The fed and rates and the markets...

Multiple common misconceptions are at play right now and I want to clear a few of them up before the truth becomes obvious so that people looking back will understand that not everyone was fooled by what is about to happen.

The big misconception is that the federal reserve controls interest rates.  This is why everyone hangs on each word out of the mouth of a federal reserve board member.  They even attributed the recent rally to remarks by James Bullard of the St Louis fed who apparently mumbled something about a possible QE extension.  Of course the real reason is that the wave count was ready to change direction but that is an argument for another day.

So let's sort this thing out once and for all.  The fed controls the fed funds rate but that is just an uncollateralized overnight loan between banks in the federal reserve system.  The fed does not control the rates for longer term debt.  The market controls those.  The rate that probably matters most to the US economy is the 10 year treasury rate as that is used by banks as a basis for real estate loans and real estate is the largest asset class in the country.  As Greenspan said (paraphrased), as real estate goes, so goes the country.  The fact that the market, during normal times, chooses to base the other rates off of the fed funds rate is just coincidental.  It is not a rule or a law and in a crisis you cannot count on these long standing relationships to be maintained.  It is possible for the fed to keep the fed funds rate at 0% while the market moves the 10 year to 5,10 or 15%.  The fact that it has not happened before is meaningless; there is nothing about the system that prevents banks from charging whatever rate is needed in order to ensure that they make enough interest on good loans in order to cover those which default.

Also keep in mind what the real purpose of the fed funds rate is: to price real time liquidity so that it can easily flow to where it might be needed in order to cover short term, localized unexpected surges in demand for cash.  This is needed in order to stay within mandated reserve requirements for individual banks.  Such short term loans enable over leveraged banks (as defined by not having enough reserves) to sell assets in order to generate cash.  These loans are thus buffers for the banks to meet instantaneous cash withdrawal demands by customers and to give them time to sell assets to cover the withdrawals.  A run on the bank is essentially a margin call which requires the bank to sell assets to satisfy it. 
 
Keep in mind that a fractionally reserved system is always technically in default because there is never and I mean not ever enough money in the system by definition to satisfy all the POTENTIAL claims on it.  Another word for a claim on money is credit.  If you take on credit, the lender has a claim on you to repay it.  When you deposit money in a bank, it is technically a loan.  So if everyone went to the bank at the same time and tried to claim their cash, the banks would all default in an eyeblink because, folks, the dollar amounts that appear on your bank statement do not actually exist.  They are owed to you on demand by the bank.  But what if the bank cannot get its hands on the cash because the overnight loan system has frozen up due to fear of having someone else's leverage take you down?

Not only do your dollars not exist, neither do those of 9 out of 10 depositors.  This is not a guess; it is how fractional reserve lending works.  Your deposits are used as reserves on loans issued by the banks and the amount of debt out there is at least 10:1 relative to reserves (and in fact, much much higher in the case of entities like Fannie and Freddy).  Again, this is not some conspiracy theory, it is math.  This chart is dated but it shows you what I mean.

Because any dynamic system like the economy can have short term "trouble spots" in the banking system, the federal reserve defined the overnight uncollateralized loan program and thus dictates its rates.  This system works during normal times but it is completely unworkable in larger crises because everyone everywhere begins to get fearful about the safety and soundness of the system.  At those times the people all run to the bank at the same time to take all their money out.  IF the problem is localized, the affected banks get short term loans until the panic subsides and the suckers put their money back into the bank.  After all, who wants to have to guard all their money at home?

So that is what the fed funds rate is all about.  It's a form of liquidity insurance.  However, as we learned back in the 2007-2009 crisis, it's also voluntary.  If banks who are asked for a loan by another bank fear that they will not get their money back, they don't make the loan and they cannot be forced to do so.  Remember, such loans are uncollateralized! This is the so called liquidity crisis that is caused by a broad run on the banks.

Bottom line is that most people don't care about the fed funds rate.  They care about rates that we have access to such as 10, 15 and 30 year home loans, small business loans, etc.  As you can see from the chart below (divide by 10 to get the actual rate), despite no change in the fed funds rate for many moons now, the 10 year treasury rate has been moving up.  In fact, it is controlled by the Elliott wave principle and so we see 5 blue waves up into black 1.  Then a clear a-b-c retracement into black 2.

Guess what comes next?

That's right.  Wave 3 up.

Now, there are a lot of people out there saying that the fed "can't" raise "the rates" because if they do the stock market and the economy will tank.  Housing prices will be demolished.  And all of those consequences are in fact true.  But I know something that seemingly few people know: the fed does not really control the rates any more than 5 cowboys control 500 head of cattle on the way to market.  IF the cattle are so stupid to go along with the deal, they end up in the slaughterhouse for their ignorance.  But if the cattle decide not to go in the direction that the cowboys are driving them then, folks, there is nothing the cowboys can do because the herd is much bigger and much stronger than even 300 cowboys on horses.  In a stampede, the cowboys just get the Hell out of the way or they get trampled.

It is no different with the finanical markets.  Those rising interest rates in the face of a static 0.25% fed funds rate tell me that the herd is getting nervous and the coming 3rd wave is where we should see some rapid rate moves that will mos def hit the leveraged longs in the pocket on their margin debt.

It's one thing to have margin debt in a rising market.  You can pay the interest out of the profits.  But in a falling market, the leverage comes off quickly because it is a double whammy on the way down.  You lose capital both in the form of falling asset prices AND in the form of a rising margin debt interest rate.  When the smart money sees this, they will head for the door or they will get creamed.

So there you have it.  Rising interest rates will cream the asset market valuations (be they cars, houses, stocks, bonds, diamonds or paintings and probably even gold and silver for a time).  And the fed does not control these interest rates.  So all this talk about whether or not the fed will raise the interest rates is really moot.  The real carepoint is when the MARKETS will raise the rates and, as you can see from the chart, wave 3 up is now upon us.