The Bond Bubble Has Burst

I am calling it. What we are seeing in the markets right now is the start of the next big financial crisis. The huge bubble in government debt has begun to burst. It took a few years, but investors have finally realized that western governments in general, and the US in particular, are trapped in a low interest rate, money printing environment. As always, the downturn arrives at the peak of optimism, when hardly anyone was expecting it. So far, it appears to be just a correction in the stocks and bond market. It will take some time, before main street and the central banks will realize the scope of what is happening. At this point, however, there is no putting the genie back into the bottle.

The common narrative so far was that everything is well. The economy is strong, and growth is accelerating. We have finally managed to escape the slump of the 2009 financial crisis and everything is on its way back to normal.

This narrative is completely false. As I said before, if the economy was as rosy as government statistics would make us believe, we would have not seen things like Brexit or the election of Donald Trump. The so called recovery has not reached most people, and the masses making their frustration heard, by voting against the establishment.

In short, most economists use GDP growth to measure the strength of the economy. This is a mistake. GDP is not a good tool to assess productivity. It merely measures the amount of money being spend. But even if we were to accept GDP as an accurate tool, the official numbers are almost certain too high. That is because the official inflation numbers, which are used to deflate the GDP value, is manipulated down, through accounting tricks.

The only thing that kept the economy somewhat above water was a tsunami of fiat money. Since 2009, central banks around the world have printed more than $14 trillion to keep governments solvent and asset prices inflated. But this party is about to end. The FED is the first of the major central banks to try to normalize interest rates, and clean its balance sheet. Other central banks are expected to follow. This is why, fiat currencies are still trusted. People always assumed that printing money was a temporary policy, and not a permanent tool to finance governments.

The problem is, interest rates cannot rise, and the money printing cannot stop, without crashing the economy, and endangering the solvency of governments. Cheap money is like a drug. Once addicted, one cannot withdraw it without getting seriously ill. And more and more of it is needed, at an accelerating rate, to keep the party going. Western economies are still addicted to cheap debt. With rising interest rates, we are going to see a massive wave of private bankruptcies, which consequently will crash the economy.

That in itself would not be such a huge problem. Sure, a lot of people, who are currently indebted, would be personally hit hard. However, for the economy as a whole, if everything was left to market forces, we would only see a short, but severe, economic crises. Once the government is out of the way, however, real, free market price discovery would kick in immediately. Bad debt would be written off, and resources would be allocated to the truly best use. Within a year or two, maybe even less, the free market would have cleared all the distortion, and the economy would be booming again.

The problem, which will make this crisis most likely bigger than anything else we have seen, is that governments too are addicted to debt. And they have much more tools to defer an insolvency, until the problem is maximized. Kicking the can down the road has definitely already been the name of the game for many years.

Probably most states in Europe will not be able to pay back their debt. And things do not look better on the other side of the Atlantic. The US has already an official debt to GDP ratio way north of 100%. And that is calculated with a GDP number artificially inflated by cheap money. In addition to that, these numbers do not even include unfunded liabilities like pensions.

By any accounting standard, most western governments are factually bankrupt. That, however, is a too painful truth to sell to voters. In order to tackle the problem, governments would need to massively, and I mean really massively, cut the size of the state. In addition to that, they would probably need to think about increasing taxation to get more revenue. The ability to steal more, however, aside from being immoral, is limited by the fact that taxation most likely already is somewhere near the peak of the Laffer curve.

Neither cutting spending, nor increasing taxes can be easily done in a democracy. People do not tend to vote for their standard of living to be cut. Amazingly, raising taxes seems to be actually easier than cutting spending. What better indication that, in addition to being immoral, the state is also a completely dysfunctional organization.

President Trump, being the ruthless populist that he is, knows this full well. Therefore, he is currently doing the exact opposite of trying to avert an insolvency crisis. He has cut taxes for many people, and simultaneously seem to go bananas on new spending. And it is this which has spooking the markets last week. Investors are waking up to the fact that the party of the last few years will soon come to an end. In fiscal 2019, the US will have to borrow at least $1.2 trillion, a lot more than ever before in its history. At the same time, the FED will be a seller of about $600 billion of US treasuries. So the question arrises, who is going to buy all that debt?

In the years since 2009, governments could rely on central banks to buy a lot of their bonds. Draghi, Yellen and co., have bought them, no matter what the price. This has inflated an enormous bubble in government debt. Consequently, governments did not need to worry about how to finance themselves.

Some governments, like Germany or Switzerland, could even borrow at negative interest rates. That means, investors have paid for the privilege to lend money to Merkel. In reality, of course, this was a front running of the central banks. It was a save version of greater fool investing, since the central banks had made clear that they would always be the greatest fool. This has destroyed any honest price signaling on these markets. What a fantastic paradise for politicians, trying to buy votes.

But governments are now being driven out of this paradise. When central banks stop buying debt, and raise interest rates, governments will need to find real buyers, with real capital to buy their debt. And these real buyers are not going to invest in it at any price.

Given the enormous amount of new debt needed, and the risk involved in lending money to insolvent governments, it is inconceivable that the US government will be able to attract all that capital without significantly higher interest rates. The law of supply and demand will not be kind to politicians. In the media we can hear worst case scenario numbers of 3.5% or maybe even 4% on the US 10yr treasury.

But in what world is that a worst case scenario? Historically, the average yield on a such a bond was more around 6%. And that was at times when the US was very much solvent and did not need to borrow anywhere near as much money. When central banks now stop their price controls on government debt, it seems more likely that the bottom will drop out of that market. In other words, 6% is way too optimistic. But the US governments cannot even afford 4%.

Interest rates on US debt have already risen for month. At the beginning of February, the interest on the 10 year treasury bond hit 2.85%. That was too much for stock investors, and the sell off began. Pretty soon, one of three things is going to happen, each one of which will lead to a major crisis.

The first possibility is that governments openly default on their debt. I would say the chances of that happening in an honest, non-inflationary way are pretty much zero. No politician is going to take the responsibility for this policy, least of which Trump.

A second option is to raise taxes and massively cut spending. Since western government are democracies, and cutting spending in any meaningful way would seriously alienate a lot of voters, the chances of that to happen are also very slim.

That leaves us with the third option. Central banks call their bluff and reverse their plans to tighten. We would see another round of even bigger QE and a prolonging of low interest rates. This is the option that historically most states have picked. And it is almost certainly the one that the US government is going to pursue.

But for how long will they be able to get away with it? After all these years of QE and low interest rates, a failed attempt to exit these policies would make it very obviously that governments are trapped. They cannot exit the cheap money environment without causing a major financial crisis in the economy, and a solvency crisis of governments. A reversal of tightening will therefore cause a crisis of confidence in the central planners, which will most likely result in a currency crisis. The latter will lead to either a massive inflation in the Dollar, Euro etc, or it will force governments to eventually default after all, in order to save their currencies.

The verdict is not out yet, which of the two latter options we are going to get. But either way, buckle up, because things are about to get very rough.

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