Why Interest Rates Should Stay High (ish).

Submitted by ThetaGangThroweway t3_zwj0ve in wallstreetbets

In 2022, the tide went out, and we all saw who was swimming naked. Every company that was heavily dependent on borrowed funds either reduced staff or collapsed completely. Namely: Buttcoin firms, green energy, and all our favorite tech stocks. This trend has revealed the perverse incentives in modern markets to go all in on growth regardless if it makes sense to do so.

  1. All employee compensation is a tax write-off, even stock options that do not technically cost the company anything. When employees are paid like this, they're incentivized to compete for market share even if it is not profitable to do so.
  2. All job-producing infrastructure is a tax writeoff, even if it flops. Again, this incentivizes competing for market share.
  3. All R&D is a tax write-off. This means R&D dependent firms are often tax-free, which does incentivize science but science is high-risk and rarely results in a marketable product. This results in a lot of pure-play firms that often crash and burn due to a single flop.
  4. The Fed has in previous decades targeted an inflation rate of 1-2% in order to incentivize people to either spend or invest rather than hoard.
  5. The Fed also targeted interest rates 2-3% in order to keep it easier for firms and individuals to borrow if needed. This is nice until you realize it makes stocks systemically more profitable than bonds during ordinary times.

These trends have been exaggerated by a number of equally important factors:

  1. Foreign governments buy US bonds with printed money. The biggest of these was by far China, which targeted inflation above the US in order to incentivize export to the US. Yes, China was lending money to Americans so Americans would buy more Chinese stuff, but this trend is falling as we speak as there are reports that China is buying Russian gold instead of T-bills this year. There are others, however, as many states peg their money to the dollar and maintain US currency reserves NOT in physical dollars, but in dollar-denominated bonds. This global trend made the spread in the Federal Funds Rate razor thin and US debt even cheaper.
  2. Everyone is looking for the "next Bill Gates" to make them rich. Everyone sees the returns of early investors in computers, and thus many people are aggressively investing into science they do not understand. Hindenburg Research, the infamous activist short seller, once reported they are mostly shorting fraudulent scientific firms and they're always finding more. There are even some venture capital firms that will go to universities and encourage students with good grades to come up with business ideas even if they don't really want to go into business.
  3. Venture capital has exploded. There are twofold reasons for this, firstly what you see above as people are trying to invest as early as possible into "disruptive technology." Cathy Woods and her ARK Invest team are simply the most high-profile case of this folley, whose funds behave like a leveraged-NASDAQ 100 fund due to all the borrowing by the firms the "disruptive" fund holds. There are currently tens of thousands of formalized venture capital firms, over ten thousand hedge funds that are historically tech-heavy, tens of thousands of "angel investors" using their personal funds, and billion-dollar crowdfunding firms. Venture capital is about as reliable as crowdfunding despite the pretension to exclusivity, as both report a success rate of about a quarter. The amount of funds raised is also about the same, as crowd-funded firms have an average of 10-20 employees and raise $1-5 million dollars, whilst early-stage venture capital firms are about the same. YOU HEAR ME! ARE YOU LISTENING TO ME!!! VENTURE CAPITAL AND CROWDFUNDING- ARE THE SAME! The only difference is crowdfunding is heavy on innovative consumer products, and venture capital is heavy on innovative business solutions. Late-stage venture capital is often just as liquid and has similar returns as stock market investing. Nonetheless, it is possible to become a CEO the exact same way one becomes a movie star.

The results of all these structural and cultural oddities are accidental Ponzi schemes. I don't mean to accuse anyone of crimes, although that is easy to get away with in this environment. However, since debt is cheap and equity is easy, a firm of unqualified engineers can simply start work on something, lead on investors with promising results, and get progressively higher and higher valuations. The increase in the paper value of the stars allows them to borrow a lot to keep the firm going and live well... Until they run out of money, as all Ponzi schemes do. But in most of these cases, there was real science going on, there was simply no way to monetize it and/or the product was far more niche than anyone liked to believe.

You can see how the tech bubble was pretty inevitable. A whole new branch of science was created and all of the men who were in the field early on was propelled to the top regardless of competency. Many actually collapsed immediately due to infighting, as there are reports of firms screwing over their employees out of pay, there was one CEO who said "now I got the money I can live a disgusting frivolous life." I'm sure we all heard of Mr. Zuckerberg's personal feud with Mr. Saverin, but that was after the tech bubble.

But it wasn't just the internet. It happens. Every. Single. Time.

