Good evening everyone!  

Welcome to spring!   Out here however, it still feels like winter.  We have not made the transformation yet.  I am looking forward to it however. 

Interest rates and the shape of things to come!

This is an unusual time in the markets and uncertain time in the U.S. economy in my opinion.  We are in the midst of a bull market in commodities that began at the lows in the late nineties (which I wrote about in 1998 in a special report on the upcoming bull market in commodities).  In addition we are likely in a bear market in stocks which won't become apparent however until we are much lower in price.  However as I have also said I believe we may enter into a period similar to 1963 - 1983 where for 20 years stock prices did nothing basically but move sideways in a large range.  The only difference here (between that period and this one) is that stock prices in the Dow and S&P500 for example could actually decline for the better part of the 20 year period as well (similar for example to Japan from 1990 - 2005).  Thus this is obviously not the 1990's anymore!!!   There's some strange occurrences right now too.  Lets discuss. 

I find the current IMPA data in Ten year notes and US bonds very perplexing at this time.  The current net-com position is at extreme high levels (EUCL) in both Ten year notes and US bonds.  The level of EUCL penetration in TY is quite astonishing in my opinion as well.  The net-com in TY for example has gone from a low of -16,678 on October 26th 2004 (price of 113.80) to the current new record high of +508,893 (price of 108.72) on March 15th 2005.   Its going to be very interesting to see how this large net-com position is resolved (I'll be watching this very closely).  Overall I have not anticipated rates coming down in 2005, but this data seems to be suggesting they will !  Thus its suggesting lower rates later in 2005, not higher rates!   Thus we have to ask -  What would cause that?  Something unexpected perhaps (such as a terrorist attack) but no one of course knows when or if that might occur.  The other event that could cause rates to fall would be an economic slow down or recession, which I believe is very possible as the U.S. economy is very vulnerable right here in my opinion.  In fact, I am more concerned about the U.S. economy today than ever, period.  I don't think the economy is all that strong and the strength that is there isn't all that sustainable in my opinion (it is far to consumer driven).  

Economic conditions in the U.S. may not be as healthy as many think.  In fact there are some warning signs that the economy is actually on the verge of a possible collapse!   What's holding it up?  Consumer consumption and world-wide confidence in the U.S. economy and currency (dollar) even in the face of a mountain of growing debt and weak currency.  As I have discussed in the past however, if for some reason this confidence is seriously disturbed the result could be devastating.  Confidence perhaps is the only thing that keeps everything from falling apart with the U.S. economy.  Confidence is crucial in a society who's currency is backed up with nothing more than a promise.  

Many changes have taken place in the last 30 years which have only recently come full-circle in my opinion.  And changes in the last 5-10 have changed my overall longer-term outlook on the possibility that the U.S economy could seriously falter in my life-time (and possibly over the next 5-10 years).   There are obvious serious issues with sky-rocketing health costs and insurance as well as government programs such as social security and Medicaid,  which are nothing more than government run ponzi schemes in my opinion (paying new money out to older contributors).  

Free trade in recent years has also brought the world closer and along with technology has improved transparency greatly.  In addition over the last 50 years America has changed from a producing economic power following WW11 to a consuming economic power accelerated in recent years due to the creation of massive amounts of temporary wealth.  This is what I call false wealth.  Let me give you an example.  The run up in dot.com stocks during the nineties created roughly 4 trillion dollars in false wealth.  The almighty U.S. consumer fed the false wealth right back into the same system, fueling prices higher and higher while pushing consumer credit debt higher and higher.  As paper profits continued to rise the consumer continued to spend more and more, dumping money right back into the same arena (software, electronics, computers and so on) which kept the dot.com's fueled for awhile.  However this could not continue for long.  The pundits all said it would continue for many years and was different "this time".  They all had intelligent reasons as to why that would be so  - but as history has proven time and time again, speculative frenzies always end the same way!  

The Nasdaq dot-com bubble burst and the trillions evaporated into thin air almost as quickly as they appeared, leaving U.S. consumers holding the bag (with mounting debt).  With the economy soon in recession following the Nasdaq bubble the Fed raced to the rescue lowering interest rates to all time lows (Fed Funds).  Short-term this was not a bad idea, however the longer-term consequences were unclear at the time.   The Fed perceived the risks to be higher on the short-term and thus moved quickly to lower interest rates (following 9/11).  This was done in conjunction with one of the largest U.S. tax cuts (for the most wealthy) in history.  This equated to a massive shot in the arm for the economy and the result was as expected!  The consumer kept on spending and a new wealth affect now appears to have been created in my opinion - A bubble in real estate prices.   

