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State of the Economy; Optimists and pessimists: Take heed

Posted: February 6, 2004
1:00 a.m. Eastern

Editor's note: The following is a guest commentary from one of WND's sponsors, Kevin DeMeritt, president of Lear Financial. If you would like to learn more about investing in precious metals, take advantage of the free information Lear Financial is making available to WND readers .

By Kevin DeMeritt
© 2004

For those of us suffering from cabin fever, there actually is an upside to the otherwise cold and dreary months of January and February. Boiled down to one word, it is "possibilities." We wonder, maybe even daydream, at the possibilities the new year has to offer. The pessimists probably don't look forward to those possibilities. The optimists, on the other hand, love believing in a bright, shining tomorrow.

And that optimism extends to the coming economy. Few of us actually invest in January as if the economy is going to tank in July. But, as wonderful and uplifting as a cheery disposition can be, there's a lot to be said for the good, old-fashioned virtue of prudence. Especially when it comes to our life savings and the portfolios we've struggled so hard to construct.

Make no mistake; we could have a great 2004. The gross domestic product could continue its stupendous (if inexplicable) late 2003 performance. The stock market could extend the impressive run it began last year. Consumer confidence could keep rising. Employment that eked ahead in 2003 could keep well eking . It could all be good news in '04, in other words.

But if the news turns out to be good, it will be because the problems detailed in the paragraphs below will have been successfully addressed. Because, whether you're a cheery optimist or a grizzled, old pessimist, you probably are aware of the fact that we do face problems big, international problems created by our record debt and declining dollar.

A 2004, four-stage dollar scenario

"All in all, the picture is not rosy it's really alarming," said Dimitri Papadimitriou, president of Bard College's Levy Economics Institute, and obviously not someone in the optimist's camp.

He's talking about the consequences of our being The World's Debtor Nation. Project the 2003 consequences over the next 12 months and, unless a dramatic remedy is provided in the meantime, you could easily arrive at a pessimist-pleasing scenario. It really all hinges on how the international community responds to our massive indebtedness in the months ahead.

What follows are the four stages of a 2004 scenario that, sad to say, is entirely possible. (my apologies to the optimists I have better news for you at the end of the article.)

1) Foreign nations adopt new tactics to deal with the falling dollar.

To date, foreign central banks have been very accommodating in sponging up our declining dollars in an effort to keep their own currencies competitive. This has resulted in a U.S. inflow of some $1.5 billion a day in foreign investment that's been absolutely essential in funding our own enormous deficits. Wrote Greg McBride of

"But what happens if foreign central banks, realizing the futility of those efforts to date (i.e., buying our Treasuries) or seeing evidence of their own economies weakening from a deteriorating export climate, decide to change course? Instead of intervening in world currency markets by buying dollars and pouring the proceeds into Treasuries, there is a danger that foreign central banks will just abandon that tactic altogether and opt to cut interest rates at home.

"The idea is to make their own currencies less desirable on a relative basis in the world currency markets by cutting interest rates. Low interest rates are one factor that has affected the dollar's standing, as investors are reluctant to buy dollars and invest the proceeds at 1 percent here when they can buy euros, earn double the return, and benefit from further currency appreciation in the interim."

This sea change in foreign strategy isn't merely conjecture the central banks in Japan and Canada, two of our biggest trading partners, have already begun cutting interest rates. "Should this trend catch on elsewhere around the globe, it has implications for long-term interest rates, and mortgage rates in particular," McBride added.

2) Interest rates in the U.S. rise.

If foreign rate cutting replaces the buying of Treasuries, the U.S. may find itself in the extraordinary position of being unable to service its own trade deficit. After all, U.S. Treasury note sales will need to exceed $800 billion this year to finance the '04 record budget deficit, analysts at Merrill Lynch & Co. and Barclays Capital Inc. have determined. But there are already indications that this may be a tough sale. Foreign reluctance to finance our debt was evident last August when CBS Market Watch reported purchases of Treasury securities by foreigners fell 78 percent from August to September (from $25.2 billion to $5.56 billion). The prospect of a U.S. losing ground to its debts and a further drop in the dollar as a consequence will not be lost on foreign investors who, as it is, have been buying up the more profitable euro.

