Maybe you’ve seen the headlines mentioning “Libor” or Bob Diamond or the fixing of interest rates. Perhaps you vaguely know that banks were tinkering with the rates for their own advantage.

Big deal, you say. So what?

So, basically investors, including your mutual fund, were hosed. So, the banks essentially stacked the deck so they would be guaranteed to win. So, it was an organized effort that included more than a dozen participants. And who orchestrated it all? The cops who were supposed to regulate them.

You should care because of all the missteps of the financial crisis, this one can’t be explained away by Wall Street’s excuses: “We were just stupid.” “It was the borrowers’ fault.” “We misjudged the risk.” “We didn’t see it coming.”

….read more HERE

Considering that interest rates have never been this low in our lifetime it’s hard to imagine that the biggest credit market risk we face is that rates keep falling…rather than going back up.

German and Swiss two year government bonds are currently around 40 basis points negative to par…that is, you give your money to the German or Swiss government and two years later they give it back to you  minus a safekeeping charge. Even the French government was able to raise 6 month money this week at negative yields. We can understand that German and Swiss rates are low (perhaps we can even understand that they are negative) because of the flood of cash fleeing peripheral Euro countries…but France borrowing at negative rates…that’s hard to understand!

Once markets cross the Rubicon to negative interest rates then there is no way of knowing how low rates might go. (Our friend Dennis Gartman gives us good advice on this matter: “Never buy a market that is going down…you have do idea how far down…down is!”)

The US Treasury sold 10 year bonds this week at the lowest auction yield ever – 1.459% – in the face of very strong demand for the issue.

The Eurodollar futures market is current pricing short term rates over the next year at around 40 basis points…about the same record low levels reached last August after the DJI fell 2000 points in 3 weeks and the VIX (the fear index) jumped to its highest level since early 2009.

My question is: if the Germans and the Swiss and even the French can borrow money at negative interest rates when will the American and Canadian governments be able to do the same? What market conditions would likely have to exist for our interest rates to go negative? A serious recession? A financial meltdown in Europe…that extends to our markets? A serious slowdown inChina? All of these things at once?

For the past few years I have continually made the point that we are (in Gary Shilling’s words) in an Age of Deflation…that the simulative efforts of governments and central banks to maintain “growth” were only a rearguard action in the face of massive private sector deleveraging…that deleveraging is a consequence of “Way more money has been borrowed than will ever be paid back!”

Low and lower interest rates (on perceived top quality credits) are a natural consequence of this deleveraging. The fear that causes money to flee peripheral European countries and banks for the perceived safety of German, Swiss or French government paper is a natural consequence of the rampant deleveraging in peripheral Europe.   

The city of San Bernardino followed Stockton this week and filed for bankruptcy. The reason: current revenues don’t cover current expenses and accumulated debts and (pension) obligations. (MammothLakes also recently flied for bankruptcy when they lost a lawsuit.) How many more local governments will come out of the closet now that the bankruptcy taboo has been broken? Meredith Whitney may yet be vindicated on her prediction that there will be 50 – 100 “sizeable” municipal bond defaults.

This week the Spanish government, in an attempt to meet Austerity demands from their lenders, proposed plans to increase the VAT from 18% to 21%, cut salaries for gov’t employees, and cut UE benefits (in a country with official UE around 25%.) Riots followed.

President Obama, in an election year cri de coeur, has declared that taxing the rich is the way to go…and the way to distinguish himself as the right political choice over filthy rich Romney (Obama’s personal net worth is publicly estimated to be ~$10.5 million.)

China reported slower GDP growth and Australia surprised markets by reporting a monthly decline of 26,000 jobs.

This week the Euro fell to a 2 year low against the USD and to a 12 year low against the CAD.

This week the Bank of England laid out a program of “rewards” for banks that increase lending to businesses and individuals.

If low interest rates have been a problem for struggling pension funds and life insurance companies imagine what will happen to them if interest rates go negative.

Betting against falling interest rates…and expecting that they have nowhere to go but up…because we think they are SO LOW relative to our lifetime experience…may be a bad bet!

For my own accounts: My long term savings are very liquid and very conservative…largely in cash. I move in and out of the markets with my short term trading accounts (rarely using much leverage) as I try to catch price swings of a few days to a few months. My net worth is ~95% cash with ~25% of that in USD, ~75% in CAD.  

