The Great Interest Rate Caper

By: Andy_Sutton

It began as any other bull market. An early burst followed by climbing a wall of worry, then bursting out (or down in this case) beyond the wall of worry, its trajectory headed for the great ethereal unknown. And just like every similar time in history, market analysts, policy makers, and the general public assumed it would go on like this forever. And it did. Until it didn’t. By the title you might have already guessed the topic of this essay but think for a minute about this first paragraph and what we’re discussing in generic terms. Of course! We’re talking about the traits of a financial bubble.

By way of introduction, this essay will not contain any images. We have found that many times graphs and charts confuse the issues rather than helping to elucidate them.

If you’re well-studied on bonds and interest rates, you can skip this paragraph. For our new readers, we’ll do a quick reset on this situation. The USGovt sells bonds to other countries in exchange for dollars to finance additional debt. Issuing bonds is a way to generate cash, whether it is a country doing it or a business. The USGovt has been selling more and more bonds recently and accumulating large amounts of debt in the process. However, investors haven’t seemed to mind because the dollar (for reasons unknown) is considered the reserve currency. Consequently, the demand for USBonds and by extension, the USDollar has been fairly strong. Strong demand for bonds pushes bond price higher and yields lower. Yields are indirectly proportional to price. The demand for bonds was so strong that it pushes yields down to all-time lows. This was great for borrowers, but a crushing blow to savers. The cost to make interest payments was kept low for borrowers, but the interest received by savers was non-existent when taxes were figured in. When inflation was added as well, the yields on every bond from 30 days to 30 years was negative. That last part is still the case, however the demand for bonds has been falling, and prices along with it. Which means yields are going up.

It's this last part about yields rising and the bubble mentioned in the first paragraph that bring us to where we are today. The bubble on bonds has clearly started to leak. However, before people start calling their brokers, it must be noted that the not-so-USFed and the Plunge Team (Yes, it really does exist!) can step in and support bond prices any old time they want. The Plunge Team has unlimited resources at its disposal and most major banks have a separate trading desk set aside for Plunge Team activities. Understand full well that the Plunge Team could have stopped the 2008 carnage – and finally did – just under Dow 6,500 on March 6, 2009.

As previously mentioned, the yield curve is still underwater – like many American families, cities, and even states. Much of the world is underwater in financial terms, so that doesn’t really bother people too much – until it negatively impacts their ability to maintain the standard of living they’re accustomed to having.

Having said all this, what do rising interest rates have to do with anything? Simply put, it increases the cost of borrowing – for all borrowers. Interest payments increase. Think of it as a credit card where your initial rate is 9.99%. Within a year, your rate is now 12.99%. Your interest payment has just gone up by 30%. Might not be a big deal if you owe a thousand bucks on your card, but imagine owing billions, hundreds of billions, and even trillions. Now we’re talking about serious money. Now the family might have to do a cash advance from another credit card just to pay the interest on their main credit card. They have to do this because they always spend more than they bring in, so there is no surplus from which to pay the extra interest. The same is true of governments. Small moves in interest rates mean big bucks. Where rates are positioned today, let’s assume the average interest on the national debt of the USGovt is 2.25%. With a 21.5 trillion principal, the interest payment alone is over $48 billion per year. Just in interest alone.

Fiscal Irresponsibility Continues Unabated

We’ve been told recently that the USGovt is back to running trillion-dollar deficits. We wrote about this many years ago when the deficit started to get smaller – keep in mind the USGovt never came close to breaking even, let alone dreaming of a surplus. We thought it would take roughly 5 years to get back to being over a trillion. It took 6. The more debt the US accumulates, the more negative pressure will be put on US bonds and the more upward pressure will be applied to rates. If the not-so-USFed steps in and starts buying the bonds itself, then the private bank will become even more a creditor of the USGovt than it already is. Since the central bank creates money with mouse clicks with no backing whatsoever, a totally counterfeit money, we call this act ‘monetization’.

