1/29/12: Where in the World to Invest? Tracking Trends in Global Real Estate
Emerging economies, free(er) trade, high speed communication and the troubled financial systems of the U.S. and Europe all add up to people, money and opportunities moving around the globe in unprecedented fashion.
It’s a lot to keep up on! But have no fear, The Real Estate Guys™ are here!
In the studio, behind the shiny silver microphones for another scintillating soiree into broadcast excellence:
- Your emerging, high speed host, Robert Helms
- Your troubled co-host, Russell Gray
In this episode, we flip the mirror around and look at the world from a different angle. Now that we’re big shot international podcasters (being downloaded in over 160 countries!), we can’t just look at the world exclusively through our U.S. centric eyeballs.
Besides, we’ve discovered through our recent trips to South Florida and Phoenix, that non-U.S. citizens are actively buying U.S. real estate that they view as being on sale. So even if you’re a U.S. citizen with no interest in off-shore investing, your domestic real estate is being affected by foreign activity.
Plus as the Chinese economy continues to climb up the food chain (nipping at the heels of Uncle Sam at last check), wealth being created overseas is affecting markets all over the world. One of our fastest growing audiences is in Australia. What’s the connection? Australia is a big exporter of commodities to…drum roll please…China! And how’s Aussie real estate been doing? Pretty hot for quite some time.
And just so you don’t think it’s just all about China, Brazil is starting to light up the economic scoreboard also. Our sources tell us the Brazilians make up a significant chunk of the buyers gobbling up South Florida real estate.
And don’t forget the Canadian dollar, eh? It’s been strong against the U.S. greenback, making U.S. dollar denominated assets more attractive. It’s too bad old guys like us don’t get more attractive when our dollars gets weak…but we digress.
Our point is, as we all learned as children at Disneyland, it’s a small world after all. And what happens in the big economies of the world, can affect you – pretty much wherever you are.
So, listen in as The Real Estate Guys™ talk trends in global real estate – and consider how those trends might create opportunities or challenges you should be aware of. Hey! It it was easy, everyone would do it. But if it can’t be easy, you can count on us to make it fun!
And speaking of fun (warning: incoming shameless plug), we’re getting close to last call for our fabulous annual Investor Summit at Sea™. As of this post, we have investors coming from at least 13 different countries. It’s a great opportunity to build you global network and gain direct personal insights into real estate markets and mindsets from around the world. To get in on the fun, click here now!
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The Disappearing Middle
Recent reports from the U.S. Census Bureau declared that the U.S. middle class is getting squeezed. Shocker. Thank you, Captain Obvious. We were hoping the disappearing middle referred to our beer bellies, but no such luck. 
Of course, our good friend Robert Kiyosaki has been saying for years that the rich will get richer, the poor will get poorer and the middle class will get squeezed. So if you’ve been paying attention, the report from the Census Bureau isn’t a surprise.
The big question is: what are you going to do about it?
If you’re in the middle class and you’re feeling the squeeze, it may be time to make the leap from employee to entrepreneur. Yes, it’s hard work. But so is being poor. If you’re reading a blog like this, you’re probably already committed to being successful, so we won’t waste time preaching to the choir.
So let’s talk about what a disappearing U.S. middle class means to you as a real estate investor.
In the Clues in the News segments of our Mentoring Club meetings, one of the things we watch for is what “the big dogs” are doing when faced with market shifts. And it isn’t just real estate investors we watch. It can be fund managers or corporations. We can learn from anyone who’s watching the economy and managing cash, cash flow, debt and equity.
We saw an article in the Wall Street Journal, As Middle Class Shrinks, P&G Marketing Aims High and Low, that talked about how big corporations are shifting to an “hourglass” marketing strategy. (When it comes to hourglasses and figures, we understand getting excited…but marketing? We must be getting old.)
You can read the article yourself, but the point here is that big corporations are making major adjustments to their businesses to adapt to a disappearing U.S. middle class. Similarly, is there anything a real estate investor should be doing to adjust to the new American reality?
Here are some things to consider:
People will move to where there are jobs. Duh. The million dollar question is where in America are their jobs? If you’ve been watching the Presidential debates, you’ve been hearing about all the jobs in Texas. Dumb luck or great leadership, it’s no surprise that more people and businesses are moving to Texas than moving out.
People and businesses will move to where it’s cheaper. State income taxes take a big bite out of most budgets, so look for good investment areas in a no tax (there’s only seven) or low tax state. Two of our favorites right now are Tennessee and Texas. Businesses also look for low cost land, a big labor pool (population), and nearby educational institutions.
People will move down before they move away. They have families and friends and don’t want to leave them. As the affluent fall down the food chain, prices will likely soften in the affluent areas, while demand will increase for lower priced properties near those affluent areas. Watch what’s happening in whatever markets you’re investing in. Talk to property managers, real estate agents, local resident (it’s amazing what you can learn in a coffee shop!) and the Chamber of Commerce. Which sub-markets are people and businesses moving away from and to? As in all investing, the trend is your friend.
Pick markets carefully with “geographically linked” economies. That is, industries that must be located in the region and can’t be easily moved, if at all. It’s also important that those industries be permanent (you don’t want to buy all the houses next to video cassette manufacturing plant).
Two great examples of permanent and geographically linked industries are commodities (like oil, gas, lumber, etc.) and distribution. It might be easy to move a widget manufacturing plant to China or Mexico, but you can’t move mining or farming offshore. Those jobs have to stay in the area – and those commodities are always in demand.
Similarly, moving boxes from point A to point B is a logistical operation. Even if the U.S. is poor, there will still be 300+ million people who need food, clothes, household products, etc. All that stuff might be made in China or Mexico, but it’s moving through the U.S., so those distribution jobs are linked to the real estate. And it’s not just location, but huge and expensive infrastructure like airports, roads and railways. Two cities that come to mind are Dallas and Memphis.
Now if the U.S. shakes off the doldrums and comes roaring back to economic life, any market that’s sound in a tough economy will only be more sound in a great economy. Either way, you win. 
The Not So Secret Formula for Stable Employment
The presidential campaign rhetoric is kicking into high gear. Texas Governor Rick Perry says he’s a job creation whiz. His detractors say it’s just dumb luck because he happens to govern a state with oil and gas under the ground. But no one is denying there are more jobs happening in Texas than any other state.
Meanwhile, no one is talking about Jack Dalrymple.
Who???
Jack Dalrymple. He’s the governor of the state with the lowest unemployment rate in the USA. And he’s the Governor of North Dakota.
North Dakota? Really?? Do you even know where North Dakota is? (Hint: It’s just above South Dakota, if that helps.)
