Beware lest you lose the substance by grasping at the shadow.
Aesop

Pray look better, sir. Those things yonder are no giants, but windmills.
Sancho Panza to Don Quixote

Financial markets are part fiction/part reality with public perception acting as the driver.

What drives markets over shorter periods of time is the belief system held by its active participants. This is no more evident than today’s widely held beliefs of a strong U.S. economic recovery with accompanying low inflation rates. While it is acknowledged that inflation rates may head up in an environment where financial markets are concerned over deflation, a slight up-tick in inflation is now welcome. In fact it is now viewed as a positive.

The U.S. economy is growing at its fastest rate since the mid-90’s. Yet these growth rates have failed to ignite the financial markets or create real jobs this year. Since January all of the major indexes have given up their gains and have now turned negative.

An element of uncertainty has been injected into the stock market. The Fed is in the process of changing monetary policy and will embark on a series of interest rate hikes that will raise borrowing costs in an economy that runs on credit. While speculators rest uneasily on pins and needles as to when the Fed will pull the trigger, the markets have already begun to react. As shown in the two charts below, interest rates on the 10-year note and the 30-year bond have risen by almost 100 basis points.

It's not a matter of if,
but when and how much.

Wall Street believes the Fed will embark on a rate renormalization program that will take the fed funds rate from its current 1% to a more neutral rate of 3%. This is an illusion. In an economy that has $35 trillion in debt, of which $15 trillion has been added in the last six years, a tripling of the federal funds rate would become disastrous. The financial sector has doubled its debt from $5,532 billion in 1997 to $11,402 billion in 2003.[1] The economy and the financial markets have become so leveraged that even slight increases in interest rates could bring the markets and economic activity to a screeching halt. In fact, it may end up collapsing both the financial markets and the economy.

What makes an aggressive change in Fed policy unlikely at this time is that the strength of the U.S. economic recovery is based on asset bubbles fed by debt, which supports consumption. In the last three years consumer mortgage financing doubled from $376.7 billion to $758.1 billion. Total consumer debt increased by $654.4 billion in 2001, $775.7 billion in 2002, and by $879.9 billion in 2003.[2] In addition to consumer and financial debt government, debt has also increased by nearly $1.5 trillion. By September 2003 (the end of the government's fiscal year), total debt stood at $6.8 trillion. Today that debt is $7 trillion and is now climbing rapidly as government deficits exceed $500 billion, ($700 billion if you count money borrowed from social security and other trust funds). It now takes $5.40 of debt to produce $1 of GDP growth.

The U.S. economic recovery is being driven by credit-induced asset bubbles, which are then monetized and turned into consumption. The main pillars of strength—consumer and government spending along with asset bubbles in housing, stocks, bonds, and mortgages—are all that keep the economy from slipping back into recession. With rates now rising, inflating asset bubbles in real estate and home equity extraction are in jeopardy. The same holds true for financial assets such as stocks and bonds, which are now negative for the year.

Bond Market is at The Wheel

Given all of the structural imbalances in our economy and in our financial markets, aggressive rate hikes by the Fed are an illusion. In fact, the Fed is impotent and in want of a policy Viagra. What is more relevant are the actions of the bond market. As shown in the charts above, interest rates have climbed close to 100 basis points. Since touching a low on March 16^th at 3.681%, the rate on the 10-year note has risen to today’s 4.8%. The 30-year bond has gone from a low of 4.643% to 5.5%. Mortgage rates keep climbing with 30-year fixed rates now averaging 6.12%. The bond market is controlling interest rates—not the Fed. Financial institutions are leveraged by 20:1 in the bond carry trade. A rise in bond yields could completely wipe out the equity of major financial institutions locked in the bond carry trade, interest rate swaps or derivatives.

Over the last three years, the rise in mortgage debt has led to ballooning balance sheet liabilities at Fannie and Freddie. Fannie and Freddie’s massive liabilities and interest rate risk have led to an explosive growth in interest rate-related derivatives underwritten by large Wall Street financial institutions led by J.P. Morgan, Citigroup, and Bank of America. As of last June, Wall Street firms had underwritten $844 billion in interest rate options sold over the previous 12-months.[3] Interest rate options have more than tripled since 1999. With mortgage debt now greater than Treasury debt, the need to hedge risk has never been greater. What essentially has transpired is that our financial markets have turned into one giant hedge fund with all of the major players linked by an umbilical cord.