Real estate prices have risen pretty substantially now across the country and we are now faced with a serious potential bubble in real estate which could in my opinion deflate like the Nasdaq if rates were to rise to quickly.  Even if rates rise gradually eventually this will choke off the demand and leave many U.S. consumers holding the bag again (those buying at the top).  The market appears to be in a frenzy not unlike the Nasdaq in 1999 at this point which means we could have a little more room on the upside. However at some point I think we're going to see a top.  The Fed appears more and more concerned about this issue and that is precisely why they are taking "baby steps" with the rate hikes in my opinion.   However what has Greenspan and the Fed perplexed as well as myself is the unusual disconnect between stable long-term rates and rising short-term rates.  The Fed has raised the short-term rate (Fed Funds) from 1% to 2.5% but the long-term rates have held steady and actually declined for part of the time (when they should have risen by most accounts).  This indicates some other force is overriding the fed manipulation basically and its unclear what it is!   But it is showing up in the COT data as well via the record size net-com EUCL penetration in the TY and near record amount of UCL penetration in US Bonds as well.  More than likely its SPECULATION in derivatives from the endowments, pensions and so on who also have a huge stake in the real estate bubble continuing!   If the bubble burst and consumers can't pay back the debt the consumers can go default which could transfer the bag to the holders of Freddie mac Fannie mae mortgage backed securities (and derivatives tied to mortgage instruments and so on) which have all benefited from massive amounts of refinancing in the mortgage industry and huge mortgages many consumers now hold (due to the run up in prices and rampant speculating in these markets, similar to the Nasdaq in about 1999 I'd estimate). If this happens the entire stack of cards known as the U.S. economy could come crumbling down in my opinion.  I've never said this before in the past, there's never been any reason to be so concerned about such an unlikely event in my opinion.  Today however there is, as its no longer that unlikely in my opinion.  

The U.S. economy is no longer an economy driven by production as today is driven by its consumers.  The symptoms of this can be seen in the import/export data and in consumer debt. Consumer spending exploded in the nineties with the run up in stock market prices creating a "wealth affect".  And the "wealth affect" is still occurring today except today its being driven in wealth generated by the real estate market.  In both cases however, whether wealth from non existent profits in high-tech companies (many of which are totally deflated today) or wealth from profits gained in surging hyped-up real estate prices, both are a symptom of consumption (buying stocks or buying real estate) and both are not ideal candidates for sustaining an economy.  The bubble in the tech stocks already burst as we know (and knew about ahead of time via our IMPA).  The bursting of this bubble and the decline in high-flying tech stocks that followed resulted in nearly $4 trillion dollars of newly generated wealth simply evaporating into the thin air it came from!   And now the same thing is happening across the country in the hottest real estate area's.   Today's U.S. real estate market is worth more than all stocks traded on the stock market!  

Bottom line -  If the American consumer keeps on spending and borrowing at the present pace (for real estate or whatever) the dollar could also be affected and it could eventually lose its status in international finance as the world's preferred reserve currency.  This could be the event that causes confidence in the U.S. economy to falter and may eventually bring down this stack of cards (U.S. economy).  All these things coming together and happening at the same time (social security, weakening dollar, real estate bubble and so on) are putting significant pressure on the economy and testing world-wide confidence in the U.S. to resolve these issues and remain the gold standard for the world... Did I mention Gold??  - If there was ever a time to own some gold, NOW is the time in my opinion - I'll repeat that - Now (for the long-term) is the time to own some GOLD!   I've never been a "gold bug" per sae but I have slowly been turning into one since the late nineties and of course bought when the IMPA was bullish at the bottom in the late nineties (1999).  However I sold some of that during the run up in 2003 - 2004 and have been buying to replenish what I sold as I believe gold is now one of the better assets to hold!  The prospects for the dollar looking forward may not be good in my opinion nor is the prospects for price stability here in the U.S.  

Floyd Upperman
March 20th 2005

SPECIAL! TRIAL ACCESS For only $9!  30-day access to the vault!

For a limited time, we are providing a 30-day $9 trial to the service!
Click here for the Trial Access ($9 for 30-days)!