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Fed’s US Debt Bomb and Interest Rates

Interest-Rates / US Debt Oct 30, 2015 - 05:42 PM GMT

By: Zeal_LLC


With the Federal Reserve’s first rate-hike cycle in nearly a decade looming, traders are working overtime trying to divine its timing and impact on the markets.  They are closely monitoring the same employment and inflation data the Fed will use to start tightening.  But there’s another little-discussed concern for the Fed, the solvency of the US government.  The Fed’s zero-interest-rate policy has spawned a grave US debt bomb.

Back in late 2008, the US stock markets suffered their first true stock panic since 1907.  This once-in-a-century fear superstorm proved catastrophic.  In a single month leading into October 2008, the flagship S&P 500 stock index plummeted 30.0%.  Over 6/7ths of these losses happened in 2 weeks, a massive 25.9% cratering!  That exceeded the threshold for a stock panic, which is a 20%+ plunge in a couple weeks.

Such extreme selling catapulted fear so high that the S&P 500 had fallen another 11.4% less than a month later!  The American central bankers certainly weren’t immune to this epic fear, so they joined the traders in panicking.  The Fed feared that the stock panic’s wealth effect, the tendency for weaker stocks to retard consumer spending, would cast the entire US economy over a cliff right into a new great depression.

So the central bankers acted quickly to try and restore confidence through shoring up the devastated stock markets.  The Fed slashed its key federal-funds rate two separate times in October 2008 for 50 basis points each.  This certainly didn’t stop the extreme stock selling, so the Fed desperately made an enormous 100bp cut in December!  That blasted the federal-funds rate to zero, beginning the ZIRP era.

Running a zero-interest-rate policy is an extreme measure that central banks rarely use.  It is reserved for dire economic emergencies, and then promptly reversed soon after.  Indeed upon panicking into ZIRP, Fed officials promised that highly-distorting condition would be temporary.  Yet here we are, 6.9 years later, and ZIRP is still in place!  The Fed has lacked the courage to normalize its extreme stock-panic policies.

ZIRP is super-problematic on all kinds of fronts.  It greatly distorts financial markets, unleashing a torrent of easy money that bids up prices.  The Fed’s ZIRP and quantitative-easing money-printing campaigns fueled recent years’ extraordinary stock-market levitation.  American corporations borrowed way over a trillion dollars at the Fed’s record-low rates, using cheap money to manipulate their stock prices higher via buybacks.

Companies certainly weren’t the only large borrowers taking advantage of the ZIRP extremes.  The stock panic and its aftermath also had an enormous impact on the United States federal government.  2008’s critical presidential elections were held in early November just a week after the US stock markets had lost nearly a third of their value in a single month.  Scared Americans desperately wanted something to change.

Provocatively, stock-market performance leading into US presidential elections happens to be one of the best predictors of their outcomes.  Since 1900, the fate of the US stock markets in the Septembers and Octobers before early-November elections has predicted the winner 26 out of 29 times.  This is a 90% success rate!  In 10 of the 12 times the stock markets fell in those final 2 months, the incumbent party lost.

And with the S&P 500 plummeting 24.5% in September and October 2008, the incumbent Republicans didn’t have a prayer of winning that election.  The Democrats’ Barack Obama won 52.9% of the popular vote, and then assumed office in January 2009.  He represents the American political party that has always been known for its fanatical devotion to excessive government spending.  ZIRP greatly facilitated that.

The Fed’s extreme artificially-low interest rates were implemented right between Obama’s election win and his inauguration.  The Democrats also won decisive majorities in the US Senate and House of Representatives in that stock-panic election.  So the party that fervently believes bigger government is the solution to all problems controlled all the levers of power, and it rushed to expand government spending.

But not surprisingly the already-heavily-indebted US government wasn’t running a surplus, so the only way it could spend more was by first borrowing that money in the markets.  Normally interest rates act as a critical constraint on that government borrowing.  Excessive bond issuance (demand for money) leads to higher interest rates, which make the debt-servicing costs more expensive to naturally limit debt growth.

