Last week the U.S reached its credit Limit of 31.5 trillion dollars the Government cannot legally borrow any More money treasury secretary Janet Yellen is now warning of a U.S default If a new limit isn't set soon and the U.S isn't the only country in trouble Today I'm going to explain why Governments are at risk of defaulting on Their debts tell you what this means for The markets and reveal why the worst is Yet to come Most governments make their money from Taxes and fees In theory this money is supposed to be Used for stuff like public Infrastructure such as roads and public Institutions such as schools in practice This money goes on military spending and Buying votes with lots of benefits not Only that but most governments spend a Lot more money than they bring in from Tax and fee revenues to make up the Difference governments issue debt in the Form of bonds a Government Bond is Basically an IOU give me money today and I'll pay you back later with interest Now the repayment date in question Depends on the duration of the bond Bond Durations range from one month to 30 Years or more and bonds are generally Considered to be the safest investment You can make That's simply because governments make
Their money by effectively taking it From citizens which means that you're Guaranteed to get paid back with the Interest that's been promised at the end Of the bond term The interest rates on government bonds Depend on factors such as the duration Of the bond the risks associated with The government issuing it the economic Conditions of the country or region Where the government is based and the Buying and selling of Market Participants Logically the longer the duration of a Bond the higher the interest rate that's Because investors need to be compensated For the opportunity cost of not being Able to spend that money that's why the Yield curve showing interest rates on All durations of government bonds Normally goes up and to the right Naturally countries considered to be High risk tend to offer higher interest Rates on their bonds regardless of Duration That's because investors need to be Compensated for the additional risk They're taking on after all there's less Of a guarantee that a country in crisis Can pay them back now economic Conditions are where things get Interesting when a country's economy is Struggling interest rates on shorter Term government debt are higher than the
Interest rates on longer-term government Debt its investors saying I'm not so Confident that you can pay me back in The short term for whatever reason When shorter term interest rates on Government bonds are higher than Longer-term interest rates on said bonds This is called a yield curve inversion And the economic signal it sends is why It's associated with a recession note That the yield curve is the most Inverted it's been in over 40 years This leaves the final and most Significant factor and that's buying and Selling by market participants and by Market participants I mean everyone Individuals institutions foreign Individuals and institutions and even Foreign and domestic central banks in General interest rates on government Bonds go up when they're being sold I.E When the prices of government bonds are Going down Conversely interest rates on government Bonds go down when they're being bought I.E when the prices of government bonds Are going up now if you're wondering Where the central banks fit in the Answer is the shortest term interest Rate believe it or not but central bank Rate hikes and cuts only affect the Overnight interest rates on loans Between commercial Banks this might not Sound like much but it affects the
Entire yield curve all the rates Here's where things get wild when Governments have too much debt they Often introduce regulations to force Domestic investors to buy government Bonds to keep interest rates low in Extreme cases the Central Bank itself Will begin actively buying government Bonds to keep rates low called monetary Financing almost every country has been Doing something along these lines for Decades that's because almost every Country is up to its eyeballs in debt That it can't pay back as such allowing Interest rates to rise would result in a Government default and inability to pay The money and interest rates owed to Bondholders now it's important to note That a government default doesn't happen Overnight what typically happens is that A government starts allocating more and More of its revenue from taxes and fees To paying off bondholders until there's Little to no money left to spend on Public infrastructure or institutions This becomes a sort of death spiral Because an inability to spend on public Infrastructure and institutions usually Means the economy will suffer which Lowers tax revenue that's why most Governments will simultaneously do what Japan is currently doing buying up bonds To keep interest rates low the issue With this approach is that it quickly
Devalues the national currency of the Country in question This is because the Central Bank uses Newly created money to buy up all the Bonds an increase in Supply with the Same or less demand means that the value Of the asset goes down in Japan's case The Yen has been collapsing in value Against other currencies because the Bank of Japan or boj has been Aggressively printing yen to buy up Government bonds to keep interest rates Low To put things into perspective Japan's Debt is more than twice the size of its Entire economy so if the boj allowed Interest rates to rise then the country Would default on its debts however Continuing to buy bonds to keep interest Rates low means that the Yen will Eventually go to zero not ideal but Luckily the boj has two options it can Tap for temporary relief The first is to sell foreign assets to Buy Japanese yen to ensure that the Currency doesn't collapse funnily enough The boj is the largest holder of U.S Government bonds outside of the US this Means the boj can sell U.S bonds to buy U.S dollars to buy yen to buy Japanese Bonds without completely crashing the Yen and this is exactly what the boj has Been doing According to data from the U.S treasury
