Where Are The Real Estate Credit Markets In Their Cycles?

By Jeffrey J. Peshut

September 14, 2015

In its last post, Can Real Estate Investors Manage Through The Boom/Bust Cycle?, RealForecasts.com presented alternative strategies that real estate investors can employ to manage through the boom/bust cycle, depending upon where the real estate capital markets and real estate property markets are in their cycles.  That of course begs the question, “Where are the real estate capital markets and real estate property markets in their cycles today?”  This post will address the question of where one sector of the real estate capital markets — the real estate credit markets — are in their cycles.

Real Estate Credit Market Cycles

The real estate credit markets can be divided into three separate categories — commercial mortgage debt, multi-family residential mortgage debt and and single-family residential mortgage debt.  RealForecasts.com uses changes in the level of mortgage debt outstanding to track the cycle for each category.

For example, Figure 1 shows commercial mortgage debt outstanding from 1978 to 2014. The last cycle for commercial mortgage debt began in 1995 at a level of $733.8 billion before peaking in 2008 at a level of $2.58 trillion.  As the supply of credit contracted after the Great Financial Crisis, commercial mortgage debt outstanding also contracted, reaching a trough of $2.23 trillion — and the end of the cycle — in 2012.  Since the start of the current cycle in 2013, commercial mortgage debt outstanding has increased to $2.39 trillion, but has yet to recover to its 2008 peak.

Figure 1: Commercial Mortgage Debt Outstanding ($ Billions)  1978 – 2014

Commercial Mortgage Debt Outstanding - $B- 1978 to 2014

The year-over-year growth rate of commercial mortgage debt outstanding since 1978 is shown in Figure 2.  The rate of growth averaged 7.26% from 1978 to 2014. but accelerated to almost 15% in both 1999 and 2005.

Figure 2: Commercial Mortgage Debt Outstanding (YOY%)  1978 – 2014

Commercial Mortgage Debt Outstanding - YOY - 1978 to 2014

Figure 3 presents multifamily mortgage debt outstanding between 1978 and 2014.  The last cycle for multifamily mortgage debt began in 1994 at a level of $268.2 billion and increased to a peak of $855.2 billion in 2009.  After the Great Financial Crisis, however, multifamily mortgage debt outstanding decreased only slightly to $852.2 billion in 2010.  Multifamily mortgage debt began increasing again — and the new cycle began — in 2011 and had reached $998.6 billion as of the end of 2014.

Figure 3: Multifamily Mortgage Debt Outstanding ($ Billions)  1978 – 2014

Multi-Family Mortgage Debt Outstanding - $B - 1978 - 2014

Figure 4 presents the year-over-year growth rate of multifamily mortgage debt since 1978.  Although the rate of growth averaged only 6.1% from 1978 to 2014. growth accelerated to 12.2% in 1999 and 2007 and 15% in 2003.

Figure 4: Multifamily Mortgage Debt Outstanding (YOY%)  1978 – 2014

Multi-Family Mortgage Debt Outstanding - YOY - 1978 - 2014

Finally, Figure 5 shows single family mortgage debt outstanding from 1978 to 2014. The most recent cycle for single family mortgage debt began in 1995 at a level of $3.45 trillion before peaking in 2007 at a level of $11.24 trillion — an increase of 226%.  Single family mortgage debt outstanding contracted significantly after the Great Financial Crisis, decreasing to $9.89 trillion at the end of 2014.  At this point, it’s not clear whether the last cycle has ended and the new cycle has begun.  Regardless, it will still be a number of years before single family mortgage debt outstanding returns to its 2007 peak.

Figure 5: Single Family Mortgage Debt Outstanding ($ Billions)  1978 – 2014

Single Family Mortgage Debt Outstanding - $B - 1978 - 2014

Figure 6 presents the year-over-year growth rate of single family mortgage debt outstanding since 1978.  Not only did the rate of growth average almost 8% from 1978 to 2014. growth accelerated to as high as 15.5% in 1985 and 14.3% in 2004.  Perhaps even more importantly, in the last year of the cycle that ended in 1995, single family mortgage debt outstanding never contracted and in fact grew at a rate of 5.1%.

Figure 6: Single Family Mortgage Debt Outstanding (YOY%)  1978 – 2014

Single Family Mortgage Debt Outstanding - YOY - 1978 - 2014

Comparing Figure 6 to Figure 4 and Figure 2 shows that the multifamily mortgage market is much farther along in its current cycle than either the commercial mortgage market or the single family mortgage market.  The marked difference in size between the single family mortgage debt market and the multifamily mortgage debt market — the single family mortgage debt market is approximately 10 times the size of the multifamily mortgage debt market — may help to explain the accelerated growth in multifamily mortgage debt outstanding since 2010.

Government Sponsored Enterprises (GSE’s) like Fannie Mae and Freddie Mac are not only the largest source of lending capital for single-family homes, but they are also the largest source of lending capital for apartment homes.  The Fed’s attempt to re-inflate the single-family residential market by acquiring residential mortgage-backed securities from Fannie Mae and Freddie Mac has arguably had the unintended consequence of flooding the multifamily residential market with an over-abundance of inexpensive mortgage debt.  This in turn could result in the over-building and over-supply of apartment homes.

Real Estate Credit Market Cycles and Cap Rate Cycles

Recently, real estate pundits have been speculating about the impact of the Fed’s expected increase in the Fed Funds Target Rate on real estate mortgage rates and real estate cap rates.  Mostly overlooked in this discussion is the impact of an increase in the level of mortgage debt outstanding on cap rates.

To that point, Figure 7 compares the NCREIF Property Index (NPI) Income Return — as a proxy for cap rates on commercial and multifamily properties — to commercial and multifamily mortgage debt outstanding from 1978 to 2014.  Note the strong inverse correlation between the NPI Income Return and the level of commercial and multifamily residential mortgage debt outstanding.

For example, as commercial and multifamily mortgage debt outstanding increased from $374.4 billion in 1979 to $1.11 trillion in 1990, the NPI Income Return decreased from 8.95% to 6.59%.  Then, as commercial and multifamily mortgage debt outstanding contracted from $1.11 trillion in 1990 to $990.9 billion in 1994, the NPI Income Return increased from 6.59% in 1990 to 9.13% in 1995.  The credit cycle during the 17-year period from 1979 to 1995 has been referred to as the “S&L Era” to reflect the new sources of commercial and multifamily mortgage debt outstanding during that time frame.

As commercial and multifamily mortgage debt outstanding increased from $1.08 trillion in 1995 to $3.4 trillion in 2008, the NPI Income Return decreased from 9.13% to 5.13%.  Then, as commercial and multifamily mortgage debt outstanding contracted from $3.4 trillion in 2008 to $3.1 trillion in 2011, the NPI Income Return increased from 5.13% in 2008 to 6.76% in 2010.  The credit cycle during the 16-year period from 1995 to 2010 has been referred to as the “CMBS Era”, again to reflect the new sources of commercial and multifamily mortgage debt outstanding during that period.

Since the beginning of the current real estate credit cycle, commercial and multifamily mortgage debt outstanding has increased from $3.12 trillion in 2011 to $3.38 trillion in 2014.  In turn, the NPI Income Return has decreased from 6.76% in 2010 to 5.36% in 2014.

Figure 7: NPI Income Return (%) v. Commercial and Multi-Family Mortgage Debt Outstanding  1978 – 2014

NPI Income Return v. Comm and MF Mortgage Debt Outstanding 1978 - 2014

Although it is hard to believe that it can go much lower, this analysis suggests that the NPI Income Return will in fact continue to trend downward as commercial and multifamily mortgage debt outstanding continues to increase during the current real estate credit cycle.  It’s less clear at this point, however, what will be the new sources of commercial and multifamily mortgage debt outstanding during the current cycle.  Those that are suggesting that this will become know as the “Shadow Banking Era” — referring to non-chartered lending institutions — could be on the right track.

Can Real Estate Investors Manage Through The Boom/Bust Cycle?

By Jeffrey J. Peshut

August 2, 2015

With the growth rate of the True Money Supply (TMS) expected to continue its inexorable decline towards the next financial crisis, what steps can real estate investors take to manage through the bust phase of the cycle?  This post will address that question.  But first, let’s take a look at what’s been happening with the TMS growth rate over the past several months.

