It is my contention that the 70-year debt supercycle has come to an
end.
To put the current financial situation in perspective, here's a long-term
history of the debt-to-GDP ratio, which reached a record high at the
beginning of the current crisis. It was a dramatic change in 2009, unlike
anything since the aftermath of the Great Depression.
The highest the debt-to-GDP ratio had previously been for the United
States was 301% at the bottom of the depression in 1933 when GDP collapsed
and debt was high. The level became unsustainable in 2009, despite low
interest rates. Weak borrowers were signing up to finance houses that they
thought would increase in price forever. The point of the chart is that this
downturn is different from all the recessions since World War II.
Total market debt includes debt of the federal government, state
governments, households, business, financial institutions, and to foreigners.
The components of the above total debt are shown below, so you can see which
ones are stabilizing and which may be approaching unsustainable levels.
Looking forward, the most important problem is that the federal
government has inserted itself into the economy with huge deficits to try to
combat the slowing of the private sector. As you can see, private-sector
borrowing has not increased, even as federal government deficits have
ballooned to unprecedented levels. In essence, we are building our recovery
on government debt.
The clear driver of this extreme expansion of government debt that I
call a "Bond Bubble" is the Federal Reserve's flooding of markets
with liquidity to drive rates to zero. The chart below shows a projection
what will happen to the Fed's balance sheet as it continues to distort the
rate to zero by extending its monthly purchases of $40 billion of
mortgage-backed securities (MBS) and $45 billion of Treasuries out to 2016:
It is my contention that the actions of the Fed, which were started to
counter the credit crisis of 2008 with four programs of quantitative easing,
have brought us the incredibly low interest rates (aka, the Bond Bubble) we
have today. By purchasing so many credit assets, the Fed is driving the price
of bonds higher, and thus interest rates much lower, than they would
otherwise be.
The black line in the chart above is the 10-year Treasury rate – you
can see that it drops with each of the big balance sheet expansions. The
resulting asset bubbles in stocks and housing are a direct result of the
monetary creation by the Fed.
The growth in Fed purchases will likely continue so that the low rates
of the Bond Bubble don't collapse. But the effects of the Fed's economic
stimulus decline with each new injection of money.
There will come a time when the Fed announces a new program of balance
sheet expansion by asset purchases that will cause the interest rate to rise
because of fears of inflation from money creation, rather than fall as the
Fed desires. At that point, we'll know the Fed's power to manipulate the
economy has dissipated.
Just How Low Can Interest Rates Go?
The chart of 10-year Treasuries below shows that the current level of
2% is lower than it has ever been, except for a brief low of 1.5% last fall
(blue line). It is the lowest in 240 years. This is happening in spite of
government deficits expanding at a trillion dollars per year as far as the
eye can see. We are at the bottom of a 32-year bull market in bonds (drop in
rate).
To get a view of how extreme today's rate is, I added the red line,
which is 100 divided by the interest rate. It shows a rise as rates fall and
makes the bubble of low rates more obvious – which is currently higher than
ever.
The point is that these extremely low rates are unprecedented, even when
looking back to the last Great Depression. They could spring back a long way.
The low rates induced by the Fed are transmitted to many other market
rates, as shown in the following charts. These charts need little comment,
except that all of them confirm the simultaneous movement to many-decade
lows.
During the credit crisis, junk bonds were the worst performers as
investors feared they would lose their money in default. Rates rose on BBB
corporate debt as well. At the same time, government debt became the safe
haven, and as people moved to the safe haven, they drove the price of
Treasuries up and their interest rate down. The premium has gone out of the
lower-rated markets, with rates even lower than before this crisis started.
It's not that risk has disappeared: I think it is more likely that the flood
of excess money is chasing any kind of return it can find, and that is
driving rates to record-low levels.
Inflation spiked dramatically in the 1973 and 1979 oil crises. More
recently, official government numbers haven't shown wild inflation. Prices
for energy, food and domestic services – like medical care and education –
have had big jumps. But thanks to cheap foreign manufacturing, we are able to
import goods at attractive prices, so overall inflation doesn't reflect the
extreme money creation by the Fed. Wage growth is nonexistent, largely due to
foreign competition and high unemployment from offshoring manufacturing.
The forces of inflation can easily overcome a weak economy to destroy
a currency: this has happened in countries like Zimbabwe, Argentina or
Yugoslavia. Once things get out of hand, it is hard to say whether it is the
weak economy that causes the government spending and further deficit
destruction of the currency, or the reverse. But that doesn't matter once
people lose confidence in the government and its paper issuance.
The chart below shows government numbers for inflation that seem
awfully low compared to what most people experience. The erratic behavior of
commodities is likely to continue, so I think prices will continue to rise.
But even using these conservative government numbers, when we subtract
the inflation from the interest rate to show the real return to an investor,
we get negative numbers. This, too, is unsustainable.
A Look at Interest Rates Worldwide
I've written extensively in previous articles about central bank
expansion, but it's worth reminding ourselves that excessive money creation
is not just a US phenomenon but a worldwide experiment. Once this feeds back
on itself as ordinary people recognize the destruction of the fiat currency
systems, we can expect inflation on a worldwide basis. The similar decline in
interest rates in Germany and Japan is the result of their central bank
interventions to support their economies by driving rates lower.
The chart below, which shows the interest rates of 187 countries, has
some underlying patterns. At first blush it just looks like spaghetti, but if
you step back, you can see that rates were rising into 1980. Then many fell
until the recent crisis, after which new deviations appear. In Europe, rates
went both ways: up for the PIIGS and down for the safe havens like Germany.
And here is a simplification of the above by just averaging the
numbers to a single line in which you can see an imprecise confirmation that,
despite wide variability, there is an underlying pattern in world markets.
The above six charts confirm that rates of all kinds are at 50-year
record lows.
Debt and Interest Rates Suggest Higher Rates Are Possible
The chart below shows the comparison of Greece's growing debt (in
blue) and the resulting rise in interest rate. You can see that as Greece's
debt to GDP rose above 100%, the interest rate rose toward 20%. Lenders lost
confidence in the ability of the Greek government to actually pay back its
debt.
In contrast, the stronger countries have been able to accommodate their
government debt increase and still maintain moderate interest rates. The
United States is shown in the following chart. Central banks have aided the
government in managing to keep rates low despite big deficits, by buying the
debt. Balance sheets of the world's central banks are growing rapidly to
support government deficits while forcing rates to low levels. It is a
bubble.
When you buy Treasury bonds, you are putting your fate in the hands of
the government, expecting it to give back your purchasing power and a reasonable
amount of interest to you, in return for the use of your money. Should you
trust these authorities with your money? I believe we are headed for a
serious loss of confidence in the value of the dollar, which will be
accompanied by a burst of the Bond Bubble.
This Ponzi scheme is getting ready to explode.