A Discussion on Interest Rates/Macro Fundamentals (Long OP)

While there was a recent thread about buying in a rising interest rate environment, I'd like to have a thoughtful discussion about where you're predicting interest rates to be in 1-2 years and how that will impact the market, if at all.

To preface the discussion: I first entered real estate shortly after the GFC and I suspect many of you did as well. Recently, I've had this nagging feeling that the market I've operated in over the past decade isn't "normal" and I should research the past 100 years (thanks, Ray Dalio). Sure, the pundits have been saying "historically low interest rates" for years, but I've just plowed forward as usual, accepting today's reality for what it is: reality.

Eventually the feeling arose that maybe I've been lulled into a "new normal" perception of the market since it's the only thing I've ever known. And what does "historically low interest rates" even mean from a contextual perspective?

Well, from 1995 to 2000, the Federal Funds Rate averaged somewhere between 5.4 - 5.5 %. During that same period, the Freddie Mac 30-year Fixed-Rate Mortgage Index averaged around 7.62% (ballparking). However, in 2001, things got wacky. Due to a recession and 9/11, the Fed Funds rate dropped to 1.75% in 2001 and 1.25% in 2002. Yet the Freddie Mac index averaged 6.97 and 6.54, respectively. Freddie Mac rates trended downwards for the next couple of years then stabilized in the high 5's to low-to-mid 6's before the GFC hit.

So, as you can see, even after a recession in 2001, rates never went as low as they are today. In fact, I had to go back to September 1, 1961 to find a Fed Funds rate under 2.00. We were sitting at 1.70 as of 5/1/2018, according to the St. Louis Federal Reserve.

As someone that's become active on the construction side of things, I've recently received written notifications from regional suppliers that there will be a substantial increase in the prices of goods across the board (think 5-10% minimum for almost everything involved in a stick-frame build). The notices didn't stop there as they stated we could expect another bump in November if things keep trending as they are now. There were a number of reasons for the increase but a unique one was the lack of labor to load the trucks and ship the materials.

Very low unemployment (3.8% and probably high 6's "real") combined with the aforementioned inflation makes my spidey-senses feel like things are going to be a lot different towards the end of 2019. I'm definitely not making the case for another GFC, but I am making the case that we need to be thoughtful about what the market could look like at that time.

Now to real assets: I recently bid on a value-add apartment deal in the sub $10MM range. I used completely reasonable assumptions that would normally have put me in contention 6-12 months ago. However, I'm 500k - $1MM off and there are tours for days on end... What's going on? Heck, I'm even using optimistic broker assumptions of where rents can go to in 2-3 years.

What are your thoughts on where this all leads to and what are your respective strategies for dealing with the uncertainty going forward? As a newly minted entrepreneur I'd like to be able to make things work, but every day things get weirder and weirder--and profit margins get smaller and smaller--as excessive liquid capital chases anything and everything. Yet, on the flip side, there's been at best equilibrium construction in most markets so oversupply isn't a big issue (assume case-by-base basis).

Within this context, I can't help but wonder where things are heading, what unique options are still available to the thoughtful investor, and what valuations could look like in 2-5 years.

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Comments (63)

Jun 3, 2018

Interesting post--should draw some good conversation on here. I think it's important to consider how M2 has changed from the 2000s to now. Said plainly, the Fed has pumped 3x the money supply into the financial system since then and a lot of that money is going straight into equities. Europe did the same thing and a lot of that money went into UST's; these cross border flows have for a long time now suppressed our interest rates. Given where bond yields are at, real estate has been very attractive on a risk adjusted basis. Given the extreme valuations in the equities markets, I think investors are getting more and more skiddish and with interest rates going up, the rent bumps built into leases seems more appealing that locking in on a long term bond whose value will continue to decrease with rising rates.

I believe cap rates will remain low for the near term as investors focus on capital preservation over growth. Real estate seems safe relative to the stock market this late in the business cycle. If the Fed unwinds it's balance sheet at a gradual pace and doesn't shock the system, I think we may see slight lift to cap rates over the next 10 years but not a major correction like last time. There's too much money out there and it's got to be placed somewhere. We are seeing lenders (and LPs) taking a more cautious approach to investing in development projects and construction pricing make penciling deals very tough right now; we are in one of the top 3 growth metros in the country. If this is occurring elsewhere and new supply is held held in check, one would think this would keep rent growth positive and cap rates from shooting up.

