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If You Think Higher Interest Rates
Will Help the Dollar, Think Again!
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Since the release of the Fed Open Market Committee
statement yesterday, much has been said about the Fed's newfound
commitment to contain inflation. However, currency traders
have apparently confused the Fed's mere mention of the word
"inflation" with an actual intention to do something
about it.
Presuming that a tougher Fed means higher interest rates,
traders have aggressively bought dollars. However, this conclusion
ignores the facts that higher interest rates will ultimately:
1) precipitate a severe recession, 2) exacerbate both the
current account and budget deficits, 3) collapse the housing,
stock, and bond market bubbles, 4) cause millions to lose
their jobs, 5) bankrupt millions of consumers, and thousands
of companies and hedge funds, 6) result in capital flight
out of the United States 7) and not even rise high enough
to exceed the rate of inflation, leaving real yields negative.
Therefore, higher interest rates will actually weaken, rather
than strengthen, the dollar. Currency traders betting on the
reverse be warned.
The Fed is attempting to do with words what it is incapable
of doing with deeds. It has neither the means, nor the desire,
to combat inflation, which is its own creation. By denying
that inflation exists, and pretending to be concerned if it
were to emerge, the Fed is able to fool America's creditors,
buy life support for the U.S. bubble economy, and postpone
the inevitable day of reckoning.
Let me elaborate on the points I mentioned earlier:
1) Precipitate a recession - As they will result in the cost
of adjustable rate mortgages and other floating rate debt
to rise, higher interest rates will crush consumer spending
and result in greater shares of household incomes going to
debt service. Consumer spending is 80% of U.S. GDP.
2) Exacerbate America's "Twin Deficits" - Due to
the short-term nature of Americas outstanding debt instruments,
higher interest rates will increase both the budget and current
account deficits, as higher interest payments are required
to service maturing debts. Also, the recession itself will
add to the deficit, resulting in even more borrowing at even
higher interest rates.
3) Collapse the housing, stock, and bond market bubbles -
Asset bubbles depend on low interest rates and continued speculation
to sustain their inflated prices. When the bubbles burst,
the shockwaves will reverberate throughout the entire economy.
Individual household net worth's will be turned upside down,
with reverse-wealth effects restraining consumption for years
to come. The entire financial system will be at risk, as asset
prices fall too low to secure the debts they currently collateralize.
In addition, as the cost of servicing those debts grows, an
increasing amount will default, exerting further downward
pressure on prices.
4) Cause millions to lose their jobs - Since the majority
of American workers depend on the discretionary spending of
other Americans, millions will be unemployed. Especially hard
hit will be mortgage and consumer finance, home building,
real estate sales, financial services, travel, entertainment,
and retailing. In other words, just about every American.
5) Bankruptcy of millions of consumers, and thousands of companies
and hedge funds - As the cost of servicing floating rate,
short-term debt rises, debts will be increasingly more burdensome
to service. Consumers have borrowed heavily with ARM's to
buy residential real estate at inflated prices, corporations
have financed long-term capital investments and share buy-backs
with short-term debts, and hedge funds have leveraged heavily
using short-term financing to buy long term bonds. If you
thought the 1998 blow up of Long Term Capital Management was
bad, multiply it by 1,000.
6) Capital flight out of the U.S. - Recession, unemployment,
collapsing assets prices, and waves of bankruptcies and foreclosures,
will cause capital, both foreign and domestic, to flee. This
will put additional upward press on interest rates and downward
pressure on the dollar.
7) Real yields still negative - Despite the fact that interest
rates will be rising sharply, inflation will be accelerating
even faster. Therefore real interest rates are likely to fall
even as nominal rates soar. This will likely weigh heavily
on the dollar.
In the final analysis, higher interest rates, especially
when they result from inflation rather than growth, will likely
be the straw that breaks the back of the over-leveraged American
economy. As the world's largest debtor nation struggles to
make higher interest payments on its massive external liabilities,
those holding its IOU's will finally come to their senses.
Realizing that the burden will ultimate proof too great, they
will attempt to sell. Unfortunately, this realization will
likely come too late, as few will be willing to take the other
side of the trade.
Peter Schiff
C.E.O. and Chief Global Strategist
Euro Pacific Capital, Inc.
pschiff@europac.net
www.europac.net
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