Red Pill / Blue Pill: Change Your Investing Perspectives Now
From the iconic scene in the Movie, The Matrix, the choice of which pill to take offers very different outcomes. One, a life lived in harsh reality but where the individual can think and act independently; and the other, a computer simulation of a comfortable life, but bereft of the ability to think and act of one’s own volition.
The same choice is offered here. Would you like to see the financial system for what it really is, as opposed to what the financial media and textbooks tell you it is supposed to be?
This Collection focuses on presenting alternate ways of thinking about our modern financial system. Expect conventional thinking, wisdom, and theories to be challenged in areas where established viewpoints are deeply entrenched. How do people normally think about these issues? What is inaccurate about established viewpoints? More importantly, what happens when we change our paradigms and view these issues differently?
The articles in here aren’t for everybody. Some will be offended by having their viewpoints challenged, and others will end up more confused than they already were. But, for those willing and patient enough to question and reconfigure how they think, the clarity brought on by new insight and understanding will be like stepping into a whole new world.
READER WARNING: FOR THE OPEN MINDED ONLY!
5 Systemic Alarm Bells You Need To Know As Credit Suisse Fails
Credit Suisse has failed, and been rescued, over the course of a weekend. While this may have prevented an immediate global banking crisis, danger remains.
Here are five alarm bells that are currently ringing very loudly.
1. Use Of The Fed’s Discount Window Is Through The Roof
The Fed runs an emergency borrowing facility commonly referred to as the “Discount Window” (now formally known as the Primary Credit Facility). It exists primarily to ensure that banks in the US financial system can borrow bank reserves from the Fed in the event of emergencies.
In practical terms, it is the Fed’s lender-of-last-resort facility, and has a reputation of being so. Due to this reputation, a bank tends to only borrow from the facility out of desperation, as being known to have borrowed from the Discount Window casts a large shadow of doubt on its operations.
Since banks run on confidence, they naturally want to avoid situations which would cause their depositors, creditors, and transacting counterparties to question their fidelity. Which means not using the Discount Window unless absolutely necessary.
Note that the largest banks can be an exception to this, especially if they have large trading/dealing operations. During times of crisis, they can sometimes act as intermediaries; by borrowing from the Discount Window to lend at higher rates to smaller banks, pocketing the difference as profit.
As such, the amount of loans borrowed from the Discount Window is an important indicator of demand for emergency funding in the US banking system. The higher its usage, the higher the degree of systemic risk.
As of last Wednesday, the amount that banks have borrowed from the Fed’s discount window hit 152.8 billion, which, as you can see from the chart below, is higher than levels in both 2008 and 2020.
The failure of Silicon Valley Bank, and now Credit Suisse, although Credit Suisse had yet to “officially” fail last Wednesday, is clearly symptomatic of a broader problem – banks are struggling to fund themselves.
2. 0% Rates Are Making A Comeback
The auctions for 4 week and 8 week US Treasury (UST) Bills held at the end of last week saw the low discount rates for both hit 0%. Note that UST Bills are zero coupon instruments, hence the use of “discount rate” as opposed to “yield”; both terms reflect the rate of interest a buyer earns.
Sharp drop offs in low discount rates at these two auctions show that there are bidders willing to pay more than their peers in order to get their hands on both 4 week and 8 week Bills. Moreover, the 0% low rate also means that these bidders are willing to lend to the US government for no interest.
Why would anyone be so desperate to get their hands on UST Bills?
Quite simply, for use as collateral in the repo market, which implies that this key global funding market is currently under severe strain. As repo is one of the most important, and liquid short term funding markets on the planet, a sharp drop in UST Bill rates, which are the best form of collateral, tells us that a good number of participants are rushing to buy as much collateral as they possibly can.
This could be due to them having an immediate need to meet collateral/margin calls, or that they are stocking up on collateral (UST Bills) in anticipation of the repo market seizing up in the near future. Either way, it speaks to a large negative change in the liquidity of the repo market, that is, people with cash are no longer lending it out easily.
You can learn more about the repo market, and collateral, here, and how low, or zero percent rates do not always mean that money is abundant here.
