Thursday, August 16, 2012

Rising Rates

Rates will rise.  This is a given.  Rates could fall further in the near future (the long bond, if not already negative, could be negative in real terms even by the Fed's guage if rates continue down), but Bernanke says they will rise sometime in 2014 (how about that for telegraphing?).  So what happens when rates rise?

First let's address who owns the debt.  Central banks own most of it, and then investors own the rest.  The investors are everyone from millionaires to 401k holders.  They have been passed the debt from institutions, who also own some debt for their own purposes (JPM's prop desk, for example).  So this debt has traveled the financial world to encompus many owners.

Where finance is concerned there are two distinct scenarios which can engulf the landscape and they are inflation and deflation.  So far we have seen inflation in such hard assets as gold and oil.  Deflation has been unrelenting concerning housing and wage increases.  Debt finds an interesting place between the two because in this environment (and we could debate if we are currently in an inflationary or deflationary one) rates have fallen while the bond prices have increased.  This should be signaling deflation, but prices of goods continue to rise, confusing the issue.

When rates rise the value of bonds will drop.  This will crush the bond trade.  Sure, many people hold bonds until their maturity, but bond traders don't.  These traders will be passing hot potatoes as they fall in value, and the value will be dropping quickly.  For every 1% that the rate of the ten year goes up, the value will drop 14%.  This is a huge loss for bond holders.

That is what will happen to the bonds, but what will happen to the holders?  Pensions and 401ks will drop in value and people will lose the value of their savings.  For the Central Banks their balance sheets will be blown out.  These banks are holding these bonds and will need a counter balance for the banks to stay at par.  So an asset will rise in the bonds place.  What will it be?

The banks could fractionally reserve their assets.  This means they would loan them.  They could loan dollars and other currencie, or they could rehypothecate gold, and other reserves.  Any of these options would be highly inflationary.

Finally, if rates rise investment will run from bonds which will force the Central Banks and their proxie holders to buy more and this will force them to compound loans to make up for the losses.  We can conclude that when rates rise we will enter a very inflationary environment until rates rise to a point higher than the inflation rate.  Bernanke says it will wait until 2014 to start the rise in rates.  How far they will have to rise to cap inflation from getting out of hand has not been discussed.  Let's see if deflation is strong enough to keep the inflation damn from breaking until then.

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