Credit buying is much like being drunk. The buzz happens immediately and gives you a lift . . . The hangover comes the day after.

~ Joyce Brothers

Yesterday's post outlined in detail the debt overhang that I believe will lead to a big debt hangover. The mechanics of how this might play out will have a major effect on where interest rates will head. Why should you care?

Well, if you have any kind of debt it will affect the interest rate you pay to service that debt. If you invest in bonds, it will affect the price of those bonds or those of the ETF or mutual fund that holds them. If a true debt spiral occurs, a market panic could ensue that triggers selling in all asset classes similar to what we saw last year. It may also affect your tax rates.

What Could Cause Interest Rates to Rise?

Earlier this week, Thicken My Wallet asked What Is the Price of Public Debt to You? One implication of higher debt at all levels of government is that interest rates are likely to go higher as a result. Here's why:

When governments spend more money than they take in, their options are the same as yours. They can essentially do one of three things, or any combination of them. Each choice has different consequences and most of them aren't very nice. We'll go through each of the 3 and explain what they mean to you:

 

 

 

 

 

 

 

 

 

 

  1. Decrease Spending: This would most likely entail budget cuts and public service reductions. Obviously, governments have gone the other way lately, spending trillions to keep the financial system from imploding. At some point, that bill is going to come due and something's got to give.
  2. Increase Income: For governments, this usually means raising taxes. Do you want to be the one to tell a struggling parent or business owner who is already having trouble making ends meet that their taxes are going up on top of everything else?
  3. Increase Debt: This is where we get to the meat of the issue. Governments generally borrow money by issuing bonds, which are basically I.O.U.s. Now most governments worldwide have already issued a ton of debt in the form of bonds to help pay for stimulus packages and bailouts. The bond market has already had to digest a lot of this paper. Buyers have had a good appetite for bonds as they were seen as health food in comparison to stocks. But even the heartiest appetite has its limits, and there is widespread speculation over whether, or when investors might just choke on this massive debt issuance. Anyone know the Heimlich maneuver?

The thing to remember about the bond market is that price and yield move inversely. That means that if prices move lower, interest rates will move higher. This is where the supply-demand balance of the bond market can move the interest rates that affect you. If demand for bonds dries up, bond prices will fall. If bond prices fall, interest rates will rise. So if investors are unwilling or unable to keep buying government debt, governments may have to pay more in interest costs to sell that debt. A debt spiral would result if they began to issue debt just to pay interest on existing debt. Yeah, that would be really bad.

What Could Cause Interest Rates to Fall or Stay Where They Are?

While I certainly understand how and why interest rates have the potential to rise, perhaps a lot, I sometimes wonder if a poor economy would somehow help to keep them in check. That's been the case over the past year. Even as equities came roaring back, many investors clung to the perceived safety of bonds. Does this paradigm break at some point, with debt regurgitation trumping economic worries, or will some investors still perceive bonds as the best house in a bad neighbourhood?

Another factor is that interest rates have been so low for so long, it seems that, if nothing else, mean reversion will eventually cause them to climb.

What do you think? Are interest rates headed higher or lower?