March 30, 2021
Interest Rates Going Up?
Last week I asked the question, “What will the world be like a year from now?”, with my answer being, “I think the World Economy will be ROARING.” And with this in mind, a year from now, “I look for short term interest rates to almost certainly have risen, AT A MINIMUM, 1/2% from these historically aberrant record low levels.”
So, without getting complicated, my point is that strong economy activity does NOT need interest rates at their almost zero levels…and with my very firm belief that the economy IS returning to a full blown recovery, common sense then argues, I think, that rates should go up, perhaps quite dramatically, over the course of the next year. And furthermore, while I believe that higher rates would definitely be on the horizon under just NORMAL circumstances, I’d offer that there is another GARGANTUAN factor to be considered that will, again, almost certainly increase the odds, and the magnitude, of higher rates being dead in front of us…And that would be the $3 Trillion Infrastructure package that the Democrats are now proposing…and most likely are going to get passed.
What then happens in the real world?
Conventional wisdom would argue that throwing all that money at the economy is eventually going to be inflationary, which obviously can contribute to higher interest rates, but where I think the impact will be felt first, and like a sledgehammer, is at the bank…as loan demand goes through the roof, taking rates immediately higher right then and there. Plain and simple, banks, whatever their size do have limits on what they have available to lend (for example, a small town bank with $5 million in assets can’t make a $500 million loan) and when a bank’s chief lending officer has people beating down their door to borrow, it’s quite natural that their price of money (interest rates) DOES go up…as in, “We could do this loan at 5%...but let’s make it 5 ½.” That’s certainly an over simplification, but that IS the real world.
So, when Congress says, “Let’s spend $3 Trillion and build out the infrastructure,” the way it really works is this: Suppose Congress (aided by each state’s representatives) decrees that 1000 miles of interstate will be built in Georgia. The first thing that happens is the congressman (or the local powers that be) select and grant contracts to numerous individuals or companies for the various aspects of planning, designing and completing the project…And the next thing those contractors ALL do, BEFORE they go to work, is GO TO THE BANK AND BORROW THE MONEY THEY NEED TO START, AND FINISH, THEIR PART OF THE JOB…And believe me, the Banks who are doing the lending understand the game well and ARE going to want their share of the pie…and they WILL be charging every extra 1/4 – 1/2% they can squeeze out of the deal. And that’s just to START the cycle…As the projects roll out over time, and borrowers are STILL showing up at the bank, you’d better believe rates will KEEP on rising…
And that is what this is all about…THAT THE GOVERNMENT DOESN’T PAY UP FRONT…WHICH THEREFORE MEANS THAT EVERY PROJECT THAT GETS APPROVED BY CONGRESS MOST LIKELY WILL MEAN SOMEBODY GOING TO THE BANK FOR FINANCING…AND GUYS, $3 TRILLION IS A WHOLE LOT OF FINANCING.
IT COULD BE THAT WE ARE GOING TO SEE GOVERNMENT “INSPIRED” LOAN DEMAND LIKE THIS COUNTRY HAS NEVER SEEN BEFORE…WHICH, IN MY OPINION, CAN ONLY MEAN “DECIDEDLY” HIGHER INTEREST RATES…BOTH SHORT TERM AND LONG TERM…IT’S NOT COMPLICATED…WHEN BANKS HAVE GOT PEOPLE LINED UP TO BORROW, THE PRICE OF MONEY GOES UP…ALMOST IRRESPECTIVE OF WHAT THE FED IS OR ISN’T DOING.
How low ARE rates?
taking a look at the chart below going back 60 years, I’m not sure what I would
say would be a “normal” interest rate…that is, what interest rates would be in a
“normal” economy, but I DO know that we ARE coming out of a COVID induced
economic contraction that IS being/ HAS BEEN reversed…And while I can’t predict
exactly how strong “normal economic activity” will be 6-12 months from now, I DO
believe that the idea of still having practically ZERO interest rates will be as
absurd as thinking the horse and buggy is coming back…
THIS IS HOW LOW RATES ACTUALLY ARE…AND WHERE THEY HAVE BEEN FOR THE PAST 60 YEARS…
The Eurodollar Futures contract (not to be confused with either the US Dollar Index OR the Eurocurrency) reflects short term interest rates. And without going into a lengthy explanation, I will simply say that if the Federal Funds Rate on the chart above is higher 3, or 6, or 12 months from now, then this March 2022 Eurodollar contract WILL be lower.
I CONTINUE TO RECOMMEND BUYING PUTS IN MARCH 2022 EURODOLLARS
Call me if you think this “Common Sense” makes sense to you…if you think interest rates will be higher a year from now…
All option prices in this newsletter include all fees and commissions. All charts, unless otherwise noted, are by Aspen Graphics and CRB.
The author of this piece currently trades for his own account and has a financial interest in the following derivative products mentioned within: Eurodollars