As the Fed winds down its printing-money-like-a-drunken-sailor program, otherwise known as quantitative easing (in most banana republics they still call it printing money), it seems like a good time to stare into the crystal ball and try and discern what is ahead for the U.S. bond market and the financial situation of the country as a whole. This exercise seems especially pertinent due to the events going on currently in Greece and Puerto Rico.
Greece is finally out of other people’s money. It took 50 years of devaluing, restructuring, cooking the books, and joining the Eurozone, but it finally happened. The Keynesians (otherwise known as people who believe you can borrow money forever and never have to pay it back) really don’t like this situation. To them, it’s all Germany’s (but secretly George Bush’s) fault. If only those evil Germans hadn’t loaned Greece all that money, Greece would be fine, goes the narrative. Usually, from the Left, there’s no mention of the decades of bloated government bureaucracy and generous, unaffordable pension benefits, but hey, who cares about the truth anyway.
No one knows what’s going to happen today in the Greek referendum but one thing’s for sure, the cradle-to-grave entitlement, welfare state in Europe is dying a slow and publicly painful death. Secret NSA cables released last weekend from Wikileaks, show how desperate the French economy really is. Italy and Spain could be right behind Greece, demanding their debt be restructured as well. This type of economic panic is what causes wars and allows young Austrian xenophobes to gain power.
In Puerto Rico (rich port), the brown matter has hit the fan as well. The governor finally acknowledges there is no way the U.S. territory can pay what it owes. In my bond trading days, customers would line up to get PR new issue bonds, as they typically paid a higher yield. Puerto Rico once more proves the point that there is no such thing as a free lunch. Investments pay higher than market yield for a reason — they’re risky. It’s not clear yet who will have to bite the bullet on these bonds. Most likely the bond insurance companies will be on the hook for serious losses; possibly even mom-and-pop investors who were told these bonds were safe by their broker.
Predictably, the Leftist media (when they acknowledge Greece and Puerto Rico at all) are pushing the narrative that the United States is not in trouble. It can’t happen here. Obama has reduced the deficit! It’s all the republicans fault for those Bush tax cuts! Obamacare will control costs and the debt long-term! It’s all fantasy.
We are in big trouble. Depending on the statistics used, our debt-to-GDP ratio has passed 100 percent, typically the level where alarm bells start going off. The deficit has come down recently due to the sequester but the Obamacare expenditures have yet to register in a material way. The estimate for the next decade is not pretty. We are approaching $20 trillion in sovereign debt and on our way to $30 trillion. This is an astounding amount of money.
The Federal Reserve Bank of the United States has been doing its darndest to keep interest rates artificially low by acting as a buyer in the bond market. We are essentially paying next to nothing to service this debt. There’s a saying on Wall Street that interest rates are low until they’re not. At some point, the bond market will wake up one day and ask the question, does the United States have the will or the ability to pay back what it has borrowed? The answer to this question could very well be a loud and resounding no! At that point, the Fed could lose control of the bond market. Interest rates could spike as investors will suddenly want a lot more compensation to loan the United States more money. This would mean substantially higher rates for businesses and consumers and could be shock to the economy.
The problem is, with the debt load we have, even a 1 percent rise in rates is hundreds of billions of dollars in debt-service cost. We simply cannot afford to pay a market rate on the level of debt we currently have, much less a decade from now. There will not be much left for entitlements, defense, wealth redistribution, etc. This scenario will have real consequences.
Many times when I speak on this issue, I get the question, “So what can we do to fix this mess we’re in?” I give the same answer every time, “What do you do when you’re in a hole and want to get out? Stop digging!” We have to stop spending money we don’t have. Second, we have to get the government out of the way of this economy. The American economy is deep and resilient and we can grow our way out of this. But only if we reduce the size and impact of government.
If we don’t do these things, there’s no way out. Bondzilla will come. He’s been waiting long enough.