|UNCOMMON COMMON SENSE
For People Who Think
THE CHICKENS ARE COMING HOME TO ROOST
Aubie Baltin CFA, CTA, CFP, PhD.
October 9, 2008
WHAT’S HAPPENED TO COMMON SENSE
Has no one noticed “That doing more of the same as what got you into trouble in the first place, only makes the problem worse?”
Has no one noticed that the lowering of interest rates has not only not worked, but has actually been counter productive for quite a long time now? If Wednesday’s Stock Market Action does not prove that I don’t what will.
Has it also escaped everyone’s common sense that pouring money (mega $ trillions worldwide) into the financial system has not only not worked, but is actually exacerbating the CREDIT CRISIS and will definitely cause HYPERINFLATION.
Is everyone so steeped in Keynesian (socialist) Philosophy that they cannot see that the world is doing exactly the same thing now days as what the German Weimar Republic did in the 1920’s - CREATING HYPERINFLATION.
Perhaps it’s time for a refresher course on what interest rates are, what their functions are and how they are supposed to work in a Free Market economy.
What's Behind the Interest Rate Conundrum?
Before we can even begin to discuss interest rates intelligently, we must first define what it is that we are actually talking about, since it appears that all the media heads and Wall Street analysts don’t seem to understand what interest rates are or how they work. Not even the constant barrage of economists parading across our TV screens seem to know what the interest rate’s primary functions are or what they are supposed to do.
WHAT ARE INTEREST RATES?
Interest rate is just another word for price. It is the price for money and it is supposed to be determined exactly the same way as the price of any other commodity, product or service - through the interaction of supply and demand.
Unlike most products, commodities or services, interest rates and money do not operate in a Free Market. Interest rates and the supply of money are manipulated by the Fed. They do this by controlling the amount (supply) of money that is available in the banking system through their Open Market Operations (buying & selling Treasury Bonds) by changing their deposits that they hold with their individual member banks, directly affecting their reserves and thus their ability to lend. They also increase the money supply the good old fashioned way, by printing it.
WHAT ARE THE PRIMARY FUNCTIONS OF INTEREST RATES?
#1 Savings and Consumption: Interest rates determine the marginal propensity of people to either save or consume. If interest rates are manipulated too low, like they are now, people are no longer willing to save. When the interest rate is so low that it becomes negative (the interest rate is lower than the inflation rate). as they are today, people take on excessive debt and risk because that is exactly what they are being paid to do. Conversely, when interest rates are high, such as in the early 80’s, people forego current consumption in order to avail themselves of the ultra high interest rates: Since the cost of everything is increased by the loss of interest that they would have to forgo, this results in much higher savings rates (15% in the early 80’s vs. – 1% today).
#2 Deposits VS. Cash in Your Pocket: When interest rates are high, the demand for cash is extremely low. People can’t wait to deposit every cent that they can spare in order to earn that high rate of interest. However when rates are low, the propensity to hold cash is very high. When the banks are paying less than 1% for deposits, there is not much to be forgone by keeping extra cash in your pocket.
#3 The Velocity of Money: Refers to how many times the money supply turns over during the year and therefore the calculation of the money supply itself is greatly affected by the level of interest rates. When rates are outside the normal range, the FED cannot calculate the velocity until long after the fact. They lose track of what the money supply really is and its effect on the economy, leading to the interest rate conundrum.
#4 To Invest or Not to Invest: Interest rates also help determine which investments should or should not be made, by the investment’s expected rates of return. When interest rates are manipulated too low, a great many investments and excessive risks are undertaken that should not have been, because these poor investments will fail at the first signs of weakness in the economy or with the eventual increase in interest rates. This is the main underlying cause behind the business cycle. The imbalances (wasted resources) in the economy must be liquidated before the economy can stabilize enough so that the misused scarce resources become available for the next growth phase.
#5 A Neutral Rate of Interest: It is the rate that neither stimulates nor restricts the economy. Greenspan was and Bernanke is in a conundrum as to what that rate is or should be. Previously, that rate was thought to be 1.5% to 3% over the inflation rate. (According to the latest CPI report (5%), the Discount Rate should be at least 6.5% to 8%). In the past, when the Fed did not manipulate the rates except at the extremes, the market was able to determine what that rate should be through the interactions of the Free Market. But today, with US savings nearly zero and the CPI and interest rates being highly manipulated, the Fed is unable to measure the Velocity of Money and with negative interest rates, the Fed does not have a clue as what the neutral rate should be.
