Macro Economics
Bonds and Interest Rates

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By washcomp
January 11, 2010

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Some of us wander outside the realms of equities and have picked up the odd bond or two.

I've been having interesting (groan!) thoughts. A few point which I think are valid (but willing to be proved wrong):

1) Both short and long term interest rates are about as low as they can get.

2) The Fed is lending money to banks at essentially zero percent

3) The Fed is supporting long term rates by purchase of these and trading to the banks for T bills, but have indicated that they would like to cease this policy in March (whether they keep this date will tell us much).

4) The dollar, while low, has stabilized in a range between +5 to +10% from its lows of summer 2008.

Now the bad news:

Some of the states are not in a position to continue raising more debt and can't (without cutting services to a level unacceptable to their citizens) pay off their current obligations. California and New York appear to be heading that way (While NY is not one of the "10 worst", it is barreling ahead to win the game and will shortly get there. The interest increases which will be demanded, the first time a major municipality fails, will paint most munis with the same brush.

I posted today about a default of a major commercial real estate mortgage ($4.5B). I suspect this will soon be commonplace. How the banks weather this storm (piggybacked on the residential real estate resets of 2010) will be instructional.

The exposure of the US Treasury to risk in addressing these issues will present the taxpayer with the obligation to pay for these expenses for years. It will be important for the Treasury and the Fed to manufacture a situation where these US dollar denominated debts would be paid off in devalued dollars.

There is an implication in the above scenario which would favor increased interest rates.

Let's first examine the results of higher interest rates in 2010. Credit would be even harder to obtain. Bonds would drop in value as interest rates rose. Stocks would drop as bonds offered higher comparative returns. Mortgages would be more difficult to get and more expensive. This coupled with higher taxes (both federal and local, to address both needs) would assure a double dip into recession, at best or more likely a full blown depression.

In the absence of distortion by the Fed, the above is the obvious route of the economy and the investor's planning would be to divest of stocks and bonds, as both would drop like a stone. The US dollar would rise, decreasing the value of commodities and foreign currencies. It would also decrease the profitability of US companies doing business abroad when profits were translated into dollars. TBT and the like would be flooded with buyers (for as long as they let the game continue).

So interest rates increasing (the obvious direction that most think they will go in) is going to create "bad stuff". Said "bad stuff" is unacceptable to the Fed and the administration (especially while unemployment is at 10%).

Now, don't get me wrong, the above scenario will play out at some point in the next few years in some form or other. The Fed hopes to delay the above scenario until the economy is far more robust than it currently is. Optimally, they would like to hold the wolves at bay until after the 2012 presidential election, but in order to do so, the distortion in the normal order of things will require unprecedented purchases of US government debt by "someone". Apparently, that "someone" is to be the American taxpayer (since no one else would continue doing so at near zero real interest rates).

OK, think about this for a minute - other than redistribution due to asymmetrical taxation - we are borrowing from ourselves to pay off foreigners. I'm still trying to visualize this, but more important than the nuances of the impact of an increase in interest rates, the gross results are easy to predict.

All that remains is to determine the most likely timing of the above.

I am wondering if there are any who disagree with the results of an increase in interest rates (if so, please let me know how you arrive at the results you anticipate).

The second issue is what your best guess of the timing of an increase in interest rates and (considering the likely headwind from the Fed), what the time frame would be. What would the signals be that we could watch in order to have advanced warning?

This event, should you agree that it's coming, could inflict a devastating effect on your finances.

This is possibly one of the most important questions that each of us will be addressing over the next year. If you own long bonds, municipal bonds, foreign currencies, gold or equities, look at the long term graphs going back to the 1970's and 1980's (which I've previously posted). You WILL NOT be protected if this scenario plays out. Timing it properly is your best hope of being able to take advantage of it (by buying stocks and bonds when interest rates are at their peak and things are at their blackest), rather than it taking advantage of you.

Just trying to look at the bright side of things,