Category Archives: financial markets

Retirement and Wealth

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Timothy Taylor points to some sobering news.

those in the 1980s were more likely to be ready for retirement than those in the 1990s; those in the 1990s were more likely to be ready for retirement than those in the 2000s; and those in 2010 were least likely of all to be ready for retirement.

I know many people in close to 60 years old, currently living upper-middle class lives, with less than $200,000 in non-housing savings. I do not think they have thought ahead very far. Some questions:

1. What does this mean for their lifestyles during retirement? Less expensive meals? Less expensive vacations? Less choice about where to live?

2. What does this mean for their level of dependence on government benefits?

3. What does this mean for the prospects of reducing Social Security or Medicare benefits?

Risk Premiums and Short-term Rates

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Jeremy Stein sees a connection.

over a sample period from 1999 to 2012, a 100 basis point increase in the 2-year nominal yield on FOMC announcement day–which we take as a proxy for a change in the expected path of the federal funds rate over the following several quarters–is associated with a 42 basis point increase in the 10-year forward overnight real rate, extracted from the yield curve for Treasury inflation-protected securities (TIPS).

…These changes in term premiums then appear to reverse themselves over the following 6 to 12 months.

…Banks fit with our conception of yield-oriented
investors to the extent that they care about their reported earnings–which, given bank accounting rules for available-for-sale securities, are based on current income from securities holdings and not mark-to-market changes in value. And, indeed, we find that when the yield curve steepens, banks increase the maturity of their securities holdings.

Thanks to Tyler Cowen for the pointer.

If this is correct, then monetary policy affects long-term real rates, although having the effect reverse itself within 6 to 12 months makes me wonder. In fact, this whole thing makes me wonder….

Sentence to Ponder

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From Peter Stella.

What many are calling central bank “money creation” “helicopter money” or “rolling the printing presses” may – in combination with tighter leverage ratios – lead to a tightening of bank credit and deflationary pressures.

Pointer from John Cochrane.

Read (and re-read) the whole thing. Stella’s interesting argument is that highly-rated securities are more liquid than bank reserves. Therefore, when the Fed supplies bank reserves in exchange for highly-rated securities, it is draining liquidity from the system.

My initial reaction is that this is just too cute. It makes it sound as though investment bankers make loans, using securities as reserves. I think of investment bankers as holding inventories of securities, financed by short-term debt. The larger the inventories they have to finance, the lower their demand for securities, and the higher the interest rates on those securities. So I still think that the Fed’s purchases go in the direction of pulling down rates on securities. Of course, I count myself as a skeptic that these effects are significant.

Two Views of the Non-Taper Rally

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1. Scott Sumner:

Note that the instant reaction of stocks is a more reliable indicator of monetary policy that long term bond yields. Long term rates rose on the announcement of QE3, and rose again on taper talk. Why is the long term bond market so schizophrenic? I have no idea.

2. A press release about a new behavioral economics study:

Dr Benedetto De Martino, a researcher at Royal Holloway University of London who led the study while at the California Institute of Technology, said: “We find that in a bubble situation, people start to see the market as a strategic opponent and shift the brain processes they’re using to make financial decisions. They start trying to imagine how the other traders will behave and this leads them to modify their judgment of how valuable the asset is. They become less driven by explicit information, like actual prices, and more focused on how they imagine the market will change.

“These brain processes have evolved to help us get along better in social situations and are usually advantageous. But we’ve shown that when we use them within a complex modern system, like financial markets, they can result in unproductive behaviours that drive a cycle of boom and bust.”

The team found that when participants noticed disparity between how much they perceived an asset to be worth and the rate of transactions for that asset, they began making poor business decisions and bubbles started to form in the market.

Professor Peter Bossaerts from the University of Utah, a co-author of the study, explains: “It’s group illusion. When participants see inconsistency in the rate of transactions, they think that there are people who know better operating in the marketplace and they make a game out of it. In reality, however, there is nothing to be gained because nobody knows better.”

Colin Camerer, Robert Kirby Professor of Behavioral Economics at the California Institute of Technology, said: “There’s a mathematical measure of when the flow of traders’ orders to buy or sell changes from steady to choppy. A choppy flow is a clue that trades are bunching up around new information or pausing to see what happens next. This way of measuring has been sitting on the shelf for years. This is the first study to show that it seems to correspond to what the brain is computing.”

My own view is that the stock market is efficient in the sense that returns are nearly impossible to forecast, but it is not rational. In 1979, stocks may have been undervalued by a factor of two or more. By 2000, they may have been overvalued by that much. Given that I think that the market can be off base by 50 percent, I am reluctant to draw inferences about moves of 2 or 3 percent.

A Question

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From the comments on this post.

if it were made clear that in the event of a crisis the shareholders would be wiped out and the bondholders would take whatever loss was required, then why should anyone care what financial structure an institution chooses?

This approach could have been taken in 2008. Several economists argued that Citigroup could have been handed over to the bondholders. Why wasn’t this done? Here are some possible adverse consequences:

1. Depositors will hear “Citigroup is bankrupt” and rush to pull deposits out, even though they are safe.

2. Holders of bonds at other banks will sell those bonds in order to buy safer assets.

Of course, these concerns can always be raised about bank debt. If the government will never allow bank debtholders to take a loss, then in effect we have 100 percent government guarantees to bank debtholders. Russ Roberts has argued vociferously that this is in fact the regime we have been under, and the consequence is that banks have the incentive to maximize their debt financing.

