Expert Commentary

Falling Interest Rates in This Environment Will Be Bearish

The is article originally appeared in The Elliott Wave Theorist on October 19, 2007, eight days after the all time high in the Dow. The new bear market accompanied a plunge in T-bill rates essentially to zero.

You cannot pick up a newspaper, turn on financial TV or read an economist's report without hearing that the Fed's latest discount-rate cut is bullish because it indicates the Fed's decision to "pump liquidity" into the system. This opinion is so completely wrong that it is hard to believe its ubiquity.

First of all, the Fed does not "decide" where it wants interest rates. All it does is follow the market. Figure D-10 proves it. Wherever the T-bill rate goes, the Fed's "target rate" for federal funds immediately follows. That's all there is to it. If you refuse to believe your eyes, then listen to the former chairman; Alan Greenspan is very clear on this point.

The Fed Follows the Market

On September 17, a commentator on CNBC asked, "Did you keep the interest rates too low for too long in 2002-2003?" Greenspan immediately responded, "The market did." Rates were not "too low" or the period "too long," either, because the market, not the Fed, made the decision on the level and the time, and the market is never wrong; it is what it is. If investors in trillions of dollars worth of U.S. Treasury debt worldwide had demanded higher interest, they would have gotten it, period.

Second, falling interest rates are almost never bullish. All you have to do to understand this point is look at Figure D-11. Interest rates fell persistently through three of the greatest bear markets in history: 1929-1932 in the Dow, 1990-2003 in the Japanese Nikkei, and 2000-2002 in the NASDAQ.

Falling Rates Are Not Bullish

The only comparably deep bear market in the past 80 years in which interest rates rose took place in the 1970s, when the Value Line index dropped 74 percent. Economists all draw upon this experience, but they ignore the others. Today's environment of extensive investment leverage and an Everest of debt in the banking system is far more like 1929 in the U.S. and 1989 in Japan than it is like the 1970s. Why is a decline in interest rates bearish in such an environment? Because it means a decline in the demand for credit. When people want less of something, the price goes down. The recent drop in rates indicates less borrowing, which means that the primary prop under investment prices -- the expansion of credit -- is weakening. That's one reason why stock prices fell in 2000-2002 and why they are vulnerable now. This is the opposite of "pumping liquidity"; it's a slackening in liquidity.

The Big Bailout Bluff

Last week, a consortium of the USA's three largest banks -- Citigroup, Bank of America and JP Morgan Chase -- agreed to create a super fund (called M-LEC) of $80 billion "to buy distressed securities from SIVs [Structured Investment Vehicles]." Of course, like the Fed's loans for only the very best paper, the super fund will buy only high-quality mortgages, not the sub-prime or Alt-A stuff.

Do you think this plan will work? First let's examine what the SIVs did to get themselves in trouble. As AP (10/16) reports,

The SIVs used short-term commercial paper, sold at low interest rates, to buy longer-term mortgage-backed securities and other instruments with higher rates of return. With the seizure of the credit markets, many SIVs had trouble selling new commercial paper to replace upcoming obligations on older paper.

Their plan, in other words, was the equivalent of a perpetual motion machine: "Money for Nothing," as the song title goes. But the world does not work like that. Oversized interest rates often mean that the investment is in fact sucking money out of principal. Sometimes investors can get away with the gambit for awhile, but eventually somebody pays the bill. The collapse in sub-prime mortgages and in the commercial paper that supported them has simply adjusted the value of the principal to make up for the outsized returns that these investors got over the past five years. But guess what: The money that banks owe on their commercial paper didn't change. Sounds like trouble. And here is what are they are doing about it:

This time around, the banks hope to not only prevent credit problems from spreading, but also are bailing themselves out. (AP, 10/16)

This idea is the equivalent to trying to levitate yourself by pulling on your legs. These banks are going to offer more commercial paper to buy mortgage assets; in other words, they are going to borrow more short-term money in order to buy long-term assets from themselves! That is, if they can borrow the money in the first place. One of the casualties in the rout was the commercial paper market; investors are realizing that it backs a lot of lousy mortgage debt, so they are backing away from investing in the commercial paper that backs the mortgages.

The last time banks colluded to hold up an entire market was October 1929. It didn't work.

On July 9, 2007, the CEO/Chairman of Citigroup said, "When the music stops, in terms of liquidity, things will be complicated." Now wait a minute. We keep hearing that the Fed will shore up all their debts with perpetual liquidity, so how do you explain this comment? Answer: The bankers know better. Liquidity, formerly the solution, is now the problem, and the bankers know it.

The only solution that bankers, regulators, politicians and the Fed can think of is to do more of what they did to get into the problem in the first place: create more debt. They know of no other response. When the big bankers met via conference calls, "Besides hearing from senior executives from each of the big banks, the group also sought ideas from others." In other words, they are flailing for a solution to a problem that has no solution aside from taking measures to make it worse. I still think there is no better analogy to a system-wide credit binge than a person who keeps going only by gulping down amphetamines. He will collapse if he stops taking them, but if he keeps taking them he will ultimately die. Bankers always choose to ingest more speed. Their choice is to collapse now or die later. They always choose later. But they cannot avoid the inevitable result.