This is the End...

[Riggerjack]

According to Yellen, the Fed is going to finally start to reduce their balance sheet. If that is true, this is finally the end of QE, in theory.

Now if you were to do a casual search, you would see that Quantitive Easing has been over for years, and that's kinda true. The Fed hasn't increased it's holdings since QEIII, but as those bonds payoff, the Fed has been quietly pouring those payments back into the MBS market. You can see this in the low mortgage rates (and correspondingly low bond rates across the board) and at:https://www.federalreserve.gov/monetary ... trends.htm

If you take the long view, it looks flat, but if you zoom in, you see that flat line is really a series of peaks and valleys of the 10 billion per month range as payoffs get recycled into new purchases.

The Fed plans to start at 10B/mo, and ramp up to 50B/mo.

They used MBSs to drop bonds across the board, and now they are finally reversing the trend. Maybe. This is the Fed, and actions rarely match statements of intent.

What does this mean to us?

Mortgage rates will probably go up. Other rates as well, but as a secondary effect. I'm trying to keep this in the direct cause/effect. Macroeconomics allows for much confusion by tracking secondary and tertiary effects that muddy the waters for many folks. And while this can be a source of political strife, (and I am more guilty of this than most) I would like to focus this thread on practical effects and moves we can make to profit from this or cut our losses.

On that note, I think the rise in mortgage rates will put a damper on real estate. Higher rates translate to higher mortgage payments, so people will be tighter on the max price they will pay for a house.

This causes me to get fired up about fixing up the Marysville house to sell, as we have been slacking on that front. It's one more reason to sell our other rental. If you have an adjustable rate mortgage, or HELOC, now may be the time to lock it down.

If you currently own bonds, now seems like a good time to review this. We have had ZIRP for long enough to get used to it. If this actually happens, you will want to be in front of it.

I don't view this as good or bad, just potentially different (at least, I try to). And if you go back to my predictions from the start of QE, you will see I have been wrong, at every stage. I could still be wrong. And the "guidance" from the Fed hasn't been any more accurate than I have, so this could all be more smoke and mirrors. I don't think it is worth panicking about, but it is big and direct enough to be factored into decision making.

You have been warned!

[Campitor]

Thanks for posting this. From an academic standpoint, in regards to Austrian vs Keynesian dynamics, I've been curious what effect QE or its lack thereof would have on the economy at this present time.

[Riggerjack]

Well, as I said, I have consistently been wrong in my predictions. Partially, it was because my mental model was too simple, (not factoring in bond duration, and how the same balance can work in different ways) and partly because I had too little appreciation of how little the average person thinks about economics, and money, outside of making payments or dodging creditors.

I have a hard time relating to the mindset of someone who equates price and value. So when I smelled something fishy, and the whole of the internet was screaming about bailouts and funny money, I assumed others would act on that. Kinda silly of me, I know.

So, after nearly a decade of watching this, I am less concerned about taking cover, and more interested in taking a profit.

My read is this will slow the overheated RE market, maybe bonds will start paying out (with the corresponding drop in bond funds), and I keep my fingers crossed for good things to come of this. Maybe the pros can pull this off. Of course, that would encourage a repeat, but we can cross that bridge when we get there.

[jacob]

@Riggerjack - For a fairly parsimonious mental image/model consider this: Federal debt/GDP (both about $20,000B) has been just over 100% for some five years now (still rising). 100% is generally considered the terminal cutoff for "growing your way out of it" because the long term growth rate happens to be equal to the pricing of the 30 year bond (about 3% currently) which is exactly what the market expect the LT growth rate to be. That's the rock.

In math terms: 1.03 * debt > 1.03 * GDP => debt will grow faster

Also consider that the debt is funded with by rolling over very short term bonds (treasury instruments have three different names according to range of terms ... and this gets confusing for those who don't know ... so I'll just call them all bonds). This way, it's cheaper to (re)finance the debt. Short-term financing is what leaves money to run the other parts of the federal government. If they were financing on 30 year terms, there would be negatives left. Since the turnover is rapid and at the short end of the curve, it also means that they can't inflate their way out of it, because their constant/ongoing need to refinance. This is the hard place.