#6 The Discount Rate: It is the rate that the Fed charges banks that need to borrow money from the Fed in order to meet their reserve requirements. The FED was originally created to be “the Lender of Last Resort”, .avoiding bank runs and liquidity squeezes. The Discount Rate charged is supposed to be a Punitive Rate; a rate that was somewhat above the Fed Funds Rates (the rate at which banks lend to each other in order to meet their overnight reserve requirements). But today, the Discount Rate is below the Fed Funds rate, drastically lowering the bank’s cost of money and reducing the amount of interest they are willing to pay for deposits. Now, massive amounts of money are being borrowed from the FED without having to worry about the excess demand increasing interest rates, greatly increasing the bank’s ability to create money out of thin air (completely negating the supply/demand function in setting interest rates). This breakdown in the function of a free market has led to the creation of “the Carry Trade.” In so doing, the Fed has completely lost control over the bank’s and near bank’s’ (AIG, FNM, FRE, GE, GMAC etc.) ability to create money and have therefore lost control over the money supply. This has led directly to the creation of the Stock and Bond Market Bubbles and finally to the ever expanding Real Estate Bubble. For a long time, regardless of the increasing demand for loans, interest rates continued to decline because the FED kept pumping money into the system, creating the biggest Credit and Real Estate Bubble in history.
When it comes to the economy, what matters most is the availability of money and not the purported interest rate stance of the Fed. For example, in order to maintain a given interest rate target in the midst of a strong economy, the Fed is forced to push more and more money into the system to prevent the Fed funds rate from rising above their target rate. This in turn causes long term rates to fall. The opposite will happen should the economy go through a period of weakness. Since they are always behind the curve, they end up accentuating the problem. Since June 2004, despite raising the Fed funds rate from 1% to 4 3/4%, the Fed has actually hiked the pace of pumping money into the system creating a flat to negative yield curve. In short, the Fed has been talking tough while acting like a very loose pussy cat. We are all now witnessing the effects of their mis-management.
Nobody seems to realize that there are always time lags whenever there are any changes in FED or Government policy, such as taxes, money supply or even oil prices or ??? . It takes time for the Free Market to send its signals through to every participant. Then it takes more time for recipients to change their habits and plans reacting to the new changes in rates. The estimated average time lag between changes in the Fed Funds policies and the growth momentum of industrial production is on average 12 to 36 months. Hence, at the same time as the FED’S attempted tighter stance (beginning June 2004), the effect of the previous and continuing loose money stance was still in force and continuing its influence for the following 24 months. So in spite of their regular ¼% increases, the yearly rate of growth of industrial production stayed strong well into 2006. However, the strong economic activity made possible by its loose money policy, has made the FED funds rate targets unsustainable—so the Fed had to continue to increase the money supply to prevent the Fed funds rate from overshooting its stated targets. This monetary pumping has in turn prevented the growth momentum of the economy from slowing, also preventing any substantial rise in long-term interest rates.
Everybody knows that inflation is at all times a monetary phenomenon. If you keep printing money (beginning in 1994) at a rate that is 10% a year above the economy’s real rate of growth, inflation must eventually raise its ugly head and it has. It first showed up in the stock market, then found its way into the bond market and eventually into real estate. Now that the economy is awash in cash, and it’s finally finding its way into the CPI, as well as into commodities, Gold and Silver; even though the government has thus far managed to convince everyone (through their ingenious manipulation of the CPI) that there was and is no inflation. Nevertheless, inflation has already begun to show its ugly face and it won’t be much longer before we see just how high inflation really is. Greenspan was, to his credit, looking to the future while the rest of our esteemed analysts are still focusing on their rear view mirrors. Bernanke tried to continue increasing rates in order to slow the economy and stop the real estate bubble from becoming unmanageable. But alas, he chickened out. He could not serve two masters and we are now suffering the consequences of short term (short sighted) policies.
It is probable that the Fed, under tremendous pressure from all sides, has mistakenly decided that it has no choice but to push the Fed funds rate even lower in a vain attempt to turn the slowing economy around. Like it or not and despite what Wall Street wants, continuing to lower interest rates no longer works. There is a time and a place for everything. At this time, continuing to lower rates and pumping up the money supply will not lead to growth; it will only result in hyperinflation. How much more proof do you need than Wednesday’s reaction to the 50 Basis point cut in the Discount rate?
