#7 THE ENDGAME: When the Fed RAISES Interest Rates

[SilverRose09]

HI Mr Fed,

Do you know that commercial banks have 700 billion parked on the Fed. to buy treasuries for a while, I wonder what this will mean? That they can hold interest rates low by buying their own treasuries?

[Crashof2008]

This represents that during the crisis banks lost faith in each other, but not the Fed. They were more interested in return OF their capital than return ON their capital. Additionally, because the Fed began paying interest on such deposits, this encouraged this type of behavior.

[lorax2013]

Yes, if rates rose dramatically, it would be extremely deflationary at the moment. It would also create massive defaults and ultimately a default on US govt debt - either directly or behind the scenes thru the necessity of buying up our own T bills offshore. So once the US had in effect defaulted on their debt obligations you would have currency collapse. Either way, the dollar ultimately loses in value - looking at the big picture, you can't run up debt and not hurt the currency.

[Crashof2008]

You assume a fact not in evidence, that the US will default on its debt. That isn't going to happen while Volcker is in charge.

But it's impossible to convey this to most Americans. Europeans understand it, but Americans can't seem to grasp it.

[lorax2013]

Yes, if you could guess when the recession would start and stop better than bond traders you could jump in and out of the bond market at the right time - obviously. You could have done the same thing in the 2001 recession. Problem is, you have to time it right or you get stuck with rapidly devaluing T bills just like after 2002.

[Crashof2008]

Look at the enormous capital gains made by holders of Treasuries over the last year. Bought on margin, they have made money hand over fist.

If you don't feel comfortable riding the yield curve, that's your choice. But that is how fortunes are made. And not many fortunes will be made in this Depression.

[supergnorf]

thank you, been watching your clips with great interest, insightful and good (if not light/optimistic) analysis.

[777aqua777]

hello Mr Fed ,..thankyou for your videos they are much appreciated ,they are as good as doing a course and are a timely reminder to us all.. please could we have a new video ? as this would be appreciated by all.thankyou.

[jasy221]

Mr fed you are so correct,george soros forced

norman lamont to raise interest rates to 15% to support the pound when traders shorted it,but it only was forcing the UK into recession,and he had to reduce interest rates by 5% or so which led traders to sell the pound,the BoE was definately following the markets lead,and got beaten, i hope you make some more videos,as a former market maker you have a lot of insight. I hope to purchase JP morgan for 30p per share in the next few years, hehe!

[JackNeedles]

This guy rocks. I love his videos.

[marcusguernsey]

with the dow hitting 11600 region,the fed held the 2 percent level, oil is way down since the 147.level,even the dollar is re-bounding (A bit) most people agree the credit crunch has only just begun......so is a 1000 point correction in order or is the market going to continue to plug along "sideways" ?? And are we in a recession or not? Forcast for 3q and 4q is less then 1 %  are we on the edge of a great storm or what?

[Crashof2008]

The accounting reports and financials are only AUDITED once every year, those arrive in January.

That's when there are FAR FEWER accounting tricks at work.

[marcusguernsey]

if you watch msbc market watch, they make it out to seem that the FED is the supreme controllers of the economy, like you said, they can guide or influence the market, but i believe you, the fed does not solely control the entire economy.

[emerson134]

So if interest rates were to go much lower from here, then is that hyper-inflationary? It seems that has been the Fed game for a good part of the last decade, which has also lowered the USD against commodities and other currencies. So if interest rates were to go sky high, one could only assume the transverse environment?...Really enjoy your videos. Thank you.

[clayvessel]

Thanks Dr. Fed (I give you this title of distinction since your analysis is brilliant...)

You have explained the endgame very simply and very succinctly...

[Redpony68]

This man is brilliant. I think I have learned more from his videos today than any class I have taken in school.

[BrightAnarchist]

I agree. In fact, I think right now we just entered disinflation (slowing rate of inflation) that will soon turn into deflation. Gold has topped and so has oil; the dollar has bottomed and is set to soar; credit is collapsing; banks are collapsing; stocks are collapsing. Got treasuries?

[protodigm]

I agree extreme hyperinflation of dollar is most likely not possible cuz its like nuclear winter! hyperdeflation is like US taking penance for sins.

But the real result may not be extremes on both, its clear Bernanke is trying to navigate between a rock and a hard place.

Whats your thought on ultimately hyperdeflation vs coordinated worldwide inflation of ALL currencies so so its transparent. After all, eu is having similar problems.

Thanks for your responses!