But first with ZIRP and later with quantitative easing, the Federal Reserve systematically removed all the free-market restraints on government spending.  ZIRP forced short-term interest rates down near zero, and the federal government eagerly rushed to borrow for next to nothing.  Then later the Fed started to actively conjure up new money out of thin air to buy US government bonds, classic debt monetization.

This gross Fed manipulation naturally led to extreme record government spending and deficits, both absolutely and as a percentage of the US economy.  This first chart looks at the latter over the past 65 years or so.  Note that the US government runs fiscal years that end on September 30th, so 2015 is already in the books.  The damage the Fed and Democrats wreaked on US finances is just staggering.

For a half-century ending in 2007 before that extreme stock-panic year in 2008, US federal government spending averaged 20.3% of US gross domestic product.  The Obama years saw this soar to a record 25.2% in 2010, and an average of 23.6%.  This is about 1/6th higher than the long-term norm, trillions of dollars of new government spending beyond precedent.  The Democrats didn’t scrimp on government largesse!

They financed their record spending with record borrowing, as evidenced by the massive red federal-deficit bars.  For 50 years prior to that once-in-a-century stock panic, federal deficits averaged 2.0% of GDP.  And in all fairness to the Democrats, the big-spending Ronald Reagan years in the 1980s saw some of the worst deficits before the panic.  But Obama and his Democratic Congress shattered those records.

Deficits under Obama skyrocketed to a crazy record 9.8% of GDP in 2009 per the latest data from the US Treasury and Federal Reserve!  Their average level during the Obama years was 6.1% of GDP, which is more than triple the half-century precedent!  The government spending since the stock panic under the Democrats has been vast beyond belief.  This couldn’t have happened without the Fed’s zero-rate manipulation.

Thankfully those extreme deficits have normalized in recent years, which Obama loves to point out in his political speeches.  The record government spending retreated to merely super-high levels, and taxes as a percentage of GDP surged with the Fed-levitated US stock markets.  But higher federal receipts are fleeting, as stock bear markets hammer them as was evident in the early-2000s and late-2000s cyclical bears.

But a far-larger problem than unsustainable levels of federal-government tax receipts are those record deficits’ contribution to the federal government’s debt.  While deficits are how much spending exceeds income in any year, debt is the cumulative total of all years’ excessive spending.  Just slowing the rate of overspending doesn’t even start to address the debt already accumulated.  And that is the Fed’s debt bomb.

Imagine if you had a $100k income but also $100k in credit-card debt after many years of spending more than you earned.  Even when you stop living beyond your means and borrowing, that massive debt load remains.  And if the interest rates charged on those credit cards rise high enough, merely servicing that existing debt could easily threaten to bankrupt you.  The US government now faces this dire situation.

This next chart looks at the total federal debt over the past 35 years or so.  Superimposed on top of that are some average annual interest rates.  They include yields on 1-year and 10-year US Treasuries that represent short and long rates.  And the blue line is the effective US interest rate, the actual money the US government pays in interest each year divided by the federal debt.  This keeps Fed officials awake at night.

Between 1983 and 2007, the quarter-century span before the stock panic, the US federal debt grew at an average of 8.7% annually.  Washington was spending almost 9% more than it took in through taxes.  And the Obama years since 2009 surprisingly didn’t greatly exceed this precedent, with average debt growth of 9.5% per year.  That’s only about 1/11th higher.  But the raw-dollar size of that borrowing was incredible.

In the Obama years, the federal debt skyrocketed $8.7t or 87% higher!  That was as much absolute debt growth in 7 years as had previously taken 25 years.  The acceleration of raw debt since the stock panic is readily evident in this chart.  It mirrors a parabolic ascent, which is very dangerous when we’re talking about federal-debt levels now exceeding the size of the entire US economy!  The Fed’s ZIRP enabled all this.

