While we normally like to comment on current trends, occasionally there is the possibility of something abnormal happening. Currently, it is the massive bailout of Ireland by the European Economic Community and the IMF.
Ireland
Interest rates on Irish bonds or securities issued by Ireland have spiked recently as a result of the possible bailout, or the possible failure of the bailout. Ireland represents only a small part of the EEC and therefore by itself, it really does not constitute a major threat if considered in isolation.
However traders in Europe have started pushing up interest rates on bonds and securities issued by other larger European countries, such as Spain, and possibly even Italy. This is a bit worrisome, and the contagion has started spreading as the debt levels of other countries are once again examined.
The Evolution of the Sub-Prime Debt Crisis
If you remember, subprime bonds and funds defaulted in 2006-7. There was a general freezing of investments in money markets and bond funds until the matter was eventually sorted out. Many investors lost substantial money in this matter. It all seems so long ago, but the effects are still being felt.
The Spread of the Contagion to the Stock Market
Sometime after this, the contagion reached the stock market, and in October 2008, the stock market crashed and liquidity evaporated. Stocks then rebounded slightly until March 2009, when the next crash took the markets down again.
The US Fed
In order to combat the evaporation of liquidity, the US Fed injected billions of dollars in the market, followed by other major economies taking similar actions. As a result, the markets gradually calmed and matters seemed to return to normal.
The stock market started climbing back up and rose in value in an unprecedented fashion. Commodities in particular showed surprising strength based on demand from new economies developing in the world.
Investment in Fixed Income Securities
As part of the recovery stimulus, governments forced interest rates down, until they approached zero. All of this was intended to stimulate the economy.
I remind the reader that Japan has followed these policies with limited results for almost 20 years.
Those that bought bonds while interest rates were falling did very well indeed. It took courage, and foresight, but the buyers of fixed income securities realized very large profits as interest rates were forced down, and accordingly the value of the bonds was forced up.
Now it may be a time to think about this type of investment. We do not express an opinion as to what will happen, but times right now are worrisome. If the spreading contagion of default in Europe is contained, the economic recovery will continue and fixed income investments will remain a solid investment.
Could the Contagion Spread to the US?
What is happening is that governments have incurred such enormous debts, that they are unable to meet their repayment obligations. As a country is unable to meet its obligations, interest rates on renewing its debt climb, further restricting the country’s ability to meet its obligations.
To understand this, just imagine the payments on ONLY one billion dollars at 2%. Real debts are much much greater than one billion dollars. The interest payments yearly would be $40 million each year. If interest rates rise to 5% (still a low rate), the interest payment jumps to $100 million each year. That doesn’t include any principle repayments which are in addition. That could push that country over the tipping point to the point of default.
Because the debts are so large, any increase in interest rates is a major negative event. Each increase in interest rates brings other country debtors into the danger area.
So far the international community has been able to come up with rescue packages, sometimes by contributions from member countries, sometimes by creating currency.
But the fact remains that debt in all Western countries remains perilously high. Federal governments are margined to the max, as are state and local governments, as are utilities and other entities. Debt everywhere is rampant.
Somehow the Western world forgot that future generations have to repay debt.
Dealing With US Debt
All of which brings us to the US debt. I remind the reader that the US has done nothing to bring their debt under control, and instead has continued to incur greater and greater debt, all in the name of adding liquidity to the market.
I do hope that matters will continue to stabilize, but there is a bit of an increased chance of this contagion spreading. If it does spread, interest rates will climb, and possibly climb very quickly. This would cause the value of fixed income investments to plummet. If they plummet, the fall could be very quick and occur before the reader is able to do anything about it.
What to do?
This is a very hard question currently. The future right now is very difficult to predict on a short term basis.
Consider whether interest rates could fall substantially further. I doubt this happening because it is hard to fall below zero. Therefore the value of bonds etc would probably not rise in value substantially in the short term.
On the other hand, if interest rates do rise suddenly, the value of those investments could fall quickly.
So maybe a course of action is to temporarily sell fixed income investments, and stay in cash for a few weeks. Just a thought.
We do not give investment advice and are not licensed to give investment advice. We are only commenting on how we see the world could unfold.
