“Nobody expects the Spanish Inquisition!” Monty Python observed back in 1970 before attempting to torture a coal-miner’s wife with a dish rack.
There’s an important investing version of this core truth: The financial market usually worries about the wrong problem. So that when the “Spanish Inquisition” (in financial terms) finally arrives, everybody is surprised.
Well, we investors and traders have done it to ourselves again. We’ve spent much of 2022 and a good part of 2023 worrying about whether Federal Reserve interest rate increases would send the economy into a recession. There are still a few recession die hards worrying about that possibility, but by and large the worry has shifted to whether or not the Fed will delay its rate cuts in 2024–and thus delay the arrival of the “rate-cut-bounce.”
While MANY–but certainly not all–investors, traders, and market analysts have been looking OVER THERE, however, the credit markets have built up a huge debt overhead and the global debt bomb looks ever closer to exploding. A crisis with the dire effects of the Global Financial Crisis of mid-2007 to 2009 is a possibility.
I’d “guess” that most portfolios aren’t ready. The time to get ready is now. This increasingly looks like a debt market crisis of the type known as a Minsky Moment.
To get ready first understand the source of the problem. I’m putting together a new Special Report for subscribers to my JubakAM.com site for next week on what to do to get ready. Today’s post is a kind of set up, a get ready for the post on getting ready, if you will.
The debt boom was built out of two moves by the world’s central banks–and their co-conspirators in national governments and in corporate management.
First, centra banks and governments let loose a global tidal wave of cheap–I mean 0% real interest rate cheap–money as they fought one crisis after another. And after each time time that they opened the money spigot during a crisis, they only closed it part way during the recoveries. And they never moved to soak up a significant amount of the money that they’d poured into the financial markets.
Second, when the Federal Reserve finally did get around to raising interest rates and starting to shrink the size of its balance sheet by cutting the amount of new Treasuries it was buying, it lit the fuse of this debt bomb. Markets, and countries, and companies that had built their financial future on continuing cheap money suddenly saw the Federal Reserve raise its benchmark interest rate by 500 basis points (or 5 percentage points in the common tongue.) Interest payments soared. Rolling over old debt into new debt got expensive, sometimes prohibitively expensive. And banks and bank-like institutions (which run a range from the International Monetary Fund to China’s black money lenders) decided to get more careful about lending. (Exactly what economist Hyman Minsky told us to expect at this stage of the credit cycle: when everybody needs to borrow, banks discover that their lending standards have been too lax.) So that some countries and companies are finding it hard to refinance (or finance) at any price.
All that results in a crisis where interest rates shoot higher–without the action of central banks–where prices of bonds and other credit instruments tank and yields rise, where borrowers can’t borrow all they need and have to find ways to replace those debt market dollars, where economic activity slows–not least because consumers are big borrowers too–and we finally get the recession we’ve feared.
So let me fill in some of the details on why I think the situation is so dire.
The gross federal debt of the United States surpassed $33 trillion in September, according to the Peter G. Peterson Foundation. That includes debt held by the public (you–if you own a Treasury or a savings bond), debt held by Federal trust funds (such as Social Security), debt held by foreign governments, and debt held by investors foreign and domestic, individual and corporate.
The U.S. government isn’t immune from the dynamics of the debt bomb. A recent rally in the bond market on hopes (again) that the Federal Reserve is done with interest rate increases, has taken the yield on the benchmark 10-year Treasury down to 4.56% as of October 11. That’s still 61 basis points higher than a year ago and I don’t expect the yield on the 10-year note to stay this low. (It was above 4.8% only last week.) The current yield is near a 10-year high and at this level it adds, massively, to the interest costs for a government that’s carrying $33 trillion in debt. Interest costs are already the fastest-growing part of the budget. Net interest costs—-a nonnegotiable expense —-nearly doubled as a share of federal outlays between 2020 and 2023, going from $345 billion, or 5% of outlays to 10%. (At that level interest costs have almost as big an effect on the Federal budget as defense spending at $815 billion or 13% of spending in 2023.) Recent interest rate increases could add $3 trillion over the next decade to interest costs, Marc Goldwein, senior policy director for the Committee for a Responsible Federal Budget, told Bloomberg.
The sheer size of the debt produces an upward push on bond yields and interest rates across the economy that’s independent of central bank policy decisions.
And it doesn’t make it any easier to sell debt that investors and traders are worried about taking losses–big losses–in the bond market. Strategists at Bank of America recently calculated that going back to the founding of the United States in 1787 there’s never been an extended period of losses like those of the past three years. Last year alone bond investors took a 12% loss in safe Treasuries.
So it’s no wonder the investors are demanding a higher yield to buy Treasury debt.
And if they’re demanding a premium to buy “safe” Treasury paper, you can imagine what they asking to buy riskier debt.
Even before the surprise in the September jobs report last week, worries about rising yields had shut down new junk bond sales in the United States, bringing the first “zero” week since the week ended August 18, according to data compiled by Bloomberg. That “hesitancy” to buy helped lift the average yield on the Bloomberg Global High Yield index to 9.26% this week, the highest since November last year and nearly double what it was at the start of 2022. If buyers aren’t buying or at the best are demanding extremely high yields for the use of their money, investors can expect to see more borrowers default on their loans.“The junk bond market needs to massively reprice to account for refinancing risk with benchmark borrowing rates so high,” Althea Spinozzi, a strategist at Danish lender Saxo Bank told Bloomberg. “I can’t see how the default rate doesn’t rise sharply and there will be stretched balance sheets everywhere.”
Ah, if it were only the corporate high-yield market. The Federal Reserve Bank of St. Louis found that the number of emerging markets in debt distress spiked significantly to 15 at the beginning of the COVID‑19 pandemic. But surprisingly the percentage of emerging market in debt distress hasn’t dropped significantly with the retreat of the Covid pandemic. The number of emerging markets in debt distress reached its high at 22 in the summer of 2022, and then dropped to 16 today. That’s still above the pre-pandemic level. And it amounts to 23% of the countries that make up the JP Morgan emerging debt index.
And these figures don’t include China where every day seems to bring news of another failure in the property development sector. And where the only reason that local and provincial governments haven’t declared bankruptcy is that the central Beijing government won’t let them. (And they really don’t account for current ongoing bailouts such as the serial good money after bad moves to the International Monetary Fund to prop up a bankrupt Argentina.)
This worries economists and market observers such as Edward Yardeni of Yardeni Research. At some point they fear, yields and interest rates will rise so high that something in the global financial system will break. It’s very scary to me that Yardeni speculates that this breaking point might be just above 5% on the 10-year Treasury.
I hope I’ve convinced you that this is a problem that you and your portfolio need to take very seriously indeed. But i don’t want to just leave you with fear and anxiety.
Watch my Special Report next week for my recipe on how to position your portfolio for the coming explosion of the global debt bomb.
And I’ll have a word or two to say about the likelihood–the just about certainty I think–that central banks will move to “save” the world again if the debt bomb goes off in order to rescue the financial markets with another flood of cash from the problem they have done so much to create.