The Threat of Rising Interest Rates

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Gold is down.
Stocks are down. Bonds are down.

What’s going
on here?

Worries about
interest rates are blamed by most commentators. But why should
worries over interest rates push all three markets lower? These
markets are usually thought to move independently or even conversely
to each other.

What commentators
tend to ignore is that there are multiple causes for rising rates.
Also, factors that push long-term rates up or down sometimes push
short-term rates in the opposite direction.

today’s situation. Short-term U.S. rates are historically low.
This is usually blamed on the Federal Reserve System, which is
said to be maintaining a loose monetary policy. I don’t believe
that this is the reason for today’s low rates. This is because
the adjusted
monetary base
, which best reveals FED policy, is moving up
at comparatively low rates — 4.3% per annum, year to year, and
under 3% since early March.

I think the
more likely explanation is the purchase of T-bills by the central
banks of Japan and China. They are creating money domestically
and buying T-bills with it. They are doing this to keep down the
price of their currencies in relation to the dollar. This subsidizes
exports. This monetary policy creates demand for dollar-denominated
short-term U.S. government debt, which lowers the T-bill interest
rate because the seller (the U.S. Treasury) can offer to pay a
lower rate and still get buyers.

rates in general also fall because other borrowers are not facing
stiff competition (high rates) from the U.S. Treasury. They can
therefore offer their debt certificates at lower rates and still
sell them.

When investors
hear Greenspan tell Congress that neither inflation nor deflation
is imminent, some of them conclude that interest rates will soon
rise because the economy is improving. There will supposedly be
more demand for loans by consumers and businesses. There is a
lot of guessing about what the FED will do then.

These days,
the FED isn’t doing much of anything. It hasn’t been doing much
of anything for over a year. So, it seems to me that financial
speculators should pay more attention to what the central banks
of Japan and China are likely to do. Not many of them do. This
may be due to the fact that most American speculators don’t read
Japanese or Chinese, languages that are even more difficult to
translate than Greenspanese.


The "carry
trade" refers to the practice of speculators to borrow money
short-term and lend it long-term. If someone can borrow money
at 1.5% and lend it at 3%, he can make a lot of money. He borrows
a million dollars and pays $15,000 a year for the privilege. He
lends out the million he has just borrowed at 3% and earns $30,000.
He makes $15,000 on the spread. How much money does he have to
put up as margin? A really big borrower can borrow on his own
name with no other collateral, or close to it. In effect, the
market is giving money away. Hint: the financial markets never
give anything away. There are no free lunches. Look more closely
at the deal.

These are
great days for carry traders. With short-term rates so low, the
carry trader can borrow a lot of money and buy long-term debt.
But he takes a risk. If short-term rates rise, the interest rate
spread will shrink. If they rise above long-term rates, which
they do about a year prior to a recession, the borrower can get
wiped out. His interest rate earnings will not pay for the interest
owed on his short-term debt. This happened to the savings &
loan industry in the late 1980s.

In any case,
rising long-term rates are another way of saying falling prices
for bonds. So, the carry trader finds that the market value of
his million dollar bonds has become $900,000. He is wiped out.
To earn $15,000 a year, he has lost $100,000 — not a good deal.
Carry traders sell their bonds, further depressing their market
price, i.e., raising interest rates.

There are
countervailing forces, of course. When carry traders pay off short-term
debt, this pushes down short-term rates: fewer borrowers. The
interest rate spread gets wider. But the magnitude of the effect
on capital value of small interest rate increases in the bond
market dwarfs the effect of lower carrying charges in the short-term
market. Carry traders bear a lot of risk. There are no free lunches
in the financial markets.

If China
and Japan’s central bankers decide to stop buying T-bills with
newly created yen or yuan, this means that their monetary policy
will change. There will be less demand for T-bills, which means
that the U.S. Treasury will have to pay higher rates in order
to attract replacement lenders. That would send a signal to carry
traders: sell long-term debt assets (bonds) and pay off short-term
loans. So, long-term rates will rise alongside short-term rates
under present circumstances, assuming that the carry traders are
major players today. With short-term rates at historically low
levels for three years, this is a safe assumption. Everyone wants
into a sure thing. "They’re giving money away!"

Central bank
policies of monetary inflation always create carry trade opportunities.
Why? Because monetary expansion (inflation) initially pushes short-term
rates lower than the free market would otherwise produce. Central
banks buy short-term government debt when they issue new money.
The supply of debt buyers rises. Short-term rates fall. Carry
traders sense a profit opportunity. The road to easy street — something
(the fat interest rate spread) for nothing (little perceived risk)
— once again beckons.

Carry traders
have done well ever since the FED pumped in massive quantities
of fiat money in response to 9/11. Making money now looks easy.
The easier it looks, the more players the interest rate spread
attracts. Fools rush in where Buffett fears to tread.


The threat
of price inflation persuades lenders to demand a higher rate of
interest for loans. The longer the term of the loan, the more
risky price inflation is. The lender will be repaid with money
that will buy less. So, he seeks to protect himself by demanding
a higher interest rate.

We have seen
the return of price inflation in recent months. Both the CPI and
the Median CPI (Cleveland FED) have risen from 1% per annum to
at least 3%. The price of oil is not coming down as expected.
Steel prices are up. Commodities are up. There is rising demand
from China for these basic commodities. For as long as the fiat
money-induced boom continues in China, this demand will rise.