Most Helpful
Jun 3, 2018

The supply of new construction and it's relation to future rent growth is an interesting topic. The issue we may run into, sooner rather than later, is that of wage growth not keeping up with rent growth. The combination of rent growth and healthcare inflation is going to continue to eat into the pockets of renters of class B and C apartments. There has to be a breaking point at some time in the future. Or let's just hope that real wage growth for the bottom half of the economy starts to pick up now that there's a shortage of labor in some sectors.

I do believe we have a looming housing crisis on our hands, which makes me bullish on apartment development in the right markets over the long-term (if you can tie up the land). I also play in the single family residential market and we are unquestionably under-built for first-time home-buyers. Yet there is no immediate solution in most metros as the cost of land + construction costs are too high to make the economics work.

Your comment got me thinking about one thing in particular that surfaced in my mind as a result of my research: we haven't been here before, or at least not in a very very long time. If true, this means our economic models are woefully unprepared to deal with "predicting the future" in any meaningful way.

While continuing to research after posting the OP I came across Howard Marks' most recent memo on the Oaktree website, in which he speaks to many of the issues I brought up in my OP--albeit in a much more eloquent and sophisticated manner. It's worth a read.

If I had to make a prediction, I'd put a decent probability on 6.5-7% interest rates in a couple years. I think it's highly unlikely that cap rates stay this low for 10 more years, but that's why there are winners and losers in markets, and I very well may be the loser.

On an asset level, this is what concerns me: take a model with 8 meaningful sensitivities (random number) and in an upswing with some decent growth and profit margins you can make things work if a couple of the sensitivities under-perform--you may even get general appreciation which alone exceeds your sale projections. However, what happens when things are "priced to perfection" (Zell) and you don't get that appreciation but your taxes go up 5-10% more on the reval and your rent growth stagnates for 3 years yet you're forced by your investors to sell?

In many cases, returns are so compressed that if you miss your 3% rent growth targets by 2% for 2 years on a 5 year hold, things change to "almost a waste of time" for the sponsor. The promote drops and the sponsors will wake up realizing they aren't making anything close to what they would have hoped for all the work and at some point a correction takes place. My models are so sensitive at this point that I'm crushed if a municipality has to increase taxes at a substantially higher rate than expected. Not "oh I won't make much money"...more like "oh, I would have made more by being in the S&P index".

Hopefully I don't sound like too much of a curmudgeon. I'm just genuinely confused at times.

EDIT: I realized I didn't address one of your core points that there's too much capital in the market. I agree with this and it seriously concerns me because it makes it so hard to compete. But at the same time I don't know what it means over the long term and how different macroeconomic scenarios can affect where that capital ends up over the next 5-10 years.

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Jun 3, 2018
Non-PC Broker:

I also play in the single family residential market and we are unquestionably under-built for first-time home-buyers. Yet there is no immediate solution in most metros as the cost of land + construction costs are too high to make the economics work.

To your point, I just licensed up in Virginia as a Class A contractor with a residential building construction specialty (something that was incredibly hard to do, btw) in an effort to build affordable starter homes in the Greater D.C. area. I've been trying to get the numbers to pencil out and I'm really struggling with it--this whole process has really demonstrated to me why square footage is king in single-family residential homebuilding. A huge portion of costs--land, HVAC systems, even roofing costs--either don't rise at all or don't rise in a linear fashion with the size of the house, but the price you can obtain does rise in a fairly linear (although imperfect) manner. In essence, most profit is derived from building big.

I'm trying to work out how to build a quality, inexpensive product rapidly for a reasonable profit ($~50,000 per unit--not a lot considering market risk + income taxes) but I'm running into an issue with cost. I just can't make it work. And the numbers keep telling me that apartments or condos are the only things that payoff if looking to build for affordability.

Jun 5, 2018

You should do a q&a if you have time! I think this is very interesting, and a lot of people on this forum would find it helpful. Don't want to hijack this thread though.

Jun 5, 2018

Land cost definitely rise with home size; that's why you're seeing dense townhouse communuties make up the majority of home deliveries.

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Jun 5, 2018
cre_questions:

Land cost definitely rise with home size; that's why you're seeing dense townhouse communuties make up the majority of home deliveries.

