Expert Commentary

The Massive Debt Deflation Risk

U.S. consumer debt hits an all-time high as it costs even less to service it. That should terrify us.

In options markets, the "Greeks" refer to various measurements of how valuations move. For instance, the Delta of an option is the sensitivity of how the option price moves in relation to a change in the underlying instrument, and Theta is the relationship between the option's price and the passage of time. One of the lesser-known Greeks is Rho, which measures the change in an option's price in relation to changes in the interest rate.

I thought of interest rate sensitivity when reading the latest report from the Federal Reserve Bank of New York, which shows that household debt in the U.S. surged last year at the fastest pace since just before the financial crisis of 2008-2009. Total U.S. household debt now exceeds $14,000,000,000,000 (14 trillion dollars). Mortgage debt rose the most but people are still bingeing on credit card, student and auto-loans. There's no doubt that many people think, "Well, why wouldn't you?!" With interest rates at multi-generational lows, it costs next-to-nothing to service the debt. As the chart below shows, even though household debt is at a record high, incredibly, debt service payments as a percentage of disposable income are at a 40-year record low!

It should be obvious to anyone with a brain (and just a modicum of math skill) that there is a terrifying risk here. As more and more debt is piled on, the sensitivity to rising interest rates increases. Should interest rates start to rise now, debt service costs will explode higher. That would result in debt deflation on a massive scale as people default and/or repay the debt if they can.

The Fed knows that rising interest rates will reap a storm of biblical proportions. That is why it is trying to artificially suppress short-term interest rates through its money market operations. In the end, it can't succeed. Interest rates will rise again and, when they do, be prepared for a debt crisis the likes of which has never been seen before.

MG 200218