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Coming to a bank near you: Europe-like financial troubles

Posted by John Reed on

Copyright 2011 by John T. Reed

I and others have repeatedly warned that the bond market will eventually stop buying U.S. bonds. The reason is simple. The U.S. government is borrowing and spending as if there were a prize for borrowing as much as possible before the inevitable federal bankruptcy.

The laws of economics say that, absent being forced at gun point, bond buyers only buy bonds if they believe two things:

1. the principal and interest will be paid to the bond owner on schedule as promised
2. the inflation rate for the U.S. dollar will be less than the interest rate on the bonds

No hope for the bonds

The inconvenient truth is there is no chance that all the bonds of the U.S. government will be paid off as promised and/or that the purchasing power of the U.S. dollar will be stable. The U.S. national debt is so monstrously large that we cannot tax or grow our way out of it or pay it off. I have discussed the arithmetic of that elsewhere. Here, I just want to point out that Europe has gone down the same road as us—promising impossible levels of entitlements—only they started down it before us. So they are closer to the end point.

So although our politicians have not shown any interest thus far in applying the stitch that saves nine, there is a chance the financial death throes of Europe’s national governments may break through the denial of the American public and their representatives in Congress.

How will we know when the day of reckoning is at hand?

• interest rate increase on U.S. government bonds
• bond auction failure (not all bonds offered at the various weekday Treasury auctions sell)
• previously unheard of fluctuations in U.S. bond prices/yields

Exponential, not linear

I thought this would be linear: first interest rates would rise reflecting bond market fears of default and/or high inflation. But watching Europe today, it appears the death spiral moves in fits and starts with a combination of interest rate rises and falls and bond auction failures with heavy but Hamletesque central bank off-and-on interference. Also, there is much greater volatility which indicates that bond investors are getting more nervous about sovereign bonds, an asset class that used to be characterized by almost total lack of nervousness. Here are some recent details.


The venue in December 2011 was Italy. Most Americans regard Italy as a funny little, inconsequential, tourist destination country with Roman ruins, pleasant Mediterranean weather, soldiers that were big on surrendering during World War II, and a character actor sort of population.

I will not argue with any of that, but you need to know some numbers.

Italy is the 8th largest economy in the world, right behind U.K. and significantly ahead of the 9th largest: Russia.

If you count the European Union as a single economic entity, it is the largest in the world, even bigger than the U.S. Italy is the 4th largest economy in the EU after Germany, France, and U.K.

Italy had to pay 7.89% to sell its bonds on 11/29/11. The Wall Street Journal of 12/30/11 says economists consider 7% to be the threshold of a financially unsustainable fiscal situation for a government. The market demanded a 6.98% yield on Italian 10-year bonds at the end of 2011.

When Italy’s auctions indicated bond buyers wanted more than 7%, the European Central Bank started buying Italian bonds, in violation of its own rules.

Italy was unable to sell all the 3-year bonds it offered for sale on 12/29/11. It was successful selling 6-month notes the previous day.

Hungary also had a failed bond auction at the end of December 2011.

Readers of mine should be concerned about this. If you are, keep an eye out for phrases like “auction failed” and national government bonds sell for prices that yield 7% or more and fluctuations in sovereign bond prices..

Sovereign default insurance

In the animal world, these signs would draw vultures and buzzards circling overhead. The financial vultures are short sellers. They buy Credit Default Swaps that are insurance against national government bonds defaulting. They are sold by banks. Watch the prices at which these insurance policies sell—typically stated in terms of dollars per $10 million of insurance. You can see a list of such policies and the current rates for each country at On the day I checked, the cost to insure Italy sovereign debt was ten times the cost of insuring U.S. debt.

Greece, which is farther down the road toward federal bankruptcy than Italy, has debt that costs 179 times as much as U.S. debt to insure. A 3-year Greek bond had to offer a 20%yield in June 2011. More often, there are no buyers at all no matter the yield. As if to underline the fact that Greece is a Saturday Night Live skit, not a country, Greece’s “IRS” employees all went on strike for the last two days of the year which are the equivalent of April 14th and 15th under U.S. law.

