The Greenspan Uncertainty Principle
John Mauldin
The Greenspan Uncertainty Principle
An Obituary to the Yield Curve?
Real World Central Banking
Greenspan says, "Trust Me"
Stanford, New Orleans, Toronto, Houston and Europe
This week we revisit our old friend, the Yield Curve. We look at what it may or
may not be telling us, how the Conference Board has changed how they look at the
yield curve as part of their leading economic indicators, and muse upon what
Greenspan is really doing. There's lot of very important and interesting ground
to cover, not the least of which is my concern about Fed policy.
But first, let me invite you to meet me in New Orleans at the New Orleans
Investment Conference October 30-November 3. This is the grand-daddy of all
investment conferences, and they always have a great line-up of speakers. This
year Steve Forbes, Ann Coulter, Jim Rogers, Marc Faber, Dennis Gartman and for
fun P. J. O'Rourke will be there, along with your humble analyst, as well as
scores of great speakers. There is a great deal of emphasis upon gold and
natural resources, as well as other types of investments.
My friends and business associates from Altegris Investments will be there as
well, and we will be meeting with clients and prospective clients. If you are an
accredited investor and would like to meet us there to look at your investment
portfolios, I suggest you contact me and let's start setting appointments as
meeting times will go fast. You can click on this link to register for the
conference and I will also give you more details at the end of the letter.
https://www.jeffersoncompanies.com/registration/confreg.php?acode=JM
Let's start with a review of the yield curve. Basically, it is the difference
between short term and long term rates. When short term rates rise above long
term rates, the curve is said to go "negative" or "inverted." This is important,
because as Professor Campbell Harvey (at the Fuqua School of Business at Duke)
first pointed out in his doctoral dissertation at the University of Chicago, the
yield curve is the best predictor of an impending recession.
(As an aside, for you research buffs, his web site has a very easy to use
dictionary for every conceivable financial term, with lots of links. http://www.duke.edu/~charvey/, plus lots of other really good material.)
Typically, when the yield curve goes negative for about 90 days or more, the
country goes into recession within 12 months. Thus, with the yield curve getting
flatter and flatter, people like me start to pay closer attention. Because,
while it should seem obvious, a necessary pre-condition for a negative or
inverted yield curve is a flattening yield curve.
The difference between the two year and the ten year is today only 21 basis
point. The ten year is at 4.24% as I write. But we normally measure the yield
curve from the 90 day, which is basically the Fed fund rate, which is now 3.5%.
For the yield curve to go negative either long rates would have to drop or short
term rates would have to rise, or a combination of both.
In one sense the yield curve is already much flatter. As I will point out below,
the Fed has made it clear they intend to keep raising rates. If they raise at
the next three meeting, the curve will be quite flat. The market is pricing in
such Fed moves, so essentially the market is anticipating a much flatter yield
curve. The question of the day is whether the Fed will deliberately force an
inverted yield curve.
I am often asked if a negative yield curve is an indicator of or a cause of the
recession, and the answer is a little of both. This is complicated, so let me
see if I can explain it simply. (By doing so I know I am at great risk of
over-simplification, and thus not being precise, but that has never bothered me
before.)
Why would someone be willing to pay less for long term money than what they
could get simply by investing in a money market? Because they have a belief that
short term rates are going to go down and probably drag long term rates down as
well. They "buy" the long term rates thinking that they may not get another
chance to get the long term rates at the current level for quite some time. In
essence, they are timing the bond market and making a prediction about the
future direction of interest rates.
Why would they think short term and long term rates are going to drop? Because
they think the economy is going to slow down or go into recession. If the
economy goes into recession, they believe the Fed will react by lowering short
term rates, and long term rates normally drop because of the recession. That
goes double in a world where deflation is a dominant theme.
Of course, when short term rates rise above long term rates, this is not good
for banks. They have to "pay" for money by giving interest and charging more for
their loans. When short term money goes above long term money, it puts a squeeze
on their profits. They also tend to lend less money and become more
conservative, which puts a crimp on business in general.
There are some very smart people who believe the yield curve is no longer a
potential indictor of recession, including apparently Sir Alan Greenspan.
