Doing The Interest Rate Limbo

The Daily Reckoning Presents: John Mauldin coming down with a rare case of bullishness. We hope it’s not contagious…


I have a letter on the wall over my desk from John Wayne to my dad. The letter refers to some legendary WW II poker games. The Duke was gloating. He won. Dad lost. But Dad made it up from Wayne’s scotch horde.

My less than sainted father was a games player. His dictum: “Tell me the rules and deal the cards. Just don’t change the rules in the middle of the game.”

Following the Treasury announcement to ditch the 30-year bond, I am tempted to ask, are the rules changing?

Upon serious reflection I’ve determined the answer is an unequivocal: Maybe.

In a concerted effort worthy of an Afghan relief mission, the Fed, the Treasury department and the U.S. Congress are trying everything thing they can think of – rate cuts, bond offerings, stimulus packages and more – to re-stimulate the economy. Not the least of which was the Treasury’s announcement regarding the 30-year note.

It was a brilliant move. It almost makes me bullish.

But there is more to this than meets the eye, in my opinion. Let’s go behind the scenes and see if we can find some clues as to who is really driving this move.

Clue #1: The Fed has cut short-term rates 10 times, and most observers now concede we will see two more cuts, as advertised here months ago.

But the problem the Fed has is that long rates have not come down very much and it is long rates that really make a difference in the economy. Long-term rates are what affect corporate bottom lines and spur recoveries. Greenspan could help a lot of companies get profitable again if he could somehow get long-term rates to come down.

Greenspan cannot be happy about the economy. The economy is in severe risk, not to mention his aura of financial wizardry, as it is beginning to look like he is pushing on a string.

Clue #2: Peter Fisher. Remember that name. He was a former executive vice president at the New York Federal Reserve. He was point man for coordinating currency moves among central banks, and was a key figure in the rescue/fixing of the Long-Term Capital debacle in 1998. At 44, he is on the fast track.

He is now undersecretary at the Treasury department. He was the one who coordinated and made the announcement about 30-year bonds no longer being sold.

Clue #3: Home values have declined for two straight months at a significant pace, somewhere in the neighborhood of 6%. This is significant. We learned this week consumer confidence is down to 85.

Now in the grand scheme of things, and given the circumstances, that is not all that bad. It is certainly no where near any long-term low. There have been times in recent memory when 85 sounded pretty good. It is just that we have come from such extreme highs that 85 looks bad.

The reality is that the consumer confidence number is not all that bleak. As a country, we are still pretty optimistic. But those who really study these things know that consumer confidence is related very closely to employment and home values. We all know unemployment is headed much higher. But home values have been holding up surprisingly well. Since homes values are our central source of personal wealth, we are not all that negative.

But if home values continue to drop for another few months, the mood could turn sour very quickly.

Mortgage rates are a key component of home values. Mortgage rates are closely linked to the rate of the 10- year Treasury. But the Fed can only affect short-term rates. What’s a Fed chairman to do?

Clue #4: The country does need some economic stimulus. The $100 billion dollar stimulus package being shoved through Congress is peanuts in the grand scheme of things. We have just watched $5 TRILLION dollars disappear in stock market value. There are scores of companies who have watched their values drop by more than $100 Billion.

If mortgage rates drop by 1%, consumers save $1,000 per year on a $100,000 mortgage. Multiply that across the country, and that becomes huge. And it is every year, not a one time shot. And it doesn’t run up the deficit.

Clue #5: Goodbye surplus. Hello deficits. The country is now going to need to raise money. Let’s see. Short-term rates are really low and long-term rates are relatively high. If we borrow only short-term money, it will help the budget.

Clue #6: Long-term bonds serve a real role in the economy. They are used by businesses and pension funds to control risk. International investors and banks love them. Without going into a lot of detail, long-term bonds can be used as a way to guarantee returns on other, more risky, offerings. There is a real demand for these investment instruments.

If you cut off the supply of new long-term bonds, the remaining bonds become more valuable. It is the law of supply and demand in action.

Yesterday, long-term bond rates dropped over 40 basis points in one day, as investors scrambled to get a “piece of the Rock”. But did you notice that rates on10-year bonds dropped to 4.25%?

