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.

If you would like my thoughts and ideas five nights a week please visit: http://www.earlywarningwire.com/Interest%20Rate%20Email%20Flyer.pdf.