By Tim Courtney, Chief Investment Officer
Even though the Federal Reserve has long stopped using the word “transitory” when describing inflation, bond and stock markets were still clinging to a hope that inflation would soon fall back to 2% and return to business as usual, with interest rates receding to the 2021 level of 0%.¹ However, with the most recent inflation level reading 8.3%,2 markets this week appear to have finally gotten over that wishful thinking.
The Fed (and other central banks) have a critical role to play in markets. They act like referees in markets by controlling money supply and the cost of money through certain interest rates. Like referees influence the flow of a game, central banks do the same for markets. And when the Fed kept rates near zero for an extended period of time, it had a big influence on the game – as if the referees suddenly stopped flagging offsides violations.
With the central bank referees not calling any penalties, many distortions have worked through markets. Let’s dive into three notable examples.
The housing market. The housing market is probably the most obvious victim of close-to-zero interest rates. With rates so low, people were incentivized to buy homes they wouldn’t have otherwise. This rush to buy created a shortage of homes and a 20% year-over-year increase in housing prices.3 Unfortunately, many people have had to cut back on other expenses to afford housing, or have been priced out of homes entirely. This higher expense has still not fully worked its way into CPI inflation numbers and could keep it high for some time.
Venture capital. It has become a very common business model for newer companies to price services or products very low (or “free”) in order to gain market share and disrupt established companies. This might work, as long as the company continues to receive low-cost capital from investors. While rates were near zero, many venture capital investors could supply more cash at a low cost to money-losing companies. This distorted the pricing and deliverables of the industries in which those companies were operating. When the Fed began raising rates earlier this year, venture capital firms immediately began reducing their financing of these companies, and hiring and spending freezes ensued. The 2022 market has probably been most harsh to companies that had been operating at losses for years but kept afloat with cheap capital.
Margin balances. In 2021, margin balances reached an all-time high,4 allowing more retail investors than ever to borrow and make market bets. Margin loans were cheap with interest rates so low. Many rolled the dice and placed bets on investments like GameStop and other meme stocks, which we’ve seen dominate headlines.5 This created a significant distortion in the market and more speculative areas became quite large.
Near zero interest rates caused a great deal of distortions. The Fed is undoing some of the distortions as they raise rates while beginning to work back their balance sheet, which jumped from around $4 trillion to nearly $9 trillion.6 They could end up raising rates too far just as they kept them too low, and that certainly is a risk for markets. However, as the market is working through these changes and adjusting to operating in a non-zero rate world, it should create a more fundamentally sound foundation and valuation for investors moving forward. If you have any questions about recent market volatility please contact your Exencial advisor.
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