Tuesday, September 29, 2009

The Longer Term U.S. Interest Rate Picture

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

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There is a debate going on in Wall Street about whether or not interest rates will be rising sharply in the next year or two. As usual the mainstream media is obscuring the most important facts that the individual investor needs to make an accurate determination. Articles frequently wave the deflation straw man argument and cite 'robust demand' for U.S. bonds. They usually don't mention that the robust demand is coming from the U.S. Fed and has only been made possible through massive printing of new money. The picture is quite different once these significant extra pieces of information are added to the puzzle.

According to a report from Barclay's, the U.S. has sold $1.517 trillion in debt securities prior to September of this year compared to $585 billion up to the same point in 2008. Barclay's estimated that only $50 billion a month of new supply was purchased in the market, which would be $400 billion in total up to the end of August. That would leave over $500 billion in new debt having been purchased directly by the Fed or approximately 56% - yes most of the new U.S. government debt issued in 2009 is being purchased by the Federal Reserve... and a lot more debt issuance is coming. Barclay's estimates that total U.S. government debt issuance will be $2.1 trillion this year versus $0.892 trillion in 2008. Estimates for 2010 are even higher at $2.5 trillion.

The Fed is supposed to stop its purchases of treasuries by the end of October. Only $300 billion has officially been set aside for this program and they have spent most of that budget. If they do indeed do this, U.S. interest rates will skyrocket overnight. So, don't hold your breath. Somehow this program will be extended perhaps under another guise if not directly. The Fed announced at its last meeting that it was extending its program to purchase agency debt (mostly Fannie Mae and Freddie Mac) to the end of the first quarter in 2010 (it was originally slated to terminate at the end of this year).

While figures are published about who holds U.S. debt and how much each party holds, these are updated at different points in time and how recent or accurate they are is open to question. The biggest holder of U.S. debt by far is the U.S. Fed. As of the end of March of this year, the Fed owned almost $4.9 trillion worth of federal debt (you can think of this number as an approximation of the amount of excess money that has been printed over time). The total U.S. National Debt is currently $11.8 trillion. State and Local governments are the 5th largest holders with a total of about $520 billion of U.S. government paper (can you see a need for them to be bailed out?). The fastest growing category this year has been the 7th biggest one, "Other Investors". Between just April and August of this year, holdings in this category went up over 50%. This includes GSEs (like Fannie Mae and Freddie Mac) and broker-dealers, who sell the bonds. This category is a great place for 'indirect' Fed purchases to take place and to remain hidden. There are also researchers who claim the Fed has been hiding purchases through off-shore money havens, such as the Caribbean Islands and Luxembourg, which are the 10th and 15th biggest holders respectively of U.S. debt.

As long as the Federal Reserve continues to purchase a huge percentage of U.S. government debt, interest rates can remain low. While supply of debt has increased tremendously, the Fed has increased demand for the debt by an even greater amount by printing a lot of new money and this holds price up and interest rates down. Excess money printing leads to inflation .. and there are no exceptions to this ever. Creating artificially low interest rates also feeds inflation. Inflation eventually leads to higher interest rates. The key determinate of when this is going to take place now is the amount of money printing that the Fed is engaging in. When this goes down (proportionately), interest rates will go up.

NEXT: Unwinding the Fantasy Trade

Daryl Montgomery
Organizer,New York Investing meetup

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

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