INTEREST RATES
Bond market cycles normally go on for decades. As
interest rates rise, Bond prices fall and losses occur for
bondholders. From the peak of 14%+ in 1984, there has
been a bull run in the bond markets right up to 2020,
when the interest rates went down to almost 0% - a
36-year bond bull market. Previously from the end of
World War II, there was a large deficit and large debt due
to the war, so the low interest rates basically rose
culminating in the Oil shock of the 1970s - and until the
1984 peak - over 35 years of bear phase in the bond
market. We have now had just 3 years of negative returns
on bonds, and the Federal Reserve is talking about
holding interest rates high for longer so the bear phase in
the bond market will last for some time.
The seeds of this bond problem were sown decades ago
and each time the problems arose it was kicked down the
road - until now the day of reckoning has come. The War
on Terror started by Bush has cost the US $ 6 tn. so far and
the repercussions are still going on. US demographics too
have not helped and the social security and Medicare
problem has been decades in the making. The Great
Financial Crisis of 2008 resulted in Quantitative Easing
with huge deficit spending. The Pandemic just hastened
the process. Last 40 years the increasing debt did not
matter as increasing debt was offset by lower interest
rates and the interest bill remained between $ 350 and
500 bn. Inflation was not a problem. Western Capital and
Eastern labour were brought together – through
globalization and this resulted in cheaper goods. Russia
opened up cheap energy to Europe - so there are a lot of
deflationary things happening. The growing amount of
debt was ignored.
However, finally, all this prolific Public spending has finally
resulted in sticky inflation where the Federal Reserve had
to raise interest rates quickly to try and tame it. Hence in a
very short time period interest rates rose from 0.5% to
5.5%. This has resulted in an estimated 30% average fall in
the price of US bonds, causing estimated losses to be to
the tune of US$ 1 tn. in just the banking system which is
not being shown up in their Balance Sheets as the US
Treasuries are being "Held to Maturity" and hence not
Marked to Market (based on their lower valuations) and no
loss is booked. Pension Funds, Insurance companies and
even other Governments are also making losses on the US
Government bonds held. However, if there is a run on the
bank, as happened with Silicon Valley Bank, Signature
Bank and First Republic Bank, the bank is forced to sell
their Government Securities at a loss. These banks were in
effect bailed out to avoid a banking crisis, by the Federal
Reserve opening a window to take over the bank's
Government Securities at par and this was ultimately
some kind of Quantitative Easing, which once again is
inflationary.
There is a conflict between the Fed tightening (Monetary
Policy) as they keep interest rates high and reduce their
balance sheet by selling bonds and not buying fresh ones - and the sheer force of fiscal
|
stimulus happening in the
form of out-of-control deficit spending by the US
Government (Fiscal Policy). Paying interest by the
government is a form of stimulus and that counteracts the
reduced credit creation by the banks. In addition, the US is
involved in 2 wars. Hence with the bank putting the brakes
on lending and at the same time the government putting
the accelerator on the spending - the engine is going to
burn out.
Who is going to buy US debt to fund the Government
spending? - the Federal Reserve is not buying (printing)
Government debt as it is trying to control inflation, nor the
banking system nor global investors due to the strong
dollar. If the dollar gets too strong they are actually going
to sell the debt to get dollars as they are in their own
currency defence mode. This is happening with China and
Japan selling US debt.
A source of liquidity is short-term debt where the interest
rate is over 5.24% highest since 2006. Investors are
comfortable in buying short-term treasuries giving over 5%
yield and this has been a source of funding for the
Government. In the end, the Government is not going to
cut spending on Social Security, Medicare, and Defence -
and interest rates are high - and taxes cannot go up easily,
especially in a slowing economy. There is a Wartime deficit
rate as a percentage of GDP in peace times and also when
unemployment is low.
On the 1st of June this year the 10-year US GSec interest
rate was at 3.6% and now, without the Federal Reserve
raising rates, they have touched 5% - the highest in 7 years.
This indicates that there is a crisis in collateral. As the losses
in Government bonds increase, or as the US Government
has to fund its deficit, more bonds have to be issued and as
the supply is too much - buyers are demanding a higher
yield to buy the bonds.
Total US Debt is now US$ 33 tn. Total US debt has grown by
$ 22 billion per day in the last month. Since the debt ceiling
crisis ended in June 2023, the debt is up $ 2 tn. in just 3
months. Service costs have more than doubled to 3% and
new debt or refinancing of old debt would be at 5%. It is
estimated that the current debt interest cost is $ 1 tn. p.a.
and next year it will go up to $ 1.5 tn. There is no solution in
sight.
|