Saturday, July 20, 2013

Noah Smith — The hard-money people throw Gene Fama under the bus

I think where one does see evidence of prices higher than they would be otherwise is likely in equities were low borrowing rates decrease the cost of margin (leverage). Cost of margin is hugely influential in speculative markets.

Housing "bubble" reigniting? No way. Prices are still way down from their highs, a historically high percentage of purchases of existing residential RE are foreclosure or underwater related and for cash, with Wall Street and flippers big buyers in expectation of exceptional ROI on resale. Rent/purchase ratio is still reflecting the bursting of the bubble, and new housing is not exactly "on fire." There is not going to be another housing bubble in the US for years and there are still housing bubbles to pop abroad.

But it's good to see the inflationistas in retreat and throwing the EMH under the bus, too, in favor of financial instability. But is the Fed creating financial instability now? No way. The Fed is still fighting the consequences of financial instability and not all that successfully.

The hard-money people throw Gene Fama under the bus
Noah Smith


STF said...

"Cost of margin is hugely influential in speculative markets."

No it's not, at least not by itself. If that were true, then you'd have never ending bubbles in every futures market where margin is tiny relative to contract size.

What matters is the cost of margin relative to anticipated capital gain + access to credit to use as margin. Where anticipated gains are high and regulation is flawed, you get bubbles regardless.

Still waiting for the "low rates drive bubbles" people to explain S&L related bubbles in the 1980s with historically high interest rates.

Tom Hickey said...

No it's not, at least not by itself.

Right. Traders don't take positions due to leverage but rather expected gain. But leverage affects gain and influences the size of positions through the ability of traders to take and hold positions. This is influenced by margin requirements and rates.

The influence of margin is well-known irrespective of rates. If there is a increase in the margin requirement, then margin calls can increase the downtrend. Similarly, a traders look at low margin use as indicating upside potential and high margin use as indicating tops. Of course, such indicators are not used along but in conjunction with others to assess the technical cycle.

This gives the authorities responsible for maintaining an orderly market a tool to regulate speculation by changing margin requirements, either cooling markets that are overheating or supporting markets when animal spirits are running the other way. Importantly, its not only the cost of leverage that is involved but the change in expectations that margin requirement involve, which often results in a market response.

For example, when margin is raised in a speculative market deemed to be too hot, e.g., gold and silver recently, enough traders will feel the pinch enough to reduce their position and this can effect price by reducing momentum, which is largely what technicians look to.

Do changes in interest rate affect margin in a similar way as margin requirements, results in traders potentially expanding positions due to lower cost of leverage and vice versa? I would assume they do, since cost of leverage is factor in expected gain and affordability could also influence the size of positions.

But margin requirements and rates are not the major factors in entry and exit choices.

However, I am very skeptical of the "rates held low too long" explanation of bubbles. People don't chase price just because rates are low and they will chase price no matter is the expectation of gain is great enough. And every case is different. The "rates held low too long" as an explanation of the housing bubble is simply not credible on analysis of all the factors.

The way bubbles are usually addressed is by raising requirements rather than rates anyway — margin for equities and commodities, and downpayment for RE.

Interest rates are almost always used wrt to controlling price level rather than asset appreciation.