

Interest Rates Will Rise Regardless of the Fed (June 10, 2008)





A very well-informed correspondent recently asked why interest rates have barely budged despite the Federal Reserve dropping the Fed Funds rate from over 5% to 2%. I asked frequent contributor Harun I. to help explain the relationship, but let's start with standard explanations: The Federal Funds Rate and How It Works: Although banks would like to loan out every dollar they can, the Federal Reserve mandates that they keep a certain amount of cash, or reserve balance, on deposit at their local Federal Reserve branch office at all times. The federal funds rate is the rate that banks charge each other for overnight loans of reserve balances. Each month the Fed, through its Federal Open Market Committee (FOMC), targets a specific level for the federal funds rate. This rate directly influences other short-term interest rates, such as deposits, bank loans, credit card interest rates, and adjustable-rate mortgages. Longer-term interest rates are indirectly influenced. Usually, investors want a higher rate for a longer-term Treasury note or bond. In other words, the Fed sets targets and pulls some monentary levers, but the price of money is still set by the market. What The Fed Funds Rate Drop Means For You: The Fed Funds rate doesnt directly affect mortgage rates. In simple terms, mortgage rates dropped because investors were pleased at the Feds decision to lower the Fed Funds rate; when investors are happy and confident in the US Economy, mortgage rates will generally go down. The Fed Funds rate is only a target interest rate; in other words, the Fed doesnt just come out of its meeting and say, "Let the Fed Funds rate be 4.75%," and it just happens. The Federal Funds Rate is the rate at which banks lend money to each other, usually overnight, in order to ensure each is meeting the cash reserves its required to maintain. If one bank has more than it needs, it lends money to a bank that doesnt have enough; the rate these banks charge each other is called the Federal Funds Rate. To drive the Fed Funds rate down, the Federal Reserve, in a roundabout way, pumps cash into the banking system. If banks have more cash, there is less demand for interbank borrowing, which leads to a drop in the Fed Funds rate. Ideally, the cash the Fed pumps into the banking system will be just enough to keep the economy balanced. If the Fed pumps too much money in, banks find themselves with a bit of a surplus, which finds its way into the pockets of you and me. If everyone has more money, they spend more, which means higher demand for products and services, which leads to higher prices for products and services, which is called inflation. So the Federal Reserve has a real balancing act to play in the US economy. If inflation starts to increase, mortgage rates will rise again simply because investors will demand a higher rate of return to counter inflation. So, while the Interest rate drop will spur the economy in the short term, what happens in the long term is anyones guess. Now let's take a look at actual interest and yield rates: current money rates (forecasts.org) Prime Rate: 5.00

30 Year T-Bond: 4.75

10 Year T-Note: 4.06

91 Day T-Bill: 1.85

Fed Funds: 1.98

LIBOR 3 Month: 2.70

Mortgage Rate 30 Year: 6.09

What the above explanations hint at but do not address is the role of risk in setting interest rates. For more on that, let's turn to Harun's comments and a chart he graciously provided: The disconnect between long-term rates and the Fed funds rate is the so-called "conundrum" of the Fed: "Hey, we are pulling the levers but nothing is happening". The Fed has lowered rates at the velocity of light and banks still will not lend to on another. To me this says in no uncertain terms that banks do not like the risk/reward scenario, i.e. the compensation they would receive (interest) was, and still is, not worth the risk. Rates should rise until banks feel they are being adequately compensated for the risk to which they are exposed. The Bond/Gold ratio chart can be thought of as a spread chart. It essentially indicates performance based on a condition of being long one asset, in this case bonds and short another, gold. If the line is going up that means the spread is narrowing and that you have a successful trade. If the line is going down the spread is widening and you are in a losing trade. Historically there has been a coupling or gearing where bond prices moved in tandem with the RS (relative strength) line, or maintained a relationship with the price of gold (and commodities), this represents value. Since 2003 an unprecedented decoupling in this relationship has occurred (the spread has widened beyond anything in my data set) which indicates that either gold is severely overvalued or bond prices are overvalued and therefore the risk is undervalued. The common reasons seem to be that since 2003 money and credit have been expanded exponentially to unprecedented levels thereby creating unprecedented liquidity which in turn created distorted (inflated) prices. That the Fed is currently printing money with reckless abandon is refuted by data that we have seen coming from sites like Mish, which indicates that the Fed is destroying capital as rapidly as it is creating it. But this a recent phenomenon and only creates stasis. What the Fed has been fighting is a delaying action; it has created a situation where losses can still be hidden but the previous excess of liquidity created by previous monetary policy still exists. Interest rates as indicated by relative performance to gold should be much higher or the price of gold should be much lower; the chart is clear and irrefutable. There are also simpler reasons. Investors are flocking to bonds in a flight to safety driving the prices up and yields down. This is exacerbated by technical buying that is triggered by price movement but ignores value. The empirical evidence (the current ongoing calamity in debt markets) suggests that interest rates should indeed be higher. The RS charts are quietly and dispassionately indicating fraud, whether consequential or intentional I will leave for others to decide. If the Fed were not accepting junk as collateral and an asset's risk of holding had to be assessed by free market forces, I believe this condition would have corrected by now or at least the process would be well underway. Here is what I do know: At some point the relationship will normalize. This may happen slowly or swiftly and it can happen in several ways: Gold can fall in price while bonds stay the same or rise.

