March 6, 2006 – Long-term US dollar interest rates rose again this past week, continuing the uptrend that began in mid-January. For example, the yield on the 10-year Treasury note closed the week at 4.68%, up from the 4.36% yield prevailing at the end of the week of January 13th.
What’s more, 4.68% is the highest yield on a weekly close since June 25th, 2004, more than 1½ years ago. Any new high achieved over that long a period of time is a significant and noteworthy development, so I am therefore sending out this interim letter to update you on the present situation and to provide my current thinking on long-term dollar interest rates.
Readers of these letters know that I have been bearish on long-term government debt for some time. And in fact, for nearly three years, yields generally have been climbing higher, while prices of these debt instruments have been falling.
The reasons for my bearish view are varied, but most basically, it is simply not reasonable to expect that the federal government can continue to incur horrific budget deficits from rampant and reckless overspending without adversely impacting the purchasing power of the dollar. As the currency’s purchasing power is eroded by a policy of monetary accommodation, yields rise in order to compensate investors for the higher risk on this government debt, namely, the risk of worsening inflation. What is “monetary accommodation”?
Having removed in 1971 the gold standard and the discipline that went with it, the spending aspirations of politicians are no longer constrained by the realities of a pocket book with dollar limits. Instead, the politicians spend what they want, thereby growing the federal debt in the process. The Federal Reserve then dutifully makes sure that the debt is turned into spendable money either by buying the debt itself and creating newly printed cash-currency (i.e., Federal Reserves Notes, which is the green paper we carry in our pockets) or by making sure that bank reserves are not constrained so that the banks can buy the debt with newly created deposit-currency (i.e., the dollars in our bank accounts). The policy of the Federal Reserve is monetary accommodation, meaning that they create whatever dollars the politicians want.
That’s how the system works. The politicians are therefore able to get all the dollars they want, but let’s consider this proposition for a moment. The politicians are not creating wealth. Obviously, creating dollars ‘out of thin air’ by monetizing debt does not create new wealth. Wealth comes from hard work, and not from bookkeeping entries.
All the politicians – with the required help from their obsequious lapdogs at the Federal Reserve – are doing is creating dollars. So it is not logical to believe the rhetoric of Federal Reserve officials who claim that they are fighting inflation. If they were really doing that, they would not be ‘monetizing’ the federal government’s debt. But given that monetizing this debt is in reality the Federal Reserve’s raison d’Ã©tre, it is clear that the Federal Reserve officials speak out of both sides of their mouth.
Of course, all those newly created dollars have purchasing power, but here’s the key point. As you create more of those dollars, each one becomes less valuable, meaning each one has less purchasing power. That erosion of purchasing power is what we usually call inflation.
What passes today for a monetary ‘system’ is inherently inflationary because this newly created currency – whether cash-currency or deposit-currency – increases the quantity of dollars in circulation. We can therefore watch how inflationary the monetary accommodation of the Federal Reserve really is by looking at the total quantity of dollars.
To do this, I use M3, which measures the total quantity of dollar cash-currency and dollar deposit-currency. In other words, it measures all of the dollars in existence.
On the accompanying chart I have plotted at each month end the 12-month growth rate of M3. You can see that there are clear trends marking inflationary and disinflationary periods. There are even a couple of months of deflation. Note that toward the end of 1992, M3 for a couple of months was lower than what it had been a year earlier. In other words, it was a deflationary period – albeit a short one – because deflation typically occurs when the quantity of money decreases.
After that brief whiff of deflation in 1992, the Federal Reserve abruptly reversed course, ushering in the reflation that fueled that decade’s stock market bubble. But all of that is past history. I want to draw your attention to what has been happening in recent months, a period on the above chart that I label as the “Bernanke Inflation”.
Recently, a new trend has begun. M3 growth rates are again climbing higher, and more to the point, the downtrend in place since the Y2K scare has been broken – note the breakout from the downtrend channel highlighted by the red circle.
Over the past several months, dollars have been created at ever higher rates of growth. I expect this trend will continue for at least several years, just like the previous trends on this chart each lasted for several years. In short, we are entering into a new period of reflation, which I suspect will end with severe inflation that will ultimately destroy what’s left of the purchasing power of the dollar. It will be the collapse of the dollar, which is the inevitable result for all fiat currency.
So let’s assume for the moment that I am right, and that we are in the early stages of what will become a horrific dollar inflation, worse than what we saw in the 1970’s. If I am proven right – and so far the trend in recent years has been one of worsening inflation – then the price of all long-term dollar-denominated debt will fall.
For this reason, I have been recommending staying away from all dollar-denominated assets, and particularly, do not invest in dollar-denominated long-term debt. It will prove to be a losing proposition. The federal government may repay the dollars it owes you, but those dollars will not have the purchasing power they do now. Even the interest you receive on that debt is unlikely to adequately compensate you for the loss of purchasing power, which will on balance erode at rates higher than the interest you will earn. And please remember, that all dollar-denominated debt – not just government paper – will be adversely effected (lower prices, higher yields).
So the question is, what do we do now? Clearly, long-term investors should remain on the sidelines. Do not buy long-term dollar-denominated debt. But what about traders?
Right now traders are on the sidelines and out of the market. And though it is tempting to sell short T-Bonds and T-Notes, I would like to see more confirmation that the uptrend will last. Take a look at the accompanying chart of 10-year T-Note yields.
We can see the clear downtrend in yield that has been in place since the high interest rates former Federal Reserve chairman Paul Volcker put into place in order to save the dollar from an inflationary collapse. However, over the past few years, we can see the counter-trend that has emerged (the green lines marking the parallel uptrend channel).
Yields are now breaking higher, and normally I would buy a break-out like this one. However, I am still not comfortable with all the government intervention in this market. Huge amounts of newly created government debt have ended up in the hands of foreign central banks as they have tried to keep the dollar from collapsing against their own national currency. This central banking purchasing has provided demand – albeit artificial – for long-term US government paper. It has also created demand for the dollar, which no doubt has kept the dollar from collapsing even worse than it has over the past several years. I’ve also included a chart of the US Dollar Index to show its downtrend.
Anyway, I do not recommend that traders sell short T-Notes and T-Bonds just yet. There is still plenty of time to jump onboard this uptrend in long-term interest rates, and there are strong reasons for doing so eventually. But, in my opinion, not just yet. The time to sell short is coming soon, and probably sooner than all of us expect.
Returning to the first chart, I would like to again remind readers that the Federal Reserve will stop reporting M3 later this month. They are throwing away the roadmap. Here’s what I said back in Letter No. 374 on November 14, 2005 about the Fed’s announcement to stop reporting M3.
“Consider first the import of this statement. The Fed exists to create money, and M3 captures all of it – all of the dollars in circulation in one form or another. Not reporting M3 is the equivalent of General Motors not reporting how many cars it produces. It is an absurd proposition that the Fed will no longer report the total quantity of dollars in circulation.
Now consider the implications of this announcement. Why does the Fed no longer want to report the total quantity of dollars in circulation? They know what’s coming – massive amounts of dollar creation to fund the worsening trade and federal government budget deficits. The Fed is just doing what other government agencies already do when they don’t like the result of their statistical calculations.“
I then went on to explain the practical significance of the Federal Reserve’s statement.
“By eliminating its reporting of M3, the Fed is shooting itself in the foot. This misstep will only hasten the rush out of dollars into the safety and security of gold.”
The price of gold has risen from $461 at the time of the Federal Reserve announcement in early November to $566 today, with more price rises to come in the months ahead as the world wakes up to the growing inflation in the dollar.