Ouch

Y\’know this thing we keep being told? That we should just borrow our way out of the slump? For there\’s no way that anything else will work: all this talk of a bond buyers\’ strike, of interest rates rising to offset any stimulus just not being about to happen?

The yield on 10-year Treasuries – the benchmark price of money worldwide and the key driver of US mortgages rates – has rocketed to 3.3pc, up 35 basis points since President Barack Obama agreed on Monday to compromise with Senate Republicans on tax cuts.

….

The US tax deal adds $1 trillion of stimulus over two years, according to BNP Paribas. America\’s budget deficit will remain stuck near 10pc of GDP, not just in 2011 but also in 2012. This will push gross public debt to 110pc of GDP under the IMF definition, near the brink of a debt compound spiral.

Ahh……

Now, it\’s true, if interest rates stay low then debt of 110 % of GDP isn\’t an enormous problem: as long as growth returns pretty quickly and boosts GDP thus bringing that %ge down.

The problem is that what if interest rates continue rising? to 8%, say, 9%? While perhaps not all that likely at present, certainly not impossible. And at that point there is a real problem. When debt interest payments get to around 10% of GDP this is, historically, about when we start to see the possibility of default soar.

And of course, the more likely people think this might happen the more they\’ll sell the bonds increasing interest rates and thus making the event itself more likely to happen. Trying to print money or to inflate your way out at the point just makes things worse.

No, I do not say that the US has now entered such a debt spiral. Just pointing out that there is indeed a limit, one which is now peeking its nose over the horizon.

18 comments on “Ouch

  1. isn’t this all quite hard to interpret? I mean, don’t interest rates rise on expectation of recovery too?

    I think I remember this in the debate about QE – (one of the ways) QE works is by pushing down long-term interest rates, but if QE works it will push up long-term interest rates.

  2. also if you are printing money to purchase government debt which is then kept on the central bank balance sheet and rolled over, how exactly are you making your debt problem worse? that reduces the proportion of debt that has to be financed out of tax revenues and should calm fears about the government’s inability to service its debt (the effects are elsewhere: inflation … which these bond market events could be a sign of: http://www.ritholtz.com/blog/2010/07/inflation-versus-deflation/ )

  3. What I don’t understand is that the pundits yak yak yak about “inflation expections” being a possible reason, but also a “return to growth” (and risk abating) and that no-one knows which.

    Well we do know which: TIPS. The yields on TIPS will tell us if it’s inflation or risk reduction, since the yield on TIPS will not rise if there’s a fear of inflation (although it will rise if there’s a fear of hard default).

    But I have rarely heard pundits even mention the existence of TIPS, let alone look at the yield gap to see what the market thinks of inflation expectations.

  4. Kay Tie

    that’s interesting …. although I don’t see the sharp distinction between inflation expectations and return to growth (the former being a probable consequence of expectations of the latter) and also default risk (doesn’t inflating away debt reduce default risk) …. but setting aside all that, as you say changes in yields on TIPS ought to be telling us something.

    Can you point us to the data?

  5. hmm, is it right to say that TIPS yields would rise if there’s a fear of default? Won’t they also rise if expectations of recovery improve, and hence expectations of when the Fed will start to raise interest rates generally … shouldn’t expectations of higher interest rates generally also raise TIPS yields, even with reduction of perceived default risk?

  6. Luis,

    I’m after something on macro economics in general that covers things guilts, bonds and all the other levers we hear about.

    Tim adds: That’s not macro so much as monetary economics. Still don’t know of a good intro guide but at least that puts you in hte right area.

  7. “But I have rarely heard pundits even mention the existence of TIPS”

    I don’t think this is true, I’ve read tens of articles about this – especially when the yield went negative a few months ago. http://www.bloomberg.com/news/2010-10-25/treasury-draws-negative-yield-for-first-time-during-10-billion-tips-sale.html

    Lookup ‘tips breakeven rate’

    FWIW the 10yr TIP is predicting 2.21%, the 30yr 2.52%, the 5y 1.58%.

