The recent turmoil on Wall Street has once again taken center stage, making headlines that capture public attention. However, at the Economic Prism, our focus shifts beyond just the stock market’s sharp declines. Today, we’re diving deeper into the implications of the credit market and what it reveals about our current economic situation.
It’s evident that society’s willingness to inflict harm upon itself is growing. While we lack concrete evidence to substantiate this claim, our observations and experiences suggest a troubling trend—the rationale for collective action seems to have spiraled out of control. Civilization might act against its own interests at any moment.
Late last Friday, Standard & Poor’s downgraded U.S. government debt from AAA to AA+. This move simply acknowledged what many have sensed: the creditworthiness of the U.S. government is now in question. Unless there are drastic spending cuts, significant tax hikes, or a combination of hefty money printing and rampant inflation, repayment of the immense debt amassed will be unattainable.
However, what stands out about this downgrade isn’t just its occurrence but the context in which it happened—10 Year Treasuries were yielding a mere 2.55 percent at the time. This serves as a clear example of how the logic of collective action is faltering.
On the first trading day following the downgrade, yields on 10 Year Treasuries fell to 2.33 percent. This paradox illustrates civilization undermining its own interests.
Isn’t it customary for junk bonds to demand higher yields compared to investment-grade bonds? Shouldn’t government debt downgrades prompt higher yields? Isn’t that how the financial world is supposed to function? What’s going on?
The Safest Investment in the World?
We’ve often expressed our expectations for rising Treasury yields, and while it feels repetitive, we are inching ever closer to that reality. Here’s why: credit markets, especially those related to government debt, tend to move at a sluggish pace. Most observers are put to sleep by the seemingly static nature of interest rates.
Creditors can also be lulled into complacency by minor fluctuations in Treasury yields. Over time, the perceived creditworthiness of borrowers—like the U.S. government—can become almost taken for granted. Day after day, year after year, it has been asserted that U.S. Treasuries represent the safest investment globally.
While they have indeed maintained a strong track record, it’s important to recognize that no entity remains at the top indefinitely. Like a once-great athlete, there comes a time when reality sets in, revealing the decline that others might not immediately notice.
The U.S. government has long relied on past successes. With Treasury yields languishing at historic lows for so long, it’s led many, including policymakers, to incorrectly assume that such cheap borrowing would persist indefinitely.
A rude awakening may be on the horizon…
When the Whole Paper Edifice Collapses
Each year, the government must repay trillions in principal to avoid default, typically by rolling over debt, meaning new debt is issued to cover maturing obligations.
As interest rates rise, not only does the cost of new borrowing increase, but so does the cost of servicing existing debt. This is similar to how an adjustable-rate mortgage can reset at a higher rate; as yields climb, repayment becomes more expensive.
The recent debt ceiling crisis made it clear that the government’s budget, along with its enormous deficit, is fully accounted for. Consequently, an uptick in debt servicing costs will create a new financial burden, consuming a more significant portion of the government budget.
The government has taken on more debt than the economy can sustainably support. Even with historically low Treasury yields, the sheer volume of debt is overwhelming. If yields continue to rise, the entire financial framework could face a catastrophic collapse.
At the Economic Prism, we argue that U.S. Treasuries are not merely at an atypical equilibrium, but rather caught in an epic bubble. Earlier this year, we released a Strategy Report discussing this phenomenon, which was provided at no cost to subscribers of our E-Newsletter. If you haven’t subscribed yet, you can learn how to get a free copy of the report here.
The core argument of the report posits that U.S. Treasuries (government debt) exist within a tremendous bubble and, after over 25 years of declining interest rates, they are on the verge of a significant upheaval. It also outlines simple strategies to protect yourself and potentially benefit as this debt bubble bursts.
Current subscribers may wish to review this information. Online readers can explore it here.
Sincerely,
MN Gordon
for Economic Prism
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