The FED is in a state of panic and is succumbing to the hue and cry from the instant gratification media and politicians, none of whom realize that doing more of the same as what got you into trouble in the first place is PURE INSANITY. They are setting in motion the Depressing effect hyperinflation has on economic activity, which is already taking effect and will begin to really be noticed by everyone more than likely within the next 3 to 6 months. Because of the lag effect they will, as they always have, overshoot their target and exacerbate the problem that they themselves have created.
In the meantime, the lag effect of the lower interest rates since June 2006 has completely distorted the economy, undermining the stock and real estate markets. Once the flight to quality subsides, it will also destroy the bond markets.
CURRENCIES AND THE CARRY TRADE
As I have been warning you for over a year now, the unraveling of the carry trade will destroy the hedge funds and completely disrupt the world’s currency and financial markets. It has never been the strength of an economy that was the primary determinant of currency values. It is always the flow of funds determined by the balance of trade and interest rates that sets currency conversion ratios.
Greenspan realized full well that the bigger the boom, the bigger the inevitable bust. His main objective was to push the time of the inevitable BUST into the next Chairman’s term and thus preserve his legacy. To give him his due, he was also trying to raise interest rates high enough and set in motion a controlled RECESSION so that the FED would then have some ammunition (cut interest rates) to lessen the size and duration of the inevitable Recession and perhaps overt a Stock Market Crash followed by Depression. I had discussions with him back in the early 70”s about the Kondratieff Wave. However this time around, it will not be similar to 2001, when we were sitting on projected huge surpluses and Bush was able to get massive tax cuts passed and succeeded in stopping the recession in its tracks. This time, the US is at WAR and with massive trade and budget deficits, a burst Real Estate Bubble, crumbling worldwide financial markets and a credit crisis, there will be no tax cuts or anything else to stop the crash that has been already baked into the cake by 20 years of over printing of money. I almost forgot - with real estate crashing and ever increasing foreclosures, most states are now on the verge of bankruptcy and all coming to Washington, hat in hand, begging for money.
Unlike the ECB who only has one goal of stable prices, the FED is trying to serve two masters. One is stable prices, the other is full employment. The two are mutually incompatible and their follies are coming home to roost as they fail in both of their objectives. Socialist policies can never solve complex economic problems; basically because they do not understand the interlocking nature of a complex economy.
Fixing the economy is like repairing a dam that has sprung a series of leaks. You can only plug the leaks in the short run while raising the danger of a complete collapse by not rebuilding the dam. The Economy must be brought back into balance by way of a controlled Recession that allows the economy to repair itself since no one is smart enough to do it piecemeal. If we continue to try as we are doing now, the result will be a 1930’s type Depression. WATCH OUT BELOW.
Mike Milken taught us all a lesson that no one seems to have learned. If the average default rate of BBB bonds is 8% and you charge 10% to 12% over risk free Treasuries, everyone can make more money if you do what interest rates are supposed do; allocate money to only the better deals, ones making a greater return on their investment than the interest rates that they have to pay. However, if interest rates are too low because the banks are flooded with money to loan, the only way they can make money is to leverage their money 50 or 60 times to lower quality borrowers at narrow spreads. Well, we are all now witnessing the result: A MASSIVE OVER SUPPLY OF OVERPRICED HOMES as well as failing businesses and defaulting credit card debt brought on by the very policies that the Banks were forced to pursue give the ultra low interest rates.
SOLUTIONS: THERE IS NO POSSIBILITY OF OVERTING THE RECESSION
#1 START RAISING THE DISCOUNT RATES and allow the Free Market to find its realistic interest rates (that will mean a falling bond market but maybe not a crashing one). Once interest rates go up to the 10 to 12% area, the banks will no longer be hesitant to loan money. They will also have a ton of money to loan as it will now pour in to their coffers once they offer 5% to 7% CD’s.
#2 FIX THE REAL ESTATE MARKET: We must clear the overhang of OVERPRICED HOMES. If we let the market take care of it itself, it normally takes between 10 to 15 years to accomplish that before the next normal housing market can begin. In order shore up the financial system and to speed up the process and make more homes affordable to more people, including all the people that lost their homes, the Government must establish a new RTC. Perhaps we can even get Bill Seidman to advise us. In so doing, we could clear the deck in 3 years instead of 15 at a cost to the taxpayer of 1/10 of what it is costing us now. That will lower prices to where the average worker can afford to buy a home and pay a normal 7% to 8% mortgage rate (taking into account that insurance rates and taxes would be lower on his/her now lower priced home).