According to a recent article by the Associated Press, “Booming oil, agriculture and manufacturing industries have helped the state keep the lowest unemployment rate since November 2008.”
Wow. Oil, agriculture and manufacturing is the magic formula. Who knew?
So what’s the lesson for real estate investors?
Well, if you believe like we do, that the best tenants are those with jobs, then paying attention to what, where and why job are happening is obviously important.
In this case, North Dakota’s experience is affirming what we’ve already come to realize: markets with industries that are strongly linked to the geography are less likely to move off shore. Oil and agriculture fit that bill.
So when you’re researching prospective markets to buy rental property, pay close attention to which businesses are “primary” (pulling money in from outside the area) and how “linked” they are to the geography. And of course, those businesses need to provide the kind of jobs that renters need. Match your property choices and price points to what the employees of the local businesses can best afford.
If that all sounds like common sense, that’s because it is. But as the legendary football coach Vince Lombardi always reminded his championship teams, winning is matter of mastering the fundamentals.
Getting Your Retail Real Estate in Shape
Retail has been a battered sector of late. It was bad enough that the internet migrated lots of shoppers out of malls and into cyberspace, but then we had to go and have a financial crisis. When it rains it pours.
Of course, with every crisis comes an opportunity. And as we’ve been saying for months, when the going gets tough, the tough get creative.
The Wall Street Journal recently published an article about how health clubs have become the beneficiary of and the a savior to a tough retail real estate market. The lesson is that when the market changes, you have to think outside the box.
If you’re facing challenges with any of your properties, then get around the most creative people you know and brainstorm about solutions. It may seem obvious, but sometimes we get stuck on a problem and just try thinking harder. Sometimes it’s more important to think differently.
Albert Einstein (we heard he was a pretty smart fellow) said:
“You cannot solve a problem from the same consciousness that created it. You must learn to see the world anew.”
How true!
And if you need a little inspiration, go to iTunes and check out our podcast Creative Solutions to Today’s Property Problems. Then use our Feedback page to tell us about your problem and creative solution. Who knows? Maybe you’ll end up as an inspiration for another investor somewhere down the road!
Treasuring Fine China
In case you’ve been living under a rock the last several years, here’s a news flash: China’s booming economy is having a big impact on the world, and the U.S. in particular.
And whether you like it or not, or agree or disagree with U.S. policy toward China, it doesn’t really matter. China matters. So, we’re learning to pay attention to China.
In case you aren’t convinced, consider that Chinese demand for raw materials (cement, steel, lumber, oil, etc.) create more demand which drives up prices. So if and when U.S. builders start building again, their costs will be higher. This means the properties they build will cost more. Which means that existing properties’ values will be pulled up by rising replacement costs.
What??? How, you ask, can we talk about rising prices when everything’s in the dumper?
It’s easy. As long as people do what they do, populations grow. The need for buildings continues in spite of the economy. And the last time we looked, people will do without a lot of things before they skip having a roof over their head. So it’s only a matter of time before building begins. Meanwhile, we sit in a rare window of time where there are low interest rates and lots of properties selling at or below replacement costs. Just something to think about…
And speaking of interest rates…
Did you hear what Morgan Stanley Asia’s honcho Stephen Roach told CNBC? He thinks China may decide to stop lending money to Uncle Sam.
In case you’re holding your breath waiting for the super-duper council of 12 deficit reduction committee to balance the U.S. budget, even if Uncle Sam miraculously produced a surplus, he still has lots of short term debt that needs to be refinanced. So if China doesn’t re-up, then who’s got the horsepower to feed the U.S. debt addiction? Greece? Spain? Italy?
Time out. Before your mind wanders off, let’s talk about why real estate investors care about all this.
Real estate investors get rich doing leveraged buyouts. Really! Just like some corporate raider. You find an income producing business (a rental property), then go get financing to purchase it. Then you use the income from the business to pay off the loan.
So, if your goal is to own a lot of these properties, you will have a lot of loans (what we affectionately refer to as “good debt”), and your cash flow will be substantially affected by interest rates. Right now, in case you’ve been napping, interest rates are REALLY LOW. And if you lock them in for the long haul, it’s hard to imagine you’ll be regretting it down the road.
But if the Chinese stop buying U.S. debt (Treasurys), then (says Mr. Roach), the U.S. may have to pay (gasp!) higher interest rates to attract buyers. And if U.S. Treasurys go up, you can bet real estate loans will be right behind them. See? Get the connection?
However, as previously posed, this presupposes there is a buyer out there with a big enough checkbook to meet Uncle Sam’s needs. If not China, then who? And if there isn’t another economy strong enough out there to buy up trillions in U.S. debt, then are there buyers at any interest rate?
So here’s another take: If China goes away, in part or in whole, our guess is that Big Ben Bernanke will get out his magic checkbook and, either directly or indirectly, will pick up the slack. In this case, Big Ben isn’t concerned with interest rates (after all, his cost basis for the money is zero), so the issue isn’t rising interest rates, it’s an increasing money supply. In other words: inflation.
(In case you missed it, we did a series of blogs on this topic when everyone was getting their undies in a bunch over the debt ceiling debate. If you want to learn more about Big Ben’s magic checkbook, search our site for “The Great Debt Ceiling Debate” or click here for Part 1 of the 5 part series.)
Here’s the bottom line (which is why it’s conveniently located at the bottom): No one knows what China will do. But if you understand the mechanics of the money, then you can make a plan A, B, C and D. And there’s even more letters available if you want to go farther than that.
If China goes away, and Mr. Roach is right and interest rates rise, do you want to be sitting on lots of low interest rate debt locked in for the long haul and being paid for by people who have to rent because home loans are too expensive to buy? We do.
If China goes away, and Big Ben’s magic checkbook comes into play, and inflation is fueled, do you want to own real assets (like commodities and real estate) that go up in value (over time…be patient) as replacement costs rise? Check.
If China keeps on buying, but demands higher interest, go to plan A.
If China keeps on buying, and is content with ridiculously low interest rates, even if the Fed doesn’t intervene, won’t low interest rates eventually lead to inflation? (Yes, they do. The whole reason the Fed alleges it keeps interest rates low is to “stimulate” the economy). Go to plan B.
We’re not saying the current de-leveraging (the U.S. is still suffering from a major sub-prime hangover) won’t suppress prices for the next few years. But if you’re a buyer, aren’t low prices, low interest rates, and a growing rental population all good things for right now?
The Great Debt Ceiling Debate – Part 5
This is the fifth and final part of our five part series on the “great debt ceiling debate” written as an accompaniment to our radio show broadcast and podcast, “Raising the Roof – How the Great Debt Ceiling Debate Impacts You”. You can download the episode on iTunes or find it on our Listen page.
