Bernanke’s day of reckoning has arrived.
Now is when he must decide precisely how to start cutting back the Fed’s massive, high-wire bond-buying escapade.
Now is when we’ll see how treacherous it can be to unwind a speculative bubble.
And now is the time you need to be prepared for the far-reaching impacts — not only on bonds of every stripe and color, but also on your stocks, ETFs, and mutual funds … your residential and commercial real estate … your business, your job, your retirement … and virtually every financial plan you’ve made or thought of making.
This is why Money and Markets interest-rate specialist Mike Larson has been standing on the rooftops to broadcast his warnings of sharply higher rates ahead.
And it’s also why I want to share with you the thoughts of another interest-rate prognosticator — my father, J. Irving Weiss.
My father began studying interest rates in the late 1930s, including work with the world’s most prominent interest-rate historian, Sidney Homer.
Dad’s unique viewpoint: Rising interest rates are not caused just by rising inflation. An even bigger factor is the relative size of the nation’s DEBT MONSTER.
As long as the debt monster continues to grow at a rapid pace, he argued, any attempt by the government to hold interest rates down is bound to backfire. Ultimately, the Fed has no choice but to remove its lid on interest rates and let them explode higher.
Based on this theory, Dad not only predicted the greatest interest-rate surge of modern history (in the late 1970s), but he also pinpointed the ultimate top in interest rates years ahead of time: 13% for long-term U.S. Treasury bonds, 17% for 3-month Treasury bills.
As you’ll see from his writings of the 1990s, which I’ve excerpted below, his insights are still directly pertinent to what’s happening today.
Why the Fed Can Never Unwind a Bond Bubble Gradually
by J. Irving Weiss (1908 – 1997)
As I write these words sitting on my easy chair, my grandson is writing his own words with my discarded papers.
Little does he realize that this story will affect him even more than it affects me.
Unfortunately for both of our generations — and especially for his — the U.S. Federal Reserve is no longer in the business of controlling inflation and moderating economic excesses.
It’s in the business of creating them.
You see, for the Fed to create a speculative bubble is relatively easy — especially in the bond market. All it has to do is ease money aggressively and pump liquidity into the economy consistently. Then, speculators rush out of safety and into risk, fueling the bubble.
Unwinding the bubble, however, is another matter entirely. Even the Fed’s most gentle and subtle pinprick can unleash panic selling in the bond markets that’s beyond anyone’s ability to control.
Case in point: The speculative bubble in bonds that the Fed created in the 1970s.
The bubble started under President Richard Nixon in 1969 when the Fed began pumping money into the U.S. banking system in huge amounts.
The Fed under Nixon thought this was the only way to revive a moribund economy. But the Fed’s critics — especially economists from the Chicago‑Saint Louis monetary school — thought the Fed was crazy.
At a meeting held in West Germany in June 1971, they asked:
Why has the Fed suddenly doubled the rate of growth in the money supply?
Why has the Fed stepped into the credit markets with one of the strongest attempts at monetary expansion in history?
Have they gone berserk?
The reply from Fed officials went something like this:
Imagine interest rates soaring to the 17% level, the housing market falling apart, unemployment rising to new heights while economic activity is almost frozen! That’s what would happen if we had followed a policy of gradual monetary expansion.
What the Fed officials didn’t realize is that, by the end of that decade, all this would wind up happening anyhow — with the added “bonus” of an out‑of‑control deficit and double‑digit inflation.
But they apparently didn’t care about the future. All they cared about was the here and now.
The Nixon Devaluation
Then, on August 15, 1971, Nixon decided that all that money pumping was still not enough to get the economy going fast enough — let alone doing so while keeping inflation under control. So he announced a series of economic bombshells:
He imposed a ninety‑day wage‑and‑price freeze. He declared a 10% surcharge on imports. He eliminated the requirement that the dollar be backed by gold held in Fort Knox. Most shocking of all, he unilaterally abrogated the international agreement — made at Bretton Woods in 1944 — designed to maintain stable world currencies.
This was a direct, frontal attack on everything I had lobbied for. Nearly all my life I fought to help the United States maintain a sound currency. Even Nixon himself, when he was Vice President, had thanked us personally for our efforts. Now, in one fell swoop, he did more to destroy the dollar than any U.S. president in modern history.
His wage‑price freeze was a joke. Just as soon as the freeze was removed, pent‑up inflation took off.
But it was the devaluation of the dollar which was the worst of all. Before Nixon’s devaluation, the dollar was the sun around which all other currencies revolved. After Nixon’s devaluation, it suffered collapse after collapse after collapse.
