Long-Term Interest Rates

What Is Going To Happen If Interest Rates Continue To Rise Rapidly?

August 18, 2013August 16, 2013 by Michael

If you want to track how close we are to the next financial collapse, there is one number that you need to be watching above all others. The number that I am talking about is the yield on 10 year U.S. Treasuries, because it affects thousands of other interest rates in our financial system. When the yield on 10 year U.S. Treasuries goes up, that is bad for the U.S. economy because it pushes long-term interest rates up. When interest rates rise, it constricts the flow of credit, and a healthy flow of credit is absolutely essential to the debt-based system that we live in. Just imagine someone squeezing a tube that has water flowing through it. The higher interest rates go, the more economic activity will be squeezed. If interest rates continue to rise rapidly, it will be more expensive for the U.S. government to borrow money, it will be more expensive for state and local governments to borrow money, the housing market may crash again, consumer debt will become more expensive, junk bond investors will be in for a world of hurt, the stock market will experience a tremendous amount of pain and there is a good chance that we could see the 441 trillion dollar interest rate derivatives bubble implode. And that is just for starters.

So yes, we all need to be carefully watching the yield on 10 year U.S. Treasuries. On Friday, it opened at 2.76% and hit a high of 2.86% before closing at 2.83%. The yield on 10 year U.S. Treasuries is up nearly 120 basis points since the beginning of May, and almost everyone on Wall Street seems convinced that it is going to go much higher.

We are truly moving into unprecedented territory, because we have been in a bull market for U.S. Treasuries for the last 30 years. Many investors don’t even know that it is possible to lose money on U.S. Treasuries. They have been described as “risk-free” investments, but that is far from the truth.

In fact, we could see bond investors of all types end up losing trillions of dollars before it is all said and done.

And those in the stock market will lose lots of money too. Low interest rates are good for economic activity which is good for the stock market. The chart posted below shows that stock prices have generally risen as the yield on 10 year U.S. Treasuries has steadily declined over the past 30 years…

When interest rates rise, that is bad for economic activity and bad for stocks. That is why so many stock analysts are alarmed that interest rates are going up so rapidly right now.

And as I wrote about the other day, we have just witnessed the largest cluster of Hindenburg Omens that we have seen since before the last financial crisis. The stock market already seems ripe for a huge “adjustment”, and rising interest rates could give it a huge extra push in a negative direction.

By the time it is all said and done, stock market investors could end up losing trillions of dollars in the next stock market crash.

In addition, rising interest rates could easily precipitate another housing crash. As the Wall Street Journal discussed on Friday, as the yield on 10 year U.S. Treasuries goes up it will also cause mortgage rates to rise…

Higher yields will push up long-term borrowing cost for U.S. consumers and businesses. Mortgage rates will rise, and investors are keeping a close eye on whether this may derail the recovery of the housing market, which has shown signs of turning a corner this year.

In one of my previous articles, I included an example that shows just how powerful rising mortgage rates can be…

A year ago, the 30 year rate was sitting at 3.66 percent. The monthly payment on a 30 year, $300,000 mortgage at that rate would be $1374.07.

If the 30 year rate rises to 8 percent, the monthly payment on a 30 year, $300,000 mortgage at that rate would be $2201.29.

Does 8 percent sound crazy to you?

It shouldn’t. 8 percent was considered to be normal back in the year 2000.

If you own a $300,000 house today, do you think it will be easier to sell it or harder to sell it if mortgage rates skyrocket?

Yes, of course it will be much harder. In fact, there is a good chance that you will have to reduce your selling price significantly so that prospective buyers can afford the payments.

Let us hope that the yield on 10 year U.S. Treasuries levels off for a while. If it says at this current level, the damage will probably not be too bad.

But if it crosses the 3 percent mark and keeps soaring, things could get messy pretty quickly. In fact, according to a Bank of America Merrill Lynch investor survey, the 3.5 percent mark is when the collapse of the bond market is likely to become “disorderly”…

Our latest Credit Investor Survey, conducted July 8-11, showed that 3.5% on the 10-year is most commonly thought of as the trigger of a disorderly rotation – i.e. higher interest rates leading to outflows and wider credit spreads – among high grade investors.

