Higher interest rates, gold and foreign currencies and fears of inflation

My next economic forecast/interest rate class will be held on Wednesday, June 10th from 6-9pm.

For those outside of Southern California I will be holding a webinar on Thursday, June 11th at 6pm.

I will be discussing my interest rate and Fed forecast for the remainder of the year and offering ideas for the safest places for your investment funds.

It’s almost June and each year it brings an increase in the fear level of investors as long-term rates rise causing a fear among borrowers that interest rates have bottomed and will soon soar to levels not seen for many years. Since we only see the future from our own past experiences one would think that investors would finally learn about the strong seasonal trend towards higher interest rates that is seen almost every May & June. With memories short and the media telling us that inflation is coming soon investors have begun their annual panic out of bonds and into anything that would hold its value (gold) in an inflationary environment. Let’s begin with some history and the fact that long-term interest rates have risen in the 1st half of the year over 75% of the time since 1966. The peak in rates has occurred in the May/June period 7 out of the last 10 years with exceptions in 2005, 2003 and 2002. These peaks always occur when rates are rising due to fears of inflation coupled with forecasts of economic growth that would increase loan demand. The last two days have seen the Treasury 10-year note increase from 3.19% to 3.45% (26 basis points) while the inflation component which measures future inflation expectations has risen 9 basis points to 1.78%. This is very typical May/June behavior for long rates as the bulk of the advance each year comes from the real rate not the inflation component. (I will be spending time at the upcoming class showing attendees how to monitor this on a daily basis). On March 18th when the Fed announced its new quantitative easing policy the 10-year plunged to 2.53% and the inflation component closed that day at 1.22%. Since that historic day in Fed history the 10-year has risen 92 basis points with only 56 bp coming from an increase in inflation expectations. The Fed would be a lot more worried about higher rates if the entire advance had come from an increase in future expectations about inflation. The Fed’s new transparency regarding policy shows they pay very close attention to this important part of the Treasury rate. They are aware of the recent increase in long rates and the damage it would do the residential and consumer borrowing market if it continued.

Interest rates are a function of demand for funds and supply by lenders and this week’s H.8 report from the Fed tells a story of credit contraction. Commercial and Industrial loans are at a level not seen since May 2008. Real estate loan growth has slowed considerably but most concerning is the fact that banks are sending money back to the Fed for safe keeping instead of lending to borrowers. In the past year cash assets of banks have grown $780 billion with $160 billion in the past two weeks. Banks are telling the world they are ready to lend but in reality they are afraid they many not be repaid and the value of the underlying collateral may decline. Until asset prices (other than stocks) stabilize borrowers will be hesitant to borrow and lenders will be afraid to lend. Gold has risen in the past few weeks more because of uncertainty in world economic conditions than a fear of future inflation. If you are long gold it doesn’t really matter why it is rising since investors would rather earn a profit without realizing why it is rising than lose $$$ despite having a good story about why it should rise.

The dollar

The Aussie dollar continues to be the #1 best bet against the dollar (as I predicted in my nightly e-mail) and the correlation with the U.S. stock market has led many to huge profits this year. The Fed’s massive infusion of dollars into the marketplace is causing supply to increase faster than demand and the dollar should continue to fall for the remainder of the year as the flight to quality bid evaporates. An increase in supply does NOT create demand and it will take a dramatic increase in velocity for inflation to pick up in the U.S. The inflation trade is becoming crowded and by the end of June the risk/reward should be tilted in favor of the small minority betting that the deflation/lower interest rate trend has not ended. It’s a very unpopular trade but the seasonal pattern of rising rates ends in about five weeks and the summer and fall should bring a renewed sense that the economy is going to be in the intensive care unit for many years. We are a very impatient society that is about to learn an expensive lesson that the end of one phase of this recession does not immediately bring back a surge in economic activity. The good news is that the majority will again be wrong but willing to accept their fate because it’s better to lose in company than win alone.

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The Fed is printing money, but it isn’t being spent

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The logs remain wet and fires are temporary despite the many matches the Fed is using to try and ignite the economy.  More time is needed for the drying process that will insure a long lasting recovery. Credit is a necessity for any economy to grow and represents the oxygen needed to sustain any lasting improvement in business conditions. Over the past 9 months the Federal Reserve has created hundreds of programs (matches) in a desperate attempt to light a fire that could burn on its own. Currently almost all lending is being done with explicit government guarantees or support and that is the only reason rates on non-government debt have fallen. The problem is that the U.S. is not starting from a healthy position but one that is clearly damaged and where existing debt is being extinguished and asset values continue to fall (except for the recent stock market rally). Since we only see the future from our past experiences and most of history has been positive we naturally expect the economy to bounce back in the near future. One has to go back to the 1930’s and the Great Depression to find a similar period where credit contracted, unemployment rose and the economy’s output fell from the previous year. But we do have an experience from more recent history that does give us some indication of what might be ahead for a country that is not used to any speed but one that presses the limit. Japan suffered what has been called a “lost decade” after its bubble burst in the late 1980’s. How soon we forget the property purchases by Japanese in the U.S. and the rise to the sky real estate values in Tokyo that became explosions heard round the world and turned Japanese banks into “zombie” banks for many years until the Japanese government couldn’t find anywhere to hide. The key to not making the same mistake again is to learn from the past and not enough time has been spent by analysts about this important period in economic history. Early in the 90’s after the initial decline in property values and the onset of deflation the Bank of Japan immediately began printing yen but was warned by worldwide economists (Milton Friedman, etc.) that this would cause a return of runaway inflation. Again because we use our recent past to predict the future these experts could only see a comeback of what caused the bubble. The Japanese stock market rose (40%) sharply confounding everyone while leaving shorts bloodied and those in cash wondering how they could be wrong twice (not selling on the way down and not buying the first rally off the bottom). Doesn’t this sound very similar to what we have seen since the U.S. stock market’s low in mid-March? As we know now the Japanese have been mired in deflation and record low interest rates for almost twenty years despite massive easing by the Bank of Japan. The Japanese learned an expensive lesson (soon to be repeated in the U.S.) that money growth is NOT inflationary if it is not lent by banks or spent by consumers and businesses. It’s amazing how often we repeat our behavior expecting different results.