The growth in America’s labor productivity, which had been increasing with only minor interruptions for nearly two hundred years, slowed down — a prelude to actual declines that would start by the end of the 1970s.
And it was due to this decline in U.S. productivity that, years later, other industrial nations, such as Japan, Korea and Taiwan, took over as world leaders in manufacturing and trade.
The inflation problem burst onto the main arena of American life with gale force. Franklin National Bank and the West German Herstadt Bank went under. New York City teetered on the brink of collapse. Wall Street was caught off guard by the sheer fury of exploding interest rates.
Economists finally recognized that inflation and high interest rates were “the most vexing and most intractable of all economic problems,” “immovable,” “hard to cure.” But repeated plans by government economists to deal with inflation and high interest rates never got off the ground.
Back in early 1970, for example, the President’s Council of Economic Advisors (CEA) undertook a massive study to find inflation’s “real causes.”
Herbert Stein, its chairman, passed the responsibility to Arthur Salomon. Several months later, he, in turn, passed the buck to an economist newly arrived at the CEA, Nicholas Perna.
When Stein appeared before the Joint Economic Committee in October 1972, Senator William Proxmire asked about the status of the study. “We are not prepared to make the conclusions of that study public,” Stein said. “We will have more to say about it in our report.” But the report, when it finally appeared, made no mention of the study.
I believe Nixon knew all along that he was pumping too much money into the economy and feeding the fires of inflation. I think his real concern was to protect his own personal interests and those of his friends, while covering up the fact that inflation — and soaring interest rates — were the inevitable consequences of their policy.
I was outraged. Our dollar and our country were being dumped down the tubes.
As the 1970s rolled by, I waited for someone in Washington to tame the federal debt monster and tackle inflation. But no one lifted a finger.
The dollar continued to sag. Then it collapsed. Between early 1977 and late 1978 — within less than twenty‑four months — the dollar plunged from nearly 300 to 175 against the Japanese yen, from 2.4 to 1.8 versus the West German mark, and from 2.5 to 1.5 vis‑à‑vis the Swiss franc.
It was the sharpest drop in American currency since the collapse of the Continental Currency two hundred years earlier.
Still, most people in Washington didn’t seem to care. They just didn’t understand how vital it was to maintain a strong currency; how dangerous it was to let it fall.
They didn’t understand its potential impact on the bond market, the stock market and even our national security.
Volcker’s Shock Therapy
Interest rates moved higher in a series of ever-greater surges. And toward the end of the 1970s, the consequences began to hit home in a big way:
OPEC threatened to refuse payment for its oil in dollars. Commodity prices surged. Inflation was about to take off into high double‑digit territory. Unless something was done immediately, our country was on its way to becoming the equivalent of a banana republic.
So on October 6, 1979, President Carter appointed a new Fed Chairman, Paul Volcker.
And from the get-go, Volcker knew that it’s simply not possible to unwind speculative bubbles gradually. He’d have to take drastic action.
He couldn’t do anything about the federal deficit. That was too far gone. Nor could he help the bond markets. It was too late for that too. All he could do was freeze the money pumps and hope that nature would eventually take its course to right-size the markets.
Volcker raised the discount rate two full percentage points. He imposed stiff controls on borrowings by America’s banks. And most important …
Volcker gave up the Fed’s recent approach of trying to control interest rates directly. Instead, he reverted back to the traditional Fed approach of controlling the money supply and letting interest rates rise to whatever level was necessary in order to balance the forces of supply and demand for money.
For months, interest rates had been bottled up, held down artificially. Now, Volcker’s actions were like yanking off the lid from a pressure cooker. Interest rates exploded!
In the first 10 days of October 1979, the yields on 30‑year government bonds surged as their price plunged four points in four days. A $1 billion IBM issue — hailed weeks earlier as a “brilliant piece of corporate finance” — was now being described as the “greatest underwriting fiasco of all time.”
But there was still a tremendous amount of inflation left in the pipeline: In January 1980, the month‑to‑month consumer price inflation surged to an annual rate of some 18%, sending interest rates further into the stratosphere.
Then in early February, an infamous landmark was surpassed: The yields on 30‑year Treasury bonds rose above 11%.
Most people didn’t understand how important that was. I did. I studied the history of interest rates in America as far back as the 18th century. I knew exactly where the critical peaks were and what they meant.
The last time Treasury bond yields hit 11%, our country was divided in two as the Civil War raged. “Isn’t it ironic,” I thought to myself, “that so many millions died back then, only to let greed undermine our country again a century later?”