TMS Growth Rate

For June, 2015, the year-over-year growth rate of TMS was 8.26%.  (See Figure 1)  This was up from 7.72% in the previous month and the highest level reported since the end of the QE3 “Taper” in October of 2014.  The lowest level reported since October was 6.53% in March of this year.

Figure 1: True Money Supply (YOY%)  01/01/78 – 06/01/15

True Money Supply - YOY - 01-01-78 - 06-01-15

Despite this recent uptick,  RealForecasts.com expects the growth rate of TMS to continue the downward trend shown by the arrow in Figure 1, especially once the FOMC raises the Fed Funds Target Rate above its current ceiling of 25 bps later this year.  For a more in-depth discussion see, How Will The End Of Quantitative Easing Impact The True Money Supply Growth Rate?

What Steps Can Real Estate Investors Take To Manage Through The Next Bust?

The two most important steps that real estate investors can take to manage through the next bust is to first shift the way they look at the economy and financial markets from “linear” to “cyclical” and then shift their investment mindset from “relative” to “absolute”.

It’s human nature to forecast in a linear fashion.  If the economy and financial markets are going up, it’s natural for investors to forecast that they will stay up and even continue to go up in the future.  If the economy and financial markets are going down, it’s also natural for investors to forecast that they will stay down and even continue to go down in the future.

Yet the economy and financial markets don’t behave that way.  They are nothing if not cyclical.

Also, most investors — especially institutional investors — have adopted a relative return mindset for their portfolios and measure their performance and the performance of their investment managers against market benchmarks or indices.  A relative return strategy performs well, however, only when the overall market performs well.  That said, if the overall market doesn’t perform well, but the investor or manager outperforms the market benchmark or index, they are still deemed to have performed well.  That sounds good in theory, but as the saying goes, “you can’t eat relative performance”.  Practically speaking, even if an investor’s negative returns weren’t as great as the negative returns posted by the market as a whole, they still lost money.

A portfolio based upon an absolute return strategy, on the other hand, is designed to provide positive returns regardless of the direction of the overall market.  Investors following an absolute return strategy will generate these positive returns by investing up and down the real estate capital structure (common equity to senior debt) and back and forth along the real estate risk/return continuum (core to opportunistic), depending upon where the real estate capital markets and real estate property markets are in their cycles.  Figure 2 shows the universe of investment alternatives available to real estate investors by the risk profile of the investment and the investor’s position in the capital structure for the investment.

Figure 2: Real Estate Capital Structure and Real Estate Risk/Return Continuum

Real Estate Capital Structure and Real Estate Risk-Return Continuum

The following section indicates where investors should position themselves in the capital structure based upon where the Real Estate Capital Markets are in their cycle.

Real Estate Capital Markets Cycle

If the Real Estate Capital Markets are either currently in or forecasted to move into the Expansion phase of the cycle, invest in real estate equity investments to take advantage of cap rate compression and appreciating capital values. If the Real Estate Capital Markets are in or forecasted to move into the Contraction phase of the cycle, rotate out of equity investments and into real estate debt investments to avoid cap rate decompression and depreciating capital values.  (See Figure 3)  Depending upon the investor’s risk tolerance and return objectives, equity investments can take the form of either preferred equity or common equity.  Debt investments can take the form of senior debt or mezzanine debt.

Figure 3: Real Estate Capital Markets Cycle – Indicated Investment Types

Real Estate Capital Markets - Indicated Investments

The following section indicates where investors should position themselves on the real estate risk/return continuum based upon where the Real Estate Leasing Markets are in their cycle.

Real Estate Leasing Markets Cycle

When the Real Estate Leasing Markets are in the Recovery phase of the cycle, invest in existing core, core plus and value–added investments to take advantage of rising occupancy rates, lease rates and capital values. During the Expansion phase of the Leasing Markets’ cycle, add opportunistic investments in new developments. If the Real Estate Leasing Markets are forecasted to move into the Recession and Contraction phases of the cycle, sell properties, pay down debt and rotate into core risk/return investments.  (See Figure 4)

Figure 4: Real Estate Leasing Markets Cycle – Indicated Investment Types

Real Estate Leasing Markets - Indicated Investments

Takeaways

RealForecasts.com expects that the growth of TMS will continue its downward trend in the months ahead, especially once the FOMC raises the Fed Funds Target Rate above its current ceiling of 25 bps later this year.  Based upon the current trajectory of this trend, and the Fed’s current policy stance, it looks like the next credit crisis could occur during the second half of 2016.  Of course, this forecast could change if the Fed changes its policy stance or if the commercial banks change the pace of lending activity.

In the meantime, it’s not too early for real estate investors to take advantage of the robust capital markets environment to begin selling some of their under-performing and less-strategic assets and using the proceeds to reduce the leverage on their portfolios.  By reducing leverage and “dealing from the bottom of the deck”, they will be improving the risk profile of their portfolios in anticipation of — and not in reaction to — the next downturn.

Many thanks to Michael Pollaro at The Contrarian Take for the TMS data used in this post.

Has The Fed Been Raising The Fed Funds Rate Under The Radar?

By Jeffrey J. Peshut

March 26, 2015

At its March 18th meeting, the Federal Open Market Committee (“FOMC”) withdrew its pledge to be “patient” about raising the Fed Funds Target Rate above its current target range of 0 to 25 basis points, thus ending “forward guidance” about its policy stance and allowing the FOMC more freedom and flexibility about the timing of a rate increase.   The FOMC indicated that as long as the employment market continues to improve, the FOMC will raise the Fed Funds Target Rate once it becomes “reasonably confident” that inflation will approach 2% over the medium term.  The FOMC added that a rate increase remained “unlikely” at its April meeting and said its change in rate guidance does not mean it has decided on the timing for a rate hike.  Fed Chair Janet Yellen later told reporters that a June move could not be ruled out.

Notwithstanding the FOMC’s statement – and despite the keen attention paid to it by Fed watchers — one question that no one seems to be asking is whether the Fed has already been raising the Fed Funds Rate under the radar.  This post addresses that question.  Before addressing it, however, let’s first review some monetary policy basics.

Monetary Policy and Policy Tools

The Federal Reserve uses monetary policy to influence the supply of money and credit in the U.S. economy.  The supply of money and credit, in turn, affects interest rates and the performance of the U.S. economy and financial markets.

Traditionally, the Federal Reserve has used three tools to implement its monetary policy:

  • Fed Funds Rate – The average rate at which a depository institution (DI) — or other eligible entity such as a foreign bank or government sponsored enterprise — makes an unsecured overnight loan of U.S. dollars to another DI (“Fed Funds Transaction”). A DI borrows money overnight from another DI to maintain its reserve balances or clear financial transactions.
  • The Discount Rate – The rate charged by Federal Reserve Banks to depository institutions (DIs) on short-term loans.
  • The Reserve Requirement – The reserve requirement is the percentage of its customer deposits that each DI must hold as reserves – rather than lend out – either in their vaults or on deposit at a Federal Reserve Bank.

Since October of 2008 the Fed has been using the payment of interest on reserves as a fourth policy tool and from December of 2008 to October of 2014 the Fed used Quantitative Easing (“QE”) as a fifth tool.

Up until the fourth quarter of 2008 — when the Fed adopted a Zero Interest Rate Policy (ZIRP), reduced the Fed Funds Target Rate to nearly zero, began paying interest on reserves and initiated QE – raising and lowering the Fed Funds Rate had been the Fed’s primary policy tool.  To implement its monetary policy, the FOMC would set a target level or range for the Fed Funds Rate consistent with the desired level of reserves and then use its open market operations to influence the reserve balances until the Fed Funds Effective Rate reached its target rate.

The Fed’s open market operations influence reserve balances by purchasing and selling financial instruments — which are usually securities issued by the U.S. Treasury, Federal agencies and government-sponsored enterprises (GSEs) — in the “open market”.   Open market operations are carried out by the Domestic Trading Desk of the Federal Reserve Bank of New York under direction from the FOMC.  The transactions are executed through a cadre of security dealers that the Fed regularly does business with, which are known as “primary dealers”.

