What Happens to the Federal Debt If the Bond Bubble Pops?

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by Peter Schiff, SchiffGold:

Earlier this month, Mint Capital strategist Bill Blain warned that the bond bubble is about to burst.

A crash in the bond market would likely take stocks down with it, but there is another impact that is less obvious. It could have a huge impact on the United States’ ability to finance its massive debt.

As Dan Kurz of DK Analytics points out, the federal government would have a difficult time even paying the interest on the debt in a “normalized” interest rate environment.

Neither US federal debt, nor virtually any OECD government debt, could be easily carried with ‘normalized’ interest rates, which would readily be 2 to 5 percentage points higher than current short-term (ZIRP-dominated) and long-term (based on 10-year OECD government bonds with no or very nominal yields) rates. For the US government, whose cost of funds is currently around 1.4% thanks to both massively lower, QE-enabled long-term rates and to a propensity to fund deficits and refinance debt with more shorter-term funding — which has been extremely cheap thanks to ZIRP or near ZIRP for nearly nine years — every one percentage point higher average cost of funding $20.5 trillion in debt would equate to a $205 billion higher annual interest expense.”

Government bond yields fluctuate wildly from the mean. In fact, they are typically at “non-mean” levels. Yields tend to spike during and after periods of marked debt expansion, wars, and/or higher inflation. When this reverses, yields tend to sink far below the mean. Falling bond yields typically take the S&P 500 earnings yield down with it, as the following chart shows.

According to Kurz, a bond bust would trigger massively higher interest rates/massively higher 10-year government bond yields, i.e., yields that would substantially exceed the 4%-5% nominal historical yields associated with “investment grade” government bonds.

Kurz provides some historical context.

For some fairly recent historical perspective, consider that 36 years ago America was still a $227 billion net creditor nation (vs. an $8.3 trillion net debtor recently), government debt-to-GDP was 31% (vs. 103% recently), one measure of ‘published’ inflation was 9.4% (vs. 1.3% recently), and Volcker’s ‘tough love’ monetary policy coupled with high inflation expectations had 10-year Treasury yields reaching 15.3%. (vs. 2.4% recently).”

He compares this to the environment today and reaches a disturbing conclusion.

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