Let’s Talk Interest Rates

Let’s talk Interest Rates… Rising or Falling in 07?

It’s the talk of the town, be it USA Today or on CNN Money. What will “Gentle Ben” and the “smooth landing” Federal Reserve do? Housing could sink the economy which would bring rates down, yet inflation still gives plenty of reason for concern. Earnings and markets are up, but what will happen when they run out of steam?

Reading through a stream of articles today, I state my humble opinions on an economy that by all practical purposes has lost touch with the standards of a true “Goldilocks” scenario. The only factors investors worry about today are market-beating returns and cheaper prices on their daily expenses. Problem is that it’s more a matter of which they’ll get first rather than when they’ll get both.

Interest Rates and Inflation

Reading through some historical charts on CrestmontResearch.com there seems to be weaker equity markets during extended periods of rising rates. Conversely, commodity and assets rise due to inflation and flight from dollar nominated assets. Of course the initial culprit for the raising rates begins with concern regarding inflation.

This correlation would seem quite reasonable. Money and wealth that is generated through increases in credit, liquidity lower interest rates and years of stock market prosperity lead to reinvestments of these dollars back into these mediums of significant return. We will call this “Financial Asset Inflation” a concept you’ll probably never hear spoken of by the Fed. As a matter of fact the Fed even discontinued their announcing of M3 – the total amount of money in circulation.

This “Financial Asset Inflation” is not currently visible for quite a few reasons. 1) These returns come mostly to those of the highest asset class who have a larger disposable income left to invest 2) Thus, these returns are in turn able to easily be reinvested without immediate need for these funds. 3) Most of this money doesn’t even exist in terms of actual dollar holdings but in credit assets, swaps, bond insurance and interest rate derivatives maintained primarily on margin.

When the Going Gets Tough

However, most of the larger players in the game including commercial institutions and hedge funds understand this game well. They know the risks of the system and in the bets made therein. Many therefore are ready on a minutes notice to liquidate just about everything. This was one of the dynamics experienced during the late 1920s. The speculators, masters and novices alike , new damn well that their money was at risk. But who wouldn’t take on that risk for gains of 20-30% a year? Furthermore, each reasoned with himself that on the first sign of imbalance money would be taken off the table, bets closed and a dashing for the door would be in order.

Of course the financial markets don’t have a very good track record of maintaining peace-of -mind for the investors that push it to sky’s limits. Let alone those who don’t even understand the monster they wish to milk their money out of. If the wise and intelligent investor were a caveman he’d say “Catch the beast when its weak and tired not when it’s mad and hungry”.

When the floor drops, as it always does, many will be quite disappointed. Some will shoot themselves dead while some will sing merry tunes of grace. Meanwhile with the dam of equities along with the credit of both housing mortgages and the Federal Reserve crashing in, the Fed will face its true debacle. Plummeting house prices, sub-prime loans defaulting all over and stocks being sold fervently, all the while flooding the marketplace with billions if not trillions of dollars of liquidity. Hence, contrary to popular belief inflation will occur regardless of whether or not the Fed and the government attempt to flood accounts with easy credit and loan Repos. Post facto this liquidity would have inevitably been filtered in through financial assets.

Why Raise?

This is where many economists get hazy. Will this cause the Fed to cut, hold or raise? (Yes, that does sound like the game of poker it is). I believe the Fed will need to raise. My reasoning is as follows:

1. Many investors then out of the market – exempt those few who were fortunate to get a decent short position beforehand – will need safe places to stash their spoils. This will end up in goods, hard assets such as gold and commodities in strong foreign currencies.

2. With the rates hovering above 5% – historical lows considering the rates of 17% in the 70s – there will be little if not zero use in lowering rates.

3. With the dollar is a steady fall the Government will have no choice but to raise substantially in order to bring some stability to the dollar keeping its safe-return competitive with the rates of the Euro, Yen and Pound.

With all this, gold and silver will only then begin to show their true sustainability amid a falling economy. Of course as the sentiment turns the interest in hard assets and commodities will once again emerge – as it did after the market meltdown of 2000 – beginning stage two, the strongest and longest of the commodities bull run.

Where to Invest

If I’m usually not a fan of overpriced issues or momentum speculation then at this point I would strongly warrant selling out of any position where the margin for safety isn’t in your favor. Remember, Buy Low, Sell High. Not “Buy High and hope to sell higher”.

Although it may be too early, a short position in any of the major indexes could be quite rewarding. I would wait for a blow-off in stocks to do so. Wait for everyone to be bullish, then go with the bears and you’ll be sure of a profit.

Hold onto any hard assets and precious metals. Although they may fall in the coming months, “We’re in a Bull market” they used to say. Don’t loose your positions no matter how rough the correction gets. If you insist on speculating don’t short and get ready to jump back in at a moments notice.

In addition, each investor should be sitting on a good cushion of cash. If the market does tank severely you want to have substantial cash on the sideline to snatch the bargains that many investors won’t be able to afford.

Articles to Read:

Home-loan house of cards to fall
Why Stocks Will Fall
World Assets hit Record Value of $140 Trillion
Markets Face Severe correction in 2007
25 Surprises for 2007
What if the Bulls are Wrong in 07?
There Are Signs the Conventional Wisdom Is Off
Short-covering Boosts Gold
Making the Bear case

If I may, I wish to repeat the words of one of the most famed investors, that should resonate with us in our investing mindset as well as throughout our lives

“After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: It never was my thinking that made the big money for me. It always was my sitting”. – Jesse Livermore


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