Here we are at our grand finale! Glad you made it. Please put on your seatbelt and keep your arms and legs inside the bus at all times.
The Debt Ceiling: What if They Do and What if They Don’t?
For starters, let’s just get clear on what the debt ceiling is. Since we have people all over the world listening to our podcasts and reading our blogs, we don’t want to assume that everyone understands what the debt ceiling is or even how the U.S. government is organized. And since there may be a few U.S. citizens who slept through Civics class, it’s probably good to lay a quick foundation.
The debt ceiling is the amount of borrowing the Congress will permit. Congress (not the President) is in charge of setting the budget. The President may (and does) submit a proposal, but Congress has the final say. Then the President’s job is to do what Congress tells him to do. He’s the Executive, and his job is to execute the will of the people as delivered to him by the people’s representatives, Congress. Sometimes a President acts like Congress works for him (a dictatorship), or that he works directly for the people (a democracy). In reality, the U.S. system is really a representative republic. That’s a whole other discussion, but something you should think about if you’re a U.S. citizen.
Now the Treasury is part of the Executive Branch, so it works for the President. That is, the Treasury reports to the President, who reports to the Congress, who report to the people. The Treasury can’t borrow money past the limit Congress says unless the people’s representatives (the Congress) say it’s okay. What Congress is finding out is that they can’t just say it’s okay if the people (those are the folks who actually have to pay for it all) say it’s not okay. Right now, there’s a large and loud group of people who are not okay with more borrowing, hence the big debt ceiling debate.
Right now, the Congress has set a ceiling on how much Treasury can borrow, and Uncle Sam has hit it. If Treasury borrows past that, then the Executive Branch has exceeded its Constitutional authority (like THAT never happens…oops, sorry, did a little sarcasm sneak out?), which, if it happens, would spark a completely different and heated debate.
As stated in our first installment in this series, we’re not here to say what SHOULD happen. And no one can say with authority what WILL happen. What we want to do is be prepared for a variety of possibilities. So let’s talk about what some of those various possibilities might be.
What if they DO raise the debt ceiling?
If Congress agrees to raise the debt ceiling, it will rile Tea Party conservatives, but it will calm the markets. The U.S. will retain its pristine record of having never defaulted. This may be the closest Uncle Sam has come to defaulting, but it isn’t the first time there’s been a debate about the debt ceiling and warnings from credit rating agencies. Some have said that Uncle Sam’s credit rating is going to take a hit anyway. It’s something to watch, because a lower credit rating will mean higher borrowing costs for Uncle Sam (higher interest rates paid on Treasury bonds), which means higher interest rates will ripple through ALL types of debt.
One thing new is that with recent financial reform, ratings agencies have less discretion about not downgrading a debt issuer’s rating when problems are apparent. A problem with the mortgage mess is that the rating agencies overlooked obvious problems and investors got snookered into buying debt that was far riskier than they bargained for. When the underlying loans started going bad, bond investors got spooked and quit buying. That meant the flow of money into mortgages stopped, and liquidity drained out of the real estate bathtub causing all real estate “boats” that were floating in that sea of money to drop.
The point is that, like any other borrower, if Uncle Sam’s credit rating drops, then the interest rates he pays will rise.
Let’s stop here and re-visit a previous thought, because it will be part of a recurring theme.
We think Big Ben wants low interest rates because low interest rates will encourage more borrowing and spending, which he thinks is the path to prosperity. You may or may not agree, but it doesn’t matter what you (or we) think. Big Ben has the Magic Checkbook (the one whose checks never bounce), so it only matters what he thinks.
So, if anything happens to cause interest rates to rise, the Fed is likely to step in with its Magic Checkbook as “the buyer of last resort” to create demand and bring down interest rates. And, as we’ve discussed in previous installments, when the Magic Checkbook comes out, inflation happens. Keep this in mind at all times.
Now, an increase in the debt ceiling means more borrowing, more interest, and more currency expansion. Why? Because the open market (think Bill Gross and PIMCO, plus all the warnings from the Chinese) doesn’t appear to have enough appetite for all the bonds Uncle Sam wants to issue at an interest rate that works for Ben and Sam. So, either interest rates will have to rise to attract more Treasury buyers or the Fed’s Magic Checkbook comes out. You may have already heard the hints about a possible QE3 coming to a theater near you.
Bottom line: If Congress raises the debt ceiling, then slow, steady inflation is the best case scenario. If productivity doesn’t increase (adding more products to the economy) to absorb some of the excess money, prices will rise at a rate that upsets the people and alerts the lenders (the bond buyers) that they’re going to get paid back with devalued dollars. So slow and steady inflation is the “mandate” that Big Ben talks about all the time. It’s what he wants to happen.
Of course, if you’re a non-Fed bond buyer (such as China) and you realize the currency of the bond you’re holding (dollars) is dropping by say 5% a year, then you’ll want 5% plus a little bit more to make sure that you really make a profit. And if you want a higher yield and Uncle Sam needs your money, then either Sam pays or another buyer needs to come in and give Sam a better deal. Again, that’s when Big Ben steps in with his Magic Checkbook to try and bring yields back down to keep Sam happy, keep bond values worldwide stable (a collapse in the bond market would be a worldwide economic wipe out), and keep interest rates low so consumers can borrow and spend. Remember, Big Ben subscribes to the notion that borrowing and spending is the path to prosperity.
Yes. It’s a vicious cycle of persistent inflation. Go look at a chart of inflation since the U.S. came off the gold standard unofficially in 1933 and then officially in 1971. What you’ll see is a clear picture of rising debt and rising prices.
What if they DON’T raise the debt ceiling?
There has been a real war going on in the U.S. government about raising the debt ceiling. What’s all the fuss about? It isn’t like Congress hasn’t raised the debt ceiling a jillion times before.
It seems that a big and loud faction of the American people is tired of the spending more than you make and borrowing to cover the difference. There is real pressure on their representatives to stop it. For them, it starts with refusing to authorize further borrowing. At least not until an agreement is hammered out as to how to cut spending.
Whatever the details, if the debt ceiling isn’t raised, there are two primary possible outcomes, neither of which is pretty. And as we’ve already seen, raising the debt ceiling isn’t all that pretty either. In other words, the U.S. economic picture isn’t pretty, no matter how you look at it. But remember, inside of all the problems are opportunities, so don’t be discouraged. Be excited…and keep expanding your education.