Hedging Risk Like A Hot Potato

The economic recovery which began in November of 2001 was based on easy credit from financial institutions. Banks and financial intermediaries made mortgage loans. These mortgage loans were securitized and sold to financial institutions such as Fannie and Freddie, pension funds, and insurance companies. In order to hedge interest rate risk, large mortgage players, such as Fannie and Freddie, had to hedge their risk of prepayments. In order to hedge this risk, they turned to Wall Street buying interest rate options and futures to protect their risk exposure. Wall Street firms issue these derivatives, but in turn must hedge their own risk. They do this by offloading some of that risk with other derivative dealers or hedge funds. The risk is never eliminated. It just gets passed around like a hot potato.

In the financial business all risks aren’t evenly hedged. Players in the carry trade borrow short-term and invest long-term to make money on the spread between short and long-term rates. This is an uneven match. Wall Street firms may underwrite options and derivative contracts that are long-term, while they hedge their own risk with short-term contracts—another uneven match. Most of these contracts are of the OTC variety, which makes them less liquid.

Don't Rock The Boat!

The big $67 trillion dollar question is this: What happens if one of the big dealers, like Citigroup or J.P. Morgan, develop financial problems? Most of these derivative contracts have no ready market and are priced by theoretical models that assign values to these contracts. The real value of many of these contracts will be determined at the point of sale, assuming there will be a natural buyer on the other side of the trade when it comes time to sell.

This is the question that is keeping the big players and the Fed up at night. Nobody really knows the answer. This is another reason why the Fed has been slow and methodical in alerting the financial markets to a policy change. It hopes that hedged and unhedged positions can be unwound gradually without rocking the boat. It is trying to allow time for all of the players to shift over to the other side of the boat without sinking it. But as one Wall Street fund manager said recently, “Whenever the Federal Reserve starts a cycle of raising interest rates, somebody blows up.” The question is who will it be? What institution or hedge fund is on the wrong side of a trade? How big are they? Who are their counterparties?

Because the economic recovery is based on debt, it’s essential that the flow of money continues to grow. The American economy and the financial markets must continuously be fed with ever-larger amounts of credit. More money and credit is necessary to fund the mortgage and real estate markets. Buttressing consumers' net worth has been rising real estate prices, which is providing a free source of additional capital through refinancing to help fund consumption. In addition to funding consumption (the American economy is made up of over 70% consumption), the massive credit flows from the banking system is also propping up the real estate market. Higher real estate prices are the collateral that keeps the banking system solvent. A massive surge in bankruptcies would force real estate prices down and collateral would evaporate.

What would bring down real estate prices? A change in policy at the Fed designed to fight inflation. So policymakers will not only tolerate inflation, they will implement policies that actually foster it. The Fed has already mentioned on numerous occasions that it is willing to live with a certain level of inflation in order to avoid deflation. Governments can’t survive deflation. Asset values collapse, markets crumble, the economy contracts, unemployment goes up, tax revenues evaporate, and voters vent their wrath at the polls.

The Fed is unlikely to take the punch bowl away. An aggressive rate-raising cycle like 1994 is out of the question. It is doubtful whether we ever get beyond a 2-3 quarter-point rate hikes before a reversal in policy is put in place. The Fed and the U.S. government can’t afford to see the bond market collapse. Higher interest rates in a financial economy is a lot like pouring gasoline on a fire. It would set the fire ablaze. The financial markets are highly geared by a ratio of 20:1. Some players, through the use of debt and derivatives, may be higher than that. We have no savings in this country, so we are totally dependent on new sources of credit and the asset bubbles that support them. The last time the Fed raised interest rates was back in 1999 and in 2000. The stock market collapsed and the economy quickly head into recession. Tack on $15 trillion in new debt with $2 to 3 trillion of new debt being added each year and you can quickly see the Fed’s predicament. They have no way out but to inflate. The only difference in tightening that we are likely to see is between massive credit expansion or aggressive expansion of money supply. It is similar to the bartender serving double martinis or a bottle of beer.

Inflation is here in the form of rising money supply and credit.

The other illusion that exists in the marketplace is that there is no inflation. Remember, inflation is defined as an increase of money and credit in the financial system—not rising prices. Rising prices are a consequence of a rising money supply and credit. Credit can expand in several ways. It can expand through the traditional measure of bank lending. It can expand through the security markets or the Eurodollar markets. It can expand through monetization of assets such as real estate or securities. The point is there are many venues for expanding credit and they keep expanding each decade. The banks and the securities markets of today aren’t the traditional banks or securities markets of our grandfathers’ day. Today’s financial institutions—whether you call them a bank, brokerage firm, GSE, money market fund, mutual fund, pension fund or financial intermediary—are credit bubble machines, acting autonomously and many times in unison. All work to create credit in one form or another by issuing it, underwriting it, or investing in it.

