Friday, September 19, 2008

Interest Rates are the Key

A government spokesman today said something that made everything click together. The statement went something like, “We don’t have to sell this stuff, we can wait until it matures and get the full value.”

With mutual funds and retirement plans, they both buy long term bonds that could mature 15-30 years out say paying 3% interest. If a fund has a lot of redemptions, the problem arises of raising cash. Selling bonds in an illiquid market is not easy. The standard procedure is to discount the face to make it attractive to investors. A 100K 2038 bond yielding 3% if discounted 50% would be sold for 50K and pay 6% interest. In 2038 you would get the full 100K. So if a fund needs money today, they discount the bond until they get a buyer. That is not happening.

The bonds are not being dumped on the market. I could be wrong, but what if the Fed is buying them and redeeming them possibly in full, to “put liquidity” back into the market? Our Government is going to hold them and get the full value when they mature.

The thing to realize here is that if this stuff was allowed to be dumped on the market, the yield on 30 years bonds might jump to 20%. That is not happening. The Fed is “saving” us. Isn't inflation at about 10%? Nah, it must be my imagination.

The neat thing about interest rates, the current price of a bond is very easy to determine, if you know the rate the bond pays, and the current interest rate. Divide the smaller interest rate by the larger one and multiply that by the face amount of the bond. That would be the current sale price on a 30 year bond. The closer the bond is to the redemption date the more they approach the face value. So if you are holding 3 month T-Bills this won’t even bother you. Waiting 30 years for your cash back is a lot of water under the bridge.

Step back for one moment and look at the national debt. Figure it is somewhere between 6 and 10 trillion dollars. What would be the interest payment on the national debt if long term rates went to 20%? Do you get the feeling that high interest rates could be the punishment that the Fed is trying to avoid at all costs? Could we afford to pay 500 billion to one trillion in interest each year on the debt? Even your Congressman can understand the math here.

I remember people saying “Housing prices will always go up.” I haven’t heard that in a while. Have you heard this one,”When capital is scarce, interest rates rise.” Could it be the problem isn’t really liquidity? Maybe interest rates are way too low. How could that be????

Common sense dictates that there is no reason to put money in a retirement fund if it’s losing money or if the banks don’t pay any real interest. Why not just spend it? People could turn to gold as an investment option. The government might have to once again make gold illegal to own.

I guess, we all need to tune into the Ben and Paul show on Monday to see what we bought over the weekend.

Copyright 2008 All rights reserved


Anonymous said...

As far as I can tell, there's absolutely no reaction to anything occuring. A five year old has more reaction to "daddy lost his job" than the average American has to the current financial situation. And that's the few that know one is going on. How about Alice for president. She, at least, knew she was in Wonderland.

Anonymous said...

I can't believe our President is so happy to nationalize the financial system of the USA. A Republican to boot, the party that has blamed the Depression on FDR's attempts during the 1930's. Paulsons actions put FDR to shame! This is more than a crime; it is a blunder! I have contacted my congressional reps to say Stop The Bailout!! I hope you do too.

Jim in San Marcos said...

Hi Anon 5:05

I don't think it has sunk in yet. Remember if you are living from paycheck to paycheck, this doesn't affect you. If you just walked from a foreclosure, the same hold true.

But if you have savings and retirement funds, you know you have been hit. This is where the money came from.

I wouldn't be surprised to see Ben and Hank in a sequel of "Alice in Federal Reserve Land" Same plot, and with enough cocaine everything would look GREAT. Plus you wouldn't give a damn.

Thank you for your comments

Jim in San Marcos said...

Hi Anon 7:46

I think you are jumping the gun a tad. The minute the President came out and declared that the economy needed help, he pretty much speeded up what will happen next. I've got a post I'm getting ready for tomorrow. I don't think that Congress has enough time to pass a bailout. The game is almost over.

Next week should be the final segment of this soap opera.

Thank you for your comments.

Shankar said...

Let me ask you a question.

Isn’t it in Treasury/Fed’s best interest to walk over the market and push the new supply in the market at lower yields - maybe short-term?

After the market debacle, refinance short-term into long-term as the yield-curve flattens.

And then finally blowing them up into pieces?