So, if the debt ceiling is not raised, then the Fed will need to decide if they want to make the Treasury’s bank account magic also. That is, the Fed can allow the Treasury to write checks that clear even though there isn’t any money. This means no default on U.S. obligations. How can they do that you say? Well, since the Fed clears the Treasury’s checks, and no one knows what goes on inside the Fed, how would anyone really know when Uncle Sam ran out of money as long as the checks keep clearing?
But overtly giving the Treasury they’re own magic checkbook lets the world know the whole system is a sham, depending on how much visibility anyone has into Uncle Sam’s revenues and expenditures. Since it’s Treasury’s job to report all of that, we’d guess they’d work to cover it all up. Some have speculated that it’s already happening. Who knows?
However, at whatever point the world realizes that the Treasury has a magic check book, investors all over the world will begin to dump dollars and buy stronger currencies and commodities. Why? Because they know that spending will continue far in excess of production, and the Treasury can simply expand the money supply at will to cover the deficit. More dollars out of thin air outpacing production means falling purchasing power (more dollars chasing less goods). Combine that with worldwide investors dumping dollars, and you have a recipe for hyper-inflation.
Hyper-inflation means that anything denominated in dollars will go up in price fast. Think Zimbabwe: a trillion dollars for a roll of toilet paper. Foreigners will be snapping up U.S. real estate (they already are). And Americans will lose purchasing power all around the world. Very ugly for Americans and anyone holding dollars. Look at what gold has done in the weeks leading up to the debt ceiling deadline. It seems the markets are prepping for long term inflation.
And of course there is the eventual outrage as the American people realize the Executive Branch has now completely circumvented Congress and is at liberty to spend without restriction. How will the American people respond to that in this age of social media?
Default: The Doomsday Scenario
The other possibility is outright default. That is, Treasury will tell the world, “Sorry, I can’t pay you.”
This scenario is being described as financial Armageddon. Since Uncle Sam has never defaulted, no one can say with certainty what would happen, but common sense says that interest rates would sky rocket. Why? Because U.S. debt would no longer be considered risk free and investors would demand a big premium to buy it.
We could speculate on which debt offering would take over as the foundation (“safest in the world”) of all debt risk pricing (interest rates). But no one knows. What matters is how the Fed would respond to rising interest rates on Treasuries.
If the Fed is true to form, they will whip out the Magic Checkbook and step into the bond market to create demand in an effort drive interest rates down. Or at least slow down their ascent.
Of course, the amount of Treasury bonds the Fed would need to buy will depend on how the rest of market responds. But it’s safe to say that it will take LARGE purchases (QE4, 5, 6 & 7?) in order to keep interest rates down. Remember what that means: Lots of new money coming into the economy. It wouldn’t surprise us if they set up straw buyers to hide the fact that the Fed is flooding the system with new money. But as we said earlier, the excess funds will eventually trickle through the economy and land at the doorstep of the American public in the form of higher prices.
Further, it isn’t likely U.S. productivity could increase enough to offset the volume of new money entering the system, so once again inflation is the likely outcome. Commodities will spike and prices will rise as the cost of raw materials works their way through the supply chain.
Now you know why Peter Schiff thinks gold will hit $5,000. It also helps explain why Robert Kiyosaki says “savers are losers”. Holding dollars in any of the aforementioned scenarios is a sure path to lose purchasing power. Savvy people will be dumping dollars and purchasing anything real. Go do a quick study of the Weimar Republic in pre-World War II Germany and you’ll get the idea. Never in America? That’s what they said about a default by Uncle Sam.
What’s a Real Estate Investor to Do?
Are you freaked out yet? You should be concerned and aware, but don’t hit the panic button. Just keep getting educated, watch the developments, and think through the possibilities. Then take action as you deem appropriate. We think you’ll find it helpful to be a part of a “master mind” group of similarly concerned and informed people, so you can discuss issues and bounce ideas off each other. It’s a big reason why we continue to run our Mentoring Clubs and annual Investor Summit at Sea™. Look to join or start a group in your area.
As real estate guys, we can no longer just think about real estate outside the context of currency, commodities and Fed policy. Those days are gone – at least in the U.S.
But if we pay attention, then we can use commodities and foreign currencies to protect the value of our cash reserves, go aggressively into debt to acquire properties that will likely increase in dollar denominated value against fix dollar debt (equity happens!), and purchase properties that are most likely to appeal to Americans who are growing poorer, and foreigners who are growing richer.
Take some time and think about that last statement, because that’s there the rubber really meets the road. We’ll talk more about all this as the weeks and months roll by. And it will be a major topic of conversation on our 2012 Investor Summit at Sea™, where we will have Robert Kiyosaki with us for an entire week – plus an all-star faculty of experts in a wide variety of relevant subjects.
In closing, let us say that while these are certainly uncertain times, those who are best educated and well-connected will prosper, while those who aren’t are more likely to sell assets, avoid debt and hoard dollars as they’re being squeezed by inflation. Think through where that will lead. Selling things that are real in order to collect paper dollars which have no intrinsic value and are losing purchasing power. Does that sound like a formula for success?
Now just one final illustration to make a point, then class is dismissed. Thanks for sticking with us this far!
Imagine if you purchased a $125,000 rental property in a market that produced something the world rally needed- something like oil and gas. Even if Americans can’t afford much, the hot economies like China will need it and be willing to pay for it. So it’s likely there will be jobs in any U.S. region that produces energy. Jobs mean people, and people mean housing. So an area like that will have a demand for rental housing. Best, those jobs can’t move away from the region because the product is locked into the land itself.
Now, imagine that you put down $25,000 of cash, which, if left in the bank would go down in value as the dollar falls through inflation. You get a $100,000 loan at a today’s low interest rates and lock it in for the long haul. Then you rent the property out for a positive $200 a month.
Big whoop, right? But at least the property is feeding you and not vice versa.
Then let’s say that you use the extra money to buy a little gold and silver every month. Of course, you run the risk that the dollar could get strong against gold, so you have to decide what you think is the most likely outcome. You could also use foreign currencies to hedge against a falling dollar.
Now, doomsday comes. Zimbabwe-like inflation hits and it now takes $100,000 to buy a loaf bread. Those $200 a month investments in gold and silver will have held their purchasing power, so you take a small fraction of your gold and COMPLETELY pay off your rental property (not that you would, but you could).
Meanwhile, gas and oil are selling to China so your tenant is earning good money. Now there’s probably lots of competition for tenants, so your rents aren’t through the roof (though they probably would be thanks to inflation), but you have cash flow. Or, you have a house that’s paid for that you could live in if you had to.
The point is that the right real estate in the right market, when structured properly, is a great way to benefit from inflation, whether it’s slow and steady (like the Fed prefers), uncomfortable (if Uncle Sam doesn’t slow down the pace of the growth of its debt), or out of control (if Uncle Sam defaults and the magic checkbooks start working overtime).
