The goal is to write a new memo once every week or every other week; however, it would be great to use the week in between to follow up with clarifications, elaborations, and reader’s thoughts. So the agenda for this Midweek Memo:
Feedback on Memo 2: The Jelly Doughnut
Deeper exploration of how monetary policy actually works
The May Fed Meeting
1. Feedback on Memo 2: The Jelly Doughnut
Our first reader write-in! A close friend and reader writes-in a response to Memo 2: The Jelly Doughnut. My emphasis in italics:
I couldn’t agree more -
I’m am also best-versed in this appetite for “excessive credit.” (He’s being humble and was a brilliant classics major)
People have been taking our interest rate climate and cheap debt for granted since the early 2010s, and a lot of investors in the real estate world are refusing to acknowledge the signs of recession in recent months. For example, the recent inverted yield curve, skyrocketing inflation, and recent actions taken by the FED. (Plenty to discuss here – I can’t wait to touch on all of this)
The market is going to correct, and it’s scary. The FED can only stop the bleeding for so long, and you are also right that low rates aren’t going to be enough to help us overcome additional market factors like lack of training in the workforce, etc.
My conclusion is that we should be investing in markets that can handle a recession and mitigate cyclical market risk (i.e. affordable housing … take a guess where he invests… but in all seriousness affordable housing, specifically LIHTC is looking very good right now – if you don’t know what this is or you followed the link and still don’t get it, well that’s sort of the point – it’s complicated / niche but benefits from strong housing trends).
I love this submission – this is what makes the time commitment to writing worth it, so please keep them coming.
2. A deeper exploration of how monetary policy actually works
A few readers wrote in looking for a deeper dive into monetary policy vs. fiscal policy and the exact mechanisms by which monetary policy can i) lift market conditions ii) spill over into positive economic conditions. This is a more than fair clarification and I’m so glad there’s interest here. I was debating including this in this week’s memo, but ultimately excluded for brevity. These are the follow-ups that will hopefully help maintain a balance that can keep these memos accessible without prior knowledge.
Ok, so let’s first review expansionary / contractionary fiscal policy tools available to the federal government include:
Cutting / raising taxes including providing specific tax incentives
Increasing / cutting infrastructure, defense, and research contracts
Cutting / implementing new regulations, red tape, and costs of doing business
Increasing / cutting social welfare spending: unemployment insurance, food stamps, child tax credits, social security, Medicare / Medicaid, student loans forgiveness even / especially UBI
Expansionary / contractionary monetary policy tools available to the Fed include:
Lowering / raising interest rates using open market operations
Using the balance sheet to buy / sell securities in the market aka quantitative easing
Other highly technical maneuvers like IOER, and the Discount Window – less important for now
Ok so for monetary policy, the jury is still out on the magnitude of quantitative easing’s effect - there’s a lot we don’t know where, and we can save this for another time. But here are the fundamentals about adjusting interest rates, the Fed’s primary tool. When the Fed lowers rates:
People / firms can either i) save money on their interest payments or ii) pay the same amount of interest but take on more debt - usually it’s a mix of the two.
Savers either i) have to lower their required rate of return on their investments or ii) they have to earn the same return by investing in riskier assets… they can also just spend the money instead of saving
This essentially means investors lower their standards for what they invest in – either investments can be less profitable, or they can be riskier. This is because the base case “riskless” alternative, government securities, return less aka opportunity cost has decreased.
This can be a healthy nudge when investors are overly pessimistic during a recession, and can act as a coordinating call to “put your money back to work”
But if rates are too low and times are already good, investors turn into giraffes, having already invested in the low hanging fruit, we become desperate for returns
In Practice: An Example About Nothing
Consider Vandelay Industries, a latex company with $10mm of annual income and $100mm of debt. They may currently pay an interest rate of 5% on their debt. An equity investor / industrialist, H.E. Pennypacker, might be happy to earn a 10% return on his investment here – so he would invest $100mm of equity to earn $10mm every year.
Now suppose the Fed lowers their benchmark interest rate by 2%, Vandelay would expect most, if not all, of these savings to pass through to debt’s interest rate which would now be 3% instead of 5%, and Mr. Pennypacker might expect to earn 2% less going forward, meaning an 8% return instead of 10%.
Vandelay saves $2mm in debt (2% x $100mm), earning $12mm in income now, a 20% increase. If Pennypacker still wanted a 10% return, he would now pay $120mm ($12mm ÷ 10%), a proportionately 20% increase in value.
But the Pennypacker’s return threshold also went down 2% well and is now 8% instead of 10%. When Vandelay was initially earning $10mm, this would mean the Pennypacker could pay $125mm ($10mm ÷ 8%) upfront to earn $10mm annually representing a 25% increase in value (not uncoincidentally equal to 10% divided by 8%).
But both of these phenomena are happening together. Vandelay is now earning $12mm, and the wealthy industrialist, Mr. Pennypacker is now willing to earn 8% - so they would now value this investment at $150mm ($12mm ÷ 8%), a combined 50% increase in value (not uncoincidentally the 120% x 125%)
This is how interest rate cuts fuel the markets. They i) improve individual’s and firm’s “fundamentals” and ii) improve assets’ “valuations.” I realize this might be way too technical for non-investors, and way to simplified for finance people but if you have questions or want to dig in further – keep the conversation going and drop a line.
The main takeaway should be just how levered our markets are to rates: a 2% decrease in interest rates could result in a 50% increase in value, a 25:1 ratio.
These numbers are made up, but they are certainly not dramatized and in fact by many measures understate the market uplift! But still, we have to separate market effects versus economic effects.
Economically, lower interest rates encourage growth. Vandelay may reinvest incremental profits to build a new latex factory or hire a new salesman. The factory requires construction workers, materials, machinery and boasts demand and employment. H.E. Pennypacker might likewise use his $50mm of increased profits to reinvest into a Peruvian mine, buy a Bentley, build a new home, and / or buy a Richard Mille - also employment drivers to various degrees. The market gains created by the rate cut spill over and multiply into other economic gains that will show up as employment GDP growth and this rising tide tends to lift boats.
I’ll take one sentence to explain the converse – if rates return to their higher level, all else equal, we should expect to give back these gains.
I’m currently drafting Memo 3, and I think it’s shaping up to be a hopefully interesting case study in our own market’s extensive dependence on low rates.
3. The May Fed Meeting
Here’s the link! Some very interesting stuff complimentary to these memos. The markets are happy right now, but still so much to unpack!