The media is now fixated on an apparently new feature dominating the economic landscape: a “fiscal cliff” from which the United States will fall in January 2013. They see the danger arising from the simultaneous implementation of the $2 trillion in automatic spending cuts (spread over 10 years) agreed to in last year’s debt ceiling vote and the expiration of the Bush era tax cuts.  The economists to whom most reporters listen warn that the combined impact of reduced government spending and higher taxes will slow the “recovery” and perhaps send the economy back into recession. While there is indeed much to worry about in our economy, this particular cliff is not high on the list.
 
Much of the fear stems from the false premise that government spending generates economic growth.  People tend to forget that the government can only get money from taxing, borrowing, or printing. Nothing the government spends comes for free. Money taxed or borrowed is taken out of the private sector, where it could have been used more productively. Printed money merely creates inflation. So the automatic spending cuts, to the extent they are actually allowed to go into effect, will promote economic growth not prevent it. Even most Republicans fall for the canard that spending can help the economy in general. But even those who don’t will surely do everything to avoid the political backlash from citizens on the losing end of any specific cuts.
 
The only reason the automatic spending cuts exist at all is that Congress lacked the integrity to identify specifics. Rest assured that Congress will likely engineer yet another escape hatch when it finds itself backed into a corner again. Repealing the cuts before they are even implemented will render laughable any subsequent deficit reduction plans. But politicians would always rather face frustration for inaction than outright anger for actual decisions. In truth though, only an extremely small portion of the cuts are scheduled to occur in 2013 anyway. If it comes to pass that Congress cannot even keep its spending cut promises for one year, how can they be expected to do so for ten?
 
The impact of the expiring Bush era tax cuts is much harder to assess. The adverse effects of the tax hikes could be offset by the benefits of reduced government borrowing (provided that the taxes actually result in increased revenue). But given the negative incentives created by higher marginal tax rates, particularly as they impact savings and capital investment, increased rates may actually result in less revenue, thereby widening the budget deficit.
 
In reality, the economy will encounter extremely dangerous terrain whether or not Congress figures out a way to wriggle out of the 2013 budgetary straightjacket. The debt burden that the United Stated will face when interest rates rise presents a much larger “fiscal cliff.” Unfortunately, no one is talking about that one.
 
The current national debt is about $16 trillion (this is just the funded portion…the unfunded liabilities of the Treasury are much, much larger). The only reason the United States is able to service this staggering level of debt is that the currently low interest rate on government debt (now below 2 per cent) keeps debt service payments to a relatively manageable $300 billion per year.
 
On the current trajectory the national debt will likely hit $20 trillion in a few years. If, by that time interest rates were to return to some semblance of historic normalcy, say 5 per cent, interest payments on the debt would then run $1 trillion per year. This sum could represent almost 40 per cent of total federal revenues in 2012!
 
In addition to making the debt service unmanageable, higher rates would depress economic activity, thereby slowing tax collection and requiring increased government spending. This would increase the budget deficits further, putting even more upward pressure on interest rates. Higher mortgage rates and increased unemployment will put renewed downward pressure on home prices, perhaps leading to another large wave of foreclosures. My guess is that losses on government insured mortgages alone could add several hundred billion more to annual budget deficits. When all of these factors are taken into account, I believe that annual budget deficits could quickly approach, and exceed $3 trillion. All this could be in the cards if interest rates were to approach a modest five per cent.
 
If the sheer enormity of the red ink were to finally worry our creditors, five per cent interest rates could quickly rise to ten. At those rates, the annual cost to pay the interest on the national debt could equal all federal tax revenues combined. If that occurs we will have to either slash federal spending across the board (including cuts to politically sensitive entitlements), raise taxes significantly on the poor and middle class (as well as the rich), default on the debt, or hit everyone with the sustained impact of high inflation. Now that’s a real fiscal cliff!
 
By foolishly borrowing so heavily when interest rates are low our government is driving us toward this cliff with its eyes firmly glued to the rear view mirror. For years I have warned that a financial crisis would be triggered by the popping of the real estate bubble. My warnings were routinely ignored based on the near universal assumption that real estate prices would never fall. My warnings about the real fiscal cliff are also being ignored because of a similarly false premise that interest rates can never rise. However, if history can be a guide, we should view the current period of ultra low rates as the exception rather than the rule.