline since it changed monetary policy in late 2012. But in the last month, there was some reversal. Interest rates rose, and the stock market declined. I believe the sudden reversal contributed to some global declines in assets, as investors who took leveraged positions in Japan in 2012 and early 2013 had to sell other assets to meet margin calls.

So, what’s going on in Japan? Is its version of QE a failure? I don’t think so. I think the recent reversal in both Japan and the U.S. are temporary. But here’s a good review of some different arguments. I agree with the bottom line of the piece, but it also does a good job laying out alternative views, in case you want to know all the arguments or you agree with the others.

Imagine, for the sake of exaggeration, that a country had a debt-to-GDP ratio of three thousand to one. Suppose this was all in 30-year bonds, so that every year the government would have to roll over about 1/30 of its total debt, or 10,000% of GDP. Suppose that interest rates are just barely above zero – low enough to allow the government to maintain this debt burden.

Now suppose that interest rates suddenly “normalize” to 1%. Next year, the government will abruptly owe 1% of 10,000% of GDP in interest on the portion of its debt that it had to roll over. 1% of 10,000% is equal to 100%, so the government would owe all of the country’s GDP in interest costs, in the first year alone. In the second year of the recovery, it would roll over another 10,000% of GDP, and thus owe 200% of GDP in interest costs!

How could it pay up? You can’t tax 100% of GDP. So the government would have to borrow the rest. It seems clear that the higher the debt/GDP ratio, the less likely it would be that the private sector would be to lend to the government at an interest rate less than the economy’s growth rate (the necessary condition for “stable Ponzi finance”; see discussion in comments with Nick Rowe for why this would be the case).

There’s no doubt that we’ve had some sweeping economic crises during the last twenty years or so. Easy money, leverage, and poor regulators were keys to each of the frauds. I’m not talking about your garden variety scam or theft. I’m talking about the big patterns of bad behavior that end up affecting a lot of people, such as the savings & loan crisis of the 1980s and the great leveraging that resulted in the crisis of 2008. Here’s one analysis that says clearly each of the last three great financial crises was a fraud, and that Alan Greenspan bears the most responsibility for them. According to Bill Black, Greenspan’s beliefs in efficient markets and his own monetary policy allowed and enabled these crises.

A dangerous cycle begins when prominent economists pander to plutocrats and bought politicians, who reward them with top posts, where they promote the perverse economic policies that cause fraud epidemics. Crises develop, and millions of people are ripped off. Those who fight for truth are ignored or ruined. The criminals get wealthier, bolder and more politically powerful, and go on to hatch even more devastating cons.

The three most recent financial crises in U.S. history were driven by a special type of fraud called “control fraud” — cases where the officers who control what look like legitimate entities use them as “weapons” to commit crimes. Each time, Alan Greenspan, former chairman of the Federal Reserve, played a catastrophic role. First, his policies created the fraud-friendly (criminogenic) environment that produces epidemics of control fraud, then he failed to identify those epidemics and incipient crises, and finally, he failed to counter them.

This blog post asserts that all copies of Microsoft Windows since 1999 have a backdoor encryption key just for the National Security Agency. Other major software programs also are alleged to have such keys. But these charges aren’t confirmed by either software makers or the government. What also isn’t clear is whether the keys are for use by the government to access people’s computers or whether it makes it easier for the agencies to run their own software programs on Windows.

Two weeks ago, a US security company came up with conclusive evidence that the second key belongs to NSA. Like Dr van Someren, Andrew Fernandez, chief scientist with Cryptonym of Morrisville, North Carolina, had been probing the presence and significance of the two keys. Then he checked the latest Service Pack release for Windows NT4, Service Pack 5. He found that Microsoft’s developers had failed to remove or “strip” the debugging symbols used to test this software before they released it. Inside the code were the labels for the two keys. One was called “KEY”. The other was called “NSAKEY”.

Fernandes reported his re-discovery of the two CAPI keys, and their secret meaning, to “Advances in Cryptology, Crypto’99? conference held in Santa Barbara. According to those present at the conference, Windows developers attending the conference did not deny that the “NSA” key was built into their software. But they refused to talk about what the key did, or why it had been put there without users’ knowledge.

I don’t make many financial predictions and don’t make portfolio recommendations based on them. Yet, most financial and investment marketing these days seems to be based on predictions. Investors in general are captivated by predictions and spend a lot of time reading different forecasts and trying to determine which is right.

