In 1994, Bill Clinton’s political adviser James Carville famously said, “I used to think that, if there was reincarnation, I wanted to come back as the president or the pope, or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”
On November 8, 2016, one day before the election, the yield on the 10-year U.S. Treasury bond stood at 1.88%. As I am writing this, it has jumped to 2.32%, a 23% increase. Also, 30-year mortgage rates are now over 4%.
Bondholders are now selling off bonds, fearing that President-elect Trump’s spending-and-trade policies will cause government deficits and inflation to go up, in turn causing interest rates to rise and the value of their existing bonds to fall.
The Reagan Model
Some hope that Trump’s Reaganesque plan of increasing government spending on the military and infrastructure in conjunction with tax cuts is the jolt our economy needs to push GDP growth from our current 2% to something north of 3%.
The U.S. and the world, however, have much larger levels of debt than when President Reagan took office in 1980. At that time the ratio of private debt to GDP was 100%. Today it is 150%. Before the Great Depression it was 140%, and right before the 2008 Great Recession it got as high as 170%.
So, with a current GDP of $17 trillion, private debt today—which includes mortgages, car loans, debts businesses have, etc.—is about $25 trillion, 50% more than when Reagan took office. This debt brought forward purchases that consumers and businesses would have made in the future. Moreover, it presents a potential “wall” for any U.S. president hoping to increase economic growth.
Rising Rates and Debt
High debt levels get exasperated with spikes in interest rates as highly leveraged consumers and businesses rush to pay down their loans. Rising rates also reduce new borrowing. Moreover, if people pay down loans faster than others take out new ones, the money supply shrinks.
Contrary to conventional wisdom, it is consumer and business borrowing activity, not government spending or tax cuts, that increases the money supply. And trying to get the economy to grow faster when the money supply is shrinking is like trying to gain weight by reducing calories.
The Whole World is Drowning in Debt
Many countries have debt levels higher than that of the U.S. Plus, many of them have banking systems that never flushed out the bad debts after the housing debacle and the Great Recession. Most of these nations have interest rates already lower than ours. And when our rates spike, money leaves the currencies of those countries and goes into our dollar, causing the dollar to rise in value vs. the euro, yen, etc.
A rising dollar puts our businesses at a disadvantage, as a high dollar makes our goods more expensive for consumers and businesses in other countries to buy. A high dollar does allow U.S. consumers to buy goods from other countries at lower prices, but these purchases help firms in those nations, not businesses here in the U.S.
The Paradox of Thrift
Even if the spending-and-tax-cuts jolt works and middle-class people finally start seeing their wages go up, there is a chance that, instead of spending that additional revenue, they will use it to start paying down their debts. If that happens, the economy may slow, because your spending is someone else’s income.
The Road Forward
Lots of important economic issues were discussed in the primaries and in the general election: inequality, stagnant wages, trade, immigration, and currency manipulation. However, maybe the most important issue—the level of private debt—was ignored. Until that is addressed, we might be trapped by the whims of the bond market.
These are the opinions of Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only, and should not be construed or acted upon as individualized investment advice.
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