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Is Good Bad ?

05/30/2014

There has never been a time when Wall Street was NOT “climbing a wall of worry.”  Today, there is considerable angst, because interest rates are TOO low.  There are lots of interest rates but the benchmark that everybody watches is the rate on U.S. Treasury bonds that have a ten year maturity.  Those rates began the year at 3% and actually touched 2.4% yesterday before bouncing up slightly.  The vast majority of analysts have been predicting higher interest rates.  What’s going on?

Classical or Austrian School economists argue that interest rates are nothing more than the price of borrowing and is dependent on the supply of loanable funds and the demand to borrow those funds.  If people want to borrow more dollars than are available to be loaned, then the price of money (interest rates) will rise.  If the supply of money to be loaned exceeds the demand to borrow that money, then the price of money will drop.  Therefore, this unexpected drop in interest rates tells us that the demand for loanable funds has decreased, and yesterday’s downward revision to first quarter GDP supports that argument.  Growing businesses borrow money.  If GDP is decreasing, interest rates should fall.  (Second quarter GDP is expected to be much stronger, more like 3%.)

Quantitative easing is nothing more than buying Treasury bonds by the Fed.  If the Fed buys $10 billion less each month, then the demand for Treasury bonds decreases, which should drive up the interest rate that Treasury needs to pay in order to sell their bonds.  Four months into reduced quantitative easing, interest rates have gone the wrong way.

Overlaying this belief is the reality that people sometimes become afraid.  When Russia invades Ukraine, as I still expect to happen, the benchmark interest rate will fall.  Why?  Because people will sell stocks and move their cash into something risk-free, such as U.S. Treasury bonds.  So, has geo-political risk increased this year, causing interest rates to decrease.

Of course, there is a conspiracy theory.(There is ALWAYS a conspiracy theory.)  There is one account in Belgium that appears to be buying Treasuries at the same rate as quantitative easing is reduced.  Because that means purchases of tens of billions of dollars every month, the mystery owner must be a central bank like the ECB or even the IMF.  The obvious explanation is that there is an “understanding” or conspiracy among central bankers.  As an trader at TD Ameritrade points out, this is probably just bonds being transferred to Belgium from accounts outside of Belgium.

While I believe conspiracy theories are generally crutches of a lame mind, there may be some truth to this one.  It is not uncommon for there to be a “market–maker” for securities.  They keep the price of a particular security from swinging too violently.  If a large order to sell stock in ABC comes in, it could drive down the price of ABC  unreasonably.  Therefore, the market-maker buys enough ABC for his own portfolio to minimize the downward pressure.  Conversely, if a large order to buy ABC comes in, he will sell enough ABC from his own portfolio to control upward pressure on the price of the stock.  Since the dollar is the only reserve currency, violent swings could easily disrupt the world economy.  I would not be surprised if such an “understanding” exists but doubt it is anything new.

As the ECB has made clear, the euro is currently too expensive compared to the dollar.  If you cannot make the euro less expensive, you can certainly make the dollar more expensive by buying a lot of dollar-denominated debt.  BOOM – mystery solved?

Of course, one could spend a lifetime “looking at a gift horse in the mouth.”  For every month that rates stay this low, homeowners stuck with adjustable rate mortgages get a break.  Interest expense on corporate income statements is reduced, which drives up profit.  More importantly, U.S. taxpayers save money on their $17 TRILLION debt burden.  Remember rates dropped from 3% to 2.4% — NOT from 12% to 6%, which would be much more important.

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