Everything You Wanted To Know
About Interest Rates
Craig Harris
President:
Harris Capital
Management, Inc. CTA
March 17, 2004
This article
is part of a series of questions and answers. To catch
up on questions already answered please refer to my archives.
In this essay I'm answering
questions 1 and 1A.
Question 1) When are interest
rates going to begin to rise and what will the catalyst be? Will
the short end rise first due to FED tightening or will the long
end rise first as a reaction to the dollar slide or perceived
economic strength?
Question 1A) Sooner or later,
interest rates will rise. What will the likely result of rising
interest rates be?
Before I get started on interest
rates, I'm going to say that the prediction of interest rates
in my opinion is without a doubt the most difficult thing to
do in finance. Almost no one can do it... and maybe I can't either.
I have a history of accurate predictions but I am often early
with those predictions. My point being that I tend to have a
very long time horizon. I don't have any interest rate positions
on at this time unless you consider being short the US dollar
an interest rate position. I would also like to say that my conclusions
are worrisome and I actually hope I end up being wrong, but I
do think I've said a lot of important things in this essay.
I think the most fundamental thing
for me to say regarding interest rates is to read some of my
other answers which can be found here. The reason I urge this is because
I believe that if you have any hope of getting the interest rate
question correct, you have to have a comprehensive and accurate
world view. That's why interest rate prediction is so hard. There
are so many variables involved. Interest rates really are at
the root of all financial market speculation and investing.
I'm going to start by itemizing
my known knowns.
1.) Interest rates are the most
fundamental financial engineering tool there is, period. Interest
rates are like the gas pedal... when the FED lowers interest
rates it's like pushing the gas pedal on your car. Alternatively,
you can think of interest rates like the strings on a puppet
(sorry, you are the puppet). Think of the monetary base as a
big fire hose. The financial engineers can direct that fire hose
(a fire hose of capital) in whichever direction they want by
the relationship of interest rates (and other incentives) to
the economy. For example, right now, the fire hose is pointed
at real estate and at the share market. It's pointed there because
both a bond investment and a savings or money market account
investment, or cash under your bed offer a negative real return.
Because of this, THERE IS A TREMENDOUS DISINCENTIVE FOR THE PUBLIC
TO SAVE OR HOLD CASH. There is a very strong inducement for you
as an investor or speculator to take on more risk and seek a
higher return by investing the money in real estate or the share
market. RETIREES AND OTHER PEOPLE WHO HAVE NO BUSINESS SPECULATING
IN STOCKS ARE DOING JUST THAT because they have no viable other
source of income... watch the puppets dance. Interestingly, as
the fire hose has been pointed in this direction, both the share
markets and real estate have become overvalued, which is what
I mean by puppet strings. If you'd like, you can use a more modern
term and call it social engineering. By creating a lack of viable
alternatives, by default the financial engineers are directing
you by remote control to point the money hose where they want
it to go. They create the money by a stroke of the pen... and
offer incentives and disincentives for you to point the hose
where they want it pointed... they are pulling on your puppet
strings, which incidentally is why Rothschild said...
"Give me control of a nation's
money and I care not who makes her laws" -Meyer Rothschild
The reason he said that is because
when you control the money you are in control of the puppets,
just like I discussed above... the world is your puppet. Meyer
Rothschild makes a strong case that if you control the money,
you control the world. I agree with him completely. Here's another
interesting point... the quote above is from a long time ago,
before derivatives were invented. If you "care not who makes
the laws" on a cash basis, and then you have the 98% leverage
of derivatives available, you're really not going to care. Think
of it as control of money on steroids.
I always think to myself what
kinds of things are said behind the closed doors of powerful
people... you might hear Greenspan say behind closed doors...
"wanna see me make people invest in the stock market again
even though they just lost most of their money a year ago in
the biggest bubble of all time???" Poof- Fed Funds
1%. Like magic the share market goes from boom to bust to boom
again.
So... to net this out, the fire
hose has been pointed into the share market and real estate and
it has created new bubbles in order to "rescue" the
economy. I think that's a very straightforward and easy to understand
analysis.
