When the Whole Paper Edifice Collapses

There was massive carnage on Wall Street yesterday – again.  No doubt, it makes for some exciting headlines.  But here at the Economic Prism we won’t take your time to ponder the stock market’s precipitous decline.  For, today, we’re more interested in the story behind the story.  What we mean is, today we’re more interested in not the stock market; but, rather, the credit market…and what inferences it offers.

For example, society’s willingness to damage itself is increasing by the day.  We don’t have hard facts or quantifiable evidence to back this assertion.  But that doesn’t make it any less so.  Our wide eyed observations and pragmatic experience supports the swelling notion that the logic of collective action has gone insane…civilization could cut its nose off to spite its face at any moment.

Late Friday, Standard & Poor’s downgraded U.S. government debt from AAA to AA+.  In doing so, Standard & Poor’s was merely recognizing what everyone who has actually thought about it already knew to be true…the credit worthiness of the U.S. government has become suspect.  Quite frankly, without massive spending cuts and massive tax increases – or massive amounts of money printing and massive inflation – the government will never be able to repay the massive amounts of money it has borrowed.

Yet the more remarkable thing about Standard and Poor’s credit rating downgrade is not so much that it happened.  But rather that it happened when 10 Year Treasuries were yielding just 2.55 percent.  This is one example that the logic of collective action has gone insane.

Yesterday, the first day of trading following the inglorious downgrade, 10 Year Treasury yields dropped to 2.33 percent.  This is an example of civilization cutting its nose off to spite its face.

Do not junk bonds demand higher compensation than investment grade bonds?  Should not a government debt downgrade demand higher compensation?  Isn’t that how the world works?  What gives?

The Safest Investment in the World?

We’ve written about our expectation of rising Treasury yields so many times that we have permanent writer’s cramps.  We know they will eventually rise…and we know that today we are one day closer to that day than we were yesterday.  Here’s why…

Credit markets, particularly those dealing in government debt, move slower than molasses in January most of the time.  Only bores and drags care to watch interest rate fluctuations. The rest of us are lulled to sleep by their appearance of inaction.

Creditors, too, can be lulled to sleep by the ever so slight and benign movements of Treasury yields.  Overtime the creditworthiness of borrowers – like the U.S. government – can become as certain as night after day.  Day after day, year after year, over and over again, it has been repeated that U.S. Treasuries are the safest investment in the world.

Obviously, they’ve had a great track record.  And for many years they were deserving of a top notch credit rating.  But like a fading athlete no one stays on top for ever.  Moreover, there is always a brief period, after the apex, where it is not blatantly obvious that something has slipped.

The U.S. government has been resting on its laurels of yesteryear.  U.S. Treasury yields have been so low for so long people have come to believe that is where they will always be. In fact, over the years it became so certain the government would always be able to borrow money for so cheap that everyone, including the U.S. government, came to expect it.

A rude awakening may soon be upon us…

When the Whole Paper Edifice Collapses

Each year the government has to pay off several trillion dollars on debt principal to avoid default.  To do so, they roll over their debt.  In other words, they issue new debt to pay off the maturing debt.

As the price of money increases via rising interest rates not only does the cost of new borrowing increase…the cost of debt service payments on existing debt as it’s rolled over increases too.  Similar to an adjustable rate mortgage resetting at a higher rate, when yields increase, the cost of repaying the debt also increases.

The recent debt ceiling debacle makes it obvious that the government budget, and its mammoth deficit, is fully accounted for.  Thus an increase in the cost of debt service payments will act as a new expense…it will take a larger bite out of the government budget pie.

The government has loaded up on much more debt than the economy can afford. Historically low Treasury yields helped make this possible.  Yet even with these low rates, there is just too much darned debt.  In an environment of rising yields, the whole paper edifice will collapse.

At the Economic Prism, we believe U.S. Treasuries are not at a normal equilibrium…but at an epic bubble.  We even wrote a Strategy Report on it earlier this year and gave it free of charge to subscribers of our E-Newsletter.  If you are not a subscriber, you can learn how to pick up a free copy of the report here.

The premise of it is that U.S. Treasuries (i.e. government debt) are an extraordinary bubble and, after over a quarter century of declining interest rates, U.S. government debt is poised to explode.  The report also offers an easy idea on how to protect yourself and profit as the debt explosion blows off a huge mushroom cloud.

Existing subscribers may want to take a moment to revisit this.  Web readers can check it out here.

Sincerely,

MN Gordon
for Economic Prism

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