Seasons Change
Being amid the advent of fall, it seems appropriate to discuss the seasonal change in markets from a macro perspective. 2023 has been a unique year for capital markets. A scene never thought to be seen again, has reared its ugly head. Interest rates are at levels not seen since the early 21st century (for dramatic effect). The cost of living is at all-time highs and Incomes are stretched to the maximally highest point in contemporary history.
Interest rates at the lower zero bound created an atmosphere of immense moral hazard. Moral hazard is a situation where an individual could invoke and impose maximum risk without thought or care to consequence. That is, they disrespected the mathematics of it all. While many dislike the financial system as it is, it has worked for many, in the same vein. Therefore, while there are many disadvantages to playing a game where you do not know the rules, learning the rules should be the priority for anyone participating. In a way, when analyzing this situation, we must disregard the fact that it is a set up because what is the alternative?
The thing that was never supposed to happen again, happened. The solvency issue of the banking system reared its ugly head early in the year. That led to further consolidation in the banking sector, thereby reducing competition and options for consumers. The main question that entered people's minds at the time was: where and how did this happen? Long-story-short, it is all accounting tricks that are either seen or not. In this instance, hold-to-maturity was the culprit.
When well-known firms disappear overnight there is typically fraud involved, which ultimately leads to bankruptcy. Enron, WorldCom, MF Global, and the list goes on. How do these events occur? Is there not demand for these services that these fraudulent events happen on repeat? While I suspect there is a portion of greed in the mix, we can only speculate without evidence to substantiate. Therefore, the best thing we can do is look at things objectively and connect the dots.
The notion of demand can be plucked from the empirical world in numerous ways. In economics, demand is all the quantities of goods or services that buyers would be willing and able to buy at all possible prices; sounds familiar. In finance, there are a few variants given the varied nature of asset classes, but the formulae are ultimately equivalent. They will be annotated in Table 1.
The notion of demand and supply is inherent in everything that we interact with. The most common example is prices for airline tickets. While nowadays some of the price changes are algorithm-driven, a lot of it used to be supply and demand driven. For example, traveling during any holiday is typically more costly than during a non-holiday. That is due to more people traveling to see loved ones. Therefore, there is more demand for long distance transportation.
The cost of capital is what drives the flow of currency in an economic system. The most common reference for the cost of capital is the Overnight Bank Funding Rate (aka Fed Funds rate). That reference rate is set by the Federal Open Market Committee (F.O.M.C.) of the Federal Reserve Board in Washington DC. From 2008 through 2022, for a total period of 14 years with a 3-year break toward the end (June 2017- March 2020), the cost of capital was set at 1% or below. A decade is a long time for people to get comfortable and develop bad financial habits.
The issue has always been bad financial habits, as were evident in capital flows. Where is the capital going? Is it being allocated optimally? What are the consequences of currency flowing to where it should not? We might soon discover how the lack of moral hazard going back 15 years, will have impact orders of magnitude greater than ever imagined.
If you have been following along, you are now slightly aware of the prospective negative effects that the misallocation of resources can have on an economy. The impact it can have on an economy’s position, in both a competitive and productive stance, is at times immeasurable until it is too late. To take a real example into account, consider the United States’ present position in terms of crude oil reserves. This is by far the weakest position the U.S. has ever been in from a financial perspective in terms of energy stores.
As of October 27, 2023, the U.S. has 351.3 million barrels of crude oil stored. At the peak, the number of crude oil barrels stored was 726.6 million on December 27, 2009. Since 2020, 244.6 million barrels of crude oil have been mandated to be sold by the present administration. That means the U.S. had 594.7 million barrels at the start of mandated selling. Therefore, at present prices it would cost the U.S. $2.057 trillion to get back to the store levels of 2020, and it would cost $3.0873 trillion to get near all-time highs. If it smells like moral hazard, then it probably is, and this wreaks of moral hazard.
With trade deficits at all-time highs (lots of “all-time highs”), this is just another line item in the realm of the trillions for the U.S.’s financial statements. This is not a position of strength, considering all the other financials issues the U.S. faces. How will this ultimately impact demand as, noted above, incomes are stretched and the cost of living only goes in one direction? While central banks are averse to lowering rates, the lack of natural aggregate demand could cause the masters of macroeconomy to act on the seasonal change that is upon us. And they wish to not see it.