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Tags: Real | Cost | Rate | Cuts

The Real Cost of the Rate Cuts

Wednesday, 12 December 2007 02:59 PM EST

Thanks to concerted efforts by the U.S. Treasury and the Federal Reserve to prevent the economy from entering a recession, long-term interest rates have risen over the past week.

As a result, bond prices have fallen!

My research suggests that bonds are headed even lower over the coming months, as inflationary pressures continue to mount, home foreclosures continue to rise, and bank lending standards continue to tighten.

So the Bush mortgage plan, and yesterday's decision by the Federal Reserve to continue lowering short-term interest rates, will likely serve only to raise long-term rates even further.

In announcing the Bush mortgage plan last Thursday, Treasury Secretary Henry Paulson said "nobody gets hurt" by this plan.

Let me see if I understand this: The Bush Administration's plan to save irresponsible, subprime "homeowners" from losing "their" homes — from being kicked out of homes that they are currently renting from the bank at less than market interest-rate payments — supposedly won't hurt anyone.

Well, I suggest for Paulson to try explaining his claim to retired Americans and other investors who currently hold investments in bonds, because if long-term interest rates continue to rise — and they likely will over the coming months — bond prices could tank.

In the event of a substantial decline in bond prices, the household wealth of consumers will likely continue to fall and consumers will therefore likely continue to curtail their spending.

Consumers have already significantly reduced their spending as a result of falling home values, persistently high gasoline and home heating prices, and concerns about their job security. In fact, aggregate consumer spending rose at a year-over-year rate of only 2.4 percent during November, as compared 3.3 percent on average during the previous 12 months.

Given that consumer spending accounts for approximately 70 percent of the total output of goods and services in the U.S., a further slowdown in consumer spending would likely cause economic growth in the U.S. to slow considerably over the coming months.

Hence, the Fed's efforts to stimulate economic growth by continuing to lower short-term interest rates could backfire, as such rate cuts will likely cause the exchange-value of the U.S. dollar to continue to fall and for inflationary pressures to therefore continue to rise.

Well, guess what happens when inflation rises? That's right, bond investors demand higher bond yields.

And when bond yields rise, the prices of bonds fall. However, the Treasury apparently wasn't content in seeing only modest declines in bond prices, because if mortgage lenders implement the Bush mortgage plan, those lenders will earn less interest on the loans that they made to subprime borrowers.

In turn, those same mortgage lenders will likely raise mortgage rates on loans that they make to future home buyers.

By the way, bond investors tend to be older, retired persons who depend heavily on interest receipts from their bond investments to fund their daily living expenses. So maybe we should assume that Secretary Paulson is planning on donating some of his fortune that he made while serving as the chairman of Goldman Sachs, the investment banking firm that made millions of dollars from selling short investment vehicles tied to subprime mortgages.

If Paulson were to be so generous, I might then be able to believe his comment that "nobody gets hurt" by the Bush mortgage plan.

The Treasury is at least being consistent. In addition to having a so-called "strong dollar policy," it now also has a "strong mortgage policy."

In reality, the Treasury doesn't have a true policy for either the dollar or the subprime mortgage market. By definition, a policy is a procedure or plan of action to guide and determine both present and future decisions.

Unfortunately, I've yet to see the Treasury implement any type of serious plan to halt the dollar's descent or to address the inherent problems of the mortgage industry.

On a more positive note, I expect the stocks of utilities companies to continue to rise over the coming months, as utilities stocks tend to perform well during periods of slowing economic growth and falling short-term interest rates.

I also expect ETFs comprised of large holdings in the utilities sector to also continue performing well.

Two utilities ETFs that we've recommended in our new investment service, The ETF Strategist, have already appreciated 10.6 percent and 12.8 percent, respectively, since I first recommended them to subscribers on September 18 of this year.

In comparison, the S&P 500 index has returned only 2.7 percent during this same period.

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Thanks to concerted efforts by the U.S. Treasury and the Federal Reserve to prevent the economy from entering a recession, long-term interest rates have risen over the past week.As a result, bond prices have fallen!My research suggests that bonds are headed even lower over...
Wednesday, 12 December 2007 02:59 PM
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