Let me quote at length from an article entitled "An Obituary to the Yield Curve
as a Leading Indicator" by those clever analysts from GaveKal. (Please note that
the word adequation is primarily a term used in French and means: The act of
equalizing; act or result of making adequate; an equivalent. In their context it
more or less means correlation.)
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 adequation 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."
Well, maybe.
It is generally not a good idea to disagree with those who are clearly smarter
than you are, but nonetheless I think giving the yield curve an obituary is a
little like Mark Twain's statement that "The reports of my death have been
greatly exaggerated." While GaveKal makes some very good points, I would
disagree on a few points.
The "platform company" model is one that I have dealt with in concept in this
letter over the last year or so. In essence, who do you want to own, the company
that makes the Ipods for Apple in China (or wherever) which has margins and
return on capital in the low single digits, or Apple which sells the Ipods with
margins of 40%?
This is causing part of the problem with the trade deficit, and is one reason
why it is becoming more of a structural problem than ever, and another reason
why it will last longer and get bigger than almost anyone now thinks. But that
is a topic for another letter.
GaveKal is correct that commercial banks only provide about 35% of capital. But
other lenders still have cost of capital. There is no free lunch. Hedge funds
must find the capital somewhere, and an inverted yield curve makes borrowing and
leverage a very difficult game. Leasing companies must go into the capital
markets to compete. I think an inverted yield curve will still be a harbinger of
decreased availability of capital.
Plus, let's not get into an Alice in Wonderland mode, where the Queen of Hearts
snaps "Verdict first and trial later!" The yield curve has been very good for a
long time as an indicator, for whatever reason. Let's see if it fails first
before we bury it. It goes against my grain to take a "this time it's different"
approach. It hardly ever is.
And, to be fair, the Conference Board, which produces the index of Leading
Economic Indicators (LEI) did not in fact unceremoniously dump the yield curve.
They simply changed how they use it. Before, as I understand the papers on their
web site, their model saw a flattening yield curve as a negative indicator. Now
they only use it as an indicator when it goes negative.
They argue that the movement of the yield curve is not particularly useful at
other times other than when it is negative. It is only when it goes negative
that we should really pay attention. You can go the paper and see the "before
and after" LEI and see that it does seem to in fact work better only using the
yield curve when it is negative. You can also see that the LEI is now turning
down on page 6 of the report.
(http://www.conference-board.org/economics/bci/NewYieldLEI_2005.pdf)
Now, why is this so important? Because the Fed is almost certainly going to
raise rates at least 2 and probably 3 or more times. We will have a 4% fed funds
rates by the end of the year. Some are now writing of a 5% rate before the cycle
is over.
I wrote at the beginning of the rate raising process that the Fed would raise
rates longer and higher than anyone expected. That is their clear pattern. They
keep raising rates until things start going soft, and then start cutting. But by
then it has been and will be too late. It takes about 6-9 months before any
policy change (like cutting or raising rates) really has an effect upon the
economy.
Personally, I think the Fed should at least pause for a session or two and see
how things are going. But they are not going to do so. Greenspan clearly
enunciated the principle that central banks should always pursue policies that
will avoid the large risks, even at the risk of smaller problems. What you want
to avoid, he argues, is the really severe downturn. Great speech. Every Fed
governor needs to read it 2 or 3 times between now and the next meeting.
In theory, Greenspan and the Fed are focused on inflation. But their last
release indicated that rising inflation is not a big risk. Indeed, if you look
at what is called "pipeline" inflation or the potential inflation coming down
the pipe, one might reasonably conclude that inflation is not a major issue.
Further, oil prices are rising and it is finally starting to have a small effect
on the economy. We are watching a significant rise in the inventory of homes for
sale in some of the nation's hottest markets. The Wall Street Journal, in a
cover story today, says in the headline that this suggests the housing market
could be cooling. In San Diego they have more than doubled. And in many other
areas are up 25-40% or more.
