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Debt Is a Powder Keg and Rising Interest Rates Are Matches

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If you look at past financial and economic crises, what is the common denominator?

Debt.

That’s why we talk so much about debt on these pages. 

As we reflect back a decade after the onset of the Great Recession, we can’t help but see stunning parallels. As a recent Forbes article put it, “Ten years have passed and the idea that we have learned our lessons seems at best quaint and at worst laughable.”

One of the most basic lessons not learned is that a massive buildup of debt tends to end in a serious financial crisis. Even a small liquidity event that gets in the way of rolling over higher and higher amounts of debt eventually brings down the whole edifice.”

It wasn’t just the 2008 crisis. Go all the way back to the tulip mania of the 1630s and debt rears its ugly head. The tulip bubble was fueled by the increase in leverage created by “tulip futures,” not unlike the housing bubble and mortgage derivatives leading up to ’08. In fact, a long line of crises, from the 1982 Latin American debt crisis, to the 1990 Savings & Loan crisis, to the 1990 Japan crash, to the 1997 Asian crisis — they can all be traced to out-of-control credit growth.

But the powers-that-be never learn. After the 2008 crash, what did the government “leaders” and central bankers do? They stoked another massive buildup of debt with artificially low interest rates and money-printing. The result? Gallons of red ink spilled in government, personal and corporate sectors.

From Forbes:

This is, alas, not surprising. As Prof. Richard Kindleberger from MIT put it in his 1978 classic book ‘Manias, Panics and Crashes’ some time has to pass after a crisis ‘before investors have sufficiently recovered from their losses and disillusionment to be willing to take a flyer again.’  Ten years, it seems, qualifies as enough time for the party to resume.”

We’ve been chronicling the massive amount of global debt over the past year or more.

In August, the US government set a single month spending record, running up a monthly deficit of $214 billion. According to conservative estimates, the annual budget deficit will come in at over $1 trillion in 2019. Total US debt stands at over $21.3 trillion.

Meanwhile, the American consumer is also drowning in red ink. Total household debt hit a record $13 trillion in 2017, eclipsing levels seen on the eve of the Great Recession. Total consumer debt rose by another $176 billion in Q2 of this year, a 4.8% year-on-year increase.

Then we have corporate debt. It currently stands at about 45% of GDP. According to Moody’s, the majority of US companies have a “speculative” credit rating, meaning they are considered high risk. According to the McKinsey Global Institute, corporate bonds issued by non-financial companies globally have almost tripled since 2007 from $4.7  trillion to $11.7 trillion.

Even the precipitous stock market rise has been driven, at least in part, but borrowing. Margin debt is also at the highest level in decades, well over 3% of GDP.

All of this debt is a giant powder keg. And rising interest rates just might be the match that lights it.

As we reported earlier today, bond yields are rising. Two-year government borrowing costs hit their highest level in a decade Wednesday and the yield on the 10-year is above 3%. Private sector interest rates are generally linked to Treasury rates, at least casually.

Just consider the impact of rising interest rates on an over-leveraged corporate world.

Higher interest rates or a slower economy may affect the ability of any given company to service, roll over or repay that debt, which then leads to a downgrade into the “non-investment grade” (i.e. junk) category. This, in turn, forces some bondholders to liquidate their holdings. If this goes beyond an isolated event, the risk of downgrades snowballing into a liquidity crisis becomes real.”

Rising rates are equally problematic for the federal government. The government spent $32 billion just servicing the current debt last month. Every uptick in the interest rate ups that number. At the current trajectory, the cost of paying the annual interest on the US debt will equal the annual cost of Social Security within 30 years.

As the Sovereign Man has pointed out, higher interest rates will have an enormous impact on just about everything.

Many major asset prices tend to fall when interest rates rise. Rising rates mean that it costs more money for companies to borrow, reducing their leverage and overall profitability. So stock prices typically fall. It’s also important to note that, over the last several years when interest rates were basically ZERO, companies borrowed vast sums of money at almost no cost to buy back their own stock. They were essentially using record low interest rates to artificially inflate their share prices. Those days are rapidly coming to an end.”

Forbes sums it up in pretty stark terms.

History shows that beyond a certain level, debt burdens become too heavy to bear. It is not clear what that level might be, when it will happen, or how severe a crisis could get.”

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