When the Fed wants to increase reserves and thereby lower the Fed Funds Effective Rate, it buys securities and pays for them by making a deposit to the account maintained at the Fed by the primary dealer’s bank.  When the Fed wants to reduce reserves and thereby raise the Fed Funds Effective Rate, it sells securities and makes a withdrawal from these accounts.  Most of the time, the Fed does not want to permanently increase or decrease reserves, so it reverses these transactions within several days.

Figure 1 illustrates how changes in reserve balances influenced the Fed Funds Effective Rate from the beginning of 1985 through the third quarter of 2008.  When reserve balances decreased, the Fed Funds Effective Rate increased and when reserve balances increased, the Fed Funds Effective Rate clearly decreased.

Figure 1: Fed Funds Effective Rate (%/Yr) v. Reserve Balances (YOY%)  01-01-85 to 09-01-08

Fed Funds Effective Rate v. Reserve Balances YOY 01-01-85 to 09-01-08

How Did Quantitative Easing Impact Reserve Balances?

Once the Fed lowered the target Fed Funds Target Rate into the 0 to 25 bps range, QE replaced the Fed Funds Rate as the Fed’s primary policy tool.  The impact on reserve balances was both immediate and remarkable.  (See Figure 2.)  Because the increase was so great, I’ve used a panel chart to be able to see the reserve balances before QE and the reserve balances after QE on the same chart.

Figure 2: Depository Institution Reserve Balances at Federal Reserve Banks ($Billions) 01-01-84 to 02-01-15

Reserve Balances at Federal Reserve Banks 01-01-84 to 02-01-15

Reserve balances went from $847.82 billion at the beginning of QE1 in December of 2008 to $1.12 trillion at the end of QE1 in March of 2010, to $1.62 trillion at the end of QE2 in June of 2011 and to $2.63 trillion at the end of QE3 in October of 2014.

The greatest increase in reserves on a on a year-over-year percentage basis actually occurred in the year leading up to QE1 when reserve balances went from a mere $5.67 billion in December of 2007 to the previously mentioned $847.82 billion in December of 2008, a head-spinning year-over-year increase of over 14,800%!  (See Figure 3.)  Again, a panel chart allows us to see the year-over-year percentage change before QE and the year-over-year percentage change after QE on the same chart.

Balances at Federal Reserve Banks (YOY%) 01-01-85 to 02-01-15

Reserve Balances at Federal Reserve Banks YOY 01-01-84 to 02-01-15

Why Did The Fed Start Paying Interest On Reserves?

The aggressive expansion of the Fed’s various liquidity facilities caused a large increase in excess reserve balances that placed extraordinary downward pressure on the Fed Funds Effective Rate.  This made it difficult for the Fed to achieve the operating target for the Federal Funds Rate set by the FOMC.  According to the Fed, paying interest on reserves allowed it to increase the level of reserves and still maintain control of the Federal Funds Rate.

Because depository institutions have little incentive to lend in the overnight inter-bank Fed Funds market at rates below the interest rate on excess reserves, paying interest on reserves allows the Fed to effectively place a floor on the Fed Funds Rate.  This floor allows the Fed to keep the Fed Funds Effective Rate closer to its target rate than it would have been otherwise able to.

Some commentators argue that once the Fed began paying interest on reserves and reduced the Fed Funds Target Rate to a range of 0 to 25 bps, it effectively decoupled changes in the Fed Funds Effective Rate from changes in reserve balances in the banking system.  They say that the Fed can now adjust reserve balances independently of the Fed Funds Effective Rate and that therefore the Fed Funds Rate is no longer a relevant policy tool.  As a result, they believe that the keen attention that people are paying to the timing of the Fed’s increase in the Fed Funds Rate is misplaced.

At first glance, Figure 4 would seem to support these commentators’ argument.  From December 2008 until today, the Fed Funds Effective Rate has been range bound between 0 and 25 bps while reserve balances have been growing at exponential rates.

Figure 4: Reserve Balances (YOY%) v. Fed Funds Effective Rate (%/Yr) 01-01-85 to 02-01-15

Fed Funds Effective Rate v. Reserve Balances YOY 01-01-85 to 02-01-15

If we zoom into the portion of the chart that relates to the period after QE1, which ended in March of 2010, we see that the relationship between changes in reserve balances and changes in the Fed Funds Effective Rate is as strong as it has ever been.  (See Figure 5.)  The changes in the Fed Funds Effective Rate are just occurring on a much smaller scale!

Figure 5: Reserve Balances YOY% v. Fed Funds Effective Rate (%/Yr) 04-01-10 to 02-01-15

Fed Funds Effective Rate v. Reserve Balances YOY 04-01-10 to 02-01-15

We also see that the Fed’s “Taper” policy that began at the beginning of 2014 has reduced reserve balances from a high of $2.8 trillion in July of 2014 to $2.3 trillion in February of this year — a reduction of 18% in eight months.  This decrease in reserve balances has raised the Fed Funds Effective Rate from 7 bps in January of 2014 to 11 bps in February of this year — an increase of more than 57% in a little over a year.

So, to answer the question raised at the beginning of this post, the Fed has indeed been raising the Fed Funds Effective Rate under the radar since January of 2014.  They’ve just been using the tapering of Quantitative Easing to reduce reserve balances instead of the more traditional method of raising the Fed Funds Target Rate.

What’s Next For Reserve Balances and The Fed Funds Rate?

To continue to raise the Fed Funds Effective Rate, watch for the Fed to reduce reserve balances in the months ahead.  It’s unlikely that the Fed will begin to raise the Fed Funds Target Rate until the Fed Funds Effective Rate approaches 25 bps, the upper limit of its current target range for the Fed Funds Rate.  Once the Fed does raise the Fed Funds Target Rate, the Fed Funds Rate should retake its place as the Fed’s primary policy tool and we’ll once again be able to pick up changes in the Fed Funds Rate on our radar screens.

When Will The Fed Begin Raising The Fed Funds Rate?

By Jeffrey J Peshut

December 20, 2014

In its press release about its December 17th meeting, the Federal Open Market Committee (“FOMC”) shifted its language about how long it will maintain the target Fed Funds Rate in the 0 to 1/4% range from “considerable time” to “it can be patient”.

Most Fed watchers have been focused on the first increase in the Fed Funds Rate as the sign that the Fed has shifted from a loose policy stance to a tight policy stance.  I suggest that the “Taper” that began in January of this year and the end of Quantitative Easing in October were the first phases in a type of monetary tightening that we haven’t seen during our lifetimes and that the tightening everyone has been watching for has been hiding in plain sight throughout 2014.

That said, the Fed’s shift in language is a sign that, for the time being, the Fed is committed to a tighter policy stance and a clue about when the next phase of tightening will begin.  Based upon language used by the FOMC in the past, here is how the Fed’s words translate into time:

“Considerable Time” = 6 – 10 months

“It Can Be Patient” = 2 – 5 months

“Measured Approach” = 1 month

Applying this translation to the current situation, it looks like the FOMC will start raising the Fed Funds Rate at its scheduled meeting in April of 2015.  Of course, even though it is unlikely, the Fed could shift its language and policy stance again between now and April.  If it does, RealForecasts.com will provided an updated forecast based upon the new information.  So, keep checking back with RealForecasts.com for the latest news about the Fed’s actions and what they mean to investors in real assets.

What Is So Good About Gold?

By Jeffrey J. Peshut

December 7, 2014

Warren Buffett — who  is the second-wealthiest man in the U.S. with a net worth of $72.7 billion according to Forbes.com — once said this about gold:

Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.

If the country’s second-wealthiest man has such antipathy toward it, what is so good about gold?  Before attempting to answer that question, let’s first take a look at what gold is and what it isn’t.

What Is Gold?

Despite Warren Buffett’s remark about head-scratching Martians, there is nothing mysterious about gold. Scientifically speaking, gold is a chemical element with the symbol Au and the atomic number of 79 — between platinum (Pt) and mercury (Hg) and directly below silver (Ag) on the Periodic Table of Elements. (See Figure 1.)  It is a bright yellow dense, soft, malleable and ductile metal.

