Rhody Trader

There’s a theory in economics which is known as the Crowding Out Effect. In simple terms, this Effect is what’s supposed to happen when the government borrows a lot (like it is now) whereby the quantity of government debt increases interest rates, hurting private sector borrowers (individuals and businesses). Brett Steenbarger brought up the subject in a recent post of his where he talks about the prospects for government and corporate bonds.

Here’s the rub, though. The effect doesn’t happen. It’s simple money mechanics and supply & demand.

When the gov’t borrows it means it’s doing one of two things. It’s either spending more or it’s taking in less in taxes (or both). In either case the result is more capital in the private sector. That, in turn, leads to either less borrowing demand or better creditworthiness (lower rates) for individuals and businesses. So we have the supply of gov’t debt rising, and the supply of private sector debt falling and/or the quality of that debt improving. The net result is going to tend to be narrowing of the spread between gov’t rates and private sector rates (like corporate bond yields).

That’s why in a situation like the one we’re in now where the gov’t is pushing out debt paper all over the place to pay for the TARP and other programs I fully expect corporate bonds to outperform Treasury debt in the intermediate to longer-term.

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