America’s debt-to-GDP ratio is currently where Greece’s was in 2004 and ours is climbing like a rocket. Greece’s debt-to-GDP ratio growth is slowing to a stop because the world bond market no longer trusts them to pay back the money they borrow.

Warning sign

These warning signs of yields, failed auctions, and high sovereign debt insurance rates are not showing a linear descent toward bankruptcy. It is more like what is known as the military crest of a hill or the slippery slope. It is a tipping point. It is the final straw on the camel’s back. When you pass the tipping point, the descent into bankruptcy is fast. If you graphed it, it would be what is called an exponential curve.


The countries leading the way to federal bankruptcy are the PIIGS nations. Portugal, Ireland, Italy, Greece, and Spain. Keep an eye on them.

My hope is that the first bankruptcy or two over there will wake up the American people so we can stop this before it gets far more painful. We are probably past the “stitch in time saves nine” point, but we may still be able to apply four or five stitches to save nine.

The ‘new normal?’

The 1/12 issue of Smart Money magazine had an article about U.S. government bonds titled “The New Normal: Wild Rides.” They got the title wrong. This is not the new normal. They are the early warning sounds you hear when an avalanche is approaching you. A more accurate phrase in the article said, “Steady Eddie [U. S. government] just joined the Hell’s Angels.” It also said the standard deviation of U.S. bond prices doubled recently. They call the standard deviation a “common measure of volatility.” A standard deviation is a bell-curve graph range that covers 34.1% of the bell curve on either side of the average. Saying it doubled means that now, 34.1% x 2 sides of the curve = 68.2% of the bond price movements fall within twice as big a difference from the average as before.

In the past, bond prices moved little. It was your grandmother’s kind of investment. It is no new normal. It is the beginning of the not-too-distant end of U.S. government bonds.

Not appropriate for human-will events

I must add that it is inappropriate for Smart Money or anyone else to use bell-curve terminology to describe human-will events like bond prices. The bell curve only applies to randomly selected samples of naturally occurring events, like the length of each water buffalo’s horns in a group of 100 randomly selected water buffalos.

All signs of same underlying problem

These price fluctuations where there previously were few if any such fluctuations are of a piece with Moody’s lowering the outlook of U.S. bonds to “negative,” S&P lowering U.S. bonds rating from AAA to AA+, and all the European bond troubles. The fundamental problem is the national debt-to-GDP ratios of the U.S. and European countries are too high and climbing. U.S. bond prices are actually going the opposite direction from the European ones, but that is a sort of mindless flight to what used to be “quality” or “safety.” Human inertia. Habit. Inability to find a better alternative. There are also many laws and written rules within investors that force them to buy U.S. bonds. Those laws and rules need to be reconsidered. They, and we, really need to find another investment because the old gray bonds they ain’t what they used to be.

Troubles with European bonds may make U.S. bonds look relatively better at the moment, but that does not mean the U.S. debt-to-GDP ratio is good or improving. It is neither.

Purchasing power? Ability to pay?

Astonishingly, the Smart Money article makes no mention of purchasing-power risk when discussing U.S. bonds as long as 30 years. Furthermore, they make no reference to the deteriorating U.S. credit or debt-to-GDP ratios except to put the words “safe and secure” and “safety” in quotation marks.

Denial until the checks stop arriving

So far, unfortunately, it looks like the American people will not believe there is a problem until their Social Security check stops coming or is cut in half. Their Plan A for when that happens is to scream at and threaten the President and their Congressman and Senators. But once the bond market stops lending the money for deficit spending, those elected officials are irrelevant with regard to how much to spend. They can only decide how to ration the inadequate amount of tax revenue that comes in.

When the bond market votes with their feet by abandoning U.S. government bonds, how the Congress votes means nothing. They will flail around and pass laws essentially ordering the market to buy U.S. bonds. That will be the equivalent of a cancer patient buying quack cures instead of getting surgery or chemo or radiation treatments. Then they will try to pay the federal government’s bills by “printing” dollars. That will fool most of the people for a while, but then the dollar will become worthless because of the “printing.” For at least the first day of what that will mean, read my web article The day the dollar dies. For a longer term view of what will happen, read my book How to Protect Your Life Savings from Hyperinflation & Depression.

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