The Interest Rate Conundrum Debt & Delusion

September 25, 2005

The Demise of Inflation

During America's 1970's flirtation with hyper-inflation, wage and price increases were driven by a rapid expansion of the money supply, created by the FED to fund government deficits. The upward spiral was finally brought under control when Reagan appointed Fed Chairman Volker who immediately raised short-term interest rates drastically, reduced monetary growth and brought on the 1982 recession, in order to wring inflation out of the economy.

The means used to create the 1970's bout of inflation was by way of the FED purchasing government bonds from the commercial banks, by the simple use of a bookkeeping entry, commonly known as "monetizing" the debt(also referred to as printing money although no printing is involved). The challenge, facing the government both then and now, is how to continue to live beyond the government's means without causing massive inflation? Volker came up with a brilliant plan to solve this problem. He figured that by selling Gov.bonds directly to private investors, through the financial markets, instead of directly to the banks, he could load the public with government debt without affecting the Banks ability to create money. By placing the bonds in the hands of the public, rather than the commercial banks he avoided the massive increase in Bank reserves and so they were not able to create new money out of thin Air. The success of his plan becomes obvious if we but examine the subsequent explosion in the size and breadth of the bond markets; Gross issuances of Gov. Bonds grew from less than $.9 trillion in 1970, to over $23 trillion by 1997 and to over $42 trillion by 2002. The second part of Volker's program was to reign in government deficits but this advice was ignored under Reagan and subsequent administrations, as government debt has continued to explode. It began to come under control under Bush I and Clinton, especially after Gingrich and the republicans took control of congress in 1995. Never the Gross Federal Debt continued to increase every single year, in spite of the phantom "surpluses" of the last two Clinton years, and have now reached stupefying levels, especially since 9/11 and wait until you see what happens in 2005 once reconstruction begins after Katrina and Rita. It is this new interaction between the explosion of debt and "the capital markets revolution" that produced a new and highly deceptive (hidden) form of inflation.

The Interest Rate Anomaly

Supply & Demand Theory teaches us; that when ever there is an increasing demand for any goods, prices must rise. This happens because sellers who value a good the least, are the first to sell. Then as buyers continue to demand greater quantities of these good, sellers, who have placed ever increasingly valuations on the goods they possess, demand ever higher prices in order for them to be induced into selling.

Under a sound monetary system, where credit cannot be created out of thin air, increased credit can only come from increased savings. If credit is demanded in increasing quantities, borrowing must take place at ever-higher interest rates: Like any other product or service.

Higher interest rates are necessary to induce consumers into deferring their consumption, so that they can avail themselves of the higher interest rates. There is however a built in limit as savers require a certain minimum amount of present consumption no matter what the rate of interest is; However this time as the government spigot of bond issuances continued to flood the capital markets interest rates have not only not increased but are now lower than they were in the 70s so that both savings and interest rates are at or near generational lows.

It is however impossible that the tremendous volumes of bond purchases in recent years could have been funded simply out of savings. This anomaly has not attracted much attention or investigation. Instead, most analysts now find this state of affairs to be utterly normal. "deficits don't matter" perfectly summarizes the prevailing attitude. The massive accumulation of government and corporate debt while still maintaining a low inflation environment (?) no longer provokes much curiosity, even among professional economists. What's even more strange, is an ever rising stock and real estate market has become accepted as the normal state of affairs, requiring no special explanation. Periodic bouts of inflation, the tell-tale signs of a long-standing debt addiction, have all but vanished. The central banks, as financial physicians, seem to have affected a miraculous cure. . . . Few have ever bothered to ask how the central banks have accomplished this feat. But as long as inflation is absent, who really cares exactly what the central banks have been up to.

The FED induced institutional monetary changes have been able to confined the price adjustments, due to rapid monetary expansion, to the financial system. The character of the 90s inflation is different from that of the 70s. Since 1987, price changes following money quantity changes, have been restricted to, stocks, bonds and real estate prices, rather than wages and consumption goods.

How can inflation sometimes affect financial assets and other times mostly consumer prices?

The particulars depend on where and how the new money enters the system, and most importantly what the initial recipients spend it on. As the initial recipients (the banks) of new (out of thin air) money find themselves with a surplus of cash relative to their needs, since they don't consume, they will bid for financial assets, which, the sellers of those assets, the government, will supply as much as is wanted. In this way, monetary expansion will affect some prices more than others. For example, after an inflation, the relative price of apples in terms of oranges might no longer be 1:2, the apple might now cost $2 and the orange $6, a ratio of 1:3. Price ratios are not stable under inflation. However, suppose that, instead of comparing apples to oranges, we compare apples relative to stocks. If today apples cost $1 and the Dow Jones Average is 5,000, and then money is created and used by the initial recipients to buy stocks, the apple may still cost $1, while the Dow is now 10,000. With financial assets absorbing all of the impact of the new money, the outbreak of inflation into wages and consumption goods that proved so disastrous in the 70s has been, for the time being, repressed. Newly created money was injected into capital markets, where it was initially spent on the purchase of bonds.