"If foreign central banks scale back their purchases of U.S. government debt in favor of trimming their own interest rates, there won't be much holding U.S. long-term interest rates near record lows. Foreign investors hold more than one-third of outstanding Treasury debt, and if any measure of that money departs these shores, the Treasury will need to offer higher returns to investors in order to finance the burgeoning budget deficit," McBride wrote.

Caught between a rock and a hard place, the Fed would have no choice but to raise interest rates. And that could prove disastrous.

3) Rising rates would have serious consequences.

While there's probably never been a time when higher rates (after a prolonged season of lower rates) were considered a "welcome stimulus," they might be absolutely devastating to the U.S. economy right now.

Consider how vulnerable the average American consumer now is (according to an article by Michael E. Kanell from the Atlanta Journal-Constitution).

  • "The average credit card holder carries about $8,500 in debt and pays about $1,000 a year in interest charges.
  • "In the second quarter of 2003, monthly payments were eating up 13.3 percent of disposable income, according to the Federal Reserve.
  • "By last November, consumer credit was nearly $2 trillion.
  • "Credit card delinquencies climbed to a record 4.09 percent of all accounts during the third quarter of last year, according to the American Bankers Association.
  • "In the year ending Sept. 30, 1.66 million bankruptcies were filed up 7.4 percent from 2002.
  • "Roughly 2.4 million jobs have been lost since early 2001."

Much of this credit overdependence has been "enabled" by our record low rates. But what happens when rates rise? "Four-decade lows in interest rates have kept monthly payments within reach. But let those rates rise, and the rate of defaults on credit cards, as well as bankruptcies, almost certainly would climb," wrote Kanell.

To this, Sir John Templeton of the Templeton Funds opined that rising rates would add the burden of higher mortgage rates, and that could readily choke the nation's real estate industry our major economic engine over the past few years and squeeze corporate profit margins. This is especially so with the proliferation of adjustable rate mortgages.

Said CNN Money: " buyers who could afford a $1,400 monthly payment on a $250,000 mortgage when rates are 5.5 percent may not be willing to pay as much for a house if rates go to 7 percent, in which case the monthly payment would be $1,660.

"Let's imagine rates go to 7 percent. I think that would take the air out of the bubble pretty quickly," said Dean Baker, co-director of the Center for Economic and Policy Research.

As Sir John believes, this could strangle, in the process, America's fledgling recovery.

4) Stagflation and investments that thrive on rising rates.

Ominously enough, and perhaps in the wake of the above pressures, the Fed just announced that it is no longer assuring Americans it will keep rates low "for a considerable period." With that inevitable uptick of rates, Sir John believes the stage will be set for stagflation.

Stagflation is a combination of economic stagnation and inflation.

"With rising rates, U.S. manufacturers will face higher costs of production, but won't be able to pass on price increases due to continued competition from lower-cost manufacturers in China and India. Profit margins for U.S. corporations will be squeezed and stock values will suffer," said Templeton, as quoted be Gary Moore, a Sarasota investment adviser. "In turn, U.S. consumers will see their living standards decline, causing them to pull back on spending, sending another Japan-like shockwave through the economy."

But before you optimists stop reading (if you haven't already) and you pessimists start licking your lips, there is an historic investment remedy you can turn to for rising interest rates.

In February of 1972, the prime lending rate stood at 4.5 percent. Two years later, in August, they nearly tripled to 12 percent. Down the road, in December of 1980, they hit a record 21.5. Interestingly, this rise correlated quite accurately with the run of gold in the '70s. From $48.26 an ounce in February 1972, gold reached a record high $850 an ounce on Jan.21, 1980. That resulted in a 1,670 percent increase in just eight years.

This fundamental higher gold/higher interest rate correlation will likely be tested again soon. So if rates do climb this year as many analysts believe, if the dollar falls another 10 percent as Merrill Lynch predicts, if gold continues to feed on higher rates as they did in the '70s, there's a good chance the precious metal will continue its bull market. Perhaps for years to come. In the shorter term, Merrill Lynch believes that gold's rise will top $500 an ounce this year. Barrons beat Merrill's prediction: That financial publication recently included the prediction that the rise in gold could exceed $800 an ounce.

Given this deep economic stew we find ourselves in, a 15 to 20 percent diversification in gold only seems like the most prudent of ideas, regardless of your optimistic or pessimistic leanings. Ponder the possibilities of that the next time it snows and you bury yourself in a pile of blankets by the fireplace


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