Figure 1: Periodic Table of the Elements

Periodic Table of Elements.jpg

People first mined gold about 5,000 years ago.  Since that time, we have valued gold for emotional, cultural, political and economic reasons.  Because of its emotional, cultural and political significance, gold has been the subject of many beliefs and false beliefs.  Although this post will focus on gold’s economic aspects, it will also attempt to dispel some of the confusion and false beliefs surrounding it.

Economically, gold is classified as a commodity, similar to other precious metals such as platinum and silver.  According to the World Gold Council, there were 177,200 tonnes of gold stock in existence above the ground at the end of 2013.

Approximately 3,000 tonnes of new gold is mined each year, an increase in the gold stock of only 1.5% to 2.0% per year.  East Asia as a whole produces 21 per cent of the total of newly-mined gold.  (China is the largest single gold-producing country in the world, accounting for around 14 per cent of total production.)  Latin America produces around 18 per cent of the total, with North America supplying around 15 per cent.  Around 19 per cent of production comes from Africa and 5 per cent from Central Asia and Eastern Europe.

On average, 45 to 50% of the gold purchased each year is fabricated into jewelry, 30% to 35% of the gold purchased is acquired for investment purposes, 10% is purchased for manufacturing in technology and 10% is purchased by Central Banks for their reserve portfolios.  During 2013, 2,370 tonnes of gold were purchased for jewelry fabrication (55.7%), 1,069 tonnes were purchased for investment (25.1%), 408 tons were purchased for technology manufacturing (9.6%) and Central Bank net purchases accounted for 409 tonnes (9.6%).  (See Figure 2.)

Figure 2: Gold Purchases 2013

Gold Purchases - 2013

Is Gold Money?

Much of the confusion surrounding gold today stems from its historical role as money.  The World Gold Council provides a comprehensive overview of gold’s role in the monetary system.  A summary of the WGC’s overview follows.

Gold coins were first struck on the order of King Croesus of Lydia (an area that is now part of Turkey around 550 BC.  Gold coins circulated as currency in many countries before the introduction of paper money.  Once paper money was introduced, currencies still maintained an explicit link to gold, with the paper being exchangeable for gold on demand.  By the late 19th Century, many of the world’s major currencies were fixed to gold at a set price per ounce, under the so-called Gold Standard.

Under the Gold Standard, nearly all countries either fixed the value of their currencies in terms of a specified amount of gold, or linked their currency to that of a country that did so.  Domestic currencies were freely convertible into gold at the fixed price and there was no restriction on the import or export of gold.  Gold coins circulated as domestic currency alongside coins of other metals and notes, with the composition varying by country.  Because each currency was fixed in terms of gold, exchange rates between participating currencies were also fixed.

The classical Gold Standard existed for only about 40 years — from the 1870s until the outbreak of World War I in 1914.  By 1900 all countries apart from China, and some Central American countries, were on a Gold Standard.

The Gold Standard broke down at the outset of WW I as countries resorted to inflationary policies to finance the war and, later, reconstruction efforts.  In practice, only the U.S. remained on the gold standard during the war.  Periodic attempts to return to a pure classical Gold Standard were made during the inter-war period, but none survived past the Great Depression.

During World War II, many believed that a new international system would be needed after the war ended to replace the Gold Standard.  The design for the new system was drawn up at the Bretton Woods Conference — named after the town in New Hampshire in which it took place —  in 1944.  The Bretton Woods system fixed the dollar to gold at the existing parity of US$35 per ounce, while all other currencies had fixed, but adjustable, exchange rates to the dollar.

In March 1968, a two-tier gold market was introduced with a freely floating private market, but with official transactions at the fixed parity of US$35 per ounce.  Finally in August 1971, President Nixon announced that the U.S. would end on-demand convertibility of the dollar into gold for the central banks of other nations.  The Bretton Woods system collapsed and gold traded freely on the world’s markets.

To determine gold’s status as money today, we must first define money.  According to Austrian School economists, the defining characteristic of money is its use as a medium of exchange.  If Austrian School economists considered gold to be a medium of exchange today, they’d be including it in their calculation of the money supply.

As explained by RealForecasts in its last post, however, the Austrian money supply — which RealForecasts.com refers to as the True Money Supply — is made up of Base Money and Uncovered Money Substitutes.  Base Money is made up of Currency Outstanding and Reserve Deposits held by the Fed.  The Uncovered Money Substitute portion of the money supply is money created by the “pyramiding” of Reserve Deposits through fractional reserve banking.  (See Figure 3.)

Figure 3: Base Money and Uncovered Money Substitutes ($ Billions) 01/01/05 – 09/01/14

Base Money and Uncovered Money Substitutes 01-01-05 - 09-01-14

During periods in which gold coins circulated as part of a country’s currency and these currencies were freely convertible into gold held by central banks at a fixed price under the Gold Standard, gold was used a medium of exchange, was part of Base Money and thus was a part of the money supply.  Gold was money.

Today, gold coins are no longer circulating as currency and are therefore no longer a medium of exchange.  Further, since the collapse of the Bretton Woods System, gold is no longer part of Base Money and therefore is not part of the money supply.  As a result, it is no longer accurate to characterize gold as money.

All that said, many investors purchase gold as a hedge against the debasement and possible collapse of a fiat currency.  They believe that gold will regain its status as money If the fiat currency collapses.  Because of gold’s potential to become an integral part of the monetary system once again, a case can be made to characterize gold as “contingent money”.

Is Gold A Good Investment?

In investment circles, gold is categorized as a “real asset” as compared to a “financial asset”.  Real assets are physical or tangible assets that have value, due to their intrinsic qualities and properties. Real assets include precious metals like gold, commodities, real estate, agricultural land and oil.  Financial assets or “paper assets” derive their value from a contractual claim. Stocks, bonds and bank deposits are all examples of financial assets.

So is gold a good investment?  Since 1978, the price of gold has reported an average increase of 8.52%, year-over-year.  (See Figure 4.)

Figure 4: Gold Price (YOY%) 1/1/78 – 10/31/14

Gold Price - YOY 1978 - 2014

Whether an asset is a good investment, however, depends upon a number of factors such as the investor’s investment style, risk tolerance, investment time horizon and investment objectives.  For example, Warren Buffett is generally known as a buy-to-hold “value investor” in the tradition of Benjamin Graham and David Dodd.  As the name suggests, value investors buy financial assets that appear under-priced based upon some form of fundamental analysis.  It’s not surprising that a value investor like Buffett would eschew a real asset like gold.

On the other hand, diversified investors who follow the tenets of Modern Portfolio Theory — as pioneered by Harry Markowitz in the 1950s — are attracted to real assets like gold because they lack correlation with financial assets, which allows them to diversify their portfolios and reduce portfolio volatility.  Still other investors choose gold as a hedge against both inflation and currency risk.  Gold’s usefulness as a hedge against currency risk is illustrated in Figure 5.

Figure 5:  Gold Price (YOY%) v. US Dollar Index (YOY%) 1/1/78 – 10/1/14

Gold Price v. US Dollar Index - YOY - 1-1-78 - 10-1-14

Note the very strong inverse correlation between the growth rate of the gold price and the growth rate of the price of the U.S. Dollar relative to other major currencies.

U.S. Dollar Index and Gold Price Forecasts

Consistent with Austrian Business Cycle Theory, we can use the growth rate of TMS to forecast the growth rate of both the U.S. Dollar Index and Gold Price.  The very strong inverse correlation between the growth rate of the U.S. Dollar Index and the growth rate of the True Money Supply (TMS) is shown in Figure 6.

Figure 6: U.S. Dollar Index (YOY%) v. True Money Supply (YOY%) 1/1/78 – 10/01-14

US Dollar Index v. True Money Supply - YOY - 01-01-78 - 10-01-14

If the Fed expands the U.S. money supply at a faster rate than the central banks of the countries of other major currencies expand their money supply, the laws of supply and demand suggest that the price of the U.S. Dollar should fall relative to the other currencies (all else being equal).  Conversely, if the Fed expands the U.S. money supply at a slower rate than the other central banks expand their currencies, the price of the U.S. Dollar should rise relative to the other currencies.  The chart in Figure 6 certainly supports these suggestions.

In its previous post, RealForecasts,com forecasted the continued deceleration in the growth of TMS through the end of 2016.  If during the same period the European Central Bank, Japanese Central Bank and others accelerate the growth of TMS for their currencies, look for the US Dollar to continue to strengthen and the US Dollar Index to continue to rise.  (See Figure 7.)

