Fed Raises Rates in the Midst of Epic Debt Bubble.... What Could Possibly Go Wrong?

The Federal Reserve Bank is an interesting creature.  It is filled with PhD Economists that worship their econometric models while ignoring the real world of human action.  Case in point: their models don't include the financial system, yet debt is arguably the most important aspect of the economy.  

Making things even more interesting, while debt is completely ignored by the Fed, they are the ones that set the price of debt!   According to many analysts, the Fed just made a "policy error" in that regard (although every policy that overrides the free-market pricing mechanism of interest rates is automatically an error in my book).  

The Fed raised rates by .25% and set a hawkish tone for 2017, with plans to raise rates three more times next year.  Yeah right!  Rates can't go much higher without causing serious problems to the economy, the financial system, and to US government finances.   

The problem with raising rates is the debt bubble that the Fed so willfully ignores.  Each quarter point makes things more difficult for businesses and consumers.  Here are just a few examples: 

1) Housing.  This should be familiar to almost everyone.  When mortgage rates go up, mortgage payments go up.   The difference between 3.4% and 4.2% (the change since the Trump election) can be the difference between a family being able to afford a particular house or not.  Rising interest rates will put downward pressure on house prices, mortgage applications, and home building.   We are already seeing that in the numbers.  Housing starts dropped 18% in November while mortgage applications have began to tumble as well.  If rates keep rising, this should get worse.  

2) Stock Buybacks.  This stock market bubble has been fueled in large part by corporations borrowing money to buy back stock.  These shenanigans are only justified by low interest rates.  If a corporation can borrow money at rates cheaper than its dividend yield, buybacks makes some sense to short-sighted managers.  When interest rates are higher than yields, it doesn't make any sense at all.  Moreover, low interest rates are the justification for stock bubble valuations across the board.  Stock market valuations should come under pressure as soon as the Trump euphoria wears off.  

3) Debt Rollovers.  We are approaching the end of the credit cycle that started in 2009 (and perhaps the credit super cycle that started in 1980).   Towards the end of any credit cycle, more and more companies have bonds coming due that can't be paid back apart from new debt, often called "ponzi finance".  Higher interest rates could make it difficult or even impossible to roll over ponzi-debt, bringing this debt binge to an end in a hurry.  

4) The Economy in General.   The US economy is addicted to debt.  Increasing debt is required to maintain any level of economic growth at this point.  And the trend is clearly that more and more debt is required to create less and less growth.  Higher interest rates will put a damper on the economy.  Ventures that once looked profitable will now be scrapped.  Econ 101.  

5) Eurodollar Liquidity Crisis.  Explaining this issue is a little above my pay grade.  However, there is an increasing chorus of concerned research analysts that are pointing towards a liquidity crisis in the Eurodollar market (US dollars held in overseas financial institutions).  The tightness has been going on for months, and an increase in interest rates will only exacerbate the issue.  

6) China... 


The China Doom Loop

Regular readers know that I like to talk about China.  The Chinese banking system is an accident waiting to happen; the Chinese Yuan is an accident already happening.  The coming debt/currency/economic crisis in China will plunge the world into recession at an unknown future date.  

China has a problem with capital outflows for a variety of reasons, mainly to do with carry trade dynamics.  The smart money is trying to evacuate the country before the housing bubble implodes and the crisis explodes.   These capital outflows are putting serious pressure on the currency.   

Image from Zerohedge.com.  

Image from Zerohedge.com.  

The crazy thing about this chart is not the level of the decline; 13% over the course of 17 months is significant, but nothing extraordinary.   The crazy thing is that this decline cost the PBOC (China's central bank) almost $1 Trillion!  That's right.  China has dumped $1 Trillion to buy Chinese Yuan to kep it from crashing, and yet the currency has still declined 13%.  What happens if they quite dumping dollars to slow the decent?  Or an even better question: what happens if they keep dumping dollars to slow the decent?   This is a lose-lose situation.

Russel Clark of Horseman Global hedge fund put it this way:


"In my view, the Trump election has made a large Chinese devaluation more likely.  Mainland Chinese investors are desperately trying to get out of the Yuan, and the People’s Bank of China is trying to defend the value of the Yuan. They are doing this by selling treasuries. The problem with this is that the more treasuries the PBOC sells, the more yields are likely to rise, putting more pressure on the Yuan. It seems to me that the PBOC is stuck in a doom loop.... the PBOC is running out of options." 


Here is the conundrum: the PBOC has to sell US Treasuries to keep the Yuan from crashing.  This selling of US Treasuries causes interest rates to rise in the United States, which makes US investments more attractive compared to investment in China, which eliminates carry trade profits.  That causes even more capital outflows, which forces China to sell even more US Treasuries to defend the Yuan, which forces USD rates even higher, which causes even more outflows.  Hence Clark's "doom loop".  

And so, China is stuck.  Doomed if they do, doomed if they don't.  As Kyle Bass put it, "All roads lead to devaluation."   Every indication is that the process has been exacerbated by the Trump election, and a shocker in the currency market could happen any day now, without warning.

The devaluation will result in crashing commodities, a wave of deflation, plunging world trade, a global recession, and another global financial crisis.  The only questions that remain: How bad will it be?  How will central banks respond?  

Those questions take an entire book to answer.  And you can the book here: