Treasuries and the U.S. Dollar: Twin Bubbles 12 comments
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Here are two ideas with the theme of deflation considered. These are the reasons why we cannot afford a Great Depression, and why the end game is ultimately inflation, either way. The bubbles (actually one and the same) follow:
1) Long treasury notes and bonds (10-30 years): China is providing $586B in fiscal stimulus over the next two years. This equates to at least their current buying rate of treasuries. If oil prices stay this low, this is less money to come back to purchase our debt. Next, when TARP money stops coming to support the long end of the market, who else will buy?
And finally, as our debt levels are unsustainable, a continued deflationary move will have a horribly negative effect on tax revenues, while we continue to spend at furious rates. Today we cannot afford a Great Depression since we now have surpassing 70%+ debt to GDP, not to mention social security and medicare entitlements weighing us down. In 1929, debt to GDP was 16.3% (16.9B of debt against 103.6B GDP). Near the trough of the Depression, debt ballooned to 27B against 66B of GDP, a debt to GDP ratio of 41%. Consider this: This was in a time without social security or medicare obligations.
During the Great Depression, the GDP moving from 103.6B to 56.4B (falling 45%). Now, with over 10T of debt against 14.4T of GDP, we are at 70%. If we saw GDP fall 45% (to 8T) and merely maintained our debt level, new debt to GDP would be 125%. If we repeated a similar scale of debt increase (+70% from 10T), our new debts would would be at 17T against an 8T GDP, with no meaningful personal savings backdrop. At 5% interest (very optimistic), our debt service cost alone would be $850B/year! All against tax revenues at most around 1.5T (reflective of an 8T GDP). We spend that alone on Medicare and Social Security right now!
Even as ideally helpful a lower trade deficit is for our currency, a new problem is introduced. Without money being exported in exchange for oil and other goods, there will be no buyers of this debt at such low yields.
Which leads to...
2) The U.S. dollar: With the velocity of money having recently fallen precipitiously despite money supply being up nearly 40% year over year, the strong dollar move is not sustainable against assets and any currencies not comparably boosting monetary supply. A strong dollar is consistent with a deflationary spiral, one we cannot afford. With current deflationary trends in place, unless we bite the bullet and almost entirely cut social security, medicare, and defence spending (potentially destroying our political hegemony), we will not be able to avoid a spiraling out of control debt threatening to devalue our currency.
I am not one to prognosticate so pessimistically that we will continue into a great(er) depression, and rather assume the current (and future) money pump will eventually stimulate the economy into some sort of recovery. But we will be left with amplified debt obligations, increased money supply (which never has had deflationary impact historically), all while our GDP is reflective of a system with less leverage. That means muted earnings growth and a flat to mildly growing GDP at best. In layman's terms, that means this: do not expect our debt to GDP ratios falling anytime soon, barring an unexpected discovery (or policy move towards) of free energy.
Considering our newly gained financial memory putting us into a new era of regulation, it is fair to assume that upon monetary velocity recovering this money supply will not be mopped up. This injection of money into the system is meant to maintain GDP at current levels with a simultaneous downshift of leverage. As banks hand out the money after they eventually have successfully recapitalized, velocity will pick up and we will start to see inflation. Decreased financial leverage and meak earnings do not put the Fed in a position to mop up excess monetary supply (unless they want another recession).
But what about Japan? Don't they offer a guide to what happens when banks fail to write dow assets, real estate bubbles collapse, and when deflation is unshakeable? To assume we will fall into Japan's past twenty year history of a depressed yield curve is dangerous, since they have savings to support it. There is real wealth and surplus that affords to keep their yields low. Their amazingly high debt to GDP ratio is supported by gigantic personal savings (in deposits along with annual savings rates). Drawing conclusions from the data point of high debt to GDP ratios alone leads one in an erroneous direction, since it fails to consider the whole picture. Almost $6T US (550T yen) sit in personal savings in Japan, while government debt is at $7T. Japan has another $1T of reserves on top of this. This is no debtor's state, despite a 195% debt to GDP ratio. That is Japan's story and it allows for low yields.
Our debt obligations are unlike Japan's in that we do not have the same cushion. What is big enough to absorb our debt, for which we do not have matching savings to offset (to keep yields low)?
Silver, gold, and bond puts all sound good if your time horizon is longer than two weeks.
Disclosure: Author holds a long position in SPY
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This article has 12 comments:
bond not good in inflation cycle - sorry.
also, i would not be sure about inflation in the scenario you are painting as money velocity would not be accelerating. in fact, in your scenario you are claiming the national debt would not be not be able to be serviced and would cause an increase in interest rates. with an economy barely turning over as you are predicting, this is deflationary and most probably depressionary.
i think inflation or hyperinflation is a real danger. but i doubt it will happen if events play out as you predict.
On Nov 12 04:20 AM The hand wrote:
> "Silver, gold, and bond puts all sound good if your time horizon
> is longer than two weeks."
>
> bond not good in inflation cycle - sorry.
>
> also, i would not be sure about inflation in the scenario you are
> painting as money velocity would not be accelerating. in fact, in
> your scenario you are claiming the national debt would not be not
> be able to be serviced and would cause an increase in interest rates.
> with an economy barely turning over as you are predicting, this is
> deflationary and most probably depressionary.
>
> i think inflation or hyperinflation is a real danger. but i doubt
> it will happen if events play out as you predict.
>
>
>
www.mof.go.jp/english/...
Translated to dollars at a rate of 95.43 yen per dollar, the total government debt is approximately $8.8 trillion. This is up from approximately $5 trillion in 2001.
Furthermore the author justifies such large deficit spending by using the country's savings rate as collateral. Many Japanese keep their money in "dollar accounts," not at the least because the interest rates are higher. Interest gained in dollars are also exempt from local taxes, which can be very high.
Has the history of issued 100-year Japanese bonds been forgotten? This article is rubbish!
Besides, neither of these bubbles are anywhere near as dangerous as the credit bubble.
Precisely. It's a race between asset value destruction and the printing presses. It's pretty obvious which one will win. Bernanke is not going to let deflation take over. There's no limit to how many dollars we can create. We can substitute new money for borrowing, or even buy Treasuries with brand-new money. The resulting devaluation has several key "benefits" to the US: housing prices rise relative to existing mortgages, incomes rise relative to mortgage payments, US wages drop relative to the rest of the world, making us more competitive. But watch out for oil prices; that will be ugly.
Note, by the way, that interest rates may not rise in this scenario, so TBT might not work the way it should in an honest world. Do you really see us paying a trillion dollars a year in interest on the national debt, much less actually paying it down or off?
Money is apparently disappearing faster than it's being created. I suspect that is a driver supporting the dollar.
When this crisis is over, in the long term, I hope the burn bins are smoking and red hot, too. We need to get the money supply back under control and not expanded on risky debt.
I suspect we'll settle into a period of slower global growth and less credit. Whether we do it through a prolonged recession or depression is the $65,000,000,000,000,00... question.