Stay defensive

by pkkiller69

Yo, I came across a very interesting read: www.jstor.org/stable/1813987?seq=1#metadata_info_tab_contents

It talks about interest rates during the Civil War and WW1. To summarize, the market rate of interest should generally follow the below formula:

Interest Rates = Pure Interest + Risk Premia + Frictions

Where pure interest is the risk-free rate (set by time preferences) and the risk premia consists of: risk of default, currency devaluation (relevant if $ pegged to gold), risk of high inflation etc. During war periods, you would expect all three factors to rise.

During the Civil War interest rates generally did increase. However, during WW1, the U.S. increased the money supply so voluminously that interest rates stayed level until 1917. The takeaway is that monetary policy is far more powerful than the supply / demand actions of the population.

The kicker — the U.S. entered two sharp recessions following WW1 as reserve requirements stretched thin needed to be scaled back and the money supply curtailed as to maintain convertibility to gold.

We have a similar situation in COVID world. The fed has set reserve requirements to 0 www.federalreserve.gov/newsevents/pressreleases/monetary20200315b.htm Also, the fed is dumping dollars into the market ($40B daily), buying securitized corp debt (unprecedented) and even non-IG debt! We are witnessing a 1-m rally in the equity markets during 20% unemployment.

What will happen when this ends? Will this even need to end? Clearly it will need to end to some degree. Reserve requirements cannot stay at 0%. But does the Fed’s balance sheet need to shrink? The answer is unclear. But, we do not need to maintain convertibility to gold unlike post-WW1. Also, during WW1, the economy faced immense inflation (+10%) which is not a factor here.

I am not advocating for a complete shift to cash. The market and the fed’s balance sheet can stay elevated far longer than what you think is possible. I am however advocating for caution and an awareness that asset prices could collapse anytime. Buy nothing that you wouldn’t hold for 1 economic cycle.

 

Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence.