Monday, May 30, 2016

Fisher Rate Can Be Used to Derive Expected NGDP

The Fisher Rate is the keystone to understand the pricing of US Treasurys as it acts as a bridge to compare the current expectations for the economy future to the longer maturity US Treasurys.  The basic principal is that the Fisher Rate is equivalent or approximate of  NGDP.  This was considered to be a given and even axiomatic when rates and NGDP were “normal” – about 3% to 5% for Fed Funds and the same for NGDP.  But as we are in extraordinary economic times – or at least let us hope we are in unique times – and given very unusual Central Bank actions starting with Bernanke plunging Fed Funds to ZLB and with three tranches of “Quantitative Easing” (QE) – the resulting ZIRP then low rates of 3/8% for Fed Funds implies NGDP is around similar levels with real GDP at “0” or less.

Despite the thoughts of the likes of Larry Summers with “Secular Stagnation” or Bill Gross’s “New Normal”, it just does not intuitively synch that the current Fisher Rate (Fed Funds) of 3/8% is equivalent to NGDP.  But as given a deconstruction of the US Treasury curve, that does in fact seem to be where the forward expectations for NGDP are currently, under 2%.  This is the stuff of the “NeoFisherism” school, with the St Louis Fed and the University of Chicago in the forefront.  They state that the Federal Reserve, via a Fisher Rate axiom, will produce the NGDP via setting the Fed Funds rate while most see it the other way around.  And furthermore  QE, once it had resolved the “lender of last resort” solvency crisis, only leverages the ZLB Fisher Rate  effect, and thus inflation becomes low and static if not moving to deflation.

If this is the case, we should see a significant change in the forward NGDP expectations when Bernanke went into the “Taper” of the QE purchases.   And in fact we did.

We derive the forward NGDP expectations in a long enough time (here 7 years)  such that we are reasonably assured that we are past the current “noise” of Federal Reserve gaming and speculative trading anticipating the next several FOMC meetings.  We therefore look at the expected NGDP in 7 years.  Since NGDP is inflation and GDP, we can relax trying to find the forward inflation rate and avoid the noise and inaccuracies in using TIPS and other popular ways to get a read on forward inflation.  We feel that most of the current ways to derive inflation expectations are not useful – be it surveys or TIPS or other methods.  The best, and in the end far more useful way, is to derive forward NGDP expectations. Our method to do so is proprietary, but it is not based on forwards or delaminating the US Treasurys using a risk premium.  US Treasurys from the compounding and their critical need as insurance for adverse large macro-economic shocks make term maturities an inaccurate data source and one cannot  get a read of overnight Fed Funds in forward space of 7 years or more. Neither do OIS indices do this as well.  For example, the compounding of US Treasurys, especially at a low interest rate environment ends with a stochastic problem to “de-convex” the Treasurys before a limit can be found in a long enough maturity to derive the spot rate.  We have arrived at a different way to calculate forward NGDP and thereby the forward Fisher Rate.

There are interesting conclusions  made when the NGDP over time, both at forward point of 7 years over time or from quarterly progressions of forward to 7 years, is observed.

One immediate condition shows that the low point for the perception of the health of the USA in forward space was not the nadir of 2009, it seems then all were aware of the exogenous nature of the crisis and had trust in the Federal Reserve and the administration to “do the right thing”.  While the Fed did carry through and obviously did everything and anything they could conceive of – and then likely more than they should or could do – clearly the administration dropped the ball and did relatively little in terms of fiscal support of the Fed or with any true stimulus for the economy.  This shows with the true “nadir” for the crisis being 2012, not 2009.  For much of that year the future prospects for the US NGDP was bleak indeed where at times a depression was being forecasted with no NGDP growth even until 2020.

The expected NGDP in 7 years over time (I have it from 2005 to 2016 (May 25 2016) ) is also interesting showing the 2012 lows but also showing that the “Taper” did not  drop NGDP expectations but also increased them by about 2% (1 ½% to 3 ½% ) which over 10 years would be an increase in NGDP cumulative of $3.4 trillion. Therefore the Taper actually was stimulative.  Since the hesitation of the Yellen Fed in ending ZLB – the forward NGDP has dropped 1% resulting in the opposite effect as the Taper, an expected  loss of cumulative $1.7 trillion in NGDP for ten years.  The NeoFisherism school would put this forward that the basic ideals of NeoFisherism, that adjusting the Fisher Rate will result in a change in NGDP expectations along with lowering QE once solvency crisis needs,  are met will raise NGDP in the forward space.  This suggests that if Yellen continues to dawdle and “go slow” or even pause with raising the Fisher Rate – Federal Funds – we will continuea  drop in NGDP.  Her caution is bringing about what she states she is seeking to avoid.

Using the Fisher Rate in forward space, we can also develop an opinion as to whether or not long duration US Treasuries are rich or cheap in comparison to expected NGDP.  We develop this model by plotting forward NGDP to long US Treasury yield.  While US Treasurys have been relatively richer in the past few years, they are extraordinarily rich considering that the business cycle phase  is likely a late phase of a recovery.  If the Fisher Rate is raised spot (Fed Funds towards, say, 1% and QE stops rolling the amortization of the QE mortgages, forward NGDP should rise from the low 1 ½% area to  3 ½ % or higher.  Then if long US Treasurys were to anticipate further improvement in NGDP expectations,  they could even trade “cheap” to an expected NGDP that is rising – this could easily put the 30 Year US Treasury towards 5%.  As can be seen – it has happened before and during a US economy which might not even be perceived to be as robust as it is now.  (2006)

A specific US Treasury can be illuminated by considering the forward NGDP rate for the maturity. Here we show the NGDP expected in 4 years which is in synch with the large movements of the US Treasury 5 years.

Furthermore there is another serious problem or risk increase for the savings of the US if the NeoFisherism is an axiom, and that is the inability to use US Treasurys as they might be if they were not at both a lower outright historical level as well as being “cheap” to the expected NGDP.  This leaves investors “stuck” with only risky assets like SP500 modified by cash and not able to have a large amount is US Treasurys to provide “insurance”.  Dalio’s  Bridgewater found this out the hard way last  August 2015 when they got clipped as both US Treasurys and SP500 traded down as the correlation between the two went positive. 

We would be happy to show how the above can be a very strong tool for the portfolio manager’s investors and clients.


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