Figure 7: US Dollar Index (YOY%) v. True Money Supply (YOY%) 1/1/78 – 10-01-14 Actual and 11/01/14 – 12/31/16 Forecast

US Dollar Index v. True Money Supply - YOY - Forecast 11-01-14 - 12-31-16

Because of the strong inverse correlation between the price of gold and the U.S. Dollar Index, when the U.S. Dollar strengthens and the U.S. Dollar Index rises, the Gold Price will likely fall.  (See Figure 8.)

Figure 8:  Gold Price (YOY%) v. US Dollar Index (YOY%) 1/1/78 – 10/1/14 Actual and 11/01/14 – 12/31/14 Forecast

Gold Price v. US Dollar Index - YOY - 11-01-14 - 12-31-14 Forecast

When the next financial crisis occurs, however, watch for the Gold Price and the U.S, Dollar Index to reverse, with the growth rate of the U.S. Dollar Index decelerating and even decreasing and the growth rate of the price of gold accelerating sharply.

This forecast is not only predicated on the Fed continuing its current policy stance, but also on the other major central banks continuing their policy stances.  In the event the Fed or the other central banks adjust their policy stances, it will alsbe necessary to adjust this forecast in light of the changed policies.  Continue to check back with RealForecasts.com for future updates.

As always, thanks to J. Michael Pollaro, author of The Contrarian Take, for the TMS data used to construct the charts in this article.  To see more of Michael’s TMS data, go to http://blogs.forbes.com/michaelpollaro/austrian-money-supply/.

How Will The End Of Quantitative Easing Impact The True Money Supply Growth Rate?

By Jeffrey J. Peshut

November 11, 2014

On Wednesday October 29th, the Federal Open Market Committee (FOMC) directed the Open Market Trading Desk at the Federal Reserve Bank of New York to conclude its asset purchase program — commonly referred to as Quantitative Easing or QE for short — by the end of October.  The FOMC also directed the Open Market Trading Desk to maintain the existing policy of reinvesting principal payments from the Federal Reserve’s holdings of both agency debt and agency MBS into agency MBS and of rolling over maturing Treasury securities at auction. Now that QE has ended, RealForecasts.com will look back to see the impact it has had on the growth and growth rate of the True Money Supply (TMS) and then provide a forecast of the TMS growth rate between now and the end of 2016.

The Impact of Quantitative Easing on the Growth Rate of the True Money Supply

Since it began in November of 2008, the Fed’s QE policy has had a dramatic impact on the growth of the TMS.  TMS grew from approximately $5.6 trillion in November of 2008 to almost $10.5 trillion at the end of September of this year — an increase of over $800 billion per year.  (See Figure 1.)

Figure 1: True Money Supply ($ Billions) 1/1/05 – 9/1/14 True Money Supply ($Billions) 01-01-05 - 09-01-14This represents an increase in TMS of 87.5% over 70 months or an average increase of 15% per year.

The growth of TMS accelerated sharply from November of 2008 to November of 2009 and from November of 2010 to August of 2011. These two periods correspond to the periods of QE1 and QE2, respectively.  Between September of 2011 and December of 2013 — the period of QE3 — TMS growth decelerated, but then grew at a relatively constant rate of approximately 8% YOY during the Fed’s QE3 “Taper” policy that began in January of this year and just ended in October.  (See Figure 2.)

Figure 2: True Money Supply (YOY%) 01/01/05 – 09/01/14 True Money Supply - YOY - 01-01-05 - 09-01-14

True Money Supply Forecast

To forecast the growth rate of TMS in a post-QE economy, we need to first separate TMS into its two component parts — Base Money and Uncovered Money Substitutes.  As explained in Is True Money Supply (TMS) Growth Continuing To Decelerate?, Base Money is made up of Currency Outstanding and Reserve Deposits held by the Fed — also known as Covered Money Substitutes.  The rate of growth of Base Money is directly related to the level of bond-buying activity by the Fed. The Uncovered Money Substitute portion of TMS is money created by the “pyramiding” of Reserve Deposits through fractional reserve banking.  The rate of growth of Uncovered Money Substitutes is directly related to the level of lending by the commercial banks.

Base Money (Currency and Covered Money Substitutes) and Uncovered Money Substitutes from January of 2005 through September of 2014 are shown in Figure 3.  The impact of the Fed’s bond-buying activity on the growth of Base Money is clearly visible in the growth of Covered Money Substitutes beginning in November of 2008.

Figure 3: Base Money and Uncovered Money Substitutes ($ Billions) 01/01/05 – 09-01-14

Base Money and Uncovered Money Substitutes 01-01-05 - 09-01-14

During the almost six-years of Quantitative Easing, three periods of accelerating growth of Base Money stand out — from November of 2008 to September of 2009, from November of 2010 to August of 2011 and from September 2012 to November of 2013.   (See Figure 4.)  The first period corresponds to most of QE1, while the second and third periods correspond directly to the periods of QE2 and QE3, respectively.

Figure 4: Base Money (YOY%) 01/01/05 – 09-01-14 Base Money YOY 01-01-05 - 09-01-14

Under a fractional reserve banking system, we’d expect that an increase in Base Money caused by an increase in Covered Money Substitutes — or Reserve Deposits — under QE would generate an increase in lending activity by commercial banks — which in turn would generate an increase in Uncovered Money Substitutes.  That is exactly what happened under QE1 and QE2, and has begun to happen under QE3. (See Figure 5.)

Figure 5: Base Money and Uncovered Money Substitutes (YOY%) 01/01/10 – 09-01-14 Base Money and Uncovered Money Substitutes 01-01-05 - 09-01-14

Notice that the peak in the growth rate of Uncovered Money Substitutes lagged the peak in the growth rate of Base Money by 18 months after QE1 and by 9 months after QE2. The last peak in the rate of growth of Base Money occurred 12 months ago, in November of 2013.  If we assume that the growth rate of Uncovered Money Substitutes lags the peak in the growth rate of Base Money by 18 months — the longer and more conservative of the periods after QE1 and QE2 — then the growth rate of Uncovered Money Substitutes should peak in mid-2015.  (See Figure 6.)

Figure 6: Base Money and Uncovered Money Substitutes (YOY%) 01/01/10 – 09-01-14 Actual and 10/1/14 – 12/31/16 Forecast Base Money and UMS Forecast 10-01-14 - 12-31-16

During the first nine months of 2014, the acceleration of lending activity by commercial banks has more than offset the deceleration of the Fed’s bond-buying activity under the QE3 Taper, which explains why the growth rate of TMS during 2014 has held constant at about 8% in the face of the Base Money’s decelerating growth.  Once the rate of growth of Uncovered Money Substitutes peaks, however, the TMS growth rate will once again decelerate, approaching 0% by the end of 2016.  (See Figure 7.)

Figure 7: True Money Supply (YOY%) 01/01/10 – 09-01-14 Actual and 10/01/14 – 12/31/16 Forecast True Money Supply - YOY - Forecast 10-01-14 - 12-31-16

So, for now, it looks like the TMS growth rate will remain constant or may even accelerate slightly through mid-year 2015, at which point it will turn downward and continue downward through the end of 2016.  Of course, this forecast is predicated on the Fed continuing its current policy stance.  In the event the Fed changes its stance, all bets are off and it will be necessary to adjust this forecast in light of the changed policy.  Continue to check back with RealForecasts.com for future updates about changes in the TMS growth rate.

As always, thanks to J. Michael Pollaro, author of The Contrarian Take, for the TMS data used to construct the charts in this article.  To see more of Michael’s TMS data, go to http://blogs.forbes.com/michaelpollaro/austrian-money-supply/.

Why Do Yield Curves of Treasury Securities Forecast Business Cycles So Well?

By Jeffrey J. Peshut

August 18, 2014

In a recent post on LinkedIn, economic strategist Paul Winghart correctly points out that yield curves of Treasury securities have an unrivaled track record of out-forecasting even the best economic forecasters — present company excepted, of course!  In support of his proposition, he cites “Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve” (Rudebusch and Williams, 2008).  Mr. Winghart veers off track, however, when he echoes Keynesians like Fed Chair Janet Yellen and argues that the yield curves’ greatest powers are their ability to capture and reflect the amount of economic slack in the economy at any given moment.