That being said, yesterday’s auction for 13 week Bills did not see a drastic change in its low discount rate. While high, median, and low rates for the auction did come down a little, no sharp drops in the manner of the 4 and 8 week Bills occurred.
Keep a close eye on UST auctions, especially for how low discount rates come in at the short end. As long as they continue to stick at, or close to 0% for the 4 and 8 week Bills, demand for collateral remains high, and by extension, funding markets remain stressed.
Should low discount rates in 13 week Bills plummet towards 0%, that would imply increasing demand for collateral, and hence higher levels of stress in funding markets. This in turn would imply a higher probability of further selloffs in global markets, possibly even violent ones.
3. Yield Curves Have Spasmed
Both the UST and Eurodollar yield curves have changed dramatically over the past week, and not in a good way.
Looking at the chart of the UST yield curve above, a few things are immediately apparent. Rates from 1 month to 3 month Bills have risen, but yields after that point have fallen. This naturally means that the curve has grown more inverted, especially between the 3 month Bill and 10 year Note.
Higher rates at the short end reflect higher funding costs than in January, although they have fallen quite a bit from where they were just 2 weeks ago, in response to the banking crisis. This fall points towards stresses in funding markets like repo, as explained previously.
On the long end, lower yields are a result of the market quite clearly pricing in lower levels of growth-driven inflation, which really does not bode well for the economy.
The curve has also steepened a little between the 2y and 10y tenors since January, although not by much. While this might seem to be cause for some kind of optimism, since if a flattening curve implies trouble, a steepening one should imply the opposite, this isn’t the case, as a lot depends on other circumstances.
In the current environment, the steepening between the 2y and 10y is largely driven by a sharp fall in 2y yields. This is an occurrence that hints at growing trouble in the financial system, which is an accurate reflection of current circumstances given the failure of Silicon Valley Bank and a few others in the US, and Credit Suisse in Europe. Lower yields at the 2y mark means that the market is pricing in lower rates, which reflects expectations of Fed rate cuts, and/or participants rushing to purchase collateral.
Both of these are reasons which do not translate into economic bullishness.
The Eurodollar yield curve has also shifted drastically from the beginning of the year, reflecting the same reality as the UST one, and is now fully inverted over the next 8 months or so.
This shift indicates a large shift in financial market participants hedging against a sharp fall in rates over the next few months, which implies that they expect more funding stress in repo, Fed rate cuts, and a slowing economy.
4. The Fed’s USD Swap Lines
The Fed announced over the weekend that it would be increasing the frequency of its USD swaps with a handful of other central banks, which is a major sign of stress in global USD funding markets (which are closely tied to collateral and repo).
After all, why make more USDs available to international counterparts if they are plentiful and easily available in the global financial system?
There are some issues here, the first of which is that only a few central banks are involved, whereas the USD is needed globally, especially in China (whose central bank wasn’t included). In order to truly avert a global crisis, Dollars must be made available to every financial system on the planet that transacts in USDs, which in current times is the vast majority of them.
In addition, the Fed making more USD swaps available does not mean that everyone who needs them will get them. Only banks with the needed collateral and creditworthiness will be able to access these USDs from their own domestic central banks.
In turn, only the most creditworthy customers will be able to access these Dollars from the banks who are able to get them in the first place. Bear in mind that the Fed’s USD swap lines are only used in times of global USD scarcity. This means that economic and financial conditions are so poor that banks aren’t willing to step up to make Dollar loans to other banks and their customers. Naturally, in such an environment, banks will only make loans to those which are most likely to pay them back.
Consequently, the Fed making more USDs available to central banks will not avert a crisis. It may help to lessen global bank failures and ease the pressure off the largest businesses, but Dollar swap lines are ultimately a tool that tends to only benefit the strongest entities.
For everyone else in dire need of Dollars, it’s sink or swim. The more who sink, the higher the risk of negative cascading effects on the economy.
Note that the Fed also has a permanent Dollar swap facility for their central bank counterparts, the Foreign and International Monetary Authorities Repo Facility (FIMA), set up in 2021. You can learn more about it, and why it isn’t the solution the Fed believes it to be, here.