"Economists and real-estate analysts say they won't be able to determine whether
the market as a whole is slowing until September or October at the earliest, and
note that housing conditions vary among communities." (WSJ)
The problem is serious, though. Rising home prices have resulted in a great deal
more borrowing. We have seen home values rise by $6.5 trillion and debt rise by
$4 trillion since the beginning of the decade. On average, consumers have
significantly less equity in their homes than they did 5 or 10 years ago, even
with the run-up in home prices.
So why is the Fed clearly signaling they are going to raise rates at least
another two times and probably much higher? I think the Fed is no longer
targeting inflation. From their speeches and from the minutes of the meetings, I
think they are clearly targeting asset prices and specifically housing. They are
worried about a bubble. "It is not a bubble yet," says Greenspan, "just a little
froth here and there."
The guide is the central bank of Australia, where they did in fact have a
housing bubble. They raised rates until the housing boom stopped, and somehow
kept housing prices from falling. The Australian housing market has been flat
for 18 months. I think the Fed would like to see the same thing happen here.
Yet, there is a problem. There is Greenspan's conundrum. If he raises rates to
4.25%, the yield curve could invert quite quickly if long term rates do not rise
alongside the short term rates. So far, they really haven't to any significant
degree.
Now, it is possible, as Campbell Harvey pointed out in a conversation today,
that it is only now that rate increases are really having an affect on long
rates. The first 8 increases merely got us back to where we should have been.
For the record, he still believes that the yield curve is a useful indicator.
Let's make no mistake about it. Greenspan is using his personal judgment here.
In fact, he has clearly told us that personal judgment is, in the end, what
central banking is about. Let's go to a speech he made at Jackson Hole, Wyoming
in August of 2003. This will go on for a few pages, but it is critical for you
if you want to understand why Fed policy is what it is.
The Greenspan Uncertainty Principle
The speech is entitled "Monetary Policy Under Uncertainty" and starts with the
very important sentence:
"Uncertainty is not just an important feature of the monetary policy landscape;
it is the defining characteristic of that landscape."
It then goes on to tell us just how uncertain monetary policy is:
"Despite the extensive efforts to capture and quantify these key macroeconomic
relationships, our knowledge about many of the important linkages is far from
complete and in all likelihood will always remain so. Every model, no matter how
detailed or how well designed conceptually and empirically, is a vastly
simplified representation of the world that we experience with all its
intricacies on a day-to-day basis. Consequently, even with large advances in
computational capabilities and greater comprehension of economic linkages, our
knowledge base is barely able to keep pace with the ever-increasing complexity
of our global economy."
He emphatically points out that models only give us at best a reference point
for policy. They cannot be prescriptive with any real degree of certainty. Nor
does he offer any hope that such models can be developed in the future. Economic
models are far from perfect and "in all likelihood will always remain so."
"Look, guys," he tells us (my paraphrasing), "stop looking at three different
trends, running them out ad infinitum and then drawing a conclusion about the
wisdom or stupidity of our decisions. The factors affecting your trends are so
complex that any number of significant events could change the relationships
between your trends and the desired policy."
Not only are past relationships not always linear, but past relationships may
change over time. This is the old principle of "past performance is not
indicative of future results." Just because things worked in the past does not
mean they will in the future, as the world is changing rapidly. A simple example
of this is all the analysts who told investors to buy stocks in January 2001
when the Fed started cutting interest rates because the "models" showed that
stocks always went up after the Fed started cutting rates. Now, we know that
such a linear relationship is not always true.
Real World Central Banking
"What then are the implications of this largely irreducible uncertainty for the
conduct of monetary policy? ...In implementing a risk-management approach to
policy, we must confront the fact that only a limited number of risks can be
quantified with any confidence. And even these risks are generally quantifiable
only if we accept the assumption that the future will replicate the past. Other
risks are essentially unquantifiable..... because we may not fully appreciate
even the full range of possibilities, let alone each possibility's likelihood.
As a result, risk management often involves significant judgment on the part of
policymakers, as we evaluate the risks of different events and the probability
that our actions will alter those risks."
