Dear Diary,
The Dow fell 238 points yesterday. And Treasury debt rallied. The yield on the 10-year T-note fell the most in nine months – to 2.4%.
News reports blamed “geopolitical challenges” in Hong Kong, the Middle East, Ukraine and elsewhere.
That may be part of it. But this is also October – the month QE is expected to end.
Between 2009 and 2014, the Fed bought $3.6 trillion of US government and mortgage-related notes and bonds. During that time $5 trillion has been added to the value of the US stock market. And the price of the average house has risen by $60,000.
This was achieved largely by holding Mr. Market’s head underwater until he stopped squirming.
Broken Legs
We don’t know what the natural real interest rate should be. Only Mr. Market, if he were among the living, could tell us.
But yesterday’s action suggests it is lower than almost anyone thought (something Chris warned about here.)
But whatever the interest rate “should” be… if it isn’t a very low number, the economy will soon be in deep trouble. And if it is a very low number, the economy already is in deep trouble.
In other words, there is no yield above, say, 3% on the 10-year T-note that won’t cripple the economy. And there is no yield below, say, 2% that doesn’t mean it has already had both its legs broken.
Does that make sense, dear reader?
A naturally low interest rate signals that there are few willing borrowers – perhaps because the economy is creaking to a halt… or perhaps because foreigners are afraid to put their money anywhere else.
A naturally high interest rate signals that business is picking up. Borrowers need money to finance expansion. Interest rates might be expected to return to “normal.”
What?
Today’s debt-soaked institutions couldn’t stand it. Businesses and government have added trillions of dollars in debt since 2008.
Both are in worse shape to withstand a crisis… or even moderately higher interest rates… than they were then before.
Gigantic Piles of Money
Take the US federal government, for example…
People typically focus on the deficit as the measure of the feds’ borrowing. Actually, it is many times that amount. Because the feds reduced their borrowing costs by shifting from long-term bonds to short-term notes and bills.
This means Washington has to roll over about $8 trillion in debt a year.
It also means that even a small increase in interest rates would be disastrous to US finances. From Michael Snyder, writing at The Economic Collapse blog:
The only way that this game can continue is if the US government can continue to borrow gigantic piles of money at ridiculously low interest rates.
In the United States today, we have a heavily socialized system that hands out checks to nearly half the population. In fact, 49% of all Americans live in a home that gets direct monetary benefits from the federal government each month according to the US Census Bureau.
And it is hard to believe, but Americans received more than $2 trillion in benefits from the federal government last year alone.
At this point, the primary function of the federal government is taking money from some people and giving it to others. In fact, more than 70% of all federal spending goes to “dependence-creating programs,” and the government runs approximately 80 different “means-tested welfare programs” right now.
But the big problem is that the government is giving out far more money than it is taking in, so it has to borrow the difference. As long as we can continue to borrow at super low interest rates, the status quo can continue.
Who Spiked the Coffee?
The vanity of the Fed’s interest policy is that it presumes a group of economists can do a better job of finding a suitable price for credit (money) than Mr. Market.
Fed economists must put something in their morning coffee. How else could they believe two contradictory things all day long without going insane?
First, they believe that only Mr. Market knows what things should cost. Second, they also believe they can get along without him.
The central tenet of the Efficient Market Hypothesis is that Mr. Market knows more than we do. If he sets a price, it may not be perfect, but there isn’t a better one.
That is the doctrine that led Greenspan, Bernanke and Yellen to tell us that they wouldn’t know a bubble if it exploded in their faces.
How could prices be “too high”?
It is logically impossible, if markets are “efficient” at setting prices.
Likewise, how could interest rates be “too low” – even if the Fed put them there?
Said efficient markets guru Eugene Fama in a 2010 interview: “I don’t even know what a bubble means.”
In theory, there is nothing to worry about no matter how “out of whack” things seem to get. No bubbles. No distortions. No problems. Every price is beautiful, in its own way.
But in practice, the Fed’s naïve meddling causes big trouble… because the economy adapts to an unreal world.
Decisions are taken, and plans are made, based on distorted prices. Pretty soon, the economy as we have come to know it can’t live without them.
The US government has added more and more expenses. Without low rates, it can’t pay them. Again from Snyder:
• Back in 1965, only one out of every 50 Americans was on Medicaid. Today, more than 70 million Americans are on Medicaid, and it is being projected that Obamacare will add 16 million more Americans to the Medicaid rolls.
• When Medicare was first established, we were told that it would cost about $12 billion a year by the time 1990 rolled around. Instead, the federal government ended up spending $110 billion on the program in 1990, and the federal government spent approximately $600 billion on the program in 2013.
• It is being projected that the number of Americans on Medicare will grow from 50.7 million in 2012 to 73.2 million in 2025.
• At this point, Medicare is facing unfunded liabilities of more than 38 trillion dollars over the next 75 years. That comes to approximately $328,404 for every single household in the United States.
• Right now, there are approximately 63 million Americans collecting Social Security benefits. By 2035, that number is projected to soar to an astounding 91 million.
• Overall, the Social Security system is facing a $134-trillion shortfall over the next 75 years.
• The US government is facing a total of $222 trillion in unfunded liabilities during the years ahead. Social Security and Medicare make up the bulk of that.
Yes, dear reader, the longer you spend in the economists’ magical theory world, the more threatening the real world becomes.
Regards,
Bill
Don’t Discount the Credit Cycle
Yesterday, I gave you five reasons bond yields could stay low for longer… regardless of the Fed’s next move.
Does this mean bond yields won’t EVER rise?
Of course not.
Just about everything in the markets – and in the economy – is cyclical.
And bond yields… interest rates… and inflation are no different.
Remember, no matter what central bankers tell you, markets and economies aren’t machines. They’re complex human systems.
That means they are subject to human psychology.
And we know a little about how that works…
Take the recent US real estate bubble, for instance.
When people see home prices rising, they want to get a piece of the action. They borrow money. And they buy a house… hoping to “flip” it for a profit.
As they see profits from home sales rising, they’re willing to pay more and more for a house… even if it means borrowing at variable rates or taking out mortgages they can’t hope to pay back.
This leads to an “up cycle” in house prices.
But this can correct very easily…
As soon as home prices stop rising… or start to fall… everyone who borrowed to the hilt suddenly wants to get out at once.
And lenders, seeing the value of their loan collateral fall, start to get nervous.
Instead of focusing on the reward side of the equation, they now all start to focus on risk.
This triggers a “down cycle”…
If you doubt that the bond market moves in similar cycles, take a look at the following chart of long-term interest rates going back over 220 years.
Source: Bianco Research
The latest of these began just after World War II.
We saw a big up cycle in long-term interest rates from a low of just over 2% in 1946 to a high of just over 14% in 1981.
Then, after Paul Volcker took control of the Fed, we saw the start of a long down cycle. This took long-term rates back down from 14% to where they are today.
We’re not quite back to the 2% level we saw in 1946. But we’re not far off.
So, although there are a lot of macro factors holding interest rates down… your base case should be for a new up cycle in rates as the current down cycle ends.
In other words, low interest rates may have a lot of macro factors on their side. And over the short term, they may confound the bond market bears.
But anyone betting on low interest rates to continue forever is betting against the continuation of the credit cycle.
And that’s likely to be a bad bet.