Your mission, should you choose to accept it, is to understand the economic mechanics of the flow of money and where and how it’s likely to flow. Then position yourself to benefit from as many of the most likely scenarios as possible. As illustrated, we like real estate for this reason. And if we had time, we could show that even if deflation occurred, you can still win with real estate. But that’s a topic for another day.
Our Prediction
You thought we forgot, didn’t you?
We think after all the yelling and screaming, that a compromise will be reached and the debt ceiling will be raised. And whether it comes through a higher debt ceiling or a secret Magic Checkbook in the hands of the Treasury, the U.S. will not default. Of course, that’s just our opinion and we could be wrong. We’ll see.
Now take a shower. That was a long workout. We’re going to buy a bag of popcorn and watch to see how the movie ends. See you on the radio!
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The Great Debt Ceiling Debate – Part 4
This is part 4 of a multi-part series on the “great debt ceiling debate” written as an accompaniment to our radio show broadcast and podcast, “Raising the Roof – How the Great Debt Ceiling Debate Impacts You”. You can download the episode on iTunes or find it on our Listen page.
We’re excited you’re here. In case you missed the header, this is Part 4, so if you just got on the bus, be sure to go back and read parts 1-3 before jumping into this one. For those who’ve been on board since the beginning, welcome back! Now go grab an espresso and let’s get into it!
How the Fed’s Purchase of Treasuries Affects the Money Supply
Most people who pay attention to the economy have heard of “quantitative easing”. But in talking to lots of people and teaching this topic in seminars, we’ve found most people don’t really understand how it works. Since there’s been a lot of QE’ing going on, and potentially more to come, it’s important for all investors, real estate and otherwise, to really understand how it works. And the topic is especially relevant in light of the current debt ceiling debate.
As you should recall from previous installments in this series, the Fed has a Magic Checkbook. We explored how and why Big Ben is inclined to use it. Now we’re going to discuss what happens when he does.
The Sound Money Concept
Big picture economics can be intimidating and confusing. But a global economy is simply a collection of national economies. And a national economy is simply a collection of many citizens’ economies. So if you understand basic economic principles on a small scale, when everything blows up (figuratively speaking, at least so far), the numbers get bigger, but the principles still apply.
So, let’s imagine that you show up at a Treasury auction and you decide to buy Treasury bonds.
When your write your check and hand it over to the Treasury, they deposit it into their bank account (with the Fed) and the Treasury’s bank balance is increased by the amount of check. When your check clears, your bank balance is reduced by the same amount. What you have done is exchanged the cash in your bank for Uncle Sam’s bond. This is your basic everyday transaction. Just like buying furniture.
Now imagine that you and Uncle Sam are the only two people in the economy. If, between both of you, there were $100,000 divided evenly, then you would each have $50,000. When you buy $10,000 worth of bonds from Uncle Sam, you write a check and Uncle Sam’s now has $60,000 cash, while your balance is now $40,000. You have a $10,000 asset (Uncle Sam’s bond) and Uncle Sam has a $10,000 liability (the debt to you). But when you add it all up, it balances. This is a “sound money” system because after the transaction is closed, everything balances. That is, the same amount of money ($100,000) is in the economy is before, it is just allocated differently between the parties as a result of the transaction.
The Funny Money Concept
Now let’s look at what happens when Big Ben Bernanke buys a U.S. Treasury bond using his Magic Checkbook. Remember, Ben doesn’t have any money in his checkbook. He doesn’t need any because his checks never bounce. They’re magic.
Big Ben buys $10,000 worth of bonds from Uncle Sam. Uncle Sam’s bank account goes up by $10,000 and Big Ben gets the bond. Seems normal right?
Well, let’s take a closer look.
In our two person economy (you and Uncle Sam), you each had $50,000 for a total money supply of $100,000. But when Big Ben buys the bond, Uncle Sam gets $10,000 for a total of $60,000 and you still have your $50,000 for a total money supply of $110,000. The money supply just grew! The technical term for expanding the money supply in this fashion is “Quantitative Easing”. You may have heard of it. There’s a lot of it going on lately.
Take It Queasy
What is the effect of this “quantitative easing” on an economy?
Remember, you can’t use money itself for anything, so it’s only valuable when you can use it to purchase products. Money (for the purists: technically, “currency”, since real money is a product, which is what make it real) isn’t a product. Money is simply a means of storing value until you can convert it to something useful (i.e., buy something).
Let’s say that in our little economy, we have 1000 bottles of water, 1000 sandwiches, 1000 magazines, and 1000 more of 7 other things so there’s a total of 10,000 products. In the real world, the price of each product would reflect the effort to locate and convert the raw materials into finished goods, and then prices would fluctuate based on supply and demand. But to keep it super simple, imagine that all the products are priced equally, so the $100,000 in our economy is divided equally among the 10,000 products. Now each product is worth $10. $100,000 / 10,000 = $10
But if our money supply expanded to $110,000 courtesy of Big Ben’s Magic Checkbook (when he bought the $10,000 of Treasury bonds), then each product is worth $11.00 because $110,000 / 10,000 = $11.00. That’s inflation. More dollars divided over the same productivity.
So simply stated, inflation occurs when the amount of purchasing power (money, credit) goes up faster than the supply of goods (production). In a stagnant economy (one that isn’t producing more stuff), when you add new money, prices go up.
The important thing to know is that when people with regular checkbooks (like you) buy Treasuries, the transaction balances out because the buyer’s checkbook balance decreases while Uncle Sam’s increases. But when Big Ben uses his Magic Checkbook, NEW money enters the system because Uncle Sam’s balance goes up, while all the regular checkbooks stay the same. Again, this is Quantitative Easing and it’s inflationary.
In the real world there are lots of moving parts, but if you just stick to the basic principles, you can clearly see what’s happening. Because it all gets blended in with real world supply and demand dynamics (and confusing econo-speak), a lot of inflation can be hidden for awhile. But not forever. After a while it all “trickles down” to the man on the street and first prices rise (you know, like food, gas, clothing, etc.), and then eventually in wages (that one hasn’t hit yet).
Got it?
If you want to understand this “trickle down inflation” better, listen to our 2/20/11 radio episode The Coming Wave of Inflation – Profiting When the Levee Breaks, available on iTunes.
So now that you have all of this under your belt (just think how much fun you’re going to have at your next cocktail party!), in our fifth and final installment, we will finally look at how all this affects the Great Debt Ceiling debate. And, we’ll unveil our bold prediction of what we think Congress will actually do about the debt ceiling.