This post will show that yield curves accurately forecast business cycles because they reflect the Fed’s manipulation of both interest rates and the supply of money and credit, not economic slack in the economy.  Therefore, Mr. Winghart presented the right chart, but with the wrong reasons for why it works.

This post will then go on to forecast the 10-Year Treasury/3-Month Treasury spread over the next 12 to 24 months and suggest the likely impact the forecasted spread wil have on the economy.

Yield Curves of Treasury Securities and Forecasting Business Cycles

The yield curves of Treasury securities — specifically the spread between yields of long-term and short-term Treasury securities — have a well-documented history of accurately forecasting business cycles in general and economic recessions in particular.  A case in point is the spread between the yield on the 10-year Treasury Note and the 3-Month Treasury Bill.  (See Figure 1.)

Figure 1: 10-Year Treasury Note to 3-Month Treasury Spread  01/01/82 to 07/01/14

10-Year Treasury to 3-Month Treasury Spread 01-01-82 to 07-01-14

Shortly before each of the last four economic recessions, the spread between the 10-Year Treasury Note and the 3-Month Treasury Bill approached zero and in the case of the last three recessions actually fell below zero.  Put differently, in each case the yield curve flattened and even inverted.  Any investor monitoring the yield curves or this chart could have easily seen the economic downturns far enough ahead to still have time to take the appropriate protective actions.

Why Do They Work So Well?

To understand why the yield curves of Treasury securities forecast business cycles so well, it’s necessary to first look at the yields on the long-term and short-term Treasuries side-by-side to see whether one or the other is more responsible for the widening and narrowing of the spreads.  (See Figure 2.)

Figure 2: 10-Year Treasury Note and 3-Month Treasury Bill  01/01/82 to 07/01/14

10-Year Treasury and 3-Month Treasury 01-01-82 to 07-01-14

You can see right away that, except for the early 1980s, yields on the 3-Month Treasury Bill have been much more volatile than yields on the 10-Year Treasury Note and that they have been much more responsible for changes in the spread than yields on the 10-Year Treasury.

Next, we need to look for a reason for the volatility in the 3-Month Treasury Bill.  Because the Federal Reserve is responsible for establishing short-term interest rates through its control of the Fed Funds Rate, comparing yields on the 3-Month Treasury Bill to the Fed Funds Rate is a good place to start.  (See Figure 3.)

Figure 3: 3-Month Treasury Bill and Fed Funds Rate  01/01/82 to 07/01/14

3-Month Treasury and Fed Funds Rate  01-01-82 to 07-01-14

Not surprisingly, yields on the 3-Month Treasury Bill move in virtual lock step with the Fed Funds Rate.  This suggests that the Fed is responsible for the volatility in the 3-Month Treasury Bill through its control of the Fed Funds Rate and, by extension, is also largely responsible for changes in the spread between the 10-Year Treasury Note and the 3-Month Treasury Bill.

Now, if the spread between the 10-Year Treasury Note and 3-Month Treasury Bill accurately forecasts recessions, changes in the yields of the 3-Month Treasury Bill are largely responsible for changes in the 10-Year Treasury Note/3-Month Treasury Bill spread and the Fed’s control of the Fed Funds Rate is responsible for changes in the yield of the 3-Month Treasury Bill, it follows that changes in the Fed Funds Rate should also accurately forecast recessions.

Here’s where Austrian Business Cycle Theory (ABCT) comes in.  Not only do changes in the Fed Funds Rate accurately forecast recessions, but the Fed’s manipulation of the Fed Funds Rate and yields on short-term Treasury securities actually causes the business cycle. That’s why the yield curves of Treasury securities forecast business cycles so well!   For a thorough explanation of how the Federal Reserve causes the business cycle, see an earlier post on RealForecasts.com titled “Does The Federal Reserve Really Cause The Boom/Bust Cycle?”

What’s Next For The Fed Funds Rate And The 10-Year Treasury/3-Month Treasury Spread?

As of July 1, the spread between the 10-Year Treasury and 3-Month Treasury was 2.51%.  (See Figure 1.)  Because the Fed’s manipulation of the Fed Funds Rate causes the business cycle — and economic recessions occur once the spread between the 10-Year Treasury Note and 3-Month Treasury Bill approaches zero — it’s important to forecast the Fed’s actions and the 10-year Treasury/3-Month Treasury spread in the months ahead.

To begin, the Fed isn’t expected to raise the Fed Funds Rate until it ends its current round of quantitative easing, commonly referred to as QE3.  In July, the Fed tapered its monthly bond buying to $25 billion and is on track to end QE3 in October of this year.

Next, the median estimate of Fed officials, released after the FOMC’s June meeting, forecasted an increase in the Fed Funds Rate to 1.13% at the end of 2015 and 2.5% by the end of 2016.  According to the median of economists’ estimates in a Bloomberg survey, the Fed will first increase the Fed Funds Rate to 0.50% after its July, 2015 meeting.  St. Louis Fed President James Bullard, who doesn’t vote on policy this year, has said that the Fed should increase the Fed Funds Rate at the end of March, depending on economic data.

Once the Fed begins raising the Fed Funds Rate, look for the 10-Year Treasury/3-Month Treasury to begin narrowing.  Because the spread is at 2.51% today, it’s likely that the Fed will have to raise the Fed Funds Rate by only 250 to 300 basis points before the spread approaches zero and the economy enters its next recession.  If the Fed officials’ forecast mentioned above is accurate, that could occur by the end of 2016.  (See Figure 4.)

Figure 4: 10-Year Treasury Note to 3-Month Treasury Spread  08/01/14 to 12/31/16 Forecast

10-Year Treasury to 3-Month Treasury Spread 08-01-14 to 12-31-16 Forecast

So, for now, it appears that the Fed will begin to raise the Fed Funds Rate, and thereby begin to narrow the 10-Year Treasury/3-Month Treasury spread, in mid-2015 — give or take a quarter.  It also appears that the Fed Funds Rate will reach 2.5%, the 10-Year Treasury/3-Month Treasury spread will approach zero and the economy will enter its next recession by the end of 2016.   Continue to check back with RealForecasts.com for future updates about changes in the 10-Year Treasury/3-Month Treasury spread.

Is True Money Supply (TMS) Growth Continuing To Decelerate?

By Jeffrey J. Peshut

July 16, 2014

In its most recent posts — What’s Next For Employment Growth?, Will GDP Growth Continue To Lose Momentum? and Where Will Commercial Real Estate Returns Go From Here? — RealForecasts.com showed that the rate of growth of TMS had been decelerating since September, 2011.  (See Figure 1.)

Figure 1: True Money Supply (YOY%) 1/1/06 – 12-01-13True Money Supply 01-01-06 to 12-01-13

Moreover, at the end of each of these posts, RealForecasts.com encouraged readers to continue to monitor the Fed’s actions during 2014 to anticipate changes in TMS.  To that point, it’s been widely publicized that the Fed has been reducing or “tapering” its bond purchases under QE3, from a high of $85 billion per month in November of 2013 down to $35 billion per month in July of 2014.   Based on a roughly $10 billion per meeting tapering schedule, the last QE3  purchases should occur in October of 2014.

As a result of the Fed’s tapering policy, I would have expected the growth rate of TMS to continue to decelerate during the first part of 2014.  I was surprised to learn instead that the TMS growth rate accelerated slightly during the first five months of the year.  (See Figure 2.)

Figure 2: True Money Supply (YOY%) 1/1/06 to 5/1/14True Money Supply 01-01-06 to 05-01-14

According to my Austrian fellow-traveler Michael Pollaro,  the recent acceleration in the growth of TMS can be explained by looking separately at the two sources of TMS — Base Money and Uncovered Money Substitutes.  Base Money is made up of Currency Outstanding and Reserve Deposits held by the Fed.  The rate of growth of Base Money is directly related to the level of the Fed’s bond-buying activity.

The Uncovered Money Substitute portion of TMS is money created by the “pyramiding” of Reserve Deposits through fractional reserve banking.  The rate of growth of Uncovered Money Substitutes is directly related to the level of lending by the commercial banks.