Greenspan says, "Trust Me"
Now let me give you a few more of my first thoughts on the speech as it relates
to our situation today. Let me start with a story from Dennis Gartman. He was
once playing with a four man group for a state golf team championship. They were
in the hunt for the outright championship, and on the 17th hole, one of the team
members (interestingly his last name was Duffer), missed a 7 foot putt by a half
an inch. Hearing the groans of his teammates, he turned around and said quietly,
"Gentleman, that is the best I could do at the time."
First, Greenspan is saying that human beings run the Fed, and they have to make
judgments. The best way to do that is to try and avoid the big risks. In
essence, the Fed is like a giant economic insurance company, trying to avoid the
big risks which could wreck the economy (like deflation, in their view) and thus
willing to take smaller risks (like inflation, again in their view).
He tells his critics who look at static models that they are being too
simplistic, and with some justification in most cases, I might add. That is not
to say I would agree with a certain policy, but in this Greenspan is right: you
cannot focus on just a few trends and extrapolate to a correct policy.
Second, he acknowledges what everyone knew: the world is vastly complex and
cannot be understood in any one way. Further, every action will have unintended
consequences, and the best you can strive for is not trying to "fix" the
economy, but assessing risk and trying to avoid the worst case scenarios based
on that risk assessment.
Finally, Greenspan is saying, "Trust Me." Not explicitly, but implicitly it is
all over this document. As he answers critics about specific actions (like 1998
monetary easing), he confidently asserts, "Gentleman, that is the best I could
do at the time."
For better or worse, that is where we are. I think Greenspan is worried about
letting the housing froth turn into a full fledged bubble. (Which is a real
worry, let's be sure to point out.) We are in a world where we have to trust
him, whether we like it or not. He is going to base his decisions on what he
sees as the risks. Maybe we get lucky and we have an outcome like Australia. No
recession, a flat housing market and no bursting of what was a bubble. But it
seems to me the Fed is going to keep at it. They are going to raise rates more
than we think unless the yield curve actually inverts in the middle of the
process.
This is an experiment in slowly letting the air out of what Greenspan calls
froth. (As Paul McCulley points out, Greenspan can't physically say the word
bubble.) This is something we will obviously be watching with close interest.
Stanford, New Orleans, Toronto, Houston and Europe
I will be going to Stanford, Toronto and Houston in September, and will be going
to New Orleans in late October. I will also be in Europe for most of the first
two weeks of October.
As I mentioned above, I will be speaking and attending the New Orleans
Investment Conference October 31-November 3. Jon Sundt (president) and Dick
Pfister from Altegris Investments (as well as my daughter and right-hand
Tiffani) will be there to meet clients and potential clients. Basically, we help
clients develop portfolios of hedge funds, commodity funds and other alternative
investments. If you would like to know more about what we do, you can go to www.accreditedinvestor.ws and sign up for my free letter on hedge funds that is
just for accredited investors (essentially net worth of $1,000,000 or more). If
you want to be able to go into specifics about your portfolio with me and Jon or
Dick in New Orleans, you must sign up soon and start a conversation with a
representative from Altegris at least 30 days prior to the conference. We will
not go into specifics with anyone with whom we have not had a substantive
relationship for at least 30 days. Those are the rules and we follow them.
(In this regards, I am president and a registered representative of Millennium
Wave Securities, LLC, which is a member of the NASD. Please see the specific
risk disclosures which follow below and on the website as well.)
As much travel as I will be doing in September and October, it is good that I am
going to be home for the next four weeks. I have a lot of catch up to do. But
Palo Alto and Stanford will be a pleasant diversion as I will be going to the
2005 Accelerating Change conference, which promises to be an interesting look
into the future. You can learn more by going to www.accelerating.org. I spoke
at the conference last year and learned so much I am going to actually pay and
go back again.
It is a lazy August Friday, and I am actually finishing with daylight to spare.
It has been relatively cool in Texas, which is odd for August. But this will
probably change. I hope you are enjoying your summer.
Your enjoying his time at home analyst,
John Mauldin
JohnMauldin@InvestorsInsight.com
www.2000wave.com
August 13, 2005
Copyright 2005 John Mauldin. All Rights Reserved.
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John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Thoughts from the Frontline may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273.
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