For the quarter-century prior to the stock panic, 1-year US Treasuries and 10-year US Treasuries had average yields of 5.6% and 6.9%.  These fair-market interest rates were what it cost the US government to borrow money in the bond markets.  They worked to constrain debt growth, because it was expensive to pay the interest on existing debt.  Those 25 years saw an average effective US government interest rate of 6.4%.

But the Fed’s gross manipulations following the stock panic radically changed prevailing interest rates on both ends of the yield curve.  The Fed’s supposedly-temporary zero-interest-rate-policy crisis measure aggressively dragged down all short-term rates.  And the US government rushed to take advantage of this cheap money by rolling over maturing Treasuries into new Treasuries with shorter average maturities.

And soon after ZIRP, the Fed formally launched quantitative easing in early 2009.  QE is just a fancy euphemism for monetizing debt, creating new money out of thin air to buy bonds.  QE1 was expanded to include direct Fed buying of US Treasuries, which QE2 and QE3 continued at ever-higher levels.  The Fed was very transparent in brazenly admitting it was buying Treasuries to manipulate long interest rates lower.

When the Fed creates money to buy bonds, this additional demand bids up bond prices.  And the higher the price of any bond, the lower its yield.  QE enabled the Obama Administration to borrow vastly more money at far lower rates than it ever could’ve hoped to in normal market conditions.  But the interest the US government was paying to service this debt was artificially low, like a temporary teaser rate on credit cards.

As the national debt was skyrocketing higher since the stock panic thanks to the Democrats’ extreme overspending facilitated by the Fed, the interest paid on each dollar borrowed was plunging.  The preliminary data for fiscal 2015 just ended suggests an effective interest rate of less than 2.2% on the US government’s incredible $18.7t in debt!  That is a ticking time bomb for the Fed, a critical rate-hike consideration.

As the Fed hikes rates, the entire interest-rate complex including the yields on US Treasuries will rise to reflect this.  And that’s a colossal problem for a US government up to its eyeballs in debt.  In fiscal 2015 the US government had to pay $402b in interest expenses on its enormous debt, less than 2.2%.  That’s only about a third of the quarter-century average effective interest rate before the Fed’s ZIRP and QE arrived.

If the Fed fully normalizes interest rates, which the global bond markets will probably eventually force whether the Fed wants to or not, the very solvency of the US government comes into question.  At the pre-ZIRP average effective interest rate of 6.4%, the interest expenses on $18.7t in government debt would rocket to $1200b per year!  That would likely prove to be an insurmountable hurdle for the US government.

There are two kinds of spending the US government does, mandatory and discretionary.  The former accounts for over 60% of all spending and happens automatically.  It includes giant welfare programs on autopilot like Medicare and Social Security.  These transfer payments can’t be lowered without a huge backlash from the voters who rely on them, and the Democrats wouldn’t cut government payments for anything.

The minority remainder of overall spending is discretionary, and includes everything else done by the federal government including the military.  In 2015, this discretionary spending totaled about $1.1t out of $3.4t or so.  If Fed rate hikes return interest rates to normal levels, it would cost the US government another $800b just to service its existing debt.  That would devour nearly 3/4ths of all discretionary government spending!

This is a nightmare scenario for the US government, which includes the Federal Reserve.  Such a giant jump in interest expenses would force catastrophic cuts in government services including the military (54% of discretionary).  The only other alternative would be to “finance” these soaring interest payments by issuing more debt.  But that’s like borrowing on a credit card to pay interest, it accelerates the debt spiral.

Even if the Fed’s coming rate-hike cycle is exceedingly gradual and prolonged, if the global markets refrain from forcing the Fed’s hand, the consequences for the US government are still dire.  If the new effective interest rate the US is forced to pay is merely halfway between current extreme levels and the quarter-century pre-ZIRP average, or 4.3%, it would still double the government’s annual interest payments!

A $400b jump in debt-servicing costs would be almost as catastrophic against a $1100b discretionary budget as an $800b jump.  There would either have to be draconian cuts in government spending on salaries and services or else a massive jump in deficits.  And running bigger deficits is super-risky since that greatly increases the odds the world markets will force interest rates higher far faster than the Fed wants.

