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THE DANGER AND
PITFALLS OF LOW INTEREST RATES
The
world, as well as all the experts, are witnessing in utter shock and
disbelief the potential break down of the world's financial system. They
still can't figure out why this is happening and therefore do not know what
they should or could do about it.
UNINTENDED
CONSEQUENCES are the main reason why free markets work and
managed markets (Socialism) must eventually break down; nobody ever even
thinks about the potential seemingly unrelated unintended consequences. Even
if there were a few smart people who do think about such things, it is
impossible to conjure up all the possible permutations and combinations that
over time only a Free Market can factor in while giving the exact right
amount of weight to each factor and come up with the exact right price and
solutions.
ARTIFICALLY
LOW (ZERO) INTEREST RATES
That's
enough of generalities; the main topic is ZERO interest rates and the
unintended consequences of the FED maintaining artificially LOW interest
rates. On numerous occasions, I have pointed out and explained the functions
of interest rates, such as determining the marginal propensity to consume vs.
save. and the most efficient allocation of scarce savings among investment
projects. But theses are well known factors even though they have been
ignored and are the main causes behind the business cycle.
LEVERAGE
has become the main unintended consequence of artificially low interest
rates.
With a real inflation rate of 3% and yield spread of only 2%, it is
impossible for Banks to make money and therefore no lending will take place
unless a way could be found to increase the rate of return on their capital:
Low and behold, LEVERAGE was discovered. If you could leverage your capital
at 10 to 1, a 1% profit becomes a 10% profit. At 40 to 1, 1% becomes 40% and at
a 100 to 1 you double your money every year. Not to bad, AY? But alas, there
is a catch; leverage is a two edged sword. A 1% loss on a 100 to 1 leverage
wipes out your capital completely. Among the first highly leveraged deals was
the carry trade; buying US Treasuries with borrowed Yen. And what a deal that
turned out to be. Initially, not only did they make money on the interest
rate spread but they made even more as the Dollar began increasing 5% to 8% a
year against the Yen. This gave rise to the Hedge Fund Industry as they
convinced everyone how smart they were. Of course they did not warn anyone
about the risks involved or of the possibility that the Yen would reverse and
go up against all currencies. Therefore the only safe thing to do was to move
the business offshore, limiting the investors to exempt investors and
institutions: Low and behold, no Government rules or oversight and no SEC
approved audited prospectus requirement: After all, exempt individuals and
institutions are supposed to be smart enough to protect themselves, right?
Too bad they had to ignore all the little suckers but never mind, there were
enough rich suckers with a lot more money to go around. What they never
expected was that after a few years of 40%+ returns, the biggest suckers of
all, the major Pension and Endowment Funds, after 10 years of no gain in
stocks, would jump into the quicksand with both feet. PARADISE FOUND.
There
is always an element of self preservation at work at all times and now that
they had found a license to print money, they looked for a way to both
increase their leverage and more importantly, protect themselves against
risks. Low and behold, Credit Default Swaps (CDS) and other insurance
derivatives against other types of risks (interest rates, currency, etc.)
were invented, which allowed leverage to be increased to unimagined levels.
But it didn't stop there. Whatever the Market was looking for Wall St.
created. The one thing Pension, Insurance and other big Investors were
looking for was AAA Bonds that paid a high enough rate of return (since
Treasuries were no longer paying enough) to allow them to stay in business
without taking undue risk. Sure enough, the experts on Wall St. provided that
using sub-prime mortgages packaged and repackaged using CDS'S as they coerced
the credit rating agencies into give them AAA ratings on junk sub-prime MBS'S
and they were snapped up like crazy. The real professionals knew that the
stock market was way overpriced and all they wanted was a reasonable 5% to 7%
return on AAA no risk Bonds. Ask and you shall receive. Wall St. couldn't
package them fast enough. But they should have known better because any time
you are offered something that is too good to be true, it usually is not
true, especially not in the volumes that were involved. They were making so
much money that Wall St. began to believe their own B.S. and so when Yen
started to appreciate and the carry trade was no longer so hot they loaded up
on their own junk. After all they had to put their ill gotten gains somewhere.