5. China Cuts Its RRR
In a surprise move, the People’s Bank Of China (PBOC) cut their reserve requirement ratio (RRR) at the end of last week. Most narratives tend to take RRR cuts as a positive for risk assets, believing them to be expansionary and good for growth.
However, such thinking ignores two very important facts. The first being that bank reserves, whose availability to banks increases when the RRR cut, are not lent out. This necessarily means that RRR cuts (or QE for that matter) are not actually expansionary, since bank reserves do not get pushed out to the broader economy. Banks making new, and more, loans is what matters, and their willingness to do so is not affected by having more bank reserves on their balance sheet.
At best, having more bank reserves available to them means that banks will be more able to meet daily transaction requirements, which could help ease pressure on those which are facing large deposit withdrawals. While this would be helpful in preventing possible bank runs, it isn’t expansionary at all.
Secondly, central banks don’t need to increase levels of bank reserves during good times, simply because the economy is growing, banks are lending freely, and the financial system as a whole is confident. In short, liquidity is plentiful and easily available for anyone needing to borrow.
Liquidity only tightens when financial actors become risk averse and reluctant to lend to counterparties. In other words, the system fails, or at least starts to exhibit signs of failure. This is when central banks step in. When they enact steps like rate cuts, RRR cuts, QE, USD swap lines, or whatever other emergency measures they can conjure, it means that the financial system and broader economy is taking a turn for the worse.
Pay Attention To Macro Markets, Not Equities
While most narratives will be focused on how the equity markets are performing, especially UBS stock, macro markets are the truest indicator of systemic risk.
Keep a close eye on developments in US rates, especially at the front end of the curve, with the understanding that volatility in short term rates is not a good development, even if rates on 1 month and 3 month UST Bills move sharply higher. A healthy rates market is one where movements are relatively small and incremental; large moves demonstrate high levels of uncertainty.
If you can, also pay attention to how Eurodollar futures are performing, as they give meaningful insight into how participants in the global financial system are hedging interest rate risk.
In addition, don’t forget to monitor the USD’s performance in the weeks and months ahead. A stronger Dollar would demonstrate rising scarcity of the world’s reserve currency, which directly translates into banks cutting back on USD lending. Nothing positive happens in the global economy when USDs grow scarce, which is the primary reason for the Fed moving to make its USD swap lines available on a daily basis over the weekend.
Should equities rally while interest rates and the USD continue to trade in a manner indicative of systemic weakness; that is, lower rates, both at the short and long end, and a steady or stronger Dollar, be very wary of narratives proclaiming that the crisis is over.
Finally, it is entirely possible for global markets to calm down substantially in the immediate future, with large rallies in equities and Dollar selling possible. This, however, does not necessarily mean that systemic pressures have been fully alleviated. Crises in global funding markets, like repo, tend to resolve themselves in their own time, more often than not after a massive deleveraging and selloff in markets.
In short, regardless of how positive stocks and the accompanying narratives may or may not be, now is not the time to be complacent.
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Silicon Valley Bank: The Big Problem That You Need To Know
The recent failure of Silicon Valley Bank (SVB) has driven markets into a frenzy of trying to understand why it happened, and what broader systemic implications it may have.
The US government has stepped in to backstop depositors in an attempt to prevent further bank runs, but mainstream narratives continue to miss a broader point – bank runs are symptoms of a much more troublesome problem.
One large enough to potentially trouble the entire global financial system.
The Repo Lurking Behind The Narrative
Popular narratives that have been used to explain SVB’s blowup run along similar lines:
- Banks took in cheap deposits when rates were low and couldn’t lend all of it out, which led them to invest in other fixed income securities, like US Treasuries (USTs) and Mortgage Backed Securities (MBS) instead. With the Fed and other major global central banks’ recent campaign of aggressive rate hikes, this narrative concludes that falling prices from rising rates caused, and will cause, banks to take major losses.
- Or, with a subtle difference, banks took in cheap deposits and invested them in longer term fixed income securities. This mismatch of borrowing and lending durations caused them to be unable to fulfill depositors’ rush to withdraw their money.
