“Davidson” submits:
Wicksell’s Natural Rate, Market Rates and Market Psychology
Markets set rates. This was seen by Knut Wicksell as he wrote in his seminal 1898 work in German “Geldzins und Güterpreise” in 1898 which was transalated to English in the 1936 “Interest and Prices”. Today, we believe we have a more modern point of view of economics and finance. We have for the most part dismissed or reinterpreted earlier economic observations believing we can better control future economic events. We have access to reams and reams of data not available in times past and have today’s modern computing power coupled to highly sophisticated algorithms. Wicksell did not. We believe today we can find the tools to control markets to avoid crashes, create a world of guaranteed returns(many advisors still speak as if they have found the magic formula to do so) and we believe ‘big government’ has the power to do this through properly selected policies. We believe the Federal Reserve can control rates and lead us to ‘soft landings’ if only they control interest rates to the right levels which find the perfect balance between ‘Boom’ vs. ‘Bust’. The fact that the past 100yrs plus of economic/market analysis has not resulted in such economic control should tell us something about our understanding of ourselves. We mostly seek immediate solutions and miss the long-term answers which have been periodically discovered and ignored. Short-term answers for short-trm outcomes when it comes to economics are mostly self-defeating. Believing we can manipulate economics to specific ends has a long history of failure. Understanding economics explains why we cannot manipulate outcomes.
Wicksell’s concept of the ‘Natural Rate’ is not the Fed Funds rate which is the current misinterpretation, but in part determined by the average underlying growth of an ecomomy within a society’s system of self-governance across multiple economic cycles. It is not a rate a Central Bank can set. It is a rate at which human capital and its creativity are permitted to develop into products which enhance a society’s standard of living under the system of checks and balances of self-governance. Free Markets with protections to individuals property rights have the better long-term returns. Measuring the ‘Natural Rate’ requires decades of data measured more or less correctly and consistently. The ‘Natural Rate’ is a long-term growth trend not the extremely short-term Fed Funds rate and not any market rate visible to investors. To convert Wicksell’s observation into a useful concept, one must shift to underlying long-term economic fundamentals and calculate the returns of a particular economy over time. The long-term trend must be free of the swings of government spending which result in artifical ebbs and flows and be adjusted for inflation. The end result is the long-term Real Private GDP. It is the long-term trend of Real Private GDP which provides part of the solution. Because economic activity always cycles, one uses the long-term trend to estimate the likely future growth rate. The ‘Natural Rate’ is composed of the current Real Private GDP trend line value and the best estimate of 12mo inflation.
The ‘Natural Rate’ can be followed and estimated, but not predicted. We, human beings, are ever evolving our perceptions of our world. In the process, our creative responses to solving problems are always more powerful, more creative and more unexpected than in the past. The future always carry a level of unpredictablity. Julian Simon wrote about this in his brillliant 1981 “The Ultimate Resource 2”. We contantly tweak the rules of self-governance. Generally we are in the right direction, but we do make errors as in the 1990’s government poverty solution policy which led to an excess of Sub-Prime lending. This was exacerbated through another tweak called FAS157 (‘Market-to-Market’ accounting rule) which was an ill-designed financial accounting rule to counter corporate malfeasance. Market psychology first drove market prices to excess in 2007 on the belief that poverty could be solved through financial manipulation. This was followed by the depths of despair as FAS157 forced the values of many sound investments to huge discounts relative to fair long-term valuation in 2009. The panic would have stopped of its own accord, but Chairman Bernanke’s comments on FAS157 is credited with the equity market turn higher in March 2009. He said that FAS157 was an accounting rule which did not fairly value the long-term economic returns of securities. He said investors should simply stop using it.
The Value Investor Index in SP500 Index vs. SP500 Value Investor Index shows how far the SP500 deviated. The Value Investor Index is the current long-term trend of SP500 earnings capitalized by the ‘Natural Rate’. The Value Investor Index is Knut Wicksell’s concept converted into a valuation index for the SP500. The fact that it is effective at identifying significant market lows means that it identifies the basis behind Value Investor decision making. Markets are what people believe things are worth. Value Investors were the only buyers during the market’s correction in 2009 when all other investors were panic-selling. Value Investors have been the only investors buying during significant market lows throughout history. Only Value Investors have a mental valuation of long-term returns relative to the general economic context with which to price equities. It should be no surprise then, that the ‘Natural Rate’ using long-term earnings data identfies significant market lows. The Natural Rate’ with the most recent Dallas Fed release of the PCE is 4.67%. This leaves the SP500 at ~10% premium to its Value Investor Index. Parts of the market such as the AMZN, FB, NFLX and etc trade at high valuation levels while others like XOM, KSU, DHR, CFX and other industrial related issues are at discounts to historical valuations. Their respective corporate insiders are accumulating shares at a strong pace. Net/net, the SP500 has a low level of speculation with economic indicators still forecasting additional economic expansion.
The ‘Natural Rate’ is compared to 5yr & 10yr Treasury rates in Natural Rate vs 5yr&10yr Treasury Rates. That there is some correlation between fixed income yields and the ‘Natural Rate’ is obvious. It should also be clear that it is not very precise. Interest rates are set by market psychology even though the consensus claims there is a tight economic rational. There is not! Interest rates only track economics over time. Our current low rate environment is only about half what the ‘Natural Rate’ indicates is reasonable. Value Investors have been very much in sync with the ‘Natural Rate’ calling the current low rates a ‘Bond Bubble’. Rates have recently seen 5,000yr lows which have been documented since the time of the Sumerians 2000 BC-4500 BC. One must think globally to understand why rates are this abnormally low.
