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Monday, May 11, 2009

Cost of Debt - Where the action is

The US Government has made it clear. It will issue unsurpassed amounts of debt in an attempt to "revitalize" the economy. The irony is, it should do the exact opposite. By the US Government needing to "sell large quantities of US Bonds", that financial instrument is "required" to be sold, and the government needs to get people to buy them.....hopefully with cheap interest rates.

If the government didn't have a burning need to sell bonds, because of deficit spending, it could offer low interest rates to bidders. If no one bought it, who cares!

But the Government has created a situation where it MUST sell debt, A LOT of debt, TRILLIONS of debt. So if people won't buy US 10 year treasury notes at 2.8%, what can the government do? It can pay more for the interest, to lure people to buying its debt, say, 2.9%, then 3.0, etc.

If the interest rates rise too high or too fast, then other competing debt vehicles rise, such as mortgages, business loans, credit cards, etc. If housing interest rates rises, then the housing crisis becomes more critical. More businesses fail since their debt costs over-take them, etc.

How can the government get people to buy their debt cheaper? Well, there is really only one legal way. And that is, if the market falls, fear rises, and people run to government debt as a safe haven. After all, a US bond is basically cash that pays interest.

Aside from the market rising very fast recently, to me indicating that the market should drop, the second issue is cost of US Debt. The government will have to make a choice, sometime between 3.3% and 5.5% that it must lower rates, or start a death spiral chain of rising interest rates, more failures, creating higher rates as credit risk/losses increase.

Unfortunately, for the government and all of us, once the market collapses to new lows, say DOW to 4,000, the government will lose the 'fear play" as an option. And THEN interest rates may rise uncontrollably. We all lose once the market is puttering around a final bottom AND cost of credit rises. Those McMansions will become cheaper than anyone's wildest dreams.
God I hope I am wrong.

Chart on Treasury 10 year notes
From WebSurfinMurf's Financial Blog

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