Why Interest Rates Can Never Rise Again

Last week the Fed released its most recent minutes which surprised markets by "exposing a rift" as to when to quit buying Treasuries as part of their ongoing stimulus. The US Federal Reserve Bank buys US Treasuries, issued by the US treasury to keep demand high for Treasuries which keeps interest rates low (The price of bonds is inversely related to interest rates). As I wrote in December, the Fed may soon go from buying 70% of all new Treasury issuance to 90% as part of its QE4ever program.

Why must they do this? Because interest rates can never be allowed to go up again. EVER!

ZeroHedge illustrates why:

They say "be careful what you wish for", and they are right. Because, in the neverending story of the American "recovery" which, sadly, never comes (although in its place we keep getting now semiannual iterations of Quantitative Easing), the one recurring theme we hear over and over and over is to wait for the great rotation out of bonds and into stocks. Well, fine. Let it come. The question is what then and what happens to the US economy when rates do, finally and so overdue (for all those sellside analysts and media who have been a broken record on the topic for the past 3 years), go up. To answer just that question, which in a country that is currently at 103% debt/GDP and which will be at 109% by the end of 2013, we have decided to ignore the CBO's farcical models and come up with our own. Our model is painfully simple, and just to give our readers a hands on feel, we have opened up the excel file for everyone to tinker with (however, unlike the CBO, we do realize that when calculating average interest, one needs to have circular references enabled so please do that before you open the model).
Our assumptions are also painfully simple:

i) grow 2012 year end GDP of ~$16 trillion at what is now widely accepted as the 'New Normal' 1.5% growth rate (this can be easily adjusted in the model);

ii) assume the primary deficit is a conservative and generous 6% of GDP because America will never, repeat never, address the true cause of soaring deficits: i.e., spending, which will only grow in direct proportion with demographics but as we said, we are being generous (also adjustable), and

iii) sensitize for 3 interest rate scenarios: 2% blended cash interest; 3% blended cash interest and 5% blended cash interest.

And it is here that we get a reminder of a very key lesson, one that even the CBO admitted on Friday they had forgotten about, in what compounding truly looks like in a country that is far beyond the Reinhart-Rogoff critical threshold of 80% sovereign debt/GDP.

The bottom line: going from just 2% to 3% interest, will result in total 2022 debt rising from $31.4 trillion to $34.1 trillion; while "jumping" from 2% to just the long term historical average of 5%, would push total 2022 debt to increase by a whopping $9 trillion over the 2% interest rate base case to over $40 trillion in total debt!
Sadly, this is no "magic" - this is the reality that awaits the US.

And for those more curious about that other critical economic indicator, debt/GDP, the three scenarios result in the following 2022 debt/GDP ratios:

• 2% interest - 169%;
• 3% interest - 183.5%; and 
• 5% interest - 217%, or just shy of where Japan is now.

Which reminds us: in the next few days we will recreate the same exercise for Japan's ¥1 quadrillion in total sovereign debt, which will show why any more "exuberance" arising from Abe's latest economic lunacy, will promptly send the country spiraling into that twilight zone where every dollar in tax revenue is used only to fund interest expense.
Once again, it is not our intention to predict what US GDP or debt/GDP will be in 2022: only the IMF can do that with decimal level precision, apparently, and not just with anyone, but Greece. The whole point is to show that when dealing with a debt trap lasting a decade, even the tiniest change in input conditions has profound implications on the final outcome. We invite readers to come up with their own wacky and wonderful projections of what the futures of the US may look like.

And that one should, indeed, be careful what one wishes for.

The results summarized for the three scenarios:

Total debt: 2013-2022.

Debt/GDP: 2013-2022:

The Zero Hedge open source model, for everyone to play around with, can be found here. Remember: don't be a CBO, enable circs!
P.S. don't even think of modelling a recession: everything Refs up then.

 Higher interest rates are a great thing when you're a saver, not so much when you're a debtor. Especially when you're already over 100% debt to GDP. If interest rates were ever to rise the national debt would no longer be manageable, well, that is to say it would become unmanageable much more quickly. The illustration above shows that our current situation cannot continue indefinitely.

Its not my opinion. Its math.

So far the Federal Reserve has managed to keep interest rates low through printing and buying of Treasuries. Can this go on forever? Unlikely. The markets have a way of asserting themselves. In economics its referred to as the Minsky Moment:

 A Minsky moment is the economic phenomenon that occurs when over-indebted investors are forced to sell good assets to pay back their loans, causing sharp declines in financial markets and jumps in demand for cash.^[1][2] In any credit cycle or business cycle it is the point when investors begin having cash flow problems due to the spiraling debt incurred in financing speculative investments. At this point no counterparty can be found to bid at the high asking prices previously quoted; consequently, a major sell-off begins leading to a sudden and precipitous collapse in market-clearing asset prices and a sharp drop in market liquidity.^[1]

 Some also call it a death spiral. At some point investors (if there are any left) will demand higher yields to compensate for the extra risk as the debt to GDP climbs. And since interest rates and bond prices move in the opposite direction, bond prices must fall. The higher rates makes credit more expensive, not just new credit, but all credit previously issued. This uses up even more cash and makes whatever entity it is, either a company or a country (US) less solvent and thereby further increasing risk (and interest rates). That's the death spiral and its exactly what happened to Greece. It can happen very quickly. It is not a linear event. It happens when humans collectively come to the conclusion that a risk exists they had ignored before.

 If central planning worked, as the US is attempting now, then the Soviet Union would have been the wealthiest country in the world. Yes, China seems to have succeeded where the Soviets failed, but all is not what it seems (Ask yourself why they build empty cities). Maybe more on that another day.

Ultimately, rates can and will rise again. When that happens, the last place you will want to be is in either stocks or bonds. Keep that in mind as you plan on, not just growing, but preserving your wealth.



Have a comment? Please feel to post here. I've noticed I've accumulated a lot of readers lately(from all around the world) and would be interested in hearing from you. What are you seeing in gold where you are, especially my international readers.