The Great Debt Ceiling Debate – Part 3
This is part 3 of a multi-part series on the “great debt ceiling debate” written as an accompaniment to our radio show broadcast and podcast, “Raising the Roof – How the Great Debt Ceiling Debate Impacts You”. You can download the episode on iTunes or find it on our Listen page.
In our last installment, we explored the bond market and how interest rates are established in the open market. Bonds are debts and the interest rates are set by risk, reward, supply and demand. Now we will explore how the Federal Reserve Bank affects interest rates. You should already know how interest rates affect you.
How the Fed Influences Interest Rates
The Federal Reserve
The Federal Reserve Bank (the Fed) is the bank of the Treasury. The Treasury is the government. The Federal Reserve is NOT the government. If you want to learn more about the Fed, we highly recommend reading The Creature from Jekyll Island, which is conveniently located in The Real Estate Guys™ Recommended Reading area.
The Magic Checkbook
For now, you only need to know that the Fed can write checks on itself that will not bounce. In other words, it doesn’t need money. It creates money simply by writing a check. That may sound unbelievable, but for now, just take our word for it. This isn’t an expose on the Fed, so you can look it up in your spare time.
Now that we know how the Fed’s magic checkbook works, let’s imagine that Uncle Sam shows up to hold a Treasury bond auction. But there isn’t enough demand, so interest rates start to go up. In prior installments, we discussed what happens to the value of all the existing debt out there when interest rates go up (it goes down), but to toss in some extra motivation for the Fed, the current Fed leadership believes that low interest rates stimulates borrowing, which stimulates spending, which stimulates production, which stimulates hiring. This is a “Keynesian” view of economics. That is, that borrowing and spending is the key to growth and job creation (how’s that working out so far?).
Side note: For an opposing viewpoint, may we recommend you look into “Austrian” economic theory, which puts forth the idea that one must actually produce before one can consume or borrow, and that production and savings are the keys to economic growth. In other words, in its most rudimentary terms, before you can eat, you need to grow or hunt food. And if you have more food than you need, then you have something of value to trade with. If you don’t have anything to eat and nothing of value to trade with, you need to either beg, borrow or steal from someone who actually does produce. And the only way to have trading partners is if they produce more than they consume, so there’s something extra for you to trade for. The bottom line is that production, not spending, is the key to prosperity. That’s why printing money or stimulating consumption doesn’t create jobs. And as real estate investors, we want to invest where jobs are being created. Because unless you’re renting to people subsidized by the government, your best tenants will need jobs to pay you rent. Now, back to our main feature….
Now if you, like Big Ben Bernanke, believe that borrowing is the key to prosperity, where do you think interest rates need to be? Hint: LOW interest rates attract borrowers. Sorry, was that hint TOO obvious?
Let’s get back to our Treasury auction. Uncle Sam is there holding his bonds out for sale, but not enough buyers show up. So Uncle Sam has to start lowering his price (increasing the yield) and interest rates start going up. Big Ben thinks this is bad. So he gets out his Magic Checkbook and buys, say $600 billion of Uncle Sam’s bonds (does the term QE2 some to mind?), to help create some extra demand. Shazam! Interest rates stay low.
Well, if you’re a government addicted to debt, deficits and spending, this makes you very happy. Just like when the interest rate on your growing credit card balance stays low. With low interest rates, you can borrow more for the same payments. No need to cut spending. Let the good times roll! The only thing better than low interest rates is an increase in your credit line (isn’t there some discussion about that?)
To summarize, when the Fed buys Uncle Sam’s Treasury bonds in the open market, the extra demand drives the bond prices up and their yields (interest rates) down. Then, the ripple effect of interest rate pricing kicks in, as all riskier debt pivots off the interest rate of Uncle Sam’s “safest debt in the world”. That is, if Treasuries pay x, then a riskier debt pays x plus a little bit more (usually denominated in “basis points”, which are 1/100 of a percentage. So 25 basis points is 1/4 of 1% or .25). The farther away you move up the risk scale, the more expensive the debt is for the borrower. This is why everyone has their undies in a bunch over Uncle Sam’s credit rating. It he loses his coveted super-duper AAA rating, then interest rates go up….and Big Ben may need to step in with his Magic Checkbook.
But what happens when Big Ben uses his Magic Checkbook? Are there any side effects we should be considering? Hmmm….? Inquiring minds want to know!
So join us next time, as we delve into How the Fed’s Purchase of Treasuries Affects the Money Supply. Hint: “Trickle Down” isn’t just for supply-siders any more.
The Great Debt Ceiling Debate – Part 2
This is part 2 of a multi-part series on the “great debt ceiling debate” written as an accompaniment to our radio show broadcast and podcast, “Raising the Roof – How the Great Debt Ceiling Debate Impacts You”. You can download the episode on iTunes or find it on our Listen page.
How does the Fed affect the interest rates on Treasury Bonds and why does it matter?
Good question. We’ll divide our answer into three parts (though we won’t get to them all in this installment):
- How Treasury rates affect interest rates on mortgages, corporate and muni-bonds and most all other debt.
- How the Fed influences interest rates in the bond markets.
- How the money supply is affected when the Fed purchases Treasuries.
After all that (and you should go grab a double espresso to make you stay awake for the whole trip), we’ll talk about what happens if Congress raises the debt ceiling, and what happens if they don’t. Then as a special prize for your time and attention, we’ll throw out our crystal ball prediction. So go grab that espresso and hurry back!
1. How Treasury Rates Affect Interest Rates on Almost Every Kind of Debt
Bond prices are determined in the open market. That means buyers and sellers coming together and negotiating a price. In actuality, the negotiation is done by auction. Think e-Bay.
When Uncle Sam (the Treasury) goes into the open market to sell bonds (borrow), investors bid on the bonds. If there are lots of buyers, the bids go up, which drives yields (interest) down.
The Inverse Relationship Between Bond Prices and Yields
Time out. Because we teach this at live seminars, this is where some people go “puppy dog” – their heads goes sideways and they get a confused (but cute) look on their faces. Since it’s important that you understand the inverse relationship between bond PRICES and bond YIELDS, we want to take a minute to explain it. It isn’t that complicated once you get the math, but it’s important that you understand because once you do, it’s easier to understand which direction interest rates are likely to go and why.
To use extreme examples with simple math:
If you pay $100,000 for a bond (a promise to pay) with a face amount of $100,000 and it yields 5% per year, then you earn $5,000 per year on your $100,000 investment. If the bond has a 30 year maturity, then at the end of 30 years, you get paid the face amount ($100,000). You earn interest along the way, then get paid the principal back at the end. Pretty simple.
