April 5, 2004  Interesting Interest Rate Perspective

Interesting article written by Martin Weiss on April 5, 2004.  His discussion of interest rates, as well as his recollection of his dad were quite interesting for me to read.  Hence I wanted to share with the readers of our site.  Mr. Weiss' site is www.martinweiss.com  . 

 

 

Dear Ron,

The last two weeks were among the worst for the U.S. bond market in recent memory. Long-term Treasury bond prices began tumbling on March 24th and have been mostly falling ever since.

Then, this past Friday, in response to the news from the labor department, bond prices suffered their WORST SINGLE-DAY DECLINE IN EIGHT YEARS!

Big banks and brokerage firms in the U.S. scrambled to dump their U.S. Treasury notes and bonds.

Central banks in Japan, China and other Asian countries, which had also loaded up on U.S. Treasury bonds recently, followed suit.

Everywhere, bond investors got clobbered with heavy losses.

By the time it was all over, the price on the longest-term Treasury bond plunged by more than 6 points in two weeks, the equivalent of about 600 points on the Dow. Interest rates, which invariably go up when bond prices fall, shot through the roof.

Long-term Treasury yields rose by nearly HALF of a full percent, driving up the interest rates on mortgage bonds, corporate bonds and municipal bonds.

Interest rates also surged in London, where investors had already been anticipating an official rate hike ... in Tokyo, where 10-year interest rates jumped to a five-month high ... in Paris and Frankfurt ... Hong Kong and Taipei ... Buenos Aires and São Paulo.

Suddenly and without warning, it seems the world's extended honeymoon with low interest rates is over, and a new period of rising rates has begun.

THE ACHILLES' HEEL OF THE WORLD RECOVERY

Strangely, interest rates are among the most widely ignored and least understood phenomena of our time. Even some of the most sophisticated investors don't quite get it.

They think interest rates are largely controlled by the Federal Reserve, which is not true.

They think interest rates and inflation are joined at the hip, like Siamese twins -- also not true.

Worst of all, they see rising interest rates as little more than a passing annoyance, a small price to pay for all the grand benefits bestowed upon us by an expanding economy. In reality, rising interest rates are the great Achilles' heel of the economic recovery.


DAD'S STORY

I first learned about interest rates from my father, J. Irving Weiss.

When I was just six, he'd sit me on his lap and somehow manage to explain to me how money, like a toy or a loaf of bread, always came with a price.

Like any other item, he said, sometimes money is more expensive, sometimes it's cheaper. That's the interest rate going up and down.

Dad was also a great story-teller. But while other parents read to their children from Hans Christian Andersen or Charles Dickens, Dad stuck exclusively with non-fiction, telling me stories about his own learning experiences. Later, when I was older, he told me this one about interest rates ...

"In the bear market of the early 1930s," Dad recounted, "virtually no one was paying much attention to interest rates -- certainly not me. I was focused entirely on the stock market. I was still in my early 20s and I knew virtually nothing about interest rates.

"I figured interest rates were just another form of inflation. When we had more inflation, interest rates would go up. When we had less inflation or actual deflation, interest rates would fall. Since deflation was raging, I naturally assumed that interest rates were not an issue.

"In those days, nobody looked at interest rates as being separate from inflation, and neither did I. Boy, was I in for a big surprise! In fact, just as I began to watch rates more carefully, every single thing I knew about interest rates -- which wasn't very much -- went by the wayside.

"Interest rates had fallen sharply during the stock market crash, which was to be expected. Then something absolutely astounding happened. Although we were still experiencing deflation, although the economy was still sinking, interest rates began to surge dramatically. The immediate reason: Bond markets collapsed."


BABIES WITH THE BATHWATER

"To understand why, consider this hypothetical example: In 1929, an investor puts $1,000 in a General Motors bond paying 3% per year, or $30 interest. But after the crash, this investor is among the many that fears GM might go broke. So he dumps the bond on the market and gets $500 for it.

"Since this bond is still paying 3% a year, the new buyer now still makes $30 in interest per year. But he has only paid $500 for the investment. So on HIS $500, the $30 interest actually comes to 6%. In other words, as the price of the bond fell in half, the yield doubled.