The treasury is steering a course between those two. Meanwhile the rock is inexorably moving towards the hard place (because the ratio is now over 100%) They're therefore trying to stave off moving the hard place towards the rock for as long as possible. The side-effect is that interests rates are too low (but they have to be for the treasury to pay the government's expenses) and this is in turn overheating the economy (another way of saying that dumb investments are being made). So they keep threatening to raise them hoping to scare people away ... but over there is the rock.

Practically speaking, I don't think a government default is completely far-fetched/outrageous. Remember that just because the government defaults, corporations don't have to. Historically kings and princes went bankrupt all the time. The real trust were in the big/transnational trading houses and bankers. Several ways to do it. Hair cuts. Or simply delaying payments (like what we've seen a few times whenever congress does their debt ceiling dance). Several ways to do that. FIFO check cutting. Or they could prioritize (they already do to some extent). The currency doesn't have to die just because one entity that uses it can't make its payments. The deal could easily work out just fine.

[Riggerjack]

Yeah, that's the way British debt cost them the Suez Canal. But they were in debt as a result of fighting Nazis, so you can make the argument that it was the better option.

We seem to be in debt because... Well, rather than get into the politics, it just seems we are in debt for the same reasons American households are in debt, bad choices and choosing not to make choices. Which seems like a good reason to be ashamed in 60 years, but I already jacked that thread, over a petty pet peeve of mine.

In the end, I decided that if it all came crashing down, ultimately, it was just a short term survival issue combined with a long term rebuilding issue. Both can be hedged against, so once I had those systems in place, I just stopped sweating it.

Since then I have been tracking the objections to the rock/hard place analogy, hoping someone thought of something I didn't. So far, no luck.

On the other hand, I have never intentionally bought a bond. (Early on, it was because stocks always outperform bonds, and I'm young, and I've collected my own debts, why would I outsource that?!? Etc...) By the time I was giving it serious contemplating, it was a losing game. And I didn't see how bond funds move in the opposite direction to bond rates, which would be how the smarter money moved... Oh well, lesson learned for next time.

While I may seem to be alarmed by this, I am actually comforted by both the declared intent, and the relative shrug from markets. But we'll see how that goes when significant money moves around.

[NPV]

Very helpful and concise explanation, thank you. What I do not understand is: why would US ever default on USD denominated obligations? Wouldn't it be much easier to just print enough dollars to service these obligations (could mean FED buying a lot of government debt - essentially another QE - or more creative monetarist solutions)? Sure, it may cause inflation, and a lot of it, but surely much less turmoil than an outright sovereign default in the centre and bedrock of the world's monetary and financial system?

[chenda]

@Jacob - Why then have countries been able to grow out of >100% debt ?

[Riggerjack]

Why then have countries been able to grow out of >100% debt ?

Examples, please.

To my knowledge, this hasn't happened in a mature economy. The fantastic growth rates of developing economies can't be replicated in a mature economy. Similar to how GE can't match the growth of Amazon, and Amazon can't match that of early Amazon.

This is not to say that we can't keep limping down the road a long, long time.

[Riggerjack]

Very helpful and concise explanation, thank you. What I do not understand is: why would US ever default on USD denominated obligations? Wouldn't it be much easier to just print enough dollars to service these obligations (could mean FED buying a lot of government debt - essentially another QE - or more creative monetarist solutions)? Sure, it may cause inflation, and a lot of it, but surely much less turmoil than an outright sovereign default in the centre and bedrock of the world's monetary and financial system?

The same reason we are in this mess. Lack of political will. At some point, someone will decide that it is to his advantage to blame his predecessor, and burn the system to the ground, then rule in the ashes. Individual self interest is usually contradictory to the interests of the masses, and explains most of politics.

Out of curiosity, where are you putting your money if you're selling bonds?

I don't own bonds. I do have a variable HELOC, and an adjustable mortgage. So I will pay off the HELOC, and the mortgage before the rate adjusts.

[chenda]

Why then have countries been able to grow out of >100% debt ?

Examples, please.

Post-1945 Britain seems to have drastically reduced its debt largely through growth, though admittedly post-war reconstruction would have helped to boost growth. There is unlikely to be another Trente Glorieuses

[Isabel]

@Riggerjack thanks for this interesting thread!

I can´t believe central banks will rise the rates. How would that be possible without state bancrupcy?

Here in Europe the ECB cannot rise the rates without sending many Eurozone Member States in the insolvency.

