Wednesday, July 8, 2009

Does Anyone Understand What It Means for Long-term Interest Rates To Double?

Yes, of course, we've been expecting this news; but don't bore me with the economic details of my life - MICHAEL JACKSON IS DEAD!

Is this the "testing" moment that Joe Biden planted like a seed in the public's consciousness immediately after taking office earlier this year (seems like a long time ago, doesn't it?)? Will California's going out-of-business sale and being unable to redeem its IOU's provide the culminating reason for the wholesale prison construction of the Bush/Cheney non-terrorist threatening era? I guess this is why the definition of "terr'ist" has been enlarged to mean anyone threatening authority anywhere in the good ole USA. (Emphasis marks added - Ed.)

US Lurching Towards Debt Explosion

The US economy is lurching towards crisis with long-term interest rates on course to double, crippling the country’s ability to pay its debts and potentially plunging it into another recession, according to a study by the US’s own central bank.

Philip Aldrick, Banking Editor

July 07, 2009 "The Telegraph"

In a 2003 paper, Thomas Laubach, the US Federal Reserve’s senior economist, calculated the impact on long-term interest rates of rising fiscal deficits and soaring national debt. Applying his assumptions to the recent spike in the US fiscal deficit and national debt, long-term interests rates will double from their current 3.5 percent.

The impact would be devastating by making it punitively expensive to finance national borrowings and leading to what Tim Congdon, founder of Lombard Street Research, called a “debt explosion.” Mr. Laubach’s study has implications for the UK, too, as public debt is soaring.

A US crisis would have implications for the rest of the world, in any case. Using historical examples for his paper, "New Evidence on the Interest Rate Effects of Budget Deficits and Debt," Mr Laubach came to the conclusion that “a percentage point increase in the projected deficit-to-GDP ratio raises the 10-year bond rate expected to prevail five years into the future by 20 to 40 basis points, a typical estimate is about 25 basis points”.

The US deficit has blown out from 3 percent to 13.5 percent in the past year but long-term rates are largely unchanged. Assuming Mr Laubach’s “typical estimate”, long-term rates have to climb 2.5 percentage points.

He added: “Similarly, a percentage point increase in the projected debt-to-GDP ratio raises future interest rates by about 4 to 5 basis points.”

Economists are predicting a wide range of ratios but Mr Congdon said it was “not unreasonable” to assume debt doubling to 140 percent. At that level, Mr Laubach’s calculations would see long-term rates rise by 3.5 percentage points.

The study is damning because Mr Laubach was the Fed’s economist at the time, going on to become its senior economist between 2005 and 2008, when he stepped down. As a result, the doubling in rates is the US central bank’s own prediction.

Mr Congdon said the study illustrated the “horrifying” consequences for leading western economies of bailing out their banks and attempting to stimulate markets by cutting taxes and boosting public spending. He said the markets had failed to digest fully the scale of fiscal largesse and said “current gilt yields [public debt] are extraordinary low given the size of deficits.”

Should the cost of raising or refinancing public debt in the markets double, “the debt could just explode”, he said, adding that it would come to a head in “five to 10 years.”

Not that anyone's really worried about it. Got to catch that next Michael special!

And from John Mauldin we hear Niels Jensen's "Story Within the Story" warning us not to start up the wild life again too quickly (and why caution is necessary in "playing the market"). (Emphasis marks added - Ed.)

I have been quite bearish for a while, suspecting that the growing optimism which has characterised the last few months would eventually fade again as reality began to sink in that this is no ordinary recession and that 'less bad' doesn't necessarily translate into a quick recovery. I still believe there is a good chance of enjoying one, maybe two, positive quarters later this year or early next; however, a crisis of this magnitude doesn't suddenly fade into obscurity, just because the economy no longer shrinks at an annual rate of 6-8%.

Going forward, not only will economic growth disappoint, but the economic cycles will become more volatile again (see chart 1) with several boom/bust cycles packed into the next couple of decades. This is a natural consequence of the Anglo-Saxon consumer-driven growth model having been bankrupted. Growing consumer spending over the past 30 years led to rapidly expanding service and financial sectors both of which will now contract for years to come as overcapacity forces players to downsize. This will again lead to higher corporate earnings volatility which will almost certainly drive P/E ratios lower, making conditions even trickier for equity investors. At the bottom of every major bear market in the last 200 years, P/E ratios have been below 10. As you can see from chart 2 overleaf, few countries are there yet. The next decade is therefore not likely to be a 'buy and hold' market for equity investors. The combination of low economic growth and pressure on valuations will create severe headwinds. The most likely way to make money in equities will be through more active trading. So now, two years into this crisis, where do we stand and where do we go from here? History offers limited guidance, as we have never experienced the bursting of a bubble of this magnitude before. The closest thing is the collapse of the Japanese credit bubble around 1990. As the Japanese have since learned, recovering from a deflated credit bubble is a long and very painful affair. Governments and central banks on both sides of the Atlantic are pursuing a strategy of buying time, hoping that a recovery in economic conditions will allow our banking industry to re-build its capital base. The Japanese pursued a similar strategy back in the early 1990s. It failed miserably and set the country back many years in its recovery effort. Ironically, the Japanese approach was almost universally condemned as hopelessly inadequate. It is funny how you always know better how to fix other people's problems than your own. A little bit like raising children, I suppose.

Read the rest here. Suzan _______________________


Liberality said...

It's so easy to see that the problem is not really being addressed. Those banks, and AIG, should have failed. The health insurance industry also needs to stay out of health care reform--anything they like will benefit them and not us and yet we continuously foot the bill.

Suzan said...

Ain't it the truth, sister?

Ain't it the truth!

But I'm publishing an exposé of this truth a little bit later as I quote John Perkins' prescriptions about the cure for what the Economic Hit Men have brought us.

Good to hear from you!