You're misinterpreting what I mean. I mean if you take a lot that's, say, 1/4 acre, you could choose to build a house that is 1,200 sf or 3,500 sf. Your land cost is essentially the same either way, which means your profit margin is much higher with a larger house, which reduces the incentive to build small. If you're building at $200 psf (including land) and selling at $300 psf then you're incentivized to build as much square footage as possible, among the many reasons we've seen a continued push over the decades of house size and the annihilation of home affordability.

Jun 10, 2018

I'd be curious to hear just how far you can take this - ppsf doesn't scale linearly and at a certain point the marginal value psf will be less than the cost of new construction for that marginal sf - which you say is $200 psf and seems about right (though the cost psf also doesn't scale linearly). is that at 5,000 sf? any models of this?

Jun 5, 2018

Double post

Jun 8, 2018

Bruh, where were you last quarter with these affordable starter homes when I was house hunting?

Jun 4, 2018

+1- fascinating thread

Jun 5, 2018

+1 - love that you mentioned Howard Marks because reading your OP he was the first thing to come to mind. His memos are fantastic and his book does a great job of outlining his thoughts on investing, cycles etc. Your whole post made me think of the phenomenon that he often discusses that investors often feel more comfortable taking risks as the market is rewarding them least to do so.

I'm not able to make any claims about where interest rates are going to be next week nonetheless in 2 years, but broadly it does feel like a good time to be mindful of the risks you're taking in a prospective investment. In the example you noted above, regardless of the time in the cycle, I don't want to be doing deals that don't work if any one of my eight key assumptions goes against me. Right now I am looking for deals where we can add some unique value (through development expertise, synergy with existing portfolio, etc.) - with a structure that isn't going to add excess risk through short-term capital/liquidity requirements, heavy interest rate exposure, etc.

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Jun 5, 2018

Thanks for the reply. It sounds like I need to pick up his book.

I like your thoughts on adding unique value. It's something I think about every day but, unfortunately, haven't been able to execute on in the past 6-8 months.

I'm still bullish on development in the right locations. We definitely haven't overbuilt in most markets, and if we have it's not so much that you can't wait it out if you're properly capitalized. It's all about finding the right land at a reasonable price which feels like finding a needle in a haystack if you're not an established group.

What I've internalized thus far is I'm probably wasting my time if I'm hoping to buy value-add B/C multifamily at a reasonable number. I'm in the NY metro, so I can either buy rent stabilized at 4.5caps-5caps in a rising rate market or I have to go to the suburbs and deal with the nescient assumptions of my competitors. NY Metro suburbs are all in high-tax states with many failing municipalities, which is different than what a lot of you in the South are experiencing. So the value-add apartment strategy may still be a nice business to be in over the long-term if you're in some of those markets. Knowing what I know now, I think I'd be a buyer of rent stabilized deals if cap rates tic up with interest rates in two years.

Lastly, despite my disdain for my oftentimes unsophisticated competitors, it's hard to ignore the fact that real estate is a lot more sophisticated today than it was 15-20 years ago. More institutional capital, more grad programs, and more syndicators (thanks, you goofball e-mentors). The case can be made that, as a result, we may never get back to the returns of the past and real estate as an asset class will have increasingly compressed returns going forward. Thoughts?

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Jun 6, 2018

Definitely worth a read - I think he's working on 2nd, will be eager to read that.

I spent some time with a MF value-add shop, and their focus was on high growth markets (generally southeast) where you can buy slightly older vintage at below replacement costs. Much different story up north. As far as the "unique value" that they were adding, mostly just using scale to drive cost savings - nothing terribly innovative. Business largely driven by cheap capital and desire for steady yields.

Last point is super interesting. I think you are right - basic supply and demand dictates that as more $ has access to industry, prices go up and returns go down. However, in my opinion, presence of unsophisticated players is going to lead to poor execution and capital structures that don't properly account for risk which is going to lead to opportunities for those of us who know what we are doing. I keep telling myself that right now is the time to be disciplined and not get caught up in the mania. Not a great time to be in a position that you NEED to close deals in order to eat.

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Jun 7, 2018

@Non-pc Broker

As someone who works in the NYC rent stabilization asset class, would you mind further explaining how operators are making money today with buildings being traded at 3 caps? What is the cost of debt that these sponsors are getting? Is it only value add plays and dealing with the upside of the destabilization?

Jun 7, 2018

A few different ways. At it's core it's a more complex value-add play. You need tenant turnover to renovate units and increase rents. There's a laundry list of regulations governing this practice, including how much you're allowed to increase rents. It becomes really complex, and I'd bet that 95% of mom & pop operators don't understand the calculations.