2.) VERY LOW INTEREST RATES OFFER
A STRONG DISINCENTIVE TO SAVE, AND AN INCENTIVE TO SPEND AND
TAKE ON DEBT. This is another puppet/string situation... and
once again you are the puppet. In spite of the fact that the
actual cure for some of the current economic problems is for
the government and public to save and reduce debt, exactly the
opposite incentive has been introduced for the simple reason
that the modern financial system has evolved to rely on ever
increasing levels of debt and inflation to sustain itself. Why
would you save when you have a negative real rate of return and
your savings are worth less every day? Why wouldn't you buy that
car you can't afford when you can finance it at zero percent
interest even if you're already in debt up to your eyeballs?
So you see, unfortunately the financial engineers have created
a situation whereby you as a consumer are being manipulated to
do the exact opposite thing you need to do for your personal
well being in order to ensure long term growth and prosperity
for the economy... (so they say). An alternative way to look
at this is that THE FINANCIAL ENGINEERS HAVE CREATED EXACTLY
THE ENVIRONMENT THEY NEED TO CREATE THE ILLUSION OF PROSPERITY
IN THE SHORT TERM AND A DISASTER WAITING TO HAPPEN IN THE LONG
TERM... FOR THE REASON THAT THERE ARE FINITE LIMITS TO HOW MUCH
DEBT YOU CAN TAKE ON AND HOW MUCH INFLATION IS NEEDED ON THEIR
PART TO INFLATE YOUR WAY OUT OF THAT DEBT.
3.) We are in an environment where
a rise in interest rates could be catastrophic for the economy.
A RISE IN INTEREST RATES COULD CAUSE BOTH BUBBLES (THE HOUSING
MARKET AND THE SHARE MARKET) TO COLLAPSE... consumer confidence
and the economy would then quickly follow suit, and the people
pulling the strings know that.
4.) We are in an environment where
if Greenspan raises interest rates before the elections it would
be catastrophic for his job security. Although the Federal Reserve
is a private corporation, the position is highly politicized.
5.) The US dollar is one of the
lowest yielding major currencies as I write this. This provides
a strong incentive for US based market participants to invest
in foreign currencies and for foreigners to be loathe to hold
US dollars because they can get higher interest rates with similar
risk outside the US. IN THE CURRENT ENVIRONMENT, THE US DOLLAR
HAS BEEN DECLARED BY THE FINANCIAL ENGINEERS TO BE THE SACRIFICIAL
LAMB. Interest rates are being held artificially low to keep
the US economy from collapsing but that draws capital out of
US investments and into higher yielding overseas investments.
The idea is that that's the lesser of all evils, and that something
in the financial equation has to be a sacrifice in order to achieve
the primary goal of preventing a deflationary collapse. If all
that is true however, if you are following this you would ask...
if this is the case, then what foreign entity is keeping the
US afloat by buying US assets? The answer is... the Japanese
are effectively monitizing US debt as they print up yen out of
thin air and buy US treasury bonds which in Central Banker talk
is a "win win". They keep the Yen down, the Dollar
up and solve the problem of too many US dollars floating around.
The reality is that this is yet another illusionary measure that
does not correct long term systemic problems. That said however,
Japan has recently indicated they are going to stop selling yen
for dollars. If this is true, it leaves a gaping hole for the
US. Either a new foreign entity would have to step in to fill
the void, or else interest rates would rise to the point where
the void was filled to attract enough foreign capital to fill
the void. This is one of the wildcards going forward.
6.) THE COMBINATION OF ARTIFICIALLY
LOW INTEREST RATES AND IT'S EFFECT ON THE US DOLLAR EQUATION
I DISCUSS ABOVE, ALONG WITH THE RAPID EXPANSION OF THE MONETARY
BASE WHICH ALSO KEEPS INTEREST RATES ARTIFICIALLY LOW IS A VERY
POTENT INFLATION GENERATOR. In fact, I'd argue that it's the
most potent combination for the creation of inflation you could
possibly have. Interestingly, if you run a household, you see
that inflation but it does not show up in the Governments numbers,
and that is by design. The financial engineering plan requires
inflationary actions but the appearance of inflation would cause
problems. So, the FED HAS ADOPTED THIS POLICY OF TALKING ABOUT
DEFLATION TO DIVERT ATTENTION FROM THE FACT THAT THEY ARE DOING
EVERYTHING THEY CAN TO GENERATE INFLATION to save the system.
