The Paradox Of QE And Interest Rates


There has been much digital ink spilled over QE and interest rates — the Fed’s claim that it is “suppressing” interest rates in the market and will continue to be effective in doing so.

Let’s cut the crap — there is a direct clash between what The Fed wants and what it is doing.

Interest rates are a combination of time value, the risk you will not get paid and inflation.

That is, nobody ever intentionally lends someone money at a loss.

Therefore, if The Fed generates positive inflation by diluting the currency, thereby raising the cost of living for the people and reducing the purchasing power of a unit of currency in relationship to tangible goods and services the interest rate must rise, all other things being equal.

The government, along with others, like low rates because they believe it allows them to borrow “cheaply.” But this is a chimera among governments and large corporations, because if the currency is diluted then it is inevitable that as purchasing power is destroyed discretionary income is also reduced and therefore the money that can be either taxed to pay (by government) or spent into the economy to pay (by corporations) is also reduced.

Japan has boxed themselves into this corner — if rates go up, even a little bit, they’re screwed — their government cannot pay the interest charges as their debt rolls to a higher coupon.

Likewise, if you look at our latest MTS, you find that our interest expense thus far this year has been $76.962 billion.  We are 8 months into the fiscal year (out of 12) so we should be spending about $115 billion this year on public debt interest; with $11.906 trillion outstanding this means we’re paying an approximate 1% (!!) interest rate.

If the 13 week T-Bill were to return to a historically-reasonable rate of about 3.5-4%, the lower end of its common range, interest expense wouldmore than triple.

Of course if it were to go back to where it was in the mid to late 1990s, or the 2005-2006 period, or for that matter where it was in the 1980-1990 time frame things would be even more dire.

This hit would not be “slow”, “reasonable” or “contained.”  It would be instantaneous and destructive.

Japan is in this hole and the gyrations they are going through in their markets are a consequence of it.  The markets are sussing out that the attempt to prevent this outcome may fail; in particular the collapse may come in the form of a consumer purchasing collapse along with a profit collapse in corporations, which destroys tax revenues as the risk premium on JGBs and inflation premium both rise.

Such a dislocation is how governments — and currencies — fail.

Bernanke knows this.

He also knows that “QE” in fact has historically been associated not with falling rates but rising ones, especially on the long end.

And yet it is rising rates that the government cannot tolerate.

In the end The Fed has two choices — hit the wall at 100mph and splatter itself and the nation all over the granite or allow deflation to win by ceasing with the monetary games.  In a deflationary environment rates falls because there is a positive carry for holding cash and therefore the rate to borrow is depressed — naturally.

Yes, it is true that in that environment wages and prices also fall and therefore in nominal terms debts becomes more difficult to pay.

But this isn’t about consumers any more or even businesses.  If you’re dumb enough to lever up into an artificially pumped market with extraordinarily high levels of debt and near-zero economic expansion, where there is a strong negative carry in purchasing power, you deserve what you get.

It is the government’s ability to finance itself and survive that will win out in the end, and for this reason Bernanke will “taper” — and ultimately stop.  I’ve said this since the current programs began and now the  evidence that the end-game is not only upon us but that the inevitable outcome will occur is mounting rapidly.

This is not because Bernanke wants to stop.

It is because he has to.

The math says so, and he knows it.

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