We live in a globally connected world. Investors are mostly free to shift their capital to where they anticipate better returns. Investors can find a means of shifting capital even in the face of the most restrictive of government policies. Capital shifts are reflected in the relative levels of individual currencies. When government policies in one country become detrimental for capital returns, capital leaves driving the host currency lower and raises the currency of the safe haven. This has been repeated over the centuries. The US with its better global property protections has always been a magnet for capital. When the US began to withdraw from its historical global defense of Democracy, the US$ became stronger.(Not shown) Capital exposed to the most risk, fled to US markets. Just as there were consequences to the SP500 with the promotion of Sub-Prime lending and implementation of an untested accounting rule FAS157, capital shifts drove Western Nation Sovereign Debt rates to historic lows. The investment character of capital had changed. The investors seeking ‘safety of capital’ overwhelmed those seeking a ‘return on capital’. A considerable portion of this capital saw deployment into Western Nation real estate. Real estate prices soared. The US, a more prominent safe-haven, saw a ~40% rise in the Trade Weighted US$ Index Major Currency, the 10yr Treasury yields fell below 1.50% and real estate prices soared. The cash-on-cash returns for US commercial REITs fell from 7%-8% historical dividend levels to mid-3%.(Not shown) This was a panic of global proportions.
We have experienced dramatic shifts in currencies in the past and over time they normalize. The US$ appears to have peaked as capital has already begun its shift back to foreign markets. The US$ will fall by 30%+ as it returns to trend. We should expect 10yr Treasury rates to gradually shift back towards 5% from the 2.25% level today. Real estate cash-on-cash returns should adjust accordingly. Real estate and long-dated fixed income have high principal risk the next few years in my opinion. Avoid!
How to predict when the Fed changes the Fed Funds Rate
You too can predict when the Fed is likely to shift the Fed Funds rate. It is actually quite simple and may even startle friends as to your acumen. The long-term history of Fed Fund rate shifts shows a very tight correlation between T-Bill rates and Fed Funds rates. The Fed is viewed historically as the lender of ‘last resort’. If you are a bank and seek to borrow from the ‘Fed Window’ at the Fed Funds rate, you are deemed insolvent. Banks or lending institutions which get to this level of credit trouble where they must seek help from the lender of last resort rarely get to this stage. The Fed usually forces a merger rather than permit panic to spread. Historically, the Fed keeps the Effective Fed Funds rate at least 0.25% (25 basis points or 25bps) above current T-Bill rates. If T-Bills rise due to investors shifting capital for higher returns, the Fed follows shortly thereafter. Likewise, falling rates are followed by Fed Funds rate reductions keeping their desired spread such that Fed Funds always remains somewhat higher. The history of US rates from 1962 makes this fairly simple to see. https://fred.stlouisfed.org
The daily T-Bill/10yr Treasury Rate Spread & FedFunds history from Jan 2014 to Present shows the Effective Fed Funds rate of 0.91% has just been exceeded as the T-Bill rose the past few days to 0.955%. If the T-Bill rate remains at this level or rises, the Fed will raise the Fed Funds 0.25%. The Fed follows. It does not lead! A Fed rate rise is imminent.
The Fed follows. It does not lead!
Summary
Market prices are driven by market psychology. The relationship to economics does follow over time, but it comes indirectly, mostly from economics surprising investors through media headlines which influences market psychology which finally influences market prices. This holds for equity and fixed income markets alike. Changes in government regulations and international policies can have a significant impact over an investment cycle, but most investors find a ‘work-around’ to identify and invest investments they deem most likely to achieve above market returns. The ‘Natural Rate’ is a derived long-term economic rate of return which is devoid of the influences of market psychology. It is useful in identifying value-based opportunities and understanding the perceptions of Value Investors. It is not a short-term rate which can be tweaked by Central Banks but is dependent on the strength of property rights protections in Democratic societies.
The Fed does not control rates either short-term or long-term. Markets have a much greater influence as investors shift capital towards higher expected returns. The Fed has followed market rates and adjusted the Fed Funds rate accordingly since 1962. The sole exception to this being Chairman Volcker’s actions to quash runaway inflation in the early 1980s. The recent below-normal rates can be tied to capital seeking a safe-haven in the US from the rise of autocratic governments and terrorism.
There has been some return of capital to foreign markets recently. It is a sign of increasing global confidence in protections to property rights. The US$ has thus far fallen ~5% from its recent highs. This is a good sign of a shift towards normalization of global capital balances. If the US$ returns to its long-term trend, global trade and economic activity should accelerate. There is a long enough history that one can expect the US$ to return to its long-term trend as a highly likely event.
I fully expect the US$ normalization to boost US and global economic activity the next 3yr-5yrs. But, even if this does not occur as anticipated, economic indicators show most US export driven companies have adjusted to current market conditions and exited the industrial recession the past 2yrs in spite of a strong US$. Hiring in these industries has recovered from its slump. Technological improvements and equipment which simply wears out require replacement or upgrade to keep US industries competitive in a global environment with many alternatives.
For Value Investors, considerable opportunity remains in my opinion.