Most buyers are putting down 35-45% in cash, and the rest via bank money. Sometimes even substantially more in cash. Banks underwrite to DSCRs.

To make the most money you need to, ideally, pick an area that will experience big rent growth over the next 3-5 years, buy out tenants, renovate some of the units, then flip it to the next guy for 2-3x what you paid for it. As you can see, it can closely resemble a game of hot potato, except for the fact that there's extremely low vacancy risk and the LTV is relatively modest.

What you end up with is a system where people refuse to renovate apartments in order to force tenants out so they can subsequently renovate and get higher rents. It's a messed up system and the worst of the worst landlords are starting to end up in prison.

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Jun 12, 2018

Right, thanks. Exactly how I approach the situation of value add.

However, who are these guys paying 2x what someone else bought it 2 years earlier? Isn't growth already baked in the price? Do the rents really increase that much to justify that price increase? Crazy to think how an operator will come in and offer an insane price to buy a property in Harlem for example when the previous landlord did all the work. Guess there is a market for that kind of asset.

Jun 4, 2018

The fed or ebc can not suppress interest rates. If they did it would cause massive inflation and you would see high inflation with low real yields.

If they suppressed interest rates it's by putting too much money in the system which would lead to inflation.

Fed policy has actually boosted interest rates.

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Jun 4, 2018

wrong ...just look at European govt interest rates....10yr italy, portugal, spain yields all significantly lower than 10yr US yields.....because the ECB bought them and pushed up their prices...and thus lowered their interest rates.

historically, central banks didn't buy long maturity debt...but after 2008 the rules changed...and that is the only reason why yields are as low as they are now.

just google it...you're welcome

Jun 5, 2018

Actually you have that backward. Europe has lower interest rates because they ran tighter monetary policy. We went all-in far earlier and it's resulted in higher rates today. Ecb tried hiking rates years ago (2013?). And it set off the European debt crisis which caused rates to plummet (where credit wasn't an issue....eventually everywhere). Deflation means lower rates.

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Jun 5, 2018

Are you trying to say that Italy is a better credit risk that the US govt? With their 30% higher debt to GDP ratio?

just google it...you're welcome

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Jun 5, 2018

Governments that control their own monetary policy do not have credit risks. Once ecb started running monetary policy for Italy it eliminated most of the credit risks.

Debt to gdp for a country is a poor proxy for credit risks. Most important thing do you control your own currency. Second most important would build in wealth to gdp and true trade deficit.

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Jun 5, 2018
traderlife:

Governments that control their own monetary policy do not have credit risks. Once ecb started running monetary policy for Italy it eliminated most of the credit risks.

Debt to gdp for a country is a poor proxy for credit risks. Most important thing do you control your own currency. Second most important would build in wealth to gdp and true trade deficit.

I'm going to chalk up this really, really bad understanding of monetary/fiscal controls to a language barrier. I'm going to give you the benefit of the doubt and assume you're confusing terms because English is a second language for you (and I'm not saying that to be mean--I think English really is your second language and you're confusing terms).

Jun 5, 2018

I will chalk this up to you being a macro tourists

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Jun 5, 2018
traderlife:

I will chalk this up to you being a macro tourists

Ok, fine. If you're not confusing terms because of a language barrier then you need to explain this, umm, obviously wrong statement:

traderlife:

Governments that control their own monetary policy do not have credit risks.

Because this is belied by, like, umm, every country in, uh, history. Most countries have their own currency and control their own monetary policy, and every country--even the U.S.--exhibits "credit risk," hence why they pay interest to investors.

Jun 5, 2018

They don't pay interest to compensate for credit risks. They pay interest because tying up money has value. Investors get a return for not being able to use their money.

That is like Day one in an investments course.

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Jun 5, 2018
traderlife:

They don't pay interest to compensate for credit risks. They pay interest because tying up money has value. Investors get a return for not being able to use their money.

That is like Day one in an investments course.

Interesting. So why does Venezuela pay a higher interest rate on its sovereign debt than the United States?

Jun 5, 2018

Inflation. Unstable value of money. And being by being a fully diversified economy adds credit risks.
Also believe they borrow in dollars.

The no credit risks isn't absolute. But it's close to non-existent in developed economies controlling their own currency. With regards to Italy their former large credit spreads were all monetary policy related.

