It’s The Debt, Stupid!

October 30, 2014

credit liability


Investors fear a stock market collapse. What they should really fear is a bond market collapse or more specifically a debt collapse. A stock market collapse can cause considerable damage. Debt collapse could lead to bankruptcy and an economic depression.

There is a lot more debt in the world then there are equities. The global stock market is estimated to be about $64 trillion. Total global indebtedness, according to ING Economics is $223.3 trillion. And that was back in 2013. Given that debt is estimated to grow by at least 10% annually total debt today could be $246 trillion. The debt number includes public sector debt, financial sector debt and household and corporate debt. It does not include the Chinese shadow banking system. Given an estimate of global GDP at about $72 trillion, that gives rise to a global debt/GDP ratio of 342%.

A ratio of 342% is not far off of the total debt/GDP ratio of the US estimated at 348%. The US is not the highest. Great Britain is closer to 550% and Japan is closer to 650%. Is a high debt/GDP ratio a problem? Debt is not a problem as long as the debtor has sufficient cash flow to cover debt service (interest).  The principle? Well as long as the country, the corporation or the individual has sufficient resources and the capability to service the debt, the debt most likely is just rolled over. The problems start when the country, the corporation or the individual no longer has the capability to service the debt let alone have the resources to pay it back.  

Trouble is the inability to service the debt happens more often than people would like to admit. History is replete with “this time is different” when debt levels pile up and then everyone is shocked when the financial crisis breaks – whether it was currency debasements, banking panics or the more recent subprime collapse of 2007-2009. In 1998, a Russian default triggered the collapse of Long Term Capital Management (LTCM) a giant hedge fund. The collapse of LTCM almost brought down the financial system. It was saved by a bailout from Wall Street with assistance from the Federal Reserve.

But it doesn’t stop there. From 2000-2002 the financial system was once again put under severe pressure with the collapse of the high tech/internet bubble coupled with 9/11. The Fed came to the rescue slashing interest rates and flooding the financial system with liquidity. That set in motion the housing bubble that culminated in the subprime collapse and the financial crisis of 2007-2009. Not only did the Fed have to come to the rescue, Governments had to come to the rescue with a bailout of the banking system including billions of taxpayer funds as well as flood the financial system with liquidity and lower interest rates to zero in order to save the financial system from complete collapse.

Since then the Fed has gone through three iterations of quantitative easing (QE) and have maintained official interest rates at 0-0.25% for an unprecedented five years with few if any signs of lifting low interest rates any time soon despite speculation that they might sometime in the future. The period 2009-2014 has seen at best tepid uneven growth despite the addition of trillions of dollars in QE in an attempt to kick start the economy.

The Fed’s balance sheet has exploded from roughly $800 billion to $4 trillion in five short years. US Government debt has soared from $9.7 trillion at the end of 2007 to $17.8 trillion today. GDP not so much, growing from $14.3 trillion in 2007 to $16.6 trillion today. Some fear that the next financial crisis could overwhelm the Fed. Maybe that is why the major OECD countries have changed from a regime of “bailouts” to one of “bail-ins” where the depositor pays rather than the taxpayer.

Of course, it does not stop with the US. The European Union zone has been through financial crisis after financial crisis for the past five years and they are now entering their third recession during that period. The ill-conceived European Union (EU) using the Euro as the currency left a neutered central bank (the ECB) to coordinate the economies of effectively 28 member states each of who maintained their own central banks and ability to run their own economies and in some cases (Great Britain) maintained their own currency. Using a common currency, the weak economies were able to borrow huge amounts of money in order to bring their standards up towards the highest standard Germany. Whether they had the capability to service the debt let alone repay it seemed to be an afterthought. 

adjusted monetary basis


Japan has been through a series of rolling recessions since they first collapsed in 1990. This has happened despite a huge build-up of debt that has now created a Government debt/GDP ratio of 235%. Debt growth has been relentless. As noted, global debt has been growing at roughly 10-11% annually even as global GDP has been growing at only 3-3.5% and the advanced economies have been experiencing growth in the 2-2.5% range.

There is little thought at this time of a debt collapse in the US or even Japan. But the Euro Union (EU)  is potentially a problem. Debt has grown to unsustainable levels in a number of “periphery” EU economies. They are Portugal, Ireland, Italy, Greece and Spain or as some like to call them “the PIIGS”.  During the recent stock market sell-off yields on government debt of these countries leaped. Yields on weak corporates in the EU zone also jumped. The PIIGS have considerable problems. They have high total debt/GDP ratios ranging from close to 300% for Italy to in excess of 400% for Ireland. It doesn’t sound that bad when compared to the US, Great Britain and Japan but then their economies do not have the economic depth and capability of those countries. The headline unemployment rates in the PIGS are respectively 15.4%, 11.4%, 12.3%, 26.4% and 24.4%. Youth unemployment is upwards of 50% in some cases.