Here’s where it gets tricky.
If you have bought a $100,000 bond when yields were 5% and the market changes, then the fair market value of your bond changes. That is, while the face amount and interest rate stays the same, what someone would actually pay you for your second hand bond in the open market (if you wanted cash now) will depend on what else is available to them at the time.
For example, if new bonds are yielding 10%, then a new $100,000 bond would pay $10,000 of interest per year. That’s obviously better to the bond holder (the lender) than the $5,000 your old $100,000 bond is paying.
So if you wanted to sell your bond in the open market, you would have to discount it (sell it for less than the face value) until the yield was comparable to the going rate in the open market. If you don’t, who would want to buy your “second hand” bond? This is an important principle even if you couldn’t care less about Treasuries because it’s the same principal used with discounted notes, which is a staple for in creative real estate. But we digress (how unusual!).
Back to bonds. So if someone wanted a 10% yield on their cash and your bond is paying $5,000 per year, what do you have to sell it for to attract a buyer? Do you remember the high school algebra you never thought you’d use? It’s time to use it.
$5,000 = 10% of what?
The answer is $50,000. Because 10% of $50,000 is $5,000.
Ouch! That’s a big haircut. Your $100,000 bond dropped in value to $50,000 in order to pay the same yield.
Now in the REAL world, it’s not that simple. Because the $100,000 bond will still pay $100,000 at maturity, that also gets factored in. But it makes the math too difficult for this article. And then it gets more complicated, because smart investors are going to factor in inflation (the decrease in the purchasing power of the dollar over time).
For purpose of our current discussion, the main point is that when a buyer pays more for a bond, the yield goes down and vice versa. So when lots of buyers show up (high demand) at a Treasury auction, interest rates go down. Conversely, when there are few buyers (low demand), interest rates go up. If you didn’t track with that, take a sip of espresso and a deep breath (not at the same time or you’ll choke), then read it again and noodle through it. Trust us. This is important for you to understand, not just as a real estate investor, but as a taxpayer and a voter.
Now the bonus lesson is that when interest rates rise, the value of the bonds you already bought goes down. Back in March, Bill Gross, the guy who manages the world’s largest bond fund (PIMCO), sold ALL his Treasuries. Where do you think HE thinks rates are headed?
Treasuries as the Foundation of All Interest Rates
Now, let’s talk about how Treasuries affect interest rates on everything else important to you, like mortgages.
Because Treasuries are considered the world’s safest debt, imagine their yields (interest rate) at the center of a target. Each ring away from the target is another type of debt. The farther away you get from the center of the target (ultimate safety), the riskier the debt is. And the riskier the debt is, the more the borrower has to pay to attract your money away from the center. After all, as a bond investor, you’re only going to buy something less safe than a Treasury if it pays you better, right?
So you could say that the yields on Treasuries are the foundation for all debt pricing. When Treasuries go up, it creates a ripple effect to all other debt offerings. And all the money that people borrow, from mortgages, to cars, to credit cards, etc. all gets packaged up and sold to investors as various forms of bond (to say nothing of derivatives!). It’s no surprise that the bond market dwarfs all other markets, including the stock market. In other words the world is swimming in debt.
To bring it back down to earth so you can relate to it, think about it this way: If you’re a real estate investor sitting on a portfolio of adjustable rate mortgages which you’re using to control millions of dollars of real estate, what happens to your cash flow if interest rates rise? It drops.
And when more of your rental revenue is being used to pay interest, do you have more or less profit to invest in maintenance, repairs, improvements and new acquisitions? Less.
Take that same principle and apply it to a government.
When a government is sitting on a large portfolio of debt (bonds it has issued), big chunks come due (mature) constantly. With each set of maturations, the bond holders expect to get paid the face value of the bond. But where does the bond issuer (the borrower) get get the money to pay off the bond?
If you had a loan come due on a property, you would have to pay it from your savings (Uncle Sam has none), sell the collateral (US bonds are only secured by the “full faith and credit” of the government, so there’s no property to sell), or refinance. Bingo! Uncle Sam needs to borrow more. Just like if you were spending more than you earn and running up your credit cards. You need the credit card company to raise your credit limit, so you can borrow more to pay off the old credit cards.
And how does Uncle Sam borrow? He sells bonds in the open market.
Now if current interest rates are higher than the rate of the bonds being paid off (retired), then the interest payable on the freshly issued bonds will be higher, and the debt service (interest payments) will take a bigger bite out of revenue.
But if you, or in this case, Uncle Sam, are already upside down (negative cash flow, i.e., budget deficits), then the rate at which you must borrow increases. You’re borrowing to pay interest on borrowed money. It’s a crushing, compounding effect.
Do you see a problem? It’s a vicious cycle of continual, perpetual debt. And you either have to find a way to out produce the problem (earn a lot more, as in higher taxes) or you have to make drastic cuts, or both.
That is, unless you have a Magic Checkbook (oooh, ahhh). And wouldn’t you like to know what a Magic Checkbook is?
Join us next time for the next exciting installment of The Great Debt Ceiling where we will discover How The Fed Influences Interest Rates and The Secret of the Magic Checkbook. Don’t miss it!
Now please pick up your trash and move in an orderly fashion to the exits. See you next time!
The Great Debt Ceiling Debate – Part 1
This is part 1 of a multi-part series on the “great debt ceiling debate” written as an accompaniment to our radio show broadcast and podcast, “Raising the Roof – How the Great Debt Ceiling Debate Impacts You”. You can download the episode on iTunes or find it on our Listen page.
As the debate rages on about whether and how to raise the U.S. debt ceiling, it’s hard not to have any discussion of the topic degrade into political diatribes.
But as real estate investors, we’re not too concerned about what the policymakers SHOULD do (since we don’t have any direct control anyway). Instead, we’re much more focused on what IS happening, what is LIKELY to happen, and what we can do in response to avoid loss and/or create a profit.
In short, we refer to discussions about opinions about what should or shouldn’t be done (or who’s to blame) as “political” discussions. After all, politics is a pretty “shouldy” business. But you already knew that, didn’t you?
We prefer that our discussions be more practical in terms of what’s likely to happen and developing a plan A, B or C to react to it. We may have political opinions (some of which leak out from time to time), but you know what they say about opinions: Opinions are like armpits. Everyone has them and most of them stink. We don’t have to like each others’ political opinions to enjoy a healthy conversation about what’s happening and how it affects real estate investors.
Since the debt ceiling debate is a complex, polarizing topic with huge global economic consequences, we thought it was worthy of a bigger discussion than our regular broadcast blog. So strap on your reading glasses and get ready for a big discussion. And be sure to listen to the podcast on this topic also. It doesn’t replace this article, but it will help if you’re new to all of this.
