Will the Recent Rise in Interest Rates Shut Down Household Spending?

June 27, 2013

Will the Recent Rise in Interest Rates Shut Down Household Spending?

Not likely. Today, June 27, the yield on the Treasury 10-year security closed at 2.47% according to the Bloomberg public (i.e., free) website. According to the Fed, this security closed at 1.66% on May 1. All else the same, household borrowing and spending would be stronger had this interest rate not risen by 81 basis points in the space of about two months. But it is doubtful that the recent rise in bond yields of many stripes will shut down consumer borrowing and spending.

Consider Exhibit A (Chart 1), the household debt-service burden. This is a Fed-generated series of required principal and interest payments for households as a percent of their disposable personal income. The median household debt-service burden from the inception of the series, Q1:1980 through the latest available data, Q1:2013, is 11.85%. The latest reading on the debt-service burden is 10.49%, the lowest burden save for 10.32% registered in the previous quarter, Q4:2012. In terms of the debt-service burden, it would seem that households have abundant capacity to take on more debt even at higher interest rates. Bear in mind, as bond yields tend to behave pro-cyclically. That is, bond yields tend to rise as the pace of economic activity quickens and fall as the pace of economic activity slows. If this pro-cyclical behavior of bond yields persists, then the upward pressure on household debt-service burdens resulting from rising bond yields will be partially offset by rising disposable personal income. And, of course, shorter-maturity interest rates have risen by much less than bond yields recently. Nowhere is it written that households must borrow at the long end of the maturity curve.

 

Chart 1

Now consider Exhibit 2 (I am a big fan of Car Talk’s Click and Clack). Exhibit 2, which is shown in Chart 2, is a comparison of the imputed yield on owner-occupied housing vs. a mortgage rate. The imputed yield on owner-occupied housing is the imputed rent on such housing (contained in the details of the personal consumption expenditures data provided by the Bureau of Economic analysis) as a percent of the market value of owner-occupied housing (contained in financial accounts of the United States data provided by the Federal Reserve).

Chart 2

In Q1:2013, the imputed yield on owner-occupied housing was 6.84% compared with an effective mortgage rate of 3.56% on sales of existing homes. Thus, the imputed yield on owner-occupies housing exceeded the cost of financing said housing by 328 basis points. Since the inception of these series, Q3:1973, the median value of the imputed yield on housing minus the mortgage rate is minus 153 basis points. That is, in contrast to recent years, typically, the imputed yield on owner-occupied housing is exceeded by the cost of financing said housing. Thus, although the recent rise in the 30-year fixed mortgage rate, all else the same, makes owner-occupied housing less attractive as an investment, owner-occupied housing remains a screaming buy in an historical context.

In sum, when the talking heads of CNBC and Bloomberg tell you that the recent rise in bond yields is going to snuff out household borrowing and spending, fade ‘em!

Paul L. Kasriel

Econtrarian, LLC

econtrarian@gmail.com

1-920-818-0236

http://www.the-econtrarian.blogspot.com

Senior Economic and Investment Adviser to Legacy Private Trust Co. of Neenah, WI

Does Fed “Tapering” Represent Fed Tightening?

June 24, 2013

Does Fed “Tapering” Represent Fed Tightening?

It depends. On what? Whether a reduction in the amount by which Federal Reserve purchases of securities increases each month represents a tightening in monetary policy depends on how much loans and securities on the books of private depository institutions (i.e., commercial banks, S&Ls and credit unions) change each month. Whether Fed monetary policy gets more restrictive or more accommodative when Fed the Fed begins to taper the amount of securities its purchases per month depends on what happens to the growth in the SUM of Fed credit and depository institution credit. If at the time the Fed tapers the pace of its asset purchases growth in the SUM of Fed and depository institution credit slows, then, in my view, Fed monetary policy would be becoming more restrictive. Conversely, if at the time the Fed tapers the pace of its asset purchases growth in the SUM of Fed and depository institution credit increases, Fed monetary policy, in my view, would be becoming more accommodative.

With regard to its impact on domestic nominal spending on goods, services and assets, both physical and financial, in theory it makes no difference whether credit is created by the Fed or by the depository institution system in a fractional-reserve regime. In both cases, credit is being created figuratively out of “thin air”, which implies that the recipient of this credit is able to increase its current spending while neither the grantor of this credit nor any other entity need restrain its current spending. 

