Federal funds rate
Morehead argues that the Fed made a big policy mistake by keeping the federal funds rate too low.
“The difference between inflation (their mandate) and their policy tool (fed funds) is much larger than at any point in history — including the disastrous 1970s,” he writes.
“They left rates at zero. Fed funds were 1.55% before the pandemic. They’ve just gotten overnight rates to back where they were before the pandemic policy eruption when inflation was only 2.30%.”
As we know very well by now, inflation is no longer at 2.30%. The latest Labor Department report showed that consumer prices rose 8.6% in May from a year ago, marking the biggest increase since December 1981.
And even that official reading was not accurate because it does not measure housing inflation in real time, argues Morehead.
Instead, the official CPI measures housing inflation using something called owner’s equivalent rent — how much it would cost a homeowner to live in their home if they were renting — and that metric only went up 5.1% year over year.
If you’ve been in the market to buy or rent a property, you’d know prices have gone up way more than that. The government says it uses owner’s equivalent rent because it’s only trying to measure the change in the cost of shelter while removing the investment aspect of homebuying.
Morehead instead looks at the S&P CoreLogic Case-Shiller U.S. National Home Price Index, a leading measure of U.S. residential real estate prices that can be viewed as a barometer of the housing market. It jumped 20.6% year over year, and Morehead says that if we use that instead of owner’s equivalent rent to calculate inflation, CPI would have gone up 12.5%.
To tame spiking inflation, Morehead says that the Fed still needs to raise interest rates “by three or four hundred basis points.”
Manipulation of the bond market
While the low interest rate policy was a mistake, Morehead says, it is “dwarfed” by the Fed’s manipulation of the government and mortgage bond markets.
He suggests that previously, the Fed let free market actors like pension plans, mutual funds and insurance companies do the lending — but things changed in 2020.
“[W]hen the Fed got into the mortgage lending business, they really went for it. They completely crowded out all other lenders.”
And that led to a huge increase in housing prices.
“They forced 30-year mortgage rates to hit 2.68%, basically daring people not to buy a house (or two or three), which would obviously create a bubble in housing, which itself contributed to a labor shortage as two million Americans retired early or otherwise left the workforce.”
Officials argue that the Fed’s purchases of securities were essential to “keep markets working” during the pandemic and “convey to the public that the Fed stands ready to backstop important parts of the financial system.”
But when you can borrow money at 2.68% to buy properties that are going up 20% in value per year on average, both homeowners and investors are going to go for it, explains Morehead.
“Over the past two years the Fed bought government and mortgage bonds equivalent to over 200% of all mortgage lending in the U.S.”
While that doesn't match the exact definition of a Ponzi scheme, Morehead argues that the Fed’s easy money policies has created a huge housing bubble.
Crypto to the rescue?
All of that does not bode well for the U.S. economy.
Plenty of experts — including Morehead — are calling for a recession. But investors are already feeling the pain. With the S&P 500 down 20% year to date, many stocks are already in a bear market.
The Fed, on the other hand, is more optimistic. Last month, Fed Chair Jerome Powell said the U.S. economy is in “strong shape” and “overall the U.S. economy is well positioned to withstand tighter monetary policy.”
Morehead expects interest rate hikes to impact bonds, stocks and real estate. But there are asset classes that are less correlated with the interest rate markets.
“I can easily see a world in, say, a year when stocks are down, bonds are down, you know, real estate's down, but crypto is rallying and trading on its own — very much like gold does, or soft commodities like corn, soybeans all doing very well.”
Morehead’s Pantera Capital specializes in blockchain technology. It launched the first cryptocurrency fund in the U.S. in 2013.
That said, Morehead did note that crypto is “very correlated with risk assets.”
Bitcoin — the world’s largest cryptocurrency — is down 57% year to date but has still returned over 900% over the past five years.
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