Interestingly, people who call themselves economists are paraded
on TV all day long with the notion that inflation is "no
problem,", and at the same time, the price of gasoline is
making all time highs, healthcare costs are going up at double
digit rates, home prices are in the stratosphere, the CRB index
is making new highs, home insurance is skyrocketing, college
tuition is skyrocketing, the price of everything is going substantially
higher... and we are told that there is no inflation by people
that are supposedly economists. It's time to think for yourself.
One last thought. Gold is the traditional inflation barometer.
If you wanted to create the conditions for inflation, but to
mask that inflation from the market participants in every way
possible, what would you do? I know what I'd do... I'd make sure
I kept my financial engineering foot on the price of gold.
So WE HAVE COME TO A TIME WHERE
THE SYSTEM'S FUEL IS EVER INCREASING LEVELS OF DEBT AND SUBSTANTIAL
INFLATION. WITHOUT EITHER, THE SYSTEM WILL FAIL. Some say that
guarantees the ultimate end game is collapse as it becomes mathematically
impossible to reconcile the personal and government debt burdens.
The hope of the Financial engineers in the shorter term however,
is that if they talk about deflation, that will reduce the expectation
of inflation and thus reduce the actual inflation and the perception
of inflation... and guess what? So far it's working. For example,
if the bond market collectively realized that real inflation
was much, much higher than reported by the government, interest
rates would soar, stocks would decline, the US dollar would go
higher, the Trade deficit would go higher and the economy would
collapse. There's a lot to digest there... read that twice if
you need to because it's critical to understanding the big picture.
7.) The Financial engineers are
going to be loathe to either raise interest rates or even allow
long term interest rates to rise. In my estimation everything
possible is being done to keep rates artificially low, using
every trick in the book and then some. Remember when the 30 year
bond was eliminated? That was a slick move because it eliminated
the supply. When you eliminate the supply of something, if the
demand remains anywhere near constant, what happens? If you get
out your supply demand charts you will see that the price goes
higher. When bond prices go higher, interest rates go lower.
This is an example of one of the many "emergency measures"
being used to keep long term interest rates artificially low.
8.) A fiat currency with no intrinsic
value relies on the fact that it pays interest to be attractive.
The less interest it pays, the less attractive it is. Interestingly,
as the fiat money in the US has been printed at a rate much greater
than the growth of the economy, you would expect it's value to
go down... and it has... both in terms of the interest it pays
and it's status among it's peers (the other fiat currencies).
As the money is piling up... it is becoming increasingly worthless
and you are seeing that happen in real time. Ultimately, you
would expect that interest rates will have to rise to compensate
holders of the debt (today's money is debt) for the increased
risk, but I think that event is further down the road, and would
happen only after the share market and or real estate bubbles
collapse, shattering the illusion of a healthy recovering economy.
So knowing all of that above,
what do I think about the future? I think the financial engineers
are slowly painting themselves into a corner. They find themselves
in a position now where interest rates are very low, and any
rise in interest rates would be a disaster for the real estate
bubble and the new share market bubble. In other words, if they
allow interest rates to rise this fragile, mostly illusionary
"recovery" is going to melt away... and they know that.
Furthermore, as they hold interest rates down, this is causing
a big problem for the US dollar... the falling dollar has been
deemed to be the lesser of evils, so it's taking the fall, but
at some point the falling US dollar will become a problem. I
guess my overall point is that as I said above, the unfortunate
reality is that this "system" has grown to be fueled
by debt and inflation. Without debt and inflation the system
runs out of gas and the whole thing comes down. It's a precarious
situation, and a situation that does not argue well for the long
term. How much debt can consumers pile on? How much debt can
the government take on? How big and for how long can the current
account deficit be sustained? As foreigners continue to own a
greater and greater percentage of US assets, at what point does
the USA become irretrievably mortgaged out to the rest of the
world?
The problem is this... the US
economy has gone from being solid and strong in the 50's and
60's to a house of cards in 2004. IN THE PAST SEVERAL DECADES,
THE US HAS GONE FROM MAKING TO BUYING, FROM SAVING TO SPENDING,
AND FROM LENDING TO BORROWING. As a result, the economy has changed
from a production based economy to a consumption based economy.