Department the boj has sold almost 200 Billion dollars of U.S bonds since November 2021 reportedly to protect the Yen and the boj still has over one Trillion dollars of U.S bonds left However you'll recall that when Market Participants sell large amounts of Government bonds it causes interest Rates for that government to go up this Means that the boj selling of U.S bonds Is essentially exporting its high Interest rate pressures to the US that's A problem because the US has big debts Too Now this ties into the boj's second Option and that's to ask an International lender of Last Resort like The international monetary fund or IMF For a dollar denominated loan instead of Selling U.S bonds for U.S dollars to buy Yen the boj can ask the IMF for a US Dollar loan and use those US dollars to Buy yen the problem there is that IMF Loans come with lots of conditions and Usually these conditions involve Changing laws for the benefit of the US And its allies the IMF also doesn't have The billions of dollars needed to fully Bail out an advanced economy like Japan At best it can only provide temporary Aid This means that Japan can only delay the Inevitability that either the Yen will Go to zero or that the government will
Default on its debt historically Governments sacrifice their National Currencies to protect themselves but it Begs the question of what happens when Governments default the answer is that The government May issue new durations Of debt change the terms on existing Durations of debt or convince Bondholders to accept a smaller Repayment and yes a country can recover From a default Greece Lebanon and Syria Have all defaulted in recent years and Still exist but the defaulting country Gets downgraded making it harder to find Bond buyers and interest rates on new Bonds soar The consequences of a debt default would Be particularly severe for the U.S for Many reasons for starters the US dollar Is the world's Reserve currency and U.S Bonds are the safest asset for investors The US also has the largest amount of Debt in global percentage terms and Dollar terms Once Upon a Time the U.S Department of the treasury had to ask For approval from politicians every time It wanted to borrow money by issuing Bonds this changed in 1917 when the debt Ceiling was introduced to allow the Treasury to borrow more because of the First world war as the name suggests the Debt ceiling sets a limit on how much Money the US government can borrow the Rationale is that it forces the U.S
Government to be more careful with how Much money it spends because reaching The debt limit would mean that it must Rely only on taxes and fees to operate As with all limits imposed by Politicians the U.S debt ceiling has Been raised over 100 times since the Early 1900s the last time being in December 2021 this raised the borrowing Limit to around 31.5 trillion dollars And this limit was hit last week this is Actually a pretty big deal now hitting The debt ceiling isn't the same as a Debt default as I mentioned earlier it Means that the U.S government can only Continue to operate on taxes and fees as You'll remember though the U.S Government has been operating at a Deficit which means it has limited funds According to Janet Yellen the U.S Government only has enough money to make It to June this is when the treasury Will have to take even more quote Extraordinary Measures this is code for Pausing spending on public Infrastructure and institutions to Continue paying bondholders by now You'll know that pausing spending on Public infrastructure and institutions Risks creating a death spiral where the Economy suffers meaning less revenue From taxes and fees so far the treasury Has paused allocation to some Pension Funds but come June it could pause
Paying government employees Whether the treasury will resort to such Extraordinary Measures ultimately Depends on whether U.S politicians can Agree on raising the debt ceiling before The actual Do or Die deadline obviously Disagreement about raising the debt Ceiling is why last week's initial Deadline was missed the tldr is that Republicans want the current Administration to cut government Spending the Democrats want to continue Increasing said spending and the recent U.S midterm elections have given the Republicans enough power to block a debt Ceiling raise indefinitely This kind of high-stakes debt ceiling Standoff has happened before the last Time was over 10 years ago and the Outcome wasn't ideal after months of Intense back and forth politicians Agreed to raise the debt ceiling at the 11th Hour in early August 2011. now the Outcome of the 2011 debt ceiling crisis Was a 17 crash in the stock market and U.S government debt being downgraded for The first time in history Now some analysts believe the current Debt ceiling standoff will result in a Similarly bad set of outcomes but it Looks like it could be much much worse Besides the fact that the US government Has a lot more debt and expenses than it Did back in 2011 political polarization
