Well, that didn’t take long…
We recently alluded to the possibility of rising rates…whether the Fed raised them or not.
Then lo and behold, this headline popped up in our news feed:
Treasury Yields, Mortgage Rates Rising at Record Pace
Of course, rates are still crazy low.
But the move is noteworthy… beyond the obvious impact on the cost of the debt we use to acquire real estate and reposition equity.
The REAL Problem with Rising Rates
So what if interest rates rise?
It’s complicated, but important. Because the debt markets (bonds and their derivatives) are BY FAR the largest financial markets in the world.
The problem isn’t simply borrowing costs. It’s what rising rates due to big players’ balance sheets… and what that means to Main Street investors.
Famed bond fund manager Ray Dalio recently suggested that just a 1% rate increase could destroy over $2 TRILLION of balance sheet wealth.
In fact, without ANY move from the Fed… $1 TRILLION in wealth disappeared right after the election.
How can this happen? And how does it trickle down to Main Street?
Bond… Licensed to Kill
Remember two basic concepts:
When bond values go down, interest rates go up… and vice versa; and…
When bond values go down, anyone holding bonds as an asset, sees their net worth go down.
The latter is arguably the BIGGEST THREAT to your portfolio… not necessarily because YOU own bonds, but because of how bonds affect the financial system your investments float in.
The Daisy Chain
Many players in the paper markets borrow against their bonds the way you borrow against your real estate.
The loans they take out become their liability just like your mortgage becomes your liability.
But that same loan also becomes the lender’s asset, just like your mortgage becomes your lender’s asset.
When you get a bunch of players in the market all borrowing against bonds to create new bonds… that the next guy borrows against, you have a daisy chain of counter-party risk. Counter-party risk is when one person’s asset is another’s liability. If the person owing goes bust, the value of the asset collapses.
Think of a group of mountain climbers all chained together hanging off a cliff. If just ONE person falls, it’s a problem for EVERYONE.
Growing Debt Means Rising Prices
All this borrowing creates purchasing power, which pushes asset prices UP.
It’s just like when a college student gets a student loan. It pulls their future earnings into the present and bids UP the price of college today.
Debt doesn’t make things cheaper. It makes them more expensive.
As these bonds and derivatives (debt) are created, the excess purchasing power has been recycled into even more bonds and derivatives in a vicious cycle of exploding debt.
Observers are watching consumer price inflation (CPI) and conclude “inflation is stubbornly low”.
Maybe consumer inflation hasn’t happened…yet. But bond price inflation sure has.
Rates Went Down, Down, Down and the Bonds Went Higher
Because as debt begat debt begat debt, all that purchasing power bid UP the price of bonds, driving yields (interest rates) DOWN.
But after going down for over three decades, interest rates have hit “the zero bound”.
In fact, in several countries, bonds have been bid up into negative yields… for the first time in history.
Seems like rates don’t have much of anywhere to go but up… which means bond prices don’t have much of anywhere to go but DOWN.
This is where it gets messy…
I Owe You, You Owe Me, We Owe Them and We’re in Debt Together
Congratulations. You’re really a hardcore newsletter reader. Thanks for getting this far.
Because here’s the TICKING TIME BOMB in the financial system…
If rates go up or bond prices go down, then the daisy chain of counter-party risk starts to implode across the too-big-to-fail players’ balance sheets… taking asset prices with it.
Read that again and be sure you’re tracking.
Because here’s the fuse…
Your Margin’s Calling
When a bond pledged as collateral in these paper derivative markets falls too far, the borrower gets a margin call.
So the borrower needs to put up cash or risk having the collateral (their bonds) sold into a falling market.
This puts a nasty dent in the borrower’s balance sheet.
If this only happens to one player, no big deal. But remember, all these players are daisy chained together.
Call the Doctor… I Think I’m Gonna Crash
When bonds fall, everyone margined needs to come up with cash fast to meet their margin calls.
Wide scale margin calls suck cash out of the system. Lots of it. Economic activity slows way down.
For players who aren’t sitting on enough cash to make their margin calls, they’ll need to sell assets into an already falling market. This is like pouring gasoline on a fire.
That’s because if everyone is short of cash, who can buy the assets?
If the cash crisis is bad enough, the markets go “no bid” and prices fall faster and farther which compounds the problem.
All the daisy chained balance sheets start to implode… pulling the next one with them into a black hole.
Bad scene. This is what happened in 2008.
Is the REAL Crash Still Yet to Come?
Money manager, best-selling author, financial pundit and Summit at Sea™ faculty member Peter Schiff, predicted the 2008 disaster in his 2006 best-selling book Crash Proof.
Peter says none of the fundamental problems which caused the 2008 crisis have been fixed. In fact, Peter says, they’ve gotten worse… and The Real Crash is yet to come.
Last time, central banks printed TRILLIONS to buy the “toxic assets”… putting a bid in a no-bid market. This stopped the free fall.
But that exploded the Fed’s balance sheet from around $800 billion to nearly $5 trillion, where it is today.
Smart guys like Peter Schiff and Jim Rickards don’t think the Fed can do it again without destroying the dollar and causing hyper-inflation. That’s why on our last Summit at Sea™, both advised our Summiteers to hold some gold.
The Role of Real Estate in a Safe Haven Portfolio
You’ve read ALL this way… so before you go full fetal… remember GREAT FORTUNES were made in the wake of the crash.
Properly structured and liquid investors went on the shopping spree of a lifetime.
Income producing real estate is arguably one of the BEST havens in ANY storm. We’re planning a future episode to discuss this very topic.
A New Sheriff In Town
Headlines are currently dominated by all things political. It’s tempting to get caught up in that. Be careful.
While the U.S. switches out the Presidency, we choose to focus on things we can control. Like our own education for effective action.
The moral of this story?
Study. Network and converse with smart people. Be proactive with your portfolio.
We say “Plan and Do” is better than “Wait and See.”
Until next time,
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