The index of stock market volatility (one measure of market fear) has risen in the past week, concurrent with large absolute point swings (although relatively low on a percentage basis).  Markets are not as volatile as they were in October, but clearly there are uncertain times ahead, and markets generally like certainty.  There are so many naturally uncertain aspects of the market even in a normal “quiescent” day to day scenario, that things that are outside the “normal” put traders more on edge.  Its hard enough for entrepreneurs to predict fickle consumers, how much more difficult is it for them to predict what Mr. “Art of the Deal” will do in trade policy with China?

Today markets are relatively steady going into the Thanksgiving holiday, but the underlying reasons for volatility will return, as surely as we knew that President Trump would pardon the turkey(s) yesterday.  As Hayek noted, markets are a discovery procedure, constantly adjusting to forecast the future valuation of earnings.  And prices can be affected by both real and monetary factors, both market-based and non-market based.  In an op-ed today, the Wall Street Journal was quick to call the recent market volatility a result of Mr. Trump’s horribly misguided trade policies, especially with markets coming to grips that there is no clear end in sight.  Now I share the WSJ’s concerns, and believe that Mr. Trump’s policies are indeed part of the problem–but only a small part.  Yet they could be the straw that breaks the camel’s back.  Worrisome also is that given the geopolitical stakes with China, combined with the fact that they really are doing some very bad things across the board (South China Sea territorial claims just one example), I’m afraid we must root for Mr. Trump to “win” here on his trade war–hopefully it will be a quick win.  His position would be so much stronger were he to clearly articulate the things that China is doing that are actually a problem (e.g., intellectual property theft) rather than inventing a fiction (that there is something meaningful about having a large trade deficit with China*).

Yet the much bigger problem, the iceberg that is below the water, is the normalization of interest rates.  We’ve had roughly a decade of negative real interest rates.  Even today, as I read in one financial commentary, despite the recent uptick in rates engineered by the Fed, there is no part of the U.S. Treasury curve that will give you a real, after-tax positive return if adjusted to broader measures of inflation that include food and energy.  While I haven’t checked the calculations, the point is well made even if not exactly true.  A decade of low interest rates has caused all sorts of problems–problems that will only be revealed when we return to normal.  Warren Buffet famously quips that we don’t know who has been skinny-dipping until the tide goes out.  It’s relatively easy to hide years of losses with uneconomic business models when finance is cheap, and especially when low interest rates necessarily drive valuations and speculative opportunities higher.  It doesn’t seem odd to me that the so-called FANG stocks (Facebook, Apple, Netflix, Google) are being hammered right now.  I love Amazon as a customer, and its been a great stock appreciation vehicle for many investors, but their model has clearly been to pour everything back into the company for further expansion.  Will there ever be a day when they actually would pay out earnings to shareholders?  Many of the new companies that are “unicorns” have never really made any money, and yet they have billions of dollars in market capitalization.  My point is not that some of these companies might not be transformative, but that they are much more possible in a low interest rate environment, and that likely many of these firms will not be able to survive a higher interest rate world.

But it gets worse than just speculating in unicorns; many market critics are concerned about greedy companies that have taken their earnings and used them to buy back shares to raise their profits rather than investing in capital that will increase jobs and wages.  In a low growth world, I can certainly understand both the firm’s manager’s approach as well as the criticism.  But in a low interest rate world, many companies have actively borrowed cheap debt to buy back their shares, which has led to a double increase in leverage (more debt and less equity).  This may be fine, but what happens when interest rates rise and the business profits don’t increase as fast as financing costs?  You can start to see the scope of the unwinding problem.  And its not only firms that get in trouble with low interest rates.  One of the more accurate ways to think about the interest rate is by defining it as “the price of current consumption.”  After all, if you consume today, you are missing out on the interest you could have received by taking that consumption money and putting it in the bank–you’re missing out on the interest you could have received.  Hence interest can be thought of as the price of current consumption.  And when interest rates go down, the price of consuming today goes down.  There is less incentive to save, and more incentive to draw future consumption forward.  It’s no wonder that the auto business has done remarkably well in a low interest rate environment (in terms of vehicle sales, if nothing else).  Yet, the interest rate reset is going to send sales in the other direction.  And let’s not mention the homebuilders.  Or did I just do that?

The S&P Supercomposite Homebuilding Index is down 36 percent in 2018, poised for the worst year since the financial crisis, while the S&P 500 Financials Sector gauge has dropped 14 percent from its high in January.  “Home stocks are always going to be first and foremost going to take a hit,” Matthews said. “Then you’re going to go through and you’re going to look at the financials space because the curve has flattened and then you’re going to start to look at other areas.”

Even the most venerable institutions are at risk; GE engorged itself on cheap debt for 25 years, and its 2015 triple A rating is now long in the rear view mirror.  Wall street speculators wonder when it will go to junk status, with credit default prices surging (a form of insurance for market speculators).  If conservatives are concerned about what happened in the last election, just wait until the economy turns south, if the scope of the problem is as large as some fear.

So what to do with the $4T+ plus problem of the Fed balance sheet?  The best thing would be for the Fed to just stop.  Seriously.  Just stop doing any buying and selling.  When something on the Fed’s balance sheet rolls off (e.g., a bond that has completed its length of term), don’t replace it.  Over time, and relatively quickly given we’re already 10 years past the financial crisis), the Fed’s balance sheet could shrink.  Let’s see what the markets would do with interest rates.  I don’t know–and very importantly, the Fed doesn’t know either–what the interest rate should be.  Let’s fix the supply and see where demand takes us.  Yes interest rates may be more volatile, but isn’t that the way it should be in a market economy?  We know that price fixing never works, and the economy’s most important price is the price of money and credit, and yet we practice socialist planning in that most important price.  Then we are surprised when we get booms and busts.

* As I’ve stated before, having a trade deficit with an individual country is no more important than you having a perpetual trade deficit with Walmart or Amazon.  At the end of the day, as long as your checkbook balances, you’re ok!  In a world of decentralized trade and specialization, we’re going to individually have “trade deficits” with some while having “trade surpluses” with others.  The same reality occurs with nations.  And with nations, any overall aggregate trade deficit is always matched by a corresponding investment surplus, i.e., if foreigners don’t buy our goods they recycle the dollars into our financial system.