How U.S. Mortgage Rates Affect Aussie Stocks

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Today’s Daily Reckoning has a simple task: to figure out what all this business in America means for Australia. Okay, it’s simple in theory, but maybe not so simple in fact. Let’s have a crack anyway.

The last few days we spent a great deal of time trying to discover the goal of the Fed’s $1 trillion foray into Treasury bonds and the U.S. mortgage-backed securities market. Why? Well, the Fed is trying to bring down ten-year U.S. interest rates. Why?

Yields on Ten-Year U.S. Notes over the Last Ten Days

tenyears.gif

Source: http://www.bigcharts.com

If it can do that (and you can see from the chart above that it CAN), it brings down all sorts of interest rates that are pegged to the ten-year rate (like 30-year mortgage). If it can jigger mortgage rates down by buying ten-year bonds, it allows Americans to refinance for thirty years at around 4%. And what does that do? We’ll tell you!

It frees up household cash-flow. If American homeowners can lighten their monthly mortgage payment (and if oil prices don’t spike again causing pain at the pump) then Americans will have more money to spend (if they don’t lose their jobs)! And if Americans have more money to spend, they will buy the things made in China. And if they buy things made in China, it means China will need more raw materials from Australia.

Do you see where this is going? Under this scenario, a recovery in the demand for Aussie resources depends on the reflation of the American consumption bubble. This is exactly the scenario Stephen Roche warned about the other day during his Melbourne visit. Roche has been warning for years about the imbalances created by a global growth model that relies on credit-financed consumption.

But it looks like the Fed is trying to revive the old way of doing things…because that’s all it knows how to do.

The other main reason we’ve spent so much time investigating the American credit market is simple: if credit is hard to come by in America, it’s going to get even harder to come by in Australia. The Australian government’s effort to provide lending to “viable” commercial real estate projects (Ruddbank) will have to be expanded to include an even broader cross-section of the credit consuming economy. Why?

Well, Australia imports capital. The Big Four borrowed abroad to provide the funds to power the Aussie housing boom. You’re going to have a hard time having another housing boom if Aussie banks are jealous of their capital and unable or unwilling to borrow abroad. The Aussie housing market, then, is directly dependent on the success of the Fed’s efforts at un-freezing private capital in America. We know that’s not exactly popular among housing bulls in Australia. But there it is all the same.

There are other questions with a lot more difficult answers. For example, it’s already clear that the Fed’s big splash into the bond market is leading to higher commodity prices. Gold futures were up nearly 8% in New York as the old yellow metal closed near $960. Oil crossed over $50.

Those aren’t huge moves, mind you. They’re not small. But if we’re right, bigger ones will come later. And as we’ve said, you can’t expand the money supply like that without triggering inflation.

But will Australia import America’s inflation? That’s the key question of course. The Fed and the Reserve Bank must be confident that with the economy so slow, it will be some time (if ever) before the big expansion in money supply translate into higher prices. The Fed itself said it wasn’t worried about inflation.

We wouldn’t be so sure. If the Reserve Bank or the Rudd Government have to step in, Fed-style, and provide credit to the private sector or support the local bond market in the same fashion, it’s going to mean more money printing. As we’ve said before, there’s never been a case before where an increase in the money supply did not lead to inflation.

The alternative theory for Australia and America is the great deflation theory. That is, you still have trillions in losses from the financial system to work through. You still have massive over capacity in global production (demand far in excess of supply). And in Australia, you still have house prices that could fall 30% or more. In this scenario you get falling prices and asset deflation, not inflation.

Which scenario is going to win out? We’ll see…

And what about the stock market? Well, for base metals and bulk commodities producers, where prices for the underlying commodity are more correlated to economic growth, you would imagine it’s going to be pretty tough sledding. Demand will remain low and credit could be a problem for firms without cash saved up.

For oil, energy, and precious metals producers (and some explorers) we expect the situation to be a bit different. Kris Sayce has been making high with his LNG stocks at the Australian Small Cap Investigator. But to be honest, the moves in gold and oil so far haven’t confirmed the inflationary hypothesis. Why not?

With oil, there are other factors at play (inventories, lower demand, production cuts at OPEC, and in the long term, a lack of supply from under investment). For punters who are comfortable with being in the market right now, we’re still tipping oil shares in Diggers and Drillers.

With gold? Well, it’s obvious now that Ben Bernanke, Barack Obama, the American Congress, Kevin Rudd, Wayne Swan, Gordon Brown, Mervyn King, and the entire global elite are both terrified and utterly clueless. The only real plays in the monetarist play book are to print money and spend it. If that doesn’t cause inflation this year, we don’t know what will.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. You still have massive over capacity in global production (demand far in excess of supply).

    Que?

    Peter Minck
    March 20, 2009
    Reply
  2. Dan: Please please please write an article on fractional reserve banking.