Everything was going fine as long as the real estate market, the ultimate
insurer, that was backing all this pie in the sky, was appreciating at a
compound annual rate of 15% to 25% plus. But alas, all good things must come
to an end as reality eventually sets in and all bubbles and Ponzi schemes
must also eventually blow-up. We are now living through and witnessing what
happens when government interferes with the free markets and no matter how
good the intentions, their inability to identify all of the unintended
consequences of artificially low interest rates, came back to bite us all in
the neck.
WONDER
OF WONDERS
It is
hard for me to understand why Economists (left & Right) still want to
continue doing what got them into trouble in the first place. Hasn't the last
20 years of Japan's, Huge Public Spending & Zero interest rate,
recession, taught them anything?
As far
back as 2004, I began writing essay after essay, trying to explain what the
functions of interest rates are and how they worked, but nobody was listening
and nobody took any interest. In letter after letter there was often a
paragraph that pointed out the perils of excessively low interest rates. What
about the savers I screamed as the nation's saving rate dropped from a high
of 15% to zero and then -1%? What about the retired seniors who had their
life savings in12% and 15% CD'S and Treasuries that were now maturing and
could only be replaced with 3% or 4% CD"S - how will they be able to pay
their bills?. Let them buy Stock Mutual Funds that have returned an average
of 8% over the last 75 years (the BIG lie). Besides, what are they
complaining about? We just gave them free prescription drugs didn't we? But
who cared, the party was a blast and the champagne (money) was flowing like
water. Besides, who wants to listen to a kill-joy when you're having fun?
Unfortunately, even the best of parties must come to an end as the sun always
rises and every party must be paid for by someone. The bigger the party, the
bigger the bill. This party was so big that the whole world will end up
paying a far higher price than anyone could possibly have imagined. (say
unintended consequences?)
If
history is any guide, World War III is near at hand. GOD I hope I'm wrong
this time.
GOLD
They've
been dumping Gold for a couple of reasons: 1) prices are falling; 2) credit
lines are either being pulled back or completely taken away. 3) In many
cases, investors have no choice but to liquidate their gold positions as they
are their only positions that have a decent bid and or are their only
positions in which they are still showing a profit. ( Great Idea; cut your
profits short, so you can pay taxes on them, while letting your losses run;
Is that how its supposed to go?)
During
the heyday of the commodity bubble, I cautioned all investors that there
would be a major supply response to continued high prices. The Laws of Supply
and Demand may be asleep but they are not Dead.
What
could keep Gold prices down?
You
would really have to get back to a place where the economic, political and
financial situations are no longer worrisome ... before you see people sell
gold and jump back into stock and bonds. That's the only likely scenario for
lower gold prices that I can come up with In the gold mining equity market or
any other mining market, even Oil and Gas, you saw that the price of the
equities were pushed much higher by the momentum players (hedge Funds) than
what could be considered a reasonable value. Now, the prices of a lot of
equities are far below what you could consider a reasonable value for the
enterprise. The rules of the game never changes but they do masquerade in an
attempt to fool the majority; the lazy and the gullible: It's the way the
world works, I guess.
WHERE
TO NOW DOW?