The issue with the first narrative is that it is quite misleading. Banks do not “lend out deposits” in quite so direct a manner as is implied by the narrative. Bank loans are made by simple ledger entry, with a bank creating an asset on its balance sheet (the loan), offset with a liability (the amount of the loan in the loanee’s account).
As such, bank loans are not a simple matter of taking $1000 of deposits from one depositor and lending that same $1000 out to a loanee.
Briefly, when a depositor receives money in their bank account, for example as a salary payment, bank reserves are transferred from the employer’s bank account to the depositor’s. Bank reserves are what banks use to settle interbank transfers initiated by its customers, and are shuttled between banks via the Fed’s Fedwire system on a net basis at the end of each day.
What this means is that a bank needs to have adequate bank reserves to cover any net outward transfers at the end of each business day. Of course, if more people are transferring funds into the bank than out of it on that day, it does not need to worry about bank reserves (at least for that particular day).
SVB getting a huge influx of deposits just means that it received a lot of bank reserves, which are not actually lent out – as explained a few paragraphs above. Consequently, the influx of bank reserves into SVB due to the tech boom did not create a situation where SVB could not lend them all out, as they aren’t lent out in the first place. (If you want to get a better understanding of these concepts, you can learn more about bank reserves here and how money is really created here)
Instead, SVB’s ability to create more loans would be determined by how stringent their loan officers were in screening new clients, as well as demand for loans by the bank’s customer base; not by how much deposits SVB received.
However, the influx of deposits did still mean that SVB was faced with a choice of how to invest them in order to get a decent return. They did so by purchasing safe fixed income assets, which brings us to the next point – banks do not need to take losses on their fixed income investments if they are classified as held-to-maturity securities.
That is, if a bank’s intention is to hold USTs as an income generating investment, and not simply to buy and sell them for a quick profit or market making purposes, they do not have to mark their investments to current market prices.
This runs contrary to the simple relationship that current mainstream narratives seem to imply, that losses from SVB’s fixed income investments were the main factor in toppling the bank. Moreover, it also completely misses out on a very important point. That is, US Treasuries can be used as collateral to raise capital quickly in the repo market, as USTs are the best source of collateral used in repo.
Which begs the question, why didn’t SVB tap the repo market?
Two broad scenarios are plausible here. The first being that SVB chose not to do so. In SVB’s 1Q23 mid quarter update, dated 8 March, SVB stated that it sold $21 billion in fixed rate available-for-sale securities (page 9 of the PDF linked above), which are securities that are not held-to-maturity, and also not purchased for trading purposes.
This was done with the intent to rebuild its portfolio with shorter duration fixed rate USTs.
In other words, SVB ostensibly didn’t sell their portfolio to raise capital to fund customer withdrawals, but to attempt to benefit from what the bank thought was going to be a sustainably higher interest rate environment. If this were entirely true, SVB’s management had their plan completely backfire, as the proceeds raised from the sale of their securities obviously wasn’t enough to cover withdrawals.
The second plausible reason for SVB not tapping the repo market is that it simply could not do so. That, even with its large holding of USTs, the bank failed to raise money in the repo market; to the extent that it had to sell its securities to raise capital.
Note that most financial institutions prefer to pledge USTs as collateral to borrow in the repo market first, as repo borrowing can be easily rolled over most of the time. Outright selling tends to be a last resort, which implies that it wasn’t just depositors who lost confidence in SVB, the repo market did too. This could have meant that SVB faced repo borrowing costs (haircuts) that were so high as to completely discourage them from transacting, and/or counterparties in the repo market simply refused to do business with them.
Moving on to the second narrative, which pinpoints the mismatch in SVB’s assets and liabilities as the main cause in the bank’s failure; in other words, borrowing in short term markets to fund longer term investments. This isn’t inaccurate per se, and actually highlights one of the biggest problems that all banks face, which is their business models naturally push them to mismatch the duration of their assets and liabilities.
Consider that all banks operate on the same basis of taking in deposits and lending on a longer term to businesses, consumers, and governments (by buying government bonds).
