The Debt vs. Interest Rate Conundrum

I've written before about the dramatic rise in fixed income rates that face investors in the very near future due to the funding issues associated with our entitlement programs coupled with the incalculable measures taken by the government in the past few weeks to stem the credit crisis. Those efforts ensure the amount of Treasury issuance will explode.

One of the major ramifications of having our national debt move above the $10 trillion mark is that the sustainability of the government, consumer spending and the economy rests on the continuation of artificially low interest rates. In fact, low rates that are the result of money printing have become our addiction.

In last week's commentary I pointed out that it now takes about 10 cents on every tax dollar collected just to pay the interest on the debt. As bad as that is, it is only because interest rates are at record lows that the debt service is still manageable.

The yield on the 10 year note as of this writing is 4.01 %. To illustrate how low that yield is in historical terms, the average constant yield on the ten year treasury going back 46 years is 7.04%. Keep in mind that this historically low yield exists at the same time consumer price inflation has increased by 5.4% over the last 12 months. Why are real yields negative while debt levels are soaring and the monetary base is growing at a 114% annual rate (you read that correctly-114% annualized in recent weeks)? Part of the answer has to do with investors' mistrust of holding debt that is not backed by the government. But to get to the main reason why rates are so low you have to understand how the Fed Funds rate is set. When the Fed wants interest rates to fall, it prints money and purchases Treasuries as well as other bank assets. Printing money, however, increases its supply and is the definition of inflation.

Can you see the conundrum? The Fed needs to constantly print money and expand the money supply in order to keep their target rate from rising. However, printing money is inflationary and demands that yields rise in order to provide a positive return for fixed income investors. The more they print the less the Federal Funds Rate will rise. And rates, especially on the short end of the yield curve, will most likely stay low-the Fed can only control the target rate for intra-bank lending, but free market short- and long-term rates also tend to be influenced by the central bank's target rate. Yet the further out on the yield curve you move, the more highly influenced rates are by inflation. It is important to stress that short-term rates have become much more important in recent years as banks and the government have increased the use of short term financing to fund their operations.

The bottom line is this: debts at the public and private levels have risen to the point that in order to insure against default, interest rates must remain at an unnaturally low and negative real level. In order to achieve that artificial level, the Federal Reserve must continually inflate the money supply. How high would the overnight rate be if not for government operations? Well, one of the consequences of the credit crisis is that banks mistrust each other's assets and are reluctant to lend to one another. If market forces were allowed to operate, intra-bank lending rates would soar just as they did several weeks ago when the Effective Federal Funds rate hit 6%! Clearly the free market rate bears little resemblance to today's Fed Funds target rate of 1.5%.

However, inflation and low interest rates cannot coexist indefinitely. One will have to give way to the other. It is my view that government efforts to keep yields low across the curve will fail. At some point, the yield curve will start to move sharply higher as short term rates remain relatively low and long term rates soar in response to inflation. It is at that juncture that market forces will prevail and send the economy into the greatly needed recession (or worse) that until this point was held in abeyance by our government. We can only hope this process happens sooner rather than later, as the longer it takes to occur the more severe the economic suffering will be.

Michael Pento is a Senior Market Strategist with Delta Global Advisors and a contributor to "http://greenfaucet.com">greenfaucet.com

Comments

[avraamjack]

.
What is $10,000,00­0,000.000.­00 amongst friends ?
.

[KillTheMessenger]

Since 30 cents of every tax dollar go into military spending, we can take ten cents out of that pot, still spend twenty cents on the military and still defend the country (against what, though, it's not like anybody is attacking us militarily, right?) and service the debt.

Easy. You just have to have the courage to say no when somebody wants another bomb toy.

[randeg]

Oh, thank you for letting me know that when the interest rates are low, the government prints money and buys treasuries. No wonder inflation is the way it is. Paying 10% to service the debts does not bode well. I see that they have to keep the interest low to be able to service the debts but you’re right to say that inflation and low interest rate cannot continue indefinitely. So what is the solution?

Evelyn Guzman

http://www.debtchallenges.com (If you want to visit, just click but if it doesn’t work, copy and paste it onto your browser.)

[joebhed]

Paying attention to the machinations of the "whatever it takes" monetary policies of this administration is a VERY good thing.
The new "we must do SOMEthing!" Republicrat politics.

By a single focus on interest rate policy, you fail to address the true nature of what is happening

We who have operated on the debt-money, fractional reserve banking system are reaching our moment of financial come-uppance.

Yes, we NEED a deep recession.
Everyone would call it a severe economic depression, were it not for the safety-net programs created by FDR after the last conflagration.
But, WHY did that recession-­depression happen last time and why it is needed again now?

The seed is in that debt-money system.
ALL new money that is used in any year to enable economic growth is created as debt by private bankers out of thin air.

And the money to be used to repay that debt next year is created as debt.
Et cetera. Et cetera.
That is the fallacy of the debt-money system.
Thus forcing an ever-increasing theft from our productive economy to pay for the use of capital.

We have not learned the history lesson.
A debt-money system is unsustainable.
We need a monetary system that can sustain the economy.
We need to do away with the private federal reserve debt-money system
Otherwise, guess what?
Our grandchildren will repeat this unlearned lesson of history all over again.

Public credits.
Monetary transformation.

[Henry]

Michael,

"In fact, low rates that are the result of money printing have become our addiction.­"

This is not only ham-handed, it is technically not correct. There are two types of money in this country: one is coin & currency (fed reserve notes) and the other is demand deposits (checkable transaction accounts). Then of course the larger sense involves sav & certs of deposit and this M-3 type of money which involves repoes and reverse repoes. Printing money in the Fed Reserve Note form has nothing to do with the government predilection about money supply. It is solely driven by the member banks who need to stuff atm machines. Demand Deposits that the member banks use to purchase Fed Reserve Notes are a separate and distinct form of money...a sort that can be wire transferred, for example. This is where bond traders keep their "sendable" cash. Here is the balance sheet of the fed... take a look at this (part 4) and see the liabliity they have Fed Res Notes and the change. Then look at the change from a year ago in the other categories­...it tells the story.
http://www.federalreserve.gov/releases/h41/Current/

[KillTheMessenger]

You are answering only your own strawman. By "printing money" he means issuing debt. Duh!

[Henry]

The fed funds rate sets the floor for the competition of lending rates in this country.. Fed Funds at 1.5% gives a Prime rate of 4.5%. (Remember when Reagan was Pres and Prime was 20.0%?)
We have low interest rates because places like China monetize our debt (like the Fed purchase Treasuries­... same thing) creating more money, more liquidity. But now everyone is unwinding, the carry trade, hedge fund speculators, and mortgage backed securities. Everyone wants out... yet there is not sufficient liquidity to permit exist from "assets" into cash. (and then to Treasuries ergo the low rate) If the Chinese, for example, were to sell all their Treasuries, where is the liquid cash (this is not paper money that is printed) that would purchase this? It would crash the dollar (because they would move into Yuan) and inflation would shoot up as would rates. And you know what that portends. But...prin­ted federal reserve notes have essentially zilch to do with this.