Freedom Lawyers of America

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Friday, August 01, 2003

IT'S LONG BUT INFORMATIVE

A LANDMARK TURNING POINT IN INTEREST RATES

A radical shift of monumental dimensions is sweeping the globe, and the
shift is about to hit the fan ...

After years of calm and complacency, bond investors are suddenly panicking,
bond prices are crashing, and interest rates are surging.

The shift is affecting Treasury bonds, Ginnie Maes, Fannie Maes, tax-free
municipals, and corporate bonds. It has struck high-rated bonds, junk
bonds, and foreign bonds. It is happening in New York, London, Frankfurt,
and Tokyo.

There is no escape and no exception. When long-term interest rates rise,
bond prices inevitably decline across the board. Indeed, right now, every
single long-term bond on the planet is falling. To better understand the
impact, put yourself in the shoes of bond investors:

If you bought the 5 3/8% Treasury bond of 2031 at its peak of $120.80, you
have seen your investment plunge to $103.62, a 14% loss in just 36 days.

If you bought the 7 3/8% Cummins Inc. of 2028 at its peak price of $101.08,
you've watched it sink to $87.92, a loss of 13% in just 43 days.

Investors holding bonds issued by Japan or Germany, or by IBM, GMAC, or
hundreds of other companies, have suffered similar declines.

If declines of this magnitude were in stocks, it would not be so
surprising. But remember: We're talking about bonds, and their declines are
ringing alarm bells in Washington ... sounding a wake-up call for fixed
income investors ... and throwing into doubt a list of widely believed myths:

The myth that bonds are "safe." The reality: The bond markets of the world
are a great bubble, artificially pumped up by the Federal Reserve and other
desperate central banks that have been trying to save their economies. Now,
that bubble is beginning to burst.

The myth that the Fed can always lower long-term interest rates (and boost
long-term bond prices) simply by cutting short-term interest rates. The
shocker: The Fed just lowered short-term interest rates to 1%, but as soon
as it did, long-term interest rates went up - not down. (See July issue).

The myth that interest rates rise only when the economy and employment are
growing. The truth: The economic recovery is still weak, with employment
still stuck in the mud. But long-term interest rates are already surging.

The myth that long-term interest rates rise only when inflation is rising.
The truth: Rates are rising despite the fact that deflation is still raging
across the globe. (I'll explain why in a moment.)

The ultimate myth - that the Fed and central banks control short-term
interest rates. Most of the time, yes. But as you've just seen, when bond
investors are determined to sell - for whatever reason - they drive bond
prices down and bond interest rates up, and there's virtually nothing the
Fed can do to stop them. Later, if bond rates rise far enough, the Fed will
have no choice but to let short-term rates go up as well.

In the final analysis, it is the natural forces of supply and demand - not
the Fed - that determine the fate of interest rates.

A Ticking Time Bomb for the World Economy

Even with US and foreign interest rates at the lowest level in more than
half a century, the major economies of the world were in a funk -

The United States in a so-called "jobless recovery" ...

Japan facing its fifth recession since 1990.

Germany in the first stages of a recession ...

These are the first-, second-, and third-largest economies in the world! If
they are already struggling, even with ultra-low interest rates, what will
happen with higher interest rates?

These three economies have the most modern financial systems, the most
powerful central banks. If they can't control their long-term interest
rates, who can?

All three countries are now running the largest budget deficits in the
history of mankind. If they have already lost control of their finances
even before big declines in their economies, what will happen if their
economies sink further?

All three are beginning to find it more difficult to attract willing buyers
for their bonds without offering higher yields. If this is already a
problem now, even with their promises of permanently low short-term
interest rates, what will happen if they are forced to break that promise?

The answer: Higher interest rates (whether long- or short-term) will
fracture the already-fragile, arthritic spine of the world economy.

Higher interest rates will drag down the profits of virtually every company
with large debts; and large debts is a permanent feature among a majority
of companies in America and around the world.

Higher interest rates will slow down corporate financing and investment,
consumer borrowing and spending. Higher interest rates will affect
trillions of transactions in virtually every sector of every economy in the
world.

In the United States, for example, one sector - easily the most vulnerable
of all to rising rates - has already begun to weaken ...

