What Strong Towns advocates need to know right now about financial markets

The New York Times last week ran a story titled Something Weird is Happening on Wall Street, and Not Just the Stock Sell-Off. It came tantalizingly close to voicing the core conundrum we find ourselves facing, but it just couldn’t cross the final gap. We’ll all get there soon enough, but today I’m going to help you be earlier than most.

The article kept wanting to compare the current gyrations of the market to the 2008 crisis, as if they are two separate events. This is like analyzing World War II as merely a Hitler-led period of German insanity without any appreciation for World War I, the Versailles Treaty, the Weimar Republic, Communism and the Bolshevik Revolution, and any number of intertwined events that set the stage for conflict.

I think we can say there were two camps coming out of the 2008 crisis. The first looked at the actions taken to “rescue” the financial markets as being largely successful, if perhaps a little distasteful for their unfairness. This point of view considered the crash to be the problem that needed to be fixed and found it very normal, and quite explainable, that the market would recover and resume a frenetic pace. These were the people saying stocks were cheap a couple weeks ago.

The author of the New York Times piece seems to be in the first camp. At the risk of oversimplification, I’ll call this group the “bulls.”

The other camp, the “bears”, were appalled – and likely shocked – by the way the markets were propped up in 2008. Many did not see the extraordinary measures that were taken coming, didn’t think they would work, and have been predicting a reckoning ever since. This group has been baffled year after year that the financial markets have continued to go up, for no apparent reason, and despite all kinds of clear warnings of trouble ahead.

You’ll hear a lot of conspiracy theories coming out of the bear group because they have not been able to predict or even satisfactorily explain, with any logic they can grasp, the past decade of economic activity. This camp believe stocks are still too expensive.

And just so we’re clear: I’m solidly in the bear camp. When people say housing prices are unaffordable for most Americans – literally people don’t have the money to live in a house – part of me throws up my hands and says, “I can’t explain that. It makes no sense.” In a system with market responses, it doesn’t. Most things in our financial system have not made sense for a long time.

Here’s a quote from that New York Times article:

Underneath the headline numbers were a series of movements that don’t really make sense when lined up against one another. They amount to signs — not definitive, but worrying — that something is breaking down in the workings of the financial system, even if it’s not totally clear what that is just yet.

Bond prices and stock prices have moved together, not in opposite directions as they usually do. On a day when major economic disruptions resulting from the coronavirus pandemic appeared to become likelier — which might be expected to make typical market safe havens more popular — many of them fell instead Wednesday. That included bonds of all sorts and gold.

And there were reports from trading desks that many assets that are normally liquid — easy to buy and sell — were freezing up, with securities not trading widely. This was true of the bonds issued by municipalities and major corporations but, more curiously, also of Treasury bonds, normally the bedrock of the global financial system.

Let me try to explain a lot of complexity in terms that, I will admit right now, are going to be oversimplified (although still generally valid).

A bond is debt issued by a government or a corporation. That note will have a principle, a term, and an interest rate. Based on the perceived worthiness of the borrower (the entity issuing the bond), the interest rate will be high or low. The federal government is considered “risk free” and pays the lowest rate. Junk bonds are highly risky, often issued by companies teetering on insolvency, and the rates are much higher.

A stock is an ownership stake in a company. Owning a stock is generally riskier than owning a bond. If you own stock in General Electric, you are going to have your entire investment wiped out before the person who loans money to General Electric in the form of a bond is wiped out. (That’s the way it’s supposed to work, but proximity to power has subverted this relationship at times.)

So, when stocks are under stress, investors will often have a “flight to safety” and put their money in bonds. The more people who want to loan money in the bond market, the lower the interest rate that people wanting to borrow money must pay (there are more people competing to loan them money). A panic such as we’re experiencing will have lots of people taking their money out of stocks and putting it into bonds as a way to protect their capital. Interest rates should be cratering.

That’s not what’s happening. Interest rates are going up instead.

For those in the bull camp, this is an interesting anomaly, one that the Federal Reserve will quickly tamp down with aggressive bond buying (which they’ve accelerated since the Times article was written). For those in the bear camp, this is the signal that we’re crossing a financial Rubicon.

People are taking their money out of stocks for reasons that are simple to understand: The market is tanking, there is no bottom in sight, what seemed solid has been shown to be a big fat ugly bubble (to quote presidential candidate Donald Trump), and there is a lot of fear. Few people believe the stock market narrative right now.

But people are also taking their money out of bonds, and that is more complicated. Bond prices are at historic highs because interest rates are at historic lows. If you own a $100 bond that pays 5% and interest rates drop to 2%, your bond will be worth more than $100 because it’s paying an above-market rate of interest. With interest rates so low, there are not many gains to be had in new bonds.

Yet, there are still gains, and they would normally be considered safe. For more and more investors, they are no longer considered safe. That’s the financial Rubicon.

Even before the pandemic, the United States government this year was going to spend more than a trillion dollars above the revenue it collected in taxes. That means it needed to borrow more than a trillion dollars to keep the government running. Additionally, it was going to have to borrow multiple trillions more to refinance the various bonds that expired and needed to be paid back during the fiscal year. Where was all that money coming from?

A big portion of it was coming from foreign creditors: Governments, corporations, and individuals in places like China, Japan, India, Europe, and ironically a host of developing countries that find it to their advantage to have their reserves in U.S. treasury notes. It’s an important lesson lost on Americans, but the reason you have a reserve is for a time of crisis. I think we agree that it’s hard to imagine a bigger global crisis than this.

All these places that bought our bonds are going to use their reserves – they are going to sell their bonds or not refinance them when they expire, which is generally within the year – and they won’t be buying more because they won’t have the money. When that happens, who is going to loan the United States all this money?

It would be a difficult math problem to work out if the virus was everywhere except here but, of course, it’s here too. Airlines are asking for bailouts. Casinos (you read that right) are asking for bailouts. Banks won’t ask for bailouts because they are just going to be given them (we’ve crossed that Rubicon already). There are going to be trillions in bailouts and, this time, the commoner is going to get theirs as well. Occupy Wall Street will look like a bingo game if not.

The central question again then is: Who is going to loan the United States all this money? We’re talking at least $10 trillion in new debt plus refinancing over the next twelve months.

Let’s just take all of Jeff Bezos’s money. Assuming he still has $110 billion in net worth, that gets us four days. Bill Gates gets us another 3.7 days. Warren Buffet is another 2.7 days. Despite populist math, Michael Bloomberg gets us only 1.9 days. We’re running through the wealthiest Americans and we’ve only two weeks of our spending covered.

Who is going to loan the United States trillions of dollars over the next twelve months? The answer is: nobody knows, and that’s why people are selling their bonds as well as their stocks.

Some will say that the Federal Reserve is going to loan us the money. They are going to print trillions of dollars and buy up all the debt. We can call this debt monetization (the old way of talking about it) or Modern Monetary Theory (the new and enlightened way), but we’re talking about the same thing. Either way, that’s a new economic system. A completely new world financial order, one where the United States shares power as an equal to many other nations, if we’re lucky.

And if you don’t think that changes everything, just give it a few months. Everything about how we live our lives as Americans is about to change dramatically. The sooner we come to grips with that, the quicker we can get to work build Strong Towns. We’re going to be here to help.

Top photo by Gage Skidmore.

Marohn, Top StoryCharles Marohnmarkets