Monday, January 29, 2018

Drum: Time To Put The Brakes On Jobs / Worry About Inflation?

Seems right to me, FWIW.


Anonymous Anonymous said...

So..that's a terrible argument by Drum.

First, one of the bigger reasons why the Fed is thinking of raising rates is because the market is signaling it is necessary through the yield on the 10 year Treasury, as it is a comparable benchmark for risk free yield but is traded in a highly efficient, highly liquid market.

Second, inflation expectations are well supported given revisions upwards of GDP forecasts, and looking at weathervanes like oil prices, which have risen almost 50% since 2017 lows, and over 100% since 2016 lows. (I happen to invest in this space a bit, and I think there is a good chance of even higher prices, because of a looming structural supply issue if investment is stimulated given demand increases).

Third, there is a very good reason to lay off if these indicators say so, and it isn't merely because of the economy "overheating". The Federal funds rate is a global benchmark for the cost of capital. It doesn't just control financial margins, it controls corporate debt, credit card rates, everything. If you misprice that, you'll misprice virtually everything, and worse, you incentivize corporations to leverage up in that sort of environment. If you want to see what happens when you do that, look at the stock prices of Chesapeake Energy (CHK), Whiting Petroleum (WLL), or California Resources (CRC). Or outside of the oil space, Freeport McMoran (FCX) or Teck Resources (TECK) up to mid 2016. The commodity sector was most sensitive to debt mispricing because it is so capital intensive, but other industries like automotive manufacturing or construction which are not quite as capital intensive could easily suffer the same overinvestment then massive collapse if things remain mispriced.

(This also means the lack of inflation in the last 3 years is something of a Trojan horse created by overinvestment in a low cost of capital environment. Things can change pretty quick considering how brutal things have been for commodity producers, and how little investment was permitted because of that.)

Drum is just showing three charts with a line he drew through them. He's hindcasting.

11:47 AM  
Blogger Winston Smith said...

FOR YOUR INFORMATION, Anon, I understand the vast majority of those words.

9:39 PM  
Anonymous Anonymous said...


Honestly though, the big upshot is that the Federal Funds Rate (what we usually call "interest rates") don't just correlate with inflation, it really controls the cost of debt. If you keep it low when the efficient price is in fact much higher, you seriously incentivize companies taking too much debt, then creating too much capacity with that debt. Eventually oversupply will crash the market they are selling in to, and that's when sh!t gets bad because they still have the debt that got them in to the mess. The commodities companies I mentioned are pretty severe examples, but housing circa 2008 was the same. Mortgage debt was terribly mispriced, which incentivized the creation of way too much housing supply, which eventually crashed housing prices (which is really bad when you then have a ton of debt secured by those housing prices).

But it's less clear now, because inflation numbers are masked by the general commodities crash of 2014-2015, which were almost entirely due to oversupply (overinvestment) for exactly the above reason.

10:29 PM  
Blogger Winston Smith said...

I know about the Federal Funds Rate, of course...but didn't/don't understand the rest of this. How sure should we be about this?

8:10 AM  
Anonymous Anonymous said...

There's really no way to be sure until the sh!t hits the fan, that's part of the problem. New debt is solvent as long as a company's earnings can cover interest with a strong margin of error. That fails when oversupply crunches their margins, and there is no model in existence that can time that. The other possibility, which is less likely currently, is that aggregate demand starts to fall (which will also crunch prices and force deleveraging). But we can predict neither.

(Well it has already happened, but largely in the commodities sector. Since the US isn't terribly exposed to those sectors, there hasn't been much of an issue in our markets, but if you look at the markets in Brazil, or Russia, or similar countries, they've all been in severe recessions.)

There is technically another risk, the yield on the debt can increase substantially too, if you look at interest rates from 2004-2008, they increase almost 4 fold. This isn't because of policy blunders, the cost of capital needs to compete with the yield you can get everywhere else in the economy. If it starts becoming clear you can get yield elsewhere, people will sell bonds yielding x% to invest in similar risk endeavors yielding x+y%, and the selling will drop price and increase the yield to market. So, if you were solvent with room for error up to a double in interest rates but they instead quadruple, bankruptcy will be inevitable (most corporate debt loads cannot be paid in full out of cash flow, instead they need to "roll over" old debt by assuming new debt. If they cannot pay the interest on new debt at when the time comes to refinance, they usually declare bankruptcy). Since rates are way at the left tail of the distribution, we could easily see massive percentage gains in risk free yield, and if a corporation is too leveraged, they'll get wrecked.

As far as debt creation among companies currently, it is a certainty that companies are more leveraged than ever. After QE started, corporate debt in the US increased by almost 50% (and a lot of stock gains are actually a derivative of this wave of debt creation). QE was much more acute in Europe, with central banks pushing interest rates negative, so I assume debt creation has been even more rapid there, although the negative yields might actually have shrunk the debt markets as investors fled such a blatantly mispriced asset.

Also what really freaks people out, one of the mechanisms to keep interest rates so unusally low was the purchase of corporate and sovereign debt on the open market by central banks (basically the market wouldn't accept that sort of yield, so you needed to create artificial bond demand to suppress the yield). Some, like the Bank of Japan, and Bank of Switzerland have actually been purchasing equities as well. So on an asset basis, the balance sheets of central banks have never carried so much risk, and it is entirely unclear how they can shrink those balance sheets without crashing the relative markets (as the selling pressure would be massive in a structurally illiquid bond market). So they're basically stuck with these assets until they mature, which makes what should have been our lenders of last resort very exposed to market risk.

So it is clear we have been piling on a ton of risk to keep things looking good overall. It's possible that nothing comes of this, but I think it was clearly the wrong strategy, most clearly evidenced by the perversion of institutions which were never meant to assume risk in the first place to achieve these goals.

9:57 AM  

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