The Coming Interest Rate Explosion

Includes: TLO
by: TacticalMan

In my first and only Seeking Alpha Article (until now because this is my second article) "The Steroid Housing Recovery" I took a detailed look at the impact of Quantitative Easing (QE) on the housing market.

The last paragraph I put in that February 20, 2013, Seeking Alpha article was the following:

The big question will be where the next bubble will take place due to these Boom/Bust policies we have been witnessing for so many years. I feel as though it will be in the bond market but at the same time that appears to be too obvious of a choice so it may occur somewhere else. One thing I know for sure is that the Fed's actions of stimulate and manipulate have created consistent boom and bust cycles because they tinker with the free market. So I would encourage everyone to keep a close eye on the market and make sure you implement proper risk management in all housing related decisions.

The reason I used the word "Steroid" in order to describe the housing recovery was because the housing/real estate recovery was and still is being "juiced" by The Fed (aka The Drug Dealer) through various QE programs (Steroids). We have all seen the "before and after" pictures of steroids on professional athletes' (Or Shrek!) bodies and their performance. Once the drug is taken away their muscle mass reduces and performance goes into decline. Will our economy go back to looking like Shrek with poor performance??

Well the same principle holds for the financial markets, because this market is addicted to QE and before that the Bailouts (TARP, TALF, etc.), which is all debt. The problem is nobody ever pays back the debt and our fearless leaders (politicians) just keep rolling over the debt forever. So we essentially live on a credit card and use the credit card to pay the interest without ever making a payment. It is absolute fiscal insanity!

Over the past few years the central banks around the world have all been issuing debt (printing) in tandem. Think of it as global central bank cooperation.

"The debt still has to be rolled and if you stop ALL spending, you still have to pay the interest or default. Unless we are going to sit down and really examine the whole process, we are standing on the threshold of a catastrophic rise in interest rates. Once those rates begin to rise, small increases are now a huge potential fueling the fire that will make the debt rise faster now than it ever has in history going into 2016. Any uptick in interest rates will affect banks on a global scale. So hang on tight."

Martin Armstrong - Armstrong Economics

2013 The Roller Coaster Ride of Your Life

Ready, Set, PRINT/BORROW! Global Central Bankers Unite!

Six years ago prior to the 'credit crisis' the U.S. National Debt was just $8.9 trillion. The statutory debt limit is $16.699 trillion so we have already breached it. How come nobody in the news media with all of these 24/7 financial networks mentioned this breach? Where is CNBC, Bloomberg, etc. on this issue?

Now the financial world is placing bets on whether The Fed Cartel starts to "Taper" the debt issuance on an economy that is clearly hooked on them or performance will suffer. However, this is not a performance in the same context of Alex "A-Roid" Rodriguez helping the Yankees make a run at the pennant. No, this performance affects everyone in the world because the bond market is the "elephant in the room" and has been the main lab rat that has been continuously injected over the past five years.

From Bloomberg:

"They want to get back to a neutral balance-sheet policy but that doesn't mean they want rates to skyrocket here," said McCarthy, a former Richmond Fed economist. "The market is hypersensitive," and the taper represents "the beginning of the end" of unprecedented monetary stimulus."

The Fed Cartel surely understands that it can't just wean the "steroid addicted economy" off QE and expect a continuous "high level performance." Just ask A-Rod what happens to his batting average when he lays off the "juice."

Certainly the Fed Cartel realizes that messing around with a bond market that is four times larger than the dotcom and housing market combined and ten times larger than the stock market is no easy task.

In a recent Seeking Alpha article, Charles Biderman from Trim Tabs stated the following:

Yes, many Wall Street types are saying that housing will stay strong even if mortgage rates average five percent. After all, five percent is still close to all-time lows. Really? That ignores the fact that at today's 4.9 percent mortgage rate, you need to be making 40 percent more to qualify for the same dollar amount of mortgage then when rates were 3.5 percent. In other words, home affordability has dropped by 40 percent! A 40 percent spike in home costs has to hurt future home sales. And as we get into September, the home sale numbers will be horrendous.

So while higher interest rates are slowing an already slowly growing U.S. economy, stock prices today are virtually unchanged from when Taper Time started May 21. Why are stock prices doing so well as bond plunge in price? Simple. The Fed is still dispensing $4 billion daily in free drug money, $85 billion monthly.

Bottom line. Higher interest rates are slowing the U.S. economy. If corporate America remains a seller, then the downside risks to stock prices seem to be much greater than any upside potential. And if the Fed does Taper in September on top of all of the above, watch out below.

In the past The Fed Cartel kept its "Steroid" bubble experiments to one sector of the economy at a time. Now it has become so experienced and talented that it feels as though it can handle three bubbles at the same time in stocks, bonds and housing. It's as almost as though The Fed Cartel can walk and chew bubble gum at the same time.

