After the Debt Deal, Where’s the Market Rally?

BY Paul Solman  August 3, 2011 at 5:42 PM EDT


Traders work on the floor of the New York Stock Exchange during afternoon trading on August 3, 2011 in New York City. The Dow closed 29 points up after a late afternoon rally, recovering from an eight day slump. Photo by Andrew Burton/Getty Images.

How could a debt deal get done, a supposed crisis averted, and yet stock markets tank worldwide, including today, though U.S. stocks ended slightly ahead for the day? Does the incredibly low rate on the 10-year U.S. Treasury bond signal happiness with the debt deal or a dreary forecast for U.S. economic growth? Almost surely the latter.

At this very moment, it’s costing the United States 2.62 percent to borrow money for 10 years. That rate has only been lower twice — for a month and a half after the Crash of ’08 and again for one month late last year -over the past fifty years. We are barely 30 basis points — .3 percent — above the all-time low yield on the 10-year bond. As for short-term U.S. interest rates, I can tell you about them personally. My mortgage is pegged to the one-year U.S. Treasury rate. This year, I’m paying 3 percent. Short term borrowing by the Treasury itself? It can borrow for a year at a cost of .14 percent. And if it promises to insure the lender against inflation by guaranteeing to pay an interest rate equivalent to the consumer price index, investors will pay the Treasury: three-fourths of a percent, just to insure against inflation. That’s right, they’ll PAY the Treasury to lend it money.

What does this mean? Most likely that investors are scared to death of putting their money anywhere else in the world except maybe Switzerland or Scandinavia. And that they expect interest rates to remain rock-bottom low because of a lack of borrowers.

Economic pessimists have long been warning of a “debt deflation”: a sagging economy as scared consumers and especially retirees – voluntary and involuntary – pay off their debts. That results in less net borrowing and thus lower interest rates.

So, as I’ve been writing here for weeks, and the Times’ Paul Krugman has been arguing for more than a year, all the talk of “bond vigilantism” seems to have been hot air. Bond investors are not demanding higher interest rates from Uncle Sam because he can’t bring the family together to lower its debt total. They’re willing to accept lower interest rates because they don’t see much promise in an economy moving toward “austerity” instead of stimulus, following the lead of the UK and Europe, whose stock markets dropped another 2-plus percent today.

The most worrisome thoughts come from the New York Times’ liberal op-ed columnists. After the debt deal, Paul Krugman wrote:

“We currently have a deeply depressed economy. We will almost certainly continue to have a depressed economy all through next year. And we will probably have a depressed economy through 2013 as well, if not beyond. The worst thing you can do in these circumstances is slash government spending, since that will depress the economy even further.”
To Krugman, we are literally repeating the mistakes that led to the Great Depression, though he doesn’t expect one.

Joe Nocera yesterday morning:

“America’s real crisis is not a debt crisis. It’s an unemployment crisis. Yet this agreement not only doesn’t address unemployment, it’s guaranteed to make it worse. (Incredibly, the Democrats even abandoned their demand for extended unemployment benefits as part of the deal.) As Mohamed El-Erian, the chief executive of the bond investment firm Pimco, told me, fiscal policy includes both a numerator and a denominator. “The numerator is debt,” he said. “But the denominator is growth.” He added, “What we have done is accelerate forward, in a self-inflicted manner, the numerator. And, in the process, we have undermined the denominator.” Economic growth could have gone a long way toward shrinking the deficit, while helping put people to work. The spending cuts will shrink growth and raise the likelihood of pushing the country back into recession.”

Now El-Erian is no card-carrying liberal. He’s a money manager. What he means is that if you borrow money at .14 percent a year but it adds more than .14 percent to your growth rate, you’re ahead of the game. The ratio of debt to GDP goes down, because the numerator – debt – grows less than the denominator – GDP.

By contrast, if you don’t borrow money and the economy contracts because you didn’t, there will be more unemployed, less spending, further layoffs, etc. – the vicious downward spiral. In that case, the debt/GDP ratio grows because the denominator shrinks.

The next few months will be a fascinating economic experiment. Is a measure of austerity just what the doctor ordered? Or a prescription on a par with medieval bloodletting?