Governments have been on the right side of that bet for the last four years, but it has to revert at some point.” If, as Nusseibeh suggests, interest rates suddenly spike as central banks try to rein in inflation once it takes root, the interest payments on the off-balance sheet liabilities will pick up even quicker, significantly adding to on-balance sheet debts to the extent countries may not be able to cope. As far back as 2009, the Social Security and Medicare Trustees Reports showed by 2030 nearly 50% of income tax revenues would be needed to cover Social Security and Medicare liabilities alone, rising to 89% by 2080. These figures pre-date Obamacare.
A grand bargain
In the same way the Democrats and Republicans need to agree on a blend of tax increases and entitlement cuts, so the whole West must come to some grand bargain to make the rich pay more in return for others getting less. The path to the grand bargain is already being paved. The one issue agreed upon at the G20 meeting in Moscow over the summer was increasing transparency on corporate tax. “That is the first step in getting corporates to pay more,” Robinson says. “Yet, equity premiums continue to rise.”
At the same time, bond holders will inevitably have to pay their share. Governments will have to choose to either default to citizens by cutting entitlements or to bond holders through inflation, currency devaluation or renegotiation. America’s continuing struggle with the debt ceiling shows the extent to which defaulting on promises made to citizens is politically very difficult and, on the whole, bond holders do not vote. The manipulation of markets by central banks will likely continue for some time to come, which will not only cost bond holders dear, it will also mean the debt problem gets worse before it gets better. According to Jon Jonsson, senior portfolio manager for global fixed income strategies, Neuberger Berman: “Debt will continue to mount in the short to medium term. There is a lot of structural reform that needs to happen before that debt is manageable. Those reforms are politically difficult though. In the US, we are more likely to see a continuation of temporary solutions. That creates uncertainty and is bad for confidence and the growth outlook.”
The good news for US and UK bondholders, at least, is any default by those nations is more likely to be indirect. Eurozone debt is a much bigger problem than the US or UK, which both have central banks willing to use their balance sheets to keep interest rates low. That is not the case for Europe so we could see a default on a sovereign’s debt. Western sovereigns are clearly not ‘risk free’ and, in the short term, balance sheets will stretch further as central banks continue their pursuit of inflation. Although protection still looks expensive, when inflation does finally kick in, it is likely to strike hard before interest rates spike sharply. Navigating this environment will be precarious for sovereigns because of the significant interest rate bet resulting from kicking off-balance sheet liabilities down the road by extending duration. Ultimately, some kind of default is inevitable as the grand bargain looms. It is just a question of what form that takes.
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