Put differently, 3.0% on the 10-year will not lead to overall wider credit spreads if there is enough buying interest from institutional investors (though note that the 10s/30s spread curve would flatten further, as mutual fund/ETF holdings are concentrated in the belly of the curve, whereas institutional demand is disproportional in the long end of the curve). However, if the probability of a further move higher in interest rates to 3.5% is high – which will be the perception if interest rate volatility is high – certain institutional investors will choose to remain on the sidelines.

Thus there may not be enough institutional buying interest to mitigate retail fund outflows and contain overall high grade spread levels.

So what is causing this?

Well, there are a number of factors of course, but one very disturbing sign is that foreigners are selling off U.S. Treasuries at a pace that we have not seen since 2007…

One of the biggest fears in the financial markets is that foreign investors will stop buying U.S. Treasury securities, causing borrowing rates to surge.

Not that this is the beginning of a frightening trend, but new data from the Treasury Department shows that foreigners were net sellers in June. In fact, this is the largest net sale of U.S. securities since August 2007.

Do you remember all of the warnings that we have received over the years about what would take place when foreign countries started dumping U.S. debt?

Well, it looks like it may be starting to happen.

Unfortunately, there is no way that the party that the U.S. government has been throwing can continue without foreigners buying our debt. We have added more than 11 trillion dollars to the national debt since the year 2000, and according to Boston University economist Laurence Kotlikoff we are facing unfunded liabilities in future years that are in excess of 200 trillion dollars.

Even with foreigners continuing to loan us gigantic mountains of super cheap money, it would still take a doubling of our taxes to put us on a fiscally sustainable course…

Writing in the September issue of Finance and Development, a journal of the International Monetary Fund, Prof. Kotlikoff says the IMF itself has quietly confirmed that the U.S. is in terrible fiscal trouble – far worse than the Washington-based lender of last resort has previously acknowledged. “The U.S. fiscal gap is huge,” the IMF asserted in a June report. “Closing the fiscal gap requires a permanent annual fiscal adjustment equal to about 14 per cent of U.S. GDP.”

This sum is equal to all current U.S. federal taxes combined. The consequences of the IMF’s fiscal fix, a doubling of federal taxes in perpetuity, would be appalling – and possibly worse than appalling.

Prof. Kotlikoff says: “The IMF is saying that, to close this fiscal gap [by taxation] would require an immediate and permanent doubling of our personal income taxes, our corporate taxes and all other federal taxes.

“America’s fiscal gap is enormous – so massive that closing it appears impossible without immediate and radical reforms to its health care, tax and Social Security systems – as well as military and other discretionary spending cuts.”

Can you afford to pay twice as much in taxes to the federal government?

Very few Americans could.

But that is how serious the financial problems of the federal government are.

And all of the above assumes that interest payments on U.S. government debt will remain at current levels. If the average rate of interest on U.S. government debt rises to just 6 percent, the U.S. government will be paying out a trillion dollars a year just in interest on the national debt.

Also, all of the above assumes that we will have a healthy financial system that does not need to be bailed out again.

But if rapidly rising interest rates cause the 441 trillion dollar interest rate derivatives bubble to implode, the bailout that the “too big to fail” banks will need will likely be far, far larger than last time.

In fact, once that bubble bursts there probably will not be enough money in the entire world to fix it.

If the picture that I have painted above sounds bleak, that is because it is bleak.

Sometimes I get frustrated with myself because I don’t feel I am communicating the tremendous danger that we are facing accurately enough.

We are heading for the worst financial crisis in modern human history, and the debt-fueled prosperity that we are enjoying today is going to go away and it is never going to come back.

You can dismiss that as “doom and gloom” and stick your head in the sand if you want, but that isn’t going to help anything. Instead of ignoring reality you should be working hard to prepare your family for what is coming and warning others that they should be getting prepared too.

When a hurricane is approaching landfall, you don’t take your family out for a picnic at the beach. That would be foolish. Unfortunately, way too many Americans are acting as if nothing like the financial crisis of 2008 could ever possibly happen again.

If you deceive yourself into thinking that all of this is going to have a happy ending somehow, you are going to get blindsided by the coming storm.

But if you make preparations now, you might just be okay.

There is hope in understanding what is happening and there is hope in getting prepared.

So watch the yield on 10 year U.S. Treasuries. The higher it goes, the later in the game we are.