Is the Mortgage Bubble Bursting?

No economist anywhere will dispute the fact that the most pivotal - and
fragile - industry in the US is housing and construction.

Throughout the last three years, while techs wrecked and manufacturing
tumbled, housing has been the last bastion of support for consumer
spending, retail sales, and the entire economy.

Problem: The housing bubble was driven by the mortgage refinancing boom;
and the refi boom, in turn, was driven by ridiculously low mortgage rates.

Now, take away the low mortgage rates, and what do you get? You get a chain
reaction of events that could lead to the greatest housing bust in decades:
A sharp slowdown in refinancing ... a sudden disappearance of cash in the
market ... a new wave of mortgage defaults ... a cascade of prices ... and,
ultimately, a bursting bubble that could make the tech wreck seem tame by
comparison.

Is it already happening? It's too soon to say with certainty. But the MBA
index of mortgage loan applications - both for new purchases and for
refinancing - has plunged 27% just in the past six weeks. If this trend
continues, it implies a prompt end to the housing boom.

An end to that boom will rock the boat of every major player in this market
- Fannie Mae, Freddie Mac, and other major mortgage lenders ... insurance
companies, banks, savings and loans, plus any investor who has bought
mortgages or mortgage-backed securities. It will knock the wind out of
consumers. And it will be murder for corporate profits.

Why the Interest Rate Rise You've Seen So Far Is Just the First Phase

In recent months, bond investors had been counting on deflation to keep
interest rates low and the value of their bonds up. They were encouraged
when, for the first time in 70 years, a Fed Chairman began to publicly
voice his own fears of deflation. And they were absolutely delighted when
Mr. Greenspan actually hinted he'd buy bonds in large quantities if that's
what it would take to prevent deflation from spreading.

But now bonds are falling (and interest rates rising) despite deflation,
and investors are wondering: WHY?

The answer: Bond prices are going down for reasons that have little to do
with inflation or deflation:

Reason #1. Bond prices are falling because they were way too high to begin
with. They were artificially pumped up by a dozen Fed rate cuts. As with
any investment vehicle - stocks, commodities, real estate - when prices
rise to the stratosphere, all it takes is a subtle shift in market
psychology, and prices come crashing down. Bond prices are no different.

Reason #2. Bond prices are falling because bond owners are selling; and
they are selling because they need the money. They need it to pay bills. Or
they want to use it for other investments.

Reason #3. Bond prices are falling because of the growing supplies of new
bonds being issued - plus the threat of still bigger supplies on the way.
Who is issuing all these new bonds? The list of just the major issuers
would fill every issue of Safe Money until the end of 2005. It includes:

US corporations like General Motors, Dominion Resources, El Paso Natural
Gas, JP Morgan Chase, Westlake Chemical, and hundreds of others! The CFOs
see that borrowing costs are still near the lowest levels in their
lifetimes, but they also see those costs starting to move higher. So, many
are scrambling to lock down any funds they might need - for future
emergencies or for future growth - now, while they still can.

Cities and states! Many just can't raise taxes or cut spending fast enough
to eliminate their bulging deficits. So, they have no choice but to borrow
the money. That means issuing new bonds in large amounts. Westchester
County, Philadelphia, Washington State, and Minnesota are just some of the
many with major recent issues.

Mortgage companies! Although the refinancing boom is beginning to cool, the
number of new mortgages created each day is still near the highest levels
of all time. These mortgages are then bundled up and sold to investors as
mortgage-backed bonds in huge amounts. Just last year, Fannie Mae sold $325
billion ... Freddie Mac, $191 billion ... and other companies another $323
billion.

Then, while each of these big players is scrambling for their share of your
money, brace yourself for the onslaught of debt issues from the biggest
borrower in the world ...

The US Government Will Dump at LEAST $350 Billion in New Debt on the Market
Before Year End

Why does the government need to raise so much money so fast? The reason is
obvious: To finance its out-of-control budget deficit.

Until recently, bond investors ignored the deficit. They assumed the Fed
would protect them, by continually lowering interest rates or even by
buying bonds directly.

