The Genies (Risk & Fear) are out of the Bottle

September 23, 2007

INTEREST RATES: 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 talking Media Heads, Wall Street analysts and Economists don't seem to understand what interest rates are or how they work. The constant parade of economists blowveating across our TV screens don't seem to know what interest rate's primary functions are, so how can they know whether to raise them or not?

#1 Interest Rate is just another word for price 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. But unlike the price for anything else, the Interest Rate is not just one set price since it must also incorporate an allowance for variable risk factors.

#2 Unlike most other products, or services, Interest Rates and Money do not operate in a Free Market but are manipulated (controlled) by the Fed. They do this by controlling the amount of excess reserves that are available in the banking system through their Open Market Operations (buying & selling Treasury Bonds in the open market) and by changing the size of 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 FUNCTIONS OF INTEREST RATES?

# 1 Interest Rates determine the propensity of people to either save or consume. When Interest Rates are manipulated higher, it influences the degree that people are willing to defer present consumption, i.e. save. If Interest Rates are manipulated too low, like they are now, people are no longer willing to save. When the Interest Rate becomes negative (the Interest Rate is lower than the Inflation Rate), people willingly take on excessive debt as well as excessive 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 were willing to forego current consumption in order to avail themselves of the ultra high Interest Rates and we ended up having high saving rates and lower trade deficits.

# 2 The Velocity of money (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 Interest Rates are high, the demand for cash is extremely low. People can't wait to deposit every cent that they can spare so as to earn that high rate of interest. However, when rates are low, the propensity to hold cash is very high because there is not much to be forgone by keeping extra cash in their pockets. Thus when rates are outside the normal range, the FED cannot calculate the Velocity until long after the fact; losing track of what the money supply really is and leading to the Interest Rate Conundrum.

# 3 Interest Rates, by its allowance for RISK function, also determine which investments should or should not be made according to the investment's expected risk and rates of return. When Interest Rates are manipulated too low, a great many investments and risks are undertaken that should not have been, because the normal free market signaling mechanism has been disrupted and those poorer investments will fail or be forced into bankruptcy with the eventual return of higher, normal 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.

# 4 The Discount Rate is the rate that the Fed charges Banks who need to borrow money to meet their reserve requirements. The FED was originally created to be "the Lender of Last Resort" in order to avoid bank runs and liquidity squeezes. The Discount Rate is designed to be a Punitive Rate; a rate somewhat above the Fed Funds Rates but today, the Discount Rate is the same as the Fed Funds rate, drastically lowering the banks' 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, and greatly increasing the banks' ability to create money out of thin air. This completely negates the supply/demand function in setting Interest Rates. This break down 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 banks' and near banks' (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, Bond and Real Estate Market Bubbles that has, after 13 years, most probably topped out and is now in the process of rolling over into a crash. For a long time, regardless of the ever increasing demand for loans and the seventeen ¼% rate increases, Long Term rates, because of the ongoing Carry trades, refuse to go up and reflect the true conditions in the market.

# 5 BAILING OUT THE BANKS. In the name of saving the poor homeowners from losing their homes the FED, which is owned by their member banks, has once again bailed banks out from their reckless lending practices (as always happens at every economic peak) at the risk of collapsing the dollar and bringing on a DEPRESSION.

Note: This latest ½ point rate cut will not save one single foreclosure nor will it halt the ongoing fall in home prices. And if anything will acerbate the real estate crash that will last at least five years.

How in the world will a ½ point Discount Rate cut help people whose teaser rates are up for resetting ow who need to refinance a mortgage that is more than 25% under water?

THE FED'S CONUNDRUM

FED Chairman Bernanke, like Greenspan before him, once again raised the conundrum of the divergence between short term and long term rates. At the end of Jan 07, the yield on the 10-year Treasury Note stood at 4.4%, still below the 4.6% rate in June of 2004, the year when the Fed funds rate was only 1%. Bernanke, like Greenspan before him, blames some mysterious 'pressures' for the divergence between the Federal funds rate and long-term rates. However , careful examination shows that there is no mystery. The so called mysterious pressure is in fact the natural outcome of the Fed, BOJ and the rest of the world's central bank's easy money policies.

