So Hilsenrath claims a little birdie (Fed insider) told him that rates will be raised later this year. I expect the Fed is just jerking him around. There is nothing fundamentally or otherwise to suggest rates will move up. I’m not sure if Hilsenrath is part of the game or just a gullible fool who is being used to keep the market off balance. Why would the Fed want the market off balance? The Fed does so intentionally because theory suggests such a strategy will improve the effectiveness of monetary policy (refer to rational expectation model).
Regardless of what the Fed says, the reality is that interest rates are not moving up anytime soon. It is shocking to me how arbitrarily economists make certain predictions. I mean don’t get me wrong, I’m not a fan of ZIRP or NIRP. I see them as theft in the same way I see inflation as theft. Both effectively destroy the time value of money by way of politics and, these days more than ever, politics is simply another word for skullduggery.
But let’s take a look to see if we can find any reason why interest rates in the US would go up soon. Let’s start with market forces. Rates would go up naturally if demand for bonds declined. Problem is that looking to Europe’s interest rates moving deeper into negative territory almost daily I can’t see why foreign demand for US bonds would decline.
But perhaps domestic demand will fade enough to offset the increasing foreign demand. Well if investors had a reason to believe the market was ready to take off we should see a reallocation away from bonds and into equities. That too would result in a higher bond yields. Problem is that institutional money is actually flowing out of equities while retail investors have already loaded up on equities, matching 2007’s all time high market levels of retail investor cash. And so it seems that there is little chance of a market force leading to higher interest rates. But that hasn’t always stopped rates from rising.
The likely catalyst then for a change in rates and particularly a rise in rates would be the pure politics of Fed action. Now on the surface we know that the Fed uses rates to increase demand by way of lowering borrowing costs and to depress inflationary pressures by increasing the marginal return on cash making the opportunity cost of spending higher thus dampening consumption. But this is a very academic view of OMO. In the real world things are not quite that black or white. When the butterfly flaps its wings the consequences are vast and can be deep.
For instance we might have inflationary pressures that have been driven by money printing while consumer demand is dead. And so if the Fed acts to raise interest rates it will slow inflation but it will also result in even lower consumer demand. That would obviously be an unwanted drag on the economy.
Alternatively we could have inflation driven by money printing with decent consumer demand that has been funded by all time high debt levels. In this instance if the Fed were to raise interest rates it could quell inflation, however, it could also very well lead to an epidemic of bankruptcies. With consumers having remarkably high debt levels accruing beside declining real incomes, free cash flows would be squeezed beyond what many households could withstand. That is, higher interest rates require higher cash flows to service household debt and if cash-flow is already razor thin any increase results in failure.
These are just theoretical scenarios that point out the Fed cannot narrowly look at inflation and decide whether or not it will raise rates. There are many parameters the Fed must take into account. My theory is that for at least the past 15 years interest rates have been driven not by inflation or employment but by debt to income levels. I recently provided solid evidence that interest rates are being driven by debt to GDP at the national level. Specifically, I proved that interest rates moved in such a way so as to keep the nation’s total debt service to GDP between 2% and 5%.
Have a look at the following chart which depicts debt service to GDP (blue line) remain within its narrow range over time despite the large increase in debt. The relationship between debt service and GDP is not coincidence as we found very strong statistical significance. That article elicited a fairly shocked response because the overwhelming belief is that interest rates are very much a function of inflation and to some degree employment yet the data clearly suggests a different driver.
This time around I’d like to test our theory on the American household. I expect this relationship to hold just as true for households as it does for the nation’s total public debt service to the nation’s income (GDP). The idea is simple and logically necessary; don’t bankrupt your debtors. If you want people to take on debt for whatever reason then make sure they have sufficient cash-flow to cover the service on that debt. On the macro level we saw interest rates change, over time, in such a way so as to keep total public debt service between 2% and 5% of GDP (income) as the above chart depicts. Again it makes sense because if too much income is being diverted to servicing debt things begin to crack rather quickly.
I should also point out there would seem to be a natural cap on the ratio of debt service to income. We know it as the the savings rate and if debt service as a percentage of income breaches our savings rate we go into arrears and ultimately bankruptcy. If our theory is right we should be able to see that at no time does debt service to income exceed the savings rate. So let’s have a look.
And the theory holds. We can see that debt service to GDP (red line) was steady just below 5% from 1980 through the mid 1990’s. However, as the savings rate (blue line) began to close in on 5% we see the debt service to income ratio decline down to 2.5% where it remains today. Savings rate actually did drop to meet the debt service to income ratio during the credit crisis, and as predicted by our theory it resulted in an epidemic of bankruptcies, but it very quickly moved back higher in 2009. And so it would seem there is very solid support for the theory that interest rates are a function of debt to income and that the relationship has its own set of constraints. But we are certainly not done yet.