[Crashof2008]

Actually, the EU response to this crisis differs markedly from the Fed response. Check the FT. Rates are high in EU comparatively, exacerbating dollar weakness and slowing down EU growth.

But Trichet could change.

Coordinated policy intervention has a better chance than unitary. It won't work if macroeconomic fundamentals are going against you.

But even the G8 is much smaller than stateless capital flows.

Such coordination is exactly what BOE and Fed talked about last week.

[protodigm]

Thanks for response

More concerns:

1. Dollar may be at bottom, Fed done lowering, other countries just starting. Higher dollar = more demand for treasury = no demand crash on treasury bubble?

2. If hyperdeflation is so imminent, why is there commodities bubble? You think it will just massively correct?

3. Fed funds = 2.25, long term loan/mortgage still 5+, there is ALREADY a major difference in long term rates discounted, you theorize this spread will rise even more?

[Crashof2008]

Hello, thanks for the good questions.

Like the Fed, I only deal in probabilities and likelihoods across a range of outcomes.

In #4 of this series, I stated that the risks of a hyperdeflationary burst have abated somewhat from the extreme weekend before the crash of Bear Stearns. It is still problematic, but somewhat less likely, although certain segments are still frozen up and there is an enormous amount of bad debt out there.

So the risk of a run on Treasuries has diminished somewhat

[Crashof2008]

My series of videos on the endgame were more to advise people why hyperinflation is quite unlikely, given the realities of the Treasuries market and the relatively small size (in holdings) of the Fed.

We share a similar assessment that this round of interest rate lowering in the US may be ending and the EU may well be poised to lower rates.

But this proves my point. That the Fed is intent on preserving the bull market in Treasuries, no matter what.

[zaber789]

"2. If hyperdeflation is so imminent, why is there commodities bubble? You think it will just massively correct?"

What commodity bubble...

How can there be a commodity bubble when supply and demand are out of whack?

[Crashof2008]

Your use of the term "print money" is outdated and vague.

Stay tuned this weekend for the videos on what actually happens at a Treasury auction and a day in the life of the open market trading desk at the NY Fed.

I recommend you be informed about the mechanics of the process; it will enhance your understanding and predictive ability.

[protodigm]

No one likes it but the US is simply too big and influential for the world to push to change its policies (iraq war). It is likely the inflation will continue for some time in the US's interest but at the expense of everyone else's. "strong dollar" is all lip service. Euro can't substitute right now as a alternative reserve currency, no UK and too much instability between euro countries. Dollar sucks but like it or not, theres no choice.

When/how do you think the US will be pushed to yield?

[protodigm]

You claim that the Fed will HAVE to eventually raise interest rates. While this is indeed true, they might not raise it anytime soon until recession is gone.

The US has lots of political muscle to push their inflationary policy whether foreigners like it or not. Foreigners devaluing treasuries would basically be shooting themselves in the foot since over half the world's wealth is in dollars.

If this was any other country (GB in past) doing this, there would've been a run long ago but not US.

[Crashof2008]

Your post limits itself unnecessarily to competing roles of sovereign central banks. This is outdated.

The capital flows from stateless actors now dwarf the sovereigns and must be included for accurate predictive analysis.

[b1gw1g]

Sorry for incoherent earlier posts - in too much of a hurry.

Print money is what happens when governments get desperate. Are you assuming that the rules won't change? Politicians always change the rules when expedient!

My contention is that under your scenario as interest rates rise (which I agree will happen) the govt will be between a rock and a hard place. Do you think they will accept the strictures of the market and downsize - or will they change the monetary rules?

Bigwig

[Crashof2008]

Bigwig, without tooting my own horn too much, I'd like to invite you to watch my video I'll post this weekend on Treasury auctions and a day in the life of the Open Market desk of the NY fed.

When I ask you to define "printing money", what is the precise mechanism whereby that is accomplished? Can you make a schematic of it?

I've always found that people using that phrase are unfamiliar with the Treasury auction process and the way the Fed works daily with their primary dealers.

[ewetubular]

You start to argue that future Fed rate actions will be deflationary.

What if the dollar isn't protectable? What if the world rejects the US dollar as the reserve currency? What if the trillions held by China etc are dumped in a rush for the exits? The value of the dollar will collapse, and bring with it much higher prices. Not because the US consumer is still spending, but because the WORLD is buying what we can no longer afford. This will lead to massively higher prices in the depression.

[Crashof2008]

You are assuming that decoupling would occur.

A subtle question, carefully reasoned, but that is a flaw in your reasoning.

