Silver, Gold and Rising Interest Rates

Before we can even begin to discuss Interest rates intelligently, we must first define what it is that we are actually talking about, since it appears that all the talking Media Heads and Wall Street analysts don't seam to understand what interest are or how interest rates work; The constant barrage of economist parading across our TV screens don't seem to know what Interest Rate's primary functions are let alone how they work.

WHAT ARE INTEREST RATES?

#1 Interest rate is just another word for price. It is the price for money and it is supposed to be determined exactly the same way as the price of any other commodity, product or service is - through the interaction of supply and demand.

#2 However, unlike every other product, commodity or service, interest rates and money do not operate in a Free Market. Interest rates and the supply of money are manipulated (controlled) by the Fed. They do this by controlling the amount (Supply) of money that is available in the banking system through their Open Market Operations (buying & selling treasury Bonds in the open market) and by changing their deposits that they hold with their individual members Banks, directly affecting their reserves and thus their ability to lend. They also increase the money the good old fashioned way, by printing it.

WHAT ARE THE FUNCTIONS OF INTEREST RATES?

# 1 Interest rates determine the propensity of people to either Save or Consume: When interest rates are manipulated (by the Fed), it influences the degree that people are willing to defer present consumption ie. Save. If interest rates are manipulated too low, like they are now, people are no longer willing to save. When the interest rate becomes negative (the interest rate is lower than the inflation rate) people, since they are now being paid to go into debt, take on excessive debt and as well as excessive risk because that is exactly what they are being paid to do. Conversely, when interest rates are high, such as in the early 80's people forego current consumption in order to avail them selves of the ultra high interest rates and we end up having high saving rates.

# 2 When interest rates are high the demand for cash is extremely low. People can't wait to deposit every cent that they can spare so as to earn that high rate of interest. However when rates are low the propensity to hold cash is very high, because at a 1 or 2% interest there is not much to be forgone by keeping the cash in your pockets.

# 3 The Velocity of money (how many times the money supply turns over during the year) and therefore the calculation of the money supply itself is greatly affected by the level of interest rates. When rates are outside the normal range the FED cannot calculate the velocity until long after the fact and thus they lose tract of what the money supply really is and its effect on the economy, leading to the interest rate conundrum.

# 4 Interest rates also determine which investments should or should not be made, according to the investments expected rates of return. When interest rates are manipulated too low, a great many investments and risks are undertaken that should not have been, because these poor investments will fail at the first signs of weakness in the economy or be forced into bankruptcy with the eventual rising interest rates. This is the main underlying cause behind the business cycle. The imbalances (wasted resources) in the economy must be liquidated before the economy can stabilize enough so that the misused scarce resources become available for the next growth phase.

# 5 A Neutral Rate of Interest is the rate that neither stimulates nor restricts the economy. Greenspan was and Berenanke is in a conundrum as to what that rate is or should be. Previously, that rate was thought to be 1.5% to 3% over the inflation rate. (According to the latest CPI report (5%) the Discount Rate should be at least 6.5%) In the past, when the Fed did not manipulate the rates except at the extremes, the market was able to determine what that rate should be through the interactions of the Free Market. But today with US savings nearly zero and the CPI and Interest rates being highly manipulated, the Fed is unable to measure the Velocity of Money and with negative interest rates, the Fed does not have a clue as what the neutral rate should be.

# 6 The Discount Rate is the rate that the Fed charges Banks who need to borrow money from the Fed to meet their reserve requirements. The FED was originally created to be "the Lender of Last Resort", .avoiding Bank Runs and liquidity squeezes.. The Discount rate charged used to be a Punitive Rate; A rate that was somewhat above the Fed Funds Rates (the rate at which Banks lend to each other in order to meet their overnight reserve requirements). But today, the discount rate is below the Fed Funds rate, drastically lowering the banks cost of money and reducing the amount of interest they are willing to pay for deposits: So that now massive amounts of money are being borrowed from the FED without having to worry about the excess demand increasing interest rates, greatly increasing the banks' ability to create money out of thin air. (Completely negating the supply/demand function in setting interest rates) This beak down in the function of a free market has led to the creation of "The Carry Trade." In so doing, the Fed has completely lost control over the banks and near banks' (FNM, FRE, GE, GMAC etc.) ability to create money and have therefore lost control over the money supply: This has led directly to the creation of the Stock and Bond Market Bubbles and more recently, to the ever expanding Real Estate Bubble. For a long time, regardless of the ever increasing demand for loans, interest rates continued to decline.

THE FED'S CONUNDRUM

Fed Chairman Greenspan once again raised the conundrum of the divergence between short term and long-term rates during his recent testimony before the Joint Economic Committee of the US Congress. At the end of May(2005) the yield on the 10-year Treasury-Note stood at 4%-well below the 4.6% rate in June of last year when the Fed funds rate was only 1%. Greenspan blames some mysterious 'pressures' for the divergence between the Federal funds rate and long-term rates. Careful examination shows that there is no mystery. The so called mysterious pressure is in fact the natural outcome of the Fed's own policies.

When it comes to the economy, what matters most is the availability of money and not the purported interest rate stance of the Fed. For example, in order to maintain a given interest rate target in the midst of a strong economy, the Fed is forced to push more and more money into the system to prevent the Fed funds rate from rising above their target rate. This in turn causes long term rates to fall. The opposite will happen should the economy go through a period of weakness. Since they are always behind the curve, they end up exacerbating the problem rather than dampening the fluctuations. Since June 2004, despite raising the Fed-funds rate from 1% to 4 3/4%, the Fed has actually hiked the pace of pumping money into the system, creating a flat to negative yield curve In short, the Fed has been talking tough while acting like a very loose street walker.

