Quick… Call The SPCA!

Tomorrow is the big day. An historic day, actually. Never before in history has something like this happened.

After seven years of the Fed’s ZIRP, short-term interest rates are expected to begin moving back to “normal.”

Yesterday, we discussed how markets work. Nothing clever or controversial about it. We just observed that they go up and down.

We also noted that if investors knew that the fix was in and that markets would go only in one direction, it would wreak havoc.

Investors, businessmen, consumers – they would all make decisions they wouldn’t otherwise make.

Corrupt Markets

For example, they may buy into a junk-bond fund…

Normally, the risk of junk bonds is rather obvious. Rates might rise, bond prices might fall, and your investment might be wiped out. Or the shaky businesses that issued the bond may default and stiff their creditors.

But when you know the Fed has your back, it’s no longer an even-odds bet. You’ve got an edge. And others will see the same opportunity.

Pretty soon, junk bonds that would otherwise sell for, say, $100 are selling for $200. The trade – borrow at a low rate, lend at a higher rate – gets crowded. And dangerous.

Corrupting a market is a little like buying a politician: You can’t count on him to stay bought. We saw that yesterday, too. Markets dodge. They duck. They go underground. They develop curvature of the spine, neuroses, and epizootics. They forget that the fix is in.

But markets don’t ever stop working…

We saw what happened in 2007. Cheap credit pulled in marginal buyers… and buyers from the future. Prices rose. The typical house became much more expensive than the typical buyer could afford. The bids disappeared. Prices fell.

House prices were the collateral of the entire mortgage derivative monstrosity, to which the geniuses of Wall Street had nailed their careers, their fortunes, and their institutions’ net worth.