Deposits are “short term” because they can be withdrawn by depositors at any time, while loan payment periods can stretch out over decades. There isn’t a bank on earth that takes in deposits and only makes overnight loans, simply because it would struggle to make any kind of decent profit.
However, not all banks fail. As a matter of fact, on a percentage basis, much more banks survive (or get bought up/merged) than fail. The evidence for this lies in the fact that the modern banking and credit creation systems have existed for a few centuries.
Consequently, the model of borrowing short term to fund longer term assets, while dangerous in its own right, not to mention awfully short convexity, is only part of the SVB problem.
As discussed above, SVB clearly could not access any kind of short term funding market in the run up to its failure. But, this does not mean that the sole cause of the problem lies in their mismatch of assets and liabilities. The other part, is, once again, the loss of the bank’s ability to fund itself in short term borrowing markets.
Financial history is littered with spectacular failures of firms, both financial and otherwise, who blew themselves up when they could no longer access short term borrowing to meet the funding needs of their long term investments.
Repo, The Root Of Systemic Problems
At this point, it is quite clear that the repo market is the unseen, and untalked about, common factor lying in the shadows of both narratives. Which brings us to a curious observation, that SVB’s failure has occurred during a seasonal period of time where liquidity in the repo market tends to be low.
This tends to happen close to the end of each quarter, and coincides with some of the largest and most disruptive financial crises in recent history.
In 2008, Wall Street was grossly over-leveraged and overexposed to the US housing market, with Bear and Lehman falling victims to their inability to fund margin calls during quarter end repo liquidity tightness. Bear collapsed in March ‘08 (late 1Q), and Lehman in September of the same year (late 3Q).
The same thing happened on a much larger scale in late Feb/early March of 2020, when global shutdowns due to the initial outbreak of COVID, coinciding with the nearing end of the 1st quarter, wreaked havoc on financial markets all over the world.
The point here isn’t to simply blame seasonal drops in repo liquidity for bank/financial system failures. It is simply to state that the probability of such failures are markedly higher when confidence in banks takes a battering during periods of lower liquidity in repo.
Which brings us to the potentially trillion dollar question. Is SVB’s failure a harbinger of things to come from a global, systemic perspective?
Due to the narratives mentioned above, which place the blame squarely on banks holding large amounts of Treasuries (and other fixed income instruments), many people are currently inclined to believe that banks all over the world are in trouble, since the value of their fixed income holdings have plummeted.
However, as also explained above, the real danger does not lie in the holdings’ themselves, but the inability of banks to fund their capital needs.
Here is a simple breakdown of what goes on:
1) Deposits are essentially unsecured loans that customers make to banks. This in effect makes depositors junior creditors. They are junior because in the capital structure, secured loans have seniority when it comes to being paid back first in the event of liquidation. Of course, with government intervention, as witnessed over the weekend, political necessities can upend the capital structure.
2) Banks don’t lend deposits out, instead, the cash is used to meet daily transfer requirements arising from the transactions of its customers, and also for a bank’s own business needs.
3) Should there be a large demand for customer withdrawals, i.e. a bank run, a bank needs to fund these withdrawals by borrowing cash. They can do so either via short term borrowing markets, like repo and the Fed Funds market, or in emergencies, from the Fed’s discount window (or other emergency Fed/government lending facility).
As such, holding unrealized losses on fixed income investments does not actually hinder a bank’s ability to meet withdrawals. If it did, many more banks, and not just in the US, would be facing bank runs at this point, given how much rates have risen over the last year, and how quickly.
Instead, as already mentioned multiple times above, but bears repeating again just because of how important it is – what matters is a bank’s continued access to short term borrowing markets. When this access is revoked, the bank will fail barring an intervention from the central bank and/or government.
This is not to say that huge losses on banks’ fixed income investments aren’t important. They are. Firstly, when a struggling bank is forced to sell its fixed income investments at a loss, it leaves them with less capital than they initially borrowed to pay back their creditors, which obviously is a recipe for disaster.
But what is of more importance here is the psychology of it. At the end of the day, our modern banking system and economy runs on confidence. When confidence evaporates, access to credit quickly dries up.
