The whole world is deflating, but long-term interest rates are moving up. (See the chart for the 10-yr Treasury at right). Why?
Tim Geithner thinks it’s because traders are recognising that the economy’s beginning to recover.
That’s one happy theory. And it’s possible (fingers crossed). But here are two less-happy theories:
First, long-term rates are going up because traders are getting nervous about future inflation. This is sensible. Given all the money the world is printing, it is quite likely that we’re eventually going to have severe inflation, which will destroy the value of savings and bonds. The question is when that will start. (Japan has been able to postpone it for 15 years and counting).
Second, long-term rates are going up because traders are realising that the world’s big economies will need to issue trillions of dollars of new debt to pay for all their deficit spending…and there’s just not enough dumb money in the world. Put differently, where is all this money going to come from?
John Mauldin ran some numbers on this over the weekend. The US is in trouble. Japan’s in trouble. Germany’s in trouble. The UK’s in trouble. Spain is in trouble. European banks are in trouble. All of the aforementioned countries, including the US, will be running deficits of over 10% a year, likely for several years to try to stave off economic collapse.
The US deficit alone will eat $1.8 trillion next year, forcing the US to issue $1.8 trillion of new debt. When you go out a few years and add in the other countries, the amount of new money required gets very big very fast. And, again, the big question is…where is that money going to come from?
Here’s John Mauldin:
The world is going to have to fund multiple trillions in debt over the next several years. Pick a number. I think $5 trillion sounds about right. $3 trillion is in the cards for the US alone, if current projections are right.
The US trade deficit is now down to under $350 billion a year. The Fed can monetise a trillion [buy debt directly from the Treasury, thus printing new money]. Maybe… US savings are going to go up, but where is the incentive to buy 10-year debt at 3.5%? Four-year debt under 2% doesn’t do much for your savings growth. Even with monetization and the Chinese buying our debt with the dollars we send them, that still leaves the bond market about $1.5 trillion short, give or take $100 billion…
I think the bond market is looking at the mountain of debt that will have to be somehow sold and wondering where such a colossal sum will come from. Where do you find $10 trillion in the next 10 years for US debt?
And that is just for US government debt. $5 trillion for new global debt in the next two years? In a deleveraged world? How much will the other countries need? What about money needed for businesses and mortgages and credit cards and so on?
If you add $10 trillion to the current $11.3 trillion (including Social Security trust funds, etc.), that totals $21 trillion in 2019. Let’s be generous and suggest that interest rates will only be an average of 5%. That would be an interest-rate expense of over $1 trillion. That is 25% of projected revenues and 20% of expected expenses. And that assumes you have nominal growth of over 4% for the next 10 years. If growth is less, tax revenues will be less.
Put another way: Interest rates may be going up because the bond market is concluding that the world’s biggest borrowers are becoming lousy credits. The only way you can induce lenders to lend to lousy credits (subprime borrowers, for example) is to charge sky-high interest rates with lots of onerous terms. So what may be happening in the bond market is that the “teaser rate” of the past few years is resetting to a usurious rate that will make it fantastically expensive to borrow the money we need.
(This is what some bond market vigilantes have been predicting for years, by the way. They’ve just been wrong for so long that everyone has stopped listening to them. Maybe now they’ll be right).
The Obama administration (and the governments of the other big countries mentioned above) is betting that it can turn the economy around in time to start paying off the mortgage before the teaser rate resets. Here’s hoping the bet works out.
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