If you
can recall my Jan. 2008 article "GOLD AND A KONDRIETIFF WINTER" If
you can't then I strongly suggest you go back in to my archives and read it
again. By the S & P breaking down below its 2002 Bear Market lows; we now
have confirmation that we are in multi-generational Bear Market of Grand
Super-cycle proportions. If it is to be only a Wave {IV} down, correcting
Wave {III} of the Bull Market that began in the mid 1700's as Prechter,
McHugh and some other well know Elliott Wave Theoreticians, believe and not
the fifth and final WAVE {5} then the good news is "The World is Not
Coming To an End" The BAD NEWS is that we will most likely see
significant NEW lows that will probably go much lower than Thursdays lows
(maybe as low as DJII 4000) before this Bear Market is over. We have
only seen the first wave (Wave A) of the Tsunami and the devastating second
Wave (Wave C) is yet to come. Luckily things are not all bad and the
good news is we are about to enter a period of relative calm, Wave B of the
Forth Wave {which is usually an a,b,c,d,e, Diagonal Triangle; with the a wave
being the longest} is often only a sideways type phase- to this three phase
Bear market. This Grand Super-cycle wave {IV} down is
correcting centuries of Bull Markets and it will seem fast, and furious. But
time-wise, it may be relatively short compared to other Grand Super-cycle
waves, but damage-wise, this Bear Market could change the world. The next 4
years and the election of 2012 could be the most important election since
1776 as it will determine whether we regress into the Demagoguery of
Communism - Fascism or explode into a new era of FREEDOM.
HAS
THE BOTTOM BEEN MADE?
We are
at or near the end of the first phase; Wave {A} down. That bottom is
imminent. In fact it may have been made Thursday, November 20th, 2008, Or, it
may need one more declining wave to complete this wave {A} down move
from October 2007, a Super-cycle wave that has wiped out a decade of
stock market gains, over 50 percent of the market's value, in just one year!
Wave {B}
up which may have started Friday, November 21st, or will within a week or so
( I will be able to get a better picture once I am sure that the Wave {A}
bottom has been made)
WARNING DO NOT
CHASE A 1000 POINT BOUNCE:
Wave {B}
up is a gift. It is for short term Traders only. Use it to BUILD YOUR CASH
POSITIONS AND GET OUT OF DEBT. It is like the calm before the storm. Your
last chance to raise cash at higher prices. Because, once it completes, the
devastating plunge will resume and take prices far lower than anyone - even
Bears can - now imagine, wave C's down behave like Wave 3's, They are usually
the longest and strongest of the waves and therefore Wave {B's} are the best
time to accumulate GOLD. The Industrials are down 2,204 points, or 22.8
percent since Election Day. The S&P500 is down 266 points, or 26.5
percent since Election Day.
What
bothers me is that Thursday did not see a DJII closing low
below the Bear Market low of 2002. But since Friday closed 5 percent higher,
I cannot rule out a bottom but I am still reticent in calling a bottom
because (a) my Elliott wave Declining pattern does not look complete and (b)
the 10 day average Advance/Decline Line Indicator actually got worse Friday
for both the S&P 500 and for the NDX, on a day when prices rose 5
percent. That is odd for the start of a rally phase after such a strong
sell-off - Call it a minor Bearish Divergence. (c) New Lows were also way too
high again on Friday, (d) 47 percent of total issues traded on the NYSE were
down. And Advances were only 63 percent of total issues traded. The start of
major rally phases normally do better than that. We also did not get a 90
percent up day Friday, which is something I would have liked to see at the
start of a major rally. And finally Friday was options expiration day which
is usually a rally day, anyway: And last but far from least The rally
according to all the media talking heads was tied to the big news that Obama
is tapping the popular New York Fed's President to be the next Secretary of
the Treasury in 2010, really? Rallies on news often can't really be trusted,
especially when the big new is really no news at all.
Aubie Baltin CFA, CTA, CFP,
PhD.
UNCOMMON COMMON
SENSE
2078 Bonisle
Circle
Palm Beach Gardens FL.
33418
aubiebat@yahoo.com
561-840-9767
Also
by Aubie Baltin
Please Note: This
article is for education purposes only and is designed to help you make up
your own mind, not for me to make it up for you. Only you know your own
personal circumstances so only you can decide the best places to invest your
money and the degree of risk that you are prepared to take. The Information
on data included here has been gleaned from sources deemed to be reliable,
but is not guaranteed by me. Nothing stated in here should be taken as a
recommendation for you to buy or sell securities.
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