National Inflation Association
On Monday of last week we told you that too many people were becoming bearish on Italy all at once and that we thought the Italian 10 year bond yield was near a short-term peak. We said that after it reaches its short-term peak, we would probably see a large decline in the Italian 10 year bond yield back down to below 6% as Italy implements more austerity cuts.
On Wednesday the Italian 10 year bond yield reached a Eurozone-era high of 7.48% and finished the day at 7.25%. We highlighted on Wednesday how the spread between the German and Italian 10 year bond yield had reached a record 553 basis points. We said that there was no reason for such a huge spread between their yields because the bonds of both countries are denominated in the same currency and there is no chance of the ECB allowing Italy to fail.
During the last two trading days of last week, the Italian 10 year bond yield declined 103 basis points from its peak to finish Friday at 6.45%. At the same time, the German 10 year bond yield bounced from 1.72% on Wednesday to finish Friday at 1.89%.
The spread between the German and Italian 10 year bond yield is now back down to 456 basis points, a massive decline of 97 basis points in just two days. This is exactly what NIA expected to happen, but the spread between Germany and Italy has a lot more room to decline substantially lower in the weeks and months ahead.
The catalyst for the decline in the Italian 10 year bond yield is exactly what NIA predicted it would be, austerity cuts. The Italian Senate approved a major package of austerity cuts on Friday, which was passed by the lower house of Italy’s parliament on Saturday.
The austerity package is designed to achieve €59.8 billion in savings and balance Italy’s budget by 2014. It includes an increase in the VAT from 20% to 21%, a freeze on public-sector salaries until 2014, and a gradual increase in the retirement age from 60 in 2014 to 65 in 2026. It also calls for the sale of some state assets and the implementation of a new tax in the energy sector.
Whether or not the package will be successful at balancing Italy’s budget by 2014 is anyone’s guess. At least Italy has a budget that is theoretically possible to balance. The U.S. has a budget that is absolutely impossible to balance. There is not a single person in Washington today who is even forecasting the U.S. to ever balance its budget again.
The White House budget for fiscal year 2012 currently projects a U.S. budget deficit of $1.101 trillion. The deficit is projected to decline in 2013 to $768 billion and to a low in 2015 of $607 billion, before rising back up to $774 billion in 2021. These projections are using the most optimistic and rosy assumptions possible, and still we get no where near a balanced budget.
NIA believes the U.S. will see substantially higher budget deficits over the next decade than what is currently being projected. The White House is projecting real GDP growth in 2012 of 3.6% and for real GDP growth to average 4.17% in years 2013 through 2015.
The U.S. just reported year-over-year 3Q GDP growth of 1.62%, almost the same as year-over-year 2Q GDP growth of 1.63%. NIA believes the deflator used in the 3Q of 2.52%, down from a deflator used in the 2Q of 2.59%, way understates the current rate of price inflation. In our opinion, if you account for the real rate of price inflation, real GDP in the U.S. today is declining on a year-over-year basis.
The GDP growth assumptions being made in the White House budget will be impossible to reach for not just 2012, but for every year moving forward. Therefore, tax receipts will likely be substantially lower than what is being projected. If U.S. GDP stays flat between now and 2015, instead of having a $1.101 trillion deficit in 2012 that declines to $607 billion in 2015, we will have a $1.225 trillion deficit in 2012 that grows to $1.310 trillion in 2015.
The Fed just revised downward their 2012 GDP growth estimates to between 2.5% and 2.9%. To have any chance of even reaching these new lower projections, the Fed will need to launch QE3. Money printing never creates real economic growth, but will lead to much higher price inflation and bond yields. This will make it more expensive to run all areas of the government and increase our interest payments on the national debt.
The White House budget is currently projecting price inflation based on the CPI to only reach 2% in 2015 and to stay at 2.1% from 2016 through 2021. We already have price inflation of 3.87% based on year-over-year CPI growth and NIA estimates our real rate of price inflation to currently be 8.5%.
The White House budget is also currently projecting the U.S. 10 year bond yield to reach 5% in 2015 and to stay at 5.3% from 2017 through 2021. From 1981 to 2000, the U.S. 10 year bond yield averaged 8.36%. From 2001 to 2010, the U.S. 10 year bond yield averaged 4.18%, exactly one half the yield of the previous two decades.
Over the past decade with the 10 year bond yield averaging 4.18%, the U.S. national debt increased by $7.887 trillion for an average of $789 billion per year. During this time period, U.S. GDP grew by only $4.668 trillion for an average of just $467 billion per year.
Over the previous two decades with the 10 year bond yield averaging 8.36%, the U.S. national debt increased by $4.767 trillion for an average of $238 billion per year. During this time period, U.S. GDP grew by $7.096 trillion for an average of $355 billion per year.
When the U.S. had normal bond yields of 8.36%, the U.S. economy grew 49% faster than the national debt. During the past decade when the Fed began manipulating interest rates to artificially low levels in order to prevent a much needed recession, the U.S. national debt grew 69% faster than the economy.
With artificially low bond yields, the U.S. national debt grew 232% faster this past decade than during the previous two decades, while the economy only grew 32% faster. We went from having a national debt that was 33% of GDP 30 years ago to being 93% of GDP in 2010.
If the Fed got out of the way and allowed the free market to set interest rates, the 10 year bond yield would not only rise to 8.36% where it averaged from 1981 to 2000, but it would quickly reach the high from September of 1981 of 15.84%. With interest rates that high, unless the U.S. government were to cut discretionary spending down to zero, we will experience budget deficits between $3 trillion and $4 trillion annually. At that point, the Federal Reserve will be the only buyer left of U.S. treasuries and we will experience hyperinflation.
If the Fed keeps doing what they are doing, they will soon lose control of bond yields anyway as inflation spirals out of control and the world rushes to dump their U.S. dollar-denominated assets. Americans will be shocked by just how fast the world loses confidence in the U.S. dollar. A decade from now after the U.S. dollar is completely worthless, nobody will remember that Greece was once the top financial story on the news each night.
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