Interest Rates: Something Wicked This Way Comes
By The Daily Reckoning Australia | July 10, 2013 2:13 PM EST
The Federal Reserve's EZ money policies will either succeed or fail. Either way, it will be a disaster.
If they succeed, interest rates will rise...and America's debt-addicted economy will get the shakes.
If they fail, the Federal Reserve will double down with further acts of reckless improvisation - including bigger doses of credit - until the whole thing blows up.
On Friday, it looked as though the disaster might come from success. Gold took another solid right to the jaw - down $39 per ounce. The Dow rose another 147 points.
The proximate cause was the latest news from the jobs arena. Apparently, employers are once again reaching out and dragging able-bodied men and women into their shops.
'What does this mean?' investors asked themselves.
'The Fed can now taper,' said some. 'Sell gold!'
'The economy is recovering,' said others. 'Buy stocks!'
We noticed a few mean-spirited comments on the internet, sniping at the figures. One website post told us that most of the new jobs are as waiters and bartenders. Another reminded us that people are still waiting more than 30 months before they find jobs...and that the workforce as a percentage of the population is at its lowest level since the 1970s.
But let's give credit where it is due. These employment numbers speak a kind of success. In spite of the Federal Reserve's policies, the economy is not only still alive...but also getting back on its feet.
If this is so, it is good news for the people who have finally found meaningful employment. As for the future of the US economy, it is a disaster.
What's the most important thing that is happening in world markets?
Treasury prices are going down; Treasury yields (and interest rates) are going up.
We are not sure if this will continue. But we guess it will. Like all guesses, it comes with a caveat lector: It ain't necessarily so. Mr. Market is a fooler. And he could be fooling us now.
But a change of direction in the bond market is inevitable. And if the current fall in bond prices marks the start of a long-term secular bear market, it will be devastating.
But for whom, exactly? How? When?
A generation has come of age in a time of falling interest rates (which move in the opposite direction to bond prices).
When the last turn came, the boomers were just reaching maturity, setting up families, beginning their careers and starting to think about investing.
From 1981 until last month, they knew nothing else: Lending rates went down...down...down...from mortgage rates of over 10% to mortgages rates of under 4%. Stocks went up (with periodic dizzy spells). Bonds went up. The economy, too, seemed to grow without much effort.
A world of falling interest rates is a gentle, forgiving world. If you get into financial trouble, you refinance at lower interest rates. It's hard to go broke when people make more and more credit available at lower and lower rates of interest. It's hard not to make money, too, when people are spending money they have never earned.
But it is a strange world too...
It is a world of make-believe, where people pretend they have income they don't really have. Where retailers make believe they have customers who can pay their bills. Where the feds' economists make believe they have things under control...and that Great Moderation is a feature of their own clever management.
It is also an unsustainable, unbalanced, rickety kind of world. A world that will fall over sooner or later.
Because people can't spend money they don't have forever. And when the turn comes, the world will not be so forgiving...not so easy...and not so readily manipulated by the feds' clumsy economists.
First, the money ceases to flow from lender to borrower to retailer to stockholder. Instead, it begins to flow in the opposite direction. Stockholders, retailers, and borrowers all see their revenues decline.
Lenders begin to see their money come back to them. But alas, even they are disappointed. Because the loans they made at 3% seem paltry and stupid in a world of 5% yields. Their money went out full of youthful confidence...it's coming back hunched over, worn out from too many late nights and too much partying.
If the rise in real interest rates were to begin now...as I believe it has...it sets the whole show running in reverse. Instead of EZ credit and smiling creditors, borrowers face grumpy loan officers and higher lending rates.
Borrowers (almost everybody, that is) also find they must cut back their spending to pay the higher rates...or go broke. And this time there is no one ready to catch them when they fall. There are no opportunities to refinance...not even at higher rates.
In a 'normal' credit cycle, all of this happens with the usual crises and catastrophes. Some businesses go broke. But some increase market share. Some households file for bankruptcy. Others prosper. Some lenders take big losses. Others manage their risks more carefully. Nothing special, in other words.
But what happens when credit has been abnormally expanded?
The last bear market in bonds (accompanied by rising borrowing costs) began after the Second World War, with far less outstanding personal debt.
What happens when people have debt up the wazoo...and interest rates rise? What happens when the entire economy - from the federal budget to household finances - depends on unprecedented levels of debt at unsustainably low interest rates?
That is what we are going to find out. Because if the economy really is warming up, the unseasonably low interest rates of the Great Correction are bound to thaw out too.
for The Daily Reckoning Australia
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