Interest Rates to Rise Following Credit Contraction

Aiy! We arrived in London this morning, greeted by a dark sky, rain and wind. Ah, the summer... we hardly knew ye...

What a delightful summer it was! (More below...)

The weather never actually turned summery – until the last two days – but it was still a marvellous respite from the workaday world of September – July.

We went back to the workaday world yesterday – taking the train up to Paris for an editorial meeting with our new French financial magazine. We are taking a risk with the publication – giving it an English title: MoneyWeek. French may be the language of Proust, but English is the language of money.

Oil dropped back to $111 yesterday, after Hurricane Gustav veered away from New Orleans and towards the Republican National Convention. Now, the storm seems to be winding down – leaving hundreds of thousands of people without electricity, but sparing both the city and the oil rigs off the coast.

Poor John McCain; upstaged by wind and rain. But who knows, maybe he’ll be able to make a comeback. Besides, he’s got a young woman as a running mate. Hey, everybody needs a gimmick. The Democrats have that young black guy. And he’s got an old white guy as a running mate. So you see, the tickets are evenly balanced. Young-old, white-black, male-female. Maybe McCain should break Palin’s legs and put her in a wheelchair; might give them an edge with crippled voters.

Remember, elections – like markets – can be fun, provided you don’t take them seriously.

US markets were closed yesterday, but the world of money continued to turn. Asian markets sold off sharply. In Europe, too, equity prices tended to go down, but less so. Oil weakened further this morning...

“You say an increase in the price of oil is ‘ineluctable,’” we questioned the French MoneyWeek team. “A bold position to take... no?”

“Well, it’s inevitable that the price of oil will go up. Supplies are tight and demand is rising. The price must rise too – that is, unless there’s a catastrophic change in the world economy.”

Ah, there’s always a bit of sand in the gears... a little bit of grit that can wreck even the most sophisticated and powerful engine.

An increase in the price of oil looked ineluctable in the early ‘80s too. So did higher and higher interest rates – over 20%, in fact. And the stock market was dying too; Business Week magazine announced it on the cover: “The Death of Equities” hit the newsstands in August, 1982.

But all those things turned out to be eluctable, after all. The price of oil collapsed to $10 a barrel, interest rates peaked out at 14% for the 10-year T-Note and stocks got up from their deathbed and began dancing the Hully Gulley, all the way from Dow 750 to Dow 12,000... and then some.

The financial world did an about-face in the early ‘80s. After a generation-long period of rising rates of interest... topped by a final squeeze delivered by Fed chairman Paul Volcker... rates were ready to come down – for another generation.

As we explained last week, our guess is that the financial world is about to spin on its heels once more. After such a long period of falling real rates of interest, they should be ready to go back up. The credit expansion of the ’82-’07 will turn into the credit contraction of the next few years – at least, that’s our guess. And again, the previous trend is given – unwittingly – a final push by the Fed. Currently, favoured institutions – member banks of the Federal Reserve – can borrow at less than half the rate of consumer price inflation. That makes their real rate of interest NEGATIVE... about -3%.

The Fed also lends to commercial banks – which it regulates – as well as to investment banks, which it doesn’t. The investment banks are the same firms that made such a hash of the mortgage market. But the feds didn’t want to see their friends and contributors from Wall Street get what they deserved. So, they’re bailing them out – openly, as in the case of Bear Stearns... and clandestinely, as in the case of the rest of the Street.

And now, everybody’s getting in line for a bailout. The feds have already practically nationalized the entire nation’s housing stock – by supporting Mae and Mac. And Detroit has asked for $25 billion – again, at negative real interest rates!

Where’s the end of the line? That’s not a rhetorical question. We want to know so we can join the queue.

And more thoughts...

*** Now we are back in the world of trains, planes and automobiles... of business meetings... taxicabs... security checks... deadlines... speeches... blah, blah, blah.

That is, we’re back in the real world...

But we pause to reminisce about the world we leave behind. We took the month of August off – like the rest of France. We did not stop working, but our work was done from home, among friends and family... and preceded at a very different pace.

Instead of rushing to the office, we walked across the yard to a pavillion that we have turned into a library. There, beginning about 7:30 AM we did our reading and writing, until the lunch bell rang at 1PM. Thence, we sat down with Elizabeth and our mother and whoever was visiting or passing through. Sometimes, we were just three. Often, we were 20 or more...