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Jun 5, 2018
traderlife:

Inflation. Unstable value of money. And being by being a fully diversified economy adds credit risks.
Also believe they borrow in dollars.

The no credit risks isn't absolute. But it's close to non-existent in developed economies controlling their own currency. With regards to Italy their former large credit spreads were all monetary policy related.

Your argument is beyond asinine. Obviously, inflation and economic growth impact bond yields, but credit risk is absolutely a real phenomenon. Why do you think credit agencies credit rate sovereign debt? There is a supply of debt with demand that is impacted by lots of different factors, including inflation, including credit risk. The idea that you would deny that sovereign debt has credit risk is beyond mind boggling. Anyone who has even tangential knowledge of bond investing understands that sovereign debt credit risk is an aspect of sovereign debt cost.

In fact, you can see this within the United States--different municipalities pay different interest rates based on their CREDIT RISK, which is why they usually do everything in their power to maintain a AAA credit rating.

Jun 5, 2018

Why would you include a discussion of muni debt with sovereign debt?

You are very confused and do not understand the subject matter.

Any sovereign would have the choice of inflation instead of credit risks.sovereign debt is about controlling inflation for a large diversified economy like the United States.

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Jun 5, 2018
traderlife:

Why would you include a discussion of muni debt with sovereign debt?

You are very confused and do not understand the subject matter.

Hello? Municipalities and states are sovereign in the United States. They don't need permission to take out debt, their credit isn't cross-defaulted with other municipalities or states, their legal authority over taxation (generally) backs debt, and their debt is not implicitly or explicitly backed by the federal government.

traderlife:

Any sovereign would have the choice of inflation instead of credit risks.sovereign debt is about controlling inflation for a large diversified economy like the United States.

I can't understand what you're saying (your English isn't great). Suffice it to say, you literally have no clue what you're talking about if you maintain your original position that governments that control their own currency exhibit no credit risk. This is demonstrably false. Credit risk is one of many factors impacting sovereign debt for all nations, including the U.S.

Jun 5, 2018

Nope you have no clue what you are talking about. It's beyond you. Municipalities can't print money.

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Jun 5, 2018
traderlife:

Nope you have no clue what you are talking about. It's beyond you. Municipalities can't print money.

Neither can Germany, but Germany still has sovereign debt...

The point is, sovereign debt issuers the world over--from Texas to Germany to Venezuela--all have debt that is partially reflected by credit risk. This is indisputable and I'm not sure why I've spent hours re-stating the obvious.

Jun 5, 2018

Sovereign refers more to a country. European countries are close to being able to issuing own currency and why credit risks isn't only there to extent they can't

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Jun 5, 2018

Countries have defaulted in the past

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Jun 6, 2018
Re.Monkey:

Countries have defaulted in the past

Correct. While it's rare for an advanced economy to experience a bond default, Cyprus, Greece, Ireland, Portugal and Puerto Rico have all experienced recent bond defaults.

Here's a master list from Canada over the last ~60 years of countries with bond defaults: https://www.bankofcanada.ca/wp-content/uploads/201...
Also, there have been 99 American municipal defaults, including the recent Detroit bankruptcy. The idea that credit risk is a non-factor in sovereign debt is, of course, ridiculous.

Jun 6, 2018

No one uses the term sovereign debt to refer to municipalities. If you invent definition you can prove anything.

I also specifically referred to countries that issue their own currency. They only default if they get in an inflation war and have to choose between default or fighting inflation.

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Jun 6, 2018
traderlife:

No one uses the term sovereign debt to refer to municipalities. If you invent definition you can prove anything.

When you lose an argument, you grind and grind on a completely irrelevant point. My point regarding municipal debt was that they are credit rated just like countries are, and even U.S. municipalities default, despite having a sterling credit record in general.

traderlife:

I also specifically referred to countries that issue their own currency. They only default if they get in an inflation war and have to choose between default or fighting inflation.

Provably false. Look at the long, long, long list of sovereign debt defaults that I presented. Most issued their own currency. As an aside, I'm not sure how defaulting fights inflation. Is that the Maduro/traderlife model of fighting inflation? If so, it doesn't work, unless Venezuela's 29,000% inflation rate is a win for fighting inflation.

But like the rest of this discussion, I'm sure you'll move the bar. "I'm right except for that instance."

Jun 6, 2018

Inflation is necessary to cause a sovereign to default. Venezuela agreed with my model.