As such, SVB’s failure, embedded together with the growing momentum of the “large fixed income losses” narrative, is a very dangerous combination that could lead to further bank runs. Adding fuel to this fire is tighter liquidity conditions in the repo market, which now has to contend with not only its seasonal quarter end issues, but also the fear and uncertainty of other bank failures.
Systemic Risk Watch: Look Beyond Equities!
The temptation at this point will be to look at US equity markets for direction, as well as indications of future selloffs in global markets. After all, bank stocks have a giant crosshair drawn on them at this point, especially in smaller segments of the banking sector, and it intuitively makes sense to look at further selloffs here as indications of a broader crisis to come.
However, from a systemic perspective, lower repo liquidity means a general, across the board withdrawal of short term funding for all other financial markets. After all, when lenders pull back on providing credit, they tend to do so en masse, and indiscriminately.
Naturally, this leads to margin calls and sell offs, which have the potential to spark a vicious and nasty cycle of liquidations across the globe.
Consequently, focus needs to be on the largest macro markets instead, namely the USD and UST rates, as they will give a clearer and more reliable indication of the probability of a global risk off scenario. The reason for this is that repo and other short term funding markets are both global and highly interconnected in nature, not to mention much larger than US equity markets.
Therefore, while US equities can be driven by wild swings in bank stocks as equity investors and traders panic, the USD and UST markets take much more to move them in a meaningful way.
In addition, the USD is a reliable indicator of global crises due to it being the world’s reserve currency, and its close connection to the global repo market, where banks, corporations, and governments regularly post collateral to borrow USDs to meet their needs. In other words, problems in the repo market, when they get big enough, will show up in the global USD market, and hence USD FX rates.
While US equities might present decent trading opportunities in the short term, both on the long and short side, depending on how you might want to position yourself amidst current uncertainty, don’t lose sight of the bigger macro picture.
This is especially important as overall macro conditions have deteriorated from where they were a year ago (except for the US labor market), and global recession is now a real concern, as indicated by deeply inverted UST and Eurodollar curves.
In other words, any economic mishaps that occur now have the potential to cause more harm than if conditions were more benign. It is also worth noting that economic mishaps, such as bank runs, tend to occur much more often during periods where economies are sliding towards recession, simply because financial conditions are no longer as forgiving as they were during expansionary parts of the cycle.
As such, look past any large rallies in equity markets driven by hope and speculation of what the Fed, and/or the US government, is, or may be doing. Focus on the USD and US rates, and if you can, Eurodollar futures.
These are the markets that really matter when it comes to systemic risk, and which really tell you what to expect in the future.
Especially keep an eye out for change in trends, breakouts of key levels, and most of all, an alignment between markets. When multiple markets start to move in tandem, and in a direction which screams danger, the likelihood of a global selloff, if not a full blown systemic crisis, is at its highest.
At time of writing, government bond yields have fallen sharply, which mainstream narratives will portray as a flight-to-safety trade. While the desire for safer assets will be a part of why rates have fallen so quickly in just 2 days, lower rates also demonstrate a collateral crunch. Simply put, participants in repo and other short term borrowing markets are dashing to get as much collateral as possible to ensure that they have enough to meet potential margin calls should volatility and uncertainty persist.
Lastly, bear in mind that a sharp and broad global selloff in risk assets may not come immediately, and indications of one may not show up for a few more months. This is not a time to be complacent, as the rest of 2023 now looks increasingly dicey for markets, which are growing increasingly vulnerable to a large global selloff.
Remember that Bear Stearns failed in mid March 2008, but the Fed intervened and everyone thought that was the end of any further mishaps… until Lehman took down everything else just 6 months later.
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Is The Value Of Your Home Going To Fall As Rates Rise? 6
Let’s conclude our discussion on mortgage rates, house prices and epiphenomena with the Fed’s role in the housing market.
As explained in Parts 3 and 4, higher mortgage rates are primarily a function of a bullish housing market, not Fed hawkishness.
By extension, the Fed doesn’t really have that much control over the US housing market, at least not through the interest rate channel.
That being said, the Fed does (or did) exert influence on the US housing market through their purchase of Mortgage Backed Securities (MBS).