Long-term interest rates rose dramatically last week with the 10-year U.S. Treasury note reaching 3.37% and giving investors concern that inflation is returning and confidence the U.S. economy has hit bottom. Didn’t we hear the same story in May 2008? May 2007? May 2006? How soon we forget painful times in bond market history. Daily subscribers weren’t surprised when rates rose as they were warned of the strong seasonal trend that has occurred 75% of the time over the last 40+ years. I have a chart that shows how much rates have risen in the first half of each year and fallen in the second half of each year and will send for free to anyone who e-mails a request. Each Spring rate worriers appear only to disappear again after July 4th wishing they had held off on refinancing a real estate loan. The price of money (interest) is a function of demand and supply as per Economics 101 rising with demand and falling with increased supply. The Fed’s balance sheet has tripled from $1 trillion to $3 trillion in the last year as the supply of available funds has increased. Recently they announced they would use much of this newly printed money to purchase mortgage backed securities and Treasury notes. The increased supply of money has gone directly into the banking system with the Fed’s purchases but these banks have taken the money and returned it to the Fed for safe keeping which defeats the purpose of the Fed’s program. Demand for loans from consumers and business’s has declined because bank underwriting standards have tightened and possible borrowers don’t apply for something they know they can’t obtain. To close the circle potential buyers of assets don’t want to borrow for fear the value of the purchase will decline thus creating a greater loss. Borrowers are afraid to obtain credit and lenders are afraid to make a loan. It is no surprise the Fed’s weekly loan report (H.8) continues to show a contraction in credit as more loans are paid off (or written off) each week than created. The only word to describe this process is DEFLATIONARY. Rising long-term rates at a time when loan demand is non-existent makes the Fed’s job more difficult because it is the only true originator of credit in today’s market. Almost all residential debt is bought by Fannie & Freddie, commercial real estate debt other than apartments (the twins) is nearly impossible to obtain and the asset based market is supported by the Fed’s programs. The Fed is well aware of recent interest rate increases and Fed Chairman Bernanke this week in a Q&A session (I tape and review all Fed speeches and testimony) gave clear guidance for Fed watchers about future Fed policy. The Fed will continue to purchase securities and is not concerned about recent interest rate increases because it monitors daily the inflation expectation component of the 10-year Treasury market (1.58%). The constant of every interest rate increase in the past few years has been inflationary expectations remaining low while the real rate rises due to false expectations about a pick up in economic activity. If rates continue to rise until the end of June (my expectation) and the inflation component stays in its current range long-term rates will come back down below 3.00% during the summer.

Where are the jobs?

Judging from Friday’s stock rally and positive comments from business television experts one would have thought the all clear signal had been given about the recession. The economy did lose less jobs (539,000 vs. 699,000) than last month but only because the government has begun to hire workers for the next census (2010) and the Labor Dept.’s faulty seasonal adjustment number added 226,000 jobs that were NOT created in the real world. The U.S. population continues to grow each month so losing jobs is not any sign of strength but if you are sinking in quick sand at a slower rate than before it might appear that you might live a little longer but you are still sinking. Unfortunately the U.S. economy is not binary in that we either go up sharply or down quickly. The next 10 years will see spurts of slow growth and decline frustrating both bulls and bears until they all give up and leave the arena. For better or worse we have elected a president that doesn’t want anyone to earn over $250,000 per year and wants to raise taxes on anyone making more than that amount. Risk taking is an essential part of any economic rebound and lowering capital gains taxes or income taxes is probably not something we are going to see in the next four years. States with the lowest tax rates are experiencing the lowest unemployment rates and highest job growth in the nation. The country is going to spend the next four years muddling through and probably seeing a continued decline in economic activity interspersed with periods of what appears to be a return to old times but the de-leveraging process that began two years ago will take at least another ten to complete.

Back up the truck investments will be few this year and the window of opportunity small for investors who must prepare and not wait until they read about it on the internet or hear it on business television. If you need to have numerous sources agree before you make a decision you will be doomed to the same results we saw from those that overstayed their welcome in the stock market and then finally sold out in March with the rationalization that it was ok because everyone else lost just as much as you. Losing in company may feel better initially but over time the pain of having reduced savings and spending power should be a reminder that winning alone allows you to earn a living and save for the future. A willingness to change is the key to surviving 2009 and an understanding that history does repeat but not always when expected. Investors must stop believing that because they read it, hear it or a friend told them that it must be correct. A healthy dose of skepticism and always asking why when someone gives you their opinion or recommendation (stocks, interest rates, real estate) will give you a solid foundation for the events of the next couple of years. Instead of trying to find winning forecasters have you ever thought about following losers? Yes, those experts that are always wrong but somehow have a loyal group that hangs on every word. Try it and you will find it to be very profitable. I will be discussing this at my next class on June 10th in Los Angeles or my webinar on June 11th.

Lastly don’t ever forget that markets are rallying because of support and liquidity from the federal government after being near death (banks) just a couple of months ago. If the feds pulled out the tubes in the next few months markets (and banks) would go right back to where they were earlier this year. The patient is alive and will recover but not for many years despite all of the prognostications by those who need to see the world as they wish it to be NOT as it is today.