The now lowed yields in government bonds have made higher-yielding, (but still low) corporate bonds and equities with low dividend yields ever more attractive The inflationary price adjustments eventually leaked out of financial markets into other assets especially real estate. Normally, the latter recipients of the new money spend it on consumer goods and cause inflation to creep into the CPI. However In recent years, money which has been injected in ever increasing amounts into the financial markets were either contained there or poured into real estate.

Normally this would show up in the CPI, but this time the government, in its infinite wisdom decided to only measure rents, which are falling, in stead of home prices which are skyrocketing. The mechanisms of this containment in conjunction with interest rate arbitrage, geared through financial derivatives, as well as a stronger economy that has been attracting 80% of the worlds savings, in conjunction with the governments management of public opinion about inflation has kept the CPI very low.

Interest Rate Arbitrage

The rate at which commercial banks can borrow from the Fed is fixed by the Fed itself. In this current institutional framework, since the FED can create as much money as it wants, interest rates do not rise with increased Bank borrowing since there is no actual scarcity nor is there any demand for real savings. To hold the interest rate below the market-clearing level, the Fed must create whatever amount of money borrowers wish to borrow, to prevent the natural rise of rates that would occur if credit were constrained by savings. As long as a rate differential between short term and long term bonds remains, an essentially risk-free profit opportunity, the "carry trade" will persist no matter how much "arbitrage" occurs. Banks and their favored clients borrow from the Fed at short-term rates to purchase bonds of longer maturity, as long as there is a sufficient price spread between them. For example, when the interest rate on a 90-day T-Bill is 3 3/4% and the 10-year Treasury yields 4 1/4%, there still exists a profit opportunity of 1/2% for a borrower who has access to these rates. This source of financial inflation is in the ability of large bond buyers to borrow volumes of newly created money from the Fed at a fixed price. Because the interest rate does not rise to meet increasing quantities of lending, this arrangement generates volumes of "synthetic demand" for the government bond markets at longer maturities. Thus the illusion of an unlimited savings pool is matched by a new confidence among prospective bond issuers.

Entrepreneurial activity, is the activity of insightful entrepreneurs who perceive profit opportunities that others have missed, and are willing to risk their capital to back up their ideas. The continuing rearrangement of productive activities by entrepreneurs aligns production with consumer preferences. But central banking and financial markets are not real markets, although they are similar enough in appearance to fool a lot of people. In this environment, the term "arbitrage" is a misnomer because borrowing and lending is no longer a risky market-driven price adjustment process.


A second mechanism of financial asset inflation is the use of derivatives to create additional purchasing power. Derivatives (options) are financial contracts between two parties. The value of a derivative contract is determined by some mathematical relation to the price of the underlying asset or commodity. For example, an option contract on ten year Treasuries might reference the price of $1,000,000, of 10 year treasuries at some futures price. These type of Derivatives on government bonds (A bet on interest rates) are by far, the largest component of the total volume of these instruments.

Derivatives are used to secure the control of a more expensive asset for a much smaller amount of money. The use of derivatives by hedge funds and the proprietary trading desks of large banks in relation to government bond markets results in a grossly inflated demand for the underlying bonds. Thi acts as an artificial support mechanism for both bond and equity markets, keeping yields lower and asset values higher than would normally otherwise be. This synthetic source of demand is critically dependent on the downward progression of bond yields and on the slope of the yield curve. While there is a sense in which all demand for financial assets are contingent on their expected performance, this is especially true of geared and un-hedged derivatives positions.

These leveraged contracts are used to generate a synthetic source of demand for financial securities. A hedge fund wishing to purchase $100 million of stock can put up $8 million and borrow the remaining amount from an investment bank.

Then use unrealized gains in financial assets (including derivative contracts) as collateral for further purchases. The persistent upward trend in underlying asset prices has amplified these unrealized gains and has enabled and encouraged the progressive doubling-up of 'long' positions, especially in government bond futures. It is easy to envisage how the cumulative actions of a small minority of market participants over a number of years can mature into a significant underlying demand for bonds. While financial commentators are apt to attribute a falling US Treasury bond yield to a lowering of inflation expectations or a new credibility that the federal budget will be balanced, the true explanation may lie in progressive gearing.

