Why Rising Rates are the Pin for this Bubble

In a bubble looking for a pin, maybe the biggest threat (pin) developing is the rise in yields or interest rates as we discussed in part on Friday.  The following is courtesy of Lance Roberts of Real Investment Advice and it is a typically concise and easy to understand explanation of the troubles ahead:

“In an economy that requires roughly $5 of debt to create $1 of economic growth, changes to interest rates have an immediate impact on consumption and growth.

1) An increase in rates curtails growth as rising borrowing costs slow consumption.

2) As of January 21st, the Fed now has $7.38 trillion in liabilities and $39.2 billion in capital. A sharp rise in rates will dramatically impair their balance sheet.

3) Rising interest rates will immediately slow the housing market. People buy payments, not houses, and rising rates mean higher payments.

4) An increase in rates means higher borrowing costs and lower profit margins for corporations.

5) Stock valuations have been elevated due to low rates. Higher rates exacerbate the valuation problem for equities.

6) The negative impact on the massive derivatives market could lead to another credit crisis as rate-spread derivatives go bust.

7) As rates increase, so do the variable rate interest payments on credit cards. With the consumer already impacted by stagnant wages, under-employment, and high living costs, a rise in debt payments would further curtail disposable incomes. 

8) Rising defaults on debt services will negatively impact banks that are still not adequately capitalized and still burdened by massive bad debt levels.

9) The deficit/GDP ratio will surge as borrowing costs rise sharply.

I could go on, but you get the idea.

Since interest rates affect “payments,” increases in rates negatively impact consumption, housing, and investment, which ultimately deters economic growth.

With “expectations” currently “off the charts,” literally, it will ultimately be the level of interest rates that triggers some “credit event” that starts the “great unwinding.”  

It has happened every time in history.

No Way Out

The problem for the market going forward, as noted, is that markets have priced in a speedy recovery back to pre-recession norms, no secondary outbreak of the virus, and a vaccine. If such does turn out to be the case, the Federal Reserve will have a huge problem. 

The “unlimited QE” bazooka is dependent on the Fed needing to monetize the deficit and support economic growth. However, if the goals of full employment and economic growth get quickly reached, the Fed will face a potential “inflation surge.”

Such will put the Fed into a very tight box. The surge in inflation will limit their ability to continue “unlimited QE” without further exacerbating the inflation problem. However, if they don’t “monetize” the deficit through their “QE” program, interest rates will surge, leading to an economic recession.

It’s a no-win situation for the Fed.”

The timing of course is unknown.  The market might crash in anticipation or effect.  Tomorrow or in 2 years, you just don’t know.  What is irrefutable is what he explains above.  Equally irrefutable is that no one know what’s next or when.

Roberts talks about the 2 pins likely to pop this ‘everything bubble’ – Inflation and Interest Rates.  Inflation is now seeming inevitable and runaway inflation like the 70’s distinctly possible and, for some, inevitable.  As most know, gold and silver exploded in that time.

Inflation always leads to higher rates and as Roberts explains above, in a market with $85 trillion of debt, that is game over for the ‘everything bubble’.