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Are Higher Interest Rates the End of the World?

by John Rubino on January 22, 2013 · 15 comments

It’s amazing what you can get used to if it just goes on long enough. Everyone with a family has experienced this personally, but it’s also true at the societal level, where one decade’s impossibility becomes the next’s normal. Not so long ago, for instance, interest rates signified the amount by which a bank CD or bond would increase your wealth each year. But today’s rates are so low that most fixed income instruments are now functionally the same as a checking account, simply a place to park your spare cash until you need it – not an investment that will grow with time. Zero interest rate policy (ZIRP) has created a depressing, in some cases impoverishing “new normal” for savers and retirees.

But the opposite is true for governments, for whom borrowing used to lead to higher interest expense, which in turn widened budget deficits. That’s no longer the case. In recent years, rolling over existing paper as rates have fallen has actually lowered the interest expense of investment-grade countries. Consider the following two charts. The first shows US government debt nearly tripling since 2000. The second shows how much its interest expense has risen: Not at all.

US government debt

US government interest expense

After a decade of massive deficits and rising debt, Washington’s interest expense remains modest because each new bond issue (and each rollover of existing paper) has been at lower rates. If you’re getting a Ponzi-like vibe, you’re right. This game can only go on as long as interest rates keep falling.

So how does it end? Possibly like this: First, US interest rates stabilize  –  which has to happen pretty soon because the average interest rate on new borrowing, at around 2%, is about as close to zero as it’s possible to get when 20 and 30-year bonds are in the mix. So this year’s $1 trillion-plus deficit will begin to add noticeably to interest expense, as will subsequent-year borrowings.

At some point, the markets will notice the new trend and seek a higher interest rate on new government bonds to compensate for rising risk. This will require the next few trillion of maturing debt to be rolled over at higher rates, which will kick interest cost expansion into overdrive. And that’s the end of the game.

Or the Fed will be forced to buy up all the bonds the government issues at below-market rates, which will, one has to believe, accelerate the dollar’s loss of purchasing power, with the same result: it gets harder and more expensive to borrow.

Unless Japan Blows Up First
But it won’t come to this because Japan is almost certain to enter a death spiral first. The short version of the story is that Japan responded to bursting real estate and stock market bubbles in the 1990s by borrowing huge amounts of money financed with domestic savings at minuscule rates, and has now accumulated government debt that dwarfs that of the US as a percent of GDP. Its economy is stagnant and debt continues to accumulate, so its newly-elected (and almost comically desperate) leader has demanded that the Bank of Japan create enough new yen to get inflation up to 2%. But here’s the catch: Japan’s current average interest rate is far lower than 2%, and if inflation picks up, so will interest rates, especially now that the country has used up all its domestic savings and has to borrow from foreign sources. According to hedge fund manager Kyle Bass’ calculations, if Japan’s average rate rises to just the US average of 2%, its interest cost will exceed the government’s  total tax revenue. Here again, game over, and potentially in the next year or two, says Bass. See here and here.

…Or Derivatives
The idea that the world’s first and third biggest economies might soon enter a post-Ponzi debt crisis is scary enough. But it get worse. Turns out that of the $638 trillion notional value of derivatives now outstanding, $434 trillion, or 77%, are linked to interest rates. Let rates start rising, and tens of trillions of dollars of hedges will be activated, forcing the handful of big banks that are on the hook to…never mind. There’s no need to explain that the banks can’t meet those obligations so taxpayers, as in 2009 with credit default swaps, will be on the hook for another multi-trillion dollar bailout. Which will cause deficits and interest expense to go up. There really is no way out.

Derivatives

The only upside is that savers might finally start earning a decent return on their savings.

{ 13 comments… read them below or add one }

timer January 22, 2013 at 8:51 pm

you have called for a collapse in the dollar now and higher interest rates now for 3 years for those that are short the dollar or betting on rates going higher they will be broke if and when your collapse theory comes true. It was easy to call the bubble in housing and the Nasdaq but without proper timing your macro call even if right is worthless. My guess is that your macro call will be right but you like 99% of Americans will not make $1 from it. Writing the book is the easy part.

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John Rubino January 22, 2013 at 9:55 pm

Timer, you are absolutely right that a too-early call is a wrong one, and this one has been going on for way too long. The main “dollar collapse” investment strategy, though, is to buy precious metals, and that’s worked out pretty well, so in this case wrong doesn’t necessarily mean broke. The secondary strategies like shorting bonds and buying mining stocks, though, have sucked to varying degrees, no argument.

Actually (a little personal history), it was hard to time the previous bubbles too. In the late 1990s I was a tech stock analyst with TheStreet.com and went bearish in early 1999. The NASDAQ almost doubled from there before it fell apart in 2000. In 2003 I wrote a book about how to profit from the bursting of the housing bubble but it didn’t burst until 2006/7. Both times I bet the family fortune, such as it was, and lost big early before making it all back and then some. Because those calls turned out to be resoundingly right in the end and because this bubble looks EXACTLY like those in all important ways, I’m going to keep pointing out the similarities and predicting the same end, because it’s coming. Just don’t use leverage to bet on it.

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PaperIsPoverty January 23, 2013 at 1:21 am

Those of us who’ve accumulated gold and silver as the anti-dollar (and anti-Euro and anti-yen, etc) are hardly crying.

