Judgments of Value
May 31, 2020 – Weekly comment
Below are excerpts of a speech given by Alan Greenspan at Jackson Hole on August 27, 1999, ‘New Challenges for Monetary Policy’
On such judgments of value rest much of our economic system. Doubtless, valuations are shaped in part, perhaps in large part, by the economic process itself. But history suggests that they also reflect waves of optimism and pessimism that can be touched off by seemingly small exogenous events.
We can readily describe this process, but, to date, economists have been unable to anticipate sharp reversals in confidence. Collapsing confidence is generally described as a bursting bubble, an event incontrovertibly evident only in retrospect. To anticipate a bubble about to burst requires the forecast of a plunge in the prices of assets previously set by the judgments of millions of investors, many of whom are highly knowledgeable about the prospects for the specific companies that make up our broad stock price indexes.
Although many aspects of this issue deserve attention, let me cite a few open questions of particular importance. Efforts to differentiate between realized and unrealized gains, and the propensity to leverage both, may afford a deeper understanding of the consequences of asset price change. And differentiating between gains that arise from enhanced profitability and those that reflect changes in discount factors may also be useful. The former may be more likely to be sustained, given the tendencies of discount factors to revert back to historic norms.
There are important–but extremely difficult–questions surrounding the behavior of asset prices and the implications of this behavior for the decisions of households and businesses.
In August of 1999, Greenspan gave a speech at Jackson Hole, ‘New Challenges for Monetary Policy’. In it (linked below) he touched on new technologies and accounting practices, values for assets and their importance for the economy in general, and waves of confidence. Although Greenspan’s reputation has lost its luster in recent years, there is no denying this speech was prescient. On Aug 27, 1999, Nasdaq closed 2402. At the end of the year it was 3684. Having sailed through Y2K worries, by March 2000 it topped at 4816, astonishingly almost an exact double from the Jackson Hole speech. From there things went sour…but it took some time. At the end of May Nasdaq was 3180. At the end of 2000, it was just under the level when Greenspan delivered his comments, at 2341. The one year decline from the late March 2000 high to the early April 2001 low of 1348 was 72%. And it still wasn’t over. [chart below]
In 2000, the initial move in NDX from the March high to May low was a decline of just under 40%. By September, it had retraced just over the 61.8% level, and then a consistent sell-off ensued. In the current episode, the upside run to February’s high wasn’t nearly as dramatic. The initial leg down from the Feb high to March low was just 30%, also more shallow than 2000. However, the rebound has been quite fierce; as of Friday the index is testing February’s highs. This has been achieved with enormous support from the Federal Gov’t and the Fed itself. “Given the tendencies of discount factors to revert back to historic norms…” we might question the durability of the rally. However, the Fed is going to great lengths to assure the market that it won’t ALLOW rates to get back to historic norms. That point was especially driven home during the last attempt at ‘normalization’ which resulted in the stock market tantrum of Q4 2018. It’s no longer the judgments of millions of investors, it’s the injection of trillions in stimulus.
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I filled up in Wisconsin for $1.87 this weekend. I have a few friends, Lenny chief among them, that announce their cheap gasoline purchases like a badge of honor, as if they’ve rigged the pump price themselves. Well, I’m joining your ranks, comrades.
Once in a while an analyst remarks that it’s ambiguous now as to whether cheaper oil prices are good for the US economy, because while it helps Lenny and me, it hurts producers, and as we all know, the US is the top producer. According to the US Energy Info site, the US produces 19% of the world’s oil and consumes 20%. Maybe we should just call it a wash. You don’t hear much about the ambiguity of net positive or negative effects from other factors. Specifically, I am referring to financial conditions. According to former NY Fed chief Dudley, financial conditions consist of short term interest rates, long term interest rates, the level of stocks, credit spreads and the dollar. Clarida glowingly outlined easier conditions in a speech last week.
Is it clearly the case that the net economic effect of easier financial conditions is beneficial? Some officials are starting to address that question. For example, with respect to short term rates, Powell again said on Friday that negative rates will not work for the US economy. [There’s such a thing as too much rate cutting?] Many commentators have said that low long term rates help borrowers and home-builders, but also hurt savers and retirees that depend on interest income. The shape of the curve is another feature that can negatively impact the transmission of monetary policy if too flat or inverted. In terms of stocks, it’s great when they rise, but if not underpinned by profitability and innovation, instability can ensue. When credit spreads don’t reflect the reality of lending based on economic fundamentals, zombies arise. With respect to the dollar, the former mantra by treasury secretaries was that a strong and stable dollar is in the best interest of the US. Now, the world yearns for a weaker USD. Everything has become murkier. The thought extends to unemployment benefits where workers are making more from staying out of work than returning.
