Submitted by ThetaGangThroweway t3_10oge5g in wallstreetbets

A lot of people are predicting a recession to match the SPY's 18% drop, and I have no doubt they'll all say "I told you so" regardless of anything happening. However, there's something much more fundamental the last couple years of market performance and Fed policy show.

Between the adoption of greenbacks and the 2020 Covid Panic, the Fed had a generous Federal Funds rate. That is the rate they both borrow and lend at, which was generally very low, generally roughly 1% above the expected rate of inflation. This was to allow people and businesses to borrow as much as they need, and was helped along by many subsidized lending programs. A great case in point is student debt, which is artificially cheap for people from middle class families and poorer families get literal free money in the form of pell grants. This vastly increased the number of people attending college, far beyond the actual demand among employers for degree baring persons. While we can excuse this because we think education makes for more refined and productive people, you also get absurd situations like mine where I have no intention of becoming a professor but I'm still in grad school for the fun of it.

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However, this spills over into stocks and bonds. Simply put, banks lend to each other at a rate proportional to the rate the Feds lend at. Obviously, if one bank is going to give the other an overnight loan, they must pay them a little more than an equivalent T-bill to make it worth their while. Likewise, all other loans are calculated at the rate of an equivalent T-bill plus the default risk.

Stocks are no different because equity funding simply shifts the risk from the lender to the borrower. Ergo, the value of a growth stock is calculated as the value of future expected earnings, minus the risk of missing that goal, minus the default risk, minus the payout of a T-bill expiring around the same time. You see why many companies choose to stay private, as the execs may have a great business model and want to keep all the money for themselves even if that means growing slower.

EVEN CALL OPTIONS have prices dictated by the Federal Funds Rate. This is because of options arbitrage where the dealers with their computers trading will buy or sell any option you like, but seek to do so risk free. A risk free option spread is to buy 100 shares, sell a call, then buy a put at the same strike. No computer will trade this spread unless the return is equal to the return of a T-bill over the same period, minus any expected dividends. This makes sense, as calls are naturally more expensive than puts because stocks can only lose 100% but they can gain any real number. The Federal Funds Rates only have a tiny effect on the price of short term calls, but add up to a lot with long term calls.

So, previously, the Fed's generously low-interest rates made it possible for anyone to borrow. This may be shown as a factor in the Housing Bubble, as a key point was that anyone could get a loan for a house and as long as you kept making payments and/or the value of the house went up then you can refinance a potentially infinite amount of times. BTW, refinancing is getting a new loan to pay an old one, and paying old debts with new debts is called a Ponzi scheme.

Accidental Ponzi schemes do appear to be a thing with the "blitzscalers." Simply put, since bonds return so little, there's tens of thousands of private equity firms and dozens of crowd funding websites where individuals seek out direct investments. This is how you get a lot of people whose net worth explode out of nowhere as these are fake rich people where private equity bought 49% of their firm at some arbitrary valuation, increasing the paper wealth of the execs overnight even though they were losing other people's money. However, if they did bring a marketable product, they could keep this going indefinitely using more and more equity funding to keep growing the business and allow previous investors to exit at a profit.

Most current allegedly self-made billionaires have done this, and for every one of them that made it, a thousand other equally talented men have failed. From Bill Gates to Trevor Milton, the latter illustrating how you don't actually need a profitable business to get equity funding.

We saw what the extremes of this will do 2020-2021, where near zero T-bill rates sent the value of everything up as any return was better than the Federal Funds Rate and people could borrow to invest. Just as in 1928 when even the shoe shine boy on the street was giving stock picks, in 2021 there were millions of sports fans and total amateurs on the internet giving their own stock picks. This produced the "everything bubble" where long-short strategies simply broke because everything was going up. Fortunately, the Fed burst that bubble by raising interest rates so they could delete all the money they printed during lockdown.

But you see a curious effect in the markets. First off we see the ousting of all the fools and frauds dependent on burning other people's money. China's housing market collapsed, crypto firms collapsed, and biotech collapsed. All private equity firms are no longer open to new investments, and voice of experience from the crowdfunding scene the place is dead. Whole countries like Egypt, Lebanon, and Turkey have become insolvent because they can no longer pay old debts with new ones. Retail trading has plummeted, as even the men who are still invested are trading less and putting less of their money into stocks. Likewise, interest in subs like this has plummeted even as the member rolls stay long people are simply not visiting trading subs so much.