    From what I understand (and it may be a poor understanding);
    – the money supply can expand due to fractional reserve banking (lending)
    – does this mean that the money supply can also contract if loans default? Can that ‘expanded’ money, contract again? Or, once it is expanded, does it not contract?
    – IF money supply can contract, what if, at a similar rate, the Fed prints money to ‘fill in the gap’ so to speak? The same amount of money would be in the system overall, right? Just apportioned differently.

    (Please don’t call me a Keynesian for asking!)

    – Pete

    Reply
  3. It’s not the same thing.

    Fractional Reserve Lending is like loaning the same dollar twice (or eight times), rather than creating extra dollars.

    If the banks have too many withdrawals, they’re in trouble with fractional reserve lending.

    If on the other hand they printed more money, they would still have a 1:1 ratio maintained, and could honor every withdrawal in their bank.

    Combining fractional reserve lending with increasing money supply means that for every $1 printed and put into the bank, about $7 more are actually put into circulation via loans. It’s all electronic money though remember.

    Oh, and the bank collects interest on all $8 not just the $1 they actually have a matching deposit for. Wonderful isn’t it? And the best part is, their security is backed by taxpayer dollars (for banks, not building societies).

    Unpopular Truth
    March 20, 2009
    Reply
  4. Reserve Banking as i currently i understand it..
    http://en.wikipedia.org/wiki/Fractional-reserve_banking

    Central bank ‘creates’ money and lends it to bank A. Bank A then keeps 10% in reserve and lends it to Bank B, Bank B keeps 10% for it’s reserves and lends the rest to Bank C, and so on..

    * Central Bank creates $100M ..

    Entity | Deposit | Loaned Out | Reserve
    ====================================================
    Bank A | $100M | $90M | $10M
    Bank B | $90M | $81M | $9M
    Bank C | $81M | $72.9M | $8.1M
    Bank D | $72.9M | $65.61M | $7.29M
    Bank E | $65.61M | $59.049 | $5.9049M
    .. AND SO ON!!
    =====================================================
    Totals | $409.51M | $368.6M | $40.3M

    So after the original $100M created by the central bank, that money is loaned and re-loaned among the commercial banks. As a result we would see up to $900M created as new loans (money) in the community. This is directly attributable to the Fraction Reserve System.

    As we (the public) pay back that $900M debt over 25 years at an average interest rate of say 6.35%, we pack back the interest and initial principle of the loan ($1,800M). This $1,800M is effectively taken away out of the system as we pay it back to the banks to strike off the loan.

    So, it seems the Reserve Bank is able to ‘create’ that $100M and inject it into the system as debt, knowing that we (the public) will eventually have to slave away over the next 25 years to strike off that debt and pay them $1,800M over the next 25 years.

    The banks have lent out far more money than they have on reserve. So if we all demand our money at once they simple can’t come to the party. We all know this as a ‘run on the bank’, it’s happened before.. it can happen. Banks have investments and capital that they can liquidate in order to payout more of the demands. If they still can’t manage then central banks usually step in.

    So, as shown, most of the available money supply in the community is actually debt. As you know, debt incurs interest. That interest has to come from the money supply. So we have an interesting situation where the money supply has to expand in order to service the interest payment. If it doesn’t expand then it’s inevitable that some borrowers must default on their debt repayments. We know that nothing can expand forever!!

    It’s only my option here, but it seems that this ‘expansion’ has come from rampant consumerism and at the expense of overpopulation. I always wondered why more wasn’t being done about consumption and overpopulation.. it seems to be the root of virtually all the pressures we face for a sustainable future. Now I know why!!

    Interest rates are simply used to ease/squeeze the public as much as possible.. keeping them on the mouse wheel, thus offering some control over expansion. Whilst inflation erodes whatever we manage to muster (that’s another story).

    It seems amazing that ‘money’ used to be a simple exchange for our hard work and productivity. Now it has become abstracted to the point where it no longer represents our hard work but actually enslaves us to the money supply.. and then there’s taxes of course ;-)

    Reply
  5. Pete,

    The money supply will contract significantly due to defaults. The ‘expanded’ money certainly ‘contracts’ and ends up on the banks balance sheets as losses (seen lots of that lately!).

    The money supply is certainly contracting, and the feds printing money is an attempt to ‘fill the gap’.. but as Dan, Bill and the others keep pointing out this is only a stop leak measure for an ecomony with dire vital signs. Further contraction is necessary for the economy to recycle, preventing it may put the whole system at risk.

    Here’s how i understand it..

    Central bank ‘creates’ money and lends it to bank A. Bank A then keeps 10% in reserve and lends it to Bank B, Bank B keeps 10% for it’s reserves and lends the rest to Bank C, and so on..

    * Central Bank creates $100M ..

