Why Interest Rates Are Rising, and Will Keep on Rising   (July 8, 2008)

The standard financial forecast calls for sunny skies and low interest rates for the foreseeable future. As usual, it's wrong. Interest rates will rise longer and higher than anyone suspects.

The reason is not complex. Money is a commodity like any other, and as a result it is ruled by supply and demand. When money is plentiful --that is, when banks have created money via extending credit to anyone with a pulse--then the cost is low.

But when money supply shrinks--as in a credit contraction--then money becomes expensive. In other words, it costs more to use the money; interest rates rise.

As the credit crunch/crisis shreds banks' ability to create money via credit, then interest rates will rise, regardless of what the Fed does or doesn't do. The Federal Reserve cannot repeal the influence of supply and demand, nor can it enable banks to create credit as their assets plummet. Finally, it cannot force consumers who have maxed out their credit and who face stunning drops in their own assets (houses, stocks, etc.) to borrow more.

The virtuous cycle of exporting money to Asia in exchange for cheap goods and then watching China trade the dollars for Treasury bills to fund our stupendous deficits is ending as well.

Those who believe China can "decouple" from the U.S. fail to weigh the reality that about 75% of the Chinese economy is export-based, in comparison to about 20% for exporters like the U.S. and Japan.

Furthermore, China's GDP is grossly overstated by the usual purchasing power parity (PPP) methodology, as noted by Harold Brown of the Center for Strategic Studies in the March/April 2008 issue of Foreign Affairs:

Per capita GDP at PPP is a good measure of affluence, that is, the of the individual standard of living. Butt he appropriate measure of the potential influence of a national economy on the rest of the world is the national GDP at exchange rates.

Even if China's remarkably high growth rate does not falter, a continued 6% gap between the U.S. and China's GDP growth would still leave the Chinese economy in 2020 at about one-third the size of the U.S. economy.

In other words, China is extraordinarily vulnerable to a reduction in exports. Its domestic economy is relatively tiny and largely dependent on exports for its growth.

As the U.S. recession cuts imports from China, its surplus dollars will shrink, and so too will its ability to buy hundreds of billions more U.S. Treasury notes.

Even as the supply of money available to borrow is plummeting, the Federal government expects to borrow ever larger sums. Recall that U.S. borrowing (public and private) has been sucking up 80% of the entire world's savings for quite some time. As supply shrinks and demand rises, what happens to price? Even Bill Gross is admitting rates will have to rise: (link courtesy of Craig M.)

Obama May Produce $1 Trillion Deficit, Gross Says

June 30 (Bloomberg) -- Bill Gross, manager of the world's biggest bond fund, said a Barack Obama administration may produce the first $1 trillion deficit and intermediate-and long- term bond yields have already reached cyclical lows.

The likely expenditures and increased borrowing suggest that "intermediate and long-term yields on government bonds have already bottomed and will gradually rise" through the next four years and possibly beyond, Gross said.

Gross domestic investment in machines, houses and inventories has fallen by $200 billion since its 2006 peak, Gross said. Domestic consumption will soon be $300 billion short of what's needed for an economic rejuvenation, he said. With the deficit already pushing $500 billion even before the next president is sworn in, Gross anticipates it will reach $1 trillion deficit by 2011.

As the credit contraction spreads, interest rates for many are already zooming: Municipal Market `Fire in the Disco' Burns Borrowers:

David Verinder, chief financial officer of the Sarasota Memorial Health Care System, received daily e-mail messages last month informing him that interest costs on an $83 million bond issue were rising to 1.45 percent, to 1.75 percent, to 3.25 percent, to 5.9 percent, and finally to 9 percent by June 24, a more than fivefold increase.

"When rates started going up as quickly as they were, it certainly caused a great deal of stress," Verinder said.

The daily increases by Wachovia Corp. had nothing to do with the financial health of Sarasota Memorial. Hospitals, airports, school districts and local governments around the country have been socked with spiraling interest bills on many of the $80 billion of insured variable-rate bonds. When units of MBIA and Ambac, the two largest bond insurers, lost the top ratings from Standard & Poor's and Moody's Investors Service last month, the institutions they insured did too.

The downgrades are the latest blow to the $2.66 trillion municipal bond market.

The usual suspects are quick to suggest that all the Fed has to do is print money and buy the $1 trillion in US T-bills needed to fund the deficit. Sounds so carefree, but why hasn't the Fed pulled this trick in the past? Why sell trillions in bonds to non-U.S. investors if it is so easy to just "print money" and fund our trillion-dollar deficits that way? (Note: it isn't as easy as it sounds to "print money.")

Could the answer be that there are disastrous consequences of such profligacy, such as the destruction of the dollar and our purchasing power? Take a look at this chart of the dollar/gasoline ratio, courtesy of Harun I. The green line depicts the actual ratio and the blue line is the raw futures price of Unleaded Gas:

Are there technical reasons to suspect interest rates could be entering a 20-year upcycle? I asked frequent contributor Harun I. for comments. (Please note that I have marked up his chart according to my own interpretation).

There is both a bull case and a bear case for bonds. I believe the bull case to be limited in scope, however my opinion will not affect the way I trade.

A triple top is in place and if one stretches a bit a complex H&S top pattern may be developing. Since 1993 price has been in a well-defined range as denoted by the SE Channel and of course there is the triangle.