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Doug January 22, 2013 at 9:57 pm

I don’t understand the part about “it won’t come to this because Japan will blow up first.” Why won’t the fed have to buy our debt if Japan blows up? I thought the bond vigilantes would go from one country to the next, with Japan going under within 2 years and probably then Europe and only then the US around 2016. What happens to the US other than short-term safe haven if Japan experiences the keynesian endgame?

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John Rubino January 22, 2013 at 10:07 pm

Doug, if Japan blows up the US probably won’t get a chance to go through the various stages of the bond bubble bursting. One big debtor nation imploding will take down all the rest more or less instantly by destroying faith in the whole sovereign debt asset class. Who in their right mind would buy the bonds of the world’s biggest debtor after the third biggest has imploded?

The Fed would, of course, but then the focus turns to the dollar and the question becomes who in their right mind would own the currency of the world’s biggest debtor when its central bank is monetizing 100% of its trillion-dollar deficits.

Lots of possible outcomes, all of them bad.

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Jake Curtis January 23, 2013 at 4:25 am

Probably because investors will be flocking into treasuries just like with the Euro crisis, a lack of demand in the bond market would signal interest rates to rise, notice after QE2 the Fed didn’t have to buy bonds for a while with all the shit going on in europe

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Doug January 24, 2013 at 1:24 am

Jake, that is the one thing I noted above but seems to me that when other countries’ currencies fail, and the dollar becomes a temporary safe haven, the standard of living in those countries will plummet, they will lose purchasing power of life savings, work until they die and not retire, etc. but then focus will go to the US. In other words, we might get a short-term reprieve but are no better off in the intermediate term. John’s statement comes off to me like crisis AVERTED, not simply delayed a little.

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Bruce C. January 23, 2013 at 5:16 am

Before commenting, I should disclose that I’ve been feeling really bummed lately. I was really hoping that 2013 was going to be a disaster for mankind but now I think we’re in for an accelerated state of reflation where everything is going to get crazier, more extreme, more absurd, more perverse, more counter-intuitive, more corrupt and more of everything else that would drive the impatient mad.

So this article is mocking to me. Of course I would like to (finally!) see a financial collapse but I dread that it ain’t gonna happen, at least not any time soon.

“This game can only go on as long as interest rates keep falling.”

If only that were true, but it’s not necessarily. All of the Treasury bonds owned by the Fed are at effectively zero interest because all interest payments from the Treasury to the Fed are returned to the Treasury. That actually means that total net interest expenses for the Treasury are currently decreasing with time as the Fed buys about $85 billion worth of Treasuries each month (which is about 90% of all new issuances). As long as the Fed is willing to do this the current deficit spending by the US can continue for a lot longer than most analysts think possible (I mean for decades).

I don’t know if Japan’s central bank (the BOJ) reimburses the Japanese Treasury of its income from government bonds but if it does then there won’t be any need to sell JGBs to outsiders who may demand higher interest rates. For the same reason explained above the Japanese government could literally enjoy decreasing debt servicing costs despite rising price inflation. Again, that can’t last forever but I wouldn’t hold my breath.

A derivatives implosion also seems to good to be true. But how can that happen if Contract law is no longer enforced? One of the great new jurisprudent discoveries by the financial elites is (I’m paraphrasing) ‘if the enforcement of any contract will upset any elite then it won’t be enforced!’ So forget about a derivatives implosion.

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Neal Ekengren January 23, 2013 at 2:03 pm

All spot on Bruce. I think we agree that those in power will do everything possible to continue the current financial chicanery. This could go on for quite some time.

oh where o where does it all end………..

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Andy Schack January 23, 2013 at 11:46 pm

Excellent post Bruce. It is good to see that I am not the only one looking around in vain for pieces of the sky to start falling. Whenever someone asks me what will “start the action” I think back to an interview I heard on Financial Sense Newshour a while back. Can’t remember who it was being interviewed but he mentioned that there was no singular event that caused the stock market bubble to collapse. Traders went to work as usual, investors brought up their trading screens while they sipped their first sips of coffee. Everything seemed normal…because it was normal, except for one important ingredient. Mood. For some reason folks realized the game was over and tried to act before the next fellow caught on and headed for the exits as well. The rest is history. Same thing for the housing market. One day we were being told that housing prices never went down (even by the revered Fed Chm) only to wake up one day to see Bear Sterns employees leaving with cardboard boxes filled stuff from their offices. While it was true that there were people like Peter Schiff who were trumpeting warnings, the main body of the herd were racing towards the cliff. The rest is history. Now we are faced with a world that has Central Banks printing with impunity. They don’t even try to hide it anymore, nor feel the need to set limits lest the markets get spooked. We are seeing things happen that if predicted a mere 6 yrs ago would have gotten you laughed at by G Edward Griffin himself. One thing is for sure, it will end. And when it does it will be historic.

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Tony D February 5, 2013 at 7:51 am

To quote Maxwell Smart (I think)
“When you least expect it, expect it”

A crash will never happen when the govt and others are in the brace position it has to be a Black Swan to be a true crash. please name a crash that occurred with the prior knowledge of the mainstream .
Don’t fret Bruce, we are only just beginning to enter conditions in which a crash will occur although it may still take a while . Once greed and hubris really take hold, then a crash can happen.
True economic crashes are always a contrarian event !

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Nihal Bhat February 10, 2013 at 10:23 pm

gr8 article. too much debt in the system. artificial low rates , and printing as well. whats the end game. 2008 was a sneak preview.

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