Fed Choice: Destroy Stocks or Destroy Housing

This article was first published by me on Talkmarkets: http://www.talkmarkets.com/content/bonds/fed-choice-destroy-stocks-or-destroy-housing?post=135926&uid=4798

If we are to believe reports regarding stocks and the housing market, the Fed could be in a box. It could destroy stocks, or destroy the housing market depending on which way interest rates go.

The recovery in stocks has been driven by financials. The reflation/inflation trade was all the rage when Donald Trump took office. But it is starting to look like this was just another bond tantrum that kind of came and went. Lots of people staked their reputations on this inflation trade.

JP Morgan has warned that a decline in rates could severely impact the stock market. It wants some inflation at this late date. But the Fed is not cooperating, as Tim Duy has said that inflation and unemployment are too low and are preventing the Fed from reaching its goals.


Tim Duy by Permission


And it looks like we are seeing some problems on the demand side. Retail is hurting and so is the food industry. According to Peter Schiff, online buying is not offsetting the retail/food service slide.

A fundamental weakness appears to be forming. Capital is winning and labor is losing. Demand is withering. We have the added pressure of oil inflation as a possibility and housing inflation.

So, the Fed could still be looking to raise interest rates by 75 basis points, which could severely hurt housing, while giving financials a boost. The only way that the Fed could raise rates and continue housing demand would be to come up with down payment assistance on a very wide scale and loosen credit restrictions. That has not worked out so well in the past. But easy money 3 percent loans are being launched by Bank of America. 

I have mentioned before that interest rates are not a leading indicator, but it depends on what you are trying to watch. If it is GDP, interest rates have proven to not be a leading indicator. If it is financial stocks and housing, it appears that interest rates could be a leading indicator of potential demand for either sector.

We have to add one other factor, and that is, no matter what the Fed does, there is a massive demand for bonds separate from what stocks are doing. Most people don't talk about bond demand being an issue apart from how stocks are doing. But it is an issue, both in times of boom and in times of bust, and in times of preparing for a possible bust. That demand created by collateral for derivatives, forces interest rates down over the long term. It is easy to be short on collateral, and that potentially limits liquidity for the huge derivatives markets. 

From the University of Pennsylvania PDF article, we see the IMF making this claim:

Safe assets are used as a reliable store of value and aid capital preservation in portfolio construction. They are a key source of liquid, stable collateral in private and central bank repurchase (repo) agreements and in derivatives markets, acting as the lubricant or substitute of trust in financial transactions. As key components of prudential regulation, safe assets provide banks with a mechanism for enhancing their capital and liquidity buffers. As benchmarks, safe asset support the pricing of other riskier assets. Finally, safe assets have been a critical component of monetary policy operations (IMF (2012, p. 82))
Got that? Safe assets are a reliable store of value. The safest assets are interest rate bonds. Debt is the safest asset. Gold is not the safest asset. Try telling the average American citizen about this reality. Many will just think you are crazy.

So, we have to look at the banks, and what the central banks will do to protect the banks. After all, banks are the Fed's constituency.  How best to protect the banks is everything to the Fed.

Add to all this, the destruction of the housing market in an era of relative full employment and relative economic prosperity has the opposite effect of destroying housing as occurred in 2008. Then, house prices cratered and there was little demand and little lending. Now, housing has become a commodity for Wall Street, and killing construction often just has the effect of raising prices and rents.

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Now we see that margin debt is at an all time high in the stock market. If the Fed has to choose between stocks and bonds, which will it choose? 

I personally think the Fed has no choice but to kill the stock market and attempt to increase housing stock but it probably won't play out that way. From a macro view, the regular guy will have to be given an opportunity to go house hunting, even with the introduction of easy money. As bad as that could be, and as bad as that could work out, rents are too high, especially in the high powered, closed access cities.

The only other solution is to force construction of a lot more houses in the closed access, high rent cities. With local laws forbidding that construction, look for severe economic dislocation if rents continue to rise.

And yet, the Fed exists to protect the banks. Raising interest rates helps the banks. The Fed has indicated it wants to raise interest rates. JP Morgan, as stated above, says lowering rates will tank the stock market.

So, the Fed will likely kill housing to protect stocks. Rents are now going up in open access cities as well as high priced closed access cities. From Cincinnati to NW Arkansas, rents are soaring as housing becomes a commodity everywhere. This is a cash cow for Wall Street. The Fed will ride this, most likely, and try to save the stock market.

It seems like pure insanity, because at some point, the consumer economy will break with these policies in place. But Wall Street has always created wealth off the backs of labor.

Will stocks continue to climb as long as there is ample liquidity, a strong derivatives market, and a Fed seemingly willing to help the financials regardless of what else happens? It could happen that way because some say derivatives are now written based upon a strong stock market. The Fed knows that like water rolling downhill, interest rates will decline on the long end if it does nothing.

It would be great if big money got out of housing. Then the Fed could raise rates, banks would lend more, and people could get loans without being pushed out of the market by speculators.. The housing-as-commodity reality joins liquidity scarcity on Wall Street as the two biggest threats to American prosperity moving forward.

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