Let’s see if we can figure out what happened. Mind you,
this is just my speculation. First, Greenspan can’t get long-term rates to come down. He calls his buddy Fisher, now the senior guy at Treasury who actually understands where the levers are, and asks for help. Fisher goes to O’Neill and points out that if you stopped selling 30-year bonds you could:

1. Lower finance costs for the government for the growing deficit.
2. Push down the key rate to which mortgages are linked, thereby stimulating the economy.
3. Help prop up home values, thereby helping consumer confidence.
4. Lower the cost of corporate long-term borrowing, helping corporate profits.
5. You get to look brilliant and the only people who get
hurt are bond traders and a few hedge funds, and who cares about those whiners?

It is a no-brainer. And who better to do it than Fisher, who has a history of making surprise economic moves? It is like declaring Jacks are wild after you deal the hand and notice you are holding a pair of them.

And because no one suspected or planned for it, it will have a big effect. When we look back 5 years from now, I predict that many economists will point to this Halloween Trick or Treat as a big reason for the economic rebound. That’s right I said it…rebound.

Rate cuts do nothing to offset the deflationary winds sweeping the world economy. Deflation is going to push long-term rates even lower, which ultimately is bullish. Then things will change, and we will talk of inflation. But not for awhile.

Jamaican tourists invariably get prodded into a round of Limbo, seeing who can bend back the lowest to get under the bar. Interest rates are now doing the Limbo. How low can we go? Many of the interest rate gurus I follow think we will see 30-year long-term bond rates below 4% in this cycle. Some are talking closer to 3% than 4%. That means 10-year rates could approach 3%. That means mortgage rates could approach 5%. Already you can get 5.125% on a variable rate mortgage with a five year lock-up before adjustments.

I have been saying for years I think we will be able to borrow money at 5% for 30 years in this economic cycle. When that happens I will tell them to back up the truck. I might buy two homes just for the heck of it.

And if you are the government, here’s the best part. Just as you changed the rules and said “no more 30-year bonds,” you can change the rules again when rates drop close to 3%. Yes, you heard it here first. The government will sell 30-year bonds again. Hide and watch.

I am reminded of the Mel Brooks line in History of the World, Part Two, when he looked at the camera and dead- panned, “It’s good to be King.”

The guys up at Treasury must be thinking, “It’s good to make the rules, especially after the hand is dealt.”

John Mauldin,
November 11, 2001

for The Daily Reckoning

John Mauldin is the founder of the Millenium Wave investment strategy. He is a frequent contributor to the Fleet Street Letter.

“I don’t know,” writes a Daily Reckoning reader, “but it seems to me that if the Federal Reserve and Federal Government try hard enough, they can create inflation. And they are certainly trying very hard at the moment.”

Yes, they are. The Fed cut rates again yesterday…the 10th time this year.

You’ll recall the confidence that followed the first rate cut last January. Even if it failed to work, commented Ed Yardeni, “there are still 600 basis points from here to zero.”

Well, now there are only 200 basis points left. And there is no sign of any recovery. “A grim economy gets grimmer,” reports a Detroit Free Press headline. “More apartments standing empty,” notes the Rocky Mountain News.

“Could the U.S. be going down the same dismal economic path trod by Japan a decade ago?” asks the Wall Street Journal.

When the Japanese market cracked in January of 1990, explains the WSJ, “there was widespread confidence that the government could easily manage the downturn.” “Our foundations are solid,” said Yasuchi Mieno, the Alan Greenspan of Japan at the time.

What did the Japanese do? They cut rates…from 600 basis points down to zero. But their foundations proved to be made of jello. Twelve years later, and the news just keeps getting worse and worse. Last month, Japan saw its biggest monthly rise in unemployment and its sharpest drop in industrial production in 20 years.

What will happen in the U.S.? We will see, dear reader, we will see. But one thing we don’t see is anything to prevent the Fed from cutting rates all the way to zero, just like the Japanese. There is no sign of recovery…and no sign of inflation…

But let’s check in with Eric and see what he sees…


Eric Fry writing from New York…

– “Facing a choice between a small symbolic rate cut and a larger reduction likelier to please investors,” writes Igor Greenwald of, “the Federal Reserve reached for the big axe, chopping its benchmark rate by half a percentage point to a new 40-year low. The year’s 10th cut took the federal-funds rate to 2%, a token of the Fed’s long – but so far unsuccessful – campaign to reverse the economy’s slide into a recession.”

