What will rising rates cause?

I get asked almost every week what will happen when rates finally rise.

This is something that most people think they kind of understand, but almost nobody has actually thought through.

The correct answer is that it depends why the rates are going up. Rates, you see, are pretty much always a dependent variable. They do not simply rise randomly and cause chaos in the world. Now, that doesn’t mean they are predictable, since the factors that affect them may not be predictable.

For example, if rates rise because the economy keeps doing wonderfully, unemployment is minuscule, wages are rising, and inflation is at 3%, then I’d guess you’d look at the correlation between rates and the market, and say what a good thing rising rates are, both lines are up and to the right.

However, as we said before, interest rates are essentially a dependent variable. People get confused about this because the Fed can change a couple of rates (either by setting them directly or with open market operations), but working ideally, the Fed isn’t making those decisions in a vacuum.

If we looked at two worlds going forward, one where rates slowly march up as the economy does well and inflation grows, and one where the Fed decides that “just because” we’re going to raise rates by 3%, you can be pretty confident the stock market and economy are going to react relatively poorly to the 3% raise (think taper tantrum), and that the ‘steady as she goes’ timeline is the better one to live in.

Remember, the next time someone asks you what will happen when rates rise, the smart answer is always “that depends on what is causing the rates to rise.”

Goals vs. Systems & Wanting It

People often get confused between goals and systems. If you have goals, you read about how what you really need to get where you want to go is a system. If you have a system, you read about how what you really need are some specific, measurable goals.

The trick that nobody talks about is that what you actually need is both. Setting specific goals that you can check off and feel accomplished by completing is important, and once you have the goal, you have to build a plan to get there, that’s the system.

The piece that people get wrong is when they set the goal, it may be measurable, specific, etc., but it isn’t what they actually want. Setting a goal to run a certain amount of miles in a certain time or make a certain amount of money might sound like what you want, but lots of times it isn’t. And if your goal isn’t really what you want to do, you aren’t going to stick with the system.

In my experience, when it comes to goals (and excellence in general), there are four kinds of people. Those who do ‘it’, those who want ‘it’, those who want to want ‘it’, and everybody else. Surrounding yourself with people who know what they want and then just do what it takes to get there is the ideal. But those people are rare. People who want it can, with the right tools and resources, become people who do it. The most dangerous group isn’t everybody else, they are obviously not who you want to be with. The most dangerous group is those who want to want it. It can be easy to confuse them with people who actually want it — for years at a time. But they don’t want it, they might think they are supposed to want it, and trap themselves into pretending they want it until their whole self-image is as somebody who wants it.

Serial Correlation: Patriots Win

The Patriots (that’s my team) beat the Falcons, Tom Brady is the GOAT, Bill Belichick is the GOAT.

How could this have happened?

ESPN’s model had the Patriots as having 0.3% chance of winning at one point, at <1% at more than 20 points.

However, ESPN’s model and many others aren’t properly factoring in serial correlation. Or at least I doubt it, I don’t actually know the inner workings of the model, other than that they use other games in similar situations to project the results.

Serial correlation is essentially the momentum effect. The application in football is thus: it’s unusual for equally matched teams to be separated by a lot of points early in a game, but because it’s a high variance sport, that can happen whether the teams are equally matched or whether one team or the other is superior.

Once one of the teams begins a comeback, if they are actually better than their opponent, they’ll be much more likely than statistics based on other similar games would show to finish the comeback. And there’s a snowball effect, if a team comes back from down 10, they’re likely to be better than their opponent, so more likely to be able to come back from down 14.

That’s because all of the actions the Patriots had to take to come back are related to each other, they’re all team A vs team B, but a sample of similar games played by various teams is going to include more closely matched teams or outmatched teams. But once team A has come back vs team B, it’s more likely that team A is actually beating team B, and will continue to do so. The probabilities have fat tails.

Anatomy of Missing the Point

The entire election and what appears to be at least the next four years have/will be dominated by the same two halves of the country talking past each other in a way that neither of them quite understand.

Let’s use a hypothetical to illustrate the point.

Let’s say the POTUS, a Democrat, were to make a statement comparing the United States to a steaming pile of shit, and assume for the sake of argument, we all agree that’s pejorative.

