For the record, I still
believe that there will not be a breach of the debt ceiling and no overt default
for the US. Things will be worked out in the nick of time, like they always
are.
However, the media is full
of articles wondering about what ‘investors’ might do in response
to a US default and/or credit downgrade. What will happen to Treasury prices?
Will they go down as investors dump them en masse in
response to a credit downgrade forcing interest rates to climb?
It’s a big question
and the most likely answer is “No, not really”. Partly because
these so-called investors have been well-conditioned to believe that another
bailout is always around the corner, but mainly because they have nowhere to
go.
The big money is trapped.
For example, imagine that
you are in charge of a money market fund with $100 billion under management
and your job is to both cover your expenses and assure a
return for your depositors and you are heavily invested in US Treasurys. Or
imagine that you are in charge of a public pension with $200 billion under
management with the same basic concerns of managing expenses and delivering
returns and a heavy exposure to US Treasurys but with a much longer time
horizon.
In either case, in light of
the possibility of a US default what would you do? Where would you put your
money right now if you were suddenly of the mind that the $50 billion you had
in Treasurys should be placed somewhere else? In reality there are not that many
places to quickly move such large sums of money. Further, there might be
fiduciary restrictions that limit your investment options to regions,
securities types and/or ratings grades or there might be a minimum liquidity
requirement for the investment pool.
So let's imagine that you
have to make very large and important financial decisions and that you have to
put your money to work; it's either an actual fiduciary or operational
requirement of yours. An excessive amount of cash is not an option and
neither are hard assets such as land, gold or silver. Where would you put it?
What realistic options exist? It turns out there are not that many.
The Treasury market is the
largest and most liquid in the world, by far. For many big money funds there
really aren’t any realistic options other than the Treasury market, and
this present reality will limit the market reaction to any downgrade.
A Foul Choice
With interest rates on
'safe' sovereign debt at or near zero on the short end, and well below the
rate of inflation on the long end, safe bonds offer a negative real yield
(meaning a yield below the rate of inflation). This is a compounding disaster
for everyone but especially for pension funds with their longer time
horizons. Worse, we now know sovereign debt can no longer be considered
safe (even the US is facing a downgrade threat) - which means that
on a risk-adjusted basis, the returns are even more unattractive than the
negative real yields on offer.
On the surface, the choice
that Bernanke has engineered for investors is between guaranteed losses via
the miracle of negative real compounding and taking on more investment risk.
But he’s managed to combine both negative returns and risk
into a very unattractive investment brew.
Most big money funds have
opted to take on more risk rather than suffer such low returns (and who could
blame them?) and have done so by going to where the yields happen to be. This
means buying up corporate paper and European debt, both of which have far
more risk than their nominally more attractive yields would imply. For
individual investors, especially savers and those living on small incomes
tied to interest rates, the negative interest rates have been especially
difficult if not an outright disaster.
Once again, we can thank Ben
Bernanke et al for driving interest rates into
punishingly-low territory forcing everyone with a desire or responsibility to
save and invest to either lose to inflation or to take on more risk.
Part of the goal behind
ultra-low interest rates was to drive money back into the stock market, which
the Fed has been specifically and openly targeting in both word and deed.
It is a well known fact that low interest rates are supportive to the
stock market and so far that strategy has worked.
On the flip side of this
success is the fact that a lot more risk has been forced into the system.
When prices are artificially distorted to the upside for stocks or bonds,
then it is axiomatic that risk becomes mispriced.
Having to choose between
mispriced risk and negative returns is truly a foul choice indeed.
The Deficit Theatre
All of this brings us to the
current sad state of affairs now put into high relief by the deficit talks in
DC, which more properly should be viewed as political theater rather than a
legitimate attempt to square the federal budget up with reality. If the talks
were truly legitimate, then on the expense side everything would be on the
table, especially and including defense spending and a balanced budget
amendment would not be a source of contention but a mutually agreed upon
goal.
Instead the Democrats are
willing to entertain higher spending cuts in the vicinity of $250 billion per
year as long as they can have a debt ceiling increase that would get them
safely past the 2012 elections. Conversely, the Republicans as represented by
Boehner are ready to concede to relatively meaningless spending cuts in the
vicinity of $100 billion per year as long as they can force the debt ceiling
to be an issue for the 2012 election cycle:
Mr. Reid, the Senate’s
top Democrat, was trying Sunday to cobble together a plan to raise the
government’s debt limit by $2.4 trillion through the 2012
election, with spending cuts of about $2.5 trillion. He would seek to
avoid cuts to entitlement programs, but it was unclear how those savings
would be achieved.
Notably, the plan does not
currently contain any new or increased taxes, an approach that many in his
caucus would probably balk at.
The contours of Mr.
Boehner’s backup plan were far from clear, but it seemed likely to take
the form of a two-step process, with a short-term increase in the
debt limit along with about $1 trillion in cuts, an amount the
Republicans said was sufficient to clear the way for a debt limit increase
through year’s end. That would be followed by future cuts guided by a
new legislative commission that would consider a broader range of trims,
program overhauls and revenue increases.
(Source – NYT)
Just looking at the proposed
levels of deficit reduction, whether it's $1 trillion or $2.5 trillion,
neither plan will drop the deficit enough to prevent the US from slipping
deeper and deeper into the red. The true drivers of the debate, such as they
are, center on political advantage and power. Count us among the unsurprised
at this turn of events.
It would be nice - essential
even - to have enough information to go on to really assess the true
dimensions of the deficit reduction proposals but, even for a committed
analyst like myself, there’s just too little detail to make a decent
analysis of any of the competing packages.