Now, let us do a thought experiment with the extreme. What happens if the Fed offers a return on T-bills roughly equal to the return of the SPY (say 10%)? In this environment, there would be no reason to trade stocks at all. All stock exchanges would collapse and see vastly reduced trading volumes, with most smaller exchanges closing completely. The effect would be most extreme in developing countries with high degrees of correlation to the US economy, like India, China, Latin America, Africa, and other places. In these countries, not only would stock trading cease but many countries would have to enforce capital controls to stop the flow of money out of the country into the T-bills of the US and US-alligned states.

Most developed countries will see their own government borrowing rates drop immediately. In places like Europe, Canada, and Japan most investors are already invested in US stocks and will simply dump both stocks and their native T-bills in order to loan to the Fed. Stock prices will be so cheap that often the only buyers will be insiders taking their companies private at a good price, with many of these firms switching to selling thing to the government because the government suddenly has lots of money.

Of course you're thinking "Why on Earth would they do that, though?" Simple: A world war.

We've had a conspicuously long period of uninterrupted peace, with very few states ever committing more than 10% of their forces to any given war ever since the conclusion of WWII. However it starts, you can be sure that the Fed can obtain funding for such a war WITHIN WEEKS via the unlimited sale of bonds, and effectively militarize the economy within months. You might think government contractors would be the exception to this, but those are simply the men selling things to the government right now. During the World Wars, sometimes the government set up their own factories in order to meet demand. Also, there are few restrictions who can sell things to the government, and private corporations of all sorts will jump into the war effort, bring down the market share of current defense giants. But more importantly, mercenaries are the historic norm, not the exception, and these kinds of contractors and volunteer organizations can appear out of nowhere as gangs of men use their own gear and recruit their own subordinates (most countries use armed contractors to some capacity already).

But I guess the point is, corporate valuations are as arbitrary as the inflation rate because they can drop to near zero due to events they have no control over. Likewise, while it seems generous for the government to offer low-interest loans, doing so encourages high-risk behavior. Likewise, the government offering to borrow at high-interest rates encourages low-risk behavior. Niccolo Machiavelli himself said that while it would be wonderful for a government to be truly generous, spending tax money in such a manner can be irresponsible if there's nothing gained in return.

We're only a free market for as long as the bosses allow it. It has always been so.

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VisualMod t1_j6eesjs wrote

>The government offering to borrow at high-interest rates encourages low-risk behavior. Niccolo Machiavelli himself said that while it would be wonderful for a government to be truly generous, spending tax money in such a manner can be irresponsible if there's nothing gained in return.

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Careless-Pin-2852 t1_j6eg9lr wrote

God dude when ever I post i have a rule 10 sentences max. I get posts knocked out because i don’t post all the minimums. Like positions etc.

You did not need to write all that to say the fed with help with national security.

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sanfrantokyotron t1_j6egvy3 wrote

Although raising interest rates may result in more people/countries buying government debt vs other investment options, the higher interest rate also negatively impacts the US government by increasing the amount of interest they must pay on that debt. The US is starting to already encounter an issue with this, as a 5% interest rate requires about $1 trillion of interest payments on the US debt which is equivalent to 33% of annual tax revenue. If the government attempted to raise interest rates to trigger war, these interest costs would go up further which would reduce funds available for other government expenditures (like the military costs of war).

Additionally, raising interest rates would likely tank the US economy. If people choose to put their funds in T-bills vs other investments, businesses will have a harder time getting funding which will cause them to start laying off employees. As a result, a world war triggered by the Fed is unlikely as it would inflict significant damage not just on the world but also the US. This is sort of like the argument that China intentionally created COVID-19...why would any country take an action to hurt others that equally hurts themselves? There are many other ways to start a war that would have less collateral damage.

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jr1tn t1_j6ej370 wrote

You would think that if someone were to write 15 long paragraphs, the very least they could do would be to write semi-coherently -- or at the very least, grammatically.

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ThetaGangThroweway OP t1_j6esepi wrote

Yes, but you vastly underestimate how much money can be raised through taxes. Interest rates can be raised to get funding NOW, while increased tax revenue takes months or years to catch up (sort of like Uncle Sam's credit card).

And no, high interest rates tank the stock market, but profitable employment will still exist. Companies that are profitable NOW will continue to be profitable and grow naturally, but companies that seek rapid growth better have some in-demand service to provide immediately.

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Ok_Manager3185 t1_j6g78f5 wrote

Just another post that makes me wish i could read. Turn it into a podcast or book on tape plz.

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LiquidZebra t1_j6gjh0r wrote

Sounds similar to “the dollar milkshake” theory by Peruvian bull. Once Fed raises rates, all the dollars get sucked back into the US, but global trade stops

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Am-a-Beast t1_j6gqtsq wrote

So… late March puts on $SPY. Got it.

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Moist_Lunch_5075 t1_j6grxn0 wrote

Hmm... an interesting scenario. Definitely worth some continued thought on my part.