    On the 5yr it was over 2% in May, fell to about 1.1% in August, reached 1.7% in October, and is currently about 1.57% .

    I believe however lots of people don’t think much of these estimates due to technical issues, such as a lack of liquidity.

  8. Simon

    other than googling “an introduction to monetary policy” I have no recommendations.

    It sounds like you also want to know about what determines bond/gilt yields …and how those markets work. again, other than google I can’t immediately think of owt.

    (i could give you tons of general intro to macro text books that have chapters on monetary policy but a lot of them use very outdated models, without even an inflation targeting central bank using an interest rate rule …. perhaps somebody else could recommend a good introductory text with a more up to date treatment)

    this is a well known text
    The Economics of Money, Banking and Financial Markets by Frederic S. Mishkin
    but I fear I might be a bit hardcore

  9. Simon,

    Sounds like “Money, Banking and Financial Markets” by Stephen Cecchetti (Bill White’s replacement at the BIS) is what you want. Intermediate / undergrad stuff and very easy to read and follow.

  10. No worries.

    Tim,

    I think this is a bizarre post. Firstly, Evans-Pritchard is basically reading the bones here. Hunched and pitching over his rickety wooden table, like some forgotten extra from the Holy Grail, he casts them across the surface with a wail. And gasps—“Horrors, ye men! The fabled 35 basis point move. The gods speak, our doom walks!” Etc, etc. And yes, ex post, it turns out they confirm all his prejudices. I’m shocked– shocked, I tell you.

    On the other hand, the nominal ten year rate is still pretty near to the lowest it’s been all decade (real rate ~1%?). Regrettably, our augur spares us his wisdom on this singular fact. Still looks a lot like USG can fund its deficit for free to me. But I’m no professional.

    Secondly, what are you actually saying? That at some point, if you can’t make the interest payments, you’re going to have trouble paying back the loan. Also, look both ways before you cross the road.

    Here’s my alternative reading of the situation: at present the US is so credit worthy, investors are prepared to hold its debt for practically no return. Therefore, now would be quite a good time for it borrow and spend, if it were waiting for such an opportunity. In addition, unemployment is high and inflation is low. Sometimes when it seems obvious, it really is obvious. I submit: this is still one of those times.

    Tim adds: the basics of my thinking (insert favourite joke here about whether Tim can think or not) comes from “This Time is Different”, the recent study of the 800 sovereign defaults we’ve had in recent centuries.

    Debt to GDP ratios of 100% ish or above are dangerous. 1) because by themselves they seem to limit GDP growth and 2) because they make a country terribly vulnerable to interest rate rises.

    It’s 2) That I worry about in the post.

    I agree that the US can currently borrow for virtually nothing. But then so could Irish house buyers years ago.

  11. Tim,

    It isn’t clear how relevant this average is to the US’s situation now. How much variation does the debt/GDP ratio explain in the sample? I strongly suspect that if you restricted the sample to properly comparable observations, you would get a very different value. Just because North West Goatistan has a higher predicted rate of default at debt to GDP ratios of 100%, doesn’t mean that the world’s largest economy, greatest military power, reserve currency issuer, with floating ex rates, flexible labour markets, etc, etc, does too.

    Irish home buyers could once borrow cheaply, I agree. But then their govt bailed out the European banking system and it all went a-over-t. USG on the other hand has the luxury of locking in extremely low long term rates now (reducing vulnerability to interest rate moves) and not guaranteeing any many-times-greater-than-current-GDP foreign liabilities of private banks.

    Tim adds: All true enough….but I really do suggest that you read “This Time is Different”. It’s packed full of the historical statistics on exactly all of the points you raise.NW Goatistan would probably be defaulting at 50-60%. Japan has raised alomst all of its debt internally and has no problems at 180% (or whatever the number is). There is indeed more than just the debt ratio to consider. Read it.

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