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Precious metals investment terms A to Z

Debt Trap

The debt trap is a situation in which a borrower rolls over the debt because he or she is unable to repay the principal. The cause – but also a consequence – of the debt trap are ultralow interest rates. Cheap credit makes debt financing more attractive, so everyone – households, corporations and governments – is encouraged to take on more debt. Indeed, the global debt as a percentage of the GDP has increased from around 100 percent in 1950 to almost 200 percent in 2007 and to 225 percent in 2017.

It is true that ultralow interest rates make debt financing more affordable, but the conventional wisdom is that the higher the debt load, the higher the cost of servicing it until the debt is retired. In such an environment, any increase in interest rates could be detrimental for borrowers.

In particular, the zero interest rate policy adopted by theFed in the aftermath of the Great Recession encouraged the government to issue more debt. Thus, the federal debt soared to levels unprecedented during peacetime. As the chart below shows, the U.S. total public debt as a share of GDP surged from 63 percent in Q4 2007 to 104 percent in Q1 2019. 

Chart 1: US public debt as a % of GDP from Q1 1966 to Q1 2019

Public Debt to GDP and Gold Chart

But high public indebtedness makes a return to a more normal interest rates much more difficult, as it would raise the costs of servicing existing debt for the governments. They would have to either increase taxes or cut spending, which they would prefer to avoid. This pressure on monetary policy leads to the trap of low interest rates and high government debt levels.
Debt Trap and Gold
Now, what is the link between the debt trap and gold? The key point is that high government debt crowds out private investment and finances otherwise untenable endeavors (malinvestment), reducing investment and hampering economic growth. It increases the risk of fiscal crisis and creates general uncertainty, lowering spending. In other words, low interest rates begets low interest rates, too much debt and too little growth. It would be difficult to come up with a stronger fundamental combination for gold.

However, although high public debt is worrisome, investors should not overlook private debt. In a way, high private debt is even more dangerous. After all, the global financial crisis was caused partially by excessive mortgaging accompanied by offloading such securities into CDOs sold to unsuspecting investors, while the sluggish recovery was accompanied by household deleveraging.

But now the most alarming might be the high level of corporate debt. As the chart below shows, the U.S. corporate debt as a share of GDP jumped from 43 percent at the end of 2007 to 47 percent in Q1 2019, a record high. Total corporate debt is actually much higher, about 74 percent of the GDP.

Chart 2: U.S. corporate debt as a % of GDP from Q1 1952 to Q1 2019.

US Corporate Debt to GDP and Gold Chart

The problem is that many companies are more leveraged now than before the Great Recession, as their debts have risen faster than their profits. Actually, many managers borrowed money just to buy back shares and thus goose corporate profitability, not to grow the bottom line. And, what is perhaps the most disturbing is that today’s universe of debtors include a higher proportion of riskier companies. In other words, the global average quality of bond issuers has declined in recent years. For example, in the U.S., the BBB-rated bonds constitute now about half of all investment-grade bonds, up from 31 percent in 2000. They are the lowest investment grade tier, just one downgrade away from being junk bonds. Once that happens, can you imagine what a forced liquidation of such holdings among institutions not allowed to hold junk would look like?

One thing is certain: gold should shine then. The sad truth about the state of the current global, highly indebted economy is that it simply cannot stomach any meaningful hikes in the interest rates. The developed world fell into debt trap, or an environment of low growth, low interest rates, and high debt. This macroeconomic background should be fundamentally positive for gold prices, as low real interest rates and excessive indebtedness (which implies an increased risk of an economic crisis) work to support the yellow metal.

We encourage you to learn more about the gold market – not only about the link between debt trap and gold, but also how to successfully use gold as an investment and how to profitably trade it. Great way to start is to sign up for our Gold & Silver Trading Alerts. If you’re not ready to subscribe yet and are not on our gold mailing list yet, we urge you to sign up. It’s free and if you don’t like it, you can easily unsubscribe. Sign up today!

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