The Bond Market Sounds the Alarm

06/03/2009 1:00 pm EST

Focus: BONDS

John Mauldin

Chairman, Mauldin Economics

John Mauldin, editor of Thoughts from the Frontline, says the recent sell-off in bonds shows that investors doubt whether the US and other countries can finance their debt.

As of this week, total US debt is $11.3 trillion and rising rapidly. The Obama Administration projects that to rise another $1.85 trillion in 2009 (13% of GDP) and yet another $1.4 trillion in 2010. The Congressional Budget Office projects almost $10 trillion in additional debt from 2010 through 2019. Just last January, the 2009 deficit was estimated at "only" $1.2 trillion. Things have gone downhill fast.

The deficit in 2010 is almost 10% of GDP. The average proposed deficit is almost a $1 trillion average for the next ten years. Ten years from now, the deficit is projected to be $1.2 trillion. And that is if government costs do not go up and inflation only averages 1.1% for the next six years.

If you add $10 trillion to the current $11.3 trillion (including Social Security trust funds, etc.), that totals $21 trillion in 2019. Let's be generous and suggest that interest rates will only be an average of 5%. That would be an interest-rate expense of over $1 trillion. That is 25% of projected revenues and 20% of expected expenses.

I think the bond market is looking a few years down the road and saying that $1-trillion deficits are simply not capable of being financed. And if the debt is monetized, then inflation is going to become a very serious issue.

When you run deficits that are 4% to 6% to 8% or more than nominal GDP, at some point things simply back up. Deficits are not necessarily a bad thing if kept in check and restraint is shown. But everyone cannot run deficits at the same time. Europe, Japan, and the US cannot try to borrow $5 trillion in the next two years without a serious distortion of the bond market.

I have long thought that "crunch time," the end game, would show up around 2013-14. But I never in my wildest imaginings thought we could run an almost $2-trillion deficit. Long before we get to 2015, let alone 2019, I think the bond markets will have called a halt to $1-trillion deficits. There will be a real crisis. Taxes will get raised beyond what they were in the Clinton years. The crisis may come much sooner if [President Obama’s] universal health-care bill is passed as proposed without offsetting cuts somewhere else.

The bond market is telling us the deficit simply can't be financed down the road. Now, maybe a few cool heads in the Democratic Party will prevail in the US Senate and the deficits will be brought under control.

It would be best to run budget surpluses, but the game does not end if there are reasonable deficits. It ends with deficits that cannot be funded except by monetization. And that will tank the dollar, except against all the other countries that are monetizing their debt.

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