The initial injection of new money into the bond market explains why the effects of inflation would show up there first. The continued containment of inflation within the financial sector as money is spent, and then re-spent on financial securities, is created by the leveraging through the use of derivatives. The funding of these derivatives is complex, but again it ultimately relies on virtually unlimited borrowing at fixed low yields from the central bank. The process circulates the newly created purchasing power again and again back into the financial sector, rather than allowing it to leak out into wages or consumption goods. Currently we have a steadily rising Fed funds rate in conjunction with falling long term interest rates, foretelling an eventual end to this game as the spreads narrow.

The Management of Expectations

The purchasing power of money depends on the supply and demand for money itself. The greatest determinant of the demand for money is public expectations of future prices. If prices have been stable, people will expect them to remain stable and money demand will remain about the same. If prices have been falling slowly for many years, people will expect them to continue to fall. In spite of accelerating money supply growth, if people do not believe that prices will rise in the future, inflation expectations can remain low while the growth of money supply expands.

On the other hand, suppose that people anticipate a large increase in the money supply and hence a large future increase in prices. . . . People now feel in their hearts that prices will rise substantially in the near future. As a result, they decide to buy now-instead of waiting for a year or two when they know full well that prices will be higher. In response to inflationary expectations, people buy now, drawing down their cash balances and raising prices.

Their lowered demand for cash and investments (bonds) pushes up interest rates as well as the prices of goods and services now rather than later. The more people anticipate future price increases, the faster will those increases occur. . . . Deflationary price expectations lower prices, and inflationary expectations raise them

Recent history would also suggest that people attribute more importance to the recent price changes of consumption goods in forming expectations about the future trends in the prices of consumption goods. Similarly, consumer's attribute more importance to price trends in financial assets in forming opinions about the future price trends in financial assets. For example, moves in asset price tend to attract little interest from the mass of investors until a trend has been in place for several years.

To the extent that any price increases at all have leaked out of financial assets into consumption goods, the deliberate distortions in the measurement of the Consumer Price Index (CPI) have been introduced in order to create a false consensus that "there is no inflation." A variety of questionable price adjustment stratagems have been instituted in the CPI computation: the exclusion of food and energy, the use of lower "quality-adjusted" prices, seasonal adjustments, and the replacement of home prices with rental rates. The index incorporates only consumption goods, when most of the price increases are showing up in financial assets and costs of health care.

So successful has been the management of expectations that inflation has disappeared from public discussion. Most of the public did not view a succession of all-time highs in the stock market as in any way relevant to the price they would have to pay for milk. Growth in the money supply attracted no analytical attention from the mainstream financial media. Some prominent "supply-side" economists even advanced the ludicrous idea that the US economy was experiencing a deflation during the late 90s stock market bubble, and called upon the Fed to inflate even more. This successful management of inflation expectations, has forestalled the eventual rejection of cash in favor of tangible goods (GOLD), that ultimately results from excessive money creation. The impressive reduction of inflation is a dangerous illusion; it has been obtained largely by substituting one set of serious problems for another. The public, intoxicated with the gains from real estate and stock and bond market inflation, has adopted a don't ask, don't tell policy toward central banks.

The Corruption of Savings

A peculiar feature of the social psychology of financial asset prices is their self-reinforcing character. The upward trend in stock and bond prices has served to enhance the respectability of capital markets and their perceived safety as repositories of money. Some commentators reason that inflation must now be quite low because the credit markets are patrolled by "bond vigilantes," astute traders ever alert to punish central banks for their inflationary indiscretions, ready to dispense rough justice in the form of higher interest rates. However this analysis assumes that inflation is reflected primarily in consumption goods, and that bond yields are free to move on their own to convey meaningful information about changes in the value of the monetary unit. These assumptions are more or less the reverse of reality: the funneling of inflation into bonds as described above provides a floor under bond prices and hence a ceiling on bond yields. The bond vigilantes have gone on an extended vacation.

Another popular argument is a stock market that is expensive measured by P/E ratios is cheap or at least fairly valued because low interest rates justify higher P/E ratios. Stocks appear to be cheap in a dividend discount model that uses the current bond yields to discount future earnings. This view fails to take into account that the bond bull market is a symptom of high inflation, not low inflation. Inflated prices for bonds might make stocks look relatively cheap in comparison to bonds, but in the absolute sense both are inflated.

