The world is awash in debt while interest rates are extremely low and at unprecedented levels. Interest rates have been engineered lower by central banks out of necessity. This “necessity” is not so much to spur the real economies on (as they say), rather, rates have been crushed to facilitate the payment of debt service. Bluntly, there would be no financial markets left if rates were at a historical norm of say 7%. The danger of course is that rates do go higher …! What if interest rates do go up? This is a question no one even asks anymore.
This is not to say central banks will ever willingly raise rates around the world. They will not, they cannot! However, there are scenarios where market rates go up all over the world in the face of and in spite of central banks. This could occur for a myriad of reasons but I believe the prime possibilities to be a currency crisis where a major currency or currencies begin to lose purchasing power rapidly, or a major default or a domino of defaults.
Thinking this through, were a major currency to collapse versus other fiats, interest rates would need to rise in that particular region to “risk adjust”. Additionally, were ALL currencies collectively lose purchasing power (think versus gold/silver “going up”), interest rates would also need to rise to risk adjust. You might want to read the previous sentence a couple of times because THIS is exactly why gold and silver have been sat on all these years, to prevent the perceived need for rates to go higher to adjust for currency risk.
Looking at the default issue, as bonds go through the process of defaulting, their prices drop. Lower bond prices mean higher yields, simple related math. If a sector or even sovereign region threaten to or actually default, rates associated will go higher. Should a default begin and turn into a global domino series, rates everywhere will go higher unless central banks buy everything sold and hold in their portfolio defaulted credits (as they did in 2008). In reality, this is exactly what caused the problem in the first place, central banks buying up everything in sight …including stocks!
Now, let’s look at what higher rates would mean? Obviously higher rates would slow business/commerce/trade but more importantly will hit the financial sector like a sledgehammer.
I used the term “sledgehammer” for a reason. Were rates to rise from 7%to 9%, yes financial assets suffer but it is not disastrous. But what if rates went from 2% to 4%? Or in the case of $17 trillion of negative yielding global debt, what if rates go from negative to a positive 2%? I haven’t done the math but 30 year bonds going from negative to 2% would mean a loss of value of over 50% in these “safe haven” investments!
Also, “who” gets killed if rates were to rise? The simple answer is anyone holding bonds… and in reality EVERYONE. Drilling down on a few examples, pension plans, banks, mortgage holders and yes, even central banks! Pension plans on average probably allocate 30-40% of their portfolios to bonds. Banks have huge debt holdings on their balance sheets and would be drastically impaired/insolvent from portfolio holdings. And the worst case of all are the central banks, they would be collectively rendered insolvent were rates to go higher. I don’t know what the exact number is but I would guess a full 2% rise would certainly kill the BOJ and ECB because they have loaded their portfolios with zero or near zero interest rate debt over the last 10 years.
About two years ago I and others were talking about the Federal Reserve having a negative net worth because the drop in value of their portfolio holdings had wiped out equity on a mark to market basis. It didn’t matter many said because the Fed would hold all their securities to maturity. This is true but 10 years or even 30 years is a long time to hold something. Besides, rates were only 1% or so higher at the time, what woud 2% higher from here mean other than “more insolvent” and deeper negative equity? Or God forbid, what if interest rates were actually made by Mother Nature and reverted to a historical 7% mean?
We could go through all sorts of examples but the bottom line to higher rates will basically mean “everything is worth nothing”! A very big statement for sure but is it really off the mark? If central banks are insolvent …and they are the ones who issue the “money” (the currency), what is the money worth? Fiat currencies are “chits” or IOU’s, would you willingly lend your next door neighbor funds if you knew him to be insolvent? Would you invest in any corporate, state/local, or even sovereign debt if you knew the issuer to be insolvent?
And the biggest question of all, would you accept in exchange for goods or your labor, a currency issued by a central bank fully known to be insolvent?
These are all hypothetical questions to this point but I believe very valid today but 100% real in the long term. As I have harped on for several years, there is not enough “money” in the world to service and pay off the amount of debt outstanding. In order to create enough money to actually pay off current debt, central banks will need to create more money?
One might ask, how do they create more money? Simple, via new debt which is how central banks increase money supply. But then even though there is more money to pay off the debt, the amount of debt outstanding has also increased… not to mention there would then be more money stock versus real assets and the money itself is diluted.
My hope is that by reading this you will go through the thinking process of what it all means. Without saying it, you just read “why” interest rates can never in your lifetime (even if you were born yesterday) go up 2 or 3% much less normalize to 7% without something very real and very important breaking. Another way of saying this is that life as we know it will change drastically (and not for the better) if rates actually begin to rise. Markets today are priced all over the world in a fashion or belief that rates will never ever rise. I assure you this is incorrect thinking and logic. No, central banks will not willingly raise rates but the grand policy error of global over indebtedness will open the door for Mother Nature to step in.
To conclude, the above in its entirety is a description of why the central banks will need to accelerate QE to infinity. It is the “how” asset prices (except gold and silver) have risen to levels never seen or even imagined before. It is why central banks have crushed rates essentially to zero and why sovereign treasuries have ruined their collective balance sheets since 2008. It is why …the shit is guaranteed to hit the fan!