There was 3d printers, biotech (ongoing), fintech, robotics, lab meat (ongoing), quantum computing, lithium batteries, reusable rockets, verticle farming (yep, that's a thing), internet of things, and so on. Every new successful innovative firm also creates bubbles around them. For instance, the success of AirBNB drove up housing prices surrounding spaceports as hosts speculated they could get great money charging all the visitors. Or on YouTube the rapid success of early YouTubers flooded the site with new YouTubers, which ended when the firm became profitable and the "ad-pocalypse" occurred when suddenly creators realized how generous their pay was previously as the quantity and quality of their share of ad revenue fell. This trend was particularly severe on green energy, which also profits from heavy government subsidies which remove at least a third of end user cost.

The list goes on, and on, AND ON...

The general rule is the harder it is to explain the utility of your job to a layperson, the more high-risk your job is. Another general rule is that the best science is not profitable. The best science goes on in universities and in government labs where no one has to worry about marketing a product, while the private market is limit to what can reasonably bring a product to market in a short time. In other words, tech companies are applied engineering, engineering is applied physics, and physics is applied math.

But for our purposes, a comparison between oil and green energy firms are sufficient because they are roughly the same over the long term. One is so science heavy that it is impossible to assess the true risk, the other only innovates to improve the efficiency of existing system. One is subject to unfair scrutiny and punitive regulation to make them less profitable, and the other has over 30% subsidies from the Feds alone. One has been threatened with lawsuits whenever their profit margins got high, the other continues to receive grants and investors despite rarely turning a profit. The one rarely builds new installations, the other depends on installations that aren't built yet. YET THE RETURNS TO SHAREHOLDERS ARE ROUGHLY THE SAME. This isn't immediately obvious because of the high volatility of both, but the reason is oil giants own a cash cow and choose to return excess funds as dividends/buybacks to shareholders and/or pay bonuses to employees, while green energy firms can ascribe all growth to increasing valuations and market share.

Likewise, it's a statistical fact that the best time to invest is right after a crash. But who has reserves in the form of cash or bonds when cash loses value and bonds give meager returns? Likewise, the margin loan individual investors get is highly correlated to the Federal Funds Rate, and even if you don't use margin the price of options factors in the Federal Funds Rate.

Likewise, we all know that buttcoin has no real world value, but the amount of serious investors who put some of their money behind crypto exchanges is prodigious. The most common excuse was "diversification benefit," but everything buttcoin has a leveraged inverse correlation to interest rates as it was all held together by lies and borrowed money. And don't take this from me, kind sirs, as Jerrome Powell expressed the SEC's official position that they believed most if not all such firms were breaking the law.

Even more mature technology firms have shown their dependence on borrowed funds. So many have announced layoffs this year as to give the casual reader the impression another Great Depression has come, but statistically unemployment is very low this year with twice as many job openings as job seekers. You can see how men like Mr. Bezos and Mr. Gates can go a whole career getting bigger with borrowed funds and paying little if any taxes, as they are tax-exempt on the way up and can simply give their huge incomes away later whilst living off the proceeds of their original investment. There's nothing wrong with that, just know that's what businessmen are incentivized to do despite the extreme risks involved.

And I know that there are people from the Fed reading what people are thinking around here (Hello kind sir!). So consider this an open letter to the Federal Reserve Board. You have the power to fundamentally change the structure of markets through Darwinistic incentives, but cannot control the vices of men. In order to reduce long-term volatility and make it more difficult for fraudulent and unprofitable firms to cause disasters, a Federal funds rate of 3-5% should be targeted. This would mean that stocks will only slightly be more profitable than bonds, and only those who really do need to borrow will borrow. An alternative solution is to target an inflation rate of 0%, meaning a lot of dumb money would be removed from the market and cash reserves will be more available from many sources.

We can all see what these nominally small changes can do to the global market. We can see what happened during the quantitative easing of 2020-2021, and during the quantitative tightening of 2022. If the current policy continues into 2023, we can expect to see a yet further purge of fools and frauds. I, and many on this thread, strongly recommend the Federal Funds Rate stay roughly where it is for the foreseeable future and bring stability to the overall market and so high-risk high-reward investing will remain relatively niche for autists like us.

​

Signed,

-A Professional Historian, Amateur Investor.

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Comments

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xDoomKitty t1_j1uwmru wrote

Instructions unclear. Dick stuck in a Bloomberg.

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Impossible-Machine42 t1_j1uxsch wrote

interest rates are not high. the proper rate should be 4.5% to 7.5%. High is above 9%. low is below 4%.

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arpatel530 t1_j1v1zi5 wrote

You could have just said inflation at 40 year highs versus a wall of text

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Dingo9933 t1_j1v34ip wrote

No one is reading this whole thing correct?

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alopz t1_j1v8v1y wrote

What do you do for work? The fundamentals of finance were out of order the past couple of years. Save 10-20% for a house, nah just buy the house and it will appreciate. Buy ETFs, nah go all in on NVDA. Buy bonds for diversification, nah why only get 4%.

