The Three Horse Economy – Week 3

Horse #2 – The Fed:

The Federal Reserve of the United States announced in May of 2014 that they were going to begin tapering their Quantitative Easing (QE). That announcement had a negative impact on the American and world economies as all commodities plummeted by at least 50%. To date, none of them have recovered to the prices in May of 2014.

Rarely reported, when the Federal Reserve reduced its QE, the European Central Bank and the Bank of Japan increased their QE by a comparable amount. Therefore, the global QE remained the same.

Now the Fed has begun to allow their assets bought during the QE to be paid off. This means that the Balance Sheet of the Fed is beginning to decline. While long-term a positive, it brings with it a short-term negative in that the amount of liquidity in circulation is decreasing.

The ECB has announced that they are going to begin reducing their QE in September of this year. That will also cause a reduction in liquidity in the global economy.

The result of a reduction of liquidity is higher interest rates. Increasing interest rates are a negative impact on the American economy. The easiest market to understand the negative impact is in residential sales. Most home buyers have a budget in which they need to stay. As mortgage interest rates increase, the number of buyers that can afford a home decreases which reduces the number of home sales.

A similar impact occurs in the commercial market as higher interest rates drive up the capitalization rate (cap rate) that investors use to determine their opinion of value. As the cap rate goes up, the value of an income-producing property goes down.

Therefore, a reduction in liquidity means higher interest rates, which means lower real estate values and a slower economy. The question is whether the growing economy and resulting increasing wages will enable borrowers to qualify to borrow more money faster than the higher mortgage rates will chase those potential buyers out of the marketplace.

It is critical to remember that land is the source of all wealth. Every product that we humans consume originates with land. Not all tracts of land are equal in quality and portfolio management requires every investor to hold some cash for liquidity. But historically, long term the best investment is land.