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Jun 6, 2018

Too much stupid. The Ecuadorian crisis of 2000 and resulting external debt default was not precipitated by inflation, but by bank failures. I'm done with this conversation. You can't fix stupid.

Jun 6, 2018

Checkers against chess. Can't fix someone whose read a couple papers and thinks they understand sovereign debt.

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Jun 6, 2018

Credit risk exists when you cannot print the currency in which your debt is denominated.

The US federal govt does not have credit risk, because they can print USD...however they do have inflation / currency risk. States have credit risk because they cannot print USD...but they do not have currency inflation risk (well, not directly anyway).

Interestingly, in the summer of 2011, the US govt almost defaulted on its debt. Congress refused to increase the debt ceiling, and since our debt payments were higher than the incoming tax revenue, that would have created a default (the US needs to constantly borrow more money to afford the interest payments on our debt...hopefully economic growth fixes this....but probably not). In the US, the Treasury and Congress are outside the central bank system...so if the central bank decides not to print, and congress does not vote to increase the debt ceiling, then the Treasury might actually default (credit risk). Congress did eventually raise the debt ceiling...but this is an ongoing battle in US politics.

So, don't forget Argentina...has defaulted in the past...had been printing currency creating hyper inflation...and now has raised interest rates to 40% to combat that inflation.

Argentina is a sovereign. Argentina has credit risk.

This convo is a little skewed, because there are 2 interest rates to think about, and most people forget about that.

1) short term, usually overnight or 1-2 week rates (set by the central bank) and is more a play on the currency that credit risk.
2) long bond rates, (usually 10yr-30yr...but nobody would lend to Argentina after their last default, so they borrowed US Dollars from the IMF at a 100 year term).

Long rates are determined by external market supply/demand forces, based on a combo of future inflation expectations, combined with credit risk of default.

Argentina currently has 12-15% peso inflation (officially)...the currency weakened as a result of this, and short rates soared as the central bank tried to stop a run on its currency. Argentina 100yr IMF bond has a current yield around 8%

Some countries are unable to borrow money from external investors outside the country in their own local currency, like Argentina, because the world highly suspects that they will just default again, or print local currency to repay those debts, thus creating hyper inflation and reducing the value of the debt below acceptable levels.

So, Argentina is a good example for this thread. They can try to issue 10yr bonds in Pesos, but nobody outside Argenina is will to convert large sums of USD into Pesos to buy those bonds...because the world assumes that Argentina in incapable of financial responsibility. So, since nobody will convert USD to lend Argentina Pesos, they are forced to borrow in an external currency (US Dollars). The only way to pay back the dollars is to gain foreign investment, or export goods to the rest of the world (which are good things). Otherwise, they will default on that debt, because Argentina does not have a supply of US dollars.

The only way Argentina has 15% inflation is because the govt and central bank allows it to happen, by printing currency. The govt needs to pay its bills (local salaries, goods, etc..)...and if it doesn't have the tax revenue, then they just print it (increasing ccy supply, thus devaluing the currency...which is why no foreign investors are willing to lock up their USD assets in Argentinian Peso debt). So, this is an example of both inflation risk (Argentinian Pesos) and credit risk (US Dollar based Argentina bonds).

Since Argentina can't print US Dollars to repay their USD debts, they can't inflate their way out of a financial crisis (which Italy is trying to do right now btw)...this is credit risk...when you cannot print the currency in which your debt is denominated.

US Municipalities cannot print USD, so they also have default credit risk. Yes, they have the power to tax, which is how they get revenue...but if the population flees, or has no assets, or is unwilling to pay taxes (Chicago, Detroit), then there is nobody to tax, and that is how municipalities default on their debts in the US.

just google it...you're welcome

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Jun 6, 2018

I don't disagree with anything you're saying except for the obviously, demonstrably, provably wrong statement that countries that can print the currency in which their debt is denominated have no credit risk. This is obviously wrong. Countries can print currency to pay for debt until they choose not to--until they choose default over more inflation.

I genuinely cannot believe I've spent so much time the last several days stating obvious truths.

Jun 6, 2018

Well it's just the wrong metric used to look at sovereign debt for a currency issuer. Technically they can default but inflation risks always comes first. It's why a country like japan debt-gdp is a meaningless metric. Sovereign debt at its core is tightly related to monetary policy and another tool governments use to control inflation. A countries sensitivity to inflation risks is the dominating factor.