Today’s Fed-conjured fantasyland of record-low interest rates combined with record-high federal debt levels is exceedingly dangerous.  It is literally a ticking time bomb that truly threatens to bankrupt the US government!  I strongly suspect this dire situation is far more pressing on the minds of Fed officials when it comes to rate-hike decisions than the usual considerations of employment, inflation, and market impact.

Thanks to the astoundingly-reckless excessive government spending under Obama enabled by the Fed’s ZIRP and QE, there’s a good chance the Fed can’t even attempt another meaningful rate-hike cycle.  It may try to manipulate rates lower forever or risk its very existence.  And politics will really come into play leading into next year’s critical presidential election as well.  Remember Janet Yellen is a hardcore Democrat.

Fed rate-hike cycles are very damaging to stock markets.  The end of easy money hammers stocks from multiple fronts.  Higher rates slow overall national spending which weighs on corporate sales and profits, leading to higher valuations.  Interest expenses rise too, further eroding earnings.  On top of all that, rising bond yields make stocks relatively less attractive.  So stock markets don’t fare well in rate-hike cycles.

And with the fate of the stock markets late next year having a 90% chance of predicting the outcome of the next presidential election, it’s hard to imagine Yellen taking the risk of all but guaranteeing a loss for her party.  And since rate hikes will initially lead to rapid federal-deficit growth since spending cuts will be aggressively resisted, the Yellen Fed will be unlikely to hike rates materially in a presidential-election year.

So with the grave implications for the Fed’s government master if interest rates even start to normalize, it is hard to imagine a big new rate-hike cycle.  The Democratic-run hyper-dovish Fed is exceedingly unlikely to risk tanking the Democratic-run epically-profligate US government.  Through its wildly-irresponsible ZIRP and QE policies, the Fed has created a US debt bomb that appears impossibly intractable to defuse.

And if the Fed can’t materially hike rates any more due to the catastrophic impact that will have on the US government, the primary beneficiary will be gold.  Along with the Fed’s ZIRP-and-QE-spawned stock-market levitation, the main reason gold has been so weak in recent years is futures speculators’ fear that Fed rate hikes will crush this zero-yielding asset.  That’s ironic because history proves just the opposite!

But if traders come to realize the Fed has painted itself so deep into a corner that any meaningful normalization of rates is impossible without bankrupting the US government, investors are going to flock back to gold.  It thrives in low-real-rate environments, the natural consequence of central-bank interest-rate manipulation.  And as gold enjoys an investment renaissance, the dirt-cheap gold stocks are going to soar.

We’ve long specialized in this high-potential contrarian realm at Zeal.  Gold stocks were the 2000s’ best-performing sector, enjoying an astounding 18x gain in that decade!  We’ve long published acclaimed weekly and monthly newsletters explaining what’s going on in the markets, why, and how to trade them with specific stock trades.  Since 2001, all 700 stock trades recommended in our newsletters have averaged annualized realized gains of +21.3%!  Subscribe today, gain an essential contrarian perspective that should prove exceedingly profitable, and enjoy our popular 20%-off sale!

The bottom line is the Fed’s radically-unprecedented easy-money policies since the stock panic have created a dangerous US government debt bomb.  ZIRP and QE artificially forced interest rates down to record lows, enabling epic overspending by the Democratic government under Obama.  The resulting debt load has grown so massive that merely normal interest rates will literally bankrupt the US government.

This Democratic-led Fed isn’t going to embark on a meaningful rate-hike cycle if it forces its government master into serious jeopardy.  The dire realty of this situation likely means lower rates for longer.  While the Fed may make isolated token rate hikes here and there, a full normalization isn’t going to happen with the US government in mortal peril.  The asset most likely to thrive in a lower-rates-forever scenario is gold.

Adam Hamilton, CPA

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Thoughts, comments, or flames? Fire away at . Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

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