I’m not the only one who’s been warning about the intense
danger of rising interest rates.
The
World Bank and the International Monetary Fund have just issued
warnings that underscore everything I’ve been telling you.
We’ve heard strident warnings from Fed Chairman Greenspan
about America’s bulging budget deficits and rising inflation.
We’re even hearing cries of concern from observers in the
housing industry and the auto industry.
If
most investors were listening, I wouldn’t be so concerned.
Or if today’s stock and bond prices already discounted the
implied risks, perhaps the warnings might actually be a positive,
contrarian sign. But, alas, neither is the case today.
The
frightening reality of our time is that the overwhelming majority
of investors are sleepwalking through a minefield.
They’re
sitting on stocks that are grossly overvalued … fumbling with
bonds that could blow up at almost any moment … jumping into real
estate precisely when the real estate bubble is about to pop.
Think
twice before you join them. At the very minimum, rejoin the tour
you began last week — so you can be among the first to hear,
first hand, the voices of reason that most other investors have
so far chosen to ignore.
World
Bank
Your
first stop is the World Bank headquarters in Washington, D.C. You
are promptly greeted by an associate of the bank’s chief economist
who ushers you into her office and launches into what appears to
be a history lesson.
“The
bank originated at Bretton Woods, back in 1944,” she says.
“That’s the same conference that established the U.S.
dollar as the great stabilizer for international currency markets
and the entire world economy.
“Now,”
she continues, “here we are, six decades later and, ironically,
the U.S. dollar is the world’s great destabilizer.
It threatens to derail the core mission of the bank. It threatens
to throw a monkey wrench into U.S. markets. It could sabotage the
entire world economy.”
A
Global Slowdown Caused By Soaring Interest Rates
“What’s your worst case scenario?” you ask.
“I
can’t tell you that. But I can tell you our BEST case scenario.”
“What’s
that?”
“A
global economic slowdown.”
“Really?
How bad?”
The
World Bank official fidgets and frowns. “We have no idea.
Normally, we’d rely on our numbers. Or at least we’d
rely on logical thinking. But we can’t.”
“Why
not?” you ask.
“Because
the fate of the entire world economy now hinges on one, single,
powerful factor that no one can measure — let alone predict.”
“Which
is …”
“The
PSYCHE of foreign investors holding trillions of U.S. dollar assets.”
“You
say that in your official report?”
“Actually,
what we say is that the severity of the coming world economic slowdown
will depend on the extent to which foreign investors lose their
nerve about buying U.S.-dollar-denominated assets. If they
start diversifying out of U.S. assets, the consequences could be
catastrophic.”
“Why
can’t you tell me how bad it could get?”
“Because
we’re economists — not shrinks. We look at GDP, current
accounts, risk spreads of different countries — trends we
can measure. Now, people are talking about ‘the fear factor,’
the ’game of chicken,’ the ‘panic triggers.’
We have no way of measuring this stuff. But we know it’s there,
and we know it’s big.”
“How
do you know it’s big?”
“Because
of the $5 trillion of U.S. corporate and government bonds now held
by international investors and central banks. Because of what we’ve
seen happen historically to other countries in a similar situation.
Because of what happened last month. Because …”
“Last
month?” you ask.
She
pauses to pick up a news clipping and then continues. “Here.
Let me read to you what my boss told a Dow Jones reporter just last
week. This is not an exact quote, but it’s close:
‘Recent
suggestions by some Asian authorities that they might be diversifying
their reserve portfolios sparked brisk sell-offs that ceased only
when firm denials of such diversification were subsequently issued.
If foreign central banks were to cut their holdings of dollars,
U.S. interest rates might have to rise more than financial markets
now expect.’”
“Can
you dissect this statement for me?”
“First,
it’s obvious that the denials by the Asian authorities are
pure BS. The only reason Chinese, South Korean, and Japanese authorities
rushed to issue denials was because they were taken aback by the
panic their own words were causing in the U.S. markets …”
“And
second?”