Chart 1 shows the behavior of the SUM of Federal Reserve and depository institution credit, depository institution credit by itself and nominal gross domestic spending on currently-produced goods and services. The data are year-over-year percent changes of quarterly observations from 1953:Q1 through 2013:Q1. The contemporaneous correlation between gross domestic purchases and the credit SUM over this entire period is 0.56 out of possible maximum 1.00. The contemporaneous correlation between gross domestic purchases and depository institution credit by itself over this entire period is higher at 0.66. At first blush, this would seem to indicate that the behavior of depository institution credit by itself is what drives nominal domestic spending, not the SUM of Fed and depository institution credit. If, however, the period beginning with 2008:Q2 through 2009:Q4 is excluded, the contemporaneous correlation between gross domestic purchases and depository institution credit by itself slips to 0.62 while the contemporaneous correlation between gross domestic purchases and the credit SUM rises to 0.66. Thus, if a cogent argument can be advanced as to why this subperiod should be excluded, it can be argued that the impact of Fed “tapering” on the thrust of monetary policy depends on the behavior of the SUM of Fed and depository institution credit.

Chart 1

The reason the inclusion of this subperiod (shaded in Chart 1) reduces the contemporaneous correlation between the two series is that the sharp year-over-year increase in Federal Reserve credit that started in 2008:Q3 and reached its zenith in 2008:Q4 was related to extraordinary increased liquidity demands by financial institutions and funds advanced by the Fed to AIG. During this period, financial institutions were reluctant to lend to each other in the ordinary course of business. In response to this, the Fed threw open its credit facilities to depository institutions and other financial intermediaries in order to prevent a wave of failures throughout the global financial system. In the event, the increase in Fed credit was not being used as “seed” money by depository institutions to create multiple amounts of new credit. Rather, this Fed credit was just being used, at best, to fund outstanding credit previously granted by depository institutions. The Fed credit extended to AIG was used to “make whole” AIG creditors, not for AIG to expand its earning assets (loans and securities).

Since the onset of the financial crisis in late 2008, the Fed’s contribution to the SUM of Fed and depository institution credit has increased significantly, as shown in Chart 2. The rebound in the credit SUM beginning in 2010 has been dominated by Fed credit creation. If Fed were to begin tapering its securities purchases later this year, as Fed Chairman Bernanke indicated at his June 19 news conference is the current conditional plan (conditional on economic activity unfolding according to the Fed’s current forecast) and if depository institutions did not add to their holdings of loans and securities commensurately, then growth in the credit SUM would slow, which, in my view, would represent a “tightening” in monetary policy.

Chart 2

Commercial bank credit, the dominant source of depository institution credit, contracted in May at an annualized rate of 1.8%. The June weekly data, however, suggest a resumption of growth in commercial bank credit. The latest Federal Reserve survey of bank lending terms showed that there was a significant increase in the percentage of survey respondents stating that their institutions had eased their lending terms. With house prices again on the rise, future home mortgage write-offs by depository institutions will continue to diminish. This will enhance the already high (in general) capital ratios of these institutions, thus enabling them to increase their loans and securities. So, it is likely that depository institutions will be stepping up their credit creation as the Fed begins to moderate the pace of its credit creation.

Let’s contemplate some numerical scenarios for the behavior of the SUM of Fed and depository institution credit in 2013. Given 2013:Q1 actual (until revised) data and assuming that Fed credit increases by $85 billion per month over the remainder of the year (i.e., no tapering) while depository institution credit remains frozen at its 2013:Q1 level, then the credit SUM will have grown by 7.1% Q4-over-Q4 in 2013. Call this Scenario I. This compares with 2012 growth of 2.8% and 1953 – 2012 median annual growth of 7.25%. In Scenario II, assume that the Fed begins to taper it securities purchases at the beginning of 2013:Q4, cutting its current purchase rate of $85 billion-per-month in half. Further assume that depository institution credit remains frozen at its 2013:Q1 level. Under Scenario II, the credit SUM will have grown by 6.2% Q4-over-Q4 in 2013. In Scenario III, assume that the Fed tapers its securities purchases as it did in Scenario II, but that depository institution credit increases by the amount that the Fed cuts. Thus, under Scenario III, the credit SUM will have grown by 7.1% Q4-over-Q4 in 2013, the same as in Scenario I. Is Scenario III farfetched in terms of the growth in depository institution credit? Hardly. Scenario III would imply 2013 Q4-over-Q4 growth in depository institution credit of only 0.9%. This compares with 2012 growth in depository institution credit of 3.5% and 1953 – 2012 median annual growth of 7.5%. Based on this what-if exercise, I do not believe the Fed’s tapering in securities purchases later this year will represent a tightening in monetary policy as depository institutions are likely to increase their net acquisitions of loans in securities by at least as much as the Fed is likely to cut its rate of securities purchases. Rather, Fed tapering is more likely to represent an effective easing in monetary policy inasmuch as depository institutions will probably increase their net acquisitions of loans and securities by a greater amount than the Fed cuts its rate of securities purchases.

