Monday, January 3, 2011


Back in late August, with interest rates at all-time lows I explained what would need to occur for interest rates to rise substantially:

“Inflation will likely occur during a recovery.? And by then all of this chatter of default and USD collapse will be long gone.? It might get the hyperinflationists hyperventilating again, but these same people fail to understand what hyperinflation actually is – it is the death of the currency that generally occurs due to a lack of faith in that currency.? And that my friends will not occur if we experience a booming recovery and a surge in loan growth.? The two simply do not go hand in hand.”

Since then, interest rates have moved higher (though still very low in historical terms).? This rise in rates happened to occur during the latest round of QE which has provided new fodder for the hyperinflation/default argument from the same pundits who have gotten that story wrong for as long as anyone can remember.? Of course, they’ve been claiming for years now that QE1 & now QE2 would result in hyperinflation and eventually some form of default.? But there is a a disconnect in their argument.? Uncle Sam’s prognosis has not deteriorated in recent months – it has in fact improved dramatically.? So what exactly is occurring here and do the higher interest rates spell impending doom for America?

When QE2 was initiated the Fed’s goal was to lower interest rates by purchasing government debt.? Some commentators said this would crash the dollar and cause runaway inflation.? It was described as “money printing” despite Ben Bernanke’s repeated efforts to explain why he was not increasing the money supply.?? But a funny thing has happened since this new policy was initiated – rates have surged.? This is a remarkable event.? Can you imagine if the Fed announced a target rate on the Fed Funds Rate and rates move in the opposite direction?? That would be a market shattering event, but in the context of QE it is overlooked largely because most people still fail to understand exactly what QE is.? As I’ve previously explained, however, the Fed can’t control the long end of the curve under the current strategy.? They’ve essentially put an unloaded bazooka on the table and the market knows it.? In order to truly control the long end of the curve the Fed would have to specify a target rate and be a willing buyer at any size.? This inherent flaw in QE proves that it was destined to fail before it ever began.? But that hasn’t stopped the hyperinflationists and defaultistas from trying to scare everyone into believing that the USA is about to sink into the same black hole that now consumes Greece and Ireland.

With rates rising they have latched onto the argument that higher rates mean we are being exposed as the insolvent nation they have long argued we are.? Of course, that’s nonsense for anyone who understands how the modern monetary system works.? In a recent article Michael Pento of Euro Pacific (Peter Schiff’s firm) writes:

“By 2015, our publicly traded debt is projected to be at least $15 trillion. Even if interest rates simply revert to their average level – not a stretch, given surging commodity prices and endless Fed money printing – the debt service expense could easily reach over $1 trillion, or about 50% of all federal revenue collected today. Just imagine what would happen if rates were to rise to the level of Greece, nearly 12% on a 10-year note, as opposed to our current 10-year yield of just 3.5%. I bet Athens, Georgia wouldn’t look much better than its namesake. Don’t forget: as interest rates rise, GDP growth slows, sending the debt-to-GDP ratio even higher.

Earlier this year, it wasn’t the nominal level of debt that suddenly sent euroland into insolvency, but rather a spike in debt service payments. Right now, the US national debt is the biggest subprime ARM of all time. Much like homeowners who thought they could afford a mortgage that was 10 times their annual incomes, Messrs. Krugman and Wesbury are blinded by deceptively low current rates of interest. These ostriches won’t poke their heads up to see the writing on the wall: low rates and quantitative easing cannot coexist for long. As rates continue to rise, the reality of US insolvency will be revealed.”

This isn’t the first time Mr. Pento or Mr. Schiff argued that the US dollar was doomed and that interest rates were going to surge and expose the USA as being insolvent.? In fact, they’ve been making this argument for well over a decade and interest rates have continued to decline and the US dollar has remained remarkably stable over the same period.? Inflation, has been remarkably low.? But what about the most recent surge in yields?? Are the gentleman at Euro Pacific finally going to be right??? The evidence says no.

Since the rally in yields began in September we’ve actually seen the hyperinflation story deteriorate further.? The surge in yields are not a sign that Uncle Sam is becoming Greece.? To the contrary, the rise in yields are a sign that Uncle Sam is recovering.? Productivity is increasing, the much feared double dip appears to be a thing of the past and yields are accurately reflecting this higher level of economic output.? Yields are rising because the economic outlook has improved – not because the US government is on the verge of imminent insolvency.? Rising economic activity will almost certainly be accompanied by higher inflation, but let’s not confuse hyperinflation (death of the currency) with healthy rates of inflation.

The hyperinflation story can be debunked easily by looking at the data itself.? As the equity markets rally on hopes of a sustained economic recovery we have seen a coinciding rally in the US dollar and a decline in 5 year US credit default swaps.? This is not even remotely close to what might happen if the government bond market were in fact pricing in default or hyperinflation.? One need look no further than the recent action in Greece for evidence.? As yields in Greek debt surged throughout 2010 their equity markets have collapsed and their credit default swaps have surged to all-time highs.? If it were not for the flawed single currency system in Europe you could guarantee that the Drachma would be absolutely collapsing right now (although the Euro has declined significantly).? The situation in the USA is EXACTLY the opposite.? Rising yields are occurring during a period when 5 year CDS are flat or falling (see chart below), equities are surging and the US dollar strengthens.? That is in no way consistent with an environment in which default or hyperinflation are likely to ensue.

So you can see that this is hardly an environment comparable to the one confronted by Greece, Ireland, Zimbabwe or Weimar.? This is not to imply that the US economy is without troubles (the still very low historical rates show that the USA has severe structural issues), but the most recent rise in yields should not be misconstrued as something that poses a risk of US default, dollar collapse or hyperinflation.? To imply as much is pure fear mongering and nothing more.? The rise in yields merely reflects a marginally higher rate of economic activity when compared to the severely depressed expectations of a few months ago.

In sum, the USA is not insolvent or on the verge of suffering a hyperinflationary collapse.? Anyone who argues as much simply does not understand how the modern monetary system actually functions in the USA.? Furthermore, the latest round of QE has been proven to be a failure as rates surge in the face of a Fed that has vowed to purchase $600B in government bonds, but failed to set a target rate on these purchases.? Make no mistake – this rise in yields is not a sign that Uncle Sam’s balance sheet is weakening.? It is a clear sign that Uncle Sam is recovering from a truly nightmarish economic situation.? Higher rates in the USA are not a sign that we are becoming Greece.? Rather, it is a sign that we are NOT becoming Japan (hopefully).? Let’s hope the recent trends truly do become sustained.? I still believe the USA faces extreme headwinds, but hyperinflation and default are not amongst them.


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