In the analysis ‘Liquidity in financial markets dries up, systemic crisis threatens’ we wrote that global debt has risen to such an extent that a system-disrupting crisis is ultimately unavoidable. That’s because Treasuries, foremost US Treasuries, serve as collateral in the global financial system to create new credit for investment or speculation, or to roll over old loans. In this way, our collective debt has grown much faster than the underlying real economy over the past thirty years. At the time when Fed Chairman Paul Volcker raised the Fed’s policy rate to 21%, the size of the US government debt was still 30% of gross domestic product. Now in Jerome Powell’s time it’s 130%. And that’s not even counting the unsecured liabilities.
Now that the global economy threatens to enter a recession and governments are forced to financially compensate citizens and companies to mitigate the high costs of the energy and food crisis, this ratio is likely to become untenable. Higher interest rates are a real threat to our prosperity. In this analysis, describe what happens if interest rates continue to rise. Inflation risk, credit risk, capital loss and the mechanism of the debt spiral are discussed. Provided, of course, we do not know when there will be an acceleration of capital flight towards security. It is also impossible to say in advance what the preferred safe harbor will be. Investing is more psychology in this regard, we cannot rely on historical data and econometric models.
More importantly, can we guard against this negative spiral that will end in debt deflation or hyperinflation? Absolute. But with a different mindset than most people consider.
At present, the global debt-to-GDP ratio is around $300 trillion. The global real economy, the basis for taxation, is around $100 trillion. Most of the interest on debt must be paid from the real economy. Suppose the average coupon rate on the debt is now 3% per year, then the real economy must grow at 9% per year to be able to bear the interest burden alone. This does not even include paying off the debt.
If the underlying economy stagnates, or even shrinks, the debt-to-earnings ratio quickly deteriorates. This naturally means more interest income for creditors, but debtors run into problems more quickly if the interest burden rises quickly. Zombie companies and governments with high debt ratios in particular will be in trouble. Take, for example, the interest on Italian 10-year government bonds, which has risen from 0.7% to more than 4% in one year.
Global debt to record high (Source: Institute of International Finance)
Interest rates have declined steadily since the early 1980s. In the mid-1980s, the interest on a 30-year US Treasury bond was about 15%. Last year, that interest had fallen to 1.2%. This means that for more than thirty years, investors in Treasuries have been able to benefit from an increase in the value of their investment. Because if interest rates fall, the value of the loan rises. Incidentally, this increase was much less spectacular if the deposit was reinvested in a loan with a lower coupon rate.
Think of the equity on a house. That seems nice on paper, but the proceeds from the sale usually have to be reinvested in a new home that has also increased significantly in value. Only if the proceeds are invested in another successful investment can there be direct profit. However, pension funds, insurers and asset managers generally chose to reinvest the money in government bonds with a lower coupon rate. On paper, these mutual funds kept getting richer, but in practice they were fictitious profits. However, that only becomes clear when interest rates start to fall.
From mid-2021, there will be a steady rise in price inflation. Central banks have long maintained that this inflation was a temporary effect and therefore kept their policy rates low. Capital market interest rates also lagged behind and lagged behind rising inflation. From the beginning of this year, however, that quickly changed. Central banks have turned like a leaf on a tree and are raising policy rates in large steps. Capital market interest rates have also risen rapidly.
Interest rate hike
If an asset manager bought a thirty-year Treasury bond with a coupon rate of 1.2% in mid-2021, it has now risen to 3.5%. The value of the deposit has fallen from 100 to 70 in the same time, which means that the asset manager would have suffered a 30% loss on the deposit if he had to sell the Treasury bond now. If price inflation continues and interest rates rise even further, many parties who have bought loans with a low coupon rate will see significant losses. The longer the term, the greater the negative effect on the value of the loan if interest rates rise.
A rise in interest rates hurts in several ways. Companies that struggle to keep their heads above water have a harder time raising capital to roll over their existing debts, because they are more likely to go bankrupt in a stagnant economy. Homeowners who have a variable mortgage rate have to pay considerably more interest per month. Equity investors are faced with falling prices. Renowned hedge fund investor Ray Dalio states that stock markets could fall by 20% if interest rates rise to 4.5%. Hedge funds with a 60/40 portfolio (60% equities, 40% loans) see their gains of recent years evaporate and turn into large losses. More than 15% this year alone. Both stocks and bonds are steadily declining.
The most important pain point, however, lies with governments that have a lot of debt. They have to pay a higher coupon rate on every loan they roll over (governments have stopped repaying loans since the 1980s). If interest rates continue to rise and remain at a high level for a longer period of time, the interest burden will steadily increase. The US currently has an interest burden of around $900 billion. If the average interest rate on their government debt goes to 4% (current rate 1-year Treasury bill), the interest expense increases to $1,400. This will not happen immediately, but the burden will increase the longer the period of higher interest rates lasts. That’s because governments are constantly rolling over their debt by issuing new bonds. If the interest rate is high for a long period of time, an increasing proportion of the total debt must be rolled over at this interest rate.