As long as the present fiat money system exists without the backing of gold or silver, governments and their respective central banks will continue to spend more money than they take in. What they can’t politically finance through higher taxes, they will finance through credit or by printing money. This means we will experience inflation somewhere in the economy or the financial markets. Indeed as Mr. Bernanke has reminded us on numerous occasions, the central bank can print unlimited amounts of money, use other extraordinary measures, or intervene directly in the financial markets to prop up asset prices—be that bonds, stocks, mortgages, or real estate.

Moving to Zero?

In last year's Federal Reserve Bank of Dallas research paper titled “Monetary Policy in a Zero-Interest-Rate Economy,” Evan F. Koenig, Vice President, and Jim Dolmas, Senior Economist, argued that given the failure of conventional policy options, extraordinary measures may be necessary. They suggested modifying standard Fed policy. Chief among them was the purchase of assets that are not perfect substitutes for money. They suggested possible candidates:

1.  Foreign exchange
2.  Real goods and services
3.  Other domestic securities [4]

They further state that perhaps the simplest option is to buy domestic securities. Taking that a step further, they pose the idea of allowing other assets such as corporate bonds, commercial paper, equities and mortgages. What you have here is the groundwork for monetizing assets during the next downturn when we reach zero interest rates. There is a growing contingent within the financial community that believe that the miraculous turn-arounds that take place in the markets that originate from the futures pit is an example of this type of intervention. On Wall Street it is the equivalent of “Don’t ask. Don’t tell.” The cognoscente on Wall Street winks and turns their eye. Yet everyone knows, when they say that a large buyer stepped in and bought futures, who that is. Monetizing financial assets is simply another way of expanding money and credit in the financial system that may become part of standard policy if times get rough.

While economists and central bankers and the financial markets fret over deflation, Average Joes worry about how they are going to cover rising living costs. Do they have to borrow more money from their credit cards, extract more equity out of their homes, or downsize the family SUV? Inflation expectations are starting to rise. In due course, these expectations could generate additional inflation, especially if the "buy now, because tomorrow it will cost more" mentality begins to set in. Once that sets in, higher wages and much higher prices come next. As long as asset prices keep inflating, most people simply shrug and bear the higher costs. If their home values or their 401(k) plan inflate, everybody is happy. When they decline, they worry—translation: loss of confidence.

Producer and Consumer Price Fiction

As far as that giant fiction known as the PPI and CPI, the Average Joe isn’t buying it. Wall Street professionals may delude themselves that there is no inflation because the numbers officially say so. However on Main Street, everyone is aware of what is left in the checkbook at the end of the month. The official inflation numbers are so doctored and massaged that they now resemble a fictional novel more than they do statistical nonfiction. The official PPI and CPI numbers are no longer designed to capture real inflation. If they did, the government budget deficits would be much larger than they are currently. Many entitlements such as social security or government pensions have COLAs (cost of living adjustments). The COLAs are tied to the CPI. The lower the CPI numbers, the lower the adjustments.

With so much of the government's budget made up of entitlement payments (currently 54%) keeping the official CPI diluted helps to manage the deficits. If real inflation numbers were included, the government’s deficit could jump by another $70-80 billion a year.

So we will continue to have fictional CPI numbers far into the future. It is a political expediency. Does anyone really believe the official inflation number of 1.7%? According to the CPI, medical care inflation is averaging 4.5% over the last 12 months. To any business owner who has to pay healthcare premiums, this number is a great fiction. Our own healthcare premiums have been going up double digits for the last three years. Deductibles have risen and the insurance company is disallowing more services. Employer healthcare costs aren’t included in CPI. Healthcare costs as measured by CPI are kept low by artificial quality adjustments.

Many of the costs that are included in CPI get statistically massaged by these quality adjustments. It is one of the main tools used by government statisticians to keep prices lower. The price may have risen 8-10-12-15%, but after quality adjustments, we may get only a 1-2% price adjustment. This mechanism is used on everything from services to household goods.

