2014 Debt

By Dave Cantey 2014 1/19/14

Over the next few weeks, we will roll out our forecasts for the coming year. Today, we begin with a status review and outlook for the most important economic variable of our time, the elephant in the room, the Debt Bubble. According to the Federal Reserves latest release of its Financial Accounts of the United States, the total interest-bearing debt in the US has grown to $58.1 trillion, the largest in history. This confirms that the debt bubble is still growing. The Fed reports the composition of this debt as: $9.2 trillion in state and local government debt, plus other miscellaneous debt, $13.2 trillion in corporate debt, $16.2 trillion in mortgage and consumer debt, including car, credit card, and student loan debt. $19.5 trillion in U.S. Treasury debt, plus government agency debt (the true national debt). The largest of these, the $19.5 trillion in national debt deserves further comment, as it is growing the fastest by far. Of this $19.5 T total, Treasury debt represents $17.3 T. With GDP at $16.1 T, Treasury debt is now at 107% of GDP. Recall our earlier analysis that identified that when Egyptian and Spanish debt exceeded 110% of their respective GDPs, the debt markets spiked their short term interest rates to over 10%. This rendered these countries insolvent. Both Egypt and Spain were subsequently bailed out by the ECB (European Central Bank), which lowered their short term interest rates back to manageable levels. As of today, both of these countries are still technically bankrupt. (Technical bankruptcy for a country occurs when it is still able to make interest payments, but economic growth is insufficient to repay the principle.) When we consider that the US true national debt is now $19.5 T, this represents 121% of GDP. The US is becoming weaker and weaker, and getting into riskier and riskier debt territory. Truly, with less than a 2% real economic growth rate, the US is already in technical bankruptcy, i.e., with such a low economic growth rate, it is inconceivable that the US will ever be able to repay its debts. (This is why GDP growth rates get so much attention from Wall Street and the Fed.) What consequences result from this increased risk? Answer: Rising interest rates. Recall, we advised you a year ago that interest rates had bottomed in July of 2012 at 1.43% (as measured by the Ten Year Treasury Note, which is the benchmark used by most professionals). Today, this rate stands at 2.86%, which is already twice the low of 2012. Looking into the future, expect rates to continue rising as US debt increases further into the riskier territory, and as the bond market continues to price this risk by raising rates. (It is not too late to get completely out of any bond funds you might own.) A related topic is the risk still inherent in the Too Big to Fail Banks. The quarterly report by the Comptroller of the Currency states that US banks still control $240 trillion worth of derivatives, which are the most highly leveraged speculative financial vehicles possible. After the financial crash of 2008, this was a hot topic of great concern, but nothing much has changed. Recall, Warren Buffet calls derivatives: WMD weapons of mass financial destruction. The four largest US banks control 93.2% of these derivatives, which concentrates enormous risk, and power, in far too few hands. Most of these derivatives are CDS (Credit Default Swaps), which the banks sell as insurance against loan defaults. These banks have grossly insufficient capital to make good on even a very small portion of this highly leveraged speculative insurance. For example, as we reviewed above, interest rates can suddenly spike when the debt of a country exceeds a certain threshold in relationship to its GDP. This could cause significant loan defaults and thereby topple this entire house of derivative cards, which would crash the whole financial system again. Will these events occur this year, or next? We cannot know this in advance or even if it will happen at all, but we see tremendous inherent risk. As weve been saying all along, financial bubbles do not end well. In God We Trust. We wish.