1-year Treasury bill (Source: Trading View)
The $500 billion increase in interest charges could be met by the government by cutting social spending or defense. The first will fuel the already great discontent, the second will not be tolerated in this time of mounting geopolitical tensions. Remains to borrow on the capital market. However, this will lead to an increase in inflation risk and credit risk, which in turn will lead to higher interest rates on Treasuries. It is a negative debt spiral that is very difficult to break. In addition, if geopolitical tensions between Russia and NATO escalate, the market could quickly lose confidence in a favorable way out.
What can be done about this as a private investor, asset manager or institutional investor? Yes, of course. In 2008, investor Michael Burry made huge profits during the credit crisis, because he had been hedging since 2005 against a fall in value of notably ‘subprime’ mortgage loans. He did this by investing in so-called credit default swaps (CDS). These are insurance policies that pay out if the value of a loan falls below a pre-agreed price. Banks, such as Deutsche Bank and Goldman Sachs, sold these financial products to Burry because they initially thought the housing market would never collapse. When mortgage loans fell sharply in value, they had to pay out the insurance to Burry. He made millions with his hedge fund Scion Capital. The feat is beautifully written by Michael Lewis in the book ‘The Big Short’, which was later made into a film.
Although government bonds from creditworthy countries are labeled as ‘risk-free’, it is also possible to invest in a CDS that hedges the credit risk of countries. The price of a CDS shows whether investors will estimate a country’s credit risk higher or lower. Countries will not go bankrupt anytime soon, however, because there is always a central bank that can buy government bonds in times of stress. As former Fed Chairman Greenspan once said in an interview: “The United States can pay whatever debt it has because we can always print money to do that.” In that case, however, credit risk will quickly turn into inflation risk. Investing directly in a CDS is then not attractive, because the payment is made in the currency of the government against which it is hedged. Part of the profit has already evaporated due to the depreciation of the currency.
Greg Foss, a Canadian investor who has thirty years of experience investing and speculating in corporate, mortgage and government bonds, calculated that holding part of an investment portfolio in Bitcoin can be seen as a CDS on government bonds. In a recent
he calculated this as follows:
Updated: Some fun #math and #btc (thread)— FOSS - Lehman CDS at 9bps in '06, 🇨🇦 now at 41 (@FossGregfoss) September 13, 2022
5yr CDS on the USA is 22bps (22k/yr to insure 10MM of debt against default)
Total federal debt for USA is $31T funded plus $170T unfunded
20yr CDS equiv is 88bps so:
$200T debt x .88%p/a = $1.76T premium#btc mkt cap of $386B
“U.S. total government debt is currently $30 trillion (of which $24 trillion can be traded). Total unsecured liabilities are $170 trillion. Right now, insuring against a $10 million loss on five-year US Treasuries costs $22,000 a year. The average duration of all outstanding loans is 20 years. The insurance cost of 20-year US Treasuries is currently $88,000 per year. Multiply the insurance premium by 200 (the total debt) and you arrive at $1.76 trillion. The current market cap of Bitcoin is around $386 billion. Foss sees Bitcoin as a CDS on US government debt that can be purchased at a 78% discount.”
Foss gives many interviews about this approach and he wrote an extensive analysis about it in 2021. In short, the debt spiral that governments will get into cannot be reversed by financial instruments sold within the debt system itself. Governments will always resort to central banks if the market loses confidence in creditworthiness. The pressure on governments to finance the deficits of consumers, companies and financial institutions will be immense. In the current energy crisis, but the corona crisis has come earlier, it is clear that governments are willing and able to let their finances get out of balance in order to buy off the constructive dissatisfaction.
It is therefore wise to insure against the risk of monetary financing. Foss’ reasoning is not based on wishful thinking. Renowned credit analyst Zoltan Pozsar of the Swiss major bank Credit Suisse also considers Bitcoin, along with physical gold, to be ‘outside money’, money that is neutral and has no counterparty risk. Currencies such as the US dollar and the euro, which derive their value from government bonds, have lost their neutrality since the political decision by Western governments to freeze the reserves of the Russian central bank.
By investing in gold and Bitcoin, an investment portfolio can be hedged against liquidity risk, credit risk and inflation risk. As we also argue in our book From Gold to Bitcoin! How much that should be depends on the personal situation. It should also be taken into account that Bitcoin is a relatively new technology and therefore a relatively new category within an investment strategy. We tell more about it in our book, but you can also contact us if you want to know more.