Effects of the Long Dated Treasury Bubble

 |  Includes: UDN, UUP
by: Nicholas Jones

More on the last great bubble...

I wanted to revisit this notion of the long dated U.S. Treasury bubble and look at it from a more simple, macro prospective. I really want to relate to you exactly how we got to this near breaking point.

Remember way back when subprime CDOs were still a ticking time bomb yet to explode in our economy? Everything was status quo with the Dow eclipsing 12k, 13k and eventually 14k. At this time, the leveraged subprime asset back paper was rated AAA by the rating agencies.

That bomb blew, and the ripple effects are still realizing themselves today. Financial markets are currently in the process of digesting the real values of these assets. Although a proper clearing system is lacking in this process, some progress has been made, but investors and Washington alike are still living in fantasy land as to their true values.

We know these details, and we also know that the rating agencies are an open faced corrupt insult to capitalism. But did you notice how quickly these assets went from AAA to junk status? The interesting thing is that U.S. government debt has the exact same AAA rating that those subprime securities once had.

Just like there was no way for the subprime mortgage holders to pay their $1.3 trillion of debt, there is no way the U.S. can pay back the $13 trillion is owes.

The macroeconomics of why and how we got here are blunt when you take a step back and look at them.

Economic Cocaine

Both government spending and tax cuts are used as fiscal tools to stimulate the economy. When they are used in unison, it creates an economic steroid of sorts.

George W. Bush's economic policy was exactly that (I would also like to note that both Senator McCain and President-elect Obama have bigger budgets planned and aggregates tax cuts to suit). He [Bush] cut taxes, increased government spending, and let the deficit spending takeover. Add that to the large amounts of currency and credit that was added to the monetary base in order to combat the "dot.com" burst and 9/11 recession, and consumers were quickly taken over by the same deficit spending our government recklessly represented.

It worked. Initially, this loose monetary and fiscal policy resulted in sustained, and at times, fantastic economic growth, but this policy can't go on forever. Eventually the market needed to rid itself of excesses.

A Minsky Look into Debt Accumulation

I believe Hyman Minsky describes this notion best in The Financial Instability Hypothesis:

Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows... Speculative finance units are units that... cannot repay the principle out of income cash flows. Such units need to "roll over" their liabilities: e.g. issue new debt to meet commitments on maturing debt.

For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle of the interest due on outstanding debts by their cash flows from operations... A unit that Ponzi finances lowers the margin of safety that it offers the holders of its debts.

The U.S. was able to act as a "hedge financing" unit for several decades. At some point during the late 1990s and early 2000s, the U.S. transitioned to what Minsky would describe as a "speculative financed" state. I believe us to be currently transitioning from a "speculative financed" state to a "ponzi unit." Just to note, Minsky passed away in 1996 without the chance to see the U.S. fulfill his beliefs about the effects of debt accumulation.

As the U.S. transitions from state to state, it becomes exponentially more expensive and economically destructive to meet its debt obligations. The end game is monetization of debt and complete destruction of the domestic currency.

Once the dollar truly implodes under its own destructive monetary policy, there will be a mad rush out of dollars and dollar denominated assets. It will be like yelling fire in a movie theater. For that reason, once this moves it will be fast and violent.

Disclosure: none