CONFIDENCE

When it comes to the economy, what matters most is the availability of money and the level of CONFIDENCE that there is in lenders being repaid and not the rates or 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 its targeted 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 exacerbating the problem rather than dampening the fluctuations. Since June 2004, despite raising the Fed-funds rate from 1% to 5 ¼%, the Fed has actually hiked the pace of pumping money into the system, thus creating a negative yield curve. In short, the Fed has been talking tough while acting like a very loose $5 streethooker.

TIME LAGS: Nobody seems to realize that there are always time lags whenever there are any changes in FED or Government fiscal policy, whether they be taxes, money supply or even high oil prices or ??? . It takes time for the Free Market to send its signals through to every participant and it then takes time for every participant to react. The estimated average time lag between changes in the Fed Funds policies and the growth momentum of industrial production is on average 18 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 30 months. So in spite of their regular ¼ % increases, the yearly rate of growth of industrial production stayed strong into the 3rd quarter of 2007. However the strong economic activity made possible by its loose money policy had 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 thus far prevented the growth momentum of the economy from slowing, also preventing any meaningful rise in long-term Interest Rates.

INFLATION: According to Milton Friedman, 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 ensue by definition 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 world economy is awash in Fiat cash, it's finally finding its way into commodities including food stuffs, private takeovers and corporate buyouts. Now with nothing much left to inflate, the money is finally finding its way into the CPI. Witness the price explosion of 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 rear its ugly head and it won't be much longer before we see just how high inflation really is.

CONCLUSION

I had hoped that Bernanke realized that he had no other choice but to push Interest Rates higher than most would even dream of in order to try and head off an explosion in inflation and avoid the inevitable Depression that must follow. However, he is first and foremost a political animal (otherwise he would not have received his appointment) even if it's in the face of the economy's growth momentum starting to trend down. Like it or not and despite what Wall Street and the politicians wants, he knows that the economy cannot continue growing above trend (1 ½ - 2 ½ %) for any sizeable length of time without going into rampant inflation. He realizes that both the USA's and the world's economies are now more out of balance and are in a bigger bubble mode than they were in 1929 or any other time in world history. He realizes (at least I hope he does) that our only HOPE is to engineer a CONTROLLED RECESSION. Hopefully it will only be a mild one, so as to avoid a combined Stock, Bond, Real Estate, Hedge Fund and Private Take-over CRASH, which would lead to a world wide depression. I had hoped that he realized that cutting Interest Rates now, especially in the face of tightening lending standards, would not only do nothing to save the Real Estate Market, but would actually bring on the depression by causing the US Dollar to tank. A crashing dollar would set the world's financial system on it ear; the results of which would be devastating. He knows full well that the lag effect of the last 30 months of Interest Rate policies will eventually end up setting in motion a depressing effect on economic activity which has more than likely, already begun to take effect. I had hoped that the FED, because of the lag effect, would NOT as they always have in the past, take the political easy road and cut rates, exacerbating the problem that they themselves have created. In the meantime, the lag effect of the higher Interest Rate policies since June 2004 in conjunction with the recent rapid increase in fear has found its way into rising real long term rates which will, once the euphoria of the recent rate cut is over, undermine the Stock, Bond and Real Estate markets that sprang up on the back of Greenspan's ultra loose monetary policy. Without this last cut I had hoped that the much needed controlled economic slowdown instead of a Bust, would have been set in motion, giving the economy a chance to self-correct its huge imbalances.

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 crash 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 before a recession and Bernanke finally took over so that the FED would then have some ammunition to hopefully slow down the crash and keep it to only a Recession. However, when "IT" finally arrives, it will at first be similar to 2001, too little and too late. In 2001, we were sitting on projected massive budget surpluses and a unified government so Bush was able to get massive tax cuts passed and succeeded in stopping the much needed recession in its tracks. But this time around, the US is not only in a "Guns and Butter Economy", but has both massive trade and budget deficits instead. With the Democrats now in control of Congress, there will be NO new tax cuts coming to save the day and stop the Crash. A looming and even bigger danger is that we may actually face tax increases and a return to job destroying NEW DEAL type policies of the 1930s that are even now working their way through Congress.