In the wake of Chairman Bernanke’s announcement of the Fed’s conditional plan to begin moderating the pace of its securities purchase later this year, the prices of risk assets, equities in particular, fell. Whether this decline in the prices of risk assets represents a buying opportunity or the onset of bear market depends critically on the behavior of the SUM of Fed and depository institution credit going forward. If depository institutions step up their net acquisitions of loans and securities such that growth in the SUM of Fed and depository institution credit is maintained or even accelerates as the Fed’s contribution to this credit SUM diminishes, then the current sell-off in risk assets will have been a buying opportunity. Based on the scenario analysis presented above, I would conclude that the recent sell-off in risk assets represents a buying opportunity.

Paul L. Kasriel

Econtrarian, LLC

econtrarian@gmail.com

http://www.the-econtrarian.blogspot.com

Senior Economic and Investment Advisor

Legacy Private Trust Company of Neenah, Wisconsin

1-920-818-0236

2013 Midyear Economic Update -- Another False Dawn?

 June 14, 2013

2013 Midyear Update – Another False Dawn?

We’ve seen this movie before since midyear 2009, haven’t we? The pace of economic activity begins to quicken and it looks as though a full-throated cyclical expansion might finally be at hand, only to have the economy slip back into the doldrums. Nominal private domestic spending on currently-produced goods and services grew in the first quarter at an annualized rate of 5.5% compared to 3.4% in the previous quarter. Consumer spending accelerated, housing sales picked up and business spending on equipment and software continued to grow at a healthy pace. Households appear to think that this is the real deal. Will they be disappointed? I don’t think so.

Why don’t I think this is just another false dawn? After all, federal fiscal policy has gotten “tighter”, what with tax rates having risen at the beginning of the year – an increase in the marginal income tax rate on upper-income households and an increase in the payroll tax rate on working stiffs -- and federal spending now declining outright as a result sequestration and other budgetary restraints (see Chart 1).

Chart 1

The reason I think “this time is different” (the most dangerous four words associated with economic prognostication) is because of the recent and expected behavior of “thin-air” credit. As you recall, thin-air credit is credit created by the Federal Reserve and/or the depository institution system (commercial banks, S&Ls and credit unions). This credit is unique inasmuch as it is created figuratively out of thin air. Credit created figuratively out of thin air enables the borrower to increase his/her current spending but does not require the lender or any other entity to cut back on its current spending. Hence, a net increase in thin-air credit, in all likelihood, will result in a net increase in nominal spending in the economy on goods, services and assets, both physical and financial. We cannot categorically say that credit granted by other sources will have the same positive impact on nominal spending because this credit is not created out of thin air. Thus, we cannot categorically say that the grantor of this credit will not curtail his/her current spending in order to fund the credit. Alright, now that you are up to speed on the uniqueness of thin-air credit, let’s talk about its behavior in recent years, as illustrated in Chart 2.

Chart 2

The Fed’s third round of quantitative easing (QE) commenced at the end of third quarter of 2012. Although depository institution credit has been growing consistently since Q2:2011, this growth has been relatively slow compared with its approximately 7-1/4% median annualized growth from 1953 to today. But when we look at the sum of Fed and depository institution credit growth of late, we see a different story. In Q1:2013, the sum of Fed and depository institution credit grew at an annualized rate of 13.8% vs. Q4:2012. To put that into perspective, the median annualized growth in this credit sum from 1953 through today has been 7.0%. Of course, the Fed’s $85 billion per month securities purchase program has been an important contributor to the recent outsized growth in the sum of Fed and depository institution credit.

