rates

The question of where rates are going and why is of paramount importance for me to determine any other strategy. This is because where rates are going will determine whether we have a bear or bull stock market.

Unfortunately, my thoughts have kept flip-flopping, with varying degrees of certainty as I consider different aspects of this incredibly complicated question.

In formulating the following analysis, I tried to take a step back from some of my recent considerations to simplify the question as much as possible.

I can see two reflexive processes at work in global economics today. The first, causing credit expansion, has continued while at the same time feeding its enemy, contraction. Eventually the contractive forces will overcome expansionary ones, at which point, the expansionary forces will disappear. Credit will contract, collateral values will shrink, and the authorities will be forced to step in to keep things from getting out of control.

Let me flesh this out a more specifically. The first self-reinforcing process is that of credit expansion. This consists mainly of China and OPEC lending money to the US to promote more demand for their goods. It is self-reinforcing, especially with China, because the system requires the creation of ever more credit to sustain the same level of trade deficit. This creates the political will to tolerate a negative rate of return in order to promote economic growth. At the same time, the system is also self-defeating. There are three main reasons for this. First, there is inflation caused by pegging currencies to the dollar. Second, asset bubbles are caused by overheating economies. Both of these cause global bank rates to go up. Third, the trade deficit is a drag on economic growth. Slower growth, together with lower currency yields than the rest of the world leads to a weaker currency.

As the dollar weakens, that in turn puts more pressure on foreign inflation, foreign asset bubbles, and makes the trade deficit worse. We can see that the contractionary forces are self-reinforcing as well.