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.
Consider 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.
Short-term 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
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 INFLATION PREMIUM IN LOANS
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 fears.
WHAT DOES ALL THIS MEAN?
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 decades.
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 further.
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.
May 12, 2004
Copyright © 2004 LewRockwell.com