Lunches were served outside. The weather was cool... so we had to wear sweaters and scarves. But it was summertime, and even though it didn’t feel much like summer weather, we stuck to our summer routine, no matter how uncomfortable it became.

Almost everything we ate came from our own garden – which is to say, we ate enough green beans to choke a mule. Then, the tomatoes and squash ripened, and our diet broadened. Meat was supplied by a local butcher... or by our gardener.... who sometimes cooked it over an open wood fire.

“Hmmm... this steak is great,” we asked him. “Where did you get it?”

“I have my ways... old fashioned ways... and they’re better,” he replied.

“What ways...?”

“I don’t want to say... but in today’s world, you have to know how to do things unofficially. Because the authorities are always trying to stop you or tax you. You know, you couldn’t get a company to paint your shutters... not the way you have done it. You just reach out of the windows and take the shutters off. That would be illegal for a licensed contractor. They’d have to put up a regulation scaffolding... and have workers with qualifications and hardhats do the work. And of course, if they went over 35 hours per week, you could be fined or put out of business. That’s why you have to go around all that stuff...”

We never found out what his ways were. But it’s illegal to butcher animals yourself – outside of a licensed abattoir. We presume that our beef was prepared in the old fashioned way.

Lunch took time. At the office, we usually don’t bother to eat lunch at all. It slows us down. But for the last month, lunch often took two hours... There was the entrée, the main course, the salad, the cheese, the dessert, and finally, coffee.

These long lunches proved very useful, helping us catch up on family matters.

Lingering over coffee, we discovered that we had six children. We learned their names and found out what they had been doing. We found that Elizabeth studied history at the Sorbonne last year, and passed her tests with flying colours.

We also had time to listen to our mother, cousins, nieces, nephews, brothers, sisters... and many people who seemed to just show up at lunch with no obvious connection to anyone.

“What are you doing here,” we wanted to ask. But it would have been rude; instead, we simply enjoyed their company.

“I got a letter today from Margaret’s son,” began our mother one day. “I knew exactly what it was.”

“What?”

“Well, when you get to be my age you’ll know. I had sent Margaret a couple of letters and got no reply... We’ve been friends since World War II when we were both in the army together... in the WACs.”

“Why did you sign up for the army,” asked a granddaughter.

“It was the war. Everyone wanted to do whatever they could. I had been at home taking care of my mother, who was very sick. She had had, well... I guess you’d call it a nervous breakdown, today. But it was very serious, and we couldn’t leave her alone.

“Every family house has some dark rooms... and every family story has some dark chapters. I feel like I need to tell you what I know, because I’m the last one. I’m the last one of my generation that you’re likely to know... at least in the family.

“But my father retired... this must have been 1942... so I was able to sign up for the army. And they sent me to Texas, where I had a job showing movies to the young soldiers. The idea of the WACs was that we were doing work that men did before; we did it so the men could go and fight. I ran the projector to show films of the Germans and what they were doing and how they fought. I can’t remember, but I think the gist of it was that if you didn’t kill them, they would kill you. I spoke a little German that I had learned in school... very little. So, later, they had me working a little with German prisoners of war too... and they were actually very nice. But I guess they didn’t want our soldiers going off to war thinking that they were going to fight nice people.

“I met your father right after I began. It was Christmas Eve. And there was something about him. I didn’t know what it was. But I had a feeling. And then we wanted to get married immediately. I don’t know why. That’s just what people did then. He had been at Pearl Harbor when it was bombed... and he was just being sent out to the Pacific. We didn’t know where... or when... or if... he’d come back. Anyway, we wanted to get married right away.

“And Margaret was my best friend. And I was so naïve... I didn’t know anything. You wouldn’t believe it today. I mean, today, everything is on television. But my family was extremely modest... and extremely discreet. So, Margaret had to explain the facts of life to me just before I got married.

“Anyway, we were very close... and we visited each other over the years. But then, I didn’t hear anything from her. And when I got this letter today, I saw that it came from Oregon, you know, that’s where she moved with her husband before he died... and it came from her son, not from her. So I knew...

“And that’s the way it is when you get old. Your friends and relatives... the people you grew up with... the people you love... one by one... they disappear. And then, you’re the only one left... and you tell yourself, well, I believe we’ll meet again... like that song... don’t know where, don’t know when...”

Bill Bonner
For The Daily Reckoning

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Interest Rates to Rise Following Credit Contraction

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