When monetization occurs, ‘money’ is created from nothing and is given to the USGovt so it has the cash to continue its debt extravaganza. The federal reserve gets the bonds from the Treasury in return. What monetization also does is increases the supply of money in the system without a commensurate rise in the population or actual growth in the economy. This extra money in the system is called inflation. The result is higher prices. Sometimes the higher prices find certain goods, sometimes prices across an entire range of goods are affected. That is very difficult to predict. However, adding extra money to an economy with all else remaining equal will result in increasing prices. This is a law of economics. Too many in academia, thinktank, and policy circles want to have a big sewing circle debate over inflation. There’s no need. A monetary event leads to a price event. This fact is easily proven. So, when the big Ph.D. economists get on TV and try to flummox you into believing inflation is a price event, you would be correct to wonder if their doctoral degree came from a box of cracker jack. Or perhaps they know exactly what they’re saying. We’ll leave you to decide.

What is needed to bring inflation into check is higher interest rates. Higher interest rates put a curb on new debt creation through the multiplier effect. What is also unique about the present circumstances we find ourselves in is that the rise in interest rates must be proportional to the largesse involved, otherwise the system won’t be cleansed. In the early 1980s, the federal reserve raised its fed funds rate to 20% in 1981. Since this rate is a target, the fed cannot be accommodative. 20% FFR slammed the door on money supply growth through the multiplier because people pretty much stopped borrowing against rates that high.

What would a 20% fed funds rate do to today’s economy? It’s a good question. There’d be a nearly instant steep economic downturn that would blow right through the recession range right to depression territory. The same thing would happen if the USGovt refused to borrow money and only spent what was collected in taxes and not a dime more. The economy, however, is used to all this excess. Imagine taking someone who has lived near the Equator their entire life up to the Arctic Ocean and tossing them in. That’s about the reaction we could expect. There would be a lot of economic pain involved with cleansing the system, which is the main reason it isn’t allowed to happen. A secondary motive is that the banks and the establishment elite are still raking in great profits while the current system is allowed to drag on. We also believe the not-so-USFed’s main directive at this point is to keep the Dollar standard era as long as possible for just that reason.

The last sentence of the prior paragraph is why we firmly believe that this unwinding will be slow, not a crash as so many are predicting and have done so for the past 20 years. Exhibit #1 – it is nobody’s best interest to allow the system to die at this point; there are far too many sheep left to be sheared. Rising interest rates will further put the screws to the system by not only increasing the carrying cost of existing debt in many cases, but making future debt accumulation a more expensive proposition as well. We believe that America is going to learn firsthand how its economy reacts to increasing rates. We believe the increases we’ve seen so far are only the beginning. That said, nothing ever goes straight up or down, even if it’s cooked longer than a Thanksgiving turkey. There will be ebbs and flows. The trend though, we believe, is for rates to continue to increase.

Perhaps the biggest reason for this comes in the form of the deals to cut out the dollar that we’ve been tracking over the past decade. It has been a steady process, albeit a slow one. Again, it is in nobody’s best interest for the whole thing to come crashing down at once, even though the idea of an overnight apocalypse sells an awful lot of newsletter subscriptions, but we digress. With more and more countries taking steps to unwind their association with the USDollar, something will have to be done to make the dollar more attractive in an attempt to lure those folks back in. Bingo – higher interest rates. Now you can see where the problem is. Rising rates may help keep some players in the dollar a little longer, but higher rates will most assuredly have a negative impact on the USEconomy.

This is where the stock market comes into the picture and why we believe it was run up this high. Even the most casual of observers understands that the stock market and bond market tend to move in opposite directions. This is not an observation that can always be made on a daily basis; we’re talking about a general trend here. So, let’s assume that we are right and that interest rates continue to rise; especially at the long end. All we need at that point is for a trader or central bank to kick off a selling frenzy (very easily done with a few keystrokes) and money will rush from stocks into bonds – thereby temporarily halting the onslaught of higher rates. This is precisely what we believe has happened over the past week and a half. The Dow Jones Industrials alone lost ~1,400 points in two days. Bond yields stabilized a bit as money rushed from stocks into bonds. Unfortunately for the central planners, money also rushed into precious metals as well. This is another trend we suspect will continue as well, the further this whole charade goes on.