The Most Important Number In The Entire U.S. Economy

July 31, 2013 by Michael

There is one vitally important number that everyone needs to be watching right now, and it doesn’t have anything to do with unemployment, inflation or housing. If this number gets too high, it will collapse the entire U.S. financial system. The number that I am talking about is the yield on 10 year U.S. Treasuries. When that number goes up, long-term interest rates all across the financial system start increasing. When long-term interest rates rise, it becomes more expensive for the federal government to borrow money, it becomes more expensive for state and local governments to borrow money, existing bonds lose value and bond investors lose a lot of money, mortgage rates go up and monthly payments on new mortgages rise, and interest rates throughout the entire economy go up and this causes economic activity to slow down. On top of everything else, there are more than 440 trillion dollars worth of interest rate derivatives sitting out there, and rapidly rising interest rates could cause that gigantic time bomb to go off and implode our entire financial system. We are living in the midst of the greatest debt bubble in the history of the world, and the only way that the game can continue is for interest rates to stay super low. Unfortunately, the yield on 10 year U.S. Treasuries has started to rise, and many experts are projecting that it is going to continue to rise.

On August 2nd of last year, the yield on 10 year U.S. Treasuries was just 1.48%, and our entire debt-based economy was basking in the glow of ultra-low interest rates. But now things are rapidly changing. On Wednesday, the yield on 10 year U.S. Treasuries hit 2.70% before falling back to 2.58% on “good news” from the Federal Reserve.

Historically speaking, rates are still super low, but what is alarming is that it looks like we hit a “bottom” last year and that interest rates are only going to go up from here. In fact, according to CNBC many experts believe that we will soon be pushing up toward the 3 percent mark…

Round numbers like 1,700 on the S&P 500 are well and good, but savvy traders have their minds on another integer: 2.75 percent

That was the high for the 10-year yield this year, and traders say yields are bound to go back to that level. The one overhanging question is how stocks will react when they see that number.

“If we start to push up to new highs on the 10-year yield so that’s the 2.75 level—I think you’d probably see a bit of anxiety creep back into the marketplace,” Bank of America Merrill Lynch’s head of global technical strategy, MacNeil Curry, told “Futures Now” on Tuesday.

And Curry sees yields getting back to that level in the short term, and then some. “In the next couple of weeks to two months or so I think we’ve got a push coming up to the 2.85, 2.95 zone,” he said.

This rise in interest rates has been expected for a very long time – it is just that nobody knew exactly when it would happen. Now that it has begun, nobody is quite sure how high interest rates will eventually go. For some very interesting technical analysis, I encourage everyone to check out an article by Peter Brandt that you can find right here.

And all of this is very bad news for stocks. The chart below was created by Chartist Friend from Pittsburgh, and it shows that stock prices have generally risen as the yield on 10 year U.S. Treasuries has steadily declined over the past 30 years…

When interest rates go down, that spurs economic activity, and that is good for stock prices.

So when interest rates start going up rapidly, that is not a good thing for the stock market at all.

The Federal Reserve has tried to keep long-term interest rates down by wildly printing money and buying bonds, and even the suggestion that the Fed may eventually “taper” quantitative easing caused the yield on 10 year U.S. Treasuries to absolutely soar a few weeks ago.

So the Fed has backed off on the “taper” talk for now, but what happens if the yield on 10 year U.S. Treasuries continues to rise even with the wild money printing that the Fed has been doing?

At that point, the Fed would begin to totally lose control over the situation. And if that happens, Bill Fleckenstein told King World News the other day that he believes that we could see the stock market suddenly plunge by 25 percent…

Let’s say Ben (Bernanke) comes out tomorrow and says, ‘We are not going to taper.’ But let’s just say the bond market trades down anyway, and the next thing you know we go through the recent highs and a month from now the 10-Year is at 3%. And people start to realize they are not even tapering and the bond market is backed up….

They will say, ‘Why is this happening?’ Then they may realize the bond market is discounting the inflation we already have.

At some point the bond markets are going to say, ‘We are not comfortable with these policies.’ Obviously you can’t print money forever or no emerging country would ever have gone broke. So the bond market starts to back up and the economy gets worse than it is now because rates are rising. So the Fed says, ‘We can’t have this,’ and they decide to print more (money) and the bond market backs up (even more).

