A question many of our clients ask is if we believe the [fill in the blank] market will continue rising in 2022. And our answer is always the same: “We don’t know, but if Congress and the Federal Reserve continue to inflate the money supply, prices of assets with the potential to outpace inflation should continue to rise.”
And make no mistake. The Fed’s bubble-blowing capacity resulted in some mind-boggling price gains if you chose the right investments. Stock prices, as measured by the S&P 500 Index, gained nearly 27% for the year. Housing prices soared 19.1% in the 12 months ending October 2021.
But the most outsize gains came in a market that’s only existed for the last 12 years: cryptocurrencies. The price of one bitcoin, the most widely traded crypto, started the year at $29,002. After reaching a peak of $67,567 in November, bitcoin prices fell sharply to end the year at $46,316. Still, that’s a very respectable, albeit volatile, total gain of nearly 60%.
In a bonus report we prepared at the beginning of 2021 for buyers of The Lifeboat Strategy, we wrote that we would be very surprised if the stock market fell significantly in 2021 so long as the Fed continued blowing bubbles and repressing interest rates. And of course, that’s exactly what happened.
In 2021, the Fed’s balance sheet grew from an incredibly bloated $7.4 trillion to an even more bloated $8.8 trillion. By comparison, as recently as 2008, the Fed had less than $1 trillion on its balance sheet.
More than half of the assets on the Fed’s balance sheet – $5.65 trillion as of December 30 – are Treasury securities. This represents about 25% of all marketable Treasuries issued.
Most of the Treasuries the Fed owns –$5.31 trillion – have maturities longer than one year. Meanwhile, in its reckless policy of quantitative easing (QE), the Fed is still buying up billions of dollars of Treasury securities each month, although it’s announced a “tapering” of that policy. QE is now scheduled to end this spring.
These enormous asset purchases have massively distorted the bond market. Their most visible effect is to keep long-term interest rates low.
Manipulating interest rates downward also fits neatly into the Fed’s long-term policy of “financial repression” – keeping interest rates artificially low in order to allow Uncle Sam to borrow trillions of dollars at those rates. Financial repression also spurs inflation, resulting in savers earning significantly lower interest rates than the inflation rate.
The reality of financial repression means that the menu for investors seeking safe, consistent returns is a shrinking one. That’s a big reason why stocks, real estate, and bitcoin all hit record highs in 2021.
How It Could All Unravel
In response to worsening inflation, the Fed announced last month that it would consider increasing interest rates in 2022. Projections released then indicate that we’ll see three interest rate increases this year, although each one is likely to be only 0.25%. That means by the end of 2022, the Fed’s benchmark short-term rate will still be less than 1%.
By ending QE and slowly raising interest rates, the Fed hopes to slowly unwind the unprecedented stimulus it’s given to the American economy over the next year. It also hopes that in doing so, its tightening won’t set off financial pandemonium.
If it succeeds, we suspect we’ll see modest increases in the prices of stocks, real estate, and perhaps even cryptocurrencies in 2022 – although the returns are likely to be significantly lower than 2021.
But a significant miscalculation by Congress or the Fed could set off an economic crisis worse than anyone alive has ever experienced. We don’t consider this imminent but make no mistake: it will happen…eventually.
As in previous recessions or depressions, it’s the banking system facing the highest risks. Most US banks are poorly capitalized and have low liquidity. And the money in your account isn’t kept in a vault; it’s lent out. If those loans aren’t paid back, your bank could be forced into insolvency.
It’s worth remembering that historically, US banks were once much better capitalized. For instance, in 1842, they had an average capital ratio of 60%. At the end of 2020, that ratio had declined to 11.02%, according to the World Bank.
Of course, there are safety nets to deal with this reality: FDIC insurance, the Fed, etc. But what the Fed gives with one hand, it takes away with the other. Financial repression with its ultra-low interest rates is a prime example of that strategy. They hurt banks for three reasons:
Interest rates on many types of loans are tied to the prevailing interest rate. Low interest rates thus squeeze bank profit margins.
Depositors don’t like ultra-low interest rates. Especially if the Fed imposes negative interest rates, as the European Central Bank has done, they’ll withdraw cash from banks in droves. The only way to stop them will be if Congress or federal banking regulators impose limits on how much money depositors can take out at one time.
Because banks have such low capital and liquidity levels to begin with, sustained withdrawals will almost inevitably lead to bank runs.
As stressors mount on banks, it’s hardly unlikely that we could see weaker banks fail.
Meanwhile, the Federal Deposit Insurance Corporation (FDIC) released this almost surrealistic video, accompanied by soothing music, to reassure Americans that the safest place to keep their money was in an FDIC-insured bank. Perhaps that placated some people, but it reminded us that the FDIC’s insurance fund only has a reserve ratio of 1.27%. For every $100 on deposit, the FDIC has $1.27 to back it.
We don’t know about you, but for us, that figure is hardly reassuring. Keep in mind that during the Great Depression, one in three banks failed. Millions of depositors were wiped out by bank failures.
Still, we don’t look at this as a likely outcome. Congress and the Fed will resort to every possible measure to avoid it, most likely reducing interest rates back to zero, resuming quantitative easing, and in the process creating even bigger asset bubbles, leading to even higher inflation. It’s something to think about as 2022 begins.
And if the Fed doesn’t act quickly enough? In that event, we could see “bail-ins” similar to what Cyprus experienced in 2013. Deposits in banks that are “too big to fail” will be recapitalized with their unsecured debt. This avoids those nasty taxpayer-funded bailouts that proved so politically unpopular during the 2008-2009 financial crisis.
And the largest chunk of unsecured debt is your bank deposits. Insolvent banks will recapitalize themselves by converting your deposits – checking accounts, but also money market accounts and CDs – into stock.
“Insured deposits” won’t be subject to this treatment. Deposits in US banks are protected up to $250,000 per depositor, courtesy of federal deposit insurance. But it’s hardly reassuring that this fund has a reserve ratio of only 1.27%.
How bad could it get? Well, when Lehman Brothers failed in 2008, unsecured creditors got about 21 cents on the dollar.
How can you protect yourself? We can’t think of a better time to buy gold (now trading at a significant discount to its year-end 2020 price) or establishing your own Permanent Portfolio.
Finally, we’ve long suggested that you place some of these assets “offshore,” out of the easy reach of Big Brother. To that end, we invite you to take a look at our new Global Stock Analyst.