TIME LAGS: Nobody seems to realize that there are always time lags whenever there are any changes in FED or Government policy, whether they be Taxes, Money Supply or even High Oil prices or ??? . It takes time for the Free Market to send its signals through to every participant. The estimated average time lag between changes in the Fed Funds policies and the growth momentum of industrial production is on average 12 to 30 months. Hence, at the same time as the FED'S attempted tighter stance (beginning June 2004) the effect of the previous and continuing loose money stance was still in force and continuing its influence for the following 12 to 30 months. So in spite of their regular ¼ % increases the yearly rate of growth of industrial production stayed strong well into 2006. However the strong economic activity made possible by its loose money policy, had made the FED Funds rate targets unsustainable-so the Fed had to continue to increase the money supply to prevent the Fed Funds rate from overshooting their stated targets. This monetary pumping has in turn prevented the growth momentum of the economy from slowing, also preventing any meaningful rise in long-term interest rates.

INFLATION: According to Milton Friedman, inflation is at all times a monetary phenomenon. If you keep printing money (beginning in 1994) at a rate that is 10% a year above the economy's real rate of growth, inflation must eventually ensue and it has. It first showed up in the stock market, then found its way into the Bond market and eventually into Real Estate. Now that the economy is awash in cash its finally finding its way into the CPI. Witness the price explosion of commodities to new all time highs as well as Gold and Silver: Even though the government has thus far managed to convince everyone (through their ingenious manipulation of the CPI) that there was and is no inflation, Nevertheless inflation has already begun to show its ugly face and it won't be much longer before we see just how high inflation really is. Greenspan to his credit was looking to the Future while the rest of our esteemed analysts are still focusing on their rear view mirror.

Conclusion

It is probable that the Fed has decided that it has no choice but to push the Fed funds rate even higher than most now expect in order for the economy's growth momentum to start trending down. Like it or not and despite what Wall Street. wants, the economy cannot continue growing above its capacity for any sizeable length of time without going into rampant inflation. But the FED by not taking into account the lag effect of their last 12 months of interest rate hikes, will end up setting in motion a depressing effect on economic activity which will begin to take effect, more than likely, within the next 3 to 6 months. Because of the Lag effect they will, as they always have, overshoot their target and exacerbate the problem that they themselves have created.

In the meantime, the lag effect of the higher interest rate since June 2004 will eventually find its way into sharply rising long term rates, undermining the stock, bond and real estate market that sprang up on the back of their ultra loose monetary policy, setting in motion the next economic bust.

Greenspan realized full well that the bigger the boom the bigger the inevitable bust: His main objective was to push the time of the inevitable crash into the next Chairman's term and so preserve his legacy. To give him his due, he is also trying to raise interest high enough before the crash so that the FED will then have some ammunition (cut interest rates) to stop or at least slow down the crash.. However it will, be similar to 2001, too little and too late. In 2001 we were sitting on projected massive surpluses and so Bush was able to get massive Tax cuts passed and succeeded in stopping the recession in its tracts; but this time the US is in a WAR with both massive trade and budget deficits instead. There will be no new Tax Cuts coming to save the day and stop the Crash. A looming and even bigger danger is if the Democrats gain control of either one or both houses of congress in November; we could then actually see Tax increases.

NOTE: The FED is trying to serve two masters. One is Stable Prices, the other is Full Employment. The two are mutually incompatible and their follies will soon be coming home to roost. Regardless of which scenario unfolds: a) The FED continues to increase interest rates too much, halting the economy in its tracks or b) stops cutting interest rates too soon, precipitating a rapid increase in inflation; either scenario will be good for Gold and Silver.

GOLD and SILVER

The Gold and Silver Bugs after serving a 25 prison year sentence mired in a Bear Market have been finally let lose: But they are still talking about fundamentals: They have been always right about the shortages of new supply vs. demand but that didn't stop the bear market. For the past few years the supply demand imbalances have become so acute that we are now in a world wide bull market for all commodities not just for Gold and Silver: But that is not from where an exploding Bull Market comes from. In order to get a 1978-1980 type explosion in Gold and Silver prices you require the combined emotions of both GREED & FEAR. So far we are only experiencing the beginnings of Greed. I know this because even the biggest and best Gold Bugs keep calling for periodic corrections. When Greed takes over there is no longer talk of correction as prices begin to jump 5 to 10% in one day and people line up to buy bullion as signs pop up every where "WE buy and sell gold". That final stage only begins as the FEAR of a collapsing currency embroils men hearts. Once both fear and greed take over the market and the short squeezes begin in ernest, there is no way of predicting how high the high. $2200 Gold and $200 Silver seems to me to be the barest minimum targets, maybe $5000 or even $10,000 could be in the cards, Your guess is as good as mine. I realize that the great majority of you may think I'm crazy, but when you yourself start thinking that these numbers might actually be too low then and only then, will we be firmly in the clutches of blind Greed and be near the final top.

Who are these people that end up buying at the top? Why they are the same ones that got in near the lows but sold out for what turned out to be only a small profit and were waiting for that pull back that never came to get back in. Be careful and make sure that I'm won't be describing YOU.

What To DO Now?

Liquidate all your short term Debt. Build up your cash position by selling most of your stock and long term bonds into this last ditch blow-off rally. (Begin by liquidating all your loosing positions immediately). Buy Gold and Silver NOW. Do not use margin to start with. Use you buying power to increase you positions if we are lucky enough to get a one last 10 to 20% pull back Otherwise just scale in but what ever you do get back in now or you will be getting back in right near the eventual top.

DISCLAIMER

The above is my personal opinion, and in no way be deemed investment advice to buy or sell anything. It is submitted purely for informational purposes, based upon my understanding of the markets.