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Tuesday, January 13, 2009


why it's tough to be a landlord today...

... and tougher still to imagine property investors coming into the market to buy up excess housing supply. john hempton of bronte capital:

In Australia it became absolutely standard practice to buy real estate with negative carry. The idea was that you could buy a house for 100 thousand using 7% money and have a 3% rental yield. You made a 4% loss each year. The 4% loss could offset other tax. But everyone accepted it because house prices rose more than 4% a year and the capital gains tax was (slightly) concessional. The negative yield was sustainable so long as people continued to expect property prices to rise.

Well there was a point where Japan was the reverse of this. Banks would fall over themselves to lend you money at 1% to buy property with a 4% yield. You got 3% positive carry in a land where almost everything yielded something close to nothing. And yet people wouldn't do it. Why not? Because everyone knew that property prices fell more than 3% per yield. Positive carry was not enough to offset property price deflation.

When things deflate at 3-5% per year then money in the bank at zero interest (of which the Japs have plenty) is a very fine investment – it yields 3-5% per year post tax real – and it is very low risk. Obviously that was a better investment than almost everyone made in 2008. In reality it is an investment better than is available to most people anywhere.

And if everyone thinks this way (cash is good, borrowing bad, don't buy assets because they fall in price) then the situation is self-sustaining. Welcome to Japan.

this is a good reason to believe that not just positive carry but a very significant positive carry in investment property will be required before house prices hit bottom. prospective landlords, in light of what may turn out to be years of high vacancies and declining rents, will need a huge margin to compensate them for the perceived risk of further price declines.

hempton explains that the alternative is to shock savers into spending -- though i suspect this can't be done now in the united states, as there are in aggregate no savers yet to shock. the fed could be said to be trying to make savers by printing money -- but that won't work.

Japan deflated because – well everyone thought it would continue to deflate. And that led to a lack of domestic investment and (eventually) the Japanese – like the Chinese – managing to fund a whole lot of really dumb lending in America. It was just bad.

Lots of people could see this – Krugman and Ben Bernanke to name just two. And a simple shock to the system which convinces people that holding the money in the bank is stupid and that they better go out and buy real assets would fix it.

What you needed was to credibly convince the population that deflation was over – and that there would be inflation. What the BOJ needed to do was credibly promise to be irresponsible.

You have to convince that cash-is-trash.

How do you do this? Well the first answer is just print money.

And that is what the BOJ did – and what central banks around the world are still doing. And it doesn't work. The reason that it doesn't work is that people are more than happy to hold the money idle in enormous quantity. It yields 3-5% post tax real after all.

Just printing money is not enough. You need a real shock

... Giving money in one-off tax breaks (as per Australia or Bush's various plans) is not the same thing. That money isn't freshly printed cash. You need to credibly convince the populace that you are prepared to risk the Zimbabwe outcome. You have to credibly promise to be reckless.

Bernanke knows this. He is on the record for suggesting it.

So when do you short treasuries?

and that's why, while planning for deflation now is prudential, one should also fear inflation -- and a lot of it -- further out. chatter on the eventual collapse of the treasury bubble is already loud, though what is immediately before us is something else, as evans-pritchard notes:

we may already be so deep into debt deflation that bonds will rally regardless. Fresh data suggest that Japan's economy contracted at a 12pc annual rate in the fourth quarter of 2008; the US, Germany, and France shrank at a 6pc rate, and Britain shrank at 5pc.

If sustained, these figures are worse than 1930, though not as bad as the killer year of 1931. The UK contraction from peak to trough in the Slump was 5pc. Gordon Brown will be lucky to get off so lightly.

The Fed's December minutes reek of fear. The Bernanke team is no longer sure that stimulus will gain traction in time.

The Fed's "Monetary Multiplier" has collapsed, falling below 1. This is unthinkable. We are in a liquidity trap.

evans-pritchard presumes that the "bernanke blitz" will in time take effect, as does hempton. but neither, it should be said, knows exactly how. and in the meantime hempton's inexorable deflationary logic regarding the attractive real return of idle cash and government bonds rules -- not least for banks, as the ft analyzes.

Shorting JGB’s was a also popular pundit play in the 1990s. For very much the same reason as now, the bonds were said to be wildly overvalued. ZIRP could not last, it was said. It was a theoretical policy. Inflation would result.

Unfortunately, the ZIRP did last. And yields stayed low. The yield curve stayed flat.

Part of the reason: For Japanese banks, faced with bleeding balance sheets; ravaged by the worst effects of deflation, JGBs were a sound buy. The banks made happy returns from the carry and rolldown on the government bonds: knowing that they would all continue to buy huge amounts of them and keep prices depressed.

Indeed, it’s not quite fair to label, as Grant does, Treasuries return-free risk: If you can borrow at 0 per cent, and then buy 10 or 30 yr notes yielding around 2.32 and 3 per cent respectively, then the return - unlevered - really isn’t so bad based on the carry and roll alone.

And as Bred Setser has previously noted, US institutions are buying Treasuries. Did they do so purely in response to the September crisis? Or are they doing so with a longer timeframe in mind? More specifically: two years of deflationary pressures that will make carry and roll trades on Treasuries attractive.

it might pay, however, to further examine the situation in international terms. american quantitative easing will obviously not occur in a vacuum -- competitive devaluation is already underway, per the ft. japan, with its globe-leading rate of contraction, marks out the danger of a strengthening currency in these times of excess capacity. as the race to the bottom takes hold, particularly as the currencies of the major surplus nations are managed against the dollar, the contraction in excess manufacturing capacity will inevitably be shifted to the united states to a much greater degree than was true in 1930s europe (who benefited from the hoover administration's allegiance to "sound money"). america could be particularly vulnerable as much of the debt that is contracting globally is dollar-denominated, and this delevering has some considerable time and distance yet to run. as setser relays, november's contraction in american trade deficit may be short-lived as the dollar strengthens and fiscal stimulus bleeds over -- and china's december trade surplus gives little reason to think otherwise.

as businesses close to effect the contraction in capacity, unemployment continues to rise, consumers default or revert to saving, and banks suffer and are driven to government resolution, it is hard to imagine an inflation taking hold. i would wager that the relative prices of raw inputs handily outperform financial assets and finished products -- and, with fiat currency debasement the rule, perhaps precious metals are a haven once again. such a cycle would further pressure profitability, feeding the downward cycle of liquidation. in other words -- the deflationary cycle in the united states could be more powerful than many currently suspect, even with quantitative easing in full effect.

but eventually, the dollar is in for a fall -- the current account will in the long run (the same one in which we are all dead) approach balance, china will cultivate domestic consumption, american export capacity will become competitive and a larger part of the american economy. if that fall is mismanaged, today's excess reserves could translate into a powerful surge of inflation.

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from perrone: gm, can you give me a really quick brief on the M1 multiplier, tracked in the graph evans-pritchard offers? thanks.

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hi perrone -- here's a simple definition -- it's essentially a proxy for the rate of turnover (velocity) of the monetary base.

normally, banks take monetary base (high-powered money) and make a multiple of its value in loans based on it through the magic of fractional reserve banking, which end up as deposits at other banks. m1 is the aggregate of the monetary base plus all demand (ie checkable) deposits.

it has now crashed because banks are now hoarding nearly a trillion in cash as excess reserves at the fed -- that is, monetary base is skyrocketing as the fed expands its balance sheet, but loans that result in demand deposits are nowhere near keeping up -- because banks are very reticent to lend and also consumers and businesses are increasingly reticent to borrow.

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