Charlie Brown And Higher Interest Rates…

Do you remember how Lucy always pulled the football each time Charlie Brown tried to kick it?  To this day, he’s fallen on his rear end and every time while Lucy just snickers.  This is exactly what the Federal Reserve has done since late 2009.  If you recall, we heard about “green shoots” in the economy and “recovery” has been the watch word ever since.  The one word you have not heard and certainly not seen is “expansion.”

You see, the real economy has never recovered and no matter how massaged or fudged the economic reports are, they cannot be altered enough to show genuine “expansion” when you scrape off the gold plating.  The Lucy/Charlie brown game has been “the Fed will raise rates later this year” …each and every year for the last five.  They are walking a tightrope where the ugly reality must be polished feverishly but not so much so that markets demand a rate hike.

The following chart (courtesy of friend M. Stevens) was generated directly from the St. Louis Fed website so what we will talk about today is directly from Federal Reserve data.

After glancing at this chart, does anything stand out to you?  What immediately stood out because it is in picture form is the inverse direction of interest rates and total debt.  I of course knew this and so probably did you, but as they say …a picture is worth a thousand words.  The inverse relationship began back in the 1980′s and becomes obvious by 1990, but why?  The answer to this is the very same answer as to why the Fed can NEVER ever raise rates again but we’ll get to that shortly.

Briefly explaining “how we got here”, the Fed has been forced several times to drastically lower interest rates since 1980.  We had the crash of 1987, the S and L crisis in the early 90′s, the dotcom bust in 2000-2001 and of course the real estate crash/great financial crisis of 2007-2009.  Each one of these booms which led to the bust were “conceived” by the lowered rates employed to alleviate the previous bust.  In other words, the tonic (lower rates) used to fix the current problem has each time led to a future crisis …until here we are at effectively zero percent interest rates.

I know you are thinking “but I already knew this”.  Do you believe the Fed knew this as they were doing it?  I believe the answer is an absolute YES!  “Yes” because they can do math as well as anyone else.   They realized the deficits which really began to swell in the 1980′s would lead to an overall debt level so high that nearly any positive interest rate would be unpayable!  Think about the math for a moment, here we are at close to $20 trillion public debt, what will happen if the Fed raises rates to even 4%?  We will be paying interest of $800 billion per year?  How about the unheard of level of 7%?  Do you see the math here?  After paying the interest, what will be left to run, much less improve the country?  Rates have been lowered to zero not to save the real economy but to make the federal debt a manageable budget item!  Don’t get me wrong, I understand the lower rates have also enabled the banking system to remain breathing and so far the derivatives blasting cap from going off.  The prime reason for these lower interest rates no matter what anyone tells you …is so the interest on the federal debt is “affordable”.

The purpose in my mind for showing you this chart is because interest rates are now just beginning to creep up on Treasury securities.  I am sure as we always have, soon hear, “higher interest rates will kill gold and silver”.  Without going into a full writing on this, it simply is not true.  Interest rates did nothing but go higher during the 1970′s when by 1980 gold traded up to $850 and silver $50.  What killed gold and silver were 15-20% interest rates competing with and popping the frothy bubbles.  You must understand this, America could “afford” these higher rates back then because we were not already leveraged up.  Corporations weren’t leveraged, neither were individuals.  The Treasury was not highly leveraged with well less than $2 trillion, and derivatives had barely been invented yet.  The U.S. simply cannot “afford” higher interest rates today.

My point is this, we may actually get higher interest rates put upon us by the market place but not by the Fed.  Will the Fed raise rates even one quarter of one percent?  Doubtful but it is possible.  I believe were we to see even a one quarter point rise in official rates, our financial markets will implode in less than a week’s time.  Higher rates will throw the $1 quadrillion+ derivatives market so far offside, the credit freeze up in late 2008 will not even be an appetizer but mere crackers to the main dish we will be served.

On Monday we wrote about Allen Greenspan and Lord Rothschild speaking of “risk” and how higher interest rates will pummel PE ratios.  Higher interest rates (or even the expectation of higher rates) will kill everything.  Stocks, bonds (obviously), make current pricing on real estate unaffordable, derivatives will blow up and destroy banks (brokers etc.) balance sheets …and last but not least show the U.S. Treasury as insolvent and unable “afford” the debt service.

To close, you will notice I used the word “afford” several times and tried to emphasize it with quotation marks.  I did this for a reason.  While we were not as a nation (world) very highly leveraged in the 1970′s, we are now.  We still had the ability to borrow back then, we no longer do.  The world has reached what I originally termed “debt saturation” levels back in 2007.  (As a side note, the flip side of debt saturation also normally means a lack of unencumbered collateral which is also the case today).  Waiting for the Fed to raise rates or you being afraid of these higher rates knocking the prices of gold and silver down are like Charlie Brown thinking he will finally get to kick the football!

The above said, this does not mean a bond rout cannot or will not happen.  U.S. Treasury bonds have been seen as “safety” during most all of our lifetimes and for good reason for many years.  This is no longer mathematically true.  The U.S. Treasury has more need for borrowings than the collective world wishes to purchase.  Were it not for the Fed (and BOJ and ECB), sovereign treasury securities would be going “un bid” at these current yields.  Instead, these central banks are bidding bond prices into negative yield territory, a truly senseless exercise and one that will blow up in our collective faces.  Were the Fed to announce any tightening no matter how small, our financial markets will be unrecognizable within a week’s time in my opinion …IF, they even remain open!

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Courtesy of www.milesfranklin.com