Another glaring example of this is the issue of housing. Assuming you don’t live in a cave or the woods and live in a major city, it hasn’t escaped your notice that housing prices have been going up by high single or double-digits depending on where you live. Where I live in the People’s Republic of California, the average middle class home ranges from the low $400-$500's. Larger middle class homes with 3,000 or more square feet can range from high $700,000 to well over a million. In our small planned community, the city requires the developers to reserve and build a low income housing bloc. The developer near us broke ground in December and is now putting up structures. From the time the sign went up in January, the price rose by $100,000. Initially the sign said "low cost affordable housing from the low $400's." The sign changed last month. It now reads "low cost affordable housing from the low $500's." These homes have zero lot lines, no back or front yards to speak of and just enough street to back out your car. Homes are close enough that you will be able hear your neighbors' toilets flush, smell what they are cooking for dinner, and hear what they are watching on TV. This isn’t the neighborhood where Larry Lawnmower and Herbie Homeowner live. This is where Ricky Renter and Freddie Inflator live.

Low cost affordable housing from the low $500,000.

Housing inflation doesn't show up anywhere in the CPI numbers. Instead, the CPI cost of shelter has risen only 2.7% over the last year. This number is quite ridiculous, if you’ve recently bought or gone shopping for a home.  In computing the cost of shelter, the government doesn’t use home sale prices. In place of actual housing prices, the government calculates a theoretical cost for renting an average home. According to the wizards that compute this cost, it has gone up by a meager 2.7%.

These theoretical costs are a lot like the job numbers we get each month from the U.S. Department of Labor, which are another statistical work of fiction. Last month’s great jump in the job numbers was a real statistical miracle. The Department bases those numbers on two surveys. The first survey is known as the household survey and consists of a sample survey of 60,000 homes. The other survey is conducted by the U.S. Census Bureau and includes 160,000 businesses and government agencies. Last month nonfarm payrolls increased by a measly 7,000. After seasonal adjustments and statistical massaging, that number was magically transformed from a mere 7,000 to a magical market-busting 308,000.

Job growth, economic growth and inflation are real works of fiction. That is why on Main Street there is real worry. It explains in part why consumer confidence is trending downward. You see on Main Street there are no job heavens and monthly budgets can’t be statically massaged. On Main Street, the Average Joe is facing daily in-your-face price increases from gas at the pump to the price of Spam or a carton of milk. This is reality. On Wall Street and in Washington, they deal with illusions. There are no illusions for the average family of four with kids in school or a home in the suburbs.

Inflation is NOT Benign

As to why everyone on Wall Street insists that inflation rates are benign, I attribute that to self delusion. Everyone wants to believe that the bubble of the 90’s will come back again and that the good times are just around the corner. Ideology keeps them from assessing actual facts. There have been many falsehoods propagated by economists, analysts, anchors and reporters. Chief among them is that stocks are still cheap, there is no inflation, and as long as interest rates rise slowly, stocks will continue to do well.

To this list of falsehoods and illusions I would add rising interest rates are bad for gold and silver and good for stocks. Please examine the chart below of gold and interest rates courtesy of my friend Frank Barbera. You will notice that gold rose along with interest rates during the inflationary 70’s. They also fell spasmodically together during the disinflationary 80’s.That was because of the slow decline of inflationary expectations by the investment public. The idea that gold can’t rise during a period of rising inflation is simply false as evidenced by the charts below.

As to the idea that rising rates are good for stocks, please examine the chart of the Dow below. As a result of rising deficits, the loss of gold backing of the dollar, government programs of guns and butter (the Vietnam War and the Great Society), stocks went nowhere for almost 16 years. Not until Paul Volcker took the reins of the Fed did inflation decline.

Do you want to own something that is real, something that is tangible, which has served as money for over 5,000 years? Or do you want to own someone else’s liability? Maybe you prefer an asset that can deflate, default, or simply become worthless? The choice is yours. I say it is time to man the lifeboats, for we are heading for the storm of the century. Perhaps it will turn into the Perfect Financial Storm?

Watch the currency and bond markets. Watch the price of real estate in your neighborhood. Pay close attention to the prices all around you. And for goodness sake, take out an insurance policy—not on your life, but on your wealth. This means buy gold and silver bullion; buy gold and silver equities, while their prices have temporarily pulled back. Buy it, while you still can afford to. Buy it, when it is still available for delivery. After a flood, insurance becomes expensive. You need insurance before the earthquake or flood occurs. We are getting closer to the point of battening down the hatches—a time when we say, “'Thar she blows! Look out below!”