For all the talk of permanently higher rates and bond yields, Connolly says the West is still on the same conveyor belt towards “ever-lower real interest rates” requiring “ever-bigger bubbles”, whether in stocks, credit and property, or in fiscal excess, or all together.

It is a trend “incompatible with the maintenance of a democratic capitalist society, and thus with the maintenance of prosperity and freedom,” he warns in his brilliant magnum opus, You Always Hurt the One You Love: Central Banks and the Murder of Capitalism.

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It is sobering to think that the US federal government was running a large budget surplus in 2000 and the gross debt ratio was 54 per cent of GDP.

A quarter of a century later the ratio is 120 per cent and vaulting past the 1945 peak. This is partly due to two big recessions and COVID, to be sure, but mostly due to three sets of unfunded tax cuts, two unfunded 21st-century wars and no serious effort to control ballooning middle-class entitlements.

David Kelly from JP Morgan says the US is looking at annual fiscal deficits of $US2 trillion this year, next year, and as far as the eye can see. This is at a time of effectively full employment and what should be bumper tax revenues. The deficit could hit $US3.5 trillion in the next downturn.

The US Treasury must roll over $US8 trillion of existing debt and raise $US2 trillion of fresh debt this fiscal year, even as the Fed tosses another $US1 trillion onto the heap under its QT programme.

‘Higher-for-longer’ tantrum

Investors have belatedly, and suddenly, woken up to the shocking implications of a structural budget deficit heading for 8 per cent of GDP even before any trouble starts. It is this that has driven up yields on US Treasuries by 100 basis points since July.

Markets have also concluded that a polarised Washington is too dysfunctional to do anything about it.

Congress had enough trouble reaching a stop-gap deal to keep the government open for another six weeks, it will be even harder after the defenestration of Kevin McCarthy by Trumpian ultras, the first time in US history that a Speaker of the House has been hounded from office in this way.

Fitch Ratings stripped the US of its AAA crown in August because of a “steady deterioration in standards of governance over the last 20 years. The repeated debt-limit standoffs and last-minute resolutions have eroded confidence in fiscal management”. Clearly the message has not reached Capitol Hill.

Part of the bond rout can be understood as a “higher-for-longer” tantrum, as the Fed talks tough and takes putative rate cuts off the table for 2024. The deeper causes are global.

It was easy enough to fund US fiscal extravaganza when China and America were still on speaking terms, during the era of surplus global capital. It is not so easy today as globalisation unravels and central banks commanding $US12 trillion of reserves, mostly in the Global South, grow wary of holding any asset that can be frozen by the US Treasury.

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Furthermore, the ECB has stopped pumping money into US bonds via leakage from its QE stimulus, which has now gone into reverse. The Bank of Japan’s retreat from yield curve control has hit the carry trade, drawing the country’s pension funds and life insurers away from US debt.

Monetary tightening and bond tightening both operate on the real economy with a lag. But we must be reaching the point where the highest borrowing costs since 2007 collide with a debt stock that was largely accumulated when policy rates were zero.

“If rates continue to rise the way that they’ve been rising, eventually there’s going to be a financial accident, eventually something will break,” said JP Morgan’s David Lebovitz on Bloomberg Surveillance.

The average rate on new mortgages in the US is near 8 per cent. Pending home sales fell 19 per cent in August from a year earlier and are likely to fall even harder through the autumn. Roughly $US1.8 trillion of US commercial real estate has to be refinanced over the next 18 months in very hostile conditions.

Almost half of America’s 4800 banks are sitting on assets worth less than their liabilities, according to a study by four leading bank experts. The market value of their loan and bond portfolios was $US2 trillion lower than stated book value as of March, and it is surely worse today. A soft bail-out by the Fed has masked the problem but cannot mask the slow erosion of capital buffers, with leveraged effects on credit through the banking multiplier.

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Trouble could start anywhere in the financial system, most likely in a pocket of the shadow banking system. “It will probably be a hedge fund that nobody has ever heard of, then we will find that some bank has lent it tons of money, and the chain reaction begins, just like LTCM in 1998,” said one City banker, referring to the collapse of hedge fund Long-Term Capital Management (LTCM), which forced the US government to intervene to prevent financial markets from collapsing.

So where do you turn? Sooner or later the US economy will snap, and the world economy will snap with it, and this will short-circuit the rise in bond yields.

You could do worse than buying 20-year or 30-year Treasuries, gilts, bunds, or French OATs, at a fraction of face value. You hold tight until central banks slash rates and abandon QT [quantitative tightening], realising how much they have over-tightened (too late, my friends), and then flip all the way to QE, this time by another name to fool us for a while.

For the brave, the contrarian bunt of the moment is Austria’s 100-year bond, trading today at 4 per cent of face value, the perfect QE play.

Or if you want a plain vanilla defence against spiralling deficits and financial repression, just buy gold.

The Telegraph, UK

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