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Author: EliasFardo Big red star, 1000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 214599  
Subject: Re: The Next Big Crisis Date: 2/3/2013 3:14 PM
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Yet, I can't help but think of your comment about a 'financial crisis which severely disrupts the economy for years' having already happened in 2007 to today and the likely result of such an event is stable or lower rates, not higher, even from today's rates.

Of course, today’s low interest rates are a result of extraordinary steps taken by the Fed. The Fed has expanded its balance sheet to $3 trillion and is increasing that every month. I think a point that people miss is that today all policy is all in. The types of tools that we use to fight a recession - deficit spending, low interest rates, monetary easing - are currently being used to an unprecedented extent. Some respectable people even believe that these policies have an unintended consequence of prolonging this poor economy. So, what if the next recession is actually caused by the very tools used to fight the previous recession? What do we do then?

The financial system basically works on confidence. People make loans based on a certain level of confidence that they will be repaid in full and on time. People make investments based on a certain level of confidence that those investments will result in profits. Confidence is a flighty thing; it can be there in the morning and gone in the afternoon. And the withdrawal of confidence does not give a lot of early warning signals. It will slowly slip away – and its retreat will be argued against as being insignificant – until it disappears in a very short time; maybe over a weekend. And if we see a few early whiffs of inflation, and few early signs of rising interest rates, and few early indicators of a weakening economy and then, God forbid, a failed Treasury bond auction, it is Katy bar the door.

So, I say that the very things that we are continuing to do to fight the previous recession may very well be the things that cause the next one. At that point we have already used our recession fighting tools. The only thing left to do is just bear it out, and you know what kind of reception that suggestion will get.

I take no confidence in today’s low and stable interest rates. In fact, I take the opposite. What will catch many off guard is how rising interest rates affect asset prices differently based on how low the current rate is. For instance, a 100 basis points increase in the 30 year rate will decrease the price of a 3% 30 year bond more than a 4% 30 year bonds. This is because the principal repayment that will occur in 30 years is a greater percentage of the total interest and principal payments for a 3% bond than a 4% bond. So, since interest rates are at historic lows, the damage done to the price of bonds will be more severe now than what was experienced in the past.

If you hold the bond outright, and you define medium at 5 to 6 years, and you hold to maturity (granted, big IFs), I'm not sure calling impending doom is really necessary.

I am pretty much an agnostic on 5 year bonds; I don’t know what they will do. But, we do know that rates can continue in one direction or another for decades. In 1980, the prime rate that banks charge hit 20.5%. Today it is at 3.25%; thirty years in the making. I have no clue so I am not going to say that rates will rise for the next 30 years. But if they do, the comfort of knowing that you will get all your money back if you hold that 3% 30 year Treasury bond till maturity will be cold indeed.
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