"But when I saw interest rates surging, I didn't understand the cause. Was it inflation coming back? Was the world turning upside down? That's when I began to look at interest rates as a powerful, fundamental force in their own right.

"The yields on low-grade corporate bonds were the first to surge as their prices plunged. It was like an aftershock from the stock market crash, but with a long time lag.

"This made sense because these were bad bonds. They were issued by companies which were defaulting on their payments. A lot of the companies simply ceased to exist. So it was natural that their bonds should become worthless. The yields went to 15%, 20%, 30%. But what good was it if you lost your principal?

"Then high-grade corporate bonds also got hit hard. Investors feared that any company -- regardless of their rating -- could go belly up, and they were right! At some companies, finances deteriorated so quickly that, by the time the analysts got around to downgrading them, it was too late.

"Amazingly, high-grade corporate bond yields surged past their pre-crash highs as their prices crashed. Someone was selling the heck out of them.

"You'd think that at least Treasury bonds would be protected from this selling panic. They weren't. Investors sold them by the boatload, driving their prices to new lows, just like the corporate bonds. The interest rates on Treasury bonds surged.

"Where was all the selling coming from? What drove interest rates up when every textbook in existence said they should be going down? It wasn't until many years later that I began to put it all together.

"To understand what was going on, I had to throw all the traditional theories about interest rates into the trash can. I had to forget about inflation, deflation, money supply, and the Federal Reserve.

"Instead, I looked at bonds like any other kind of investment -- no different from stocks or commodities. When investors sold them, they went down in price. When investors bought them, they went up. Simple.

"These investors didn't give a hoot about textbooks. All they cared about was the fact that they had bought too many of them. They had speculated heavily on rising bond prices -- just like other investors had speculated on rising stock prices. Now they were overloaded, their portfolios bulging with bonds bought at sky-high prices.

"In other words, the bond market was a BUBBLE -- just like the stock market had been a bubble years earlier. When the bond bubble burst, these investors stampeded to the exits, and it was every many for himself.

"Tremendous amounts of bonds were dumped on the market. High-grade bonds. Low-grade bonds. Muni bonds. Treasury bonds. It didn't matter what color or denomination. Everywhere, big financial institutions and businesses were getting rid of their bonds."


THE INFLATION EXCUSE

"I asked some of my business friends WHY they were selling the bonds. They talked about 'inflation coming back,' about the danger of 'reflation,' as they called it.

"True, the pace of deflation had slowed temporarily. And true, some commodity prices were jumping. But later, I realized that most of the inflation talk was just an excuse. The main reason they sold the bonds was because they were afraid they were going to get stuck with huge losses. Or because they needed the money.

"The bond selling was especially severe among those that traded for banks or insurance companies. They had a big fear that losses in their bond portfolios would wipe out whatever remained of their capital. So they had no choice. They HAD to sell or they'd go bankrupt."


THE FEDERAL RESERVE WAS POWERLESS

"The folks at Federal Reserve wanted to do something about the bond market crash of the early 1930s, but they were powerless. Most people couldn't understand why, and nor could I. But later in my career, I figured it out.

"First, the Fed doesn't have any direct control over bonds. They don't fix the bond prices and they don't set the bond interest rates. That's almost entirely done by the market, by the forces of supply and demand for bonds.

"Second, there are special times in an interest rate cycle, when even the Fed's control over official interest rates is useless:

"If the Fed lowers interest rates, investors say it's acting recklessly, and they're going to bring back inflation. So the investors sell their bonds.

"If the Fed raises rates, investors figure that's even worse. So they sell even MORE bonds.

"Either way, the Fed is stuck in the middle. Powerless.

"This is especially true when interest rates fall to rock bottom levels, like they did after the crash of '29. How can the Fed lower official interest rates if they are ALREADY close to zero?

"Obviously, the Fed has only two choices: To raise rates or NOT to raise rates. That's not exactly a stable situation. But that was the situation we had in the early 1930s."


HOW I LEARNED ABOUT INTEREST RATES

"I finally learned a lot more about interest rates years later, when I was in my late 30s and early 40s.

