Wednesday, May 30, 2007

Why Interest Rates Will Have to Rise

This may be one of the most important entries of the year
. I admit, it's not truly earth-shattering like the news of which airhead starlet has been arrested this week for a DUI on the Pacific Coast Highway, but since it's about money on a global scale, it might be of some interest (pun intended).

Let's go through the standard reasoning about interest rates. One school of thought believes that the bursting of the global debt bubble will lead to deflation, and this will cause the Federal Reserve to lower interest rates in order to keep the bubble (borrow and spend) economy pumped up.

The other school of thought foresees inflation or even hyper-inflation as the inevitable result of a hyper-inflationary monentary policy (easy lending, low rates, endless funds available for lending). To save what's left of the dollar, the Fed will eventually have to raise interest rates.

What if both scenarios are missing the point? What if interest rates will have to rise regardless of inflation or deflation or the slowing economy?

Let's start with a chart, courtesy of (the debt clock). This is an inflation-adjusted depiction of the U.S. National Debt--the debt which has accumulated from years of massive deficit spending and borrowing from foreign entities. (The comments in black are mine.)

Please go to to view charts.

Do you notice the tiny little difference between the previous Bull Market era of prosperity (1946-1966) and the current era of "prosperity"? Hmm, this is a tough one. . . could it be those decades of massive, explosive deficits?

What kind of "prosperity" requires borrowing trillions of dollars to sustain it? Can it even be called "prosperity" if a significant driver was borrowed money?

Even during the "non-prosperous" Bear Market era of stagflation in the 70s, the nation didn't borrow much more than it had during boom times (adjusted for inflation, which rose in the late 70s and early 80s).

For a comparison of that era and our own, let's turn to correspondent Mark P.'s recent observations: (emphasis added)

"I was reading this article on rising gasoline prices and started to think about the past, particularly the late 70s when I was a kid.

This article is pointing out that gas prices are going to hurt consumers soon and cause the consumer to reduce consumption (this should be a world wide phenomenon in industrialized countries). This spending pullback may tip the economy into recession (considering that last year the economy was barely growing and 70% of the economy in consumer spending).

Remember in the late 70s we had some inflation, a little growth and then pow, a huge gas spike... That sent the economy into stagflation. I believe that we may be looking at that same scenario again. Remember how the government solved the stagflation of the early 80s??? Ronald Reagan spent about 1 trillion dollars (doubled the national debt at the time) to buy military equipment and Paul Volcker raised interest rates to insane levels.

The interest rates cause the value of the dollar to increase thus making foreign products cheaper. Producing more spending, combined with government spending righted the economy.

If the same scenario happens again the first question is: can the government make the same kind of impact? We have all seen that the Fed doesn't have anywhere near the same ability to control the interest rates as it once had almost 30 years ago. We also know that it is taking more and more spending to generate each dollar of economic growth.

In the current situation the interest rate change will make the dollar rise and make foreign products cheaper. Remember house values and interest are inversely proportional. So high interest rates could implode the housing bubble.

But a side effect of high interest rates could be a huge impact to all of the people with adjustable rate mortgages. Would people whose home values are plummeting or that are losing their houses (because that can't be sold for what they are worth) be willing to spend more for stuff (the people that lost their homes would have no place to store the stuff)??? Any interest rate increase would impact the already leaking housing bubble. I can't believe that the politicians could even fathom this option.

If the government tried to spend their way out of a stagflation scenario they would have to borrow MASSIVE amounts of money (possibly double the national debt). Currently, there is enormous downward pressure on the dollar due to all of the debt being created by the US goverment (due to the borrow and spend Republicans). The dollar has suffered about a 25% decline against the Euro since early 2001 ( Federal Reserve website). The dollar has fallen against most unpegged worldwide currencies ( Federal Reserve).

So, what would massive federal spending do?? First it would cause massive federal borrowing, causing the dollar to fall if not collapse. Since most of the goods we buy come from foreign countries debt creation would in turn cause inflation, which would make an inflationary situation worse and reduce economic growth.

Unfortunately, the government looks like they would have limited solutions in this scenario. I think they would try the easy way out first, just making the problem worse. "

Mark's commentary led me to this conclusion: the debt is already so large, the Treasury will soon have no choice but to raise long-term interest rates. To see why, let's look at another chart:

Notice how the Chinese central bank has ramped up its purchase of U.S. Treasuries to what is clearly an unsustainable rate.

Before we go on, let's recall a few key points:

Interest rates are not set by the Fed--they're set by the bond market and the Treasury Department, whose job it is to sell the Treasury bonds. If there are no buyers at 4.5%, they must raise rates until buyers appear.

It's not just new bonds (i.e. new deficit spending) which must be sold--hundreds of billions of old debt rolls over and must be re-sold. Those 6-month, 2-year, and 5-year Treasuries come due and must be rolled over to new buyers. Recall the Treasury got rid of the long bond (30-year bond) for a number of years, meaning all debt sold in those years is short or medium term.

Foreign entities are major buyers and owners of Treasury debt. Simply put: if foreign buyers decided to diversify their holdings and/or stop buying U.S. bonds en masse, there is no evidence that U.S. investors would or even could absorb those trillions in Treasuries.