Data provided by Michael shows that the recent acceleration in lending activity by commercial banks has more than offset the deceleration in the Fed’s bond-buying activity.  It’s too early to tell whether this relationship will continue long enough to be characterized as the beginning of a trend.

Even if it doesn’t develop into a new trend, the interruption in the deceleration of TMS could delay by five or six months the events forecast by RealForecasts.com in recent posts.  Keep checking back with RealForecasts.com for future changes in the growth rate of TMS.

As always, thanks to J. Michael Pollaro, author of The Contrarian Take, for the TMS data used to construct the charts in this article.

Are We Eating Our Seed Corn?

By Jeffrey J. Peshut

March 30, 2014

The U.S. has a rich agricultural heritage.  This heritage includes an expansive body of wit and wisdom in the form of aphorisms, admonitions and advice that have been accumulated by farmers over hundreds of years of plowing and tilling fields, planting and harvesting crops, feeding and milking cows, etc.

“Don’t eat your seed corn!” is one of these admonitions.  In literal terms, it suggests that farmers who choose to consume the corn from this year’s harvest that they will need for planting next year — rather than saving it for planting — will reduce crop production in the next year.  Figuratively speaking, it refers to living beyond our means today at the cost of reducing our standard of living tomorrow.

Austrian Business Cycle Theory

In its January 14th post titled Does The Federal Reserve Really Create The Boom/Bust Cycle?, RealForecasts.com explained how the Federal Reserve creates the boom/bust cycle by artificially expanding the supply of money and credit, lowering interest rates below their market or “natural” level and thereby creating an unsustainable economic boom which inevitably results in a bust.  According To Austrian Business Cycle Theory, one of the negative consequences of the boom/bust cycle is that it depletes an economy’s pool of funding.

Dr. Frank Shostak, adjunct scholar of the Mises Institute (www.mises.org) and principal of Applied Austrian School Economics, Ltd (http://aaseconomics.com) has written extensively about the pool of funding.  According to Dr. Shostak, the pool of funding is made up of all of the final products and services produced by an economy.  In the case of an individual farmer, the pool of funding is made up of the farmer‘s entire corn harvest.

It is important to recognize that an economy’s pool of funding is produced to be consumed by individuals to support their standard of living, just as the individual farmer’s crop harvest is produced to be consumed by the farmer and his family to support their standard of living.  Not all of the pool of funding can be consumed, however.  For consumers to maintain their standard of living, they must save enough of the pool of funding to maintain the current level of production of final products and services.  This is known as the economy’s pool of real savings – its “seed corn” if you will.

For consumers to improve their standard of living, an economy must increase its productive capacity and production.  To increase the economy’s productive capacity, producers must invest in the production of better tools, equipment, machinery, etc.  To make the resources available for investment, consumers must save more than the minimum required to simply maintain the current level of production.  They must increase the size of the pool of real savings.  Of course, to save more, they must consume less.

For example, to improve their standard of living, the farmer and his family must cut back on corn consumption today to save enough to invest in a better tractor, better farm implements to be used with the tractor or education to learn better farming techniques.  These investments, in turn, will allow them to produce more corn in the future and raise their standard of living.

Thus we can see that the pool of funding can be used for either current consumption or saved and invested for future production.

It’s important to recognize that the use of money in an economy doesn’t change the essence of the pool of funding.  Products and services are paid for with products and services – not with money.  Money is simply a medium of exchange that facilitates the transactions.  The farmer exchanges corn for money and then exchanges the money for boots.  The boot maker exchanges his boots for money and then exchanges the money for corn.  Ultimately, however, the farmer pays for the boots with the corn he produces and the boot maker pays for corn with the boots he produces.

So, how does the artificial expansion of the supply of money and credit, the lowering of the interest rate and the unsustainable boom and inevitable bust deplete the pool of funding?  It depletes it in two ways.

When the Federal Reserve expands the money supply, it creates money out of “thin air”.  The holder of the newly-created money can exchange it for final products and services in the pool of funding without having made a prior contribution of final products and services to the pool.  They can consume without having produced.  As a result, there are now less products and services left in the pool of funding than there were before the Fed expanded the money supply.  The pool of funding has been partially depleted.

Also, when the Federal Reserve lowers interest rates below their market or “natural” level, it sends a misleading signal to producers about consumers’ true time preferences.  As the Fed drives down interest rates, producers are led to believe that consumers are saving more today to consume more in the future and that now is the time to take advantage of the lower interest rates and invest in longer-term production projects for new products in the future.  In fact, consumers haven’t said that they want to save more today and consume more in the future.  Because the holders of the newly-created money used it to siphon off products and services from the pool of funding, consumers may demand more products and services today just to consume the same amount as the have been consuming.

Similarly, just because the Fed has decided to force interest rates down, it doesn’t mean that consumers want to invest more of their savings to complete future production capacity and future production.  As suggested above, people may not only prefer to continue to consume the same amount of resources today, they may want to consume even more.  This creates an unchanged or even shrinking pool of real savings from which to fund a growing number of new investment projects.

Something has got to give.  The boom in economic growth precipitated by the artificial creation of money and credit and lower interest rates is not sustainable.  The bust is inevitable.

The bust may occur because producers incorrectly forecasted future consumer demand for the future supply of their products and services.  As a result, these projects will become unprofitable.  It may also occur because producers incorrectly forecasted the size of the pool of real savings from which to complete their future projects and they won’t be able to complete them.  It can even occur because the Fed decides to reverse its monetary policy — from a “loose” policy stance to a “tight” policy stance – based upon a concern about how the increase in the money supply will affect consumer prices, asset prices or the price of the dollar relative to other currencies.  But occur it must.

Once the bust occurs, the market liquidates the unsustainable projects or “malinvestments”.  All or part of the pool of real savings that was invested in these projects is lost or “consumed” by the unsustainable and unsuccessful projects.  The result is a further depletion of the pool of funding.

According to Austrian Business Cycle Theory, then, the Fed’s intervention in the markets for money and credit creates the boom/bust cycle and depletes the pool of funding and the pool of real savings.  To the extent the Fed’s intervention depletes the pool of real savings, we are in fact “eating our seed corn” and thereby reducing both producers’ ability to maintain and improve their productive capacity and production and consumers’ ability to maintain and improve their standard of living.

But does the data back this up?

Empirical Data

The chart in Figure 1 shows year-over-year percentage increases and decreases in the True Money Supply from 1978 through 2013.  The positive slope of the trend line shows that, overall, the True Money Supply has been increasing at an increasing rate over the past 35 years.

Figure 1: True Money Supply (YOY%) With Trend Line 1978 – 2013

True Money Supply YOY With Trend Line 1978-2013

The charts in Figure 2 and Figure 3 show  year-over-year percentage increases and decreases in the Real Growth Domestic Product and Total Non-Farm Employment, respectively, from 1978 through 2013.

The negative slope of the trend line in Figure 2 shows that, overall, Real Gross Domestic Product has been increasing at a decreasing rate over the past 35 years.

Figure 2: Real Gross Domestic Product (YOY%) With Trend Line 1978 – 2013

Real Gross Domestic Product YOY With Trend Line 1978 - 2013

Similarly, the negative slope of the trend line in Figure 3 shows that, overall, Total Non-Farm Employment has also been increasing at a decreasing rate over the past 35 years.

Figure 3: Total Non-Farm Employment (YOY%) With Trend Line 1978 – 2013

Total Non-Farm Employment YOY With Trend Line 1978 - 2013

The acceleration in the growth of the True Money Supply and the deceleration in the growth of the GDP and Total Non-Farm Employment supports the Austrian School’s view that the Fed’s intervention has in fact been depleting the pool of real savings in the U.S. — i.e., we have been “eating our seed corn” — and that this has reduced the ability of producers to maintain and improve their productive capacity and levels of production.

Say’s Law and the Permanent Recession

In Say’s Law and the Permanent Recession, Robert Blumen argues that the most recent recession, often called The Great Recession, actually began in 2000 and not in 2008 and that there has been little if any real economic growth in the U.S. since 2000:

John Williams, an economic statistician and the proprietor of the web site Shadowstats, has produced a version of the real GDP based on the government’s nominal GDP deflated by his own GDP deflator. (The GDP deflator is sort of like the CPI, a price index that is used to convert nominal GDP into real GDP. For some reason they don’t use the same price index for both consumer prices and for this). Like Williams’ own CPI, his GDP deflator is computed with older rules from before the time when the BLS began cooking the books to hide inflation. Williams’ measure of real GDP shows low to negative growth over the period since 2000.

