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.

Sunday, May 1, 2016

Sir Charles Bean Report on GDP Under Reporting and Spurious US Employment Data

Today a good friend and I visited the Metropolitan Art Museum and after we had finished with the American Wing we sat down in the courtyard in front of the entrance to the federalist building facade.

My friend in the in the alternative industry and he relayed there is an ever building buzz or unease with the current depiction of GDP, that the group he hangs with are suspecting it is under reporting.  He cited the  Independent Review of UK Economic Statistics by Sir Charles Bean as the main reference for this group.  Bean maintains that GDP is missing the impact of the digital age.  This is not a new idea and first came to light in the 90s with the work on "weightless" by the work of Dr. Danny Quah and even Greenspan was citing "weightless" as the reason productivity at the time was being understated at the time.  Quah and Greenspan turned out to be right event though it ended in a rather messy bubble, but still Google is with us to this day.

Sir Charles Bean has taken this idea (here a summary in Vox Dec 2015) and applied greater granularity and applied it to GDP measurement. His work is exhaustive in the larger study The Independent Review of UK Economic Statistics It is a fascinating read and will require more hours of study - and I admit I am late as missed this when it first came out in the end of last year.  It has chock full of great analysis and graphs, one of the first such studies to full embrace "data science".

After I received the email from my friend that provided the Vox link to Bean, I responded that I have noted a similar under reporting in employment and sent him this email:

I think only employment now offers a good read into the current strength of the economy, and only claims non seasonally adjusted provides that read.
The largest part of the hit in 09 tool place in January 2009 and a fair amount of that hit was considered to be seasonal.  I suspect this was political and not a misread.  Unemployment likely hit 12% at the worst but the UER 3 headline was capped at 10% so as to avoid panic.  Remember a key part of the TALF ABS were auto loans and the generally accepted wisdom was that default of the auto loans would equal unemployment and most Auto ABS would start to fall apart at 11% or higher, though supposedly able to survive up to 18% UER.
The difference between 12% ad 10% is about 2.6  million employed and I think the "fix" was achieved by shoving the larger unemployed into a reduction of the Labor Force Participation Rate.  The same seasonal jiggering was made to claims data at the same time. 

While the seasonal and nonseasonal could be tampered with via the LFPR reduction, and thereafter fixed into the ARIMA seasonal machine, claims data could not be so tampered with for long in seasonal and certainly not at all with non-seasonal claims.  When the economy rebounded each change was fairly accurately reported for the monthly survey, but the labor force had to be gaining at a faster rate than reality, to bleed back in the political fix.  The recovery in emplyment has been so strong they are just starting to get caught up but I calculate there is about 1 million under reporting in the monthly data and Seas adj claims data is pretty well caught up given the 5 year memory in the ARIMA seasonal machine, and of course non seasonal adjusted claims data has always been accurate, by definition.

So I examine the year over year change in non seasonal claims data and it shows complete recovery was reached last year and the recovery has been an unusually strong and swift recovery in claims, as shown by examining the data since 87.  The best way to show this data is via a heat map provided here (I cap the levels reached for both claims series so I have more shades of granularity).  Looking across a row gives you a specific week from week 1 to week 52 since 1980.  I find this startling, almost worthy of starting an Inspector General investigation given how out of whack claims are to the monthly data at 5% currently:


The BLS/CES website notes that weekly claims data trumps the survey and once a reasonable time period has gone by to avoid weekly noise, the survey is to re-calibrate to the claims data.  Remember the huge payroll jump we had after the 82 Reagan Recession, or the lesser amount but still shock in 1994?  That was this re-calibration kicking in but this time, even though the recession was equal or worse than the Reagan Recession we have not had the shock re-calibration.

This discrepancy also shows up where there was not a heavy hand in seasonal fudging or manipulating the Labor Force size.  The Beveridge Curve for insured labor force - JOLTS v insured unemployment rate shows a normal recession followed by a normal recovery.  But when a Beveridge Curve is put together for JOLTS v headline unemployment one can see the date they put the fix in to cap headline unemployment at 10% in2009 and 2010.  This is so obvious I stopped keeping the graphs current past last year and here is my last one (I have the axis reversed to usual Beveridge Curves having the JOLTS as causal (x)):

This all fits with the Bean thoughts on GDP for the above political fix could only be allowed if GDP was slow "secular stagnation" type of pattern.
I think the actual headline monthly household unemployment rate is now no more than 4 1/8% and that means GDP is under reported by 1% to 2%.

Feel free to share.....  "