3065 Rosecrans Place #203
San Diego, CA 92110
None of the Following is investment advice. In fact, everything herein is purely speculation and should not be relied upon. Also, this is a rather quick memo without too much jargon or numbers.
Why does the Federal Reserve (“the Fed”) need to raise interest rates? Why does it need to reduce liquidity in the economy? What is stopping the Fed from “pivoting” like it has done so many times in the past?
These might seem to have obvious answers, but I believe the true answers are not obvious. If you answered that the Fed needs to curb inflation, I doubt that is the most correct motive. In this memo, I discuss a possibly more correct motive for the Fed’s aggressive actions. Importantly, there is no precedent whatsoever for quantitative tightening, but there certainly is precedent for quantitative easing and lowering rates. This fact is most important, I believe, in our discovery of the true motive, with specific years in mind, such as 2000, 2008, 2019, and 2020. The answer to these questions should provoke thought that will allow us to make better investing decisions in the future. Keep in mind that the US economy itself is stagnating while the Fed is confronted with these challenges.
First of all, the following is the top search result from Google.com for “Why does the Federal Reserve raise interest rates.”
“So, the Fed is seeking to bring demand back in line with supply. By raising interest rates, the Fed hopes to rein in consumption and borrowing, which in turn should put downward pressure on prices.”
I see this answer being impossibly nebulous. Where is demand and where is supply today? Where are we bringing them to? How can the Fed do anything about either one? And if it can’t, why would it risk destroying a significant number of businesses and careers?
While the Fed was engaged in Quantitative Easing (1999 to March 2022), American home prices increased almost 4 times (on average), Bitcoin went from a few cents to $65,000, the Nasdaq increased 8 times, etc. First, those rates of return don’t seem normal. Second, I could ask you how much of those price gains were derived from the Fed, but the truer question is: why did the Fed do nothing until now? Why is it now that the Fed must quell inflation even though assets were inflating extremely quickly for over 2 decades?
My guess is that 2008 is happening all over again, but this time in reverse. In 2008, banks owned tens of billions in risky debts that were all at risk of blowing up. When the default rate of the underlying loans hit above 6%, two things happened.
Today, the government owns trillions of those same bonds, and with default levels currently rising, the government seems to be looking for the same bailout that it gave the banks. Will foreign countries purchase those debts? Auctions are not showing dramatically good results for the Fed. According to thestreet.com, “foreign buyers, the data indicated, took down around 53% of the [September 2-year treasury auction], down from the 66.1% figure reported in August, suggesting overseas buyers are seeing attractive yields in other markets as central banks around the world signal further near-term rate hikes.”
Thus, the Fed might need to raise rates higher still and hope that a country has enough liquidity to afford trillions of dollars in debts. Quite a tall order given that most countries have their own problems, including what appears to be a significantly underestimated war in the East. The parallels of hundreds of countries racing to sell these risky debts and the banks of 2008 racing to sell are striking. Enjoy this clip showing what the 2008 fire sale looks like in real time.
Reiterating the point, the dollar is at risk if the US experiences too many bankruptcies. Early in my career, I deduced that the US Dollar is like the stock price of the USA. You might say quantitative tightening is like a stock buyback, with the stock being the US Dollar. So, like banks with failing stock prices in 2008 trying to offload risky debts, the Fed seems to be nervous about its own balance sheet, trying to offload risky debts to support the dollar. If the Fed does raise rates significantly, but is still unable to offload enough debt, the dollar will ultimately own the losses. This is a main ingredient of long term inflation.
While the dollar is on a rampage right now (Charts show USD near 20 year highs), none of us can know if the Fed has sold enough risky debts, or if rates are high enough to entice people to buy treasury securities, which house those debts. If the treasury rate isn’t high enough, the government and the Dollar will absorb any bankruptcies in the debt and the government will book a net loss on such investments.
Ironically, banks are in good shape right now. Instead of having the government’s trillions of dollars in risky debts, banks have trillions of dollars of liquidity, a perfect mirror of 2008. More below. While treasuries pay 4.5% on a 2 year note, a 5 year CD at private banks, on average, is about 0.55%, according to this chart of historical CD rates. This discrepancy in rates proves that banks don’t need any liquidity, while the Fed seems desperate to sell its debts.
“Fed Pivot” is defined by Investopedia as a reverse of policy from tight to loose or from loose to tight. The terms “loose” and “tight” are empirical, of course. In 2022, pundits like Barrons Magazine believe a Fed Pivot won’t occur because inflation is high. This is a symptom, and not the cause. A Fed Pivot from here would be akin to banks in 2008 buying more toxic debts to continue driving up there prices, even though the chance of those debts being worth nothing is significant.