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Jun 6, 2018
traderlife:

Well it's just the wrong metric used to look at sovereign debt for a currency issuer. Technically they can default but inflation risks always comes first. It's why a country like japan debt-gdp is a meaningless metric. Sovereign debt at its core is tightly related to monetary policy and another tool governments use to control inflation. A countries sensitivity to inflation risks is the dominating factor.

Why can't you just admit that you were wrong to say that credit risk doesn't exist in sovereign debt? It obviously does exist. I've showed it to you time and again that it exists. Even the USA has a debt ceiling law--as pointed out--that puts it in danger of default. Basically, your model holds true except for all of the exceptions.

Jun 6, 2018

Debt ceiling is stupid and doesn't involve a credit risks. It's not like they won't pay the money back.

If sovereign debt reaches a point where it becomes a credit risks you've already lost 90% on inflation.

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Jun 8, 2018

has a country that can print its own currency ever defaulted on their debt denominated in their local ccy?

just google it...you're welcome

Jun 5, 2018
traderlife:

The fed or ebc can not suppress interest rates. If they did it would cause massive inflation and you would see high inflation with low real yields.

If they suppressed interest rates it's by putting too much money in the system which would lead to inflation.

Fed policy has actually boosted interest rates.

I'm open-minded to this position because I've never really thought about it, but I've literally never read anyone--anywhere--who has argued that the Fed lowering their interest rate targets actually boosts interest rates. If that's the case, then it's news to everyone.

If what you're saying is that the Fed doesn't really control interest rates, then there's truth to that that most people would acknowledge, including the Fed, which is why they call it rate targets--ultimately, the market does set interest rates.

Jun 5, 2018

The fed controls interest rates, but it's data dependent. It has such a large and powerful position it could raise rates if it wanted to

Jun 5, 2018

It's fairly well known.

They can move short rates. Rates outside of the shortest term are a product of how monetary policy is effecting long term nominal growth rates

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Jun 5, 2018

Most things in monetary policy are opposite immediate logic. Ideas like these are well backed by Friedman and Chicago guys.low rates are a sign of tight monetary policy. It makes sense when you think about whether the fed could keep rates at zero in a booming economy. The demand to borrow would be extremely high to borrow at zero and invest in high growth. The demand for money would force the fed to abandon low rates.

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Jun 3, 2018

I think it's important to be humble and acknowledge the unknowable. It's as simple as Dalios economic machine model and then just testing the waters as you move in it. At this point in the cycle don't be too aggressive and acknowledge that this time isn't different it's just elongated due to the central bank activity

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Jun 4, 2018

Dalio & Howard Marks "The Most Important Thing Illuminated" are good reads right now!

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Jun 5, 2018

Dalio work only applies to a gold standard. It doesn't work anymore the way he describes things now.

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Jun 5, 2018

Dalio published his model after the gold standard broke... what are you even saying

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Jun 5, 2018

It still has assumptions that are similar if you really understand the monetary policy.

More towards the ability of the fed having unlimited fire power to prevent deflation, control inflation, escape the credit cycle.

Gold standard just ties in because it was a limiting factor

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Jun 4, 2018

This is so far outside my paygrade / competency to address the question properly, but I did get a good nugget from one of our institutional LPs who had Yellen as a lunch speaker that I think is worth sharing here. She shared her belief that the 10 year UST will top out at 3.4% and that she is not seeing any real signs that would cause a recession. She thinks unemployment will tick down to low 3s and that when a recession comes, unemployment may tick up to mid 4s given structural considerations in the economy today.

Not endorsing that view, but an interesting and well informed opinion.

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Jun 5, 2018

I find Yellen's commentary interesting. On the one hand, she's an insider and may have the right information, but on the other hand she's out as a result of the new administration and their opinions may diverge. The 10yr is currently 2.90+ and they are projecting a minimum of 2 more rates increases this year plus another 2-3 next year. So, she must think something between now and then will happen to keep rates down. Maybe the ramp up in QE will have an effect?

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Jun 5, 2018

Totally agree, but I have no idea what is driving her beliefs. I guess my layman's view is that she knows a shit load more than me, and if I knew what the 10yr was going to do I wouldn't be doing this shit.

Jun 5, 2018

She thinks the rate hikes will cool off the economy and limit the need for more rate hikes.

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Jun 4, 2018

just google it...you're welcome

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Jun 5, 2018
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