RISKS vs. Rewards:
False Signals in the Financial Markets Means Turbulence
Never in my life did I think that I would feel a sense of joy at the announcement by the Love of My Life that she was now able to obtain toilet paper as a part of her grocery order. Later I realized that it was because her announcement removed a sense of uncertainty from my life. Now if I can just get my hair cut, life may approach a new resemblance of “normal” especially when I ditch the miserable mask. Uncertainty is not desirable.
Capitalism does a fantastic job of allocating resources using signals including the cost of producing a good or service with its price determined by supply versus demand. But in order to function correctly, capitalism is dependent on functioning financial markets to accurately price risk and the cost of money. In a completely functional financial market, the interest rates on the various Treasury notes and bonds represent the “Risk Free” cost of money. All other rates of return are built off the appropriate Treasury interest rates.
A simple example is mortgage interest rates. Normally, the interest rate for a 30-year fixed rate mortgage is 1.5% – 2.0% higher than the 10-year Treasury interest rate. The 10 year is used because the average home loan is paid off after 7 years because the homeowners sell the home for some reason (larger home, relocation, etc.).
Since mortgage rates are the greatest determinate of home sales which affect about 30% of the USA economy, The Fed has been manipulating mortgage rates since 2008. When it started Quantitative Easing (QE) in 2011, The Fed bought both 10-year Treasuries and mortgage loans in order to drive mortgage rates DOWN so the housing market would RISE. As a result of QE, The Fed’s Balance Sheet increased from $900 Billion to $4.5 Trillion or 500%.
You may recall that in 2018 The Fed began to reduce its Balance Sheet down to $3.8 Trillion which indirectly caused interest rates to increase. But they made the mistake of also raising interest rates directly. The combination was too much too soon. Their mistake was reflected in the new home market which in the first half of 2018 was on its way to a great year. By midyear 2018 interest rates were so high they negatively affected the new home market which ended the year struggling to get back to the volume level of 2017. Economic growth in the USA slowed.
Why is this history important? Because it frames the impact of The Fed’s response to the Wuhan Virus by announcing QE that will expand their Balance Sheet by as much as an additional $6 Trillion. That means $10+ Trillion of Treasuries owned by The Fed in a total $24 Trillion Treasury market. The Fed is not just distorting the Treasury market, it IS becoming the Treasury market. Goodbye capitalistic market signals, danger ahead.
To the average observer, the current stock market seems to suggest recovery is at hand. Call me a Doubting Thomas. I believe the stock market is currently trading on massive stimulus from The Fed and Congress along with hopes and aspirations, not the numbers the quants crave and their algorithms depend on. The recent stock market rebound looks to me like a “Dead Cat Bounce”.
I am not licensed to advise folks on the stock market. But the formula the stock market quants rely on to price stock is based on the performance numbers of publicly traded companies not on hope and aspiration. Those performance numbers for the second quarter (April – June) will bring a new definition to the word “ugly”. When they get reported in July…well brace yourself as reality will get discounted by the stock market. That risk is real.
Meanwhile, the bond market is reflecting a combination of the influence of The Fed QE, investors fleeing the European markets, and unemployment in the USA exceeding 20%. The commodity markets are in turmoil for a combination of factors.
There is a strong correlation between the financial markets, the general economy, and the land market. In a normal, functioning financial market the interest rates are set and assets allocated because the return on investments needs to exceed the cost of funds. In this distorted market, those signals are artificial and subject to abrupt change meaning what appears to be low risk is actually high risk. We are in an “Alice in Wonderland” financial world.
The good news is the land market is continuing to function. But the numerous ripple effects coursing through the economy and attendant cross currents are simply not discernible at this moment. They will unfold over the next 12 – 24 months. Do not be lulled to sleep. This financial crisis is huge and we will only know the complete answers somewhere in the future.
Today may feel more “normal” than a few weeks ago. That is the effect of the amazing amount of economic stimuli that is flowing into the USA economy. But just because there is now a supply of toilet paper in the stores does not mean the economy is functioning in a “normal” manner. It simply means that one facet of uncertainty has been removed. There are many more.
In life there are only four constants – death, taxes, change, and my Lord and Savior. In the middle of the dramatic changes that are occurring and coming –
“May the God of hope fill you with all joy and peace in believing, so that you may abound in hope by the power of the Holy Spirit.”
(Romans 15:14, New Revised Standard Version, Oxford University Press)
I serve an awesome God. God plus one human makes a super majority.
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