All of the sudden it becomes clear that money printing not only isn’t the solution, but it’s the problem. Well, with rates going from where they are to 3%+ on the 10-Year, one of these days the S&P futures are going to get destroyed. And if the computers ever get loose on the downside the market could break 25% in three days.

And as I have written about previously, we have seen a huge spike in margin debt in recent months, and this could make it even easier for a stock market collapse to happen. A recent note from Deutsche Bank explained precisely why margin debt is so dangerous…

Margin debt can be described as a tool used by stock speculators to borrow money from brokerages to buy more stock than they could otherwise afford on their own. These loans are collateralized by stock holdings, so when the market goes south, investors are either required to inject more cash/assets or become forced to sell immediately to pay off their loans – sometimes leading to mass pullouts or crashes.

But of much greater concern than a stock market crash is the 441 trillion dollar interest rate derivatives bubble that could implode if interest rates continue to rise rapidly.

Deutsche Bank is the largest bank in Europe, and at this point they have 55.6 trillion euros of total exposure to derivatives.

But the GDP of the entire nation of Germany is only about 2.7 trillion euros for a whole year.

We are facing a similar situation in the United States. Our GDP for 2013 will be somewhere between 15 and 16 trillion dollars, but many of our big banks have exposure to derivatives that absolutely dwarfs our GDP. The following numbers come from one of my previous articles entitled “The Coming Derivatives Panic That Will Destroy Global Financial Markets“…

JPMorgan Chase

Total Assets: $1,812,837,000,000 (just over 1.8 trillion dollars)

Total Exposure To Derivatives: $69,238,349,000,000 (more than 69 trillion dollars)

Citibank

Total Assets: $1,347,841,000,000 (a bit more than 1.3 trillion dollars)

Total Exposure To Derivatives: $52,150,970,000,000 (more than 52 trillion dollars)

Bank Of America

Total Assets: $1,445,093,000,000 (a bit more than 1.4 trillion dollars)

Total Exposure To Derivatives: $44,405,372,000,000 (more than 44 trillion dollars)

Goldman Sachs

Total Assets: $114,693,000,000 (a bit more than 114 billion dollars – yes, you read that correctly)

Total Exposure To Derivatives: $41,580,395,000,000 (more than 41 trillion dollars)

That means that the total exposure that Goldman Sachs has to derivatives contracts is more than 362 times greater than their total assets.

And remember, the biggest chunk of those derivatives contracts is made up of interest rate derivatives.

Just imagine what would happen if a life insurance company wrote millions upon millions of life insurance contracts and then everyone suddenly died.

What would happen to that life insurance company?

It would go completely broke of course.

Well, that is what our major banks are facing today.

They have written trillions upon trillions of dollars worth of interest rate derivatives contracts, and they are betting that interest rates will not go up rapidly.

But what if they do?

And the truth is that interest rates have a whole lot of room to go up. The chart below shows how the yield on 10 year U.S. Treasuries has moved over the past couple of decades…

As you can see, the yield on 10 year U.S. Treasuries was hovering around the 6 percent mark back in the year 2000.

Back in 1990, the yield on 10 year U.S. Treasuries hovered between 8 and 9 percent.

If we return to “normal” levels, our financial system will implode. There is no way that our debt-addicted system would be able to handle it.

So watch the yield on 10 year U.S. Treasuries very carefully. It is the most important number in the entire U.S. economy.

If that number gets too high, the game is over.

A Nightmare Scenario

July 16, 2013 by Michael

Most people have no idea that the U.S. financial system is on the brink of utter disaster. If interest rates continue to rise rapidly, the U.S. economy is going to be facing an economic crisis far greater than the one that erupted back in 2008. At this point, the economic paradigm that the Federal Reserve has constructed only works if interest rates remain super low. If they rise, everything falls apart. Much higher interest rates would mean crippling interest payments on the national debt, much higher borrowing costs for state and local governments, trillions of dollars of losses for bond investors, another devastating real estate crash and the possibility of a multi-trillion dollar derivatives meltdown. Everything depends on interest rates staying low. Unfortunately for the Fed, it only has a certain amount of control over long-term interest rates, and that control appears to be slipping. The yield on 10 year U.S. Treasuries has soared in recent weeks. So have mortgage rates. Fortunately, rates have leveled off for the moment, but if they resume their upward march we could be dealing with a nightmare scenario very, very quickly.