– So what. The stock market loves it…and isn’t that really all that matters? All the major stock averages soared to new post-Attack highs. The Dow gained a cool 150 points to 9,591, while the Nasdaq surged 2.3% to 1,835. And for the second day running, Internet stocks like “Chinadotcom” made a big splash – although not nearly as big a splash (or is that splat?) as they will make after this rally runs out of gas.

– Ironically, even as many stock market investors peer into the future and perceive the faint outline of an economic recovery ambling their way, commodity investors look into the very same shadowy future and see nothing but a black hole. The CRB Index of commodity prices is matching the S&P 500 Index downtick-for-uptick.

– Oil prices touched a fresh two-year low yesterday and most other commodities continue to drift lower as well. The CRB Index has fallen almost 20% so far this year. Demand seems to be the culprit – as in, there isn’t any. Consumers may be spending a little bit here and there. But most American companies aren’t.

– “Companies are consumers writ large,” writes Barron’s Alan Abelson. “When they earn more, they spend more…just as a more subdued mood begets retrenchment and job losses.” Retrenchment is the order of the day.

– Furthermore, Moody’s reports that corporate credit ratings are deteriorating significantly. Among the companies currently under its review, Moody’s will likely downgrade five for every one that it upgrades.

– Net-net, says Abelson, “The destruction of corporate profits that we’ve been suffering through for many long months now shows few, if any, signs of letting up, and recovery is apt to be both tentative and slow. If corporate profits are the key to jobs and jobs are the key to consumer behavior and consumer behavior is the key to whether the economy declines or rises, and the outlook for neither profits nor jobs nor consumer behavior nor the economy is bullish, why in the world is the stock market selling at 25 or 35 times earnings?

– “That’s a valuation more consonant with the tops of bull markets than the bottoms of bear markets,” Abelson reminds us, “and, in fact, [it] is three to four times the multiple at which bear markets have typically bottomed out. Maybe [the market is] on to something. Or maybe it’s just on something.”

– Is the bear market truly over? Or is it just taking a breather? James Grant, editor of Grant’s Interest Rate Observer, thinks the U.S. stock market has a little unfinished business: The bubble may have sprung a leak, but it still holds an air pocket or two.

– “When Osama bin Laden finally steps in front of a bus, the United States will be left with a more intractable foe, the legacy of its own boom,” writes Grant. Citing the work of Goldman Sachs economist, John Youngdahl, Grant compares Japan’s bubble in the late 1980s to America’s experience a decade later. “In each case, stock prices soared by about 25% a year for the half- decade under the speculative spell, while business fixed-investment outlays climbed at a greater than 10% rate, nearly double the rate of growth in private demand. In the aftermath, too, parallels are striking: in both countries, stock prices plunged by about one- third in the year-and-a-half after the peak.”

– Therefore, Grant wonders, “Will the U.S. follow Japan into a long stagnation? Unlikely, Youngdahl concludes: the Fed cut rates quickly and aggressively; the Bank of Japan dithered. U.S. fiscal policy turned easy fast, Japan’s not for three years. There is one catch, however. Americans owned more high-priced stocks than the Japanese did.” As of year-end 2000, stocks made up about 30% of America’s household wealth – or about twice as much as Japanese households held when the Nikkei peaked in 1990.

– To judge from Greenspan’s aggressive monetary response, the solution to the problem is elementary: reinflate the bubble.


Back in Baltimore…

*** Good news from Nicaragua…

*** “After a peaceful & long electoral day,” writes my friend Silvio Lacayo from Managua, “90% of the Nicaraguan voters elected Don Enrique Bolanos as the new President of Nicaragua. International accredited observers to the Nicaraguan elections give the new President an almost landslide victory over the Sandinista Party.”

*** “We couldn’t be more bullish about this place,” adds International Living editor Kathleen Peddicord. “It offers the last great property deals of Central America. It is the quintessential sun-drenched tropical paradise. And now it has assured the world of its commitment to peace and prosperity. Nicaragua has been largely misunderstood and undiscovered. This will change now. Maybe quickly.”

*** I hope it doesn’t change too much. I’m building a house on the Pacific Coast, where I like the wild solitude and the low prices. But it can be lonely for a gringo.

*** The biggest news today is that my son Edward turns 8years old. Happy birthday, Edward…

The Daily Reckoning