Using predictions is a mistake for several reasons. It’s hard to make an accurate prediction. Plus, you have to be right not only about the big picture prediction but also about how the markets will react and which investments to buy and sell. It’s not unusual for markets to have surprising responses to events. You also have to be right more than once. Investing based on a prediction means you’re betting your portfolio on one outcome and giving up diversification. If the prediction turns out to be true, at some point you have to change your portfolio to preserve your profits and take advantage of what comes next.

Here’s one person’s view of the three worst financial predictions in the last five years. There’s a lot of competition for the winners, so this is something we can argue about. I especially like the forecasts of hyperinflation as among the worst predictions.

There was a bubble in hyperinflation predictions in 2008/9 following the huge fiscal stimulus package in the USA and the supposed “monetization of the debt” which people still believe to this day due to misconceptions over quantitative easing.  Personally, I think the hyperinflation predictions have to rank among the very worst economic predictions of all-time because the reasoning was so misguided.

Those who predicted hyperinflation were not only entirely misinterpreting the debt de-leveraging, but were misinterpreting how the monetary system works at an operational level.

The New York Federal Reserve established under the Dodd-Frank law an Investment Advisory Committee on Financial Markets. The committee, composed of a lot of well-known leaders from hedge funds and major investment firms, tells the Fed what they see in the markets and economy. They last met in April, and the minutes were released around May 18.

What’s interesting is that the committee members apparently complained a lot about the negative effects that zero interest rates are having on the markets. The members said that the markets were not pricing in an earlier-than-expected tightening of Fed policy and that many investors and especially certain market sectors were vulnerable to an unexpected change in policy or increase in interest rates. In other words, investors are reaching for yield and leveraging.

Is it a coincidence that shortly after the meeting interest rates began rising, culminating in a very bad month of May for bond investors? Did this discussion cause Ben Bernanke to change his testimony to Congress in May, testimony that caused a number of market observers to worry that the Fed soon would end quantitative easing? Did some of these committee members begin selling bonds are this meeting?

The meeting concluded with a discussion of the current state of investor positioning for a potential rise in interest rates. The business model of agency REITs was viewed as vulnerable to any sharp rise in rates, given relatively high leverage and perceived duration mismatch between assets and liabilities. Regional banks were also cited as having some sensitivity to losses in the case of a sharp rise in rates, particularly as banks have added higher-yielding assets to their portfolios in the low rate environment. Finally, members discussed risks associated with the potential reaction of ret ail investors to a sharp rise in rates. Note was made of the larger footprint of retail accounts in credit markets given rising allocations to fixed income instruments over recent years.

The Fed also has a Federal Advisory Council composed of bankers from around the country. The minutes of its recent meeting also are very interesting and provide a great deal of detail about the economy, though the information is anecdotal.

There are potential risks associated with current policy. The Fed’s securities purchases have reduced mortgage yields and, to a lesser extent, Treasury yields. Current low bond yields are disruptive to management of fixed-income portfolios, retirement funds, consumer savings, and retirement planning. They may encourage unsophisticated investors to take on undue risk to achieve better returns. MBS purchases account for over 70% of gross issuance, causing price distortion and volatility in the MBS market. Fixed-income investors worry that attractive mortgage-backed securities are in very tight supply. Higher premium coupons carry too much exposure to prepayments, potentially led by new government support programs for housing. Many are concerned about the Fed’s significant presence in the market. They have underweighted MBS in favor of corporate, municipal, and emerging-market bonds. There is also concern about the possibility of a breakout of inflation, although current inflation risk is not considered unmanageable, and of an unsustainable bubble in equity and fixed-income markets given current prices.

The Federal Reserve’s policies will kill risk taking and eventually the economy. That seems to be the warning in the latest monthly essay from Bill Gross of PIMCO. Gross admits that quantitative easing was necessary to stabilize the economy. But it hasn’t translated into normal economic growth, much less above-average growth typical of recoveries. Gross says the central bankers believe that higher asset prices eventually will generate higher growth, but Gross says there isn’t a lot of empirical support for that theory. Add to that the negative effects of low interest rates, and Gross says there are a lot of reasons to be worried.

Why it might not be working is fairly clear at least to your author. Once yields, risk spreads, volatility or liquidity premiums get so low, there is less and less incentive to take risk. Granted, some investors may switch from fixed income assets to higher “yielding” stocks, or from domestic to global alternatives, but much of the investment universe is segmented by accounting, demographic or personal risk preferences and only marginal amounts of money appear to shift into what seem to most are slam dunk comparisons, such as Apple stock with a 3% dividend vs. Apple bonds at 1-2% yield levels. Because of historical and demographic asset market segmentation, then, the Fed and other central banks operative model is highly inefficient. Blood is being transfused into the system, but it lacks necessary oxygen.