But what does it matter if stock and bond prices rise relative to consumption goods? "It's paper gains today, paper losses tomorrow; who cares?" The problem with financial inflation is that investment decisions by entrepreneurs are based on relative prices and interest rates. When relative prices are disrupted, by financial inflation, the entire productive structure of the economy is distorted. The movement of real savings into real investment is stymied and we end up with jobless growth and or into enterprises that should have not been ebtered into because their rate of return is too low given the risks involved. All this ends up denigrating all currency matters and distorts economic calculation. Like it or not A GUNS and BUTTER economy must eventually produce inflation.

The expansion of the financial sector relative to that of the economy (mining, agriculture, manufacturing, transportation, energy, transportation, and retail)--is but one example of these distortions. The increasing domination of the stock market capitalization and the economic activity by financial institutions and financial services companies have quietly come to dominate not only the S&P 500 but the entire economy. For example, Right now, financial companies make up 21.1 percent of the index, up from 12.8 percent 10 years ago. The current weight of financial services is almost double that of industrial company stocks and more than triple that of energy shares.

… It is also worth noting that the current weight of financial services companies in the S&P is significantly understated because the 82 financial stocks in the index do not include General Electric, General Motors, Chrysler or Ford. All of which have huge financial operations that last year represented more than 100% of their earnings. Financial companies now generate about 30 percent of the profits, after taxes, of all United States' companies, whish is up from 7 percent in 1982. In addition, profit margins at financial companies in the first quarter of 2004 stood at 32.6 percent of all corporate output, around 11 percent higher than their average since 1929.

The economic purpose of capital markets is to provide a nexus between savers and borrowers for the financing of productive investment.

Financial entrepreneurs, such as venture capitalists, traders, and speculators, need a true interest rate essential in forecasting the best uses of available savings and the measuring of risk in an uncertain world. But a society cannot prosper by printing ever-increasing quantities of paper tickets representing claims for real goods and drawing more of the population into trading these tickets back and forth among themselves. All of this is nothing but a financial fantasy. The fantasy being that central bankers have found a way to inflate without any negative consequences. While the effects of money supply growth can be confined to stocks and bonds, inflation is hidden in plain sight.

The inevitable adjustments cannot be postponed indefinitely and its unwinding will neither be easy nor painless and is most probably threatening both an economic as well as financial disaster.

Greenspan's Conundrum

The question that most analysts and especially Greenspan are asking is: Why are long term interest rates still falling in the face of 11 consecutive ¼ point discount rate increases? The answer my friends is both simple and very worrisome. All these Banks, h\Hedge Funds and other Financial institutions that have had it so good for so long, making all that easy money through arbitrage and gearing previously described are now between a "rock and a hard place", they are locked in as their profit spreads continue to narrow. They can't get out because there is nobody to sell to. They are all forced to continue to keep playing the game until the bitter end. The same hold true for all the Central banks that have been buying up all the governments newly issued paper. They too are caught between the proverbial Rock and hard place. In order to maintain employment in their countries they must continue to export and protect the value of the US dollar. They can talk all they want about diversification but they too like the arbitragers have no one to sell too. They are all locked in and must continue to play the game.


Now that i have hopefully addressed the question that heretofore nobody has bothered even asking. What's making the stock and bond markets behave like they have never done before, if it's not a New Paradigm? If as I surmise, that a financial and economic disaster is in our future, then the only question not yet answered is, when and how will it begin? The best answer that I can come up with is, it depends. Since I don't have a crystal ball I can only guess and probably not very well at that. But…Since Bush won the election with a workable plurality in both the house and senate and if he can quickly pass legislation reforming (privatizing) the Social Security systems; which would then cause a massive inflow of funds into the stock and bond market, the here to for ridiculous figure of a 36,000 DOW becomes not only a possibility but a probability, before the shit must eventually hit the fan. If this happens then quite possibly the looming disaster could be pushed out to maybe as far as 2008. However as the President's popularity continues to drop to what to day is only 38% the likely hood of passage has in my opinion dropped to one in a million. What's even worse there is more and more talk, even by some Republicans of increasing taxes to pat fore Katrina and Rita. Then the disaster could possibly be triggered either by the interest rate curve inverting which would then begin to generate tremendous losses to all the institution heretofore mentioned as the arbitrage is stopped dead in its tracks: Or failing that by the election results of 2006 Elections. If the Republicans lose even one of the houses of congress the likelihood of a reversal of the Bush Tax Cuts become a virtual certainty, then watch out below. But in either case, eventually "The Piper Must Be Paid" the only question remaining is when.


Aubie Baltin CFA, CTA, CFP, Phd. (retired)
Palm Beach Gardens, FL


26 September 2005

A one-ounce gold nugget is rarer than a five-carat diamond.

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