I don´t know how it will play out for the USA but for Eurozone I am expecting more financial repression.

There will be ban of cash (large denominations will be prohibited etc.), there will be compulsory state mortage on home ownership (like a additional tax, Macron is already working on it), more taxes on assets and also some debt cuts for states.

I am not sure if this will be sufficient. Therefore social unrest is also possible. In that case it is possible that there will be some more exits from the EU. Then there will be danger of strong inflation and currency reform.

I think on the financial site it is better to prepare for both: inflation and defaltion. It can play out both ways.

[Riggerjack]

Ok, so let's compare.
British debt history:https://en.m.wikipedia.org/wiki/History ... ional_debt

Look at the chart at the top, it really tells the whole story. You see how interest went down around WWII? As debt was skyrocketing? Does that seem natural to you?

Britain borrowed heavily from the US during World War I, and many loans from this period remain in a curious state of limbo. In 1931, President Herbert Hoover announced a one-year moratorium on war loan repayments from all nations, due to the global economic crisis, but by 1934 Britain still owed the US $4.4bn of World War I debt (about £866m at 1934 exchange rates). Adjusted for inflation, that would amount to around £40bn today, and if adjusted by the growth of British GDP, to about £225 billion. During the Great Depression Britain ceased payments on these loans, but outstanding bonds such as the War Loan were finally paid off in 2015.[8][9]

Between the wars Edit
By the mid-1920s, interest on government debt was absorbing 44% of all government expenditure, comfortably exceeding spending on defence until 1937 when, as war clouds drew near, re-armament began to get underway in earnest.[10]

World War II Edit

During World War II the Government was again forced to borrow heavily in order to finance war with the Axis powers. By the end of the conflict Britain's debt exceeded 200 percent of GDP, as it had done after the end of the Napoleonic Wars.[5] As during World War I, the US again provided the major source of funds, this time via low-interest loans and also through the Lend Lease Act. Even at the end of the war Britain needed American financial assistance, and in 1945 Britain took a loan for $586 million (about £145 billion at 1945 exchange rates), and in addition a further $3.7 billion line of credit (about £930m at 1945 exchange rates). The debt was to be paid off in 50 annual repayments commencing in 1950. Some of these loans were only paid off in the early 21st century. On 31 December 2006, Britain made a final payment of about $83m (£45.5m) and thereby discharged the last of its war loans from the US.

By the end of World War II Britain had amassed an immense debt of £21 billion. Much of this was held in foreign hands, with around £3.4 billion being owed overseas (mainly to creditors in the United States), a sum which represented around one third of annual GDP.[10]

So, end of the war, Britain had debt to GDP of 200%. But, this was a massively reduced GDP. The war, the lost workers, the destroyed factories and infrastructure, all lead to an artificially low denominator, and the goal in the US was to rebuild all the players from the war to avoid repeating the mistakes after WWI. Massive outside investment, artificially low interest, and still a currency crisis and debt problems, and hell, today your debt is at around 85% of GDP.

After WWII, Japan grew at an astronomical rate, for the same reasons. But, even with 1500% growth in the postwar period, they were still smaller after reconstruction than before the war.

If there were a benevolent economy willing to support American recovery after a default/crisis, it would still be better for everyone to avoid it. But that simply isn't the case. All the rest of the planet working together to stop us from drowning would still be pulled down with us.

If it helps, this: https://papers.ssrn.com/sol3/papers.cf ... _id=891620 is a look at global swings in equity premiums. Not terribly relevant to our discussion, but it puts into perspective how rare large runs of growth are, and how unnatural the postwar period was.(go to section 4, or scroll to the tables.) Also, they did a fine job of working the global historical data, better than I have found anywhere else.

In short, your example shows just how unrealistic it is to expect a repeat, and that it can't be repeated at the scale of today's economies and debts. Which is not to say that we are facing only doom. Maybe there is a way out, but I haven't found any examples of anyone getting out in a way we can replicate.

That being said, the big question of QE was how to stop it, and reverse it, without triggering the delayed collapse. The Fed is making noises about trying to do that, so I am cautiously hopeful.

