Under normal circumstances the rising risk-free rates
(treasuries) coincide with a rally in the markets as corporate
bond spreads narrow, and, thus, corporate borrowing costs
decline. However, if rates rise too high, that process no
longer matters, as rising rates start dragging borrowing costs
higher for everyone. We are essentially at that point now -
interest rates rose since December 2008, and spreads + volatility
in the markets declined as the crisis abated. However, as
10 year rates hit 4%, that was too high to become bad.
The situation is rather precarious. Due to the record budget
deficit (low revenues, high expenses on stimulus and stuff)
our government is essentially bankrupt and has to sell a lot
of bonds into the market. This process is leading to higher
rates, while it is only partially monetized by the Fed.
Note that the same exact process happens when countries
experience a run on the currency. The Fed wowed to bring
mortgage rates down to 4-4.5% by the Summer through
Quantitative easing (printing and buying longer maturity
bonds). That process so far backfired as 10-year rates rose to
4% and mortgage rates above 5%. While entirely expected
(the government has to sell a lot of bonds to fund stimulus!),
this Fed failure undermines the credibility of the Fed.
Thus, it, most likely, will lead to a crisis of confidence
in the Fed and a new leg of the crisis. In other words,
the worst is yet to come... Things could get very, very
ugly. I am not predicting they will, but they certainly could.
Oh, and the currency could drop also.
Ouch.
In other words, the next leg of the crisis will likely
be a currency run.
On the positive side, the currency run is always the last
leg of the crisis.
On the negative side, it is that way because things get
extremely ugly, and, in fact, the crisis may not end
there if the Central bank cranks up the presses. Then
things get from bad to worse, as the currency disintegrates
completely in hyperinflation that completely destroys the
whole country. The latter is known to last decades in some
countries, until
the corrupt link between the government and the financial
sphere is broken. |