The Austrian
theory of price increases blames rising money, not rising demand.
Rising demand, apart from rising money, means rising production.
Buyers must purchase more goods and services by means of increased
productivity. But increased productivity lowers prices. There
should be rising demand and falling prices generally: "more
goods chasing the same amount of money." Price inflation
comes when there is monetary inflation. Today, there is not much
monetary inflation in the domestic money supply, i.e. dollars.
Or, better put, there is not much reported monetary inflation.
The FED seems to be cautious.

The ringer
is offshore monetary inflation: the Eurodollar market. Offshore
banks can pyramid dollar accounts but do not have to report to
the FED. This has always been a threat to American consumers:
the threat of increased demand, in dollars, from offshore. That
would produce price inflation: more demand from abroad for goods
and services here. The old refrain, "when the dollars come
home, inflation will appear," is quite old. I have heard
it for three decades. So far, so good. It can happen, but it has
not happened yet.

I think price
inflation will press upward. The rate of price inflation is still
under the rate of monetary inflation, no matter which definition
of money you select. But I don’t see double-digit price inflation
as likely in the near future, despite rising oil prices.

So, any talk
about the FED’s pushing up rates seems misguided. The FED is not
doing much to keep rates low, so why should we expect it to do
much to push rates up? The FED is of course able to expand the
U.S. money supply, but it doesn’t have to. Economic growth is
expanding at a rapid clip. The FED has breathing room.

If the FED
tightens money by purchasing fewer T-bills, this will tend to
push up short-term rates. This would raise long-term rates because
of the carry trade effect. But today, rising long-term rates seem
to be the product of fears about price inflation, not fears regarding
the carry trade. Short-term rates are staying low, but longer
rates are rising. This points to inflation fears, not carry trade


First, those
who predict price deflation still have the same old problem: no
statistical evidence. I mean none. Money is expanding, prices
are rising, and OPEC is cheering.

Second, those
who predict mass inflation are not much better off than the deflationists.
The economic system is bumping along, productivity is rising,
output is increasing, so prices are not rising rapidly. But they
are rising faster than they were three months ago.

Third, long-term
rates are rising. I think this will continue. This will tend to
slow down the economy. It will hurt the bond market, as existing
holders of bonds see rates rising. The market value of a promise
to pay a low rate of interest falls when new borrowers are paying
higher rates than yesterday’s borrowers.

The stock
market likes low long-term rates, which favor business expansion.
The U.S. stock market for over two years has risen in response
to the promise of the stimulative effects of low rates. Now these
long-term rates — bond rates — are rising. It is becoming more expensive
to finance business expansion by issuing new bonds.

Profits have
yet to rebound significantly. The cost of raw materials is rising:
Chinese demand. So, with what net revenue will businesses repay
new debt? The squeeze is on: rising costs (interest rates, commodities)
and the threat of falling consumer demand as interest rates rise.
He who is maxed out on his credit cards faces a big problem when
rates rise. His disposable income shrinks. He has to cut back
on spending.

The bond
market is falling. It will continue to fall if long-term rates
keep rising, which I think is likely.

The stock
market falls when business costs rise and profits get squeezed.
Neither the Dow nor the broader stock indexes ever regained their
highs of the year 2000. The NASDAQ never even reached the 50%
mark. The recession of 2001 was short-lived, but the recovery
has been miserable — the weakest of all recoveries in modern times,
stretching back to 1907.

The case
for a rising stock market is more difficult to make than the case
for a falling market. Bullish sentiment has remained high. Aging
investors still have hopes that the stock market will provide
them with a secure retirement. But low dividend payments are universal
today, so this dream is not likely to come true. The number of
Americans who can live comfortably on their stock dividend payments
is so small as to be statistically irrelevant. In the long run,
most stock owners will have to sell their stocks to finance their
lifestyles. We are in a secular bear market that will last for

But what
about for the remainder of this decade? Dan Denning, in the April
7 issue of Strategic Investment, made this prediction:

I believe
you’ll soon see falling prices for most financial assets, but
rising prices for most raw materials and tangible goods. In
other words, you’ll get deflating financial asset bubbles and
inflating raw materials bubbles. Good for commodities and commodity
stocks, generally bad for stocks, particularly financial stocks.

I think this
assessment is accurate. We are on the edge of a downward move
in stocks because we are in the midst of rising prices and on
the edge of the reaction to central bankers’ funding of the carry
trade. They "gave away money," and the result has been
the subsidizing of debt in all areas of the economy. Now, in order
to keep multiple asset bubbles from bursting, the central bankers,
especially in Asia, must make a decision: Is it wise to continue
subsidizing the U.S. Treasury with below-market loans when the
new fiat money can buy debt inside their own countries? When their
answer is "no," the carry traders in America will face
a day of reckoning. Rates will climb, and bonds will fall even
more. Margin calls will go out to the carry traders. They will
be forced to sell their bonds, thereby depressing prices even

I don’t think
we are far away from this scenario.


There is
no such thing as a free lunch. When you see markets rising sharply
where expected revenues don’t justify the increase, you are watching
a bubble. It’s the greater fool theory in action. The investors’
hope is not to buy a stream of income; it’s to make a killing
by selling to a greater fool.

Central bankers
are the initiating fools. The greatest fools are those debt-burdened
consumers and fool-seeking investors who expect the free lunches
provided by central bankers to go on forever. There is a price
to pay for free lunches at central bank tables.

12, 2004

North [send him mail]
is the author of Mises
on Money
. Visit
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