Rising Rents

There was an interesting article on Business Insider today about the rising cost of rental housing in America. If you rent your home or apartment, or know someone who does, you're well aware of what has happened to rents over the past five years. The article mentions one important factor driving demand, the shift from homeownership to renting following the financial crisis, with 36% of people currently renting versus 31% before the crisis.

This is a very compelling consideration, and raises some important questions about housing policy, the banking sector and the Federal Reserve. What's driving the increased demand for rental housing are several factors, including limited supply and cumbersome local zoning/approval requirements for new development. But also driving rents are the tightened mortgage approval standards of banks for home ownership, following the collapse of the shadow banking market. The shadow banking market (or the market for private label mortgage backed securities) fueled the growth of sub-prime loans, no-doc loans and other inventions of the early 2000s by providing a secondary market for banks to sell these newly originated loans. With this market still largely defunct and in an environment today of weak personal income growth and rising bank lending standards, those seeking new housing are increasingly forced into the rental market.

Now landlords, amidst this growing demand for rental housing are for the large part killing it. They've been able to finance new multi-family or refinance existing developments at historically low interest rates, while enjoying ever escalating rents from tenants. Nice work if you can get it. But this pronounced shift to rental housing once again highlights Fed policy, post recession and it's wealth effect on the average citizen.

Large corporations have been able to reduce borrowing costs dramatically since 2008, now borrowing 10-year debt at interest rates as low as 3.00%.  But small businesses have struggled to access financing for new projects. Owners of homes have been able to refinance their mortgages at generally lower rates, although bank standards have biased approvals to the wealthiest with the best credit in an environment of greater regulation. And let's not forget the wealth effect the Fed has created for the owners of stocks. But bear in mind, as with home refinancing and corporate financing, stocks are very narrowly held (with 80% of stock ownership held by the top 10% of Americans by wealth) thereby shifting this benefits of Fed policy to the wealthiest.

All this raises the very obvious question about who has benefited and who has not from the Fed's six-year policy of zero interest rates and whether it might be time to redress these imbalances that the Fed has created.

Fidelity: 401(k) and IRA Balances Hit Record Highs

Earlier today, CNBC posted a report with the above title on their website.  The article referenced a new report of Fidelity Investments that claimed that 401(k) and IRA balances hit record highs in the first quarter of 2015, with the average balance now standing at $91,800.  Now, the article doesn't exactly identify what constitutes the "average", whether this is intended to be the median balance of accounts at Fidelity or just the simple arithmetic mean.  Either way, it doesn't quite square with other research, including data of the Federal Reserve.

Tracking just how much individuals have saved in IRA and 401k accounts is tricky business, due to the various measures used to report the data.  Many sources, including brokerage firms and mutual fund companies report their data as a simple arithmetic mean: they add up the total balances in all IRA and 401k accounts they manage and divide by the number of people holding those accounts.  Thus, the estimated $102 million that Mitt Romney is believed to hold in his IRA is averaged in with the $15,000 of the average middle class household.  It’s just not a meaningful number.

No slight to Mr. Romney’s contribution to America’s retirement savings, but for the data to be reported in a way that is of any value in understanding the current retirement crisis, the “average” balance needs to be calculated on the basis of the median.  To do this, of course, you simply line up all the account balances at a place like Fidelity from smallest to largest, and find the account in the precise middle by value, with exactly fifty percent of accounts holding greater balances and fifty percent holding lesser.  This would only tell you, of course, what the average balance is of investors who hold accounts at Fidelity (and, therefore, not representative of the average American) but it’s certainly more realistic than reporting an arithmetic mean.

While the median value of retirement assets has risen in recent years, according to recent data of the Federal Reserve Bank the portion of respondents who even owned a retirement account of any sort fell to less than half, continuing a downward trend that began in 2007.  For those who are fortunate enough to have a 401k account, even with recent record gains in stock prices, the median balance of 401k/IRA accounts was just $59,000 at the end of 2013.  At a four percent recommended annual spending rate in retirement, an account of this size would produce (pre-tax) retirement income of less than $200 per month, or less than the average American family spends on groceries each week. 

UST Negative Yields

Sounds crazy, doesn't it? The idea that the US Treasury, or any government could be paid to borrow money is contrary to everything we've learned about finance and the time value of money. Yet, strange as it sounds, there are now 17 countries whose sovereign debt trade at negative yields, including Austria, Belgium, Denmark, Finland, France...well, you get the idea. Even 2-year sovereign debt of the Czech republic traded in negative yields this week.

As of this writing, the German 2-year bond is yielding -0.27%, while the 5-year was at - 0.11%. This means that an investor will accept -0.27% less of his principal investment back each year for the next two years, for the privilege of keeping money parked with the German government . When Swiss yields dropped below zero, everyone rolled their eyes, but reconciled the silliness with the idea that this was Switzerland where wealthy foreign investors, for reasons of safety, have stashed large sums of cash  for generations. Swiss government bond yields are now negative out to ten years.

But yesterday's crossing of Japanese bond yields into negative space, has us really scratching our heads. After all, there as many highly informed, highly educated investors who believe that Japan's fiscal woes are unsolvable, as not. If repayment is in question, then how are investors being compensated for risk?

The question is, what's happened to credit spreads; the idea that each borrower's debt yield "spreads" to some "risk free" rate of interest, based upon credit-worthiness? With US credit ratings previously in question, the risk free rate has more recently shifted to Germany. And with the ECB now buying bonds of european central governments, many of these nations' debts are showing negative yields.

Bill Gross, the legendary bond king came out last week and argued that the German 10-year, currently at 0.16% is the short of a lifetime. Meaning, those investors betting that German yields will rise (and therefore the price will decline) stand to be handsomely rewarded. Far be it for us to disagree with any bond royalty, but in this case maybe not so fast.

What's far more interesting is the credit spread of the 10- UST to German bond, with UST now yielding 1.80% over the Bund (http://www.investing.com/rates-bonds/government-bond-spreads). By the way, if you're looking for something more juicy, take a look at the Brazillian 10-year, now yielding 12.60%. Wasn't it just a few years ago that all the talk was about the BRICs? Now, the Russian 10-year is at 11.20%, India at 7.66% and what did the "C" stand for again?

Getting back to the point. While German 10-year yields may be unsustainable at this level, shorting the Bund is a dangerous proposition. Remember John Maynard Keynes adage, "markets can stay irrational longer than you can stay solvent". The more interesting trade is the US 10-year, now yielding a 25-year high relative to the Bund (ideally, you'd want to short the Bund and go long UST to play this trade, but a simple long position might be worth considering). 

It's also interesting to consider what could cause this credit spread to widen. Negative economic news in the US? While theoretically, bad economic news should widen a spread to the risk free rate, such news would also cause interest rates more generally to decline (due to lower inflation risk) thereby improving the long trade. And good news? This might cause rates to rise, but in a compressed fashion by a tighter spread to the Bund. Thus, the ECB is effectively anchoring the yield of most developed world debt. This all suggests that the most likely scenario is that credit spreads narrow over time, lowering UST yields and boosting prices. Safer to be long the UST 10-year, than short the Bund.

As to the Fed and raising rates, we think the Fed is in a box for quite some time, the subject of a future post.