In particular, the yield on 10 year U.S. Treasuries is a very important number to watch. So much else in our financial system depends on that number as CNN recently explained…

Indeed, since May, just before Bernanke announced a probable end to QE3, the yield on 10-year Treasuries has jumped around almost one percentage point, to 2.6%, wiping out more than two years of interest payments. The markets clearly fear that far higher long-term rates are lurking in the absence of exceptional policies to rein them in.

That’s a crucial issue, because those rates are highly influential in determining the future performance of stocks, bonds, and real estate. Investors grant equities higher multiples when long-term rates are lower; both longer-maturity Treasuries and corporate bonds jump when rates decline; and developers pocket more cash flow from their projects when they borrow cheaply, raising the values of office and apartment buildings. When rates reverse course, so do all of those prices the Fed has been endeavoring to swell as a tonic for the economy.

Even though the yield on 10 year U.S. Treasuries has risen substantially, it is still very low. It has a lot more room to go up. In fact, as the chart posted below demonstrates, the yield on 10 year U.S. Treasuries was above 6 percent back in the year 2000…

And the yield on 10 year U.S. Treasuries should rise substantially. It simply is not rational to lend the U.S. government money at less than 3 percent when the real rate of inflation is about 8 percent, the Federal Reserve is rapidly debasing the currency by wildly printing money and the federal government has been piling up debt as if there is no tomorrow…

Anyone that lends the U.S. government money at current rates is being very foolish. You will end up getting back money that has much less purchasing power than you originally invested.

Why would anyone do that?

But if interest rates rise, the U.S. government could be looking at some very hairy interest payments very rapidly. For example, if the average rate of interest on U.S. government debt just gets back to 6 percent (and it has been far higher than that in the past), the federal government will be shelling out a trillion dollars a year just in interest on the national debt.

State and local governments all over the nation could also very rapidly be facing a nightmare scenario.

Detroit is already on the verge of formally declaring the largest municipal bankruptcy in the history of the United States, and there are many other state and local governments from coast to coast that are rapidly heading toward financial disaster even though borrowing costs are super low right now.

If interest rates start rising dramatically, it would cause a huge wave of municipal financial disasters, and municipal bond investors would lose massive amounts of money…

“Muni bond investors are in for the shock of their lives,” said financial advisor Ric Edelman. “For the past 30 years there hasn’t been interest rate risk.”

That risk can be extreme. A one-point rise in the interest rate could cut 10 percent of the value of a municipal bond with a longer duration, he said.

Many retail buyers, though, are not ready for the change and “when it starts, it will be too late for them to react,” he said, adding that he was encouraging investors to look at their portfolio allocation and make changes to protect themselves from interest rate risks now.

In fact, bond investors of all types could be facing monstrous losses if interest rates go up dramatically.

It is being projected that if U.S. Treasury yields rise by an average of 3 percentage points, it will cause bond investors to lose a trillion dollars.

And already we have started to see a race for the exits in the bond market. A total of 80 billion dollars was pulled out of bond funds during the month of June alone. If you want a visual of the flow of money out of the bond market, just check out the chart in this article.

We are witnessing things happen in the financial markets that have not happened in a very, very long time.

And junk bonds will be hit particularly hard. About a decade ago, the average yield on junk bonds was about twice what it is right now. When the junk bond crash comes, there is going to be mass carnage on Wall Street.

But of much greater importance to most Americans is what is happening to mortgage rates. As mortgage rates rise, it becomes much more difficult to sell a house and much more expensive to buy a house.

According to CNBC, there is an increasing amount of concern that the rise in mortgage rates that we are witnessing could throw the real estate market into absolute turmoil…

The housing recovery is in for a major pause due to higher mortgage rates. It is not in the numbers now, and it won’t be for a few months, but it is coming, according to one noted analyst. The market has seen rising rates before, but never so far so fast; there is no precedent for a 45 percent spike in just six weeks. The spike is causing a sense of urgency now, a rush to buy before rates go higher, but that will be short term. Home sales and home prices will both come down if rates don’t return to their lows, and the expectation is that they will not.

