Macro-Finance for ManagersPart I

Highlighting a Few Key Ideas and Issues

Macro World Views:Compressed & Simplified

Demand-Side Shocks & Amplifiers

Consumer Spending (as cause, not effect)

Inflexibility in prices (especially wages) amplify

Macro World Views:Compressed & Simplified

Demand-Side Shocks & Amplifiers Consumer Spending (cause, not effect) Inflexibility in prices (especially wages) as amplifier

Supply-Side Shocks and Amplifiers Tech/Structural Shifts; Oil Price Spikes

Incentive effects as amplifiers

Macro World Views:Compressed & Simplified

Demand-Side Shocks & Amplifiers Consumer Spending (cause, not effect) Inflexibility in prices (especially wages)

Supply-Side Shocks and Amplifers Tech/Structural Shifts; Oil Price Spikes

MacroFinancial Shocks and Amplifers Shocks to Risk Perceptions

▪ Bubbles, Crashes▪ Asset Prices, Debt Growth, FX

Risk Perception Drives Asset Prices and Likely Many Macro Changes

1970s Thinking: All About The Numerator Finance: Expected earnings (numerator) drives asset prices, P/E

ratios Macro: Expected earnings, expected income same thing, so whatever

driving changes in incomes, driving changes in asset prices

2000s Thinking: All About The Denominator▪ Finance: Perception of risk (denominator) drives asset prices, P/E

ratios▪ Very High P/E = current risk assessment overly optimistic▪ Very Low P/E = current risk assessment overly pessimistic▪ Macro: Consumer spending too?

Shiller Data:PE Ratios and SP500-GDP Ratio

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.35

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SP500/GDP (left scale)

SP500/Earnings (right scale)

Crash of 2008:Debt/GDP Explosion of 2000s

Managers and Market Risk

Using Market Information to Gauge Market Risk

Composite Indexes from STL Fed and KC Fed:Indexes Based on Spreads

Rate Spreads

Natural Experiments Think “Twin Studies”

Rate Spreads

Natural Experiments Think “Twin Studies” Example: LIBOR, Fed Funds, TBills

▪ Very short term loans between (usually) reliable parties

▪ Normally, rates within small fractions of 1 percent

▪ Unusual differences implies something amiss in important short term lending markets

Rate Spreads

Natural Experiments Think “Twin Studies” Example: LIBOR, Fed Funds, TBills

▪ Very short term loans between (usually) reliable parties

▪ Normally, rates within small fractions of 1 percent

▪ Unusual differences implies something amiss in important short term lending markets

Example: 10 Year Treasury – 3 Month Treasury▪ Both loans to U.S. government▪ Average difference about 1.5%▪ Unusually differences imply something

divergent views near term and longer term

Recession Risk:Treasuries Rate Spreads & Yield Curve

Treasury Spreads & Treasury Yield Curve: Steep: High growth expected Flat/Inverted: Low growth expected Warning: these expectations hinge on

steady inflation expectations

US Treasury Site

Treasury Spreads & Recessions 10 Year – 3 Month

Few False Positives or False Negatives

Recessions in Grey

Financial Stress and Short Term Spreads

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Kuwati Invasion

Asian Debt

07-08

Libor – TBill blue

Commercial Paper – Tbill red :

LIBOR – Tbill (TED) Spread During 2007-08 Crisis

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2006 2007 2008 2009

KC-FSILIBOR-Tbill

Fannie-Freddie

BearStearns

Lehman-AIG

Real Estate Asset Price Risk: Housing Price to Rental Ratio (computing “spread” as ratio rather than a difference)

Inflation Risk:10-Yr Rate – Inflation Indexed (TIPS) 10-Yr Rate

Nominal 10-

Inflation Indexed Rate

Nominal Rate