Let’s have a look now at the American household to see if our theory holds true on a more microeconomic view. The following chart depicts household consumer debt (no mortgages) and real household incomes. Remember that as incomes decline, there is a follow on decline in demand which must be propped up with increasing consumer debt levels to avoid the appearance of a contracting economy. This makes sense given the government wants to show economic growth, even if it must be just an illusion from debt. But so let’s have a look at what we find with the American household.
The above chart depicts real median household income (red line) and household consumer debt (blue line). Clearly there is no correlation or similarity between the two functions. During the first 15 years both income and consumer debt trend higher while the latter 15 years had debt continuing its trend higher while real incomes reversed and trended lower.
Dislocation of the income and debt levels is both intentional and problematic. As discussed above the debt is required to fill the demand void stemming from declining incomes but it also becomes quite risky. However, it has been decided by those who decide such things that creating the illusion of a prospering economy is important enough to take on all that extra consumer debt in order to create that illusion. But it requires some finesse to ensure that debt remains manageable and that finesse is being done through interest rates.
To quickly show that debt has been necessary given the desire to portray a growing economy let’s have a look at the following chart which depicts an adjusted GDP (adjusting out debt – orange line) and normal GDP (blue line).
We see that without the $10 trillion in debt we’ve taken on since 2008 our nation’s output would be half what it is today. Prior to 2000 the adjusted and unadjusted real GDP figures were very close. Then the gap widened slightly for the next 8 years but both were still growing. In 2008 however, something changed. Adjusted GDP simply collapsed. This signifies that something very significant did in fact change in the way we utilize debt as it became almost completely ineffective having a velocity of 0.2. That is for every $1trillion in debt we generated only $200B in output. The obvious reason for this is that debt is being used for consumption to a far greater extent than ever before, whereas historically debt was taken for investment and thus generated positive rather than negative returns.
Borrowing to consume is a troubling sign. But again it is necessary to perpetuate the Giant Con of economic prosperity. But continuously rising debt levels can be unsustainable while incomes decline, especially as we near peak debt levels. This requires interest rates be used to optimize debt service levels, meaning they need to track income. That is, when income goes up debt service levels can be allowed to move up but when incomes are on the decline debt service levels need to be pulled back. Because it is difficult to adjust principal levels in the short term and that economic strategy is to continually increase debt principal, the mechanism for adjusting debt service must be interest rates. Let’s see if we can find support for this theory showing up in the data.
And so we see exactly what our theory predicts. All we did here was to take the earlier chart above (household consumer debt vs real household incomes) and applied to it the historical 10 yr yield (which we used as a proxy for average interest on total public debt). That produced the total debt service levels (blue line) which we compared with real household incomes (red line). You can see that while we found no correlation earlier between household debt and real household incomes, here we find household debt service tracks almost perfectly to real household incomes, the only difference being interest rates.
That is strong evidence for our theory that interest rates are being used to maintain a debt service to income range in the American household the very same way we proved it was happening with the nation’s total public debt service to GDP. Let’s look specifically at the ratio range of household debt service to real household incomes. Here we will replace the 10 yr yield at the household level with the primary loan rate as it is a more accurate proxy for consumer debt rates.
What we find is absolutely incredible! I could not have fictionalized these results any better than how they are falling into place in support of our theory. Notice the household debt service to real household income ratio range is exactly the same as what we found with the total public debt service to GDP coming in at 2% to 5%. Meaning that at both the national level and the household level it has been set that debt service will range between 2% and 5% of income.
If you think this is a magical coincidence, well bless you you’re very sweet indeed. It’s not a coincidence and it’s not magic either. Not at all. This phenomenon is of necessity. That is, this relationship has to exist because of what debt consumption has become over the past 20 years as it relates to our economy. It is the foundation of the Giant Con and, as such, everything revolves around it. Not even interest rates escape its event horizon.
This is not to suggest that inflation is not a concern or that it is ignored. It is very much a concern and is receiving a lot of attention. However, inflation, to a large degree, is perception. And perceptions can be controlled by information and muscle, at least for a while. But I will save that discussion for another day. The bottom line here is that interest rates will continue to decline until the ratio of debt to income declines sufficiently so as to allow interest rates to move higher while maintaining a debt service to income ratio below our savings rate and in line with historic levels of between 2% and 5%.