While the Fed has called time on making new net additional purchases as it begins to tighten monetary policy, it is still reinvesting principal payments on previous MBS purchases.
This has led many to believe that the Fed is still acting to artificially keep mortgage rates low, thereby contributing to higher housing prices.
While this sounds logical and seductively simple, it isn’t true.
Firstly, most people believe that the Fed’s MBS purchases gives banks carte blanche to make as many new mortgages as possible. This is not the case, as banks must make mortgages in accordance with GSE (Fannie, Freddie, etc) requirements in order to sell them to the GSEs.
The Fed can’t, or rather, won’t, purchase them otherwise.
As such, the Fed does have some influence in that particular subset of the market (GSE mortgages), but not outside of it.
The real driver of the US housing market is total bank mortgage lending, as detailed in our article on QE’s effect on housing.
Bank mortgage lending is in turn determined by two main forces.
First is of course the bank’s willingness and ability to originate new housing loans, and second, the demand for such loans from potential home buyers.
The interaction of these two forces is what truly matters, not the Fed.
Furthermore, we know that the “low rates = high house prices” line of thinking is empirically untrue. This is easily observed, yet somehow missed by mainstream commentators, in the current environment where house prices and mortgage rates have been rising together.
If the Fed’s MBS purchases really did keep rates low, wouldn’t mortgage rates continue to be low even as house prices skyrocketed?
Ultimately, misunderstanding, or grossly overestimating, the Fed’s role in the housing market stems from two different but interconnected sources.
The first is a Fed-centric paradigm, where the Fed is mistakenly perceived as sitting in the center of the financial system, and therefore thought to be omnipotent. (Spoiler alert: The Fed isn’t the center of the financial universe, and it isn’t omni-anything)
The second is a conflation of epiphenomena; the direction of interest rates and house prices, which turns out to be nothing more than a more specific instance of the interest rate fallacy.
Finally, it is important to note that real estate prices are a famously local phenomenon, hence the adage “location, location, location”.
The purpose of this series of articles is to demonstrate the relationship between rates and home values from a broad macro standpoint, hence our use of the National home price index in earlier parts.
If national home prices do fall, it will be for a combination of factors. Chief of which being demand falling due to buyers facing economic uncertainty, or an oversupply of housing, perhaps even a mixture of both.
Mortgage/interest rates will certainly play a part as the cost of financing, but in all likelihood they won’t be the major cause.
If you ever find yourself getting caught up in mainstream narratives conflating rates with house prices, remember Fat Tony words!
Is The Value Of Your Home Going To Fall As Rates Rise? 5
Mistaking mortgage rates for the real estate market is what is technically termed an epiphenomenon.
The word simply refers to a secondary phenomenon that occurs alongside a primary one.
Since they occur together, people mistakenly attribute a causal relationship to both, even though this often isn’t the case.
A different, and more drastic example will help to further illustrate the point, courtesy of Nassim Taleb.
In his book Antifragile, Taleb uses the example of the First Gulf War to highlight the dangers of falsely attributing causal links in markets.
As with any war or instance of geopolitical unrest in the Middle East, oil gets caught up in the middle of it, and the First Gulf War was no exception. Taleb recounts, through the character Fat Tony, how the analyst community and financial media were predicting a rise in oil prices should war break out.
Consequently, resources were devoted to studying and trying to ascertain the probability of the US taking military action, and how quickly such action could last.
In other words, they were focusing on the possible event of war, to the exclusion of the oil market itself.
The war here, in the minds of these folks was the primary phenomenon, and the effect on oil prices the secondary one.
In their minds, if war broke out, it would cause oil prices to rise. This is after all, a notion that is both simple and very “common-sense”.
Unfortunately, the opposite turned out to be true.
War did break out, but when it did oil prices tumbled by almost half.
Which also meant that everyone who correctly predicted that war would break out and went long oil ended up losing a lot of money. Ultimately, the oil market had been building up inventory in anticipation of war breaking out, which created too much of a supply overhang.
