On the heels of another wild trading week in world markets, today one of the top economists in the world sent King World News an incredibly powerful piece about the death of free markets as deflation engulfs the world.  Below is the fantastic piece from Michael Pento.

By Michael Pento of Pento Portfolio Strategies

January 17 (King World News) – On January 7th CNBC’s Rick Santelli and Steve Leisman engaged in a heated debate that posed an interesting question:  Is the free market at work keeping interest rates low, or is it the central banks’ put?  This made me consider the real question to ask which is:  Where would rates be if central banks didn’t exist?

Deflation Engulfing The World

What would happen if the Fed liquidated its balance sheet and sold its $4.5 trillion worth of Mortgage-Backed Securities and Treasuries and closed up shop?  Some claim, after an initial spike from all that selling, rates would subsequently tumble due to a deflationary cycle that would result from the end of central bank money printing.  These people also maintain that rates are currently historically low because of the overwhelming deflationary forces that exist in the economy.  Yes, we now see deflation pervading across the globe and that does tend to push down borrowing costs, but I am not convinced rates would remain this low for very long.

Let me explain why rates will not remain low.  The level of sovereign bond yields is both a function of real interest rates AND sovereign credit risk.  While there is now a deflationary environment causing yields to fall to record lows, the market is still aware if push came to shove central banks would step in and create a perpetual bid for government debt.  However, without a central bank in place, global GDP (which has been fueled by asset bubbles) would quickly get eviscerated.

Coming Panic

Therefore, faltering GDP in the U.S. would cause bond holders to panic over the Treasury’s ability to pay back the over $18 trillion in debt that it owes—which is now already over 5.5 times the annual revenue collected.  To put things in perspective, 5.5 times annual revenue would be similar to a family who brings in just $50,000 a year, and holds a $275,000 mortgage.  But as bad as that condition is it would get even worse because faltering GDP — resulting from rapidly rising debt service payments — would send the current half trillion dollar annual deficits soaring back above one trillion dollars in short order.

U.S. Downgrade – Greenspan Responds "Zero Probability Of Default"

Markets have an innate understanding that central banks can always make good on the principal and interest payments on sovereign debt.  If you don’t believe me, maybe you will believe Alan Greenspan, who said as much on Meet the Press after the U.S. debt was downgraded by Standard and Poor’s in 2011.  Clarifying the downgrade as more of a hit to America’s “self-esteem”, the former Chairman of the Federal Reserve went on to say, “This is not an issue of credit rating, the United States can pay any debt it has because we can always print money to do that. So, there is zero probability of default."  The truth is central banks stand as the ultimate co-signer of sovereign debt; a co-signer with a printing press.  Credit ratings on sovereign debt have become more of a formality because they don’t actually mean anything anymore.

Consider this, Moody’s downgraded Japan’s debt by one notch to A1, from Aa3 in early December of 2014, and bond yields fell almost immediately. Japan’s Five-year yield fell to a record low just two days after the downgrade. Was this the market screaming that Moody’s got the call wrong?  On the contrary, the drop in rates was solely driven by the Bank of Japan’s decision to expand its record bond-buying program, thus tightening supply and driving down rates.  Think about it, with a debt as a percentage of tax revenue well over 1,000 percent, I have a hard time believing the free market would extend any country, or business for that matter, credit for 10 years at just one quarter of one percent.

The real mental exercise here is to determine what interest rates the free market would assign to sovereign debt if there were no printing presses?  The best insight we can gleam to answer this question is to look at what happened to rates in Greece and Southern Europe during 2010-2012. When Greece and these other countries joined the Euro, they forfeited their respective printing presses to the ECB.  After the fall out from the 2008 financial crisis, the ECB was initially reluctant to bail out countries with new money. 

Instead, they suggested Greece and other Southern European countries cut spending to counter mounting deficits brought about by overspending and low tax receipts.  Greece’s revenue to GDP actually stood remarkably better than Japan’s, at about 475%.  However, without the ability to print its own currency and the ECB’s initial reluctance to rescue Greece, the market’s reaction was profound.  The Greek Ten-year Note, which averaged around 5% prior to the crisis, soared to just under 40% by March of 2012.  Then, in July of 2012, ECB Chairman Mario Draghi vowed to do “whatever it takes” (read—buy unlimited amounts of Greek debt) to push yields back down.

Staggering Amount Of Developed World Debt

Because of the record amount of government debt in the developed world that exists today, there is a significant risk that not only would interest rates rise, but they could actually spiral out of control until an explicit restructuring and default occurred.

But the real conundrum is that current bond holders believe the Fed can monetize trillions of dollars of Treasury holdings without creating inflation and destroying the purchasing power of that debt. This spurious belief has been bolstered by the Fed’s previous QE programs that did not immediately lead to intractable inflation. However, history has clearly shown that a nation cannot habitually monetize massive amounts of debt without suffering runaway inflation.

It would be silly to think this time is different. Therefore, having a central bank ready and willing to monetize a significant percentage of a nation’s debt shouldn’t provide any solace to bond holders at all. Soon investors in government debt will come to understand that a default is in store either through restructuring or inflation. And the answer to our question is that interest rates are headed much higher in the near future. ***ALSO JUST RELEASED: What's Next After A Week Of Terror, Desperation And Total Chaos CLICK HERE.

To learn more about Michael Pento’s financial management services CLICK HERE.

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The audio interviews with MEP Nigel Farage, Dr. Paul Craig Roberts, Gerald Celente, Lord Christopher Monckton, Michael Pento, Bill Fleckenstein, David Stockman, Dr. Philippa Malmgren, Egon von Greyerz, Stephen Leeb, Andrew Maguire, John Embry, Rick Santelli, John Mauldin and Marc Faber are available now. Other recent KWN interviews include Jim Grant and Felix Zulauf — to listen CLICK HERE.

Eric King
KingWorldNews.com