My first thought is that the US government doesn't really have a short-run when it comes to capital available for military efforts. I do suspect that a world war would strain us for more than people think, but I also know that with current bond funding and a low interest rate, the US government has access to options that would have less impact on the economy, such as temporarily raiding entitlement program funds through internal bond transfers and just straight up borrowing the money directly from reserve lenders at a sweetheart interest rate.

Raising the FFR to achieve the goal without having to wait for taxes would be much more costly and probably not necessary given the rather significant bulk of military forces in the United States... in other words, we already have such a high percentage of the military production, staffing, and spend that a scenario where a modern war would require us to massively grow our military is unlikely. Even against China.

It would probably require several large nations ganging up on us with no allies to speak of... which is not likely to happen.

And a modern world war wouldn't really be fought with massive armies. Like if destroying the global economy is on the table, massive cyber warfare and nuclear war are probably also on the table... and a cyber war would require an upscaling in resources, but a nuclear war/nuclear deterrent cycle is already basically paid for... or priced in, if you will...

So that's blocker #1, and I think it's pretty significant.

Blocker #2 has to do with the cyclical nature of bond yields. Basically, if to promote bond sales, the Fed upped the FFR, driving the risk-free rate of return way up and juicing the 10-year T-bill above 10% yield (many of these calculations use the 10-year as a yardstick for the bond rate) it would drive massive demand into those bills, creating a drop in the yield.

Bond yields are decided in part by auction, which is how the 10-year rate is now lower than the FFR. Basically, the government doesn't want to just throw free yield around, so they increase the yield to move the number of bonds expected at the best yield possible at volume. As demand shoots up, competition for bond notes increases and as a result deals can be made at auction with lower yield.

That would wind up crashing the yield and that would create the equilibrium to re-open markets elsewhere our capital needs were met.

Still an interesting exercise in what happens if the risk-free rate of return were to spike suddenly and extremely... I do think you're right that such a scenario would probably cause a larger market crash as flows went to risk-free return.

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ThetaGangThroweway OP t1_j6gt9q7 wrote

Dude, you're falling into the classic trap that the last decades of fights are "the future of war. " This simply isn't so.

But a key factor of any war that is that no one has any idea what they're doing. Not you, not me, not the politicians, not the commanders, not the grunts, not the drill sergeants, not the enemy, not anyone. Any major war effort is a chaotic mess that gets better as people fix stuff, then the war ends and everyone forgets about it.

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Moist_Lunch_5075 t1_j6gx942 wrote

Re-read my comment again. I did not say that the last decades of fights are the "future of war."

What I said was that IF a world war broke out, it would be explicitly DIFFERENT from the last decades of wars in that it wouldn't be an escalation of people so much as an escalation of threat and action.

I have no idea where you got that I was ' falling into the classic trap that the last decades of fights are "the future of war. " ' but it definitely wasn't from what I wrote.

What you're not considering is that the scenario you've suggested would completely tank the global economy, hurt our allies, and crash our own economy in the process. When there are other options, they're not going to do that.

Currently there's about $20T unspent in government bond rotational funds to tap. Then there are the loans accessible to the government via the reserve. The military's expensive, but a mass mobilization can still be done with that money without crashing the economy.

Your scenario is literally one of the most destructive things a country can do to its economy. You can't just accept that they're going to do that without considering the alternatives.

What I am saying is that if we DID get to that point where "destroy the economy" is on the table, you basically have to ask how much things have changed.

Have they changed in that circumstance enough to have a nuclear exchange?

Your last paragraph says it well: War is chaos. It's unpredictable... but we're not relegated to absolute blindness. We can measure the amount of risk a country has to be at to make certain moves. The move you're suggesting is basically economic seppuku, and in a world with nukes we have to consider that once you're there, you've entered the "existential risk" space of risk.

That's what I'm getting at... not that it'd be like the last several decades, but rather it'd be drastically removed from that to an even more extreme threat than you're accounting for.

I'm actually accounting for MORE chaos allowance than you are.

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Interesting-Corgi136 t1_j6hawog wrote

If any theory pivots on world war 3, put that up front. Because I'm not betting on 12% returns or whatever in that case ... world war 3 means game over from this system and marathon watch doomsday preppers.

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ThetaGangThroweway OP t1_j6jdbt5 wrote

Dude, it was easy to spot by what you thought "modern war" was like. What I say plagues even the Pentagon where most commanders assume the last big war plus recent tech trends equal "modern war." Also, most army commanders don't know a thing about strategic theory.

