OPINION: Current Potential Dislocations in Asset Prices
Dislocations in asset prices can work both ways, they can be dislocated to the downside as well as the upside. In this article, I am going to attempt to give you (my readers) an idea on how I see the financial world at this specific point in time regarding the asset prices around us.
Since the early 2010’s, we have been in a low interest rate “regime”. When I started in the business, one of the most common statements I heard on TV was TINA (There is No Alternative in 2018). This was used to describe the equity market vs the debt market. Due to the low rates on loans, investors adamantly believed that there was no alternative to owning equities in the public markets. In that point in time, they were correct. The problem was that they cannot be right forever. Why? Because as always; it is not what you buy, it’s what you pay for it. Also, price is what you pay and value is what you receive (and when prices for assets are going up and discounting future ups in an aggressive way, it leads to destruction of the value in the statement above). The higher stock prices/asset prices went, the lower the potential future return. Note that the future return can never be accurately calculated in the present, but also know that lower prices potentially bring that future return HIGHER just as higher prices can bring it LOWER.
Interest rates over time work like gravity to asset prices. Why? Because debt is used to get extra capital to build out a business, real estate, or even pay bills when the person/business issuing debt doesn’t have enough capital today to layout for the tomorrow they want to build (or don’t have enough capital for their consumption today). When it is cheap to get that extra capital (aka, the interest rate), over time, more and more people/businesses take advantage of that “cheap” capital. The problem is that this demand actually ends up raising the price of leveraged assets, or arguably all assets directly or indirectly tied to it. For an example, you can purchase a stock with cash, but one can also purchase the stock with a “debt” called Margin. Problem might not be the correct word to use; but the longer this process marches on, the more likely for things to get out of balance (with fewer noticing as time goes on w/o the imbalance showing).
Lets’ review what has taken place in the last few years. In 2020, our federal government cut their federal funds rate down to virtually 0%, while simultaneously creating large amounts of dollar supply. With this, our government was able to finance this money creation with “cheap” debt. This was a seed of the big dislocations I see today. Understand though that doing this kind of monetization is not necessarily a bad thing (an argument can be made by some that this is a necessity in times of stress). In my opinion, the “bad thing” is more about the volume vs. the action of doing what was done. This continued for almost two full years with the low rates on top of the money creation. In the past, this tends to lead to inflation and look what we have seen, no wonder!
By the end of 2021, we had experienced a huge boom in asset prices hand in hand with artificially low interest rates. This asset price boom was fueled by money created out of “thin air” via low interest rates & a hotter than expected financing arm (figuratively the printing press & "monetizing the debt” or in other words, FED buys bonds and private investors get money in exchange for those bonds bought by FED). In this period, these friendly rates were passed on to the private markets. On top of this, the economy was in a frozen state for longer than one would want, which helped lead that fresh, “cheap” money to flow from consumption to investment seemingly all at once. For example, if you’re a homeowner, odds are you refinanced your mortgage during these times and are in no rush to pay it off or sell the home.
By the start of 2022, over $80 Trillion dollars in US Residential Real Estate’s market value was refinanced over that roughly two-year period (source 1). Is this a bad thing? Not necessarily for the homebuyer, especially if the price of the home stays above the amount of debt on it. My problem is that this surge in demand for loans led to home prices exploding higher even to this day in 2023. Think of who in the heck owns all of these mortgages? For someone’s liability is always another’s asset. Well, whoever owns those mortgages is losing money to not only inflation being above the interest payments they receive, but also (if the debt owner is a private entity) being taxed on the little interest they receive as well. This has created a weird dynamic in which the homeowners have been the beneficiaries, and the owners of the mortgages have seen major market value corrections for those loans.
Why? Well, if I was buying a bond today, would I rather:
Buy a Treasury bond paying me let’s say closer to 4.5%?
Buy a mortgage with a 3% coupon, and also take the risk of potentially not being paid back in full? (Government will pay on the treasury, the question is what is a dollar worth when paid back?)
For option 2 to be my choice, I would REQUIRE a lower price for that bond than the Treasury.
This is the dynamic we are facing today. The owners of these mortgages believe they can hold the asset until maturity to realize their return of principal, instead of selling that bond to me at a discount. Maybe they can, but I wouldn’t consider it anything more than a “hope I can” situation.
With the low, locked-in mortgage rates, a normal housing market has gone out the window. No one wants to sell their home, no financial institution wants to own the mortgages on that home (unless they receive a proper discount), and few who want to buy a home (and don’t already own one) can actually afford a home because of the price and interest on that price demanded in the market today.
This in my opinion is leading to a very unpredictable set of circumstances, and note that mortgages are far from the only unpredictable thing. From Government debt issued in those years to fixed corporate or commercial debt, they all have similar characteristics with different amounts of money in each basket. I could never tell you how I think it will all play out, because no one knows the future. All I can do is give you my opinion on where I think we are today.
Well, where are we? We are in a tightening monetary cycle that seemingly will not go away until a pipe bursts under the pressure. Am I afraid? No, because I am an eternal optimist at heart, believing the world gets better around us whether we choose to notice or not. IT JUST TAKES TIME. Time is the question mark today. All I know is that I see imbalances that could:
1. Process smoother over a long-period of time, potentially decades
-or-
2. Rapidly, which would in hindsight shorten the amount of time needed to get back into balance.
Which would I prefer? Option 2 would be more painful initially. In my opinion though, it might be the healthier choice for the long-term growth of not only the US, but the world. I say this because we would first off know where things went offsides quicker, thus recognizing the imbalances sooner. This “should” lead to better decision making in a shorter time frame as well. Nonetheless, my opinion can never be fully correct. Because the danger is not what you know, but what you don’t know. All I can say is there is plenty of things out there I understand as well as the pot of gold at the end of a rainbow. I’ve never found it!
All the best to you readers out there! I hope that this article not only gives you some insight into how I am seeing things today, but also helps build your understanding of what I am trying to describe here as well. This article should not be taken as the unequivocal right answer, but should also not be shrugged off as something that will never affect you. With all of that behind us, know that there are still plenty of positives within the investment world today! Just know that you have to do your best to give yourself perspective on not only where we are going (the value), but where we are at on the path to getting to where we are going (the price).
Riley Sisson
Branch Manager, RJFS
(Source 1) https://www.freddiemac.com/research/insight/20220425-trends-mortgage-refinancing-activity
The information contained in this blog does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Riley Sisson and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Past performance does not guarantee future results.
Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. Holding bonds to term allows redemption at par value. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise.
