The Fed will have to act regardless of the impact upon the Federal budget. They raised rates under Volcker to insane levels, despite the fact that it raised the national debt from $1 trillion to $6 trillion on interest rates alone. So, the budget has NEVER prevented the Fed from raising or lowering interest rates in the past. However, raising rates in this environment will cause national debts to explode. This is the Fed now trapped and this is what central banks are scared about. They have lost control and the old theories are collapsing. The desperate move is to tax money, eliminate cash, and go negative on rates but that too would compel selling of government debt producing the same net effect as raising rates – eventual monetization. Negative rates will compel the central banks to buy the debt when private entities will not while raising interest rates will explode the deficits. Either way leads to monetization. Manipulating interest rates is its only real tool. Buying in paper as in QE1 to 3 is indirect and there is no guarantee those who sell them the debt are domestic holders so the stimulus leaves.

This is the classic battle between DEFLATION and INFLATION. This is the essence of BIG BANG. Governments have become addicted to low rates that it has reduced their interest rate expenditures, creating a false sense of budgets under control. When rates start to rise, that is when capital will shift from PUBLIC to PRIVATE to get away from insane government debt. That is where rates would normally rise with no bid.

Yet, we may see central banks forced into buying government debt when no one else will both if rates went negative or explode and capital flees government moving to corporate debt and shares as began to emerge during the Great Depression after the sovereign debt default of 1931. That may soften the rate rise, but it will merely transfer the debt into monetization without interest, and that will produce the ASSET INFLATION that should emerge. That will not appear because of an increase in money supply, but because of a collapse in PUBLIC CONFIDENCE.

Every slice of the debt crisis exposes another layer of insanity. The real question becomes, how far do we go before this whole nightmare explodes in our face? It looks like we have 2 years perhaps, at best. This is the Sovereign Debt Crisis and the twists and turns are very interesting, to say the least. Those who focus on only one aspect will never see the whole. This global nightmare is not going to end nicely.

The impact in the pension funds further accelerates the mess. Here, pension funds chased long-term rates to match their maturities and that drove long-term rates lower. Some have run off to emerging markets desperately trying to get yield. An uptick in rates is needed to make them solvent yet most pension funds will lose money on the uptick because their current domestic paper will decline in value and those who bought emerging market higher yield will be slammed. This will force more people to invest in stocks as well. The emerging market debt issued in dollars will blow up, and as I wrote before, municipals in Germany are starting to issue dollar debt at zero interest rates trying to play the decline in the Euro.

Obviously, there are so many layers to this debt crisis you cannot focus on just one fundamental relationship. This is a convergence of many trends going wrong all at the same time. This is the classic flaw in analysis. The typical attempt is always to reduce everything to a single cause and effect. Every government investigation tries to lay blame on one cause. This is a fools game for events are NEVER the result of a single cause. You must see the world dynamically and this is why there are so few good hedge fund managers who can grasp the world and play the capital flows no matter where they lead. The person who can only discuss matters in domestic terms will never make the cut.