The backdrop

Financial markets are currently experiencing unprecedented circumstances :

• Already high debt levels are spiraling out of control: total US debt has reached $80 trillion, some 400% of GDP. (Plus, there are well over $100 trillion in unfunded future liabilities for pensions, medicare, etc.) Past growth was artificially subsidized by an unsustainable debt bubble.
• There has been massive and continuous stimulus since 2008, now reaching a crescendo: the US Senate last week approved $1.9 trillion of stimulus (in addition to $4 trillion of stimulus in 2020). The US is discussing another $3 trillion infrastructure plan.
• Money supply growth has been high and is accelerating: twenty two percent of circulating US Dollars were printed in 2020 alone¹.

The largest financial market in the world is the US Treasury market, and the most important economic signal — US Treasury interest rates. (The rates going from 0-30 years create a curve know as the yield curve). The 10 year interest rate shot up by 60% in February 2020² (reaching 1.6% on March 5th). Markets (and presumably also the Fed) are concerned not just about the absolute rate, but the speed at which rates are rising.

Higher interest rates impact individuals, corporations and Government. For example, if the cost of financing $80 trillion of US Federal Government debt goes up just 1%, that’s an increased interest cost of $800 billion per year, more than a quarter of federal tax receipts. The US experienced a post World War II record 16% deficit-to-GDP ratio in 2020 –quite an accomplishment given the very low interest rates at the time.

The world is awash in such massive debt levels, it cannot support higher interest rates.

What are the Fed’s Options?

The Fed is caught between the proverbial rock and a hard place.

There is the option of letting interest rates rise—which would rapidly suck oxygen out of the economy, causing a crash that may rival or exceed the Great Depression.

The only possible justification for recent equity valuations has been low interest rates; a rise in interest rates triggered the recent tantrum on stock markets—interest rates rising much further could trigger a crash.

The other option for the Fed is to suppress interest rates (via YCC). It can do so because it may print virtually infinite amounts of money, with which it may buy bonds, (thereby driving up prices bonds, reducing yields).

YCC was successfully used after World War II to help pay back mountains of wartime debt. We are likely to see YCC for the first time since the 1940’s.

Why YCC is the likelier option: what to expect in the short-term?

The Fed will do everything possible to avoid YCC– a massive distortion of free markets which would increase moral hazard and risk taking. The Fed will wait until there is a trigger point of pain in financial markets, which leaves no choice. The turbulence of the past weeks is a prelude to the volatility we are likely to experience in coming weeks, until either interest rates subside without YCC (unlikely) or the Fed implements YCC.

Why are interest rates rising? The Fed claims it indicates a healthy recovery; an likelier explanation is that rising inflation expectations are driving up interest rates. If the latter, it has the power to drive interest rates much higher.

There are many direct and indirect signs of inflation:

• Commodity prices—from soybeans to metals–are rising dramatically, working their way into the supply chain.
• Transport and logistic costs are also rising (container costs from China to the US have more than doubled in 2020).
• There has been strong job growth in the US; a doubling of minimum wage is under consideration by Congress.
• Chinese exports were 60% higher in February 2021 compared to a year higher.
• Microchips shortages are creating bottlenecks. For example, several auto manufacturers had to shut plants for weeks.

Many market observers foresee an unleashing of demand once the pandemic subsides, speeding up velocity of money.

While acknowledging that there are also strong deflationary forces at work, I would wager that over a 2-5 year horizon, inflationary forces will dominate. Inflation often appears as a surprise; once the toothpaste is out of the tube, it’s very difficult to put it back in. Inflation expectations will push interest rates to a level leaving the Fed no choice but to implement YCC.

Implications of YCC

YCC would likely suppress 10 year interest rates below 2% in the US, with lesser rates on shorter maturities. It would represent an unprecedented transfer of wealth from savers to borrowers and cause a loss of confidence in the US dollar, leading to its devaluation. This in turn will help trigger even higher inflation in the US. Turbulent times ahead.

This article does not constitute investment advice and makes certain projections for the future which may or may not materialize.