Where's the money for the bailouts going to come from - Germany? Politically, that will be a tough sell in a country that's in a much worse recession than the US. How do you tell your citizens you need to bail out banks in other countries with their tax dollars? Italian and Austrian banks are going to need a lot of capital - more than their governments can pay. It's going to be a very tough problem.

Governments around the world are responding to the global recession by running massive deficits. In addition to the US, the UK, Japan, Russia, Spain and Ireland are all running deficits of over 10%.

And, as in the case of the US, these aren't going to be one-time deficits. The IMF predicts that England will shrink again next year, and the recovery in the US will be modest at best. The US economy is expected to grow by 0.2% (far from the optimistic projections of various US government agencies), the 16-nation eurozone will eke out a modest gain of 0.1%, and the Group of Seven (G7) leading industrial economies will, as a whole, will only grow by 0.2%. They project that Japan's economy will stagnate next year.

Where Will the Money Come From?

Now let's look at what's bumping in my worry closet.

The world is going to have to fund multiple trillions in debt over the next several years. Pick a number. I think $5 trillion sounds about right, considering $3 trillion is in the cards for the US alone, if current projections are right.

Just exactly where is that money going to come from? The US trade deficit is now down to under $350 billion a year. The Fed can monetize a trillion. Maybe. Look at the yield curve on US government debt below (Bloomberg). US savings are going to go up, but where's the incentive to buy 10-year debt at 3.5%? Four-year debt under 2% doesn't do much for your savings growth. Even with monetization and the Chinese buying our debt with the dollars we send them, that still leaves the bond market about $1.5 trillion short, give or take $100 billion.



The world is deleveraging. Debt is being drawn down. Securitization of various types of debt has seriously slowed. Banks are cutting back on lending. Home prices are dropping all over the world. Commercial real estate is rolling over, and banks all over the world are exposed. "Recession turns malls into ghost towns" is the headline in today's Wall Street Journal. Personal savings and unemployment are rising, and retail sales are flat to down.

All this should be massively deflationary. Interest rates should be falling, or at least not rising. But a funny thing is happening: In the past 2 months, the yield on the 10-year bond has risen by 1%. It has moved 0.38% or almost "4 big handles" in just 2 weeks. Look at the chart below. What's happening?


Click to enlarge

According to Merrill Lynch, the size of the world bond market is estimated to be approximately $67 trillion, with the shares of US, Euroland, and Japanese securities each representing less than 50% of this total. (PIMCO)