As Chart 2 shows, this is not the first time in recent years that there has been a spike in the growth of the sum of Fed and depository institution credit. Will this recent surge in thin-air credit growth peter out as it has earlier in the current economic recovery/expansion? Not likely, for two reasons. Firstly, although the Fed may very well “taper” the monthly amount of its securities purchases sometime in the second half of 2013, it is unlikely to go “cold turkey” and completely cease all purchases. Secondly, depository institutions are likely to step up their creation of thin-air credit, although there was not much evidence of this in May. Why? Depository institutions, in general, are now very well capitalized, which will enable them to take on more earning assets. With house prices on the rise, more and more “underwater” mortgages on the books of depository institutions are rising toward the “surface”. This implies a reduced amount of future loan losses, thus a larger capital cushion.

Evidence of a greater ability/willingness of depository institutions to step up their net acquisitions of earning assets, specifically, loans, can be found in the Federal Reserve’s quarterly survey of bank senior loan officers with regard to their lending terms. Each quarter the Fed asks senior loan officers whether their institutions have tightened terms, eased terms or left terms unchanged on various types of loans. The data in Chart 3 pertain to lending terms on small business loans and prime home mortgages. A datum point in positive territory indicates that the percentage of respondents stating that lending terms had been tightened in the past quarter exceeded the percentage stating that lending terms had been eased. A datum point in negative territory indicates that the percentage of respondents stating that lending terms had been eased in the past quarter exceeded the percentage stating that lending terms had been tightened. So, data points above zero suggest banks, on net, are tightening their lending terms. Conversely, data points below zero suggest banks, on net, are easing their lending terms. (Be aware that a datum point can drift toward zero if respondents who last quarter tightened their lending terms and subsequently do not tighten further, but maintain the same degree of restrictiveness as the prior quarter.)

Where was I? Oh yes, Chart 3. There was a sharp increase in the percentage, on net, of banks tightening their lending terms on small business loans and prime mortgages starting in 2008. Although the net percentage of respondents stating that lending terms on both types of loans declined significantly in the second half of 2010, as mentioned above, this does not necessarily that there was a lot of easing of lending terms going on. Rather, it was more likely that many respondents were stating that their institutions were maintaining previously tightened lending terms. When we come to the latest data, the data for Q2:2013, it appears that there has been a significant percentage of respondents stating that their institutions had eased their lending terms, especially on small business loans. Thus, it is likely that as the Fed tapers its provision of thin-air credit, commercial banks will be stepping up their provision.  

Chart 3

In conclusion, I expect that the pace of nominal domestic demand will surprise on the upside over the second half of 2013. The principal reason for my bullish economic outlook is my expectation that growth in thin-air credit over the course of 2013 will be strong compared to what it was in the prior four years. On a Q4/Q4 basis, the sum of Fed and depository institution credit is likely to grow in the neighborhood of 7% to 8% for 2013. This would compare with changes of -4.2%, +2.8%, +5.2% and +2.8% for 2009, 2010, 2011 and 2012, respectively. The investment implications of this are that risk assets, such as equities, junk bonds, real estate and commodities should outperform relatively “safe” assets such as Treasury securities and investment grade corporate bonds.

While on the subject of bonds, it should be pointed out that although the Fed has increased significantly its holdings of Treasury coupon securities in recent years, as shown in Chart 4, relative to the amount of Treasury coupon securities outstanding, the Fed’s holdings, while elevated, are well below its relative peak holdings back in the early 1970s. Moreover, the very low correlation coefficient of 0.05 out of a maximum possible 1.00 between the Fed’s relative holdings of coupon Treasury securities and the yield on the 10-year Treasury security suggests that this yield marches to a different drummer than Fed quantitative easing. To borrow a 1992 Clinton presidential campaign slogan, “it’s the economy, stupid” when it comes to the behavior of Treasury bond yields.

Chart 4

The investment environment in 2014 is likely to be more challenging. I expect that during the course of 2014 the Fed will not only have ceased its QE, but also will be allowing its policy interest rates to rise. If so, then both stocks and bonds will have the wind in their face.

Paul L. Kasriel

President and Senior Research Assistant

Econtrarian, LLC

Sturgeon Bay, WI

http://www.the-econtrarian.blogspot.com

econtrarian@gmail.com

1-920-818-0236