    Entity | Deposit | Loaned Out | Reserve
    ====================================================
    Bank A | $100M | $90M | $10M
    Bank B | $90M | $81M | $9M
    Bank C | $81M | $72.9M | $8.1M
    Bank D | $72.9M | $65.61M | $7.29M
    Bank E | $65.61M | $59.049 | $5.9049M
    .. AND SO ON!!
    =====================================================
    Totals | $409.51M | $368.6M | $40.3M

    So after the original $100M created by the central bank, that money is loaned and re-loaned among the commercial banks. As a result we would see up to $900M created as new loans (money) in the community. This is directly attributable to the Fr*ctional Reserve System.

    As we (the public) pay back that $900M debt over 25 years at an average interest rate of say 6.35%, we pack back the interest and initial principle of the loan ($1,800M). This $1,800M is effectively taken away out of the system as we pay it back to the banks to strike off the loan.

    So, it seems the Reserve Bank is able to ‘create’ that $100M and inject it into the system as debt, knowing that we (the public) will eventually have to slave away over the next 25 years to strike off that debt and pay them $1,800M over the next 25 years.

    The banks have lent out far more money than they have on reserve. So if we all demand our money at once they simple can’t come to the party. We all know this as a ‘run on the bank’, it’s happened before.. it can happen. Banks have investments and capital that they can liquidate in order to payout more of the demands. If they still can’t manage then central banks usually step in.

    So, as shown, most of the available money supply in the community is actually debt. As you know, debt incurs interest. That interest has to come from the money supply. So we have an interesting situation where the money supply has to expand in order to service the interest payment. If it doesn’t expand then it’s inevitable that some borrowers must default on their debt repayments. We know that nothing can expand forever!!

    It’s only my option here, but it seems that this ‘expansion’ has come from rampant consumerism and at the expense of overpopulation. I always wondered why more wasn’t being done about consumption and overpopulation.. it seems to be the root of virtually all the pressures we face for a sustainable future. Now I know why!!

    Interest rates are simply used to ease/squeeze the public as much as possible.. keeping them on the mouse wheel, thus offering some control over expansion. It seems all our hard work ends up paying enormous taxes, repaying money that was ‘created’, and paying interest on that ‘created’ money.

    It seems amazing that ‘money’ used to be a simple exchange for our hard work and productivity. Now it has become abstracted to the point where it no longer represents our hard work but actually enslaves to those in control of the money supply..
    and taxes of course ;-)

    Reply
  6. Thanks UT

    So I guess money printing would only fill the gap so to speak if a bank went bankrupt. So the gov could potentially add $X to the money supply with no impact(?), where $X = total bank loans minus recoverable money (foreclosures, etc).

    However, how that money is apportioned to the public is another matter.

    I think the real problem with that idea is that if a bank fails, the economy is probably contracting for a reason (especially in our case right now) and adding a bunch of money will still cause loads of problems.

    Thanks :)

    Reply
  7. Dan,
    as a neophyte investor, what is the best way of getting into gold in Australia, if one has limited funds (having lost a significant amount of my super).
    Would you recommend Gold bullion securities (ASX: GOLD) or the physical stuff ( and to start with, where could I source 1 or 2 troy ounces from, in Sydney?)

    The local banks here are pretty useless at providing any info.
    Thanks for your help.

    Reply
  8. “Well, it’s obvious now that Ben Bernanke, Barack Obama, the American Congress, Kevin Rudd, Wayne Swan, Gordon Brown, Mervyn King, and the entire global elite are both terrified and utterly clueless.”

    Obvious? The only thing glaringly obvious is that the global elite know exactly what they are doing. Do people really believe that the entire global elite are bumbling around, biting their fingernails wondering what on earth to do? It is piracy, it is mass looting. Why else does the FED continually rufuse to tell congress where the money is going? Greenspan has admitted on television that the FED is an “independent agency” and “there is no other agency of government which can overule actions that we take”.

    Whatever is coming has been engineered. The world needs to wake up and smell the bs.

    “This Act establishes the most gigantic trust on earth. When the President signs this Act the invisible government by the Money Power, proven to exist by the Money Trust Investigation, will be legalized. The new law will create inflation whenever the trusts want inflation. From now on depressions will be scientifically created.”

    Congressman Charles A. Lindbergh Sr. 1913

    Reply
  9. RS you can buy gold on the ASX from the Perth Mint ASX Code ZAUWBA or buy phisical gold on deposit.
    http://www.perthmint.com.au/investment_depository_overview.aspx
    The real difference with ASX :GOLD is this is in a vault in London whereas you can come to Perth and take physical possesion.

    Reply
  10. Dan,

    With regards to Quantitative Easing.

    Why would anyone (for example the Chinese Government) go to auction and bid for an asset, knowing that the Seller of the asset is bidding against you using unlimited amounts of printed money?

    I know nuthin about ecomanomics – can you explain?

    Stumped

    Reply

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