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Those who
take issue with the outlook of Austrian economists in general, and Euro
Pacific Capital in particular, have pointed to the persistence of low bond
yields as proof that our philosophy does not hold water. We argue that as the
United States takes on ever more debt and prints greater quantities of
dollars, that buyers of our debt will demand higher rates of interest to
compensate for greater risk.
In fact, our
philosophy leads us to believe that rates would currently be spiking as
Washington debates whether to raise the debt ceiling yet again or default on
existing debt. Instead, rates are hitting close to multi-year lows. As a
result, our critics have found a seemingly valid issue. However, we believe
that there are strong market reasons that are holding rates low for now that
do not invalidate our central thesis.
Looked at
objectively, there are a litany of reasons why rates should be much higher
than they are. Official government data from the Labor Department has year
over year consumer inflation rising at 3.4%. With the Ten year note offering
a paltry 3.1%, negative real interest rates now extend out over a decade! At
the same time, total non-financial debt as a percentage of GDP is at the
highest level on record and in our view there are no credible projections
that show the trend reversing anytime soon. In addition, with the end of
quantitative easing, the Federal Reserve will apparently no longer be soaking
up 75% of all new Treasury issuance. Given this, does it make sense that
yields on Ten Year Treasuries are trading 60% lower than their 40-year
average? Forget the flowers, where have all the global bond vigilantes gone?
But, what
makes these low yields on U.S. debt even more unfathomable is the current
debate over raising the debt ceiling. If a deal to lower the trajectory of
debt isn't reached by August 2nd, we are being told that America could enter
into default.
But you
wouldn't know it from looking at the bond market. It seems that everyone is
convinced the U.S. will never renege on her obligations and that the
Democrats and Republicans will come to an agreement with time to spare.
Peter Schiff
subscribes to this logic. He believes the bond market is pricing in an
increase in the debt ceiling that temporarily lays
to rest any fears of default.
As a result,
he believes that traders are buying bonds now so they can sell into the
"positive" news that will result from a debt deal in Washington.
However, Peter believes, as I do, that an increase in the debt ceiling is
actually very negative for bonds. That means that after the dust settles he
expects interest rates to rise dramatically. But that won't stop the traders
from booking a quick profit.
However, I
believe there is little to support the belief that a deal will be made.
Republicans
have very little incentive to agree on a deal that includes tax hikes, which
are an essential prerequisite for Democrats to assent to dramatic spending
cuts. The Republicans want spending cuts without any tax increases and that's
exactly what they will get if the August 2nd deadline comes and goes. In
fact, the Republicans will force a severe dose of austerity upon the American
economy, which could be a double-win for the GOP. They may simultaneously
balance the budget without increasing revenue and engender a recession that
will force the current party out of the White House.
I believe
that bond investors may be hedging their bets. If an agreement is not reached
there will be a huge reduction in borrowed money that is printed by the Fed.
The result will be a severe reduction in the money supply. This forced
deleveraging will bring about a needed round of dramatic deflation like we
experienced in the fall of 2008. From my perspective that is the best
justification for the current low yields on U.S. debt. Maybe the bond market
has it right after all; but reasons completely contrary to those offered by
market bulls who see low yields as a sign that all is well on the economic
front.
Peter and I
may differ on the current psychology of bond investors, but we do believe
that once the economy slows in earnest once again, the authorities will not
hesitate to reignite the monetary madness thereby punishing bond investors
with weaker dollars.
Michael Pento
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