Interest Rates Are On The Launching Pad

03/16/2011 02:08 pm ET | Updated May 25, 2011

When the chorus of recovery cheerleaders reached their peak voice not too long ago, they used statistics like expanding consumer credit and surging U.S. trade deficits as their evidence for an economic rebound. In doing so, they denied the very nucleus of this past crisis; namely one engendered by onerous debt levels and inflation induced asset bubbles.

Once one recognizes the problem, the only viable long-term solution seems obvious. Put simply, we must deleverage as a nation while boosting the value of our currency. However, instead of allowing markets to function freely the Federal Reserve, in full cooperation with the government, has now fully succeeded in putting us back on a path of destruction.

Last week's release of the Flow of Funds report issued from the Federal Reserve clearly underlines the fact that as a country, not only haven't we deleveraged, but to the contrary, debt accumulation is still increasing. As of the end of Q4, total non-financial debt (household, business, state, local and federal debt) reached an all time record high $36.2 trillion. More importantly, not only is the nominal level of debt at a record but also if stated as a percentage of GDP. In Q4 2007 total non-financial debt registered 222% of GDP. In 2007, 2008 and 2009 it was 222%, 238% and 243% respectively. As of Q4 2010 that figure was 244% of GDP. To put those numbers into perspective, back in the year 2000 the level of total debt to GDP was 182%. That's still bad but far below where it is today.

The above numbers clearly illustrate that the over-leveraged condition that brought the economy down in 2008 still exists today; but only worse. All that we have accomplished is to transfer private debt onto the Treasury's balance sheet. Now that the Fed is (hopefully) just months away from ending their manipulation of interest rates, the paramount question is how interest rates will climb. The Fed has been able to temporarily send yields lower. The ironic part here is that they accomplish this by creating inflation. However, the process of creating inflation to keep interest rates lower cannot last very long. This can only be achieved by convincing the majority of investors that deflation is a very credible threat.

But the Fed and Administration's epoch for pulling off that ruse has come to an end. The unrelenting growth of the Fed's balance sheet, increasing monetary aggregates, surging gold and commodity prices, $100 barrel oil, soaring food prices and the projected trillions of dollars of new debt that must be printed in the future have served to vanquish the deflationists. Any vestiges of those once prominent voices can barely be heard today. In fact, those who still dare to mention deflation today are quickly and quite appropriately derided.

So therein lies the problem for the Fed. Any further debt monetization by the central bank now becomes counterproductive. That's because as inflation rates climb bond investors demand higher interest rates. The lower real interest rates become the less participation there will be in the bond market from private sources. If you don't believe me ask Bill Gross.

The Fed is now in the position of damned if you do and damned if you don't. Interest rates have been artificially suppressed for such a long time that no matter what Bernanke does come June, interest rates will rise. If they extend QE2 into continued iterations of Treasury monetization, the Fed may find themselves the only players in the bond market at that price. Of course, the Fed could potentially buy all of the auctioned Treasury debt if it wanted to in order to keep rates low--as uncomfortable a position as that may be--but all other interest rates from bank loans to municipal debt would skyrocket. Unless..., the Fed decided to buy all that debt too;--hello Zimbabwe!

But as unlikely as that scenario may be, the truth is that only a central banker could afford to own bonds that are yielding rates well below inflation, and growing even more so. Then again, if Bernanke stops buying at the appointed termination of QE2, yields will rise to at least the level in which they provide a real return after inflation. How much higher will rates go you ask? Well Mr. Gross has some thoughts on that: "What I would point out is that Treasury yields are perhaps 150 basis points or 1½% too low when viewed on a historical context and when compared with expected nominal GDP growth of 5%. This conclusion can be validated with numerous examples: (1) 10-year Treasury yields, while volatile, typically mimic nominal GDP growth and by that standard are 150 basis points too low, (2) real 5-year Treasury interest rates over a century's time have averaged 1½% and now rest at a negative 0.15%! (3) Fed funds policy rates for the past 40 years have averaged 75 basis points less than nominal GDP and now rest at 475 basis points under that historical waterline."

To the above I say; not bad for a start Mr. Gross. But these aren't exactly average times. We have never had a Fed balance sheet anywhere near the $2.6 trillion that it is today. In addition, the nation has never faced the prospect of $1 trillion deficits as far as the eye can see. Nor have we ever had our total debt as a percentage of GDP reach 244%.

Now, Japan has not only been taken offline from buying our Treasuries, they may even be forced to sell a significant portion of their $882 billion dollars worth of U.S. debt.

The bottom line is that a massive increase in the supply of debt coupled with rising rates of inflation will always place upward pressure on interest rates. Once the Fed steps aside from buying 70% of the Treasury's current auctioned output they will leave a gaping hole. And for those Pollyannas who claim we are in an economic recovery, I would ask them the following questions. Who will supplant the Fed's purchases of Treasuries at current yields? Since the level of debt in the economy has grown since the recession began, why will rising rates not place us back into an economic funk? Can the Fed unwind its balance sheet before inflation further ravages the country? And if the Fed isn't able to raise rates significantly, what will stop the dollar from falling apart. Then again, I guess it all comes down to one simple question; do you believe the laws of supply and demand apply to U.S. Treasuries. If you do, then watch out for soaring yields.

Michael Pento is the Senior Economist for Euro Pacific Capital