The Dividend Cafe - No Free Lunch with Interest Rates

Episode Date: April 28, 2023

Today's Post - https://bahnsen.co/3ncX8V7 The subject of bank stability has really been a big conversation topic since the failure of Silicon Valley Bank and Signature Bank back in mid-March.  People have wondered who was to blame, what went wrong, what could have been different, and what else is still going to happen that we may not know about. I have written in these pages already about Sunday afternoon dramas and the market instabilities that generally create such events.  Notice how I worded that, for it was intentional.  Sunday afternoon dramas do not create market instabilities; market instabilities create Sunday afternoon dramas.  And as we navigate through a change in the present financial cycle, a little perspective is warranted on what has been driving financial cycles.  In fact, if we do this well we may just understand not only how this fits into Sunday afternoon dramas and the broad reality of market disruption risk; we may also understand a lot more about the federal reserve, interest rates, and basic financial behavior. So let's jump into the Dividend Cafe ... Links mentioned in this episode: TheDCToday.com DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Hello and welcome to the Dividend Cafe. I love recording here from our Newport Beach studio. And I love the topic of this week's Dividend Cafe. We're talking a lot right now in the markets about where we are in the banking system, where the Fed is in their cycle with interest rates, and what it means to the overall economy. And I think that when you start talking about financial cycles, it behooves us to review monetary policy, but have a better understanding of the way the world works. And this is a passion of mine to apply the sort of behavioral logic of economics to monetary policy. And I think that there is a lot of interesting application to that when you apply it to personal finance, when you apply it to individual investment decision making.

But I also think on the macro that when we understand it better as it pertains to policymakers, to governments, and yes, to banks, that we get a clearer understanding of the way the world works. get a clearer understanding of the way the world works and maybe, just maybe, what can be done to make it better in the future, learning from mistakes that one could argue have been made. One of the great principles in understanding economics is the notion of trade-offs being an inevitable reality, sort of codified in a famous line that Milton Friedman used in a paper where he said, there's no free lunch. And I ended up titling my last book the same thing, there's no free lunch. And all that concept is really trying to capture is that there are trade-offs and that people do cost-benefits analysis and that that's okay. It doesn't mean everything is bad just because there's a cost to it. We voluntarily take on cost

all the time, but we do so when we've consciously weighed the cost against what it is that we're trying to achieve. I think that one of the fundamental errors of modern policy, contemporary approach to monetary policy, is this notion that we can use easy and overly accommodative policy without a trade-off, that there won't be a price to pay for excessively low interest rates for an excessive amount of time, for example. And I will argue that I, first of all, have spent much of the last several years in the Dividend Cafe talking about what some of those costs are, whether it be distortions of markets or whether it be eventually getting a diminishing return on the effect of monetary stimuli

that ends up creating disinflationary and deflationary pressures in an economy a la Japan. But that is not so much my point here today. I rather want to focus on the specifics of how the Fed's staying too low too long. And some of the consequences of that are really behind where we are right now with the banking system and the questions about what exactly we're going to do to have a robust and healthy and stable banking system in our country. Dr. Lacey Hunt, who I think is one of the great monetary economists alive today, has been publishing academic material since the 1970s. He's become a friend and one who I've learned a great deal from. But he lists five things as sort

of the major consequences of excessively easy or overly accommodating monetary policy. First of all, how do we know when it's overly accommodating? I mean, there is a backward looking component there that might not be very helpful and there is some subjectivity, but I'm really kind of sold on the basic Austrian idea that there is a natural rate at which the rate that is embedded in the cost of capital, the interest rate, so to speak, is neither so tight that it is suffocating economic growth or so loose that it is encouraging malinvestment and encouraging excessive leverage. Now, of course, quantifying what that natural rate would be is the million dollar question. And I very much believe it is effectively in line with the growth rate of nominal GDP, that whatever the economy is growing at

represents a pretty good discount rate to apply. And when you get an interest rate far below that or ahead of that, you end up with some very unnatural results. But regardless, we don't really deal with central banks that are generally struggling with being too tight or too loose. They're generally too loose, and then they end up getting too tight in response to being too loose, which is what we're dealing with right now. And I assure you, it ain't going to last much longer. But I digress. The excessive accommodation to Dr. Hunt's model is that, first of all, it leads to money supply growing too fast for too long. And despite the fact that we have been dealing with downward pressure and velocity

for other reasons that are not good, excessive growth of money supply is most definitely inflationary when you have stable velocity. This is kind of Fisher quantity theory of money 101, something I've never in my life disputed. Our problem now is that we are not generally seeing money supply growth create excessive inflation because velocity is offsetting it. But regardless, excessive money supply growth and then money supply contraction that is a greater pace than would be normal in the ebb and flow of economic activity, it creates distortions and instabilities in the economy. But Lacey's point number two is that credit being available too long, and he calls it too available for too long, leads to too much debt. I mean, we can use the word credit all we want because the person giving it out is giving out credit. The person taking it is taking on debt. It's the same word just applied to a different actor in the transaction. Okay. And when there is too much credit available for too long, the result is you get too much overall debt that puts downward pressure on growth because the

debt has to be paid back in the future. You've pulled forward future growth in the present. This isn't complicated. Number three in an overly accommodative monetary system is when you end up with rates that are too low for too long. And that misprices risk. That's happened quite a bit. And it's certainly something I think we were dealing with a lot last year. And it can lead to real extreme manias, the Bitcoin stuff and the hot tech, non-profitable tech space. We remember the dot-com boom. We certainly dealt with the real estate housing boom and all that stuff. And these things have interest rates that are too low, too long, that enable people to miscalculate the risk of the leverage you're taking, the risk of the underlying asset and misprices in the economy. I've talked about this one probably the most over the years. It's not complicated either.