We have seen the number of mortgage applications fall for four weeks in a row, and at this point mortgage applications have declined by 28 percent over the past month.

That is an absolutely stunning decline, but it just shows the power of interest rates.

Let’s try to put this into real world terms.

A year ago, the 30 year rate was sitting at 3.66 percent. The monthly payment on a 30 year, $300,000 mortgage at that rate would be $1374.07.

If the 30 year rate rises to 8 percent, the monthly payment on a 30 year, $300,000 mortgage at that rate would be $2201.29.

Does 8 percent sound crazy to you?

It shouldn’t. 8 percent was considered to be normal back in the year 2000…

This is what we are talking about when we talk about the “bubbles” that the Federal Reserve has created. The housing market is now completely and totally dependent on these artificially low mortgage rates. If rates go back to “normal”, the results would be absolutely devastating.

But of course the biggest problem with rapidly rising interest rates is the potential for a derivatives crisis.

There are several major U.S. banks that have tens of trillions of dollars of exposure to derivatives. The following is from one of my previous articles entitled “The Coming Derivatives Panic That Will Destroy Global Financial Markets“…

JPMorgan Chase

Total Assets: $1,812,837,000,000 (just over 1.8 trillion dollars)

Total Exposure To Derivatives: $69,238,349,000,000 (more than 69 trillion dollars)

Citibank

Total Assets: $1,347,841,000,000 (a bit more than 1.3 trillion dollars)

Total Exposure To Derivatives: $52,150,970,000,000 (more than 52 trillion dollars)

Bank Of America

Total Assets: $1,445,093,000,000 (a bit more than 1.4 trillion dollars)

Total Exposure To Derivatives: $44,405,372,000,000 (more than 44 trillion dollars)

Goldman Sachs

Total Assets: $114,693,000,000 (a bit more than 114 billion dollars – yes, you read that correctly)

Total Exposure To Derivatives: $41,580,395,000,000 (more than 41 trillion dollars)

That means that the total exposure that Goldman Sachs has to derivatives contracts is more than 362 times greater than their total assets.

The largest chunk of those derivatives contracts is made up of interest rate derivatives.

I have mentioned this so many times before, but it bears repeating that there are approximately 441 trillion dollars worth of interest rate derivatives sitting out there.

If rapidly rising interest rates suddenly cause trillions of dollars of those bets to start going bad, we could potentially see several of the “too big to fail” banks collapse at the same time.

So what would happen then?

Would the federal government and the Federal Reserve somehow come up with trillions of dollars (or potentially even tens of trillions of dollars) to bail them out?

The Federal Reserve has created a giant mess, and when this current low interest rate bubble ends our financial system is going to slam very violently into a very solid brick wall.

As Graham Summers recently pointed out, entrusting Federal Reserve Chairman Ben Bernanke with control of our financial system is like putting a madman behind the wheel of a speeding vehicle…

Imagine if you were in the car with a driver who was going 85 MPH down a road with a speed limit of 35 MPH (this isn’t a bad metaphor as there is absolutely no evidence that QE creates jobs or GDP growth so there is no reason for the Fed to be doing it in the first place).

The guy is obviously out of control. The dangers of driving this fast are myriad (crashing, running someone over, etc.) while the benefits (you might get where you want to go a little faster assuming you don’t crash) are minimal.

Now imagine that the driver turned to you and said, “I’m thinking about slowing down.” Seems like a great idea doesn’t it? But then a mere two minutes later he says “ we need to continue at 85 MPH for the foreseeable future.”

At this point any sane person would scream, “STOP.” The driver is clearly a madman and shouldn’t be let anywhere near the driver’s seat. Moreover, he’s totally lost all credibility and isn’t to be trusted.

That’s our Fed Chairman.

Sadly, most Americans do not understand any of this.

Most Americans have no idea about the immense economic pain that is going to hit us when interest rates go back to normal levels.

All of this could have been avoided, but instead the American people let the central planners over at the Federal Reserve run wild.

When the bubble finally bursts, the official unemployment rate is going to rocket well up into the double digits, millions of families will lose their homes and America will find itself in the middle of the worst economic crisis in modern U.S. history.

Please share this article with as many people as you can. We need to help people understand what is coming so that they will not be blindsided by it.