But you understand my basic view. We face a risk of the market selling Treasuries and causing rates on Treasuries to skyrocket as they fell out of favor.

The Fed could only follow the market in bringing rates higher, and then lead the markets as it raised interest rates even further.

Because of coupling and interlinkages, hyperdeflation is therefore a big risk.

[Crashof2008]

As consumer demand plummets worldwide, prices also fall.

[joe60606]

Excellent videos, thank you for sharing.

Since the fed holding treasuries is a concern, what are your thoughts on the following:

Since Dec. 6, just before the Fed instituted its Term Auction Facility to auction loans to banks, its holdings of Treasury securities plummeted from $780 billion to an average of $589 billion in the week ended Wednesday.

As MacroMavens' Stephanie Pomboy points out, at this rate the Fed will be out of Treasuries before Labor Day, or Aug. 14 to be exact.

Source:Barron's

[jmborchers1974]

Here are some things I would consider:

Too many are expecting a stock market crash. This will prevent it from occuring quickly. I do think it will happen, just over time. The Plunge Protection Team (see wikipedia) was created after the 1987 crisis.

Our recent economic boom was by investing heavily in Asia and building it. That's just about complete as China's Shanghai market already has crashed 50%. Now no one wants involvement.

[markmti]

actually the mtg secondary market for subprime started to freeze up in Nov 2006, which put Bills Dallas Own-It down. The first real press it got was March with New Century folded. But all through Spring/Summer when they said it was 'contained' and rallied the markets to new highs, the mtg capital markets were in turmoil. Everyone likes to think this happened in Aug or Oct but thats just when Main Street found out and the crooks had to admit they were wrong because it was too big to keep a lid on

[daveextra]

mr fed, your describing a catastophic collapse ? dave over the pond

[barbaglia111]

The NY Fed has 800 Billion to trade with, but remember there are twelve Federal Reserve Banks, one in each of the Federal Reserve Districts in the United States

[Crashof2008]

Yes, but only the New York branch conducts open market operations.

[karetare]

What do the regional federal reserve banks do? Everything seems to done in New York.

[Crashof2008]

Good question. Some of them are of the view that they do not do enough. Four of them are allowed to sit (and vote) on the FOMC on a rotating, one-year basis. And it should be noted that 2 of them voted AGAINST this recent 3/4 percent cut a few weeks ago, so it is clear that there is a growing concern in the FOMC about the decline in the dollar. This trend could cause the Fed to RAISE interest rates in the future.

They also report on local economic conditions.

[JP5466]

I don't think the even Fed cares about the value of the USD. They only care about saving their pals on Wall Street.

The Fed has lowered the interest rates, yet credit cards and mortgage rates are still rising.

"Free market" days are over. The stock market is completely rigged and manipulated.

[jmborchers1974]

Yes, our gov't with the Fed are pinning up the stock market right now. Any bank news comes out and they buy the futures, options or equities of those banks forcing anyone short to cover. This is called the PPT.

[MaverickCentricity]

In the scenario you describe with the a rapid rise interest rates (I agree with you on this point), why would the Federal Reserve raise its interest rates? The bulk of Federal Government debt is based upon adjustable rate bonds, so a rapid rise in interest rates might cause a default. Bernanke will never allow the money supply to shrink, and if he has to print money all night and shower it onto the streets, he will do it. That's my perspective and why I looking for a inflationary depression.

[Crashof2008]

With all due respect, I recommend you read the Financial Times more.

Do a search for "Black Wednesday" on the web. You will learn from your search that the Bank of England was overwhelmed in its efforts to defend the pound because it was a puny player in the markets. That forced out Thatcher.

The Fed would similarly be overwhelmed. Look at the balance sheet of the Open Market Desk of the NY Fed. It's public info. They only have 800 billion to trade with at the open market desk.

[b1gw1g]

Mr Fed :-),

Three thoughts/questions (across posts to avoid limit).

1. I agree that the UK govt was unable to defend the pound and that the market overwhelmed them. However you seem to be arguing from that that

(i) the market always defeats government intervention

(ii) therefore deflation must occur.

I'm not sure whether your conclusion is correct, but I don't follow your logic.

[Crashof2008]

These are not my premises.

What is clear is that the relative strength of the sovereigns, either through unitary or coordinated intervention, is rapidly shrinking relative to stateless capital flows.

[OCForeclosures]

Interesting. So if the FED is looking to preserve the value of their treasuries and willing risk further deflation of housing turn economic growth negative, how does the average person hedge against this scenario?

Inquiring minds would like to know.