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ThetaGangThroweway OP t1_j1v9ahe wrote

Replying to CoffeeMaster000 (#1,095,618)

The market is full of perverse incentives to take excessive risk and create bubbles around innovative products and services. This can be fixed either by keeping interest rates where they are now or perhaps higher, and/or setting the targeted inflation rate to zero.

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ThetaGangThroweway OP t1_j1vjkys wrote

Replying to CoffeeMaster000 (#1,096,952)

Yes, but we can do it consistently. In fact, every new marketable invention has produced some kind of bubble in recent decades. There are even single-stock bubbles, and bubbles that form around successful companies. Like how right now college athletes found they can make more on OnlyFans than they ever will make in the real world. That isn't just sad, but will definitely right itself as soon as all the small-scale porn shows move onto the platform and squeeze the true amateurs out (fortunately).

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kifra101 t1_j1vkqt3 wrote

Replying to ThetaGangThroweway (#1,096,493)

You do realize that the government also owes debt and pretty much keeping it at those elevated levels will eventually lead to default? Sure, the short term debts can be rolled over to higher interest bearing debts but how long can you keep that going if tax revenues decrease (due to higher unemployment, lower demand, lower profits, etc.)? Even if Yellen does funny accounting on the back-end, the government still has to service those higher interest payments one way or another. We are not talking billions at that point. We are talking trillions in just interest payments before spending a single penny on the welfare, military, government jobs, etc.

The fed can keep raising rate but they defeat their main objective if the government defaults and people lose faith in the dollar overnight. We are risking hyperinflation if rates stay high for too long (because government defaults) or if the rates drop too quickly (turn on the money printer before we reach 2% inflation). The window for a soft(ish) landing is extremely narrow which is why folks are thinking it won't be attainable.

This is why people are putting money into alternate assets -> gold, buttcoin (lol), real estate. It's good that you are drawing from history but we have never been in this exact situation before so there isn't a clear roadmap. Shit can go south very quickly.

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ThetaGangThroweway OP t1_j1vl28j wrote

Replying to CoffeeMaster000 (#1,097,333)

There are micro-bubbles all the time that depend on ease of equity and cheapness of debt. Ever heard of Amazon Aggregators?

I forget the exact study, but investments with lottery like payoffs tend to be systemically overvalued whether it's micro-cap stocks, short-term options, or innovative startups. People feel better about a chance of extremely high returns than they do about giving that chance up. Until this year, any new business could be given a lottery like payoff (or even be turned into a ponzi scheme).

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ThetaGangThroweway OP t1_j1vmm8q wrote

Replying to kifra101 (#1,097,335)

The government has a money printer and has been deficit spending for its entire existence. What we should worry about is countries with economies highly correlated to the US, but whose government bank's are working at cross purposes to ours. This is America, it's not hard to turn a profit as parts of the country are still receiving new settlers. And the Fed is full of men smarter and more responsible than you and me.

And as several pointed out, current rates aren't very high in absolute terms.

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ThetaGangThroweway OP t1_j1vp0ac wrote

Replying to kifra101 (#1,097,843)

I literally am a historian. And the late Roman Empire's pursuit of fiat currency was actually a success and I have written my own arguments for both their rise and fall which are pretty unique. The point here is an inflation target of zero isn't too much to ask for as we do run a developed and profitable country here. We target net positive inflation to deter hoarding rather than because we need the money (we have taxes for that).

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kifra101 t1_j1vqojq wrote

Replying to ThetaGangThroweway (#1,097,973)

Look, by the end of Roman empire, their coin had less than 1% of the original gold content then when they were at the peak of the empire. Their purchasing power collapsed to the point that they left the safety of the empire to move outside the walls and survive on the land to feed themselves. This left them open to invaders later on.

They had taxes then as well. In fact, they realized after taxation that they did not have enough to sustain the extravagances of the city which is why they started money dilution to begin with. Enormous government spending eventually leads to collapse. The point I am making here is that our spending and debt have reached a point now where it is near unsustainable. Raising the interest rate to 7% or higher is no longer a practical reality because our real debt is substantially greater than they were in the Volcker-era. No amount of money printing will bring back the purchasing power of the dollar unless something changes -> supply chains explode, technology advances massively, energy becomes near abundant, etc.

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adultswim_antifa t1_j1vrn04 wrote

Sure, I agree. The degree of speculation has been rising for decades and had gotten to truly absurd things like trading jpegs of cartoon monkeys. Bitcoin seems dumb to me, but the "forever ape" is the most absurd thing the market has ever produced in my opinion. That said interest rates are probably going down again eventually, even lower, and something even more incredibly fucked up awaits. The expansion of credit is the only thing keeping the economy alive and it makes the rich richer, and that is very popular with the rich people that determine policy so they're going to do it and ignore whatever weird shit that crops up as a result, until there are no future cash flows at all. Then maybe we'll change course when the absurdity can not be denied by anyone, maybe.