It is widely accepted that all these bubbles will not pop because the central banks won't let them pop. That's nice, but if this were the case, then why did stocks crater in 2000-2001 and 2008-2009, and why did the housing bubble implode in 2008-2011? Did they change their minds for some reason? The scarier question is what if all three markets 'pop' at the same time? God help us!

The big story in the financial markets over the past summer has been the carnage in the bond markets. Since early May, the 10-year U.S. Treasury yield has spiked from 1.6% to 2.85%, a rise of 125 basis points. It is a case of an overvalued market turning on news of the Fed's "tapering" plans, and finding itself with insufficient buyers, apart from the Fed, to absorb the collective selling pressure from bond fund redemptions, foreign central banks (esp. China and Japan), and the unwind of leveraged "carry trades."

Putting it All Together: The Currency Lynchpin - June 4th 2013

A forced liquidation of assets in the wake of a confidence crisis would obviously have dramatic impact on all the markets we have mentioned in addition to a multitude of others. We have shown that capital concentrations tend to build slowly but unwind swiftly. As such it is not beyond the realm of possibility that all gains seen over past 4 years in the bond and stock markets could be unwound in a very short period of time. Going back to the idea of the web of capital, the lynchpin looks to be the currency markets and specifically the US Dollar. With the Federal Reserve immersed in aggressive balance sheet expansion through the use of quantitative easing the Greenback has become a form of funding especially within the emerging markets through various official and unofficial pegs. At the behest of the Fed through its forward guidance, investors have borrowed these cheap dollar assets to invest in higher yielding non-dollar ones. Looking at the difference between the growth in FX reserves and cumulative current account surpluses we can estimate the rough size of the short USD carry trade. According to the most recent data it is at least around $2 trillion based on this metric! The whole trade, however, is built on the notion that the Fed and other central banks will continue with this policy into perpetuity. For this reason even slightest realistic hint that the Federal Reserve is set to move away from ZIRP has the potential to unravel the whole thing. All those who have borrowed dollar assets will be forced to buy back their dollars forcing the currency higher - some 2 trillion USD worth! This de facto policy tightening would have grave and dramatic knock on effects for emerging and developed markets alike. Pay close attention to the dollar. Prolonged strength in the currency could be the unexpected tail that prompts the beginning of the end in the latest central bank induced asset bubble.

--- Written by Kristian Kerr, Senior Currency Strategist for

Well The Fed Cartel hinted at exactly what would unwind the $2 Trillion carry trade, which is 'The Taper.' Then we witnessed an emerging market sell-off which has resulted in panic for certain countries' currencies, which have each lost between 10-20% versus the US Dollar since May 2013. Could this be just one of many future casualties of 'The Taper' that is set to begin in the fall? Mr. Kerr was right on the money with the analysis above and now we must watch the U.S. Dollar.

In conclusion, I feel we are about to witness an additional and significant rise in interest rates due to the following factors:

1. The 30-year bull bond market cycle appears to be over. Below is an interesting chart of what happened the last time we experienced negative interest rates. Will history repeat itself?

Source: Money and Markets

2. According to the U.S. Treasury Department, there was a record $40.8 billion of net foreign selling of Treasuries in June. That was the fifth straight month of outflows in long-term U.S. securities. China and Japan accounted for $40 billion of those net Treasury sales.

3. When The Fed Cartel stops buying Treasuries via QE so will everyone else. Buyers will not come back until they feel the borrowing costs are more aligned with the free market price now the manipulation is over. What will that number be on the 10-year note? I doubt it will be lower! Is it 4%, which is where the TNX was before QE began in November 2008? We are currently 1.25% away from 4% on the 10-Year Yield [TNX].

4. The Fed has already warned the market it is going to 'Taper' QE. Even if it does not 'Taper' yields have been trending higher since August 2012 before the 'Taper Talk' began.

5. Investors are not going to want to deal with the volatility or risk/reward in the bond market as this major QE experiment is phased out to the tune of billions each month. This has already been demonstrated with bond outflows over the past few months.

6. The Fed Cartel is NOT very good at controlling bubbles. The mainstream media gives The Fed Cartel way too much credit when it has been wrong so many times.

7. The Fed Cartel currently owns $1.678 trillion in 10-year equivalents, or 31.89% of the total. Maybe The Fed Cartel realizes it has to 'Taper' and reduce the TNX position or risk losing massive amounts of money by holding one third of the TNX in a rising rate environment. Think about what it has lost in the past year holding this position!

8. The Bank for International Settlements term premium (price of uncertainty) model collapsed to negative 140 basis points (1.4 percentage points) in December 2012. Look at how the term premium has collapsed since the creation of QE in late November 2008.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.