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A few months ago, the chorus sung by the recovery
cheerleaders reached a crescendo when expanding consumer credit statistics
and surging US trade deficits provided them with "evidence" of an
economic rebound. In declaring victory, they overlooked the very nucleus of
this past crisis: namely, the enormous debt levels and bubbling inflation
that created fragile asset bubbles. If they had recognized the original
problem, they would have remained silent. In reality, only a reduction in US
debt levels or increase in the value of the dollar would have signaled a
budding recovery; but, thanks to the Federal Reserve and Obama
Administration, there is virtually no way those results will ever be seen.
Last week's Flow of Funds report issued by the Federal
Reserve clearly underlines the fact that we, as a country, haven't just
avoided deleveraging, but rather continue to accumulate debt. At the end of
the last fiscal year, total non-financial debt (household, business, state,
local, and federal) reached an all-time record high of $36.2 trillion. Not
only is the nominal level of debt at a record, but also debt-to-GDP - a far
more worrying statistic. In Q4:07, total non-financial debt registered 222%
of GDP. In 2008 and 2009, it was 238% and 243% respectively. As of Q4:10,
that figure had risen to 244% of GDP, For some perspective, look back to the
turn of the millennium, when total debt-to-GDP was 'just' 182%. Even that
level points to a sick economy, but today's make you wonder how the patient
is still breathing.
It is clear to me that the overleveraged condition which
brought the economy down in 2008 still exists today - only worse. For all the
suffering and displacement that has gone on, all we have accomplished is an
unprecedented transfer private debt onto the Treasury's balance sheet. Now
that the Fed is (hopefully) just months away from taking the printing presses
off overtime, the paramount question is how fast interest rates will climb.
The Fed has been able to keep yields this low through relentless devaluation
and a propaganda campaign that convinced the majority of investors that deflation
was a credible threat (kinda like those phantom Iraqi WMDs).
But Washington's ability to continue that ruse is coming
to an end. The unrelenting growth of the Fed's balance sheet, increasing
monetary aggregates, surging gold and commodity prices, $100/barrel oil,
soaring food prices, and trillions of dollars of new debt projected for the
near future have served to vanquish the deflationists. Any echoes of those
once prominent voices can barely be heard amid the thunderous roar of
oncoming inflation.
So therein lies the problem for the Fed. Any further debt
monetization by the central bank now becomes counterproductive. That's
because as inflation rates climb, bond investors demand higher interest
rates. The lower real interest rates become, the less participation there
will be in the bond market from private sources. If you don't believe me, ask Bill Gross.
The Fed is now damned if it does and damned if it doesn't.
Interest rates have been artificially suppressed for such a long time that no
matter what Bernanke does come June, interest rates will rise. If it enacts
another iteration of Quantitative Easing, the Fed may find itself the only
player in the bond market. Of course, the Fed could potentially buy all
of the auctioned Treasury debt in order to keep rates low-as uncomfortable a
position as that may be-but still all other interest rates, from bank loans
to municipal debt, would skyrocket. Unless... the Fed decided to buy all that
debt too. Hello Zimbabwe!
That scenario is still farfetched, but Bernanke's logic
eventually leads there. The truth is that only a central banker could afford
to own bonds that are yielding rates well below inflation, and growing even
more so. Even if Bernanke ceases firing dollars into the bond market, yields
will still have to rise to the level at which they provide a real return. How
much higher would rates go, you ask? Well, Mr. Gross has some thoughts on
that:
"Treasury yields are perhaps 150 basis points or
1½% too low when viewed on a historical context and when compared with
expected nominal GDP growth of 5%. This conclusion can be validated with
numerous examples: (1) 10-year Treasury yields, while volatile, typically
mimic nominal GDP growth and, by that standard, are 150 basis points too low;
(2) real 5-year Treasury interest rates over a century's time
have averaged 1½%, and now rest at a negative 0.15%!; (3) Fed funds
policy rates for the past 40 years have averaged 75 basis points less than
nominal GDP, and now rest at 475 basis points under that historical
waterline."
To the above I say: not a bad start, Mr. Gross, but these
aren't exactly average times. We have never had a Fed balance sheet anywhere
near the $2.6 trillion that it is today. The nation has never faced the
prospect of $1 trillion deficits as far as the eye can see. Nor have we ever
had our total debt as a percentage of GDP reach 244%.
The bottom line is that a massive increase in the supply
of debt coupled with a rising rate of inflation will always place
upward pressure on interest rates. Once the Fed steps aside from buying 70%
of the Treasury's current auctioned output, it will leave a gaping hole. And
for those Pollyannas who claim we are in an economic recovery, I would ask
them the following questions: Who will supplant the Fed's purchases of
Treasuries at current yields? Since the level of debt in the economy has
grown since the recession began, why won't rising rates place us back into an
economic funk? Can the Fed unwind its balance sheet before inflation ravages
the country? And, if the Fed isn't able to raise rates significantly, what
will stop the dollar from collapsing?
Then again, I guess it all comes down to one simple
question: do you believe the laws of supply and demand apply to US
Treasuries? If you do, then watch out for soaring yields
Michael Pento
Senior Market Strategist
Delta Global
Advisors, Inc.
Delta Global
Advisors : 19051 Goldenwest, #106-116 Huntington Beach, CA 92648 Phone:
800-485-1220 Fax: 800-485-1225
A
15-year industry veteran whose career began as a trader on the floor of the
New York Stock Exchange, Michael Pento recently served as a Vice President of
Investments for GunnAllen Financial. Previously, he managed individual
portfolios as a Vice President for First Montauk Securities, where he
focused on options management and advanced yield-enhancing strategies to
increase portfolio returns. He is also a published economic theorist in
the Austrian school of economic theory.
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