Friday, March 28, 2008

Interest Rates and Supply and Demand

Astute reader Than H. recently posed this question:

"I know you have done a number of pieces on interest rate cuts, but it's sort of overwhelming to understand the complexities, so is there a quick correlation you can tell me about or would you just recommend I read your posts on the subject? I understand that in a sense, cuts are good for Wall Street short-term, but bad for the U.S. (and Dollar strength) long-term, and I don't quite grasp why."

Despite the many complexities Than alludes to--for instance, currency carry trades-- I think we can achieve some basic clarity by looking at credit as a commodity, i.e. in terms of supply and demand.

So first, let's understand that the Fed Funds Rate which the Fed had dropped 3% in the past few months is the rate charged to banks, not consumers. While there is a correlation between the Fed lowering rates and the cost of credit to various financial players, it is virtually nonexistent in terms of consumer credit.

The reason is that in a credit crunch, lenders are (suddenly) wary of risk, and their ability to insure themselves against loss either disappears or rapidly increases in cost. As a result, auto loan and mortgage rates have not dropped 3% in the past few months; they have actually increased. (Needless to say, credit card interest rates haven't dropped 3% either.)

Until recently, lenders could bundle their consumer and commercial loans and mortgages and sell them to institutions around the world. This increased the velocity and volume of credit. If you wrote $100 million in new home mortgages, you could quickly offload those loans to an investment bank who would bundle and sell them as mortgage-backed securities. This cleared your loan book and you could then sell another $100 million in new mortgages.

The demand for debt was thus high, and so the supply could increase by leaps and bounds. Credit was easy, and debt was easily sold.

Now that risk is being recognized and re-priced, institutions are wary about buying new debt whose risk is essentially opaque. That is, recently they trusted AAA rated debt and they lost huge sums of money as that debt lost value. So now they are restrained from buying more potentially risky debt.

The demand for new debt has dried up, and so the supply of credit is drying up, too. If there are no buyers for new debt, then the lenders have to keep whatever loans they write on their own books. That reduces how much credit they can extend, regardless of the qualifications of the borrower.

Put another way: as risk is recognized as opaque/unknown and trust vanishes, de
mand for new debt drops. The supply of credit is thus restricted, and an imbalance is created between supply of credit (tight) and demand for credit (high). As with any commodity, tight supply and high demand leads to higher prices.

Consider the point of view of the lender: I can borrow from the Fed at low rates, which is nice, but where can I extend new credit without risking losses? Housing? You've got to be kidding. Consumer credit and auto loans as the country slides into recession? Forget it. Now that pension funds, insurance companies and non-U.S. institutions are suffering stupendous losses on the U.S. debt they purchased in the past, then I can't sell new debt. That tunnel is now a pinhole.

In other words, the supply of actual available credit has shrunk, regardless of what the Fed does with its Fed Funds Rate and Discount Window. That means the cost of credit is rising.

Let's look at some charts. The first chart (above) shows that on the Federal level, the demand for credit/borrowing via selling Treasury bills is set to skyrocket as the cost of entitlements (Social Security and Medicare) are poised to ramp up dramatically for decades to come. With the U.S. government already in deficit, this massive demand will drive up the cost of money: it's simple supply and demand. As credit supply tightens and demand soars, prices rise--perhaps by a lot.

From the technical point of view, we see in the next chart courtesy of frequent contributor Harun I.) that the interest rates on U.S. bonds appears poised to increase. (Recall that bond yields and face value are inversely correlated; as interest rates rise, the face value of existing bonds drops; as interest rates drop, the face value of existing bonds rises.)

Here we see how bond yields (interest paid) runs in cycles of about 20+ years. We also see how interest rates could stay low even as the U.S. borrows ever more prodigious sums: China and other nations have, via their central banks, bought astounding quantities of U.S. bonds. The high demand (deficit spending) has been met with equally high supply (of buyers willing to snap up U.S. bonds for a pathetically low rate of interest/yield).

But now this virtuous cycle has reversed. As the dollar plummets (again, for reasons of supply and demand), central banks are unloading their U.S. debt and cutting back their new purchases. The demand for new U.S. debt is dropping--precipitiously for mortgages and commercial debt, and more slowly for long-term Federal debt.

As demand for credit increases (due to deficit spending and a consumer economy), and supply decreases (nobody is dumb enough to keep buying U.S. mortgages), then the price of credit rises.
If you look at these charts, it seems highly likely that the cost of credit (the interest rate needed to pursuade someone to buy the debt) will rise for the next 15-20 years.

What are the consequences of such a cycle? No mystery there: a staggering rise in the cost of servicing the Federal debt and the consequent restraining of Federal spending, and the constriction of consumer debt and thus spending.

Some smart analysts are calling for an 18-month recession. Based on the charts and the simple laws of supply and demand, I suggest looking for an 18-year recession.

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