Alan Greenspan was on CNBC this past Friday saying that he’s worried the markets will revolt against the US government and the dreaded bond vigilantes will attack sending yields shooting higher and sending the USA into some source of downward spiral similar to Greece. CNBC reports:
The former central bank leader — nicknamed “The Maestro” by his supporters — said he worries the current economy could be heading on a path similar to 1979, when the 10-year Treasury note was yielding around 9 percent before surging dramatically, gaining 4 percentage points in just a few months.
“I listen to a lot of what people say that we don’t have to worry. We can do it in our own time,” Greenspan said in regard to trying to bring down Washington’s $1.2 trillion budget gap. “Good luck. The markets have not been told this.”
Dr. Greenspan’s been saying this for a long time now and I’ve been taking the other side of this coin for a long time. The difference in opinions is quite simple. So bear with me while I elaborate a bit. The United States Treasury has a very unique relationship with its banks and Central Bank due to political unity. While it’s true that the US Treasury must always have funds in its account at the Fed, it’s also true that the Treasury will never have trouble procuring funds to credit this account. It’s a simple process. The Fed and Treasury have a symbiotic relationship in which they coordinate their actions. The debate over Fed “independence” is a semantic one. Whether you want to call the Fed “independent” or not doesn’t accurately portray the reality that the Fed works very closely with the Treasury to ensure that funding is always available. And they do this by harnessing the private banks as agents of the government. The Primary Dealers are required to bid at US Treasury auctions. That’s just part of the gig. And so long as the Fed is coordinating their actions with the Primary Dealers (which they do daily) then we shouldn’t expect Treasury bond auctions to fail (these are well coordinated events designed NOT TO FAIL).
So what’s the key for bond investors? Well, they know that they never have to worry about getting paid by the US Treasury (unless Congress decides to default via some silly self imposed constraint like the debt ceiling). It’s also important to note that this is nothing like Europe where there is no political unity between the governments and the ECB. It’s a design flaw that creates a solvency risk. What Europe really needs is an autonomous currency issuer either in the form of each nation having its own currency (and control of that currency) or some form of US of Europe.
Now, to be clear, there is a form of solvency risk in the USA which could send rates shooting higher. And it comes in the form of inflation. But this is a very different constraint than the solvency constraint that many assume exists in the USA. In the USA, with high unemployment, low capacity utilization, stagnant wages and a persistent balance sheet recession (de-leveraging) there is no fuel for very high inflation like we had in 1979. I’ve been downplaying the potential for high inflation or hyperinflation for 5 years now. It’s just not happening! The de-leveraging is barely being offset by the government budget deficit (which is slowly shrinking now). Of course, that doesn’t mean it can’t happen, but we have to understand that the most likely causes of higher inflation would be the following:
- A big economic boom resulting in higher wages, lower unemployment, pricing power, etc (Did he say “economic boom”, hahaha – seriously, given the mounting headwinds, it’s just not happening – I wish I was wrong about this one).
- A supply side shock in the oil market reverberating through the economy and likely ending in recession (not out of the realm of possibility, but looking increasingly less likely given the weakness in the global economy).
- A colossal collapse in domestic production (not happening).
What about hyperinflation? Well, you might be interested in reading my paper on this because I’ve found that hyperinflation is a very unusual phenomenon that occurs in specific instances. None of which currently applies to the USA. This is another event I’ve been downplaying for years now (not to toot my own horn, I get plenty wrong, but I’ve been very right on much of what’s being discussed in this story). The bottom line is, the reasoning behind the argument for surging interest rates just doesn’t add up. If anything, we’re looking more and more Japanese and not Greek.