The distortion in valuation in the ratio charts (T-Bill yield to gold, below) is still a stark warning of how things can disintegrate rapidly. Money is a commodity. Your thesis has as much merit as any. As banks hoard capital to cover losses and consumers begin to save because they can no longer borrow to spend, money and credit will contract and money will become dear. Long bond rates will not remain indefinitely low. The onslaught of defaults is not over no matter how much Bernanke tries to talk it into being. But this is an election year and strange things happen during election years.

But don't forget that our government is on the hook for promises it cannot keep. We have allowed it to be perceived as omniscient and omnipotent. The collapse of this illusion reveals the Emperor has no clothes. But there is nothing inherently wrong with a naked Emperor. It was the collective acceptance of the illusion that prevented a real solution. No matter how naked we become all we have to do is believe and get everyone else to believe that we are adorned in the finest garments. This is the illusion which prevents real solutions.

Those who represent us in government believe (mostly for political expediency) that we should be insulated from unpleasant consequences of poor policies and actions. But every moment is perfect. The universe is never wrong. Therefore, if we remove the adverbs and adjectives (perception) we simply are left with the reality of "what is", the moment, neither good actions or bad actions, only actions. This will lead us to understand that we have come to believe that a man should be separated from the consequences of his actions. Nonsense. Eventually we will noticed that not only does the Emperor have no clothes but that he is not even the Emperor.

Interest rates will rise longer and higher than anyone but a few expect. It is not about being the smartest guy in the room, it is simply the nature of trends. However, it is the timing that will be tricky.

For further fundamental evidence of credit contraction and a reduction in the supply of credit, here are two stories courtesy of astute reader J.B.:

BIS slams central banks, warns of worse crunch to come

A year ago, the Bank for International Settlements startled the financial world by warning that we might soon face challenges last seen during the onset of the Great Depression. This has proved frighteningly accurate.

The venerable body, the ultimate bank of central bankers, said years of loose monetary policy had fuelled a dangerous credit bubble that would entail "much higher costs than is commonly supposed".

From a Bank for International Settlements (BIS) 2005 report:

THE SUPERCYCLE OF DEBT

"The Supercycle is a description of the long-term decline in balance sheet liquidity and rise in indebtedness during the post-WWII period. Economic expansions have always been associated with a build-up of leverage. However, prior to the introduction of automatic stabilizers such as the welfare state and deposit insurance, balance sheet excesses tended to be fully unwound during economic downturns, albeit at the cost of severe declines in activity.

"Government policies to smooth out the business cycle were successful in preventing the frequent depressions that plagued the pre-WWII economy, but the downside was that the balance sheet imbalances and financial excesses built up during each expansion phase were never fully unwound.

"Periodic 'cyclical' corrections to the trend occurred during recessions, but these were not enough to reverse the long-run trend. Each time that liquidity was rebuilt during a recession, it failed to bring the level back to the previous recovery high. Meanwhile, the liquidity rundown during the next expansion phase established new lows.

"These trends led to growing illiquidity, vulnerability and volatility in the financial markets. The greater the degree of illiquidity in the economy, the greater the threat of deflation. Thus, the bigger that balance sheet excesses become, the more painful the corrective process would be. So, the stakes have become higher in each cycle, putting ever-increasing pressure on the authorities to reflate demand, by whatever means are available. The Supercycle process is driven over time by the building tension between rising underlying deflationary risks in the economy, and the ability of policymakers to create inflation."

From there let us go a quote brought to my attention by Michael Lewitt in the HCM Market Letter by economist Joseph Schumpeter. Schumpeter was a famous economist who brought us the insight that capitalism is a form of Creative Destruction, which we will look at in more detail below. As you read the following, think about the nature of our current recovery. Is the stimulus for the current recovery real or is it artificial?

"Our analysis leads us to believe that recovery is only sound if it does come from itself. For any revival which is merely due to artificial stimulus leaves part of the work of depression undone and adds, to an undigested remnant of maladjustments, new maladjustments of its own." - Schumpeter

In summary: as credit contracts, money becomes dear. Interest rates rise. And as rates rise, real estate is slammed, stocks are slammed and existing bonds are slammed. All asset classes will decline in unison, leaving investors "no way out" except commodities, which will suffer their own contraction of demand as the global economy contracts sharply.

In a nutshell: real estate and housing are entirely dependent on cheap, easily available credit. Once those disappear, real estate values fall.

Why risk money in stocks, which historically earns 7% or so, if you can get 8% in short-term bonds? High interest rates destroy stock valuations.

As interest rates rise, the market value of existing long bonds paying 3-4% interest will plummet, just as they did in the early 80s when rates rose sharply.

If history offers any lessons, gold and cash earning high interest rates will outperform real estate, stocks and long bonds.

Here is a visual display of the dynamic:

Put another way: how much longer will bond buyers accept a bond yield which doesn't even keep pace with the depreciation in the dollar's buying power? How much longer will they be content to lose money on every bond they buy? History suggests the answer is: not much longer.

Interest rates dropped for 22 years, from 1981 to 2003. Could rates rise for the next two decades? The long waves of price interest rate movement provide clear historical evidence that the answer will categorically be "yes."



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