Robert’s article further supports the Austrian School’s view presented by RealForecasts.com in this post.

Refilling Our Seed Corn Bins

To increase producers’ ability to maintain and improve their productive capacity and production — and consumers’ ability to maintain and improve their standard of living — the Federal Reserve must first stop creating money out of thin air and expanding the supply of money and credit, allow the market to liquidate the unsustainable projects or “malinvestments” and allow interest rates to return to their natural levels.  Once this occurs, interest rates can begin to play their role of coordinating production over time — matching the production of goods and services with consumers’ true time preferences for consuming today or saving today and consuming tomorrow.  The pool of funding and the pool of real savings will be replenished.  Unlike a credit-fueled boom, which is unsustainable, savings-based growth is sustainable.  Consequently, over time, the economy will gradually return to health.

Or, to paraphrase our metaphorical farmers with whom we began, we must “stop eating our seed corn” and begin refilling our seed corn bins.

As always, my thanks to J. Michael Pollaro of The Contrarian Take who provided the TMS data used to create the chart in Figure 1.

Where Will Commercial Real Estate Returns Go From Here?

By Jeffrey J. Peshut

March 20, 2014

On January 24, the National Council of Real Estate Investment Fiduciaries (NCREIF) released results for the NCREIF Property Index (NPI) for the fourth quarter of 2013.  The NPI reported a Total Return for the quarter of 2.53%, comprised of a 1.34% Income Return and a 1.19% capital Appreciation Return.  For the year, the NPI returned 10.98%, which included an Income Return of 5.61% and an Appreciation Return of 5.16%.

NCREIF is an association of professionals involved with private-market real estate equity investments owned by pension funds, who come together to promote research on the asset class and address important industry issues.  www.NCREIF.org  The NPI consists of a portfolio of 7,029 investment-grade, income-producing apartment, office, retail, industrial and hotel properties with a year-end market value of approximately $354 billion.  The NPI includes property data from over 195 Metropolitan Statistical Areas (MSAs).

NCREIF Property Index – Historical Perspective

Since its inception in 1978, the NCREIF Property Index has reported a Total Return of 9.15%, made up of an Income Return of 7.52% and an Appreciation Return of 1.54%.

After returning 15.85% in 2007, the NPI Total Return declined to – 6.46% in 2008 and – 16.85% in 2009.  Total Return for 2008 was comprised of an Income Return of 5.13% and an Appreciation Return of -11.15%.  The impact of The Great Recession was even more pronounced in 2009, with an Income Return of 6.17%, but an Appreciation Return of -21.98%.

In response to the Fed’s first and second rounds of Quantitative Easing, the NPI rebounded in 2010 with a positive return of 13.11%  The NPI has been on an impressive run since, posting Total Returns of 14.26%, 10.54% and 10.98% for 2011, 2012 and 2013, respectively.  See Figure 1.

Figure 1: NPI Income, Appreciation and Total Return  1978 – 2013

NPI Income Appreciation and Total Returns  1978 - 2013

Notwithstanding this impressive run, the Appreciation Index Value for the fourth quarter of 2013 of 173.47 is still 12.9% below the Appreciation Index Value of 199.16 reported for the fourth quarter of 2007.  This puts into perspective just how far the Appreciation Index Value had fallen by the end of 2009.

The Income Index Value for the fourth quarter of 2013 of 1359.87, on the other hand, is 41,1% above the fourth quarter of 2007 Income Index Value of 962.3.

Based upon the positive contribution of the Income Index Value, the Total Index Value for the fourth quarter of 2013 of 2,334.57 is 23.3% above the fourth quarter of 2007 Total Index Value of 1,892.85, resulting in an average annual Total Return since the end of 2007 of approximately 3.9%.  See Figure 2.

Figure 2: NPI Income, Appreciation and Total Index Values 2007 – 2013

NPI Income Appreciation and Total Index Values  2007 - 2013

NCREIF Property Index – Forecast

In its February 13th post titled What’s Next For Employment Growth?, RealForecasts.com pointed out that the rate of growth of the True Money Supply (TMS) has been slowing over the past two years and forecasted that it will continue to slow as the Federal Reserve reduces its bond purchases, euphemistically referred to by the Fed as “tapering”.  By extrapolating the TMS’s current trajectory into the future, RealForecasts.com forecasted that TMS growth should approach zero in early 2015, setting the stage for the next credit crisis near the end of 2015 or the beginning of 2016.

Based upon a one-year lag between TMS growth and Employment growth since 2009, RealForecasts.com also forecasted that the growth of Employment will begin to decelerate in 2014 and expects it to approach zero in the 2015 to 2016 timeframe.  See Figure 3.

Figure 3: Total Non-Farm Employment (YOY%) v. True Money Supply (YOY%)  1978 – 2013 Actual and 2014 – 2016 Forecast

Total Non-Farm Employment YOY v. True Money Supply YOY  1978 - 2013

In its March 4th post titled Will GDP Growth Continue To Lose Momentum?, RealForecasts.com identified a similar one-year lag between TMS growth and GDP growth since 2009 and forecasted that the growth rate of GDP should continue to lose momentum and approach zero in early 2016.   See Figure 4.

Figure 4: Real Gross Domestic Product (YOY%) v. True Money Supply (YOY%)  1978 – 2013 Actual and 2014 – 2016 Forecast

Real Gross Domestic Product YOY v. True Money Supply YOY 1978 - 2013

It won’t be much of a surprise to real estate investment industry veterans that there is a strong correlation between Employment and GDP growth rates and the NPI Returns.  After all, employees occupy apartment, office and hotel properties and products fill industrial and retail properties!

The correlation between NPI Total Return and the Employment growth rate is illustrated in Figure 5.  The peaks and troughs of the NPI Total Return closely follow the peaks and troughs of YOY change in Employment, with a slight lag during some time periods.

Figure 5: NPI Total Return v. Total Non-Farm Employment (YOY%) 1978 – 2013 Actual and 2014 – 2016 Forecast

NPI Total Return v. Total Non-Farm Employment YOY 1978 - 2013A and 2014 - 16F

Similarly, the correlation between NPI Total Return and the GDP growth rate is illustrated in Figure 6.  The peaks and troughs of the NPI Total Return closely follow the peaks and troughs of the YOY change in Real Gross Domestic Product, but without a lag.

Figure 6: NPI Total Return v. Real Gross Domestic Product (YOY%)  1978 – 2013 Actual and 2014 – 2016 Forecast

NPI Total Return v. Real Gross Domestic Product YOY 1978 - 2013A and 2014 - 2016F

Finally, shortly after the NPI Total Return begins a cyclical decline, the NPI Income Return turns upward.  Real estate values and cap rates — for which the NPI Income return can be viewed as a proxy – are inversely related.  This occurred during 2008 and 2009 and would have continued in 2010 and beyond if the Fed had not forced yields back down through its quantitative easing policy.  Now that the Fed is reducing its bond purchases with the aim of ending quantitative later this year, the NPI Income Return will likely resume the trajectory it was on before the Fed’s intervention.  See Figure 7.

Figure 7: NPI Income Return v. NPI Total Return 1978 – 2013 Actual and 2014 – 2016 Forecast

NPI Income Return v. NPI Total Return 1978 - 2013 Actual and 2014 - 2016 Forecast

As with the forecasts contained in RealForecasts.com’s two previous posts,  the current forecast is predicated on the Fed’s continuation of its current policy to gradually reduce the amount of bond purchases until it ends quantitative easing later this year.  Because continuation of the Fed’s current policy is likely, this forecast represents RealForecasts.com’s base case scenario.  To prepare for possible changes in the TMS, Employment and GDP growth rates — and the NCREIF Property Index returns — RealForecast.com recommends that readers continue to keep a close watch on the Fed’s actions as 2014 unfolds.

Many thanks to J. Michael Pollaro, author of The Contrarian Take, for the TMS data used to construct the charts in this article.