"The man who taught me was my good friend, Dana Skinner. He was a mentor to me, patiently walking me through the history of interest rates and the ins and outs of the bond markets.

"From what I recall, he was also a mentor to a bond trader on Wall Street by the name of William Townsend, who I met a few times. Bill later went on to partner with a young man named Alan Greenspan, creating Greenspan, Townsend & Co., Inc., a small research firm with some large business clients.

"But Mr. Greenspan himself didn't learn the same lessons about interest rates from Townsend as I learned from Skinner.

"I can't say I know more about interest rates than Greenspan. But I can say that I see them in an entirely different light than he does.

"Since Greenspan didn't personally experience the bond market crash of the early 1930s, he's probably among those who figure it was mostly caused by a Federal Reserve policy blunder.

"That's what the historians have written. In fact, those same historians say it was the Fed that was mostly to blame for the severity of the ensuing depression.

"Hogwash! I was there. The historians weren't. The Fed didn't cause the depression. As I just explained to you, the Fed had no choice but to raise official interest rates. Why?

"Three reasons ...

"First because lowering them was virtually impossible -- they were ALREADY close to rock bottom.

"Second, because so many bond investors were afraid of inflation and 'reflation.' The Fed had to do SOMETHING to send the signal it meant business. So it had to raise rates.

"Third, people don't realize that even back then, our borders were wide open. Money flowed back and forth from America to Europe, especially Britain. So unless the Fed let U.S. official rates rise, American capital, already in short supply, would escape overseas.

"Mark my words: If the Federal Reserve ever pushes interest rates down to rock bottom levels again, they're going to be in exactly the same predicament. Precisely when higher interest rates are the biggest threat to the economy -- that's when they're going to have to jack 'em up again."


BACK TO THE PRESENT

Whenever I look at the Federal Reserve and the bond market today, Dad's words ring in my ears, and I see the uncanny similarities between his experiences and ours.

As in the early 1930s, we have recently experienced a prolonged stock market decline. As in those days, interest rates have been driven to historic lows -- the lowest in 45 years. Also like then, the Federal Reserve has only two choices: To raise official rates or NOT to raise them.

If the Fed fails to raise interest rates, it risks losing all credibility. Investors loaded with bonds will dump them out of fear of returning inflation -- just like they did in the early 1930s ... just like they did this past Friday.

International investors, in particular, who have far more access to foreign money markets and foreign bonds, will rush out of the United States to countries that are ALREADY offering much higher yields. The dollar will plunge. Bond investors will sell still more. Market interest rates -- the ones the Fed does NOT control -- will surge even further.

If the Fed DOES raise its official interest rates, the net result will be the same: A panic to dump bonds and the return of higher interest rates.

Why? Because no one in his right mind will believe this is the Fed's "first and last" interest rate hike. Everyone will be convinced -- and rightfully so -- that it's just the first interest rate hike of MANY.

Despite the similarities, however, there is one big difference between my Dad's experiences in the early 1930s and our situation now:

Back then, the use of credit and debt in America was not nearly as widespread as it is today.

The average family was not up to its ears in credit cards or second mortgages. They didn't even exist!

The federal government was in far better shape financially. It wasn't about to sell tens of billions in new notes or bonds, like it is this week and as far as the eye can see.

Even cities and states, despite their difficulties in the 1920s, were healthier.

That means that rising interest rates are potentially a lot deadlier today than they were then.

With that in mind, the Fed may try to put up a wall of resistance a while longer, keeping a tight lid on its target for Federal fund -- the official rate which has become its primary focus in recent years. But it's a pressure cooker. Once they raise the lid ever so slightly, it will explode.

Watch out! Learn the lessons of my father's experience. Don't underestimate the power of rising interest rates to change the future course of the economy, and your personal future as well.

One last thought: Don't expect rising interest rates to douse the boom in gold and other natural resources, especially while the Fed is still resisting the rise. It's only much later, after the Fed has pro-actively pushed rates much higher, that it will be time to take your profits in gold-related investments.

Good luck and God bless!

Martin

Martin D. Weiss, Ph.D.
Editor, Safe Money Report
Chairman, Weiss Ratings, Inc.
martinonmonday@weissinc.com