How The Era of Free Money Ends…Badly

I don’t think most people understand just how extraordinary a financial moment we’ve been living in for the past dozen or so years. We’ve all become so numb to the Fed printing money that we get distracted by more urgent matters like the latest election or the job growth number or the price of Bitcoin or the latest scandal at Facebook.

But truly nothing has mattered more to the US, and arguably the world’s, economy than what the Federal Reserve has done making money free. It has caused such great distortions in market behavior that it pretty much effects everything.

Bitcoin only exists because of monetary policy. Remember, it was promoted as a response to its supporter lack of faith in the dollar.

The record bull market? That’s clearly due to Fed policy. The magic letters FOMO (fear of missing out) and TINA (there is no alternative) are driven by the Fed eliminating the return on any safe asset and forcing people into risky behavior.

Robinhood and meme stocks? Well, that is where people went to engage in that risky behavior. They don’t exist without the Fed egging them on.

Wealth disparity? When the Fed encourages risk taking, that benefits people with the means to take risk, aka the wealthy. Don’t blame the billionaires for doing what they were incented to do. Blame the enablers for selling them the weapons.

I can keep going and going but let’s take a moment to reflect on the mechanics of how all this works and what happens when it stops.

Free Leverage

So what behavior did the Fed actually promote? They begged investors (particularly institutional ones) to buy risky assets with lots of leverage.

They did this in three ways. First, they took interest rates to zero to make it cheap to borrow. Then, they began buying up such large quantities of low risk fixed income assets that prices rose to the point where nobody would logically buy them. This created TINA and forced people to buy risky assets with that free leverage. Finally, they began buying riskier assets, even including junk bonds, thus taking credit risk out of the economy.

Yes, the same Fed who got excoriated for orchestrating bailouts of investment banks a dozen years ago made every corporation in America too big to fail and was cheered on for it! By removing default risk from the economy, investors could buy whatever they wanted without any fear of losing.

So, let’s bring that all together…you can borrow for free and buy speculative assets with no risk of default. Who wouldn’t want to do this??? After all, leverage has risk (we’ll get to this later), but only if asset prices go down.

Essentially, the Fed created a legal way to all but write large checks directly to institutional investors (and the new class of retail investors who figured out options were a way of creating leverage without having to qualify for a loan).

And the public barely noticed…even during the period of greatest populism in our country in over one hundred years!

Now, it’s really important to reiterate that key condition that made this work so well. The Fed removed default risk from the economy. You don’t need to be a genius to figure out how to take advantage of this. In fact, the more you understood about complex risk models, the less likely you were to participate because you were stuck in an outdated paradigm.

Isn’t This Like the Housing Bubble?

By the way, if this sounds a lot like what happened in the housing market fifteen years ago, you are absolutely right! There was free leverage (no money down mortgages), no credit risk (even the worst subprime borrowers could buy), and no risk of losing money (housing prices never go down!).

We all know how that ended. In some ways, this period is worse because the bubble has spread so widely. It is every asset class, not just one. On the other hand, part of what exacerbated the housing problem was the illiquidity. Once the buyers disappeared price declines overshot because you couldn’t “trade” the asset.

At least when the easy money bubble ends, you will be able to exit most of your depreciated investments. That’s not all good. For example, margin calls caused by temporary negative marks will cause a lot of pain, but we’ll get to that shortly.

How It Ends

Let’s return once more to that key phrase: The Fed removed default risk from the economy. When that condition ends, behavior will change even if interest rates were to stay low (which they wouldn’t).

What makes it end? Well, it could be the Fed suddenly has an awakening and realizes they are subsidizing poor capital allocation, creating inflation, and other bad policy and voluntarily withdraws support for risk takers and accepts the consequences. Possible, but probably not likely.

The other way we get there is markets lose confidence in their ability to invest “risk free” and the Fed has to play defense. This seems more likely.

Note, the Fed thinks they know how to deal with this. After all, when Covid arrived or the Taper Tantrum happened, they printed more money and bought more assets to reassure markets that all was well.

This works as long as inflation is low. Print more money. Monetize more debt. If symptoms persist, repeat as needed.

However, if markets truly believe inflation is real, they will no longer be reassured by these tactics. Instead, they will find them counterproductive. This will lead to the Great Delevering.

The End of Leverage

If investors begin to reassess credit risk, the first response is to decrease leverage. This, in and of itself, is bad for economic growth. The withdrawal of leverage reduces the money multiplier effect and thus economic activity.

From a practical standpoint, it becomes harder for corporations to borrow to finance growth. Instead of borrowing $500M at 75bp over the Treasury curve, maybe you can only get $300M at 125bp over.

Note, capital will get withdrawn first from the riskiest activities. That means SPACs looking to invest in obscure cryptocurrency projects will likely be first to find the window shut. If you’re wondering why growth stocks are starting to wobble, this is why. The end of easy money is toxic to the growth trade.

The Panic Begins

But there’s another big issue and that’s market volatility. Once the market realizes delevering has started, they will almost certainly overreact. Even those who don’t need to delever will start selling. Why? Well, for one, they might be worried the delevering isn’t done and they better sell before the rest of the sell orders arrive.

Then, you have the opportunists who will anticipate they can create more selling by frontrunning. In other words, if they know other investors will have to reduce leverage more the more that the price goes down, they will try to force the price down by aggressively short selling or buying puts to cause a stampede.

This is what causes extreme bear markets. You have round after round of delevering forcing selling which leads to panic which causes more selling and the need for more delevering until we eventually hit rock bottom.

The impact of this volatility can be greater than the textbook economic effect from the higher cost of funding. In fact, that borrower mentioned above who had to settle for $300M instead of $500M? There’s a good chance they have to pull their offering because markets are too frantic to fund even good borrowers.

Yes, the Fed will try to assuage markets and calm fear, but how? By printing more money to buy more private debt? That won’t work anymore. That will only serve to spook markets further. The toolbox gets limited pretty quickly.

By the way, this is not just a problem for corporate markets. Who is going to buy government debt auctions if the Fed is out of the game? Bitcoin will likely be proven to be a risk asset, not an inflation hedge. Nobody is buying options on Robinhood anymore. There will be rampant margin calls for aggressive retail investors.

Are We There Yet?

No, probably not quite yet, but the risk meter is definitely going higher. The internet bubble took years to deflate. So did the housing bubble. The easy money bubble is finally reaching its inflection point. The second derivative is turning negative. We now have to wait for the first derivative to flip.

That will require a lot more certainty in the persistence of inflation than we currently have. For all the fear of future inflation, the ten year Treasury is still below 1.5%. In other words, it’s still acting like inflation is 0% for the next ten years.

While that may sound insane to you and me, that’s the reality today. When the ten year is approaching 4% and looking to go higher, that’s probably a sign things are about to get ugly.

If you believe real rates should be positive, then 3-5% recurring inflation would suggest a 5-6% ten year. Financial markets would collapse under that weight.

So watch the ten year closely. It will tell you all you need to know. The other tell is credit spreads. If we see high yield, or better yet, A rated credit spreads widen than you know the game is almost over.

There is no need to be a hero trying to call a bear market early, but when you see the panic begin to build, rush to the exits before it’s too late.