By mid‑February, the bond market was approaching a doomsday scenario. Now, no matter what the yield, the Treasury could not find enough buyers willing to buy its bonds.
Bonds were supposed to be safe. If they fell by more than three or four percentage points, that was big. But now investors had losses totaling at least 25% of the market value of their bond holdings, or more than $400 billion. They were absolutely terrified.
One analyst quoted in the Wall Street Journal put it this way:
“Unless those that brought us this disgusting inflation want to see a government, corporate and tax‑exempt market worth $3.5 trillion, along with a mortgage market worth $2.5 trillion, wiped out, it is clear they are going to have to do something. … If that includes taking away the money that has made this sickening inflationary party possible, then we could have an awesome hangover.”
The bond market collapse continued as interest rates surged. Treasury bills hit passed 16%. Bonds hit 13%.
However, it was much more than just a collapse in the price of bonds. We began to see a collapse in the bond market mechanism itself.
You see, the plunge in prices caused huge losses to the Wall Street bond dealers who acted as middlemen between the United States Treasury and the public. Many of the dealers were on the verge of running out of capital.
So they were forced to cease their bond operations. They closed up shop. Only a few larger dealers, such as Merrill Lynch and Salomon Brothers, continued doing business.
“If the plunge continues,” a leading press commentator wrote, “the bond market will have to close down completely.” There would be no money for government paychecks, no money for Social Security checks and no money to run the government.
I called my son, Martin, who was in Japan at the time, to get his opinion.
“Either Carter deflates the economy or he shuts down the government,” he said. “There are no other choices. It doesn’t matter that he’s a Democrat, that this is an election year, that it will kill his chances for re‑election. This isn’t politics. It’s national survival.”
Martin was right. The politicians knew that it was the Treasury’s borrowing power which guaranteed that their own paychecks wouldn’t bounce. They had a personal, vested interest in protecting it. Besides, what good is it to be re‑elected to a government if there is no government left?
Sure enough, on April 15, 1980, 8 years and 8 months after Nixon devalued the dollar and started the crisis, Carter did the unthinkable:
He imposed a rigid series of credit controls. He shut down the life blood that fed the economy — credit.
For the first time in history, a Democratic President, in an election year, took steps to deliberately force the economy on a downward path. This event, above all, demonstrated the enormous power of exploding interest rates.
Credit controls didn’t last very long. But just as soon as they were lifted, interest rates surged to new highs. And again, Fed Chairman Volcker clamped down.
In the years that followed, I thought that America’s leaders had learned something from their mistakes of the 1970s and 1980s. But, they didn’t learn a darn thing.
Why Interest Rates Will Explode Again
All the blind blunders of the past are going to be repeated.
The Federal Reserve is pumping massive amounts of reserves into the banking system. They think they can get away with it, but they can’t.
The Fed has artificially pushed interest rates down to the lowest levels in decades. They think they can do this with impunity, but they can’t.
The Fed has encouraged widespread gambling on interest rates by thousands of banks, brokers and insurance companies. History has proven they’ll never get away with that either.
The Fed’s policies have prompted millions of small savers — people who can’t afford any losses whatsoever — to switch from conservative CDs or money markets into stocks and mutual funds, a hotbed of unbridled speculation.
My old friend, Dr. Kurt Richebächer, former Chief Economist of Germany’s Dresdner Bank and editor of Currency & Credit Markets, puts it this way:
“The Federal Reserve has deliberately and knowingly sponsored the most dangerous speculative bubble of all time. For more than a year, the Fed has had one single monetary target — a Fed Funds rate of 3%.
“In order to keep it there, the banks have been flooded with reserves. This is the exact reverse of the course Fed Chairman Paul Volcker followed throughout most of the 1980s. He controlled bank reserves and let interest rates go wherever they might. Today’s policy is sheer recklessness. It’s causing severe dislocations in America’s liquid resources — forcing a shift from safety to speculation.”
Like a giant balloon mortgage, the world’s debts are about to come due. In the federal budget, just the compounding cost of interest alone has threatened to cause an uncontrollable surge in the deficit. The mushrooming entitlements — not to mention health care — are about to produce still another burst of red ink.
In every single recovery of the postwar years, whenever there was a clash between private borrowers and Uncle Sam, interest rates rose. It happened under Johnson and under Nixon. And it happened under Carter.
But back then, the deficits were much smaller than they are today, even in relative terms! After the next recession, the deficit could jump to $700 billion, $800 billion, even $1 trillion. Interest rates will explode again.