In the words of Fat Tony himself:
“Kuwait and oil are not the same ting [thing]”Nassim Taleb, Antifragile
In the context of the US housing market, house prices are the primary phenomenon, and interest rates the secondary one.
Focus on what housing prices and rising mortgage rates are telling you, that demand is currently outstripping supply for homes. This imbalance is driving a bull market in housing that is dragging mortgage rates higher in its wake, not the other way around.
Which also means that when house prices and mortgage rates turn, and start to fall together, it won’t be because the Fed raised rates by too much.
Instead, it will be because supply and demand in the housing market have come into some sort of balance, or driven to the opposite extreme of imbalance (supply outstripping demand).
Channeling Taleb’s Fat Tony: Mortgage rates and house prices are not the same thing!
To be continued…
Is The Value Of Your Home Going To Fall As Rates Rise? 4
Now that you have a better understanding of how the interest rate fallacy applies to the housing market, let’s take a look at another often misinterpreted chart.
This one shows how 30y mortgage rates have trended down, and US national home prices trended up, since the late 1980s. Note that this chart shows the index value of home prices, and not the change in the index value, as depicted in the chart from Part 1.
These opposite trends, together with the strongly entrenched interest rate fallacy, has led to many people screaming that lower rates are causing housing bubbles.
This may have been true prior to the Great Financial Crisis (GFC), when housing credit availability was much higher (remember banks and subprime lending?).
But, beware the trap of mistaking correlation with causation!
Based on what we now know about the interest rate fallacy and the Housing Credit Availability Index, our post GFC reality is clearly more complicated than what this chart implies.
Yes, mortgage rates have undoubtedly fallen over the past few decades together with US Treasury yields. However, this does not mean that higher rates will cause national house prices to fall in a dramatic fashion.
Firstly because, post GFC, lower mortgage rates have only benefited a small subsection of the overall home buying population – those who are very creditworthy. As such, higher rates won’t be the main factor in popping the bubble of today’s high home prices.
This is due to the fact that the ones doing all the borrowing, buying, and selling are some of the most creditworthy folks in the country. It will take a much larger interest rate shock to drive this particular demographic into mass defaults.
Secondly, and arguably more importantly, real estate is its own market.
What does this mean?
Simply that the financial media likes to point towards a single external factor as causing a particular market to rise and fall, when it’s really the internal factors that matter more.
That is, the supply and demand dynamic in the particular market.
Good examples of such thinking are plentiful, from low interest rates being blamed for high equity prices, to QE and almost every market.
At the end of the day, most, if not all of these examples represent the conflation of correlation and causation. A deeper understanding of these markets and how the external factor supposedly affects them will reveal this.
Now, the same thing is happening in US real estate.
As hysteria over Fed hawkishness mounts, even with uncertainty over the second order effects of war in Ukraine, folks are forgetting that what really drives prices in the housing market is demand running ahead of supply.
For whatever reason, since the onset of the pandemic, folks who are able to get banks to finance them have been piling into the housing market.
No complicated analysis is needed to see this, rising home prices tell the story succinctly. Demand is running ahead of supply.
Until this changes in a significant way, the housing market will remain bullish, regardless of what interest rates are doing.
A simple way to see the truth of this is again by understanding the interest rate fallacy. As explained in Part 3, banks make more mortgages when demand is high, driving mortgage rates higher.
This implies that folks who are purchasing homes for investment or speculative purposes think that the rate of return they can earn is higher than the mortgage rate they have to pay.
Put another way, would you borrow at 4% to purchase a house that you intend to flip if you think that you can only sell it for a 3% return?
You would only be willing to take out a mortgage at 4% if you think that you can get a return greater than 4%.
All of this is not to say that interest rates have no effect on house prices – of course they do.
How much potential homeowners have to pay to finance their purchase is one of the factors affecting their final decision. If mortgage rates rise to the point where they exceed buyers’ expectations of future returns, the market will obviously be negatively affected (at least for a while).
Ultimately, it is important to remember that real estate is its own market.
Interest rates are but one of the many factors that affect the supply and demand dynamic within it, and should not be seen as the only, or main, factor driving prices.
Thinking otherwise is dangerously reductive!
To be continued…
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