In the country is at an all-time high This means that it's going to be Extremely difficult for opposing Politicians to come to consensus and Some would rather let it all burn more Importantly the treasury may run out of Money sooner than June this is partly Because the FED will likely raise Interest rates again and partly because Countries like Japan are being forced to Sell U.S bonds for dollars to buy their Own currencies to buy their own bonds Further raising U.S interest rates now I'm no macro expert but I'm pretty sure This means that the treasury will be hit With a double whammy less revenue from Taxes and fees because High interest Rates are crashing the U.S economy and More expenses because the interest owed To U.S bondholders has gone up also Because of higher rates the end result Result is less runway for the treasury Which is probably why President Biden is Focusing his efforts on getting a deal To raise the debt ceiling approved by Mid-april at the latest as per CNBC make No mistake if that April deal doesn't go Through the markets could crash by a lot More than 17 at this point the FED would Probably lower interest rates to give The treasury more breathing room if That's not enough then the FED could Start buying U.S bonds to keep interest Rates low like the boj is doing this
Would be truly unprecedented but it's Arguably inevitable for every country Unlike the boj the FED would only have One option to protect the purchasing Power of the US dollar selling off Foreign assets for US dollars to buy U.S Bonds but the FED doesn't have many Foreign assets the IMF wouldn't be an Option either because the US is just too Big This leaves China which has become an International lender of Last Resort in Recent years Now the idea that the U.S would tap China for foreign aid is unfathomable But China would be one of the few Countries that would be capable of Purchasing enough U.S bonds to keep Interest rates low Unfortunately for the US the seizure of The assets of Russia's Central Bank Means that China would not be very keen On accumulating U.S Bonds in an Emergency situation even with favorable Terms in fact it's another reason why China and other countries have been Selling lots of U.S bonds lately now as Provoking as this hypothetical outcome Is it's unlikely to occur anytime soon This is mainly because almost every Other country is in much worse shape Than the us as far as debt burdens go Even with the debt ceiling standoff Dozens are on the brink of default and
This could be by Design If you're confused take a second to Consider what effects the fed's rate Hikes have been having on the global Economy the US dollar is the world's Reserve currency meaning it's used for International trade it also means most Foreign countries have dollar Denominated debts now the interest rates On dollar denominated debts are of Course influenced by interest rates on U.S government bonds and these rates Have been rising This has sent countries scrambling to Get their hands on the dollars they need To pay the additional interest on their More expensive debts this is a big part Of why currencies were collapsing Against the US dollar late last year Many countries had no other option but To sell their currencies to buy dollars To pay their debts causing their Currencies to crash some countries Didn't have this ability and this forced Them to turn to the IMF for US Dollars The result was a record high level of IMF bailouts with over 40 loans being Given out last Autumn the IMF went on to Warn that the worst was Yet to Come Meanwhile IMF managing director Crystalina georgieva was shaking hands With the leaders of troubled countries Knowing that the contracts had been Signed you might remember that these IMF
Loans come with lots of conditions which Force these countries to comply with the US and its allies when you realize that A bipolar world is forming it looks like The FED is intentionally pushing these Countries to the brink of default to Make sure they end up on Team America And as an added bonus countries that Lean on the IMF are likely to start Accumulating U.S bonds this could be a Condition of their debt deals or because Those appointed to key institutions are Suddenly pro-usa this buying pressure Could help keep the lid on interest Rates in the U.S And this seems to be more than Speculation because lots of macro Analysts such as Brent Johnson have Underscored the fact that the US dollar Has been weaponized for political Purposes this means that the FED could Keep interest rates higher for longer Even if inflation comes down and Unemployment Rises for context the fed's Dual mandate is to ensure inflation Hovers at around two percent and that Unemployment remains steady at around Four percent however many have argued That the FED has an unofficial third Mandate and that's to ensure that the U.S dollar Remains the world's Reserve Currency at all costs Given that U.S Supremacy is now being Challenged by China it would make sense
For the FED to find every excuse to Maximize demand for U.S dollars around The world by raising interest rates and Keeping them High the plot twist is that The IMF isn't the only International Lender of Last Resort anymore in case You forgot China has recently become an International lender of Last Resort it Has no shortage of dollars on the Balance sheet that it wants to get rid Of dollars that these countries Desperately need as it so happens China Is the second largest holder of U.S Bonds with nearly 900 billion dollars Worth on hand now the difference between China and the IMF is that China Frequently requires that countries Provide physical infrastructure as Collateral for their loans when the Loans aren't paid back China takes Possession of key airports seaports Highways you name it with control of key Infrastructure China gets the leverage It needs to force these countries to Come to it the next time they're short On dollars instead of the IMF or other U.S Affiliated lenders maybe next time The loan will be in Chinese Yuan instead Of US dollars maybe it'll be in digital Yuan Speculation aside the main takeaway here Is that we are in the middle of a de Facto Financial war between superpowers And it is therefore unwise to see
Interest rates and debt defaults in a Vacuum I may not know the specifics of what's Coming but I know for sure that it's Going to be absolutely crazy [Music]
