Riksbank’s governor Stefan Ingves likened the balancing act of Sweden’s monetary policy to “sitting on top of a volcano.”
There is no doubt by now that the housing shortage is morphing into a full-fledged housing bubble due to easy credit and buyers in a rush to close deals. Anecdotally, a friend of mine recently told me that “it is better to buy now, not next year,” because “what if prices continue to go up?” The first step to getting to a healthier place is to recognize the problem. Buyers are not.
Neither are central banks. They keep repeating that inflation is due to a supply shortage and is transitory, but it has been with us for months, accelerating, and outshot their target by a factor close to three. And they keep buying mortgage-backed securities (MBSs), adding fuel to fire in the housing market. They seem to be prisoners of their own promises. They want to give certainty by being predictable, and thus they can’t change policy quickly because that would introduce uncertainty. However, by not adjusting policy with changing economic conditions, the policy becomes mismatched. Current monetary policy was appropriate in the depths of the pandemic, but it is no longer now. This line of action creates a whole host of other problems, not least their conviction that, if inflation were to become a real, endemic issue, they would have the tools to fight it. True, but imagine the market reaction if they are forced to slam on the breaks of credit creation. Imagine the damage on the balance sheets across the board, from individuals to corporations and governments.
We don’t have more time to pontificate on such macro issues—I tend to think, as any other value investor, that they are largely unknowable and speculative in nature—and whether or not they’re right. The effect is knowable and tangible. Not only is CPI reaching 6% in the U.S. and edging higher across the globe, but also housing is getting unaffordable in many markets. Without a correction, the vast majority of people will spend more on housing and other essential items, and less money on activities for long-term value creation, than ever before. The risk is that less money will be invested, which will affect productivity and impact the long-term growth of the economy on a structural basis.
Based on the choices of the last few decades, I believe that central banks will try to “solve” the problem by tripling down on their current policies—the same ones that allowed irresponsible governments and other parties to accumulate mountains of debt. They will keep pushing on a string—keeping rates low, buying assets, and exacerbating an already historically high wealth inequality to unprecedented levels unless they U-turn.
The big problem—and opportunity for the cautious ones—is that rates are already negative in real terms almost everywhere in the developed world and debt is already high compared to historical standards. I don’t want to delve into a debate on the sustainability of the current trajectory—it boils down to short-term vs long-term sustainability as well as sustainability for whom. What I care more about are the second-order consequences.
My viewpoint is that debt plus low rates make the entire financial system fragile. In the present context, I’m using the word fragile as the opposite of robust. In physics and engineering, a robust system is, roughly speaking, one whose output is slowly and smoothly affected by the change of its inputs. If a small change—a “delta”—in the input implies a big change in the output, the system is not robust. Imagine driving a car whose steering wheel’s sensitivity is exponential in the steering angle and you get an idea of a system that is not robust.
Financial markets are, at this point, vulnerable to a rapidly cascading situation if something goes wrong. The catch with every crisis is that nobody sees where it comes from until after the fact—in hindsight, it becomes “obvious.” But we can clearly observe that the playing ground is getting riskier by the month. The conditions for a significant correction—a fast one—are all here.
Why is it so? Imagine assets as systems with inputs and outputs. One of the inputs is the interest rate. One of the outputs is the cash flow.
Suppose that the cash flow is $100 per year until “judgment day,” as Warren Buffett would call it. At a 5% interest rate, the asset fair value computed by discounting future cash flows is $2,000. The fair value with the same cash flow discounted at 6% is about $1,666. The impact of changing the interest rate by 1% is, therefore, relatively modest—a 15% depreciation.
What happens when interest rates are low and they change by the same 1%? Suppose that the interest rate is 3%, near today’s 30-year U.S. bonds. The fair value becomes $3,333—this is the “wealth effect” or the magic of lowering interest rates. If interest rates rise by 1%, the cash flow is worth $2,500. The impact of changing the interest rate by 1% is now more severe—a 25% depreciation. Changing the input by the same delta equal to 1% implies a 10% delta in output—25% instead of 15%.
This is what one could expect with U.S. rates—the highest in the developed world. If we repeat it with European rates, the situation is likely to be worse. This is exactly why they can’t change course—with all the social consequences that it entails.
Suppose now that there’s a market accident. The problem of a huge debt, and thus huge leverage, is that there’s no one out there with enough money to catch the knife. In other words, when the sell-off starts, it will be precipitous. The spasms of the market will become as violent as ever before.
At this point, no one should be surprised that market accidents do occur now and then, and it’s impossible to forecast them. Covid is a prime example of a black-swan event that nobody would have predicted in 2019. But there’s also the possibility that a sell-off is triggered by central banks themselves if they were to taper or even hike for whatever reason. “The Lady isn’t tapering,” said Mrs. Lagarde, but also Mr. Powell told us in 2018 that what they were embarking on was not the fourth round of QE. To the inexperienced eye—mine—it was. In other words, I apply the cybernetic principle, “a system is what it does,” and don’t focus on what they say, rather I focus on what they do. After all, Japan’s bubble burst when the Bank of Japan hiked.
The solution is already tried and tested by the Japanese: Central banks can create enough money to catch the knife by directly buying equities. But how fast, how much, and with what side effects are open questions.
The opportunity lies ahead for all those of us who are playing it safe now and stashing cash to be deployed on rainy days. I suspect that it will rain rocks and lapilli this time, though.
I surely can’t predict when the volcano will erupt, but it’s not wise to build a house on its flank and live in it expecting that, if something were to happen, a helicopter will come to the rescue. The rescue will likely come in force since apparently there are plenty of people living on the flank.
But a Pompeii has already occurred.
Here you can follow my portfolio—facts, not just words.
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