“Second,
the only reason they want to avoid a panic in U.S. markets is so
they themselves can exit quietly, without making a big
wake. The foreign central banks want out. They want to get away
from the dollar. But after their near-traumatic experiences last
month when they tried to give the market some hints, they’ve
decided they’re going to use a different tactic. They’re
going to wait for the right moments. Then they’re going to
sell in silence — without telegraphing their punches.”
“You
mean their denials are lies?” you wonder out loud.
She
pauses, searching for the right words. “Let me put it as diplomatically
as I can: This is a very brittle, explosive situation. No one wants
to be the first to set it off.”
“But
what would they have to do in order to avoid a blow-up?”
“A
lot. The U.S. government would have to shrink its record budget
and trade deficits. Europeans would have to make sure their monetary
policy doesn’t get tighter than America’s monetary policy.
Major Asian nations would have to revalue their currencies —
let them rise against the dollar. And all these countries would
have to mobilize together — in one, unified, coordinated response.”
“Is
that possible?”
“I
don’t know. But I do know this: Right now, the U.S. is doing
NOTHING to fix its current account deficit. Last year, it hit a
record-smashing $666 billion or 5.6% of the gross domestic product.
This year, it could be even worse.”
“I
know. So what else is new?”
World
Finance Turns Inside Out and Upside Down
“What’s
new is that the U.S. trade gap used to be financed mainly by foreign
private investors. But now those investors have been retreating.
So the U.S. has become more reliant on the foreign central banks
for financing.”
“What
does that mean?”
“It
means the U.S. used to attract more investment money from foreign
citizens and companies. But now, it’s relying more on charitable
contributions from foreign governments! And those governments are
now realizing that charity begins at home.”
“I
see.”
“Plus,
there’s one more facet to this situation that’s new
— and very dangerous.”
“What’s
that?”
“Remember
how rich countries used to finance poor countries? Well now, the
entire world of international finance is turning inside out and
upside down. Now, DEVELOPING countries are chipping in the big bucks
to help finance the United States!”
“What?
Which ones, for example?”
“I’m
talking about China and India. I’m talking about Thailand,
Malaysia, Venezuela, the Czech Republic — even Pakistan. Many
of these used to be the kinds of countries that were in trouble,
that needed bailouts from us. Now, it’s the UNITED STATES
that’s getting the financing from THEM.”
“What’s
wrong with that?”
“It’s
hot money — very unreliable. If you thought the world economy
used to be in danger because of a sudden flight of capital
from developing countries, imagine what kind of danger we’ll
be in now if we see a flight of capital from the United States!”
“Spell
it out for me.”
Double-Digit Interest Rates
“I’ve
been with the bank for more than 30 years, and I’ve seen it
happen over and over again. In Scandinavia. In Thailand. In Mexico.”
“Give
me a play-by-play description.”
“It
starts with good news: The country stabilizes. Investors trust it.
So investment capital rushes in. Soon, there’s a boom …
and then there’s a bubble. In their economy. In stocks. In
real estate.”
“And
then?”
“Then,
for whatever reason, some foreign investors begin to shy away. They
decide the country’s assets are too expensive. They find greener
pastures somewhere else on the globe. Or they’re spooked by
the country’s deteriorating finances — bigger budget
deficits and trade deficits.”
“So
…”
“Soon,
the money that was rushing in starts rushing out and, suddenly,
investment capital in the country dries up. One moment, there’s
plenty of money floating around. The next moment, it’s gone.”
“Let
me ask you this: If someone like me wants to be ready for something
like this ahead of time, what signs should I look for?”
“First,
watch the country’s currency. Has it been declining in value?
If so, that’s your first sign. Like we’ve seen in the
U.S. in the last few years.”
“And
the second sign?”
“Interest
rates — like we’ve seen in the U.S. in the last few
months. When the country starts offering higher interest rates to
try and keep the money at home — that’s the second telltale
sign.”
“But
I thought higher U.S. interest rates would persuade foreign investors
to stay, that it would support the dollar. What’s wrong with
that theory?”
“Here’s
what’s wrong with it: For every foreign investor who sticks
around for the higher yields, there are probably two others who
run away even faster.”
“Why’s
that?”