We STRONGLY encourage you to plow through it all because the discussion of the U.S. debt and financial system has a DIRECT impact on interest rates, availability of loans, job creation (the best tenants have jobs), wages and the value of your real estate – Just a few things that are probably pretty important to you.
In a Rising Tide, All Ships Rise and Vice-Versa
We all found out a few years ago that no matter where or what kind of real estate boat you were floating, when the MBS (mortgage backed securities) money drained out of the tub, values dropped. Really astute investors paid attention to the macro trends BEFORE this happened and drained their own equity while the tide was still high (back in 2005 we did some shows on “equity hedging strategies”, which you can find in the Backstage archives). The rest of us learned (the hard way) that we better pay closer attention to the big picture for next time.
The big question is: will there be a next time? That is, will real estate values rise again? If real estate is down, never to rise again, then you can still make money, but you need to approach the problem differently. If the tide of currency (the money supply) rises, then real estate values are likely to rise over time and you would structure your portfolio accordingly.
So what’s LIKELY to happen? And how does the debt ceiling debate impact you?
You could say that prices are so low they can only go up. Just like at the peak, when people said that prices were so high they could only go down. Those are nice sayings, but even a broken clock is right twice a day. What are the economics behind the predictions? Is it all such a complicated mystery that merely guessing or listening to the loudest voice is the only way to know?
No.
Here’s the good news. You can understand all this. In fact, you may be surprised at how easy it is. So the goal of this series of articles and the accompanying podcast is to give you a basic understanding of “the mechanics of the money”, so you can begin to plot cause and effect, then decide for yourself what you think will or won’t happen. But keep in mind, the best strategy will consider all possibilities.
At a recent conference, we heard a quote that has become one of our favorites:
“Better to prepare, than to predict” – Henry Brock
So in this series we’ll take a look at what happens if the DO raise the debt ceiling and what happens if they DON’T.
Of course, who can resist the temptation to predict? So, at the end, we’ll go out on a limb and make a prediction. Just keep in mind that our prediction is just our own opinion, and probably about worth what you paid for it.
Ready? Here we go.
The U.S. Money Supply
First, let’s talk about how money gets into the U.S. system. When the government needs money, the Treasury either taxes (takes it from the productivity of the people) or borrows (pledge the future productivity of the people). Since the government has a chronic problem of spending more that it takes in (does that happen?), it’s no surprise that they both tax AND borrow. In fact, most of the taxes go to pay the interest on the debt. But no matter how you slice it, the productivity of the people pays the bill.
When Uncle Sam borrows, he writes IOU’s called bonds and sells them in the open market. Uncle Sam’s bonds are called Treasuries and, at least up until recently, Treasuries have been considered the safest debt you can buy. After all, they’re backed up by the “full faith and credit of the U.S. Government”, which is really an euphemism to say “the full power and authority of the I.R.S. to tax the earnings of the most productive people on the planet”.
Do you feel any temptation to talk politics? Stay calm. Keep your arms and ammunition in the vehicle until the ride comes to a full and complete stop.
So who buys Uncle Sam’s IOU’s? Lots of people. Private investors, banks and foreign governments to name a few. Over the last several years, China has purchased trillions and is now the largest single foreign holder of U.S. debt. Recently, there’s been another big buyer whom we’ll talk about momentarily. But for now, let’s talk…
Interest Rates
If you’re already bored reading all this, just think about how important interest rates are to you. From your savings account, to your mortgage, to your credit cards, to your car loans and all your investment properties, interest rates affect what you earn and what you pay. More importantly, interest rates are at the heart of the great debt ceiling debate and the motivation behind much of the Fed’s monetary policy. So stick with us, even if you’re not sure how the Fed’s policies affect you. You’ll know before this is over.
Interest rates are the price the lender charges for the risk of making the loan. That’s why if you have bad credit or bad collateral, the rates are higher. Common sense, right?
But interest rates are also a function of supply and demand. This means that when there’s lots of money to lend, but not too many borrowers, rates are low. The lender lowers the price to entice you to borrow. Low rates encourages borrowing. High rates encourages saving. Think about that one. But not for too long, because we need to move on.
Conversely, if a borrower wants ( really needs, is desperate, etc.) to borrow, he may have to offer a higher interest rate to attract a lender’s money. In other words, if there’s a big demand for loans, but not many lenders willing to lend, the interest rate a borrower must offer to a lender will rise until someone wants to buy the debt (make the loan). So far so good?
The Bond Market
Remember: Bonds are debt. So when someone buys a bond, they are effectively lending to the bond issuer. So when Uncle Sam wants to borrow, he goes into the open market to sell bonds. This is elementary to some of our audience, but less so to others, so in keeping with our “no investor left behind” mantra, we wanted to make that clear before moving forward.
Now, let’s talk about that other big bond (debt) buyer we mentioned earlier: The Federal Reserve or “The Fed”. That’s the private (as in, not Federal) network of international banks (that is, not U.S.) whose leader is appointed (that is, not elected). How accountable is the Fed to the United States citizenry? You don’t want to know. Let’s just say, not very.
Contrary to popular myth, the Fed does NOT set interest rates – at least not directly for things like Treasury Bonds. The interest rates the Fed sets are the rates at which the banks do business with each other. There’s two: the discount rate (what banks pay when they borrow from the Fed) and the federal funds rate (the rates banks pay when they borrow from each other). We’re not going to talk about those now because they have nothing to do with the debt ceiling or Treasuries. Well, that’s not entirely true, since Treasuries are competing with banks for the savings of all the “A” students who produce more than the consume and save the excess. So if the Fed wants Treasury rates low, the banks better be low too, or people would put their money in FDIC insured savings accounts.
Hmmm….there seems to be a relationship between the Fed, the banks and the bond market. This would be a fun topic to explore, but we’ll leave that to you for extra credit. For now, we just don’t want you to confuse the rates the Fed sets directly (the Discount Rate and the Federal Funds rate) with how yields (interest rates) are established in the open market where bonds are sold.
Summary of Key Points
- Money gets into the system when the Fed purchases U.S. Treasury Bonds
- Interest are determined in the open market by supply, demand and risk versus reward
- Private investors, including the Fed, purchase U.S. Treasury Bonds, effectively lending to Uncle Sam
- U.S. Treasuries are considered the safest of all all debt (so far) and are the basis for virtually all other bond offerings, with higher risk investments paying higher interest rates
In our next scintillating article in this series, we’ll discuss the mechanics of how the Fed affects interest rates on Treasury Bonds and why you should care. Don’t miss it!
