The housing and credit crisis first became evident to most in 2007 with the distress in the subprime mortgage market. The foundation for the housing bubble was low interest rates, which were provided by the Fed, and passed along to consumers via commercial banks and the shadow banking system. Those low "teaser rates" from the Fed compelled consumers to take on too much debt and for banks to become overleveraged. Excessive lending in the real estate sector of the economy caused home prices to skyrocket out of reach of most consumers. Home prices subsequently fell and the assets on banks' balance sheets tumbled in value. The result was the biggest economic contraction since the Great Depression.
Similarly, rock bottom interest rates provided by the Fed and from foreign central banks recycling our trade deficit are misleading the government into believing it can take on a tremendous amount of debt by spending significantly more money than it collects in revenue. Those low rates have also duped the Treasury into believing it can sell a virtual unlimited amount of debt without ever incurring a substantial increase in debt service expense. Of course, this is not unlike homeowners who took on onerous mortgage payments, believing home prices would always increase.
And just like those homeowners who took on adjustable rate loans, our Treasury has set itself up for a bout with intractable mortgage rate resets. Interest rates are currently at historic lows, but instead of choosing to take advantage of those rates by locking them in for decades, the U.S. Treasury has chosen to follow the lead of subprime borrowers. The government should be taking on the equivalent of a thirty year fixed-rate mortgage by issuing only 30 year bonds. However, they have chosen the path of what amounts to a short term adjustable rate mortgage by moving their debt duration to the short end of the yield curve.
Today the Treasury has an average maturity on its debt of just about 5 years. Compare that with the U.K. which is about 14 years and even to Greece which is about 8 years in duration. That means the U.S. must roll over its debt much more frequently and is much more susceptible to rising rates. The only logical explanation for this practice is that the U.S. doesn't feel it can issue long term debt and still afford to service its interest rate expenses.
Another similarity between the housing and bond market bubbles is that the housing market of circa 2006 and the U.S. bond market of today contain all three elements of a classic asset bubble; massive oversupply, an unsustainably high price level and over-ownership of the asset class in question. In the early part of the last decade, home builders began to increase construction volume to twice the intrinsic demand for home ownership. Home price to income ratios eventually reached unsustainable levels. And levels of home ownership reached a record high percentage of the population. Likewise, the U.S. Treasury is dramatically increasing the supply of debt each year to fund our $1 trillion deficits. The public has plowed their savings into the U.S. debt market as commercial bank holdings of Treasuries have reached an all-time high. And bond prices have soared, pushing the yield on the 10 year note to 3.6%, which is less than half the average yield of 7.3% going back to 1969.
Therefore, all the elements of a bubble in the bond market are in place, just as they were for the real estate market in the middle of the last decade. And now, if we do not cut aggressively cut spending on the federal level, the bond market may be ready to enter a multi-decade bear market in prices. The trigger for this secular move higher in yields will be the resurgence of inflation and the overwhelming effect supply has on bond prices.
However, a temporary reprieve from significantly higher yields has been given courtesy of Europe. Investors are fleeing Greek debt and the Euro currency in favor of the U.S. dollar and our bond market. But this is a temporary phenomenon and in no way bails out America from its own fiscal transgressions. In just a few years our publicly traded debt will reach nearly $15 trillion. If interest rates just rise to their historic averages, the interest on our debt (depending on the level of economic growth and tax receipts) will absorb anywhere from 30-50% of total Federal revenue. If we indeed reach that point, massive monetization of the debt may be deployed by the Fed in a vain effort to keep rates from spiraling out of control.
One last similarity between to the two bubbles is that the prevailing consensus of not too long ago was that home prices could never decline on a national level. Today we are being told that the U.S. dollar will always be the world's reserve currency and that Treasuries will always be viewed as a safe haven by global investors. Remember how those in Washington and on Wall St. also assured investors that the subprime mortgage problem was well contained and would not bring down the housing market-much less the entire global financial system. Well, regardless of what those same people are saying now, these record low yields on U.S. Treasuries are unsustainable and cannot last given our massive $13 trillion national debt, $108 trillion in unfunded liabilities and the record-high $2.3 trillion Fed balance sheet. Astute investors should prepare now for the likelihood of much higher interest rates in the not too distant future.
Senior Market Strategist
Delta Global Advisors