There is no guarantee that the world will be able or willing to fund our current debt, never mind the next $5-10 trillion we might want to borrow. We have been lulled by the stupifyingly lopsided buying of the Chinese central bank into thinking that no matter how much we borrow via deficit spending, some kindly soul will pony up a trillion in cash to buy our new debt.

If there's no longer buyers of Treasuries at 5%, then the rate will rise to 6%. If there aren't enough buyers at 6%, then the rates rises to 7%, and so on. That's how you get 10% interest rates-- which were once the norm.

The cliche repeated in the mainstream media is that China continues buying hundreds of billions of U.S. bonds every year as a "safe" investment." How "safe" is an investment which has lost 1/3 of its value in the past 5 years? (The dollar Index has fallen from 120 in 2002 to 82.) We all know the real reason China has been pouring the vast majority of its foreign reserves into Treasuries--to support low interest rates and therefore the purchasing power of the dauntless "borrow and spend" American consumer.

The larger question is: how sustainable is a debt machine dependent on the fortunes and good will of one's trading partners?

What could cause the Chinese to cease new purchases or to even start selling Treasuries from their horde of $1.3 trillion? (It's rising by about $125 billion a quarter.)

A U.S. Congress-mandated trade war might induce the Chinese to stop playing patsy to the U.S. Treasury. Many observers are claiming a veto-proof tariff bill is now a near certainty.

The Shanghai Composite stock market collapsing (now a mere matter of days or weeks away) could trigger a massive government spending spree to quiet the social unrest caused by tens of millions of neophyte investors being wiped out. How to raise a needed $100 billion or so? Sell Treasuries, and stop buying them.

A U.S.-led consumer recession will take a huge bite out of China's surplus, reducing their ability to purchase more Treasuries. (Recall that their global surplus is far less than the surplus they run with the U.S.)

The dollar's steady erosion is already forcing the Chinese to diversify their holdings; their appetite for another 30% loss of value is declining rapidly. With a $1.3 trillion stake in the dollar, another 30% decline will shave off $400 billion in value from their holdings. This is not a trivial loss, even to the Chinese government. There are already voices there saying that the governemnt should invest those hundreds of billions in China rather than gamble them all in the market for U.S. Treasuries. And who could disagree?

Once the Chinese either decide to stop supporting the U.S. debt machine, or find they no longer can do so regardless of their desire, the market for low-interest rate Treasuries dries up. Yes, the Gulf states are big buyers, too, but there is no evidence they can double or triple their bond purchases to cover what China currently buys.

How vulnerable are we? Very. One solution is to stop running deficits of $300 - $400 billion a year; that would be $400 billion less debt we need to find buyers for. But which of our elected officials would have to courage to cut $400 billion in spending?

The real problem is the debt is already unsustainably large. Even if we as a nation stopped spending more than the government collects, the existing debt constantly rolls over and has to be refinanced. If money dries up globally, we are in a real pickle. With a negative savings rate, does anyone seriously believe we can fund our own deficit?

And here's one more "follow the money" line of thought. Who gets hurt if the Treasury refuses to support the plummeting bond/dollar by raising interest rates? Joe Sixpack? Not really.

How much does Joe Sixpack buy that is made in Europe or Japan? The Japanese nameplate vehicle he buys is actually made in the U.S.; only the profit is repatriated to the home country. If he travels outside the U.S., then the weak dollar will hurt his purchasing power--but how often does Joe Sixpack go to Europe or Japan? (Recall that the Chinese yuan is pegged to the dollar and does not fluctuate much even as the dollar tanks.)

As for food--it's mostly priced in dollars. Ditto oil/energy, so a plummeting dollar will have little effect on Joe's purchase of these commodities (unless OPEC starts pricing oil in euros. Then it's Katie Bar the Door.)

No, the big losers in a bond/dollar collapse are the wealthy. As documented here many times (via links to the Wall Street Journal), the top 5% of U.S. citizens own about 2/3 of all the stocks, bonds and real estate in the country. If the bond and/or dollar drops through the floor, their holdings will be worth a lot less globally--and the wealthy of the world are global players.

So ask yourself: if our patsy trading partners are no longer willing or able to gamble all their surpluses on the dollar and Treasuries, or we have finally worn out our welcome in China and the Gulf so that politicians/bankers in those regions decide to stop supporting low interest rates in the U.S., then will our politicians really care about Joe Sixpack losing his bubble-priced home?

The short answer is no. They will care about the wealthy, who fund their campaigns. Joe Sixpack doesn't even bother to vote (U.S. voter turnout is barely 40%; in the recent French election, turnout was 85%.) Yes, there will be tearful speeches and a lot of hot air expended about poor Joe, but when push comes to shove, the Treasuries have to be sold--there is no Plan B--and the wealthy's holdings in dollars will have to be defended.

Joe Sixpack? Sorry pal, suck it up; you blew it signing that adjustable rate mortgage and paying bubblicious prices and tapping all your equity with a home equity line of credit. Too bad you believed all that mainstream media shuck and jive about interest rates staying low forever.

Thank you Abrey M. ($25.00) for your generous and quite unexpected donation. I am greatly honored by your support. All contributors are listed below in acknowledgement of my gratitude.

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