No more! Today, no one can possibly ignore the most rapid swing from
surplus to deficit in over a half century ... the largest federal deficit
(in absolute terms) in the history of mankind ... and most troubling of all
... the fact that the government's deficit estimates are shifting so darn
rapidly.

Just two years ago, the Office of Management and Budget (OMB) projected a
surplus of $2.9 trillion for the six years between 2003 and 2008. Now, the
same government agency is estimating a total deficit of $1.9 trillion. It
is one of the most dramatic reversals of all time - a total swing of $4.8
trillion!

Heck, just in January, it said the deficit for 2003 would be $300 billion,
already a shocker at that time. Now, only six months later, it says it's
going to be $455 billion?!

I don't expect perfection, and I I'm sure you don't either. We can tolerate
forecasting errors of 5% or even 10%. But an error of over 50% in just six
months?! It's both unbelievable and unforgivable.

Do you fully recognize how serious this really is? It means that the
government and its agencies will probably have to raise at least $350
billion in new funds between now and year-end.

Moreover, it means that no one - let alone bond investors - can trust the
government's projections any more. The estimates have been so wildly
optimistic, they have lost all credibility.

And sadly, the current government figures are equally wild in their
optimistic assumptions - rosy forecasts for the economy, rosy expectations
for the reconstruction of Iraq ... plus dicey budget accounting.

I've warned you about this repeatedly in Safe Money. Back in 2000, I told
you the so-called "budget surplus" was a mirage that would soon be
transformed into the largest budget deficit in history. In 2001 and 2002, I
repeated those warnings.

Then, just three months ago, I warned you again. I told you that the
administration's budget estimate was far off target, and that you should
expect the deficit to mushroom to the $500 billion level.

That's exactly where it is today. We have the admission by the OMB of the
$455 billion deficit excluding Iraq reconstruction costs plus the admission
by Defense Secretary Donald Rumsfeld that those costs have doubled to $3.9
billion per month. Add them together, and there you have it: A $500 billion
official deficit.

But that's just the tip of the iceberg. Much like big companies jury-rigged
their pension fund gains to make it look like they had bigger profits ...
the US government manipulates Social Security surpluses to make it look
like it has bigger revenues. And much like Enron and others hid debts and
expenses in subsidaries and partnerships, the US government hides big
deficits in government-related agencies.

Last year, the total amount the government and its agencies borrowed was
$812 billion, and in the next two years, it could average over $1 trillion.
This is the real deficit. It's huge, and it's not going away.

The Stock Market: Between a Rock and a Hard Place

The stock market may have some more room to rally - there's no law that
says it must respond immediately to the interest rate rise. But overall,
it's between a rock and a hard place:

* To justify its recent rise, it desperately needs to get a lot more
confirmation of an economic recovery.

* BUT ... any new evidence of a recovery will send bond markets into a
tailspin, drive long-term interest rates skyward, and doom that recovery to
a premature end.

In the weeks ahead, you may see some additional news of economic
improvements in some sectors. And you will no doubt hear many Wall Street
analysts dismiss the interest rate rise and its causes. Watch out!

Don't believe Wall Street when they tell you "the interest rate rise is of
little importance." As you've seen already, its consequences can be dramatic.

Don't believe administration officials when they tell you "the deficit is
manageable." That's hogwash - even in comparison to GDP, it is near the
highest levels in history.

Most important, don't count on Fed Chairman Greenspan's promise to keep
short-term interest rates low. As long-term interest rates go higher, they
force borrowers to get their money from medium-term markets; and as
medium-term rates are driven higher, they force borrowers into the shortest
maturities.

Slowly at first, but with gathering momentum, the demand for money cascades
down the yield curve, from long term to short term. The rates on Treasury
bills, commercial paper (short-term corporate IOUs) and other money market
instruments will drift higher. Sooner or later the Fed will have no choice
but to recognize the reality.

Mark my words: One day in the not-to-distant future, Mr. Greenspan will
shock the world with the first of a series of interest-rate hikes.

It will be Wall Street's worst nightmare. But they have no inkling it's
coming. Their heads are buried in the sand.

posted by FLoA # 8/01/2003 09:03:44 PM

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Friday, August 01, 2003

IT'S LONG BUT INFORMATIVE

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