On January 7th CNBC's Rick Santelli and Steve Leisman engaged in a heated
debate that posed an interesting question; is the free market at work keeping
interest rates low, or is it the central banks' put? This made me consider
the real question to ask which is: Where would rates be if central banks didn't
exist?
What would happen if the Fed liquidated its balance sheet and sold its $4.5
trillion worth of Mortgage Backed Securities and Treasuries and closed up shop?
Some claim, after an initial spike from all that selling, rates would subsequently
tumble due to a deflationary cycle that would result from the end of central
bank money printing. These people also maintain that rates are currently historically
low because of the overwhelming deflationary forces that exist in the economy.
Yes, we now see deflation pervading across the globe and that does tend to
push down borrowing costs, but I am not convinced rates would remain this low
for very long and here's why.
The level of sovereign bond yields is both a function of real interest rates AND sovereign
credit risk. While there is now a deflationary environment causing yields to
fall to record lows, the market is still aware if push came to shove central
banks would step in and create a perpetual bid for government debt. However,
without a central bank in place, global GDP (which has been fueled by asset
bubbles) would quickly get eviscerated.
Therefore, faltering GDP in the U.S. would cause bond holders to panic over
the Treasury's ability to pay back the over $18 trillion in debt that it owes
-- which is now already over 5.5 times the annual revenue collected. To put
things in perspective, 5.5 times annual revenue would be similar to a family
who brings in just $50,000 a year, and holds a $275,000 mortgage. But as bad
as that condition is it would get even worse because faltering GDP--resulting
from rapidly rising debt service payments--would send the current half trillion
dollar annual deficits soaring back above one trillion dollars in short order.
Markets have an innate understanding that central banks can always make good
on the principal and interest payments on sovereign debt. If you don't believe
me, maybe you will believe Alan Greenspan, who said as much on Meet the Press
after the U.S. debt was downgraded by Standard and Poor's in 2011. Clarifying
the down grade as more of a hit to America's "self-esteem", the former Chairman
of the Federal Reserve went on to say, "This is not an issue of credit rating,
the United States can pay any debt it has because we can always print money
to do that. So, there is zero probability of default." The truth is central
banks stand as the ultimate co-signer of sovereign debt; a co-signer with a
printing press. Credit ratings on sovereign debt have become more of a formality,
they don't actually mean anything anymore.
Consider this, Moody's downgraded Japan's debt by one notch to A1, from Aa3
in early December of 2014, and bond yields fell almost immediately. Japan's
Five-year yield fell
to a record low just two days after the downgrade. Was this the market screaming
that Moody's got the call wrong? On the contrary, the drop in rates was solely
driven by the Bank of Japan's decision to expand its record bond-buying program,
thus tightening supply and driving down rates. Think about it, with a debt
as a percentage of tax revenue well over 1,000 percent, I have a hard time
believing the free market would extend any country, or business for that matter,
credit for 10 years at just one quarter of one percent.
The real mental exercise here is to determine what interest rates the free
market would assign to sovereign debt if there were no printing presses? The
best insight we can gleam to answer this question is to look at what happened
to rates in Greece and Southern Europe during 2010-2012. When Greece and these
other countries joined the Euro, they forfeited their respective printing presses
to the ECB. After the fall out from the 2008 financial crisis, the ECB was
initially reluctant to bail out countries with new money. Instead, they suggested
Greece and other Southern European countries cut spending to counter mounting
deficits brought about by overspending and low tax receipts. Greece's revenue
to GDP actually stood remarkably better than Japan's, at about 475%. However,
without the ability to print its own currency and the ECB's initial reluctance
to rescue Greece, the market's reaction was profound. The Greek Ten-year Note,
which averaged around 5% prior to the crisis, soared to just under 40% by March
of 2012. Then, in July of 2012, ECB Chairman Mario Draghi vowed to do "whatever
it takes" (read -- buy unlimited amounts of Greek debt) to push yields back
down. And down yields went, thanks to the ECB's promise.
Because of the record amount of government debt in the developed world that
exists today, there is a significant risk that not only would interest rates
rise, but they could actually spiral out of control until an explicit restructuring
and default occurred.
But the real conundrum is that current bond holders believe the Fed can monetize
trillions of dollars of Treasury holdings without creating inflation and destroying
the purchasing power of that debt. This spurious belief has been bolstered
by the Fed's previous QE programs that did not immediately lead to intractable
inflation. However, history has clearly shown that a nation cannot habitually
monetize massive amounts of debt without suffering runaway inflation. It would
be silly to think this time is different. Therefore, having a central bank
ready and willing to monetize a significant percentage of a nation's debt shouldn't
provide any solace to bond holders at all. Soon investors in government debt
will come to understand that a default is in store either through restructuring
or inflation. And the answer to our question is that interest rates are headed
much higher in the near future.