But an interesting point is that nuclear deterrence prevents major formalized governments from seeking conventional war, but there are many states that could breakup or spontaneously unify at any moment. There are also many points in history where large rogue armies sprung up overnight, and internal wars in countries where the conventional forces are either unable or unwilling to act, and extended periods when governments were defunct. You should not think all war is confined to conventional arms or insurrectionists.

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SwissPrivateWanker t1_j6k7g5f wrote

Average debt to equity for the S&P is 1.6 - raise rates to 10% or above and you are about to find out that you don't have many companies left that will be able to be "good". Unless you qualify as good any company that does not have any debt, but that makes no business sense given the tax incentives associated with debt in the current system. Look at PE shops that have bought out the US, their business is to overload companies with debt, and they are everywhere.

You did not answer u/sanfrantokyotron main premise: the US is under a shit load of debt - if its creditors see that they will be unable to repay their debt they will stop buying its bonds. New issues will start having to print at much higher rates, and that's what happens in EM markets... Taxes can arguably be raised - but when your country is going through a gigantic wave of bankrupcy due to insane rates, you will be bringing economic collapse to your civilisation. I doubt that's what the Fed is mandated to do...

So if I see the Fed raising rates so drastically, will I prefer to hold one of your "good" companies with low debt and a sound business model that will likely outlast a government that's hell bent on destroying its credibility? Probably, in other words, some public companies might be ok. Companies are global, and fetch capital abroad - you are also talking about the collapse of the USD in your instance. So a domestic producer exporting abroad would do particularly well in this scenario. As the USD collapse they could repay their debt in EUR or Rimnibi in a heartbeat.

I am afraid while interesting to read, your arguments do not hold. We do not live in a vacuum and killing your credibility by aiming to bankrupt your country is probably not the smartest move. The ECB, the Fed, the BoE etc... work together, that's why the system works - no bank can simply go rogue otherwise the repercussions on its economy could go horribly wrong, just look at that idiot in the UK in the fall as an example...

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ThetaGangThroweway OP t1_j6k8y6v wrote

Come on. Americans complain about government debt no matter what it is. Out here in Kansas we complain about Topeka's use of money markets, which are overnight loans for when taxes and payroll don't match up. The Federal debt is the rough equivalent to a mortgage.

But more importantly, rising interest rates effect future debts and not current ones. If a company has a fixed rate mortgage for 7%, they will keep paying that no matter what the Fed does (although refinancing will be impossible).

And why the frick would people dump the dollar? It's such a cliche to predict its collapse that you said it with no logical connection to the topic at hand. The US government does all business in US dollars, meaning the more the government takes over the more the more people HAVE to use dollars.

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SwissPrivateWanker t1_j6kdbqa wrote

Because it won't just happen over time what you are suggesting. You are suggesting a brisk and fast rate movement in the FFR to 10%+ with the additional insane spending idea of getting companies to produce as much goods as possible for the government to buy for the war effort. If am a US creditor, I say fuck this - I'll go and get something safer and park my cash in a government that will remain solvant for longer. The US government can do all the business it wants in dollars, it's also the largest importer of goods in the world, so they better have a currency people accept before going rogue.

So yes, the largest creditors would dump US bonds, and thus the dollar will go down with it. If you intend on spending, you won't be able to raise new debt for this spending. The old debt won't be your problem, the US government NEEDS new debt to operate, plain and simple. This is what happens in the EM world, and the US is not protected from this either. Sure thing 60% or more of global trades are done in USD, but as with Russia, we see how countries can adapt VERY fast at the new reality of being cut out from the USD.

Again, "it's such a cliche to predict its collapse" - your scenario IS bringing its collapse, so I am not even arguing today about the collapse of the US, because the US is not in your hypothetical situation thank goodness.

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ThetaGangThroweway OP t1_j6lrxhh wrote

You underestimate the Fed's power, and the brutality of men. Not only will there being NOTHING else to invest in, but given the circumstances you could face legal or extralegal consequences for not participating in the war effort. In fact, it is unlikely you will be investing at all, but buying gear in order to participate. I don't know who you are, but it doesn't matter, you're going to get involved.

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Moist_Lunch_5075 t1_j6nsl4u wrote

>You should not think all war is confined to conventional arms or insurrectionists.

You're just not paying attention to what I'm saying because you seem to want an argument rather than a discussion.

You just rephrased my entire point as if it was a retort. LOL

You literally just distilled my entire argument into one sentence and then acted like that was somehow correcting me.

Also if the scenario you're talking about happens and world powers fragment and fracture, the Fed Funds Rate's not gonna be a thing anymore. Your entire scenario depends on the continuation of the world power structure, which is the core of my point... once we hit that point where the poison pill makes sense, things have radically changed in much more significant ways.

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