How do interest rates rise safely?

3 mins. to read

Since the collapse of the Bretton Woods agreement, and with it the gold standard, monetary policy has changed dramatically. Instead of observing the money supply changing as a function of economic conditions, central banks now control it directly with the help of conventional tools as interest rates, and also unconventional tools as quantitative easing.

The continued rise of the welfare state has led to ever increasing sovereign debts around the developed world and monetary policy has simply become an extension of fiscal policy to help governments achieve their goals of issuing these growing mountains of debt. A rising national debt could however only lead to bankruptcy if no distortion is induced by an institution such as the central bank. This is the unique privilege that Governments enjoy. Just try going to your bank asking for loan after loan, one to finance the other… I’m pretty certain what my local manager would say! At first, they may accommodate with a raised interest rate until the point it become obvious that you just can’t repay and then no one would lend you a cent. But, this hasn’t been happening in bond markets. Interest rates around the world are relatively low. And the answer to this conundrum lies squarely with QE.

The US national debt was around $5.6 trillion in 2000 and has now risen to the current $16.8 trillion. This is a rise of 186%, and which means national debt has almost tripled in less than 13 years. In the same period, the real growth rate for GDP was around 20%. With expenses rising at a much faster pace than income, the situation is unsustainable. 

But, let’s look to 10-year Treasury bonds. They’re currently yielding 2.06%. Something is quite wrong here…

Investors aren’t collectively so naive, so why are they buying Treasuries yielding around 2% at a time national debt is rising to unsustainable levels and inflation probably rising above 2%, so making the real return negative?  Answer is that ‘investors’ aren’t. The FED is the primary buyer.

Since 2000, the FED jumped into the bond market to help the US government. At first they did this through keeping interest rates low but, after 2007, they were forced step in with additional measures as interest rates were already low and of course the GFC was just beginning. The FED is now buying Treasuries directly and so this extra demand is what keeps yields on the 10 year at a wholly unjustified 2%. The FED has created an economic distortion and which continues to find an outlet through localised asset bubbles at the same time.

Interest payments on the current $16.8 trillion debt pile amount to $335 billion at a rate of 2%, should a more realistic level of 5% be applied then the cost would rise to $840 billion. If interest rates rose to the 1981 level due to late stage inflation, the debt servicing cost would rise to a huge $2.6 trillion – 100% of tax receipts.

With all this in mind, monetary policymakers now face a dilemma – to let interest rates rise or not. The options they face are as follows:

1. Let interest rates rise – This option means halting the central banks bond buying programs and allowing for a natural interest rate adjustment. With the reduction in Treasuries demand that would result, Treasuries would fall whilst yields rise and Governments could eventually be forced to restructure debt. Banks would fail. The world, in its current form, would be back in a mess.

2. Prolong as possible any interest rate rises & let inflation ebb away at the real cost of the debt – This will keep interest rates artificially low but will generate, ultimately perhaps not hyperinflation but very sharp rising prices as main street finally cottons on and faith in fiat money wanes. Debt remains elevated in nominal terms but will be easier for the government to pay it.

Can you guess the route the FED will follow? Grab that silver, platinum, gold miners and gold while you can is our mantra.

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