A Fed Pivot today would probably have the same effect as the Fed Pivots of the past – a mindless pump of asset prices. In 2019, I was very sour on economic fundamentals. In March 2020, I saw what we are going through right now happening. Instead, the Fed pumped up asset prices even higher, for no real reason. To say that the Fed made mistakes in 2021 and 2022 is nearsighted – fact is that we didn’t need the pump in 2020. The Fed continued buying the riskiest bonds the economy had to offer, and now they are having a fire sale of all of those bonds.
Unlike 2008, there are no ways for analysts to determine what constitutes the risky debts the Fed purchased over the past 20 years. Prospectuses for 2008’s debt vintage were and still are available for analysis. What exactly is in the 2 year treasury security grab bag? Will it ultimately yield more or less than 4.5%? God only knows, and for that reason, there’s very little to do with bonds right now. If you cannot know whether, in the next 12 months, bond yields will be at 2% or at 8%, why would you make a decision at 4.5%? This is perhaps why cash yields at banks are still rather paltry: many investors are staying on the sidelines.
For 20 years, we have believed that government debt didn’t matter. Total public debt outstanding has reached at or above $30 Trillion this year, with no end in sight. Meanwhile, In the year 2001, as opposed to today, the government ran a surplus, whereas it sported a $2.77 Trillion deficit in 2021, the largest such deficit in history. In light of these figures, and rapidly rising treasury yields, we should show concern for what constitutes that debt and who will pay the price. But we haven’t addressed these issues as a public society (that I’m aware of) because after all, does anyone truly have a grasp on how big those numbers are? This head-in-the-sand strategy made a lot of sense in retrospect. But now, that debt looks like all those subprime loans of 2008. Many people say today that there are no subprime loans like in 2008. Could it be that the US government is housing all the highest risk debt that the banks sold them?
Of course, US banks are doing fine. Banks will struggle along with everyone else, but on the other side of the massive Quantitative Easing for 20 years were the banks packaging debt to get off their books…. At par. In cash. Trillions in cash. And today, banks are paying 0.5% on deposits and lending at over 5%. In an ideal world, the banks, who seemingly have all the cash in the economy (JP Morgan alone has over $1 Trillion), could use that cash to buy government debt. In an ideal world, banks would provide rates for mortgages at just over the cost of the money. The cost of the money itself is the deposit rate at the given bank (i.e. 0.5%), but the argument could be made that a slowdown would force the bank to raise rates on new loans. The point is that banks have the cash to lend and the government doesn’t. Therefore, banks seem to be the giant winner of the Quantitative Easing experiment.
Businesses aren’t helping the situation either. Losses in businesses, like losses on treasuries, affect the representative prices (i.e. stock prices). For 20 years, with the government financing those losses by purchasing almost any bond in the system, businesses had an easy out. The government is now selling bonds at prices that last year would have been very high yield, and banks are now “Going Conservative“.
While inflation could roll on near 40 year highs, businesses will probably fare even worse than the Fed, without the ability to finance losses with new debt or refinances. If the government can’t sell debt, how can a money-losing business? Shareholders themselves will be responsible for, but will ultimately sell the business interests. Even cash flow positive businesses are yielding roughly 4% in aggregate at these levels. Those yields, given a constant stock price, are likely to erode further with deteriorating business conditions. Inflation is likely to remain elevated along with US treasury rates.
One thought regarding the lowest rung on the ladder: the consumer. Higher prices without higher wages or the ability to generate investment returns safely. Pretty much sums up where we are.
To conclude, taking the 2 year rate from 0.76% to 4.51% looks to me like a fire sale. Had such a bond traded like that in the business world, without provocation otherwise, we would call it a fire sale. Inflation seems to be a symptom of a larger problem, which is that the government is sitting on a massive bomb of bankruptcies. Were those assets very safe, there would be a lower yield and higher price of treasuries, as has been the case until this year. Inflation might appear to have come out of nowhere, but I think it was always lurking, waiting for governments to stop stepping in to mindlessly buy the worrisome financial assets.
So when you hear “[insert country]’s Central Bank is raising rates”, it probably means governments are trying to right-price their treasury securities, because they too can’t use new debt to fund budget deficits like they used to. Governments all over might be stuck with worthless debts, which could lead to problems I won’t begin to describe (including government shutdowns). Clearly, banks are the winners of the last 20 years – they are the only ones with net cash positions.
Last but certainly not least, I make no attempts to determine the direction of interest rates or the balances of private and public debts in America. The Fed has pivoted many times in the past 20 years, and each time was just as unlikely as today. A pivot would likely cause treasury yields to temporarily drop, even if the composition of the treasuries themselves are relatively questionable. The levels of uncertain behind all of these questions are immense, and should not be underestimated.
3065 Rosecrans Place #203
San Diego, CA 92110