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Dumb Money, Day 5

I've spent the weekend pondering how to bring this series to a conclusion and I decided that these last two pieces -- the optimistic and the pessimistic view of the future -- will, for the sake of focus, have to deal with only a couple of variables. Assuming an end to the Federal Reserve's Quantitative Easing program and an end to the artificial suppression of interest rates, I am going to examine what would happen in the housing market, the stock market and with the federal budget.

To summarize where we've been, I spent the first two days last week explaining some fairly straight forward, but not widely known or understood, ways in which the financial system operates. On Day 3 I shared startling concerns that were raised by the Federal Advisory Council -- a group of advisors to the Federal Reserve -- in their most recent meeting minutes. Finally, in Day 4 I tied it together to make three main contentions: (1) stock markets gains are not real but simple a byproduct of cheap credit, (2) rising housing prices reflect this same bubble and likewise are not real and (3) we can't make up for a lack of savings by simply printing money.

So let's assume, in a very optimistic sense, that Fed interventions have the desired effect, the economy begins to grow on its own and the Fed is then able to reduce QE and allow interest rates to return to market prices. 

The housing market is then going to have some huge downward pressure. First, the main buyer of Mortgage Backed Securities (MBS) is now the Fed, which purchases 70% of all new mortgages that wind up on the secondary market (nearly all). Without that buyer, rates will rise. Optimistically, this will present a buying opportunity for those that have kept cash under the mattress (granted -- not sure who those people would be as QE and the other Fed interventions have been designed to get all that cash into the market) and others who are looking for higher yields, perhaps from overseas investors looking for a place to put their dollars (and not worried about recent history in the housing market).

As rates go up, those investors that own low rate MBS sell them to avoid getting burned in the carry trade (see Day 1). While this wave of selling makes rates spike, once the shock passes and banks (and pension funds) have taken their losses, the market stabilizes at a new normal of moderate interest.

So interest rates will rise, by definition, as the Fed stops artificially suppressing them. As rates rise, purchasing power declines as the same payment now buys less house. While this has traditionally exerted downward pressure on home prices, the vigor of the recovery and the pent up demand (?) for housing convinces those (few) people who qualify yet don't own a home overlook the fact that they didn't buy at historically low interest rates. This, along with immigration, allows the housing market to remain healthy.

As part of this, homebuilders -- used to the mode and method of housing construction developed over the past sixty years -- begin modifying their approach en masse to correct the imbalance between single family homes and and households of single individuals. As such, the number of one and two bedroom units being constructed begins to climb as the number of new 4+ bedroom units declines rapidly. This is a different approach for home builders, appraisers, lenders, brokers, realtors and insurers -- not to mention inconsistent with our tax and regulatory structure -- yet there are market incentives to make the shift and so it occurs in relative order. 

As Baby Boomers seek to sell their suburban homes and relocate to other areas, there are enough Millennials -- as well as recent immigrants -- with sufficient affluence to purchase all of these homes at higher rates. Some places of the country fare better than others, but the worst performers are not sufficiently bad as to drag down the national economy.

As this is going on, the stock market continues to climb steadily. Stock prices are a reflection of earnings and earnings a reflection of sales and margins. A climbing stock market indicates that companies are still expected to make increasing earnings, improve sales and increase their profit margins while interest rates rise. 

Rising interest rates will certainly dispatch some high growth companies whose business models rely on low borrowing costs to build new stores and expand their market position. Rising rates will also force the liquidation of a number of companies that are highly indebted when those companies now have to take their narrow profits and pay competitive rates of interest. These bankruptcies will only make room for other competitors to gain in the market.

As interest rates rise, consumers -- particularly the prolific spenders that are carrying high debt levels -- will be squeezed by higher debt payments. Home equity loans will not longer be as readily available or as lucrative. Despite this, the growing economy increases optimism about the future.  People feel they will have increased capacity in the future so they begin to take on (even) more debt for consumption purposes, despite the higher rates. This allows businesses to continue to grow and expand justifying elevated stock prices.

Despite higher interest rates, commercial construction continues as national chains, and local enterprises, expand to more and more locations. In contrast to the established approach for national retailers, their protocols for store siting, their chains of suppliers and the entire regulatory and tax structure, business models begin to shift to respond to a new geography. Fewer strip malls are being built and business expansion is now taking place within traditional neighborhoods. This transition represents something of a new market niche and profits continue to soar, justifying broadly higher stock prices.

Finally, as interest rates climb and the Federal Reserve backs out of being the primary buyer of US Treasury bills, Congress is forced to deal with the rising deficit problem. A national debt of $17 trillion financed at less than half a percent interest suddenly becomes unwieldy when rates rise to 5%. The "devastating" sequester of $83 billion looks paltry in the face of what is now an additional $800 billion annually just in interest.

So Congress is forced to act decisively. A 2 to 4 percentage point increase in tax rates relative to GDP along with steep declines in military spending (and military commitments) and means testing of Social Security, Medicare and whatever emerges once Obamacare is implemented. These policy changes are made without any defaults and without any downgrading of the US credit rating. Foreign governments remaining willing (and able) to pick up the gap now that the Fed has exited the market, with Europe, China and Japan now buying trillions of dollars of US debt each year.

All of this allows the US economy to sail on, the Great Recession a nasty episode that we resolved by learning the lessons of the Great Depression and acting aggressively in times of crisis.

Later this week -- or early next week -- I'll give you a more pessimistic version of how this will all go down. In the meantime, I welcome your comments and critiques, particularly if you think I've not been fair in describing the optimistic outcome we culturally seem to want to believe in.

Editorial Notes: Dollars wave via Shutterstock. Reproduced at Resilience by permission.

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