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ThetaGangThroweway OP t1_j1vsdyh wrote

Replying to kifra101 (#1,098,205)

Don't get me started on the fall of Rome, I could literally go on all day. Suffice it to say that was a symptom, not the cause, and their fiat currency kept prices stable even as the gold content fell. By the time Rome started losing territory, the population size across the empire had already fallen massively and the legions had been cannibalized in a list of ways long before then.

And regardless, that's not the proof you're looking for as deliberate inflation acts like a hidden tax on savings and we're not looking to increase spending, but rather change the manner in which we raise revenue. I.E. We can reduce inflation and raise income taxes for higher brackets, as long as net revenue is the same... Who cares?

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TheSneedles t1_j1w1x3h wrote

A well thought out, well articulated post on Wall Street bets? Where am I? Rather where are you?

The only disagreement I guess is that I think the Fed is going to fold over like an aluminum chair once things get bad. In my view, the Fed has developed a “never again“ view to 2008/2009 where deep recessions are unacceptable, and the first major signs of sinking in our economy will be met with similarly strong actions to re-orient the economy for growth. We saw this, never again approach at the early stages of the pandemic, the Fed was scared, and the more reasonable approach would’ve been to wait and see how much fiscal stimulus would’ve actually been necessary

I don’t think the fed is really as committed as it says it is, and so much of the economy at this point, relies on debt and borrowed funds and credit, that a crisis or even a sharp normalization would damage the economy far more than the GFC.

I personally thank you for some QC on wsb

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Degenereth t1_j1wbqnx wrote

Hopefully JPow or an intern at the Federal Reserve will see this post, ponder on its merits, and take it into consideration for 2023 and beyond.

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BasedSliceOfWinning t1_j1wmxvg wrote

Conflating the terms tax write-off and expense as the same thing.

Yeah, you belong here.

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ThetaGangThroweway OP t1_j1wpjpg wrote

Replying to BasedSliceOfWinning (#1,102,512)

Same end result. For solar especially, EVERY STAGE of the process has a tax write off up to 30% of the value of panel. Makers, installers, and buyers alike. The profitability of solar went up accordingly the moment these tax breaks went into effect. It's not unreasonable to believe panel cost would rise by 50% if these subsidies were removed.

And BTW, tax breaks on job producing infrastructure is exactly what ecoterrorists are referring to when they lie and say oil giants are heavily subsidized. Not saying you're one of those guys, but you definitely can't have it both ways.

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Snoo_96430 t1_j1wvif2 wrote

Just say poor's need to be crushed more they are getting a bit uppity alot of words to say that.

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ThetaGangThroweway OP t1_j1xdjqn wrote

Replying to Mega-Lithium (#1,105,468)

Not necessarily as it depends how many buck sales they can do and how long they take to do it. And you know they usually hold until maturity, right?

At the moment, the Fed's focus is bringing the real inflation rate down to the target. In his announcements, Mr Powell cited the consumer price index MINUS materials affected by the war in Europe.

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ThetaGangThroweway OP t1_j1xdu9t wrote

Replying to Snoo_96430 (#1,105,982)

If you're in college, I will ask you to lose the hyperbole because we all know you're investing in yourself.

If you ain't, I'll wager you steal things too. I know people who borrow money and refuse to pay it back.

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54321Joe t1_j1xj8ha wrote

Sounds like communism to me.

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ac62617 t1_j1y7ggb wrote

Interesting. Well thought post. I don’t necessarily agree. 75% of VC investments go to zero, it’s expected that many of them are false actors/aren’t gonna make it, whether the FFR is 0% or 5% doesn’t make a difference in that. The idea is one of the investments will hit and be the next Airbnb or Uber.

I’m sure there’s been books written by smarter men than me on why 2% inflation is the target. A 0% inflation mandate seems like it could lead to low growth/no economic development.

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ThetaGangThroweway OP t1_j1zwz2a wrote

Replying to ac62617 (#1,110,381)

It doesn't bother you that VC and crowdfunding have identical payoffs? I say it's more evidence of the efficient market hypothesis, but for the post's purposes it shows how the system as it is set up incentivizes rockstar CEOs. Mr. Gates and Mr. Jobs were among the first, and Mr. Musk is simply the most recent. But you'll notice all the above keep announcing new R&D projects that require funding regardless if their team has finished the old one. The big bucks are in starting massive projects, not finishing them. Once they are finished their profits can be easily valued with conventional math and the stock price (and executive options/shares) will crash. Furthermore, micro-industries surrounding them will crash. Like Amazon Aggregators that simply buy a portfolio of profitable online stores with VC and borrowed money... Turns out the returns of those were identical to leveraged exposure to Amazon.

You don't need a mastermind creating growth. People will figure that part out even if you don't want them to. I argue no one should try to manipulate markets in any fashion, even if it is done with the best intentions.

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