A few months ago, the chorus sung by the recovery cheerleaders reached a crescendo when expanding consumer credit statistics and surging US trade deficits provided them with “evidence” of an economic rebound.
In declaring victory, they overlooked the very nucleus of this past crisis: namely, the enormous debt levels and bubbling inflation that created fragile asset bubbles.
If they had recognised the original problem, they would have remained silent. In reality, only a reduction in US debt levels or increase in the value of the dollar would have signaled a budding recovery; but, thanks to the Federal Reserve and Obama Administration, there is virtually no way those results will ever be seen.
Last week’s Flow of Funds report issued by the Federal Reserve clearly underlines the fact that we, as a country, haven’t just avoided deleveraging, but rather continue to accumulate debt. At the end of the last fiscal year, total non-financial debt (household, business, state, local, and federal) reached an all-time record high of $36.2 trillion.
Not only is the nominal level of debt at a record, but also debt-to-GDP – a far more worrying statistic. In Q4:07, total non-financial debt registered 222% of GDP. In 2008 and 2009, it was 238% and 243% respectively. As of Q4:10, that figure had risen to 244% of GDP, For some perspective, look back to the turn of the millennium, when total debt-to-GDP was ‘just’ 182%. Even that level points to a sick economy, but today’s make you wonder how the patient is still breathing.
It is clear to me that the overleveraged condition which brought the economy down in 2008 still exists today – only worse. For all the suffering and displacement that has gone on, all we have accomplished is an unprecedented transfer private debt onto the Treasury’s balance sheet. Now that the Fed is (hopefully) just months away from taking the printing presses off overtime, the paramount question is how fast interest rates will climb. The Fed has been able to keep yields this low through relentless devaluation and a propaganda campaign that convinced the majority of investors that deflation was a credible threat (kinda like those phantom Iraqi WMDs).
But Washington’s ability to continue that ruse is coming to an end. The unrelenting growth of the Fed’s balance sheet, increasing monetary aggregates, surging gold and commodity prices, $100/barrel oil, soaring food prices, and trillions of dollars of new debt projected for the near future have served to vanquish the deflationists. Any echoes of those once prominent voices can barely be heard amid the thunderous roar of oncoming inflation.
So therein lies the problem for the Fed. Any further debt monetization by the central bank now becomes counterproductive. That’s because as inflation rates climb, bond investors demand higher interest rates. The lower real interest rates become, the less participation there will be in the bond market from private sources. If you don’t believe me, ask Bill Gross.
The Fed is now damned if it does and damned if it doesn’t. Interest rates have been artificially suppressed for such a long time that no matter what Bernanke does come June, interest rates will rise. If it enacts another iteration of Quantitative Easing, the Fed may find itself the only player in the bond market. Of course, the Fed could potentially buy all of the auctioned Treasury debt in order to keep rates low—as uncomfortable a position as that may be—but still all other interest rates, from bank loans to municipal debt, would skyrocket. Unless… the Fed decided to buy all that debt too. Hello Zimbabwe!
That scenario is still farfetched, but Bernanke’s logic eventually leads there. The truth is that only a central banker could afford to own bonds that are yielding rates well below inflation, and growing even more so. Even if Bernanke ceases firing dollars into the bond market, yields will still have to rise to the level at which they provide a real return. How much higher would rates go, you ask? Well, Mr. Gross has some thoughts on that:
“Treasury yields are perhaps 150 basis points or 1½% too low when viewed on a historical context and when compared with expected nominal GDP growth of 5%. This conclusion can be validated with numerous examples: (1) 10-year Treasury yields, while volatile, typically mimic nominal GDP growth and, by that standard, are 150 basis points too low; (2) real 5-year Treasury interest rates over a century’s time have averaged 1½%, and now rest at a negative 0.15%!; (3) Fed funds policy rates for the past 40 years have averaged 75 basis points less than nominal GDP, and now rest at 475 basis points under that historical waterline.”
To the above I say: not a bad start, Mr. Gross, but these aren’t exactly average times. We have never had a Fed balance sheet anywhere near the $2.6 trillion that it is today. The nation has never faced the prospect of $1 trillion deficits as far as the eye can see. Nor have we ever had our total debt as a percentage of GDP reach 244%.
The bottom line is that a massive increase in the supply of debt coupled with a rising rate of inflation will always place upward pressure on interest rates. Once the Fed steps aside from buying 70% of the Treasury’s current auctioned output, it will leave a gaping hole. And for those Pollyannas who claim we are in an economic recovery, I would ask them the following questions: Who will supplant the Fed’s purchases of Treasuries at current yields? Since the level of debt in the economy has grown since the recession began, why won’t rising rates place us back into an economic funk? Can the Fed unwind its balance sheet before inflation ravages the country? And, if the Fed isn’t able to raise rates significantly, what will stop the dollar from collapsing?
Then again, I guess it all comes down to one simple question: do you believe the laws of supply and demand apply to US Treasuries? If you do, then watch out for soaring yields.