Former manufacturing powerhouses like General Electric now make
the majority of their revenue in financial services. Furthermore,
the currency has lost it's intrinsic value. THE US HAS BECOME
THE HIGH COST PRODUCER OF GOODS AND SERVICES (the opposite of
what you want). The public has gone deeply into debt, the government
is running a one year deficit of nearly 750 billion dollars using
the Accrural method of accounting (which the government doesn't
use in spite of the fact that they require business to do it
that way). There is this notion that I don't think any of the
FED members actually believe, that the US economy has transformed
from a "manufacturing economy" to a "services
economy". I would argue that is a ridiculous notion for
the simple reason that IF YOU COULD BUILD A SUCCESSFUL ECONOMY
BASED ON SERVICES AND CONSUMPTION, EVERYONE WOULD HAVE ALREADY
DONE THAT AND WE WOULD HAVE PEOPLE IN ARGENTINA DRIVING NEW SUV'S
AND GETTING FOOT MASSAGES AND MANICURES RATHER THAN DIGGING THROUGH
DUMPSTERS TO FIND FOOD when their currency collapsed. THE NOTION
THAT YOUR ECONOMY CAN BE SUCCESSFUL NOT BY MAKING THINGS THE
REST OF THE WORLD WANTS, BUT BY BUYING ON CREDIT, SHAKING MONEY
BACK AND FORTH, AND CONSUMING IS AN INSULT TO MY INTELLIGENCE
and it would be an insult to the intelligence of the US congress
when they hear Greenspan say that... if they had any intelligence...
but that's another essay.
A healthy economy produces things
that people want and are willing to buy, and they are willing
to buy those things either because they can't produce those things
themselves, or because you can produce them more cheaply (ie
the same reason nearly everything in Wall Mart comes from China
today).The basic idea is that you make those things and sell
them for a profit. That's how the US got to where it is today,
and now this ridiculous notion of a "services economy"
is being used as a smokescreen for an economy that is an illusionary
house of cards waiting for a strong wind. The interesting thing
about this part of my essay is that it argues that China has
it right and the US has it all wrong.
So THE POINT IS THAT THE "HEALTH"
OF THE ECONOMY HAS BECOME A FINANCIALLY ENGINEERED ILLUSION.
Things seem ok, but it's like a castle that seems to be made
out of rock which is really made out of paper mache... when the
illusion evaporates, there's nothing underneath to hold it up
and prevent a catastrophe.
Now with all that said, here's
my best guess for an interest rate forecast. I believe interest
rates on both the long and short end will be held low..artificially
low, for a long time..certainly into 2005 if you ask me... for
the simple reason that if rates are allowed to rise, the mostly
illusionary recovery would have to face the prospect of declining
home prices and share prices. WHEN INTEREST RATES DO RISE, THE
REAL ESTATE BUBBLE WILL DEFLATE AND THE SHARE MARKET WILL DEFLATE.
AT THAT POINT WE WILL EITHER HAVE A GLOBAL DEPRESSION OR A FIAT
CURRENCY COLLAPSE AND HYPERINFLATION. My money is on hyperinflation
for the following simple reasons.
1.) every fiat currency ever invented
eventually failed... when it did you had hyperinflation
2.) the Financial Engineers have
a very convenient way of preventing deflation... it's called
a fiat printing press. The prospect of a deflationary collapse
will be met with printing presses running 3 shifts... If they
print enough money to ward off deflation, the US dollar will
become worthless. Worthless money equals hyperinflation. When
the world's only superpower and owner of the worlds reserve currency
faces hyperinflation, the global financial system is at risk.
"I CAN'T DENY THE POSSIBILITY
THAT THE WHOLE SYSTEM MIGHT COLLAPSE." -Alan Greenspan speaking
in Berlin Jan 13, 2004
I always feel more comfortable
with a conclusion reached by simple, uncomplicated analysis.
Now, excuse me, it's time for
my massage and then I'm going out to buy a new SUV with no money
down and zero percent financing... then stop by Wal Mart to buy
some stuff made in China to max out my new credit cards... then
I'm going to eat a half gallon of ice cream while I criticize
the rest of the world.
Craig Harris
President
Harris Capital Management, Inc. CTA
website: http://www.harriscapitalmanagement.com
email: bcharris@gate.net
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