Higher Rates Reflect Default Risk
By
Paul Lamont
June
14, 2007
From
our last report on the Panic of 1837, titled ‘May 10th Credit Collapse’:
“In
late 1836, the Bank of England concerned with inflation raised interest rates.
As rates rose in England, credit tightened, and U.S. asset prices began to
fall. On May 10th, investors panicked and scrambled for cash.”
The markets are now tightening credit with higher
interest rates. The 10 year Treasury Bond has recently confirmed its break out
of the 1982-2006 trend channel.
This
movement caused Bill Gross, manager of the world’s largest bond fund to remark
that he’s “now a bear market manager.” He also asked investors to consider:
“These
increases in rates over the past few days have placed the 30-year mortgage
market at close to 7% in conventional terms…This will decimate the housing
market if it wasn’t already decimated before, and certainly put the Fed on
hold, and maybe allow the Fed to reduce rates…six to nine months from now.”
To
financial historians, the increase in bond rates comes as no surprise. At the end
of every credit boom, there has always been a realization point that the debts
(yes, even mortgages) accumulated during the boom have become unsustainable.
Interest rates (the cost of debt), then rise to reflect the increase in default
risk.
The Last Time This Happened
The
historical chart below comes from data from Ian Gordon:
www.thelongwaveanalyst.ca. During a period of falling interest rates from
1920-1928, a credit boom contributed to speculation in subdivisions, Florida
beachfront properties, skyscrapers, and most famously stocks. In 1928, the U.S.
Treasury Bond similarly broke out of the channel and rose to a higher yield.
This coincided with the end of ‘easy’ money which forced the deleveraging of
the economy and concluded with the financial crisis of 1929-1932.
To
see a striking comparison of the two periods, see the Bond Buyer 20-bond Index
below, which is a composite of long-term municipal bonds rated A or better.
This chart, provided by Elliotwave.com, is in price, so a fall reflects an
increase in yield.
With
debt becoming more expensive, leveraged assets are less profitable or
unprofitable to hold. So assets are sold and price falls. With the drop in
price, more leveraged positions have to be liquidated. The vicious cycle feeds
on itself until the debt is destroyed. This is what happened in the forced
selling of positions to cover margin calls in the 1929 stock market crash. It
is now manifesting itself in the foreclosures on U.S. real estate. As we
reported in May 10th Credit
Collapse, $1 Trillion dollars of ARM’s will be resetting to higher rates
over the next 5 years. The margin calls are coming due.
Couldn’t The
Fed Prevent This Today?
Common perception is that the Federal Reserve could
somehow stave off the credit bust. Let’s take a look at their track record.
Murray Rothbard, in the A History of Money and Banking in the United States
describes the action of the Fed in 1931:
“The Fed promptly went into an enormous binge of
buying government securities, unprecedented at the time. The Fed purchased $1.1
Billion of government securities from the end of February to the end of July,
raising its holdings to $1.8 Billion. The Fed, under Meyer, did its mightiest
to inflate the money supply-yet despite its efforts, total bank reserves only
rose by $212 million while the total money supply fell by $3 Billion.”
Why wasn’t this successful? He continues: “The more that
Hoover and the Fed tried to inflate, the more worried the market and the public
became about the dollar, the more gold flowed out of banks, and the more
deposits were redeemed for cash.” So the Federal Reserve can print money, but
it cannot create credit or confidence. ‘Money’ is therefore hoarded, by either
the public or the banks themselves (if they are concerned about an increase in
redemptions).
***As we go to
press: A Bear Stearns’ Hedge Fund: High-Grade Structured Credit Strategies
Enhanced Leverage Fund is “scrambling to sell $4 Billion in mortgage-backed
securities to prepare for investor redemptions and margin calls.” According to
BusinessWeek, the highly leveraged fund is down 23% this year (April losses at
18.97%) due to bad bets on subprime. Because of its lack of cash, it has
currently suspended redemptions. One investor, who had been trying to get out
since February, commented: “At the end of the day, I’d like someone to be
honest with me about what’s going on.” In a June 8th conference call,
Bear Stearns responded with: “We are not taking any questions.”
Our Position
We have been advising over the last 7 months to sell
assets as this credit boom comes to an end. It is always better to get out with
cash profits than to have your funds frozen or stuck in bankruptcy. Therefore
we continue to recommend to investors to sell assets and hold interest-bearing
cash at a secure financial institution. For more about our investment
management services, visit our website.
Starting in July, our monthly Investment
Analysis Report will require a subscription fee of $40 a month. Current
subscribers should have received their PayPal invoice for half price ($20 a
month). To sign up for our Investment Analysis Reports subscribe at FeedBlitz.com.
Copyright ©2007 Lamont
Trading Advisors, Inc. Paul J. Lamont is President of Lamont Trading
Advisors, Inc., a registered investment advisor in the State of Alabama.
Persons in states outside of Alabama should be aware that we are relying on de
minimis contact rules within their respective home state. For more information
about our firm, or to receive a copy of our disclosure form ADV, please email
us at advrequest@ltadvisors.net, or call (256) 850-4161.