Number four would be subpar borrowers and subpar deals. People that maybe shouldn't be the ideal borrower of money are able to get loans when rates are too low, too long, when monetary policy is too loose. And then they are applying it into deals that are not great deals. Why do we know they're not great deals? Because the good deals already got done. The debt and equity that went into high quality deals was done and you start going down the food chain and you're going down the food chain and quality of deals with excessively long, overly accommodative monetary policy, but you're also

going down the food chain of the people doing the deals, subpar borrowers. But then the fifth point that Dr. Hunt makes is forward guidance really becomes gospel. That in overly accommodative monetary policy, the markets, financial markets, significant actors begin relying on the expectation of what will be going forward. And this is very much, in my opinion, what we're dealing with now. Really, you could argue that 2022 was much more about points one through three. High money supply growth, credit was available too long, and too much debt built up, rates were too low too long, and risk was dramatically mispriced. There may be some of those things to still kind of work through, but those were really 2022 lessons. I think so far, 2023 has been more about subpar borrowers, certainly subpar deals, the quality of some of the loans and commercial real estate, for example, not as good. But then number five, this is kind of the one that I just can't believe is not getting more conversation, which is that you really had every reason in the world to believe 14 months ago, beginning of 2022, that rates were going to start to come up, but very slowly.

The Fed was telling you that they were going to end the year at a one and a half percent Fed funds rate. And now here we are, five percent, and it looks like they're going to hike again next year. The Fed has given forward guidance, and market actors rationally acted on that guidance. And yet the Fed has pulled the rug, and now you end up with instability in some of the banking system. You go, well, yeah, but all that these big banks had to do is not give bad loans. But see, they didn't give bad loans. There has not been credit impairment. The rates are too low. But see, the Fed had rates at 0%. So how's the bank to make money? They were giving low rate loans to depositors who brought over a lot of money and

they weren't expecting interest on their deposits. So that gave the bank adequate net interest margin and a higher deposit base to go out and grow and do more business. It's the banking model. And it was predicated on that low rate environment that changed behavior. It changed the behavior of depositors who were willing to take 0% deposits, of borrowers who were borrowing at low cost money, doing deals, and maybe they should or shouldn't have been doing, the bank willing to lend on those deals at lower rates. And then even a bank like Silicon Valley Bank, we talked about six weeks ago, I've been very critical of a company having a $100 billion bond portfolio

and not hedging out the interest rate, buying long dated bonds. But if the Fed's told you they're going to keep rates low and just kind of increase a quarter point at a time, that's what they've always done in the past. And that forward guidance gets baked in. It is not irrational that people would have taken the Fed at their word. And yet they end up doing four three-quarter point hikes in a row. And so this boom-bust cycle is exacerbated in the faulty forward guidance given by a central bank. There was no free lunch. You were not going to have that period of too low, too long, overly accommodative monetary policy without a bigger buildup of debt, without governmental debt building that has to get paid back, part of my planification thesis, subpar borrowers and subpar deals, distortion of risk, and then ultimately decisions made by rational humans, and particularly in this example,

the banks themselves, that has now led to an instability, all brought about by the Fed's effort to bring business cycle stability through monetary policy. It doesn't work. The natural rate is where you want to be at some level at which nominal GDP is growing and some rules-based approach that takes away on the margin these more excessive booms and more excessive busts. So I think humans act. I think economics is the study of human action. I think humans were made by God to be pretty reasonable, rational, incentive-driven economic actors. I think banks are mostly run by humans. And I think that when we put ourselves in a system where the monetary policy is going to distort these principles,

we will not get a free lunch out of it. We will not get the wonderfulness of a boom without the byproduct of a bust, however that takes shape, whether it is having to reprice risk around the reality of a natural interest rate, whether it's having to reprice debt levels or reset debt levels because of excess of leverage that exists in the system, or even when it means people that have gotten on the wrong side of deposit rates, lending rates, what their loan book looks like, and the overall stability within that of the entire banking system. So I don't think we're going to learn from it, by the way. I don't share this as like now all of you Diven and Cafe readers and listeners and viewers can go play a role in us not doing it again.

We're not Federal Reserve governors. can go play a role in us not doing it again. We're not Federal Reserve governors, and there is a rather fatal conceit that believes that they can kind of turn the knobs here and there to make it all work out in the end, but there isn't a free lunch. An overly accommodated monetary policy comes back to bite and forces me as a portfolio manager to make, because humans act, and that includes those who run money for a living like I do and my team does. We have to run money with the reality of an instability that, if it was not the reality, would enable us to perhaps do things differently, easier, more opportunistic, whatever the case may be. Hope you get the point. Hope you follow what I'm saying. Hope you've learned from it, and I certainly welcome your questions

as I try to keep you informed in our view of monetary policy, the basic economic reality that there's no free lunch that includes for central bankers. Thank you for listening and watching and hopefully many of you reading the Dividend Cafe. Have a wonderful weekend. We'll see you next week. The Bonson Group is a group of investment professionals registered with Hightower Securities LLC, Have a wonderful weekend. We'll see you next week. This is not an offer to buy or sell securities. No investment process is free of risk. There is no guarantee that the investment process or investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors. in are from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other information contained in this research is provided as general market commentary and does not constitute investment advice. The Bonser Group and Hightower shall not in any way be

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