“Because
not all foreign investors have their money in short-term government
securities or bank CDs. They have their money in long-term bonds.
They have it in stocks and real estate. They run because they know
what higher interest rates will do to those investments.”
“Interest
rates go up and they run away anyhow?”
“Yes.
It’s a vicious circle. The more the currency falls, the higher
the interest rates go … and the higher interest rates go, the
bigger the threat to the economy and the greater the flight of capital.
Capital is scarce. So interest rates — the cost of capital
— go through the roof.”
“How
high?”
“There’s
no limit. During the European currency crisis in 1992, for example,
Swedish interest rates surged to 50% or more.”
“FIFTY
percent?”
“Yes,
50%. In Mexico, Brazil, Thailand, Indonesia, and other countries
that suffered a similar currency crisis, interest rates also skyrocketed
to ridiculous levels.”
“Do
you really think U.S. interest rates can go that high?”
“No.
But that gives you some idea of why a U.S. dollar crisis is so frightening
to so many people around here.”
International
Monetary Fund
Your
next stop is the International Monetary Fund, also in D.C. On the
surface, their report is more optimistic. They rave about “solid
global economic growth,” “buoyant financial markets”
and “continued improvement” in balance sheets.
But
when you talk to one of the report’s authors in person, you
see that their fears are not all that different from the World Bank’s.
“In
times like these, the big risk is not what you see,” he exclaims.
“It’s what you don’t see.”
“Like
what, for instance?”
“Complacency!”
“Is
that one of those things you can’t measure?”
“Actually,
we CAN measure complacency. With risk premiums.”
“Please
explain.”
“Essentially
there are two kinds: There’s a risk premium you pay to cover
for the possibility of rising inflation. And there’s the risk
premium you pay for the possibility of a debt default.”
“So
what’s the situation right now?”
“Right
now, these premiums are extremely low … despite the fact that,
everything WE see indicates that the premiums should be much higher.
We have obvious big dangers … but at the same time, we have markets
that have failed to recognize those dangers — so far.”
“Result?”
“The
result is that there is little or no margin for error.”
“What
kind of error are you talking about?”
“Human
error. System error. Accidents.”
“Can
you be more specific?”
“First,
the low risk premiums I just told you about. If inflation is worse
than the market expects, it could be a big shock. Or if debt defaults
are worse than the market expects, it could be another
big shock. Or both at the same time!
“Second,”
he continues, “don’t forget about derivatives! These
are complex financial instruments. No one really understands them
— let alone tracks the real risks. All we do know is that
they could ultimately become hazardous to financial markets.
“Third,
too much reliance on the so-called ‘risk-management systems’
— every big financial institution has one. These systems are
supposed to work like smoke alarms. If a bank or a big brokerage
firm is taking too much risk or is on the verge of a blow-up, the
bells are supposed to start ringing. But the systems are untested.
There’s no way they can accurately simulate a real-world emergency.”
What
To Do
There
are more urgent places to go on this tour — to talk to officials
in the U.S. housing and mortgage markets … to see observers of
the U.S. auto industry … to the major banks. But you don’t
have time for that now. Save it for another week.
Instead,
get back to your own portfolio …
- Seek
protection. Get out of the way of rising interest rates.
More so than any other force in the economy, they have a sweeping
impact, like a tidal wave, respecting no artificial borders between
industry sectors and no regional boundaries.
There
are some noteworthy exceptions: Investments such as gold
and energy that are driven higher by the same forces driving up
interest rates. Or you may be able to find safety in a professionally
managed investment program that properly monitors and hedges your
risks. No matter what, though, your first priority must be to
protect what you own.
Your second priority is profits. Get yourself into investments
that are specifically designed to benefit from rising interest
rates.
I will
give you specific recommendations for both in a follow-up
edition of Martin on Monday that I’m wrapping up right now.
I’ll
e-mail it to you tomorrow. So stand by.
Good
luck and God bless!
Martin
D. Weiss, Ph.D.
Editor, Safe Money Report
President, Weiss Research, Inc.
martinonmonday@weissinc.com
Martin
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