QE is ending in the US. Supposedly, it is a sign that the US economy has been performing well. Headline unemployment is down to 5.9% but according to Shadow Stats  --  However, the unemployment rate is 23.1% when one counts all of the long-term discouraged workers unemployed and those working part-time seeking full time positions. Long-term discouraged workers are not considered a part of the US labour force. US economic growth has been very uneven with the upper 20% of the economy doing well while the remaining 80% continues to hang on - barely. The housing market despite supposedly strong growth remains sharply below the peak of 2006. Corporate earnings have surpassed previous periods,  but they are now at levels higher than they were prior to the 2008 financial collapse.

The end of QE in the US has been problematic for numerous other countries. Countries that are dependent on international financing to finance their deficits are now having trouble raising foreign capital. Countries such as Turkey, Brazil, India, South Africa and Indonesia have seen a move out of their currencies that are now exacerbating domestic problems. The yanking back of QE in the US is resulting in a drying up of liquidity for international markets. QE acted as a stimulus not just for the US economy but also for the rest of the world. Take away the QE and problems start to develop. That is how dependent the world was on the US’s QE. But without QE the tepid growth seen in the past five years would most likely not have happened.

No one is stepping up to replace the US’s QE. The EU has constantly vacillated about QE and has never really put in place what one would call a QE program comparable to what the US had. It is hard because Germany runs the EU -- and the Germans understand the dangers of programs such as that.   Instead austerity replaced QE…and that in turn has also been a disaster as the EU economies teeter between tepid growth and outright recession. The times have given rise to numerous anti-EU political parties including xenophobic parties eager to blame immigrants and others for the problems. This is not dissimilar to what was seen in the 1930’s with the rise of the Nazi party in Germany.

Japan, who was the first to really use QE, has moved back and forth with its program,  but ultimately they are not capable of replacing the QE that was generated by the US.  The Japanese economy has been sliding back into recession. The question now begs with both Japan and the EU sliding back into recession:  can the US stay out of recession even as they have ended the most unprecedented period of monetary stimulus ever known. The market seems oddly focused on when the US might hike interest rates. They are not focused at all it seems on the US sliding back into recession.

Something that should be focused on is that yield spreads are slowly widening. No they are not yet at levels seen during the 2008 financial crisis…but they are rising. Whether it is 10-year Treasury notes and AAA Corporate bond yields, or BAA Corporate bond yields or junk bonds,  the spreads have been rising. The charts below show the slowly rising spreads.

Yield spreads on US Government Treasury notes and BAA corporates appear to have broken a downtrend. Downtrends appear to have been broken as well for an assortment of BBB corporate bonds and high yield bonds (aka junk bonds). This suggests that one should be cautious about corporate and high yield bonds going forward. Note that none of the spreads is anywhere near the levels seen during the 2008 financial crisis. To get there would take a heightening of problems and yield spreads would only explode to the upside during a crisis. It may be that this is just another temporary blip in the widening of yield spreads,  but given the end of QE, odds could favour growing liquidity problems in the global bond market.

corporate bond yield






The Fed has ended QE. The biggest casualty so far has been gold and silver.  Bond prices have been relatively steady and the stock market has started to wobble. The focus appears to have shifted as to when the Fed might hike interest rates.  Given the problems in the EU and Japan, the focus appears to be ill thought out. Yield spreads are widening on lesser credits vs. US Treasuries.  In the EU the “peripheral” nations of the PIIGS are seeing their yield spreads widen. This is particularly the case with Greece where once again the thoughts of default are on the upswing once again. That the ECB and Germany can’t allow it is beside the point.  What is the cost of another Greek bailout or worse and Italy or Spain bailout?

Liquidity problems are rising in a number of markets with countries having trouble-finding financing. The potential of defaults are not limited to just the Euro zone. In Latin America, both Venezuela and Argentina are prime candidates for default. There could be others. Sovereign defaults are nothing new. The world has been through numerous periods of sovereign defaults in the past most notably during the Great Depression. Sovereign defaults reverberate directly onto the banking system triggering a potential banking crisis and collapse.

Maybe the last words should be for former Fed Chairman Alan Greenspan who in speaking at the New Orleans Investment Conference said that the Fed’s balance sheet is a “pile of tinder” that gold is a “good place to put money these days” as it will rise “measurably” in the next five years. Greenspan noted that while QE helped lift asset prices and lower borrowing costs it did little for the broader real economy. “Effective demand is dead in the water,” he said. It has boosted asset prices benefitting the wealthy. As for the rest – well……

Greenspan also said rather bluntly:  “I never said the central bank was independent”. The statement begged the question of how much are central banks, in this case the Fed, being dictated to by politicians to increase their popularity or re-election or worse still by powerful banks and bankers. The Fed is not as many believe an agency of the government.  Its shareholders are some of the most powerful banks in the world.

Greenspan might well have added, “It’s the debt, stupid”. Instead, I’ll say it. All historical financial collapses and depressions are all about debt collapse. For years, the advanced economies have kept trying to push the debt problem into the future. The future may soon be upon us. Each successive banking crisis has been worse than the previous one. The last one required the efforts of the Fed, the US Treasury and the taxpayer to prevent a complete financial meltdown. The causes of the financial crisis were not changed. They were merely tinkered with. The result is that little has changed. The next financial crisis is most likely brewing today. What could it bring?


Copyright 2014 All rights reserved David Chapman

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