#3 RETURN OF BONUSES: In order to regain the confidence of the American taxpayer and provide some fairness, we must get every company that failed or has been bailed out or has accepted any Government assistance to re-evaluate and restate their last 5 years of earnings. In addition, the last 5 years of executive bonuses should be confiscated (since they were all based on phantom mark to model profits) including the $90 million bonus that Franklin Rains took from FNM after restating the $5 billion profits into $5 billion in losses (friend of Dodd, Frank and Obama or not).
#4 BRING BACK AND ENFORCE THE GLASS STEAGLE ACT: Our Financial and Credit Crisis had its germination back in 1995 when President Clinton and his Treasury Secretary Rubin gutted the provisions and protection of the 60 year old Glass Steagle Act, that came into force after the 1930’s crash. Their action allowed banks, brokers and insurance companies to merge into a hodgepodge of interlocking companies with a myriad of conflicting interests. No CEO and certainly no Board of Directors could possibly understand the complex and interlocking risk factors involved, so each division had a free reign to do whatever they wanted and take risks that even they properly understood. Fire Paulson because like Rubin, he cannot serve two Masters (the public and Wall Street - that’s where all is $ billions are). Who do you think comes first?
Any statement made to the public by a politician, Government official or company executive should be made as if he was under oath and any lies, miss-statements or misleading, self-serving comments should be prosecuted to the full extent of the law as if they were committing perjury.
We are absolutely positively already in RECESSION and well on our way towards DEPRESSION. If the world’s central bankers continue on with what they are doing, it will lead to HYPERINFLATION, which has always resulted in DEPRESSION.
THE STOCK MARKET
GOOD NEWS - The market is in better shape than the economy. Although we have not yet hit THE bottom, let me remind you that the stock market hit its all time low in 1932 even though the economy did not hits its absolute low until 1937 and the Depression was not over until 1946 (not a misprint). I can’t do anything about fixing the economy (they won’t listen) but we can still continue to prosper as individuals in the market. So stay tuned.
We are probably very near a short term bottom - could be as much as a 1000 pt. rally. For the time being, option premiums are so high that the only thing that we can do is buy stock or the double Indexes and sell options against them. I am not usually smart enough to pick bottoms, but who knows. I may get lucky this time. Buy your favorite stocks, use close stops (10%) and if we get a 500 point bounce, sell November calls against your positions.
Would you all be mad at me if I say “I told you so!” I still stand by my long held projections of $1200 to $1425 Gold by the end of 2008. As far as Gold Stocks are concerned, the Juniors are now so low that there is no place else to go but up. Kind A reminds me of what happened to PM stocks in 1975 during the 50% pull back from $200 back to $100 in Gold Bullion. Great Prospects could not get financing, so I flew to Vancouver and started making deals with whoever I thought were the better promoters. That was before computers and I ended up making so much money I couldn’t count it. But I sure could spend it! I don’t know what else to tell you at this time except STICK with your Gold positions for at least another 6 years and continue to accumulate on weakness. As I have said many times, “don’t be afraid of sell-offs”. They are gifts of buying opportunities. DO NOT TRADE YOUR CORE POSITIONS. How many of you sold above $900 and got back in below $750 to $800? I’ll bet not one was able to do that. I have warned you many times to be careful or you will get caught with your worthless money in your pockets as the Golden Rocket Ship blasts off. My minimum target is still $2,500 with a likely target of $6,250
That’s all for now. This is my third letter in less than 2 weeks and I am beat. As you can well imagine, the market has been good to me and I have just covered most if not all of my short positions. But since I only have 10 fingers and 10 toes it will take me some time to count my money.
I am offering a Special two year subscription for only $339. The one year subscription is still a reasonable $199 until the end of the year at which time price will increase to $269.00 and $469: Extend your subscription Now http://www.gold-eagle.com/baltin_webpage/baltin.html
“PROCRASTINATION IS THE THIEF OF LIFE”
GOOD LUCK AND GOD BLESS
UNCOMMON COMMON SENSE
Aubie Baltin CFA, CTA, CFP, PhD.
2078 Bonisle Circle
Palm Beach Gardens FL. 33418
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