Are You Prepared for the Upcoming Sovereign Debt Crisis?
A global sovereign debt crisis is brewing, and the evidence is only everywhere. It has now escalated from a “what if” scenario, to a serious possibility. Official pronouncements that “all is well” are becoming more suspect against the rising tide of declining balance sheets.
There are several reasons why this is happening now, and most of them are rooted in financial and economic policy over the past few decades.
The Bond Bubble Since 1980
There are all kinds of theories about what has been driving the US economy since the recession of the early 1980s. But the most consistent driver, and almost certainly the most powerful, is the steady decline in interest rates. That has created a bond bubble of historic proportions.
Bond prices run in the opposite direction of interest rates. When interest rates rise, bond prices fall. Conversely, when interest rates fall, bond prices rise. Interest rates have been on a slow steady decline since 1980. That means that we been in a rising bond market for the past 35 years. 35 years looks a lot like a bubble.
Consider that the Prime Rate peaked at 21.5% on December 19, 1980 and stair-stepped down to 3.25 on December 16, 2008 It has remained at that low level ever since – or for nearly seven years.
Flat or declining interest rates have become an article of faith in the US over the past several decades. The assumption is low interest rates forever, and all kinds of economic and financial decisions are made with that idea in mind.
This is also likely the major reason why the stock market has been in a parallel bubble over the same space of time. With interest rates being so low – current rates on short-term U.S. Treasury securities are well below 1% – bonds cannot compete with stocks. In order to get healthier returns, investors have been pouring money into the stock market since 1982.
This has created twin bubbles in both bonds and stocks. But both are paper assets, with no intrinsic worth. And both are likely to unwind for the very same reasons. In that environment, neither will represent a meaningful diversification from the other.
The New Reality: Debt Replaces Cash
In an environment of super low interest rates, it’s easy for governments, companies, and individuals to borrow money. In fact, it’s easier to borrow money than it is to save it up. As a result, debt has now replaced cash as the preferred medium of exchange.
Rather than issuing stock in order to expand their businesses, public companies are instead using debt both to finance growth, but also to repurchase their own stock. These repurchases reduce the number of shares outstanding, and generally increase the share price. In that way, the price of the stock can rise even though the underlying fundamentals of the company don’t improve.
But there’s no need to improve, or to save money, when debt can be had so cheaply.
Low Interest Rates Guaranteed One Thing: More Debt
It has often been thought that low interest rates would represent an opportunity for debtors to reduce their debt loads. With declining interest rates, debt service payments will also be lower. In theory, that would enable debtors to pay higher amounts of debt principal, thereby getting out of debt faster.
The opposite has been true. Since servicing debt has become so inexpensive, the levels of debt of almost every kind has steadily expanded in recent years. There is more debt outstanding now than there was going into the Financial Meltdown.
Student loan debt is an excellent case in point. Back in February, the New York Fed reported that student debt had reached $1.16 trillion, up from $90 billion in 1999. That’s greater than a 12 fold increase in only about 15 years.
The Global Sovereign Debt Dominoes Are Already Falling
Once major countries begin defaulting on their sovereign debts, there’s no telling where – or if – the defaults will stop. Russia and Brazil already have junk debt status and they are two of the largest economies in the world. Both countries were “awarded” junk status in 2015, representing a disturbing trend.
Should investors and citizens of those countries begin unloading their currencies, that could translate into a general panic out of paper – including stocks, bonds, and yes, even US Government Treasury securities.
The US Government is Not Immune to a Sovereign Debt Collapse
The stampede out of paper could be exacerbated by debt problems that have become epidemic in the US.
In 1980, the US National Debt stood at just under $908 billion. In that same year, the US gross domestic product (GDP) was $2.86 trillion. The national debt represented less than 32% of GDP in 1980.
What that means is that not only has a nominal amount of the US national debt increased by a factor of 20 since 1980, but its percentage as measured against the GDP has more than tripled.
The US is now flirting with third world levels of sovereign debt obligations. A collapse of the debt could happen, as a result of any one or combination of a number of factors, including a general meltdown in paper assets, a serious decline in the economy, the dramatic spike in government obligations as a result of the economic decline, or even a general panic.
The possibility of a sovereign debt crisis in the US can no longer be ignored.
States and Municipalities are in Even Worse Shape
There’s a complication with the US debt situation that makes it even more precarious. Mirroring the federal government, various US states have been spending more than they take in for decades.
As just one example, Illinois’ unfunded liabilities may exceed $160 billion. And Illinois is not the only example, though it is one of the worst. Many states, especially the big ones, have very large obligations, both official and unfunded.
It is not inconceivable that at some point in the near future, such as during an economic collapse, the various states turn to Washington for help. When they do, both the US fiscal and debt situations will become substantially worse.
We’re no longer talking theory here – a sovereign debt crisis is now a distinct possibility.
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