FWIW #30 Liquidity

FWIW #29 addressed the confusion in the markets and the need for patience. This time we’re going to discuss the most important aspect of financial life: liquidity. The country is leaving a period (1990–2021) when the monetary authorities were controlled by debtors, the largest of which are the political establishment in Washington and their friends and supporters on Wall Street.

To understand where the country is in this migration from debtor-friendly interest rates to creditor-friendly interest rates, it’s important to start with the past.

Paul Volcker focused the Fed’s monetary policy to stop the inflationary cycle of the 1970–79 period. He did this by allowing the market to determine interest rates while he reduced the money supply growth rate. Throughout the 1980s and early 1990s, the Fed maintained disciplined money growth. But this policy changed during Alan Greenspan’s term as Fed chair. The monetary authorities started suppressing interest rates to smooth out the business cycle. How? By allowing for faster growth in the money supply than was needed to sustain the economy. Congress helped by passing tax laws that made it attractive to own real estate. Up until 2008, real estate boomed on the back of these loose fiscal and monetary policies.

What is important for you to understand is that the focus on keeping interest rates below a market rate required the printing of excess money. Along came the Great Recession of 2008–9 and the Fed’s response of further lowering interest rates, which is another way of saying the Fed printed even more unnecessary money and injected it into the economy. Because the economy, which had been brought to its knees, did not respond as rapidly as the political and monetary authorities wanted, the Fed took unprecedented steps to buy treasury bonds, mortgage bonds, and eventually corporate bonds, flooding the economy with even more surplus money. The economy began responding to this almost-free money. Along came Covid-19, and the Fed and political establishment lost any sense of reason or discipline. The political establishment gave trillions of dollars to anyone whose name was in the IRS database. Trillions more went to various ill-thought-out rescue plans. The Fed accommodated this spending by digitally printing money faster and faster to finance the checks. Eventually, everyone had free discretionary money and they began spending it.

Understand that when the Fed creates money, it goes first to banks and then to bank clients who are usually large speculator/debtor government supporters, who use the money to buy assets, pushing up asset prices. Accelerating asset prices started in 2009 and continued gaining momentum with the Fed’s policies to accommodate Covid-19 fiscal spending. Visualize a geyser of money (just like water) pushing up the prices of everything and in particular assets. Now, think about what will happen to prices as that geyser of money loses some of its strength. In other words, as the Fed slows the creation of new money and, at the same time, withdraws some of the money already in the economy (shrinking its balance sheet), demand for goods, services, and assets will fall, and prices will begin coming down. That process has begun. What’s going to happen?

First, interest rates are going up, as we have seen. The Fed’s control of interest rates is still accommodative, still creating more money than needed. If they were to get out of the way, interest rates would quickly move up to a level compensating the creditor for inflation plus a real rate of return. The friends and supporters of the political establishment would feel severe pain if that happened. You can hear today the debtors saying the Fed is moving too fast and going too far. The strong geyser of money supporting the financial markets and the economy is less powerful today than it was last year, and if the Fed follows through as it should, the geyser will continue to grow less powerful as time goes on. What does that mean? It means that asset prices as well as consumer prices will come down. Second, a less powerful geyser will mean borrowers in general pay more to borrow money. That alone will cause the demand for goods, services, and assets to shrink. More importantly for everyone is what could (notice the word could) happen to the debtors who took advantage of the free money of the last decade and bought assets that can’t sustain themselves. There are two wild cards in this evolving picture. First, will the marginal asset buyers or the asset buyers who bought too much be forced to liquidate their positions as interest rates rise? That is the biggest risk today.

The other wild card is the resolve of the Federal Reserve and monetary authorities. The Fed balance sheet prior to 2008 was approximately $800 billion; it is now over $8.5 trillion. The amount of pain to be sustained in the asset markets and the general economy is directly correlated with increased interest rates and the shrinking of the Fed balance sheet. With a president and a secretary of the treasury who are labor friendly, both of whom were culpable in the Fed’s grievous mistake of creating inflation through too much money, we are about to find out the Fed is not as independent as the monetary and political authorities profess. Between the elections next month and the presidential election in 2024, the political establishment will be exerting tremendous pressure on the Fed to moderate its monetary fight against inflation.

When stocks and bond prices spike higher, they reflect speculators’ belief that the Fed will not follow through in the inflation fight. No one knows what they will do. Their job is tougher because the political establishment, fearing loss of control in next month’s election, is attempting to spend more money any way they can before the change in government next year. Further, no one is mentioning all the billions of dollars the country is spending in Ukraine. These are “off- budget” expenses, but still financed by deficit spending and digitally printed money. The Fed will be put in a position of having to either neutralize the fiscal policies or capitulate and watch inflation stay high for years. Be alert to one critical point: The powers that control Washington are both Democrats and Republicans. Do not believe for one minute that the true powers in Washington want inflation brought down quickly. While inflation hurts the lower and middle levels of society, its effect on the elite is either neutral or beneficial.

What does all this have to do with maintaining above-normal liquidity? The Fed is expected to raise interest rates and shrink its balance sheet. Raising rates is an easy way to measure its commitment to reduce inflation to its goal of 2%. To accomplish this goal, the Fed funds rate should be above the core inflation rate. Core inflation now is 6.6%; however, as the economy slows, that core rate will decline, so the Fed rate hikes can move above the inflation rate at a lower level. Right now, the market believes that will be between 4.5% and 5%. The Fed funds rate is not at that level and won’t be until early next year. If the Fed stops increasing rates at a level below the core inflation rate, the stock market will likely soar since it will signal the Fed has bowed to political pressure, and inflation will persist. Whatever level it reaches with interest rates, you’ll want to take advantage of the higher rates. Use the bond strategy in 19 RULES FOR GETTING RICH AND STAYING RICH DESPITE WALL STREET to determine how to spread the maturities of your fixed-income securities.

The balance sheet reduction is much trickier and more dangerous. From 1982 to 2008, the Fed did not buy bonds in the current massive amounts it does today to sustain and boost the economy. When Lyndon Johnson brought the country to its knees with his Viet Nam War and Great Society programs, the Fed accommodated the spending by printing money, leading to the 1970s inflation and the draconian Fed policy changes by Paul Volcker. What no one knows is what balance sheet level is proper to sustain the economy and avoid adding to inflation. If the Fed shrinks the balance sheet too far or too fast, there is a high probability of a financial crisis. Financial crises usually result from speculators not being able to meet their obligations. In that case, they must sell anything they can at fire sale prices. Take time now to identify the companies you want to own in case this scenario arises. Having liquidity ready to buy fixed-income assets as rates move higher and buying quality companies at depressed prices with above-market dividends are the primary reasons to have liquidity now. Then there is the potential for a black swan event.

The Ukrainian war appears to be going against Russia. It’s unlikely Putin will accept defeat. Some analysts and policymakers are worried he may use nuclear weapons. That is unlikely since everyone will know he did. His style in the past has been to maintain deniability. If backed into a corner, we believe he will use biological weapons that are untraceable. Don’t be surprised if the plague or some other highly contagious illness appears in the country. If it happens, the stock market will likely go into a tailspin.

Having liquid assets is more important today than it has been in a long time. Don’t get caught without them.