It appears that the government cannot credibly commit to letting bank creditors bear some of the losses from an insolvency. If that is the case, then it would seem that taxpayers have an interest in forcing banks to have a capital structure with less debt and more equity.

A Time to Buy Put Options?

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I note this, from Tobias Adrian and Michael Fleming:

we present a table listing attributes of the fifteen largest bond market selloffs since 1961. The three selloffs highlighted in this post—1994, 2003, and 2013—are ranked fifth, ninth, and thirteenth, respectively, and are highlighted in blue. Beyond reporting figures behind the earlier discussion, the table shows the change in the ten-year, zero-coupon yield and in the spread between the ten-year and three-month yields between the start of each selloff and the maximum selloff date. Of note, the recent episode and 2003 are instances in which the yield spread moved almost as much as the ten-year yield itself (that is, the three-month yield rose little), explaining the importance of the term premium in those cases.

Pointer from Mark Thoma.

and this, from John Mauldin.

The Shiller P/E is now 24.4, about the same level as August 1929, higher than December 1972, higher than August 1987, but less extreme than the level of 43 that was reached in March 2000 (a level that has been followed by more than 13 years of market returns within a fraction of a percent of the return on Treasury bills – and even then only by revisiting significantly overvalued levels today). The Shiller P/E is presently moderately below the level of 27 at the October 2007 market peak. It’s worth noting that the 2000-2001 recession is already out of the Shiller calculation. Moreover, looking closely at the data, the implied profit margin embedded in today’s Shiller P/E is 6.3%, compared with a historical average of only about 5.3%. At normal profit margins, the current Shiller P/E would be 29.

John Cochrane on Valuing Government Pensions

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He writes,

A good response occurred to me, to those cited by Josh who want to argue that underfunding is a mere $1 trillion. OK, let’s issue the extra $1 trillion of Federal debt. Put it in with the pension assets. Now, convert the pensions entirely to defined-contribution. Give the employees and pensioners their money now, in IRA or 401(k) form. If indeed the pensions are “funded,” then the pensioners are just as well off as if they had the existing pensions. (This might even be a tricky way for states to legally cut the value of their pension promises)

I suspect the other side would not take this deal. Well, tell us how much money you think the pension promises really are worth — how much money we have to give pensioners today, to invest just as the pension plans would, to make them whole. Hmm, I think we’ll end up a lot closer to Josh’s numbers.

That is, one way to value government pensions is to ask workers how much they would be willing to take in the form of an individual retirement account to give up their pensions. Of course, if the government workers believe that their pensions are at risk, they might take a low figure. But if we take that possibility off the table, then workers are likely to demand a lot more money than the current stated value of the pension obligations.

I think others have pointed this out before, but when the subject of Social Security privatization comes up, aggressive assumptions about stock market returns seem reasonable to those on the Right and crazy to those on the Left. But their positions reverse when the subject changes to state and local pension funding. My own preference is to make conservative assumptions about stock market returns for both discussions.

Should You Buy Bonds?

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Lacy Hunt and Van Hoisington write,

Presently the inflation picture is most favorable to bond yields. The year-over-year change in the core personal consumption expenditures deflator, an indicator to which the Fed pays close attention, stands at a record low for the entire five plus decades of the series

True.

Over the past year, the Treasury bond yield rose as the nominal growth in GDP slowed. The difference between the Treasury bond yield and the nominal GDP growth rate (Chart 4) is important in two respects. First, when the bond yield rises more rapidly than the GDP growth rate, monetary conditions are a restraint on economic growth. This condition occurred prior to all the recessions since the 1950s, as indicated in the chart. This condition also signaled the growth recessions in 1962 and 1966-67. Second, the nominal GDP growth rate represents the yield on the total economy

True.

But then I downloaded from the Fred database the 10-year Treasury rate and the level of nominal GDP. I took the three-year average of nominal GDP growth rate, and I subtracted it from the 10-year rate, to get a rough measure of the differential between the 10-year rate and the growth rate of nominal GDP. From 1963 to present, this differential averages -.18. A super-simplistic model is that the nominal interest rate should revert to this average differential. So, if nominal GDP growth is 6.25 percent and the average differential applies, the nominal interest rate should be 6.07 percent.

For the latest three years, ending in Q1 of this year, nominal GDP growth has averaged 3.85 percent. Using the super-simplistic model of the nominal rate, it should now be 3.67 percent. In fact, it is now 2.52 percent.

Hunt and Hoisington are betting that the nominal interest rate is going to fall, but when I look at the same GDP data they do, I think it ought to be higher than it is now.

How to Interpret Asset Market Prices?

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Jeremy Stein says (in my words) “Don’t try.” His words are

fundamentals only explain a small part of the variation in the prices of assets such as equities, long-term Treasury securities, and corporate bonds. The bulk of the variation comes from what finance academics call “changes in discount rates,” which is a fancy way of saying the non-fundamental stuff that we don’t understand very well–and which can include changes in either investor sentiment or risk aversion, price movements due to forced selling by either levered investors or convexity hedgers, and a variety of other effects that fall under the broad heading of internal market dynamics.

If true (and I believe it is), this is a very important statement. It implies that events are in the saddle and ride the Fed. Not the other way around.

Pointer from “G.I.” of The Economist blog, via Mark Thoma.