Signposts in a Changing World

We have arrived at the point where it’s time to discuss markers or signposts, if you will, that will indicate that the trend is continuing, has paused, or has accelerated. There will not be an announcement that the USDollar is no longer the world’s reserve currency. While such a day may be announced in the future, it will come as the result of a ‘meeting of the minds’ when they announce the new monetary system – much like the Bretton Woods agreement was announced. The changing of the guard has already occurred. It is happening in phases.

1) Countries make side deals with each other for normal trading activities and instead of using the dollar, they will opt to use their own national currencies instead.

2) The establishment here in the US has the propensity to react in military fashion when countries have announced intentions to dump the dollar in the past. Iraq is an excellent example. We expect the US to use sideshow allegations such as what is going on in Syria rather than overtly threatening countries who dump the dollar with violence. Expect the crescendo of side deals cutting out the dollar to continue. Expect threats of military action for unrelated transgressions to continue as well.

3) The two biggest players at this point are Russia and China. They have some allies as well in their venture to dump the dollar, but they are the two main players right now. India is edging into the fray as well, and we should expect that to continue. The three of them having been buying gold hand over fist for the last decade plus. That activity continues. We have observed Russia unloading chunks of its USTreasury holdings. China has been oscillating back and forth, but it seems the general trend is to unwind their USDollar-based holdings. The BRICS bank, now known as the ‘New Development Bank’ has gotten precious little media coverage, but it consists of Brazil, Russia, India, China, and South Africa, although others are welcome. It is still unclear exactly what their end game is, but we are going to go out on a limb here and predict they will seek to launch a gold-backed currency at some point. This may be quite a few years down the road yet. Such a launch would accompany the proclamation that the USDollar is no longer the world’s reserve currency, referring back to the aforementioned discussion of the USDollar’s status.Look for the NDB or BRICS Bank to continue to seek additional partners. Venezuela immediately comes to mind, even though it just launched its own oil-backed cryptocurrency.

4) War. Forecaster Gerald Celente has discussed for many years now that first come trade and currency wars, then world wars. There is no reason to think this will be any different. Behind the currencies is a power struggle, which is global in nature. Any ground that has been gained by any of the parties involved in the ongoing escalation of currency and trade wars is not going to be given back easily. It will have to be taken. Others have more than adequately analyzed what form a war will likely take, so we’ll stick to the economics. There is already one major economic struggle that has a semi-hot war going on around it and that is Syria. The US wants a pipeline for natural gas from Qatar to the Mediterranean. The Russians would like their relative monopoly on the European natural gas market to continue. The war in Syria is not the direct result of a currency war per se, but this is a very good example of what we can expect moving forward.

Conclusions

Once again, we covered a lot of material; the interconnected nature of global, economic, and policy events requires painting with a fairly broad brush. We’re sure you’ve heard many predict impending doom and gloom due to the aforementioned subject matter. Of course, anyone may be proven wrong at any time and a black swan type event may blow our predictions right out of the water. Such is the nature of economic forecasting, especially when there’s much more than just the laws of economics to consider. If you believe the circumstances to require action on your part, our advice is to get started. A well-laid plan takes considerable time to develop, then implement. As always, we encourage you to spend the time to research these matters on your own. Don’t simply rely on this or any other publication. Watch the blog for signpost events. Even if your government (not just in the US) can’t be bothered with getting its fiscal house in order, there is nothing to prevent you from doing it on a personal level.  Beware debt and ‘specials’ on low interest rates. Read the fine print. You will likely be surprised at what you find.

By Andy Sutton

http://www.andysutton.com

Andy Sutton is the former Chief Market Strategist for Sutton & Associates. While no longer involved in the investment community, Andy continues to perform his own research and acts as a freelance writer, publishing occasional ‘My Two Cents’ articles. Andy also maintains a blog called ‘Extemporania’ at http://www.andysutton.com/blog.

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