Bonds can fall in price while gold either stays the same or rises.

Gold can fall in price and bonds can fall in price but do so at a greater rate than gold.

Bonds and gold can rise in price but with bonds doing so at a greater rate relative to gold. There are probably are more permutations but you get the idea. Regardless of the why, which may not be fully understood for some time, we know that:

1. There is an unprecedented mispricing of assets.

2. Normalization will occur, catastrophically or gradually.

3. We have our charts to see when this is occurring and can position to take advantage. To clarify my understanding, I asked Harun to explain the relationship between bond prices and yields: A bond's coupon yield, or nominal yield, is set at issuance and printed on the face of the bond. The nominal yield is a fixed percentage of the bond's par value. A coupon of say 6%, indicates a bondholder is paid $60 in interest annually until the bond matures. Current yield (CY) measures a bond's coupon payment relative to its market price (Coupon payment / Market price = Current Yield). Bond prices and yields move in opposite directions: as bond prices rise, yields decline and vise versa. When a bond trades at a discount, its current yield increases; when it trades at premium, it current yield decreases. Example: A 6% coupon bond trading at $750 has a current yield of 8% ($60 / $750 = 8%). Conversely, the current yield of a bond bought at a premium is lower than its nominal yield. If you bought a 6% bond for $1,200 you receive a 5% current yield ($60 / $1,200 = 5%). So when interest rates shot up in the early 1980s, the yields on newly issued bonds was high (15%) and as a consequence the market value of old bonds yielding 6% was essentially destroyed (dropped to mere pennies on the dollar). What could cause the interest-rate repricing Harun suggested is inevitable? Here are some fundamental issues that come to mind: 1. The risk of loaning money backed by declining real estate is finally priced in. Once the government guarantees against default or price deflation are exposed as worthless, then what will the price of mortgage money be? How about 12%? That was the "average" "typical" cost in the mid-1980s and by no means "impossible." 2. The global "savings glut" which supposedly created the global real estate bubble vanishes. Asset destruction/deflation and recession will remove trillions of dollars from the global system, and like anything which has become scarce, money will become dearer. 3. Peak oil/stubbornly high oil prices/demand will spur investment in alternative energy even as they drain money from global savings. If you have to spend twice as much on oil and goods which depend on oil for transportation and manufacture (i.e. everything), then you have less to save. And if everyone has less to save, then the pool of capital available for investment shrinks. With virtually every major government borrowing hundreds of billions in deficit spending, reduced global savings and asset deflation, we have increased demand for borrowing as the pool of available capital is shrinking. That supply/demand imbalance guarantees rising prices for money--higher interest rates. Based on the above, I would hazard a guess that interest rates could very easily double and then triple: mortgages will shoot from 6% to 12%, and the interest on government debt will skyrocket, diverting tax revenues away from other government spending. Interestingly (at least to me), Harun's chart and commentary point to the same possibility.

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