[chenda]

So, end of the war, Britain had debt to GDP of 200%. But, this was a massively reduced GDP. The war, the lost workers, the destroyed factories and infrastructure, all lead to an artificially low denominator, and the goal in the US was to rebuild all the players from the war to avoid repeating the mistakes after WWI. Massive outside investment, artificially low interest, and still a currency crisis and debt problems, and hell, today your debt is at around 85% of GDP.

That's why I linked that to that article. Britain, along with the rest of western Europe, thrived for 30 years, as it rebuilt itself and caught up with the US. (UK debt incidentally had fallen to <30% prior to the 2008 bank bailouts) The US itself had a debt to GDP of 120% in 1945, which may be a somewhat more relevant example, given its own post-war boom.

In short, your example shows just how unrealistic it is to expect a repeat, and that it can't be repeated at the scale of today's economies and debts. Which is not to say that we are facing only doom. Maybe there is a way out, but I haven't found any examples of anyone getting out in a way we can replicate.

I'm sure we are not going to see a repeat of the growth of the post war period. But would surely take some staggering political ineptitude for a default to occur, and not because debt crossed a particular % threshold.

[Riggerjack]

https://en.m.wikipedia.org/wiki/List_of ... ebt_crises

Here is a list of 294 cases of debt crisis in the last 217 years. So more than one per year, including 8 from the US, if you include state defaults, and 4 British examples.

This doesn't strike me as uncommon enough to not be concerned.

[Riggerjack]

The US itself had a debt to GDP of 120% in 1945, which may be a somewhat more relevant example, given its own post-war boom.

And again, using the reduced GDP of the war, as a reduced denominator inflates the ratio. For instance, if Multistan, (the fictional country for this comparison, and the name of my Plan for peace in the Middle East ) has a debt of 10T and a GDP of 10T at the end of the war, then, the following year, when everyone goes back to work, and they suddenly have a GDP of 15T. Without paying back a dime, we can say that they have reduced their debt to GDP ratio to 66%. Growth, you say. I say if that is growth, how do you plan to repeat it?

[jacob]

@chenda

In math terms: 1.03 * debt > 1.03 * GDP => debt will grow faster

More accurately, as per the text, the 1.03 on each side are not necessarily the same, so here's the next-level model:

IF Market_Expect(LT growth) * debt > Actual(LT growth) * GDP * debt/GDP-ratio THEN debt will grow faster

Add: Market_Expect() = Current_Price()

The assumption that market_expect = actual (that the market is correct ... right after a war, this is more difficult than usual) is what leads to the simpler model (with the 1.03) above, where debt/gdp=1. If you break that assumption, the debt/GDP ratio determines "what you can get away with" or what you need to grow your way out, if actual!=expect.

E.g., currently for the US, debt/GDP = 1.061 and market_expect is 2.84%. However, if the actual growth over the next 30 years turns out to be 2.84*1.061=3.01%(*) or more, the economy can grow its way out. Otherwise, it can't --- and measures would require budget-cutting. Another way of stating this is that the 1.061 ratio is how much the bond market has to be wrong about the future. 6% error on the bad side is not asking for a lot. 25% is asking for a lot, but I can see how post-war estimates could be way off.

(*) If this actually turns out to be the case, LT bonds are currently overvalued.

PS: This is still a very parsimonious model yet somewhat more complex than the understanding of the average politician or at least what they'll admit to in public. The next level of complication begins to involve the entire yield curve and the term-schedule of the outstanding debt. I've mentioned how it's loaded up with short-term stuff. The level after that involves demographics and regulations.
PPS: Think of this as a poker game (note: I don't care much for poker, so I'm probably missing some poker-specifics). When you first start to play, you learn the rules and the various hands (cf. duration, terms, various yields i.e. YTM, and pricing). Next level, the probabilities of the hands. Next, the change of the probabilities based on cards seen and bids. Next, you start playing the players (the tells). Next, playing the players based on what you know about them (risk tolerance, bank roll, ...). Most of the time, players will be unaware of higher levels. There will be a kind of fish/shark relationship in the game.

[chenda]

@jacob, thanks for detailed response, that makes much more sense.

[Stahlmann]

Money Printer Go Brrr

is it like Austrian perma bears were not correct one more time?

1 more point for govermental intervention

hmm. the question is how this gonna play in the longterm. sure, it's about "being CONSISTENTLY SLIGHTLY less wrong than "average"".

[Lemur]

@Stahlmann

I’ve no idea how this gonna play out.