I was praying that Bernanke was not only smart but lucky as well, but more importantly had the GUTS to do what was right because he is our only chance to prevent a major financial catastrophe. I am sad to say that it now looks like I was wrong about him.

GOLD and SILVER

The Gold and Silver Bugs, after serving a 25 year prison sentence mired in a Bear Market, have been finally set free: But they are still talking about fundamentals. They have been always right about the shortages of new supply vs. demand, but that didn't stop the Bear Market. For the past few years, the supply demand imbalances have become so acute that we are now in a world wide Bull Market for all commodities and not just for Gold and Silver. However, that is not where an exploding Bull Market in Gold and Silver comes from. In order to get a 1978-1980 type explosion in Gold and Silver (and their stocks) prices, you require the combined emotions of both GREED & FEAR. So far, we have only been experiencing the beginnings of the Greed phase. I know this is a fact because even the biggest and best of the Gold Bugs have been calling for periodic corrections. When FEAR combines with full blown Greed, there is no longer any more talk of correction as prices begin to jump 5% to 10% in one day and people line up to buy bullion as signs pop up everywhere, "WE buy and sell gold". That final stage only begins as the FEAR of a collapsing currency embroils men's guts. Once both fear and greed take over the market and the short squeezes begin in earnest, there is no way of predicting how high the high. $2200 Gold and $200 Silver seems to me to be the barest minimum targets, maybe $5000 or even $10,000 could be in the cards, Your guess is as good as mine. I realize that many of you may think I'm crazy, but when you yourself start thinking that these numbers might actually be too low, then and only then, will we be firmly in the clutches of the blind Greed and Fear phase that will mark the beginning of the final top.

Who are these people that will end up buying at the top? Why they are the same ones that got in near the lows but sold out for what turned out to be relatively small profits and were waiting for that one more pull back that never came (it came, it was 36% but it only lasted two weeks) to get back in. Be careful and make sure that I am not describing YOU. Remember The GOLDEN Bull will always do whatever it has to do to make the majority of the people fall off.

WOULDA, SHOULDA, COULDA

We are now firmly into the next up stage (most likely to be its strongest up phase) and that last correction in Gold and Silver that everyone was dreaming of has come and gone without anybody noticing. (Go back and re-read my RIDING THE GOLDEN BULL articles). We have completed Wave 2 and have entered the explosive Wave 3. So now that its here, how many of you are actually buying and/or fully invested? You are about to learn what a real Bull Market in Gold looks like when this market, which has now entered Wave 3 of 3, finally explodes and starts to go up so fast you won't have a chance to get back in.

Just in case you haven't noticed, the final HOOK in the Stock Market that I have been warning you about is in the process of completing its top. Perhaps it will take one more rate cut and a breakout to a new all time high to set that final and biggest BULL TRAP in history.

WHAT TO DO NOW?

Liquidate all your short term debt. Build up your cash position by selling most of your stock and long term bonds into any further rally. Buy Gold and Silver NOW. Use your buying power if you have no cash to increase your gold and silver stock positions. But whatever you do, get back in now or you will be sucked back in right near the eventual top.

GOLD & SILVER STOCKS

You should have noticed by now that every new BULL MOVE is always led by the big name quality Stocks and a Bull Market is never over until the cats and dogs have their day.

 

GOOD LUCK AND GOOD BLESS

 

 

Aubie Baltin CFA, CTA, CFP, Phd. (retired)
Palm Beach Gardens, FL
aubiebat@yahoo.com
561-840-9767

In 1934 President Franklin Delano Roosevelt devalued the dollar by raising the price of gold to $35 per ounce.

Gold Eagle twitter                Like Gold Eagle on Facebook