Another topic that seems to have fallen out of fashion is ‘equilibrium’. It used to be that economists talked about the market finding a new equilibrium when a shock occurred. In fact, I don’t hear the word much anymore. A google trends search for ‘economic equilibrium’ shows modest annual spikes in February, apparently coinciding with the initial leg of the semi-annual Humphrey-Hawkins testimony. Just another anachronistic footnote of what used to be the capitalistic system.
I’ll end with a note regarding Loretta Mester’s appearance on BBG on Friday. The interviewer asked her, regarding yield curve control, would she think about it as “focused on the front end to the belly of the treasury curve, or would you think about doing what Japan is doing, which is all the way out to ten years?” Mester responded that, while it’s not under serious consideration for this phase, her view is that it would be a support for forward guidance. She added that “right now the yield curve is very flat at the short end…maybe it’s not necessary to emphasize that forward guidance.” And concluded, “If we were to use it, I would view it as reinforcement to forward guidance on the short end.”
It’s perhaps worth noting that the thirty year yield in Japan hit a new ytd high this week just over 50 bps. I’d further mention that the US spread between 5’s and 30’s reached a new high over 111 bps, not seen since mid-2017. Control of the short end may not hold the long end down.
Finally, circling back to consumer pessimism and optimism and forecasts for confidence, note that the final readings for U of M’s inflation expectations were released Friday, with the one-year at 3.2% up from the preliminary release of 3% and the 5-10 year was revised up to 2.7 from 2.6! This, in spite of yoy PCE Core prices coming out at just 1% yoy. Another thing Mester said in her interview was that when the Fed considers new tools, we have to think about how to implement them and about how to exit from them. My guess is that the Fed is going to be spending a lot more time in the near future wrangling with the latter rather than the former.
OTHER MARKET/TRADE THOUGHTS
There was a buyer last week of 75k EDM1/M2 spreads for 6-6.5. This calendar ended the week at 5.5, up 0.5 on the week. Further out the curve, THREE-month spreads are nearly the same level. For example, EDU3/EDZ3 settled 5.0 and EDH4/EDM4 settled 4.5. EDM3/EDM4 closed 16.5, exactly 3x higher than the nearer version. These spreads give the impression that either inflation will begin to press higher over time, or that the Fed will cede control to the market. EDH’24 settled at 9949.5, just 4.5 bps lower than the lowest settle ever for the 16th quarterly, which was earlier in May.
I did a bit of review on spreads during the taper tantrum of 2013 which occurred in May. The second red, or ED6, went from around 9960 to 9920 from early May to end of June. (This period also encompassed a contract roll). The second green, ED10 went from 9940 to 9830, while the second blue, ED14 went from 9885 to 9740. Therefore, deferred contracts sold off harder. That period may or may not provide a good analogy for what is coming up in the US, but is worth noting.
Copper/gold ratio compared to the US ten year yield is one of Gundlach’s indicators. This week the former ratio ticked a bit higher while the ten year yield fell 1.5 bps. The divergence may not be enough to warrant a trade, but worth keeping an eye on.
| 5/22/2020 | 5/29/2020 | chg | ||
| UST 2Y | 16.6 | 15.6 | -1.0 | |
| UST 5Y | 33.3 | 30.0 | -3.3 | |
| UST 10Y | 65.9 | 64.4 | -1.5 | |
| UST 30Y | 137.0 | 140.5 | 3.5 | |
| GERM 2Y | -68.0 | -65.9 | 2.1 | |
| GERM 10Y | -48.7 | -44.7 | 4.0 | |
| JPN 30Y | 44.9 | 50.3 | 5.4 | |
| EURO$ M0/M1 | -11.3 | -10.8 | 0.5 | |
| EURO$ M1/M2 | 5.0 | 5.5 | 0.5 | |
| EUR | 108.98 | 111.04 | 2.06 | |
| CRUDE (active) | 33.25 | 35.49 | 2.24 | |
| SPX | 2955.45 | 3044.31 | 88.86 | 3.0% |
| VIX | 28.16 | 27.51 | -0.65 | |
https://www.newyorkfed.org/newsevents/speeches/2017/dud170330
https://www.federalreserve.gov/boarddocs/speeches/1999/19990827.htm
https://www.eia.gov/tools/faqs/faq.php?id=709&t=6