However, we can be almost
certain that their baseline assumptions about GDP and revenue growth that
undergird the putative future deficit levels are unrealistic. They always are
in these sorts of circumstances, which means the amount of future savings
being bandied about are unlikely to be as robust as claimed.
For example, the most recent
CBO budget projections (the foundation upon which the deficit reduction
proposals are most likely built), assume that over the next 5 years (2011
– 2016) that revenue will grow at a compounded rate of 11.4% per
annum(!), expenses by 3.9% and GDP by a whopping 4.95%.
Per year.
(Source)
These assumptions are
just silly. Costs have risen much faster, and revenue and GDP far
slower, over the prior five years, and if these pie in the sky projections do
not come to pass then all of the deficit numbers will blow out to the upside
in those future years.
For example, if we assume
that GDP growth is 2.5% per annum instead of nearly 5% (and that revenues are
tied to GDP),adn that revenues will therefore 'only' increase by 5% per annum
(both completely reasonable assumptions at this stage) then the additional cumulative
deficit that will accrue between 2011 and 2016 is $2.7 trillion dollars.
That will completely
eliminate all of the projected savings from even the most agressive of the
proposals on the table. Is this unlikely? No, in fact these are a
far more defensible set of assumptions than those currently being put forth
by the CBO.
To really make a mockery of
the current budget projections, there is absolutely no chance of the
government both cutting its share of GDP by 2% per year and having
the GDP grow by nearly 5% per year. Implied is a rate of economic growth in
the private sector that would be truly extraordinary. Further, there is
no chance of revenues climbing by more than 11% per year over the next five
years without an enormous increase in taxes, which neither party is currently
proposing.
In short, without knowing
the underlying assumptions that are driving the projections, we cannot say
much about the proposals themselves. All I can tell you for sure is that for
as long as I have been crunching government numbers, taking their rosy
projections and cutting them in half has always been a reliable and
reasonable starting point.
A Dawning Awareness
What should not be lost on
anyone is the degree to which some of the biggest names in the financial
world are starting to openly question fiat money and the entire system of
debt itself. They’re even doing it on TV, in prime time and on the
op-ed pages of the largest newspapers.
Again, by the time we are
seeing such open questioning of the very firmament of the entire system, this
tells us something about how far along in the narrative we really are. Just a
few years ago such talk would have been relegated to the very fringes of the
blogosphere.
Here are a few recent
examples:
Debt talk damage
has already been done
As Washington dithers over
raising the nation's debt ceiling, investor confidence is flowing
away.
"The issue is not just
whether Moody's or Standard and Poor's were to downgrade (U.S. Treasury
debt), it's whether the market decides to downgrade,"
said Rochdale Securities bank analyst Richard Bove.
"If they lose
faith in the Congress and the government to, in essence, create a
solid security for the buyers of that security, then you get the
downgrade," he said.
The sentiment was echoed
overseas, where many countries hold U.S. Treasuries as an investment. "An
adverse shock in the United States could have serious spillovers on the rest
of the world," warned Christine Lagarde, the managing director of
the International Monetary Fund.
"We live in a highly
interconnected international financial world that is really based
upon confidence," said financial services industry lobbyist Paul
Equale.
"And without
confidence, both domestically and internationally — that the United States
is mature enough and has a system that can handle making the big decisions
— without that confidence we're going to see things like the
dollar becoming less important as the world's reserve currency."
Debt-based fiat money relies
on multiple levels of confidence. There has to be confidence that the money
will not be over-produced in response to every perceived crisis (oops), that
its allocation is justified and fair to all parties when it is placed into
circulation (oops, again), and there has to be confidence that the future
will be exponentially larger than the past to justify ever-increasing levels
of debt (this is the big
‘oops’).
We are drawing ever closer
to the recognition that endless growth is simply neither possible nor a
reasonable expectation. There are even doubts now that growth as we’ve
recently know it will return for one last cameo appearance over the next five
to ten years.
With the evaporation of that
all-important narrative of growth, everything else becomes immediately
suspect, especially money itself.
Sometimes you will hear or
read someone exclaim that ever since the slamming of the gold window in 1971
that US dollars are not backed by anything. This is not true, they are backed
by debt. Debt is an incredible motivator and assures that the person, entity
or country under its yoke will dedicate some portion of their productive
efforts towards servicing that debt.
Another Big Round Number
(and a Nice Symmetry)
On August 15th 2011 we
experience the 40th anniversary of the slamming of the gold window back on
the same date in 1971. Perhaps we should all bow our heads and have a silent
moment to mark the occasion.
Interestingly, that’s
almost exactly the date, give or take a few days, on which the US treasury
will run out of money here in 2011:
“We don’t think
there will be a default,” Ahrens, head of U.S. rates strategy for UBS
in Stamford, Connecticut, said yesterday in a telephone interview. He
estimates the Treasury has enough cash to make all payments until
Aug. 8-10.
(Source)
Forty years between a final
abandonment of the last vestige of external restraint on money/credit
creation and the dawning recognition that the US has simply gone too far,
spent too much, and is now in an enormous fiscal predicament. In the
annals of history that's just about right for the lifespan of a purely fiat
currency.
Mark the date on your
calendars: we’ll certainly be observing the anniversary here at
ChrisMartenson.com. Forty is a big, round number and therefore important.
So what's likely to happen
to the dollar and key asset classes in the aftermath of the looming August 2
deadline? In Part II of this report: What Should Happen
and What Will Happen we analyze the probable future
direction of stocks, bonds, precious metals, commodities, real estate and
other assets. Additionally, we assess the odds of a resumption of
quantitative easing by the Federal Reserve, and what changes to the picture that
will cause when/if it occurs.
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