Now, that President’s detractors, Republicans, are going to say, “whoa whoa whoa, that is simply un-American, and perhaps not true”. Democrats support their leader and point out that while it might be hyperbole, there are certainly things that could be better.

Now the next POTUS, a Republican, makes a statement comparing the United States to Russia, and assume for the sake of argument, we all agree that’s pejorative.

It might not seem like it, but the conditions are in place for a total meltdown of the brains of both sides.

Now the Democrats say, “whoa whoa whoa, you told us that was un-American! Also, that’s un-American!”. The Republicans respond, “It wasn’t so un-American last time, it was an accurate representation of the facts, you have changed your mind to suit the narrative”.

Both sides have now made both arguments, but more importantly, they’re now making the argument that the other side has played both sides of the coin and is either a) now wrong or b) inconsistent and therefore idiotic/puppets of their party. Neither side considers door c) which is of course that the other party is now correct and was incorrect before (and that their idiocy isn’t an unforgivable sin which makes them wrong even when they are right).

We are now stuck in a loop. Welcome to the next four years.

Confirmation Bias

No, the stock market is not ‘finally taking “X” [insert pet cause] seriously’ when there are back to back down days.

Not very many things move the market, and when they do, they almost always move it fast. If your inclination when seeing the market go down 1% is to shout from the rooftops that at last your worldview is vindicated because the markets agree with you, keep in mind there is a 95% chance the market couldn’t care less about whatever you think the problem of the day is.

The market goes up and down — many times for no discernible reason.

 

Consumption Smoothing

WCI touched on consumption smoothing in a recent post. This is one area where classical economics and real life observation (and behavioral economics) differ greatly.

Consumption smoothing is the act of consuming a more equal amount over your lifetime than just a percent of income or some other measure. The textbook says if you expect your earnings from 40 years old and on to be $1,000,000+ each year, but only $30,000 before that, you should borrow and spend as much as you can get your hands on in your 20s and 30s because you’re probably going to die sleeping on a fat pile of money anyway, so there is no reason to share the kitchen with cockroaches even when you are young and poor.

However, nobody knows the future, and as soon as we start looking even 5 years out, there are so many unknowns that from a stress minimizing perspective, any appreciable attempt to smooth consumption would, at least for me personally, be totally counter productive.

There is also a (puritanical?) values system that suggests living young and lean so that later you can be comfortable and use the optionality you’ve created. This is as opposed to consumption smoothing from the beginning, and getting yourself to a place of negative optionality because you’ve accumulated debt which you have to pay off, limited your future possibilities.

Now, don’t get me wrong, there is certainly some place for consumption smoothing, but as the original link says, moderation is key. When I moved to California after school, I was paying more than 50% of my take-home pay on rent and saving very little at all. This is definitely consumption smoothing in action, as my expenses have increased much more slowly than my (expected and actual) wages since then. However, I’m still early in my career, and classic consumption smoothing models should still have me saving very little, yet that is not my preference.

I’m not sure exactly why not, and haven’t come across (though I expect it exists) a model that describes my utility curve. Something about a very low/negative discount rate on future spending, a desire for optionality early on, and a high aversion to debt.

Jack’s Links

This week, a few links about Trump that won’t cause you to claw your eyes out because of the terrible journalism.

  • Scott Sumner on Trump the mailman: Scott’s main points that Trump doesn’t drive the economy or the stock market, and that he shouldn’t get credit or blame for either, and that a person can be good-neutral for the market and a terrible person are all well made.

The vast majority of my commenters do not know how to read for content; they indulge in mood affiliation.  “Sumner said Trump was horrible, so if Trump does something good, or if stocks rise, then Sumner was wrong.”

In the social media age, observers tend to equate silence with approval, or at least disinterest.  At least in my case, you shouldn’t.  By default, please assume I think all of Trump’s immigration policies are terrible.

Another reason for promoting lying is what economists sometimes call loyalty filters. If you want to ascertain if someone is truly loyal to you, ask them to do something outrageous or stupid. If they balk, then you know right away they aren’t fully with you. That too is a sign of incipient mistrust within the ruling clique, and it is part of the same worldview that leads Trump to rely so heavily on family members.

Trump specializes in lower-status lies, typically more of the bald-faced sort, namely stating “x” when obviously “not x” is the case. They are proclamations of power, and signals that the opinions of mainstream media and political opponents will be disregarded.